##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-K

|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended January 31,
    2004                                              
|          
|OR        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from           to                                             

Commission File Number: 000-21287

Peerless Systems Corporation

(Exact Name of Registrant as Specified in Its
Charter)


|                                                                                  |  |                                         
|--------------------------------------------------------------------------------- |  | ----------------------------------------
|Delaware                                                                          |  | 95-3732595                              
|(State or Other Jurisdiction of
    Incorporation or Organization)                |  | (I.R.S. Employer
    Identification No.)
|                                                                                 
|2381 Rosecrans Avenue, El Segundo, CA(Address of Principal Executive
    Offices) |  | 90245(Zip Code)                         

Registrants telephone number, including
area code

(310) 536-0908


Securities registered pursuant to
Section 12(g) of the Act:

Common Stock, $.001 Par Value Per
Share

(Title of Class)


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 þ          No o

Indicate by check
mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any
amendment to this
Form 10-K. o

Indicate by check
mark whether the registrant is an accelerated filer (as defined
in Rule 12b-2 of the Act). Yes
o          No þ

The approximate
aggregate market value of the Common Stock held by
non-affiliates of the Registrant, based upon the last sale price
of the Common Stock reported on the Nasdaq National Market on
July 31, 2003 was approximately $47,151,809.

The number of
shares of Common Stock outstanding as of April 23, 2004 was
15,835,074.

DOCUMENTS INCORPORATED BY REFERENCE

Certain parts of
the Peerless Systems Corporation Proxy Statement relating to the
annual meeting of stockholders to be held on or around
June 24, 2004 (the Proxy Statement) are
incorporated by reference into Part III of this Annual
Report on Form 10-K.











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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 the U.S.
Private Securities Litigation Reform Act of 1995. Statements
prompted by, qualified by or made in connection with such words
as may, will be, continue,
anticipates, estimates,
expects, continuing, plans,
exploring, intends, and
believes and words of similar substance signal
forward-looking statements. Likewise, the use of such words in
connection with or related to any discussion of or reference to
the Companys future business operations, opportunities or
financial performance sets apart forward-looking statements.

In particular, statements regarding the
Companys outlook for future business, financial
performance and growth, including projected revenue, both
quarterly and from specific sources, profit, spending, including
spending on research and development efforts, costs, margins,
the timing and number of design wins, and the Companys
cash position, as well as statements regarding expectations for
the digital imaging market, new product development and
offerings, customer demand for the Companys products and
services, market demand for products incorporating the
Companys technology, future prospects of the Company, and
the impact on future performance of organizational and
operational changes; all constitute forward-looking statements.

These forward-looking statements are just
projections and estimations based upon the information available
to the Company at this time. Thus they involve known and unknown
factors and trends affecting Peerless and its business such that
actual results could differ materially from those projected in
the forward-looking statements made in this Annual Report on
Form 10-K. Risks and uncertainties include, but are not
limited to: a) changes in the marketplaces in which the
Company offers its products; b) the failure of
Peerless business to produce projected financial results
or design wins; c) the failure of Peerless to maintain its
margins due to changes in its business model in reaction to
competitive pressures; d) the delay in or the
non-acceptance by the market of new product and technology
offerings; e) the failure of the digital printing market to
achieve anticipated growth rates; f) unfavorable economic
conditions resulting in decreased demand for original equipment
manufacturers (OEMs) products using
Peerless technology, making it difficult for the Company
to obtain new licensing agreements; g) OEMs
determinations not to proceed with development of products using
Peerless technology due to, among other things, changes in
the demand for anticipated OEM products, age of Peerless
technology, concerns about Peerless financial position and
Peerless competitors offering alternative solutions;
h) Peerless competitors coming to market with new
products or alternative solutions that are superior or available
at a lower cost or earlier than anticipated or believed to be
possible; i) the costs associated with the development and
marketing of products for imaging and networking may be higher
than currently forecasted; j) changes in demand for the
Companys products and services based on market conditions
and the competitiveness of Peerless products from both
technological and pricing perspectives; k) the
Companys inability to maintain or further improve
operating efficiencies or to further streamline operations;
l) the impact on the Companys financials of any
future need to expand the organization to meet customer or
market demands; m) expected incremental costs of operations
arising out of the change in the law, including the
Sarbanes-Oxley Act of 2002; and n) other factors affecting
Peerless business and the forward-looking statements set
forth herein. Those factors and trends affecting Peerless and
its business include those set forth in pages 16 through 23
of this Annual Report on Form 10-K.

Current and prospective stockholders are urged
not to place undue reliance on forward-looking statements, as
such statements speak only as of the date hereof. The Company is
under no obligation, and expressly disclaims any obligation, to
update or alter any forward-looking statements, whether as a
result of new information, future events or otherwise. All
forward-looking statements contained herein are qualified in
their entirety by the foregoing cautionary statements.

2



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PEERLESS SYSTEMS CORPORATION

ANNUAL REPORT ON FORM 10-K

For the Year Ended January 31, 2004


TABLE OF CONTENTS

|              |  |                                                                                                                      |  |      |    | 
|------------- |  | -------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|              |  |                                                                                                                      |  | Page
|              |  |                                                                                                                      |  |     
|PART I       
|Item 1.       |  | Business                                                                                                             |  |      | 5  | 
|Item 2.       |  | Properties                                                                                                           |  |      | 23 | 
|Item 3.       |  | Legal Proceedings                                                                                                    |  |      | 23 | 
|Item 4.       |  | Submission of Matters to a
    Vote of Security Holders                                                              |  |      | 23 | 
|PART II      
|Item 5.       |  | Market for Registrants
    Common Equity, Related Stockholder Matters and Issuer Purchases
    of Equity Securities |  |      | 24 | 
|Item 6.       |  | Selected Financial Data                                                                                              |  |      | 24 | 
|Item 7.       |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                            |  |      | 25 | 
|Item 7A.      |  | Quantitative and Qualitative
    Disclosures About Market Risk                                                       |  |      | 33 | 
|Item 8.       |  | Consolidated Financial
    Statements and Supplementary Data                                                         |  |      | 33 | 
|Item 9.       |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure                             |  |      | 33 | 
|Item 9A.      |  | Controls and Procedures                                                                                              |  |      | 33 | 
|PART III     
|Item 10.      |  | Directors and Executive
    Officers                                                                                 |  |      | 35 | 
|Item 11.      |  | Executive Compensation                                                                                               |  |      | 35 | 
|Item 12.      |  | Security Ownership of
    Certain Beneficial Owners and Management and Related Stockholder
    Matters               |  |      | 35 | 
|Item 13.      |  | Certain Relationships and
    Related Transactions                                                                   |  |      | 35 | 
|Item 14.      |  | Principal Accounting Fees
    and Services                                                                           |  |      | 35 | 
|PART IV      
|Item 15.      |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                                                  |  |      | 36 | 
|EXHIBIT 10.69
|EXHIBIT 10.70
|EXHIBIT 10.71
|EXHIBIT 10.72
|EXHIBIT 10.73
|EXHIBIT 10.74
|EXHIBIT 10.75
|EXHIBIT 10.76
|EXHIBIT 10.77
|EXHIBIT 10.78
|EXHIBIT 10.79
|Exhibit 21   
|Exhibit 23.1 
|Exhibit 31.1 
|Exhibit 31.2 
|Exhibit 32   



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TRADEMARKS

Peerless®, Memory Reduction Technology®
(MRT), PeerlessPowered®, WinExpress®,
PeerlessPrint®, redipS®, AccelePrint®,
SyntheSys®, QuickPrint® and PerfecTone® are
registered trademarks of Peerless Systems Corporation.
MagicPrintTM, VersaPageTM and
EverestTM are trademarks of Peerless Systems
Corporation and are the subjects of applications pending for
registration with the United States Patent and Trademark Office.
PeerlessPageTM, ImageWorksTM,
PeerlessDriverTM, and WebWorksTM are
trademarks of Peerless Systems Corporation. Peerless Systems,
P logo, and Peerless logo are trademarks and service marks
of Peerless Systems Corporation registered in Japan. Peerless is
a trademark of Peerless Systems Corporation that is registered
in France and Taiwan and is the subject of applications for
registration pending in Australia, China, the European
Community, France, Hong Kong, Italy, Korea, Spain, Taiwan and
the United Kingdom. RedipS is a trademark of Peerless Systems
Corporation registered in Canada and in the European Community.
PeerlessPrint is a trademark of Peerless Systems Corporation
that is the subject of an application for registration pending
in Japan and the European Community. PeerlessPrint (in Katakana)
is a trademark of Peerless Systems Corporation that is the
subject of an application for registration pending in Japan.
Everest is a trademark of Peerless Systems Corporation that is
the subject of an application for registration pending in
Peoples Republic of China, Japan, Korea and the European
Community.

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PART I




Item 1.     Business

Peerless Systems Corporation, together with its
wholly-owned subsidiary Peerless Systems Imaging Products, Inc.
(together, Peerless or the Company),
licenses software-based imaging and networking technology for
controllers in embedded, attached and stand-alone digital
document products and integrates proprietary software into the
printers, copiers, and multifunction products of original
equipment manufacturers (OEMs).

The Company has developed and continues to
develop controller products and applications for sale to OEMs
and distribution channels. Digital document products include
monochrome (black and white) and color printers, copiers, fax
machines and scanners, as well as multifunction products
(MFPs) that perform a combination of these imaging
functions. In order to process digital text and graphics,
digital document products rely on a core set of imaging software
and supporting electronics, collectively known as a digital
imaging system. Network interfaces supply the core technologies
to digital document products that enable them to communicate
over local and wide area networks and the Internet. The Peerless
family of products and engineering services provide fully
integrated advanced and proprietary imaging and networking
technologies that enable the Companys OEM customers and
third party developers for OEMs to develop stand-alone and
networked digital printers, copiers, and MFPs quickly and cost
effectively. The Company markets its solutions directly to OEM
customers including Canon, KonicaMinolta, Kyocera/ Mita, Lenovo
(formerly Legend), Oki Data, Panasonic, Ricoh, and Seiko Epson.
The Company has expanded its solution offerings by incorporating
related imaging and networking technologies developed internally
or licensed from third parties. The Company has developed more
diverse distribution channels for its products and expanding its
target markets to distributors, value added resellers, system
integrators, OEM sales operations, and geographically to the
Peoples Republic of China and Taiwan.

The Companys traditional embedded
development focus has historically been to offer high performing
systems at a lower cost compared to competitive offerings.
Peerless controllers achieve their performance objectives by
interpreting printer description languages such as Adobe
PostScript3, PeerlessPrint 5C or PeerlessPrint 5E, and
PeerlessPrint 6 while simultaneously executing raster image
processing commands on Peerless proprietary co-processor.
Lower component costs result from reducing the amount of random
access memory (RAM) required to process raster
images through the use of Peerless proprietary application
specific integrated circuit (ASIC) compression
technology. Integrating network components further reduces the
cost of Peerless solutions and software typically supplied
by third party technology vendors in separately mounted network
interface cards. Peerless software has a modular architecture
allowing for fast replacement of the key components required to
support new printer and copier engine interfaces. This
architecture helps OEMs meet the fast time to market
requirements in todays hardcopy imaging business. These
three core areas of higher performance, lower cost, and fast
time to market describe the competitive advantages of Peerless
technologies in the printer controller markets.

In addition to its core monochrome technologies,
Peerless has recently developed and commercialized a high
performance color imaging and printing technology and new open
architecture named Peerless Sierra
Technologies. Peerless believes that based on the
Peerless Sierra Technologiesarchitecture, it can address
key growth areas in the imaging market including: increased
demand for color imaging, the emergence of MFPs, and continued
demand for faster low cost monochrome printing solutions. The
Peerless Sierra Technologiesline of products can produce
high resolution color quality imaging on an architecture that
can print full continuous tone (contone) color at
speeds ranging from 20 pages per minute up to 100 pages per
minute (or more). Peerless Sierra Technologiescan
achieve monochrome printing speeds well in excess of 150 pages
per minute. Peerless believes that its new Peerless Sierra
Technologieswill contribute an increasing percentage of the
Companys overall revenue in the future.

In June 1999, Peerless acquired Auco, Inc., which
became a wholly-owned subsidiary of the Company and was re-named
Netreon, Inc. (Netreon). On January 29, 2002,
Peerless divested itself of Netreon while retaining the
networking technology obtained from the acquisition. The Company
continued to hold a minority

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interest in the newly independent storage
management software company arising from the divestiture through
the fiscal year ended January 31, 2003. All interest in
Netreon was sold for $1 million on February 2, 2003,
just after the close of fiscal year 2003.


In December 1999, the Company acquired HDE, Inc.
(HDE), a developer of digital imaging and Internet
printing products. After the acquisition, HDEs name was
changed to Peerless Systems Imaging Products, Inc.
(PSIP) and PSIP became a wholly-owned subsidiary of
Peerless. This acquisition expanded Peerless presence in
the digital imaging and Internet printing solutions markets, and
added new customers to the Companys portfolio. In
conjunction with PSIPs strategic relationship with Adobe
Systems Incorporated, Peerless now ranks among the leading
embedded Adobe PostScript suppliers to the imaging market. PSIP
has engaged in the development of Internet printing solutions,
such as enabling users to print without the need to load printer
drivers on their computing device.

Peerless was incorporated in California in 1982
and reincorporated in Delaware in September 1996. Peerless makes
its periodic and current reports available, free of charge, on
its website (www.peerless.com) as soon as reasonably
practicable after such filing is electronically filed with, or
furnished to the Securities and Exchange Commission.

Digital Document Products  Industry
Background

Todays office and home/office environment
is increasingly dependent on a variety of electronic imaging
products such as printers, copiers, fax machines, scanners, and
MFP devices. Historically, most electronic imaging products in
the office environment have been stand-alone, monochrome
machines, which were dedicated to a single print, copy, fax or
scan function. However, with the proliferation of personal
computers, desktop publishing software, network computing, and
high resolution color graphics, documents are increasingly being
created, stored and transmitted digitally, thereby increasing
the need for digital document reproduction and printing.

Digital documents have also become increasingly
complex and typically include digital text, line art or
photographic images. In order to process these documents,
digital document products rely upon a core set of imaging
software and supporting electronics collectively known as a
digital imaging controller. A digital imaging controller may be
integrated with a digital document product in a variety of
configurations:



| |   |                                                                                                
| | - | -----------------------------------------------------------------------------------------------
| |  | embedded, where it resides completely inside the
    imaging device,                           
|
| |  | attached, where it resides outside the imaging
    device but is physically attached to it, and
|
| |  | stand-alone, where it resides completely outside
    the imaging device.                       

To date, the majority of embedded imaging systems
have been developed and produced internally by digital document
product manufacturers such as Hewlett-Packard, Xerox, and Canon,
whereas attached and stand-alone imaging controllers have, for
the most part, been developed by third party suppliers. Based
primarily on International Data Corporation (IDC)
projections, the Company estimates that the total worldwide
digital document hardware market (defined as worldwide color and
monochrome laser printers, MFPs, single function digital
copiers, and wide format printers) will be approximately
$42 billion in 2004. The Company also estimates that its
core color and monochrome printer and MFP market (defined as
monochrome laser devices 14 pages per minute and faster and
color laser devices 10 pages per minute and faster) includes
some of the fastest growing segments for its controller and
licensing products. IDC projects that, combined, they will be
$30 billion in 2004 and grow at a compound annual growth
rate of 8% from 2002 to 2007. IDC forecasts that unit shipments
of worldwide monochrome laser MFP devices 14 pages per
minute and faster will grow at a compound annual rate of 9% from
2002-2007, and that unit shipments of worldwide color laser MFP
devices 10 pages per minute and faster will grow at a
compound annual growth rate of more than 26% from 2002 to 2007.
The market value for the latter segment will grow at a compound
annual growth rate of almost 19% during that period, to
approximately $7 billion by 2007. The Company is targeting
this segment with its new products.

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Developments in the Digital Document Products
Market

Rapid changes in technology and end-user
requirements have created challenges for digital document
product manufacturers, particularly in the area of digital
imaging systems. These changes include the increased demand for
higher performance products at lower prices, the demand for
color imaging, the emergence of MFPs, the increased role of
networking, and the emergence of Internet printing standards.

Demand for higher performance at lower
prices.Like other high technology
markets, the digital document products market is under constant
pressure to offer higher performance products and higher quality
solutions at prices that are equivalent to or lower than
previous levels. Digital imaging companies are employing a
variety of software and hardware technologies in order to
process greater volumes of data in a cost effective way. As end
users demand higher levels of print performance and quality,
digital imaging systems must increase in sophistication without
becoming prohibitively expensive.

Demand for color
imaging.Market research indicates
that the desire for cost effective color printing in the office
is increasing and end users are demanding color printing at
monochrome speeds and prices. Digital document product
manufacturers are addressing the performance issue with more
sophisticated imaging devices that are capable of printing
multiple colors concurrently (so called tandem print
engines), which in turn require more sophisticated digital
imaging systems to supply them with print data. An entire new
market is emerging for products that offer
convenience color printing in the office and
Enterprise. These products are designed to replace their
monochrome equivalents at competitive price points with
affordable total cost-of-ownership. The Companys new
Peerless Sierra Technologiesis ideally suited to help
Peerless OEMs and channel partners bridge the gap between
monochrome and color digital imaging in this new market.

Emergence of multifunction
products.The advent of MFPs has
eroded the boundaries between the previously distinct printer,
copier, fax and scanner market sectors. MFPs range from small
home products to large high-speed office devices. MFPs offer
several functions,(i.e., copying, printing, emailing,
scanning, and faxing) in one product. Most of the dominant
vendors in the printer, copier and fax markets have now
introduced MFPs, which has required each vendor to broaden its
imaging expertise. At the same time, the need for concurrent
processing of multiple digital document product functions has
created the need for real-time, multitasking operating system
support. Peerless Sierra Technologieswas designed to
address the complex requirements of driving and managing these
richly featured MFP devices.

Increased role of
networking.Within the office
environment, digital document products are increasingly being
deployed in a networked configuration. Because multiple local
area network protocols and network operating systems are
deployed in the corporate network environment, networked digital
document products must support a broad array of networking
technologies in order to maximize accessibility by various user
groups. The network environment is also changing rapidly and
becoming increasingly complex, with a growing requirement for
remote network management that extends across local area
networks, wide area networks, the Enterprise information
technology (IT) environment and the Internet. A key
indicator of the growing network management requirements is the
increase in the deployment of directory based management systems
that consolidate information about all network resources and
users in a centrally managed directory such as Microsoft Active
Directory or Novell Directory Services. The Companys core
networking technology, the Peerless Software Print Server(SPS) has been completely integrated into its
family of controller products and is also available to its
customers as a stand-alone software development kit(SDK). The SPS SDK is widely recognized as one
of the most complete networking solutions in the imaging
industry.

In addition, because the majority of office
digital document products are networked, the image processing
intelligence may be partitioned and located anywhere within the
network: at the site of document or image origination, at a
server, or, as is typically the case today, inside the digital
document product itself. In some instances, such as when
printing to a remote location, it can be advantageous to perform
image pre-processing and compression at the document origination
site prior to transmission over usage-sensitive or congested
facilities. In other instances, such as when printing from a
graphics workstation, it can be advantageous to perform most of
the image processing at the printer in order to offload a host
computer that is under a heavy workload. In order to accommodate
the emerging needs of the networked office environment, an
optimal

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digital imaging system should employ a modular
architecture capable of serving and managing distributed
corporate resources.


Growing need for device and document
management.Shared imaging devices on
a network require greater levels of administrative control than
stand-alone devices. Users and administrators should be able to
discover printing services on a network, and a well designed
imaging device should be able to advertise its
capabilities. Systems that are capable of processing a high
volume of print jobs originating from a variety of clients are
expected to report back considerable detail about those jobs for
accounting purposes and to alert remote users about error
conditions that require human intervention. Such systems are
often capable of holding documents for printing at a later time
or routing documents to other parts of the network for
additional processing. Document security is also a paramount
concern in the corporate market and manufacturers are
researching improved ways to protect document security.

Change in market patterns of OEM
demand.There has been a general
decline in the rates of growth for the monochrome work group
printer and copier market segments in which Peerless, in the
past, has been primarily engaged. While the markets for these
products have continued to grow in absolute numbers, the rates
of growth have declined. With the decline in the rates of
growth, the OEMs that produce products in these markets have
reacted by engaging in internal controller development and
consolidating through mergers and acquisitions. In addition, the
OEMs are now introducing new product platforms and engines at a
slower rate than they had in the past.

Technology

In response to the challenges and demands upon
digital document manufacturers, the Company continues to develop
proprietary technologies for the digital imaging and digital
document marketplace that are designed to provide meaningful
improvements in performance, cost and time-to-market for
Peerless OEM customers. The Companys traditional
proprietary object-based imaging system reduces the size of
digital document imaging files with virtually no loss of visual
quality. This proprietary technology enables the Companys
OEM customers to increase print quality and speed, and reduce
memory cost while eliminating or reducing the need for
incremental compression technology. When optimized, this
component of the digital imaging system can provide significant
cost savings and performance differentiation to digital document
product manufacturers. The Company incorporates complementary
technologies, or makes its technologies compatible with third
party technologies, in order to provide its customers with a
more comprehensive imaging solution.

Over the past year, Peerless has developed new
high performance color printing and MFP technologies under the
umbrella of its Peerless Sierra Technologiesarchitecture. These new technologies enable the Company to
provide products and offerings in previously unreachable markets
within the Enterprise, such as the convenience colormarket.

Object-based image
processing.While developing
Peerless Sierra Technologies,the Company made advances
in its proprietary object-based image processing technology.
These advances improve the rendering quality of the Peerless
color processing pipeline. They take advantage of the increased
computing power of modern microprocessors to perform complex
calculations that enhance the fidelity of the printed output
with respect to the original digital document. Enhancements
associated with these advances include a new patent pending
lossless compressionalgorithm and sophisticated methods
for identifying different graphical objects after the page image
has been fully rendered.

The Companys object-based image processing
technology provides more significant benefits as the image
processing workload increases, which occurs with increased
resolution or a transition from monochrome to color printing.

Systems
architecture.The Company has extended
its core systems architecture to include new features and
functions, such as support for its new PCL-XL 3.0 emulation,
PeerlessPrint, and the latest version of Adobe PostScript 3, a
fast tandem print engine interface, and advanced networking.
Additional architectural improvements occurred during the
development of Peerless Sierra Technologies. This new
architecture takes

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advantage of modern hardware and software design
methodologies that have allowed the Company to establish a
modular approach to its architecture and support such functions
as job management, color management, networking, scanning and
faxing. This modular approach has enabled the Company to have
standardized interfaces for its family of products and further
allows for its imaging solutions to be ported to a variety of
platforms, printer languages and applications. One significant
advantage of this systems modularity is that the
standardized PeerlessPage interface provides the ability to
support multiple printer languages. The PeerlessPage
object-based imaging modules are both platform and
device-independent, and are able to accommodate a variety of
print engines and controller architectures. An important example
of this systems portability is the fact that prototype
versions of Peerless Sierra Technologieswere designed to
run on top of the VxWorks operating system while current product
quality versions are designed to run on top of the Linux
operating system. The Peerless Sierra Technologiesarchitecture is capable of supporting very high resolution
monochrome and color digital documents and products.


A key component of the architectural philosophy
underlying Peerless Sierra Technologiesis a completely
open controller design in the form of an XML-based application
interface called the Open Workflow Architecture(OWA). The OWA allows third party application
developers virtually instant access to all the features and
functions embodied in a Peerless Sierra Technologiesbased controller using modern, standardized interface and
communications methods.

Technology partners.The Company has established relationships that permit it to
offer its customers complementary technologies developed by
various technology partners, including Adobe and Novell. Adobe
has been a development partner with Peerless since 1992 and the
relationship has grown with each new application of Peerless and
Adobe technologies. In 1999, Adobe and Peerless entered into a
PostScript Software Development License and Sublicense Agreement
that expanded the application and integration of the respective
technologies. The Companys relationship with Adobe permits
the Company to offer a convenient and optimized Adobe
PostScript-enabled solution, as well as directly license
PostScript to its OEM customers. Peerless has also invested in
the development of PSIPs VersaPageAPI technology
which is designed to better enable OEMs to integrate Adobe
PostScript into their products.

Peerless also has a strategic partnership with
Novell. The partnership covers networking and device management
software licenses for imaging devices across the Novell
Directory Services server environment, which includes Novell
Embedded Systems Technology Server Software. The Companys
agreement with Novell enables Peerless to directly license
embedded directory and network services technology for multiple
market segments, allowing Peerless to offer greater
functionality for all network devices, extending the
Companys reach from digital output systems to other
devices such as set top boxes and cable modems. Peerless also
provides custom engineering to OEMs for implementation of Novell
Distributed Print Server gateways.

The Company has also established semiconductor
agreements with some of the leading developers and manufacturers
of reduced instruction set computer (RISC)
microprocessors including IBM and NEC. These relationships have
allowed the Companys semiconductor partners to offer
integrated processor and co-processor solutions, which combine
the Companys basic imaging technology with an
industry-standard microprocessor.

Strategy for Business

The Companys overall objectives for growth
in the imaging business are to develop more diverse distribution
channels for its products, to broaden the number of supported
imaging devices to include higher margin color copier and
printing devices, to reduce the time-to-market of Peerless-based
products through the increased use of standardized PC hardware
and software tools, and to increase its focus on developing
applications that perform job, document, and content management.
The Companys imaging software is portable to a wide range
of technology platforms, and the Company can take advantage of
that fact to move its product line both up market and down
market in relation to its traditional market presence. The
Company has devoted research and development resources on its
line of applications to support an end-to-end solution for ease
of use during the printing process. The key to the
Companys overall technology strategy is to offer its

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customers products, services, and time-to-market
advantages that exceed what they are capable of doing without
having Peerless as a supplier or partner.


The Company is focused on the following growth
strategies:

Aggressive development of new technologies.The Company has invested substantially
in developing new products for the imaging marketplace. Despite
reducing its operating expenses significantly, Peerless has
continued to invest in research and development. The
Companys strategy is to continue to introduce imaging
technology innovations designed to increase performance, reduce
cost and address a broader range of emerging digital document
product requirements, including MFP and color applications. The
Company is seeking to further develop its intellectual property
in embedded imaging for various equipment applications and
technologies, expanding their application into attached and
server based applications.

Increased packaging of Company technologies
for licensing as SDKs.As a result of
the development of the modular Peerless Sierra Technologiesand its enhancement of its existing monochrome capabilities,
the Company is packaging its technologies in SDKs allowing OEMs
to pick and choose the components that they need to address
specific product development needs.

Develop and expand relationships with key
industry participants.The Company has
established relationships with leading color and monochrome
printer industry companies, such as Canon, KonicaMinolta,
Kyocera/ Mita, Lenovo, Oki Data, Panasonic, Ricoh, and Seiko
Epson (collectively, OEM Partners). Peerless seeks
to expand its relationships with its OEM Partners by offering a
broad range of solutions for additional digital color and
monochrome devices produced by its OEM Partners. The Company is
also establishing relationships with other digital copier and
printer companies.

Leverage technical expertise to expand
products and markets.Peerless has an
experienced team of technology experts with backgrounds in image
processing, compression, language interpreters, printer drivers,
networking, ASIC and hardware engineering, software engineering,
color reproduction, real-time operating systems and systems
integration. Applying its expertise in these areas allows the
Company to continue to expand the technical superiority of its
products and gain access to new markets.

Develop and enhance strategic relationships in
the digital document market.The
Company intends to develop and enhance its relationships with
key participants in the digital document product market. For
example, the Company has strategic partnerships with industry
leaders such as Adobe, Novell, and IBM.

Expand sales channels.Early in fiscal year 2004, the Company
hired key sales and marketing professionals to focus on channel
expansion. The Company expects to leverage its new technologies
and industry expertise to provide compelling solutions to
distributors, value added resellers, system integrators and OEM
sales operations. Peerless continues to engage in discussions
with several large distribution and service organizations.

Expand geographical presence and market reach.Peerless has established relationships
with co-development firms such as Metatechno and NTL of Japan
and WeSoft of Hong Kong. The Company has begun to market and
sell its products into the Peoples Republic of China and
Taiwan.

Products and Solutions

The main source of Peerless revenues comes
from its licensed software-based imaging and networking systems
for the digital document product marketplace. The Companys
technology and engineering services provide advanced imaging
solutions that enable the Companys OEM customers to
develop digital printers, copiers and MFPs cost effectively. The
Company delivers its products to its OEM customers in multiple
ways, including: licensing of the Companys SDKs that
provide imaging and networking technology for the OEMs
internal product development; turnkey product development
whereby the Company provides the technology and the additional
engineering services necessary to integrate the appropriate
technology into a complete imaging system solution optimized to
the OEMs specific requirements; and a co-development
relationship that combines the licensing of Peerless technology
with joint Peerless and OEM engineering resources.

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Peerless technology allows copiers and
printers to be shared across work groups, a distributed
enterprise and the Internet. The Companys products support
a wide range of digital printing devices for both direct connect
and networked configurations, including: desktop color printers;
digital black and white copiers; digital black and white laser
printers; digital color copiers and language-enabled (i.e.,
PostScript, PeerlessPrint5C, or PeerlessPrint6), as well as
raster-based desktop inkjet printers. Peerless
raster-based solutions (often referred to as GDI or
Windows printing technology) are marketed under the
trade name AccelePrint, and are capable of driving a
variety of lower cost monochrome and color devices, including
both printers and copiers.

In addition to existing products, Peerless is
developing new controller products and solutions targeted for
direct sales to the distribution channels. These markets include
OEM distributors and companies that sell OEM engines and
peripherals which in some cases are privately branded.

Architecture.Peerless high performance
architecture includes all the components necessary to construct
a world class controller supporting color printing, scanning,
and faxing, with extensions to support the addition of
value-added functions such as integrated copying. The
architectural components consist of a complete object-based
imaging system capable of rendering a variety of document
formats into high fidelity printed output, as well as a print
engine driver, object-based image processing model, graphics
library, color management, font management, hard disk
management, print job management, distributed scanning, high
speed faxing, user control panel interface and a full suite of
direct and networked connectivity options. These components are
accessible to other networked devices through Peerless
OWA, which provides the interfaces for device status and control
using standard XML processing.

Page Descriptor Languages (PDL).Peerless provides OEMs with support
for the most widely used and standard PDLs, namely Adobes
PostScript Software and Hewlett-Packards Printer Control
Language (PCL). The Company offers PeerlessPrint
technology, which emulates Hewlett-Packards PCL. The
current level of emulation coincides with Hewlett-Packards
PCL-XL Protocol 3.0 specification.

PDL printer drivers.The role of the PDL printer drivers is
to convert user application data into device specific commands.
The Companys printer drivers consist of the necessary
software to run the targeted print device, as well as
translation software running on the workstation computer. This
software translates the document from device independent data
into device specific data and a format suitable for network
transmission and interpretation at the printer. The latest
versions of the Companys printer driver software
incorporate advanced color management features that have been
designed with ease-of-use for the office knowledge worker in
mind.

ASICs.The
Companys ASICs provide an integrated chip implementation
of key components of its imaging technology. Peerless has
licensed its proprietary ASIC designs to semiconductor
manufacturers, such as IBM, Motorola and NEC, which gives them
the right to manufacture and sell these ASICs directly to
digital document product manufacturers. The Company uses a
fabless model to sell its devices, either directly
or through its distributor in Japan.

Job management software.Peerless job management software
enables print job management from different computer platforms
through OEM, third party, Web or Peerless developed user
interfaces. This software enables remote access to print queues
so users or administrators can track and control their print
jobs.

Color management software.Peerless color management software is
based on the use of industry standard International Color
Consortium (ICC) profiles, which ensures the highest
degree of fidelity and user-specifiable flexibility when
rendering digital documents on color output devices. This
software supports four different rendering intents,
Perceptual, Saturation, Relative Colorimetric, and Absolute
Colorimetric, which allows the end user to select the
appropriate rendering mode for diverse document types such as
reports, presentations, and photographs.

Engineering services.For those OEMs that wish to outsource
the development of some or all of the imaging system for a
digital document product, the Company offers engineering
services. These include controller design and custom engineering
for vendor-specific features that complement the Companys
standard imaging technology. The Company has assembled an
experienced team of technical personnel with backgrounds in
image processing, compression, language interpreters, printer
drivers, networking, ASIC and

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hardware engineering, software engineering, color
reproduction, real-time operating systems and systems
integration. The resulting systems conform to accepted
standards, ranging from networking protocols to language
syntaxes and color processing methodologies.


Networking technology.Peerless supports a broad array of
networking protocols allowing its OEM customers to address the
majority of end-user networking requirements, including Windows
Printing, Macintosh OS Printing, printing across TCP/ IP
networks, and SNMP-based device management. To accommodate the
need for remote network management of digital document products
over LANs and across WANs, including intranets, the Company
supplies management information base tables (MIBs)
that may be utilized by open industry-standard network
management applications.

Directory services technology for Microsoft
and Novell environments.Peerless
currently offers printer management capabilities through
directory services technology that integrates into Microsoft and
Novell environments. Peerless interface to
Microsofts Active Directory and Novells eNDPS
technologies allows networked devices full access to directory
services through which they can advertise their
presence and capabilities across the network.

Certification services.To complement the licensing of
PostScript that the Company provides through its relationship
with Adobe, Peerless provides engineering support to PostScript
licensees to certify the OEMs PostScript implementation.
This service includes support for all phases of the
certification process and reduces the time to achieve final
product certification.

Customers and Markets



| |          
| | ---------
| | Customers

Peerless markets its imaging and networking
technology to OEMs that manufacture digital document products
for the medium to high performance sector of the office market.
In addition, the Company markets its imaging and networking
technology to technology partners, which incorporate certain
components of the Companys technology into integrated
product offerings that are ultimately marketed to digital
document OEMs. The Company currently derives substantially all
of its revenues from direct sales to digital document product
OEMs.

Three of the Companys customers,
KonicaMinolta, Oki Data and Seiko Epson, each generated more
than 10% of the Companys total revenues for fiscal year
2004. Revenues from the Companys top three customers
accounted for 61%, 55%, and 56% of the Companys total
revenues for fiscal years 2004, 2003, and 2002, respectively.
Although the Company has expanded and diversified its customer
base through focused sales efforts, the Company anticipates that
its future revenues may be similarly concentrated with a limited
number of customers. The Companys largest customers vary
to some extent from year to year as product cycles end,
contractual relationships expire and new products and customers
emerge. Many of the engineering services and a number of
licensing arrangements with the Companys customers are
provided on a project-by-project basis, are terminable with
limited or no notice, and in certain instances are not governed
by long-term agreements. Because a limited number of customers
generate a large percentage of the Companys revenues, any
loss of these customers would have a material adverse impact on
the Companys results of operations. See Certain
Factors and Trends Affecting Peerless and Its
Business  Peerless relies on relationships with
certain customers and any change in those relationships will
harm the Companys business, for a discussion of the
Companys reliance on a limited number of customers.

As discussed previously, there has been a general
decline in the rates of growth for the monochrome work group
printer and copier market segments in which Peerless is engaged.
For those product platforms that do go forward for development
and customer introduction, the OEMs, in a number of instances,
have not selected the Companys solutions. This occurred in
some cases because the OEMs perceived that the Companys
solutions did not meet their technical requirements. In other
cases it occurred because the OEMs either developed the
technology themselves or utilized lower cost offshore software
competitors. However, the Company has begun to focus on higher
growth segments such as color printing and color MFP markets
with the OEMs and with companies in the distribution channels.

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| |        
| | -------
| | Markets

Segments.The
Company sells its products and services to OEMs which produce
products for the Enterprise and office sector of the digital
document product market, which is characterized by digital
document products ranging in price from approximately $1,000 to
in excess of $40,000 each. These products typically offer high
performance differentiated by customized features. In many
cases, digital document product manufacturers demand turnkey,
customized digital imaging solutions that include imaging
software, controller design and network interface card design.
As a result of these unique requirements, Peerless typically
addresses the office sector of the digital document product
market via direct OEM relationships with individual digital
document product manufacturers. The Companys major
customers in the office market in the fiscal year 2004 included
Canon, KonicaMinolta, Kyocera/ Mita, Oki Data, Seiko Epson,
Panasonic, and Ricoh.

Geography.Since the
majority of the Companys OEM customers are comprised
primarily of companies headquartered in Japan, revenues from
customers outside the United States accounted for 87% of the
Companys total revenues in each of the fiscal years 2004,
2003, and 2002. Further, the Company expects that sales to
customers located outside the United States may increase in
absolute dollars in the future. These customers sell products
containing Peerless technology primarily in the North
American and European marketplaces. See Managements
Discussion and Analysis of Financial Condition and Results of
Operations for further discussion on Asian markets.

All of the Companys contracts with
international customers are, and the Company expects that in the
future will be, denominated in U.S. dollars. As a result,
the Company is currently not subject to foreign currency
transaction and translation gains and losses. However, see
Certain Factors and Trends Affecting Peerless and Its
Business  The Companys international activities
may expose the company to additional risks associated with
international business.

Sales and Marketing

The Company markets its products to the leading
OEMs that sell digital document products to the worldwide
market. The Company directs most of its sales efforts through
its headquarters in California and its subsidiary in Japan.
Sales to European digital document product manufacturers are
conducted out of the Companys California headquarters. The
Company has extended its sales efforts to include distributors,
value added resellers, system integrators, and geographically
based OEM sales operations. The Company has invested in an
additional regional sales presence on the east coast of the
United States. The Company markets its technology directly to
OEMs, as well as through focused trade relations and branding
programs. Direct OEM marketing consists of focused public
relations activities and the development of sales collateral,
mailers, trade show attendance, and sales support. The Company
has devoted increased time and resources on increasing
Peerless presence in media accessed by OEM customers. The
Company directs public relations and product branding programs
toward building awareness of the Peerless brand name.

Product Development and Engineering
Services

The Companys product development activities
are located at two sites, El Segundo, California, and Kent,
Washington. These activities primarily consist of new product
development, enhancement of existing products, product testing,
and technical documentation. The Companys engineering is
focused on two primary areas: research and development, which
focuses on development and enhancement of the Companys
products and core technologies; and engineering services, which
focuses on customized customer design activities.

The Companys engineers work closely with
OEMs that desire a turnkey solution, developing customized
interfaces and applications specific to individual OEMs. The
Company typically receives a fee for such engineering services.
To further support the development of technology and products
for the Companys OEMs, Peerless has established
co-development relationships with Metatechno, a Japan based
company that provides product development support for some of
the Peerless OEMs in Japan, and WeSoft, a Hong Kong based
company that currently supports development and testing of
customer projects. The Metatechno

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relationship provides local technical support to
Peerless OEMs and has proved valuable in addressing the cultural
and language differences. In addition, the Company has
established a relationship with NTL of Japan, to focus on the
integration of server-based development. WeSoft will play a
similar role as Peerless addresses the Southeast Asia market,
including China.


Intellectual Property and Proprietary
Rights

The Companys success is heavily dependent
upon its proprietary technology. To protect its proprietary
rights, the Company relies on the combination of patent,
copyright, trade secret and trademark laws. The Company also
enters into nondisclosure agreements and other contractual
provisions and restrictions.

The Company has forty-four patents and patents
pending on a world-wide basis. As of March 31, 2004, the
Company had 10 issued U.S. patents,7 pending
U.S. patent applications and various foreign counterpart
patents and applications. The Company has four pending patent
applications in the European Patent Office, six applications
pending in Japan and one application pending in each of Hong
Kong and Taiwan, three in China, two in Australia, two in India,
and two in Korea. The issued patents relate to techniques
developed by the Company for generating output for continuous
synchronous raster output devices, such as laser printers,
compressing data for use with output devices, filtering
techniques for use with output devices and communicating with
peripheral devices over a network.

There can be no guarantee that the patents held
by the Company will not be challenged or invalidated, that
patents will be issued for any of the Companys pending
applications, or that any claims allowed from existing or
pending patents will be of sufficient scope or strength (or
issue in the countries where products incorporating the
Companys technology may be sold) to provide meaningful
protection or any commercial advantage to the Company. In any
event, effective protection of intellectual property rights may
be unavailable or be limited in certain countries. The status of
United States patent protection in the software industry
continues to evolve as the United States Patent and Trademark
Office grants additional patents in this area. Patents have been
granted to fundamental technologies in software after the
development of an industry around such technologies, and patents
that relate to fundamental technologies related to the
Companys business may be issued to third parties.

As part of its confidentiality procedures, the
Company enters into nondisclosure agreements with its employees,
consultants, OEMs and strategic partners and takes further
affirmative steps to limit access to and distribution of its
software and other proprietary information. Despite these
efforts and in the event such agreements are not timely made,
complied with or enforced, the Company may be unable to protect
its proprietary rights. In any event, enforcement of the
Companys proprietary rights may be very expensive. The
Companys source code also is protected as a trade secret.
However, the Company from time to time licenses its source code
to OEMs pursuant to protective agreements, which subjects the
Company to the risk of unauthorized use or misappropriation
despite the contractual terms restricting disclosure,
distribution, copying, and use. In addition, it may be possible
for unauthorized third parties to obtain, distribute, copy, or
use the Companys proprietary information, or to reverse
engineer the Companys trade secrets.

As the number of patents, copyrights, trademarks
and other intellectual property rights in the Companys
industry increases, products using the Companys
technologies increasingly may become the subject of infringement
claims. There can be no assurance that third parties will not
assert infringement claims against the Company in the future.
Any such claims, regardless of merit, will be time consuming,
result in costly litigation, cause product shipment delays, or
require the Company to enter into unfavorable royalty or
licensing agreements. Such royalty or licensing agreements, if
required, may not be available on terms acceptable to the
Company, or at all, which could have a material adverse effect
on the Companys operating results. In addition, the
Company may initiate claims or litigation against third parties
for infringement of the Companys proprietary rights or to
establish the validity of the Companys proprietary rights.
Litigation to determine the validity of any claims, whether or
not such litigation is determined in favor of the Company, will
result in significant expense to the Company and divert the
efforts of the Companys technical and management personnel
from productive tasks. The Company may lack sufficient resources
to initiate a meritorious claim. In the event of an adverse
ruling in any litigation regarding intellectual property, the
Company may be required

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to pay substantial damages, discontinue the use
and sale of infringing products, expend significant resources to
develop non-infringing technology, or obtain licenses to
infringing or substituted technology. The failure of the Company
to develop or license on acceptable terms a substitute
technology, if required, could have a material adverse effect on
the Companys operating results. See Certain Factors
and Trends Affecting Peerless and Its Business  If
Peerless fails to adequately protect the Companys
intellectual property or faces a claim of intellectual property
infringement by a third party, Peerless could lose the
Companys intellectual property rights or be liable for
damages.


Competition

The market for outsourced imaging systems for
digital document products is highly competitive and
characterized by continuous pressure to enhance performance, add
functionality, reduce costs and accelerate the release of new
products. The Company competes on the basis of a refreshed base
of core technologies and new MFP technologies, plus technology
expertise, product functionality, development time and price.
The Companys technology and services primarily compete
with solutions developed internally by OEMs. Virtually all of
the Companys OEM customers have significant investments in
their existing solutions and have the substantial resources
necessary to enhance existing products and to develop future
products. These OEMs have or may develop competing imaging
system technologies and may implement these systems into their
products, thereby replacing the Companys current or
proposed technologies, eliminating the need for the
Companys services and products and limiting future
opportunities for the Company. In fact, OEMs have increasingly
been shifting away from third party solutions in favor of
in-house development. Therefore, the Company is required to
persuade these OEMs to outsource the development of their
imaging systems and to provide products and solutions to these
OEMs that favorably compete with their internally developed
products. The best way to accomplish this continues to be to
offer products, services, and time-to-market advantages that
exceed what the OEMs are capable of doing using their own
internal resources. The Company also competes with software and
engineering services provided in the digital document product
marketplace by other systems suppliers to OEMs. In this regard,
the Company competes with, among others, Destiny Technology
Corporation, EFI Electronics Corporation (formerly Electronics
For Imaging), Zoran Corporation (formerly Oak Technologies),
Global Graphics Software Ltd., and Software Imaging (formerly
Software 2000).

As the industry continues to develop, the Company
expects that competition and pricing pressures will increase
from OEMs, existing competitors and other companies that may
enter the Companys existing or future markets with similar
or substitute solutions that may be less costly or provide
better performance or functionality. The Company anticipates
increasing competition for its color and multifunction products,
particularly as competitors develop and introduce products in
this market. Some of the Companys existing competitors,
many of its potential competitors and virtually all of the
Companys OEM customers have substantially greater
financial, technical, marketing and sales resources than the
Company. In the event that price competition increases,
competitive pressures could cause the Company to reduce the
amount of royalties received on new licenses and to reduce the
cost of its engineering services in order to maintain existing
business and generate additional product licensing revenues.
This could reduce profit margins and result in losses and a
decrease in market share. No assurance can be given as to the
ability of the Company to compete favorably with the internal
development capabilities of its current and prospective OEM
customers or with other third party imaging system suppliers,
and the inability to do so would have a material adverse effect
on the Companys operating results.

Employees

As of April 23, 2004 the Company had a total
of 121 employees plus 19 who performed efforts as consultants
and contractors. None of the Companys employees is
represented by a labor union, and the Company has never
experienced any work stoppage. The Company considers its
relations with its employees to be good.

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Certain Factors and Trends Affecting Peerless
and Its Business



| |                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Companys near term revenue may drop
    as a result of the timing of licensing revenues and the reduced
    demand for its existing monochrome technologies.

The Company has traditionally generated its
revenue from the licensing and sale of monochrome solutions to
OEMs. While the Company is continuing to provide monochrome
solutions to OEM customers and continuing to seek out additional
distribution channels and customers for its monochrome
solutions, the Company is increasing the focus of its research
and development and marketing efforts on its Peerless Sierra
Technologiesproduct line of high speed, color imaging
solutions. Until the Companys Peerless Sierra
Technologiesbecomes accepted in the marketplace 
if such technology does become accepted in the
marketplace  the Companys overall revenue may
stagnate or even decrease. If the Companys revenue
stagnates or decreases, the value of the Companys
securities may be adversely affected.



| |                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If the Company is unable to introduce the
    Peerless Sierra Technologies on a timely basis, the
    Companys future revenue and operating results may be
    harmed.

The Companys future operating results will
depend to a significant extent on the Companys ability to
introduce the new Peerless Sierra Technologieson a
timely basis. The Company has spent a significant amount of time
and capital developing the new Peerless Sierra
Technologies. The Company currently expects to formally
launch the Peerless Sierra Technologieshardware product
into channel sales in the second quarter of fiscal year 2005,
and obtain a design win with an OEM customer during fiscal year
2005, with licensing revenues expected in early fiscal year
2006. Any delays in the launch of channel sales or a design win
with an OEM customer could harm the Companys financial
results.



| |                                                                                                                                                             
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If the marketplace does not accept
    Peerless new Peerless Sierra Technologies, the
    Companys future revenue and operating results may be
    harmed.

Peerless Sierra Technologiesmay not be accepted by the marketplace
for many reasons including, among others, incompatibility with
existing or forthcoming systems, lack of perceived need by
customers, uncertainty whether the benefits exceed the cost, the
availability of alternatives, and unwillingness to use new or
unproven products. If the marketplace does not accept the
Peerless Sierra Technologiesor if the marketplace takes
additional time to accept the Peerless Sierra Technologiesthan Peerless is expecting, the Companys future
revenues and operating results may be harmed.



| |                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Companys existing capital resources
    may not be sufficient and if Peerless is unable to raise
    additional capital, the Companys business may
    suffer.

The Companys cash and short-term investment
portfolio was $9.4 million at January 31, 2004 and the
current ratio of assets to current liabilities was 2.3:1. For
the fiscal year ended January 31, 2004, Peerless
operations used $9.7 million in cash.

The Companys principal source of liquidity
is the Companys cash and cash equivalents and investments,
which, as January 31, 2004 were approximately
$9.4 million in the aggregate. If Peerless does not
generate anticipated cash flow from licensing and services, or
if expenditures are greater than expected, Peerless most likely
will reduce discretionary spending, which could require a delay,
scaling back or elimination of some or all of the Companys
development efforts, any of which could have a material adverse
effect on the Companys business, results of operations and
prospects. Furthermore, if Peerless experiences negative cash
flows greater than anticipated, and Peerless is unable to
increase revenues or cut costs so that revenues generated from
operating activities are sufficient to meet the Companys
obligations, Peerless will be required to obtain additional
capital from other sources. Such sources might include issuances
of debt or equity securities, bank financing or other means that
might be available to increase the Companys working
capital. Under such circumstances, there is substantial doubt as
to whether Peerless would be able to obtain additional capital
on commercially reasonable terms or at all. The inability to
obtain such resources on commercially acceptable terms could
have a material adverse effect on the Companys operations,
liquidity and financial condition, the

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Companys prospects and the scope of
strategic alternatives and initiatives available to the Company.
Peerless does not have a credit facility.




| |                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Companys near term revenue from
    engineering services may drop as the Company may change its
    strategies in how it offers its products in the
    marketplace.

Traditionally, the Company has generated its
revenue from engineering services through engineering turnkey
solutions for OEMs or licensing the Companys SDKs to OEMs.
In order to gain market acceptance for its new Peerless
Sierra Technologies, as well as to make its current
technologies more attractive, the Company may enter into
contracts with OEMs wherein the Company may agree to provide
initial customization and maintenance services without charge in
order to obtain increased license revenues in the future. Under
these contracts, the Company would normally recover development
expenses through recurring license fees. The OEM would normally
be asked to guarantee minimum licensing fees. However, the
Company may elect to take certain risks with the OEM by not
requiring minimums and the Company would have no guarantee or
assurance that the OEMs would sell the products that contain the
Companys technology. If the OEMs under these contracts do
not sell sufficient numbers of the product containing the
Companys technology, the Company may be unable to make-up
for the revenue lost. If the Company is unable to make-up for
the lost engineering revenue, the Companys overall revenue
may decrease  which may adversely affect the price of
the Companys securities.



| |                                                                       
| | ----------------------------------------------------------------------
| | Peerless has a history of losses and
    anticipates continued losses.

Peerless was unprofitable in fiscal year 2004,
and does not expect to be profitable in fiscal year 2005 until
its fiscal fourth quarter. While Peerless believes that it could
reach sustained profitability by the end of the fourth quarter
of fiscal year 2005, there is no assurance that the Company will
be profitable at such time or at any time in the future.

Future losses will deplete the Companys
capital resources. The factors noted below have had and may
continue to have a material adverse effect on the Companys
future revenues and/or results of operations.



| |                                                                       
| | ----------------------------------------------------------------------
| | The future demand for the Companys
    current products is uncertain.

Peerless monochrome technology and products
have been in the marketplace for an average of 24 months as
of January 31, 2004. This is flat with the average of
24 months that the Companys products had been in the
marketplace as of January 31, 2003, but represents a 17%
decrease from the average of 29 months as of
January 31, 2002. The decrease in the average age of
current technology and products in the marketplace reflects
several very old products that have stopped shipping which has
offset the decline in demand for the Companys monochrome
technology and products. Although Peerless continues to license
the Companys current technology and products to certain
OEMs, there can be no assurance that the OEMs will continue to
need or utilize the current technology and products the Company
offers.



| |                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------
| | Peerless relies on relationships with certain
    customers and any change in those relationships will harm the
    Companys business.

A limited number of OEM customers continue to
provide a substantial portion of Peerless revenues.
Presently, there are only a small number of OEM customers in the
digital document product market to which the Company can market
its technology and services. Therefore, the Companys
ability to offset a significant decrease in the revenues from a
particular customer or to replace a lost customer is severely
constrained.

During fiscal year 2004, three customers,
KonicaMinolta Holdings Corporation, Oki Data Corporation and
Seiko Epson Corporation, each generated greater than 10% of the
Companys revenues and collectively contributed 61% of
revenues. Block license revenues for the same time period
totaled $16.0 million, or 63% of revenues. During fiscal
year 2003, two customers, Oki Data Corporation and Konica
Corporation, each generated greater than 10% of the revenues,
and collectively contributed 47% of revenues. Block license
revenues during the same period were $20.6 million, or 65%
of revenues.

17



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##### Table of Contents





| |                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Peerless relies on relationships with Adobe
    Systems Incorporated and Novell Inc., and any change in those
    relationships will harm the Companys business.

The Company has licensing agreements with Adobe
Systems Incorporated and Novell Inc. to bundle and sublicense
their licensed products with the Companys licensed
software. These relationships accounted for $13.4 million
in revenues and an associated $6.4 million in cost of
revenues during fiscal year 2004. Should the agreement with any
of these vendors be terminated or canceled, there is no
assurance that the Company could replace that source of revenue
within a short period of time, if at all. Such an event would
have a material adverse effect on the Companys operating
results.



| |                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------
| | The Company, as a sublicensor of third party
    intellectual property, is subject to audits of the
    Companys licensing fee costs.

The Companys licensing agreements that
include third party intellectual property result in royalties
contractually due and payable to the third parties. The rates
are subject to interpretation of contract language and intent of
the contracting parties, and may result in disputes as to the
correct rates. Peerless is subject to audits of the
Companys data serving as the basis for the royalties due.
Such audits may result in adjustments to the royalty amounts due.



| |                                                                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company is currently in discussions with
    Adobe Systems Incorporated and Canon Inc. to remedy a contract
    dispute, which, if not remedied, could result in the loss of the
    Adobe agreement and harm to the Companys
    business.

Peerless is in negotiations with Canon Inc.
regarding the PostScript sublicense agreement between Peerless
and Canon executed as of April 1, 2001. The sublicense did
not include several terms required to be included in all OEM
sublicenses by Peerless license with Adobe. Although Adobe
has indicated to Peerless that it has no current intention to
pursue claims for alleged breach of the Adobe Peerless
PostScript Sublicensing Agreement, Adobe has not agreed to waive
the requirement that the missing terms be included in the Canon
sublicense. To date, Peerless has been unable to amend the Canon
sublicense in a manner acceptable to both Canon and Adobe.
Furthermore, there is no assurance that Peerless will be able to
resolve the issues in manners acceptable to both Adobe and
Canon. Thus, Adobe may exercise its right to terminate its
license agreement with Peerless and take other legal action
against Peerless, if it so chooses. Termination of the Adobe
agreement would have a material adverse effect on Peerless
future operating results. Approximately 41% of Peerless
revenue for fiscal year ended January 31, 2004 and
approximately 49% of Peerless revenue for the fiscal year
ended January 31, 2003 were derived from its licensing
arrangement with Adobe Systems Incorporated. See Peerless
relies on relationships with Adobe Systems Incorporated and
Novell Inc., and any change in those relationships will harm the
Companys business.



| |                                                                                                               
| | --------------------------------------------------------------------------------------------------------------
| | Peerless may be unable to develop additional
    new and enhanced products that achieve market
    acceptance.

Peerless currently derives substantially all of
its revenues from licensing and sale of the Companys
monochrome imaging software and products and the sublicensing of
third party technologies. Peerless expects that revenue from
imaging products will continue to account for a substantial
portion of revenues during fiscal year 2005 and beyond. The
Companys future success also depends in part on the
Companys ability to address the rapidly changing needs of
potential customers in the marketplace, to introduce
high-quality, cost-effective products, product enhancements and
services on a timely basis, and to keep pace with technological
developments and emerging industry standards. The Companys
failure to achieve its business plan to develop and to
successfully introduce new products and product enhancements in
the Companys prime markets is likely to materially and
adversely affect the Companys business and financial
results.

18



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##### Table of Contents





| |                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If Peerless is not in compliance with the
    Companys licensing agreements, Peerless may lose the
    Companys rights to sublicense technology; the
    Companys competitors are aggressively pursuing the sale of
    licensed third party technology.

Peerless currently sublicenses third party
technologies to the Companys OEM customers, which
sublicenses account for over 50% of the Companys gross
revenues. Such sublicense agreements are non-exclusive. If
Peerless is determined not to be in compliance with the
Companys agreements with its licensors, Peerless may
forfeit the Companys right to sublicense these
technologies. Likewise, if such sublicense agreements were
canceled, Peerless would lose the Companys right to
sublicense these technologies. Additionally, the licensing of
these technologies has become very competitive with competitors
possessing substantially greater financial and technical
resources and market penetration than Peerless. As competitors
are pursuing aggressive strategies to obtain similar rights as
held by Peerless to sublicense these third party technologies,
there is no assurance that Peerless can remain competitive in
the marketplace if one or more competitors are successful.



| |                                                                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The industry for imaging systems for digital
    document products involves intense competition and rapid
    technological changes and the Companys business may suffer
    if its competitors develop superior technology.

The market for imaging systems for digital
document products is highly competitive and characterized by
continuous pressure to enhance performance, to introduce new
features and to accelerate the release of new products. Peerless
competes on the basis of technology expertise, product
functionality, development time and price. Peerless
technology and services primarily compete with solutions
developed internally by OEMs. Virtually all of the
Companys OEM customers have significant investments in
their existing solutions and have the substantial resources
necessary to enhance existing products and to develop future
products. These OEMs possess or may develop competing imaging
systems technologies and may implement these systems into their
products, thereby replacing the Companys current or
proposed technologies, eliminating a need for the Companys
services and products and limiting the Companys future
opportunities. Therefore, Peerless is required to persuade these
OEMs to outsource the development of their imaging systems to
the Company and to provide products and solutions to these OEMs
that cost-effectively compete with their internally developed
products. Peerless also competes with software and engineering
services provided in the digital document product marketplace by
other systems suppliers to OEMs.

As the industry continues to develop, competition
and pricing pressures will increase from OEMs, existing
competitors and other companies that may enter the
Companys existing or future markets with similar or
substitute solutions that may be less costly or provide better
performance or functionality. Peerless anticipates increasing
competition for the Companys color products under
development, particularly as new competitors develop and enter
products in this marketplace. Some of the Companys
existing competitors, many of the Companys potential
competitors, and virtually all of the Companys OEM
customers have substantially greater financial, technical,
marketing and sales resources than Peerless. In the event that
price competition increases, competitive pressures could require
the Company to reduce the amount of royalties received on new
licenses and to reduce the cost of the Companys
engineering services in order to maintain existing business and
generate additional product licensing revenues. This could
reduce profit margins and result in losses and a decrease in
market share. No assurance can be given as to the Companys
ability to compete favorably with the internal development
capabilities of the Companys current and prospective OEM
customers or with other third party digital imaging system
suppliers, and the inability to do so would have a material
adverse effect on the Companys operating results.



| |                                                                        
| | -----------------------------------------------------------------------
| | The Companys reserves for accounts
    receivable may not be adequate.

The Companys net trade accounts receivable
was $6.1 million as of January 31, 2004, an increase
from $2.0 million as of January 31, 2003, reflecting a
$2.5 million receivable from a customer not received until
February 2004 and significant collections from several major
customers in fiscal year 2003. Although Peerless believes that
the Companys reserves for accounts receivable are adequate
for the remainder of fiscal year

19



---



##### Table of Contents



2005, there can be no assurance this is the case.
If the Companys reserves for accounts receivable are
inadequate, it could have a material adverse effect on the
Companys results of operations.




| |                                                                                                                                                                                                                                                             
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If Peerless fails to adequately protect the
    Companys intellectual property or face a claim of
    intellectual property infringement by a third party, Peerless
    could lose the Companys intellectual property rights or be
    liable for damages.

The Companys success is heavily dependent
upon the Companys proprietary technology. To protect the
Companys proprietary rights, Peerless relies on a
combination of patent, copyright, trade secret and trademark
laws as well as the early implementation and enforcement of
nondisclosure and other contractual restrictions. As part of the
Companys confidentiality procedures, Peerless
policies are to enter into written nondisclosure agreements with
the Companys employees, consultants, prospective
customers, OEMs and strategic partners and to take affirmative
steps to limit access to and distribution of the Companys
software, intellectual property and other proprietary
information.

Despite these efforts, Peerless may be unable to
effectively protect the Companys proprietary rights and
the enforcement of the Companys proprietary rights may be
cost prohibitive. Unauthorized parties may attempt to copy or
otherwise obtain, distribute, or use the Companys products
or technology. Monitoring unauthorized use of the Companys
products is difficult. Peerless cannot be certain that the steps
it takes to prevent unauthorized use of its technology,
particularly in countries where the laws may not protect
proprietary rights as fully as in the United States, will be
effective.

The Companys source code also is protected
as a trade secret. However, from time to time Peerless licenses
the Companys source code to OEMs, which subjects the
Company to the risk of unauthorized use or misappropriation
despite the contractual terms restricting disclosure,
distribution, copying, and use. In addition, it may be possible
for unauthorized third parties to copy the Companys
products or to reverse engineer in order to obtain and
subsequently use and distribute the Companys proprietary
information.

The Company holds patents issued in the United
States, France, Germany, Great Britain, Japan and Hong Kong. The
issued patents relate to techniques developed by the Company for
generating output for continuous synchronous raster output
devices, such as laser printers, compressing data for use with
output devices, filtering techniques for use with output devices
and communicating with peripheral devices over a network.

The Company also has patent applications pending
in the United States, the European Patent Office, Japan, Hong
Kong, Taiwan, China, Australia, Korea, and India.

There can be no assurance that patents Peerless
holds will not be challenged or invalidated, that patents will
issue from any of the Companys pending applications or
that any claims allowed from existing or pending patents will be
of sufficient scope or strength (or issue in the countries where
products incorporating the Companys technology may be
sold) to provide meaningful protection or any commercial
advantage to the Company. In any event, effective protection of
intellectual property rights may be unavailable or limited in
certain countries. The status of United States patent protection
in the software industry will evolve as the United States Patent
and Trademark Office grants additional patents. Patents have
been granted to fundamental technologies in software after the
development of an industry around such technologies and patents
may be issued to third parties that relate to fundamental
technologies related to the Companys technology.

As the number of patents, copyrights, trademarks
and other intellectual property rights in the Companys
industry increases, products based on the Companys
technologies may become the subjects of infringement claims.
There can be no assurance that third parties will not assert
infringement claims against the Company in the future. Any such
claims, regardless of merit, could be time consuming, result in
costly litigation, cause product shipment delays or require the
Company to enter into royalty or licensing agreements. Such
royalty or licensing agreements, if required, may not be
available on terms acceptable to the Company, or at all, which
could have a material adverse effect on the Companys
operating results. In addition, Peerless may initiate claims or
litigation against third parties for infringement of the
Companys proprietary rights or to establish the

20



---



##### Table of Contents



validity of the Companys proprietary
rights. Litigation to determine the validity of any claims,
whether or not such litigation is determined in the
Companys favor, could result in significant expenses and
divert the efforts of the Companys technical and
management personnel from productive tasks. In addition,
Peerless may lack sufficient resources to initiate a meritorious
claim. In the event of an adverse ruling in any litigation
regarding intellectual property, Peerless may be required to pay
substantial damages, discontinue the use and sale of infringing
products, and expend significant resources to develop
non-infringing technology or obtain licenses to infringing or
substituted technology. The Companys failure to develop,
or license on acceptable terms, a substitute technology if
required could have a material adverse effect on the
Companys operating results.




| |                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------
| | The Companys international activities
    may expose the Company to risks associated with international
    business.

Peerless is substantially dependent on the
Companys international business activities. Risks inherent
in the Companys international business activities also
include:



| |   |                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | disruptions by terrorists of normal channels of
    distribution;                                                                                                          
|
| |  | disruptions by terrorists of normal
    communications lines;                                                                                                              
|
| |  | major currency rate fluctuations;                                                                                                                                          
|
| |  | changes in the economic condition of foreign
    countries;                                                                                                                
|
| |  | the imposition of government controls;                                                                                                                                     
|
| |  | tailoring of products to local requirements;                                                                                                                               
|
| |  | trade restrictions;                                                                                                                                                        
|
| |  | changes in tariffs and taxes; and                                                                                                                                          
|
| |  | the burdens of complying with a wide variety of
    foreign laws and regulations, any of which could have a material
    adverse effect on the Companys operating results.

If Peerless is unable to adapt to international
conditions, its business may be adversely affected.



| |                                                                                    
| | -----------------------------------------------------------------------------------
| | Demand from Pacific Rim customers has
    continued to and may continue to decline.

During the past several years, and continuing
into fiscal year 2005, the Pacific Rim economies have been
financially depressed. As a result, companies in the imaging
industry have reported negative financial impacts attributable
to a decrease in demand from Pacific Rim customers. The
Companys Pacific Rim customers are comprised primarily of
companies headquartered in Japan. These Japanese OEMs sell
products containing the Companys technology primarily in
the North American, European, and Asian marketplaces. These
revenues have declined and there can be no assurance that
revenues from Japanese OEMs will not continue to decline in
future quarters.



| |                                                                                    
| | -----------------------------------------------------------------------------------
| | The Companys stock price may experience
    extreme price and volume fluctuations.

The Companys common stock has experienced
price volatility. In the 60-day period ending April 23,
2004, the closing price of the stock ranged from $1.71 per
share to $2.28 per share, and, since the beginning of
fiscal year 2004, the stock has closed as low as $1.37 per
share. Such price volatility may occur in the future. Factors
that could affect the trading price of the Companys common
stock include:



| |   |                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------
| |  | macroeconomic conditions;                                                                                                  
|
| |  | actual or anticipated fluctuations in quarterly
    results of operations;                                                 
|
| |  | announcements of new products or significant
    technological innovations by the Company or the Companys
    competitors;
|
| |  | developments or disputes with respect to
    proprietary rights;                                                           

21



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##### Table of Contents





| |   |                                              
| | - | ---------------------------------------------
| |  | losses of major OEM customers;               
|
| |  | general trends in the industry; and          
|
| |  | overall market conditions, and other factors.

In addition, the stock market historically has
experienced extreme price and volume fluctuations, which have
particularly affected the market price of securities of many
related high technology companies and which at times have been
unrelated or disproportionate to the operating performance of
such companies.



| |                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Companys business may suffer if the
    Companys third party distributors are unable to distribute
    the Companys products and address customer needs
    effectively.

Peerless has developed a fabless
distribution model for the sale of ASICs. Peerless has no direct
distribution experience and places reliance on third party
distributors to maintain inventories to address OEM needs,
manage manufacturing logistics, and distribute the product in a
timely manner. There can be no assurance that these distribution
agreements will be maintained or will prove adequate to meet the
Companys needs and contractual requirements.



| |                                                                                                                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Peerless relies on certain third party
    providers for applications to develop the Companys ASICs.
    As a result, Peerless is vulnerable to any problems experienced
    by these providers, which may delay product shipments to the
    Companys customers.

Currently, Peerless relies on two independent
parties, IBM Microelectronics and NEC Microelectronics, each of
which provides unique application specific integrated circuits
incorporating the Companys imaging technology for use by
the Companys OEMs. These sole source providers are subject
to materials shortages, excess demand, reduction in capacity
and/or other factors that may disrupt the flow of goods to the
Companys customers thereby adversely affecting the
Companys customer relationships. Any such disruption could
limit or delay production or shipment of the products
incorporating the Companys technology, which could have a
material adverse effect on the Companys operating results.



| |                                                                        
| | -----------------------------------------------------------------------
| | Peerless licensing revenue is subject to
    significant fluctuations.

The Companys recurring licensing revenue
model has shifted from per-unit royalties paid upon OEM shipment
of its product and guaranteed quarterly minimum royalties to a
model that results in revenues associated with the sale of SDKs
and block licenses. The reliance on block licenses has occurred
due to aging OEM products in the marketplace, OEM demands in
negotiating licensing agreements, reductions in the number of
OEM products shipping and a design win mix that changed from
object code licensing arrangements to SDKs. Revenues may
continue to fluctuate significantly from quarter to quarter as
the number and value of design wins vary, or if the signing of
block licenses are delayed or the licensing opportunities are
lost to competitors. Any of these factors could have a material
adverse effect on the Companys operating results.



| |                                                                                            
| | -------------------------------------------------------------------------------------------
| | The Companys revenue from engineering
    services is subject to significant fluctuations.

Peerless has experienced a significant reduction
in the financial performance of its engineering services that
has been caused by many factors, including:



| |   |                                                                                                                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | product development delays (see Peerless
    must adapt to technology trends and evolving industry standards
    or the Company will not be competitive above);                                                                                             
|
| |  | potential non-recurring engineering reduction for
    product customization (see The Companys near term
    revenue from engineering services may drop as the Company may
    change its strategies in how it offers its products in the
    marketplace.);

22



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##### Table of Contents





| |   |                                            
| | - | -------------------------------------------
| |  | third party delays; and                    
|
| |  | loss of new engineering services contracts.

There can be no assurance that these and similar
factors will not continue to impact future engineering services
results adversely.



| |                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------
| | Peerless may be unable to deploy the
    Companys employees effectively in connection with changing
    demands from the Companys OEM customers.

The industry in which Peerless operates has
experienced significant downturns, both in the United States and
abroad, often in connection with, or in anticipation of,
maturing product cycles and declines in general economic
conditions. Over the past two years, Peerless has experienced a
shift in OEM demand from the historically prevailing requirement
for turnkey solutions toward SDKs. Because Peerless has
experienced a general decrease in demand for engineering
services, engineering services resources have been re-deployed
to research and development. Should this trend abruptly change,
Peerless may be unable to re-deploy labor effectively and in a
timely manner, which inability could have a material adverse
effect on the Companys operational results.



| |                                                                       
| | ----------------------------------------------------------------------
| | Peerless may be unable to implement its
    business plan effectively.

The Companys ability to implement the
Companys business plan, develop and offer products and
manage expansion in rapidly developing and disparate
marketplaces requires comprehensive and effective planning and
management. The growth in the complexity of business
relationships with current and potential customers and third
parties has placed, and will continue to place, a significant
strain on management systems and resources. The Companys
failure to continue to improve upon the operational, managerial
and financial controls, reporting systems and procedures in its
imaging business or the Companys failure to expand and
manage its workforce could have a material adverse effect on the
Companys business and financial results.






|        |           
|------- | ----------
|Item 2. | Properties

The Company leases its principal facilities in El
Segundo, California. The operating lease, as amended, expires in
December 2007. The Company also leases office space in Kent,
Washington for PSIP and in Japan. The lease on the Kent property
expires in May 2005. The lease on the Japan property expires in
May 2004. The Company believes that its existing leased space is
adequate for its current operations and that suitable
replacement and additional space will be available in the future
on commercially reasonable terms. In March 2004, the Company
terminated a lease due to expire in May 2004 for leased space in
Redwood City, CA, which was in excess of the Companys
needs.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

None.






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

No matters were submitted to a vote of the
Companys stockholders during the fourth quarter of fiscal
year 2004.

23



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##### Table of Contents






PART II






|        |                                                                                                                     
|------- | --------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity,
    Related Stockholder Matters and Issuer Purchases of Equity
    Securities

The Companys common stock has been traded
on the Nasdaq National Market under the symbol PRLS
since its initial public offering on September 26, 1996.
The table below sets forth, during the periods indicated, the
high and low sales price for the Companys common stock as
reported on the Nasdaq National Market.

|        |  |                               |      |      |  |      |      |     |  |   |      |  |  |   |      | 
|------- |  | ----------------------------- | ---- | ---- |  | ---- | ---- | --- |  | - | ---- |  |  | - | ---- | 
|        |  |                              
|        |  | Fiscal Year Ended January 31,
|        |  |                              
|        |  |                               |      |     
|        |  | 2004                          |      | 2003
|        |  |                               |      |     
|Quarter |  | High                          |      | Low  |  | High |      | Low
|        |  |                               |      |      |  |      |      |    
|First   |  | $                             | 2.12 |      |  | $    | 1.36 |     |  | $ | 1.93 |  |  | $ | 0.86 | 
|Second  |  | $                             | 3.33 |      |  | $    | 1.43 |     |  | $ | 1.95 |  |  | $ | 1.01 | 
|Third   |  | $                             | 4.00 |      |  | $    | 2.75 |     |  | $ | 1.42 |  |  | $ | 0.72 | 
|Fourth  |  | $                             | 3.70 |      |  | $    | 1.91 |     |  | $ | 1.63 |  |  | $ | 0.97 | 

The closing price of the Companys common
stock on April 23, 2004 was $1.87. As of April 23,
2004, there were approximately 140 holders of record of the
Companys common stock.

Dividend Policy

The Company has not declared or paid any cash
dividends on its common stock during any period for which
financial information is provided in this Annual Report on
Form 10-K. The Company currently intends to retain future
earnings, if any, to fund the development and growth of its
business and does not anticipate paying any cash dividends on
its common stock in the foreseeable future.






|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

The statement of operations data for the fiscal
years ended January 31, 2004, 2003, and 2002 and the
balance sheet data at January 31, 2004 and 2003, are
derived from, and should be read in conjunction with, the
audited consolidated financial statements and notes thereto
included elsewhere in this Annual Report on Form 10-K. The
data set forth below (in thousands, except per share data) are
qualified in their entirety by, and should be read in
conjunction with, Managements Discussion and
Analysis of Financial Condition and Results of Operations
and the audited consolidated financial statements and notes
thereto included elsewhere in this Annual Report on
Form 10-K.

|                                  |  |                         |        |      |  |      |        |      |  |      |         |   |  |   |         |   |  |   |        | 
|--------------------------------- |  | ----------------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------- | - |  | - | ------- | - |  | - | ------ | 
|                                  |  |                        
|                                  |  | Years Ended January 31,
|                                  |  |                        
|                                  |  | 2004                    |        | 2003 |  | 2002 |        | 2001 |  | 2000
|                                  |  |                         |        |      |  |      |        |      |  |     
|Statement of Operations Data:     |  |                         |        |      |  |      |        |      |  |      |         |   |  |   |         |   |  |   |        | 
|Net sales                         |  | $                       | 25,254 |      |  | $    | 31,757 |      |  | $    | 29,767  |   |  | $ | 27,407  |   |  | $ | 42,076 | 
|Income (loss) from operations     |  |                         | (5,793 | )    |  |      | 240    |      |  |      | (9,948  | ) |  |   | (17,228 | ) |  |   | 4,133  | 
|Net income (loss)                 |  |                         | (4,861 | )    |  |      | 124    |      |  |      | (10,997 | ) |  |   | (17,649 | ) |  |   | 3,441  | 
|Basic earnings (loss) per share   |  |                         | (0.31  | )    |  |      | 0.01   |      |  |      | (0.73   | ) |  |   | (1.19   | ) |  |   | 0.25   | 
|Diluted earnings (loss) per share |  |                         | (0.31  | )    |  |      | 0.01   |      |  |      | (0.73   | ) |  |   | (1.19   | ) |  |   | 0.22   | 

|                      |  |                         |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|--------------------- |  | ----------------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ |  |  | - | ------ | 
|                      |  |                        
|                      |  | Years Ended January 31,
|                      |  |                        
|                      |  | 2004                    |        | 2003 |  | 2002 |        | 2001 |  | 2000
|                      |  |                         |        |      |  |      |        |      |  |     
|Balance Sheet Data:   |  |                         |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|Total assets          |  | $                       | 19,307 |      |  | $    | 24,107 |      |  | $    | 24,934 |  |  | $ | 37,108 |  |  | $ | 52,565 | 
|Long-term obligations |  |                         | 366    |      |  |      | 1,384  |      |  |      | 2,181  |  |  |   | 2,357  |  |  |   | 3,165  | 

24



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Selected Quarterly Financial Data
(Unaudited):

|                                  |  |                             |       |                             |  |         |        |        |  |        |        |       |  |        |        |       |  |   |       |   |  |   |       |   |  |   |        |   |  |   |       |  
|--------------------------------- |  | --------------------------- | ----- | --------------------------- |  | ------- | ------ | ------ |  | ------ | ------ | ----- |  | ------ | ------ | ----- |  | - | ----- | - |  | - | ----- | - |  | - | ------ | - |  | - | ----- | -
|                                  |  |                             |       |                            
|                                  |  | Year Ended January 31, 2004 |       | Year Ended January 31, 2003
|                                  |  |                             |       |                            
|Quarter                           |  | Fourth                      |       | Third                       |  | Second* |        | First* |  | Fourth |        | Third |  | Second |        | First
|                                  |  |                             |       |                             |  |         |        |        |  |        |        |       |  |        |        |      
|Revenues                          |  | $                           | 7,653 |                             |  | $       | 5,762  |        |  | $      | 6,152  |       |  | $      | 5,687  |       |  | $ | 8,290 |   |  | $ | 7,776 |   |  | $ | 7,092  |   |  | $ | 8,599 |  
|Gross margin                      |  |                             | 5,751 |                             |  |         | 3,004  |        |  |        | 3,126  |       |  |        | 3,037  |       |  |   | 5,559 |   |  |   | 4,973 |   |  |   | 4,087  |   |  |   | 5,066 |  
|Gross margin %                    |  |                             | 75.15 | %                           |  |         | 52.13  | %      |  |        | 50.81  | %     |  |        | 53.40  | %     |  |   | 67.06 | % |  |   | 63.95 | % |  |   | 57.63  | % |  |   | 58.91 | %
|Income (loss) from operations     |  | $                           | 800   |                             |  | $       | (2,648 | )      |  | $      | (2,522 | )     |  | $      | (1,423 | )     |  | $ | 748   |   |  | $ | 339   |   |  | $ | (1,039 | ) |  | $ | 192   |  
|Net income (loss)                 |  |                             | 643   |                             |  |         | (2,527 | )      |  |        | (2,797 | )     |  |        | (180   | )     |  |   | 528   |   |  |   | 180   |   |  |   | (1,162 | ) |  |   | 578   |  
|Basic earnings (loss) per share   |  |                             | 0.04  |                             |  |         | (0.16  | )      |  |        | (0.18  | )     |  |        | (0.01  | )     |  |   | 0.03  |   |  |   | 0.01  |   |  |   | (0.08  | ) |  |   | 0.04  |  
|Diluted earnings (loss) per share |  |                             | 0.04  |                             |  |         | (0.16  | )      |  |        | (0.18  | )     |  |        | (0.01  | )     |  |   | 0.03  |   |  |   | 0.01  |   |  |   | (0.08  | ) |  |   | 0.04  |  



---



|  |                                                                                                                                                                                            
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | The Company has reclassified the amounts of $138
    and $23 in the second and first quarter, respectively, from cost
    of revenues to operating expenses  research and
    development.






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis of
    Financial Condition and Results of Operations

The following analysis contains forward-looking
statements that involve risks and uncertainties. The statements
contained in this Annual Report on Form 10-K that are not
purely historical are 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,
including without limitation, statements regarding the
Companys expectations, beliefs, intentions or strategies
regarding the future. All forward-looking statements included in
this Annual Report on Form 10-K are based on current
expectations, estimates, forecasts and projections about the
industry in which Peerless operates, managements beliefs
and assumptions made by management. These statements are not
guarantees of future performance and involve certain known and
unknown risks, uncertainties and assumptions that are difficult
to predict. Therefore, actual outcomes and results may differ
materially from what is expressed or forecasted in such
forward-looking statements. The Company undertakes no obligation
to update publicly any forward-looking statements, whether as a
result of new information, future events or otherwise. For a
discussion of factors and trends that could impact the
Companys business and results, please refer to the section
above entitled Certain Factors and Trends Affecting
Peerless and Its Business.

The following should be read in conjunction with
the audited consolidated financial statements and related notes
thereto contained in this Annual Report on Form 10-K.

Highlights

Consolidated revenues for fiscal year 2004 were
$25.3 million, a 20.4% decrease from the prior fiscal year.
The decrease in revenues was primarily attributable to lower
product licensing fees and engineering services revenues, which
was partially offset by an increase in revenue from the
Companys application specific integrated circuits (ASICs).
Product licensing revenues decreased as a result of decreased
demand for OEMs products containing the Companys
technologies, which resulted from the shift in demand from
monochrome to color technologies and with OEMs developing their
own solutions in monochrome product offerings. Engineering
services revenues also decreased in fiscal year 2004 due to lack
of expected design wins. Product licensing revenues for fiscal
year 2004 were $19.9 million, including $16.0 million
of block licenses, a decrease of 19.8% from the previous fiscal
year. Thirteen block licensing agreements totaling
$9.4 million were signed during fiscal year 2004, all of
which was recognized as revenue during fiscal year 2004. This
last fiscal year the Company has been presenting its new color
technologies to its customers. Although there have been no
design wins as of January 31, 2004, the Company has been
engaged with a number of OEMs that are looking at the
application of the Companys Peerless Sierra
Technologiesin a number of specific products. The Company
believes that, if it is able to successfully launch its high
performance MFP color controller in May 2004, there will be a
validation of the Companys color offering, which will
facilitate future OEM design wins.

Engineering services and maintenance contract
backlog at January 31, 2004 approximated $0.4 million;
this compares to $1.4 million as of January 31, 2003,
reflecting the lack of design wins in fiscal year 2004.

25



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##### Table of Contents



On February 20, 2003, the Company announced
the sale of its remaining interest in Netreon. As a result of
the sale, the Company recorded in other income a gain of
$971,000, net of expenses, associated with this transaction in
the first quarter of fiscal year 2004. The Company had announced
the divestiture of its Netreon storage management operations on
January 31, 2002, effective January 29, 2002. Peerless
retained the networking technology obtained from the
Companys 1999 acquisition of Netreon for continuing
integration into Peerless core document imaging products.
As a result of the divestiture, the Company experienced a
decline in operating expenses of approximately 30% in fiscal
year 2003 from levels experienced during fiscal year 2002.
Because the effective date of the divestiture so closely
approximated the Companys year end, the fiscal year 2002
consolidated results of operations included Netreons
results for the entire year.

During fiscal year 2004, the Company continued to
improve on and support its core monochrome imaging operations
and technologies; however, the Company also continued to
increase its focus on developing its new high performance color
architecture  Peerless Sierra Technologies.
The Company believes that on a going forward basis revenue
generated from the Companys Peerless Sierra
Technologieswill begin to increase as a percentage of total
revenue.

General

The Company generates revenue from its OEMs
through the sale of imaging solutions in either turnkey or SDK
form. Historically, OEM demand for turnkey solutions had
exceeded demand for SDK solutions. However, in the fiscal year
2000, the Company experienced a shift in demand away from
turnkey solutions towards demand for the Companys SDKs,
particularly for its mature monochrome solutions. The Company
has attempted to expand its high performance color solutions, by
seamlessly incorporating the Companys networking
technologies and related imaging technologies licensed from
third parties.

The Companys product licensing revenues are
comprised of both recurring per unit and block licensing
revenues and development licensing fees for source code or SDKs.
Licensing revenues are derived from per unit fees paid
periodically by the Companys OEM customers upon
manufacturing and subsequent commercial shipment of products
incorporating the Companys technology. Licensing revenues
are also derived from arrangements in which the Company enables
third party technology, such as solutions from Adobe or Novell,
to be used with the Company and/or OEM products.

Block licenses are per-unit licenses made in
large volume quantities to an OEM for products either in or
about to enter into distribution into the marketplace. Payment
schedules for block licenses are negotiable and payment terms
are often dependent on the size of the block and other terms and
conditions of the block license being acquired. Typically,
payments are made in either one lump sum or over a period of
four or more quarters.

Revenue received for block licenses is recognized
in accordance with SOP 97-2, which requires that revenue be
recognized after acceptance by the OEM and if fees are fixed and
determinable and the collection of fees is probable. For block
licenses that have a significant portion of the payments due
within twelve months, revenue is recognized at the time the
block license becomes effective.

The Company also has engineering services
revenues that are derived primarily from adapting the
Companys software and supporting electronics to specific
OEM requirements. The Company provides its engineering services
to OEMs seeking a turnkey imaging solution for their digital
document products. The Companys maintenance revenues are
derived from software maintenance agreements. Maintenance
revenues currently constitute a small portion of total revenue.

As part of the total solution offered to its
OEMs, the Company developed a direct distribution channel for
its ASIC chips. Under this fabless model, Peerless
supplies ASIC chips from the foundry directly to the OEMs
through third party distributors, which include Arrow
Electronics and Marubun Corporation. The Company is responsible
for marketing and sales administration, including the billings
and collections to and from its OEMs and distributors, and the
third party is responsible for the coordination of production
with the foundry, maintenance of necessary inventories, and
providing just-in-time delivery to OEMs and distributors.

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Historically, a limited number of customers have
provided a substantial portion of the Companys revenues.
Therefore, the availability and successful closing of new
contracts, or modifications and additions to existing contracts
with these customers may materially impact the Companys
financial position and results of operations from quarter to
quarter.

Peerless technology has addressed the
worldwide market for monochrome printers (21-69 pages per
minute, or PPM) and MFP (21-110 PPM). This market
has been consolidating, and the demand for the monochrome
technology and products offered by the Company declined
throughout fiscal year 2004. The Company believes that unit
volume for these types of printers will grow at lower rates than
in past years. Available data indicate that retail prices are
declining in these segments. There has been a decline in the
number of monochrome contracts that the Company has with OEMs
under which the Company is currently performing services and
granting licenses, and this decline is likely to continue along
with the demand for the monochrome technology and products the
Company presently offers. Competitors have merged into larger
business units with the resulting strength to acquire and impose
a competitive advantage in the Companys market segments.

Sales decreased during fiscal year 2004, as the
Company is continuing to meet sales resistance from its
customers. In the past, OEMs have reduced the absolute number of
new products being developed and in some instances, OEMs have
preferred to perform in-house development projects for the
products that they are developing and/or planning to launch.
Although there have been fewer opportunities for the Company to
sell its turnkey services and SDKs, the Company continued to
support its current OEM controller customers in the digital
printing devices business with its existing technology and has
sized the organization to provide the necessary support and
maintenance.

In response to the Companys belief that the
demand for the Companys core monochrome offerings may grow
at lower rates than in past years and that the Company may
continue to meet sales resistance from its customers, Peerless
has recently developed and commercialized high performance color
imaging and printing technologies and a new open architecture
named Peerless Sierra Technologies. Peerless
believes that products based on its Peerless Sierra
Technologiesaddress key growth areas in the imaging market
including: increased demand for color imaging, the emergence of
MFPs, and continued demand for faster low cost monochrome
printing solutions, to which many of the Peerless Sierra
Technologiesattributes are applicable.

During the last fiscal year, Peerless introduced
Peerless Sierra Technologiesat trade shows in the United
States and demonstrated it in Japan. Peerless believes that
Peerless Sierra Technologieswill increase the
Companys future license revenues if the Company is able to
successfully introduce it into the marketplace and the Company
begins sale of this technology. Peerless believes that the
launch of its high performance color MFP controller into the
distribution channels will be followed by sales to OEMs for
utilization of its high performance color technology, with
licensing revenues beginning in early fiscal year 2006. See,
however, If the Company is unable to sell the new
Peerless Sierra Technologieson a timely basis, the
Companys future revenue and operating results may be
harmed and If the marketplace does not accept
Peerless new Peerless Sierra Technologies, the
Companys future revenues and operating results may be
harmed in the section entitled Certain Factors and
Trends Affecting Peerless and Its Business of this Annual
Report on Form 10-K. Peerless believes that its new
Peerless Sierra Technologieswill contribute an
increasing percentage of the Companys overall revenue in
the future.

The Company has addressed the deterioration in
the demand for its solutions by investing in leading edge
technologies, by sizing its organization to manage the current
business requirements of imaging for digital document products
and has adapted its pricing model to changing market conditions.
The Company has also addressed the deterioration in revenues by
expanding its offerings in new geographic regions and in
distribution channels.

In addition, as a result of the decline in the
embedded controller business, the Company is exploring
opportunities to enhance the value of the Company, including new
market opportunities, mergers, acquisitions, spin-offs and/or
the sale of all or a portion of Companys assets.

27



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##### Table of Contents



Critical Accounting Policies

Managements Discussion and Analysis of
Financial Condition and Results of Operations addresses the
Companys consolidated financial statements, which have
been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these
financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets and
liabilities and the 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. On an on-going basis, management evaluates its estimates
and judgments. Management bases its estimates and judgments on
historical experience and on various other factors that are
believed to be reasonable under the circumstances, the results
of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent
from other sources. Actual results may differ from these
estimates under different assumptions or conditions.

Management believes the following critical
accounting policies, among others, affect its more significant
judgments and estimates used in the preparation of its
consolidated financial statements.

The Company accounts for its software revenues in
accordance with Statement of Position (SOP) 97-2,
Software Revenue Recognition as amended by
SOP 98-9, Staff Accounting Bulletin No. 104,
Revenue Recognition and Emerging Issues Task Force
99-19, Reporting Revenue Gross as a Principal versus Net
as an Agent. Over the past two years, the Company entered
into block license agreements that represent unit licenses for
products that will be licensed over a period of time. In
accordance with SOP 97-2, revenue is recognized when the
following attributes have been met: 1) an agreement exists
between the Company and the OEM selling product utilizing the
Companys intellectual property and/or a third partys
intellectual property for which Peerless is an authorized
licensor, 2) delivery and acceptance of the intellectual
property has occurred, 3) the fees associated with the sale
are fixed and determinable and 4) collection of the fees
are probable. Under the Companys accounting policies, fees
are fixed and determinable if 90% of the fees are to be
collected within a twelve-month period, in accordance with
SOP 97-2. If more than 10% of the payments of fees extend
beyond a twelve-month period, they are recognized as revenues
when they are due for payment, in accordance with SOP 97-2.
As of January 31, 2004, the Company had no such revenues to
be recognized in future periods.

The Company recognizes revenues for certain of
its engineering services projects on a percentage-of-completion
basis, in accordance with Accounting Research Bulletin 45,
Long-Term Construction-Type Contracts and
SOP 81-1, Accounting for Performance of
Construction-Type and Certain Production-Type Contracts.
The estimates to complete the projects are determined by the
individual project-engineering manager responsible for the
oversight of the individual projects. The estimates are made at
end of each accounting period and are subject to unforeseen
circumstances that can increase or decrease the hours necessary
to complete the efforts. For fiscal year 2004, the Company
reported no engineering services revenues on a
percentage-of-completion basis.

The Company provides an accrual for estimated
product licensing costs owed to third party vendors whose
technology is included in the products sold by the Company. The
accrual is impacted by estimates of the mix of products shipped
under certain of the Companys block license agreements.
The estimates are based on historical data and available
information as provided by the Companys customers
concerning projected shipments. Should actual shipments under
these agreements vary from these estimates, adjustments to the
estimated accruals for product licensing costs may be required.
Such losses have historically been within managements
expectations.

As of January 31, 2004, the Company had net
operating loss carryforwards available to reduce future federal
and state income of approximately $7.0 million and
$6.4 million, respectively, which expire through fiscal
years 2022 for federal and 2013 for state, respectively. In
addition, as of January 31, 2004, the Company had tax
credit carryforwards available to reduce future income tax
liabilities of approximately $6.9 million, which expire
between fiscal years 2005 and 2023. The realization of these
assets is based upon managements estimates of future
taxable income. The Company has provided a valuation allowance
for all of its net deferred tax assets because of the
uncertainty with respect to the Companys ability to
generate future taxable income

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to realize the deferred tax assets. With a change
in managements assessment of the uncertainty, the
valuation allowance will be adjusted accordingly.


The Company grants credit terms in the normal
course of business to its customers. The Company continuously
monitors collections and payments from its customers and
maintains allowances for doubtful accounts for estimated losses
resulting from the inability of any customers to make required
payments. Estimated losses are based primarily on specifically
identified customer collection issues. If the financial
condition of any of the Companys customers, or the economy
as a whole, were to deteriorate, resulting in an impairment of
their ability to make payments, additional allowances may be
required. Such losses have historically been within
managements expectations.

The Companys recurring product licensing
revenues are dependent, in part, on the timing and accuracy of
product sales reports received from the Companys OEM
customers. These reports are provided only on a calendar quarter
basis and, in any event, are subject to delay and potential
revision by the OEM. Therefore, the Company is required to
estimate all of the recurring product licensing revenues for the
last month of each fiscal quarter and to further estimate all of
its quarterly revenues from an OEM when the report from such OEM
is not received in a timely manner. In the event the Company is
unable to estimate such revenues accurately prior to reporting
financial results, the Company may be required to adjust
revenues in subsequent periods. Fiscal year 2004 revenues
subject to such estimates were minimal. Actual results have
historically been consistent with managements estimates.

Results of Operations

The following table sets forth, for the periods
indicated, the percentage relationship of certain items from the
Companys statements of operations to total revenues.

|                               |                     |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |   |     |     |    | 
|------------------------------ | ------------------- | ------------------------------------ | ------------------------ | ----------------- | -- | -------- | -- | ---- | -- | ---- | -- |  | -- | --- | -- |  | --- | --- | --- | - | --- | --- | -- | 
|                               |                     |                                      |                          |                   |    |          |    |     
|                               |                     |                                      |                          | Percentage Change
|                               |                     | Percentage of Total                  |                          | Years Ended      
|                               |                     | Revenues Years Ended                 |                          | January 31,      
|                               |                     | January 31,                          |                          |                  
|                               |                     |                                      |                          | 2004 vs.          |    | 2003 vs.
|                               |                     | 2004                                 |                          | 2003              |    | 2002     |    | 2003 |    | 2002
|                               |                     |                                      |                          |                   |    |          |    |      |    |     
|Statements of Operations Data: |                     |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |  
|                               | Revenues:           |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |   |    
|                               |                     | Product licensing                    |                          |                   | 79 | %        |    |      | 78 | %    |    |  | 73 | %   |    |  | (20 | )%  |     |   | 15  | %  
|                               |                     | Engineering services and maintenance |                          |                   | 13 |          |    |      | 16 |      |    |  | 21 |     |    |  | (37 | )   |     |   | (18 | )  
|                               |                     | Other                                |                          |                   | 8  |          |    |      | 6  |      |    |  | 6  |     |    |  | 16  |     |     |   | (9  | )  
|                               |                     |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |  
|                               |                     |                                      | Total revenues           |                   |    | 100      |    |      |    | 100  |    |  |    | 100 |    |  |     | (20 | )   |   |     | (7  | ) 
|                               | Cost of revenues:   |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |   |    
|                               |                     | Product licensing                    |                          |                   | 25 |          |    |      | 26 |      |    |  | 21 |     |    |  | (23 | )   |     |   | 31  |    
|                               |                     | Engineering services and maintenance |                          |                   | 12 |          |    |      | 9  |      |    |  | 19 |     |    |  | 8   |     |     |   | (50 | )  
|                               |                     | Other                                |                          |                   | 4  |          |    |      | 3  |      |    |  | 4  |     |    |  | (4  | )   |     |   | (19 | )  
|                               |                     |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |  
|                               |                     |                                      | Total cost of revenues   |                   |    | 41       |    |      |    | 38   |    |  |    | 44  |    |  |     | (14 | )   |   |     | (9  | ) 
|                               |                     |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |  
|                               |                     |                                      |                          | Gross margin      |    |          | 59 |      |    |      | 62 |  |    |     | 56 |  |     |     | (24 | ) |     |     | 19 | 
|                               |                     |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |  
|                               | Operating expenses: |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |   |    
|                               |                     | Research and development             |                          |                   | 47 |          |    |      | 31 |      |    |  | 46 |     |    |  | 21  |     |     |   | (28 | )  
|                               |                     | Sales and marketing                  |                          |                   | 18 |          |    |      | 14 |      |    |  | 20 |     |    |  |    |     |     |   | (24 | )  
|                               |                     | General and administrative           |                          |                   | 17 |          |    |      | 16 |      |    |  | 23 |     |    |  | (14 | )   |     |   | (25 | )  
|                               |                     |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |  
|                               |                     |                                      | Total operating expenses |                   |    | 82       |    |      |    | 61   |    |  |    | 89  |    |  |     | 7   |     |   |     | (27 | ) 
|                               |                     |                                      |                          |                   |    |          |    |      |    |      |    |  |    |     |    |  |     |     |     |  

29



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##### Table of Contents



|                                          |  |                      |     |                   |  |          |   |      |  |      |     |    |  |  |      |   |  |  |      |   
|----------------------------------------- |  | -------------------- | --- | ----------------- |  | -------- | - | ---- |  | ---- | --- | -- |  |  | ---- | - |  |  | ---- | --
|                                          |  |                      |     |                   |  |          |   |     
|                                          |  |                      |     | Percentage Change
|                                          |  | Percentage of Total  |     | Years Ended      
|                                          |  | Revenues Years Ended |     | January 31,      
|                                          |  | January 31,          |     |                  
|                                          |  |                      |     | 2004 vs.          |  | 2003 vs.
|                                          |  | 2004                 |     | 2003              |  | 2002     |   | 2003 |  | 2002
|                                          |  |                      |     |                   |  |          |   |      |  |     
|Income (loss) from operations             |  |                      | (23 | )                 |  |          | 1 |      |  |      | (33 | )  |  |  | *    |   |  |  | (102 | ) 
|Other income                              |  |                      | 6   |                   |  |          |  |      |  |      | 8   |    |  |  | *    |   |  |  | *    |   
|Loss on divestiture of storage operations |  |                      |    |                   |  |          |  |      |  |      | (8  | )  |  |  | *    |   |  |  | *    |   
|Interest income, net                      |  |                      | 1   |                   |  |          | 1 |      |  |      | 2   |    |  |  | (63  | ) |  |  | (50  | ) 
|                                          |  |                      |     |                   |  |          |   |      |  |      |     |    |  |  |      |   |  |  |      |   
|Income (loss) before income taxes         |  |                      | 7   |                   |  |          | 2 |      |  |      | (31 | )  |  |  | (778 | ) |  |  | (107 | ) 
|Provision for income taxes                |  |                      | 3   |                   |  |          | 2 |      |  |      | 6   |    |  |  | 42   |   |  |  | (73  | ) 
|                                          |  |                      |     |                   |  |          |   |      |  |      |     |    |  |  |      |   |  |  |      |   
|Net income (loss)                         |  |                      | (19 | )%                |  |          | 0 | %    |  |      | (37 | )% |  |  | *    | % |  |  | (101 | )%
|                                          |  |                      |     |                   |  |          |   |      |  |      |     |    |  |  |      |   |  |  |      |   



---



|  |                                               
|- | ----------------------------------------------
|* | Percentage change calculations not meaningful.



| |           
| | ----------
| | Net Income

Net loss for the twelve month period ended
January 31, 2004 was $(4.9) million or $(0.31) per
basic and diluted share, compared to net income of
$0.1 million, or $0.01 per basic and diluted share, in
fiscal year 2003, and a net loss of $(11.0) million, or
$(0.73) per basic and diluted share, in fiscal year 2002.



| |         
| | --------
| | Revenues

Consolidated revenues for fiscal year 2004 were
$25.3 million, compared to $31.8 million in fiscal
year 2003, and $29.8 million in fiscal year 2002. The
decrease from fiscal year 2003 to fiscal year 2004 was primarily
attributable to decreased licensing and engineering services
revenues, which were partially offset by higher ASICs revenues.
The increase in fiscal year 2003 was generally attributable to
increased licensing revenues, which were partially offset by
lower engineering services and maintenance and ASICs revenues.

Product licensing revenues for fiscal year 2004
were $19.9 million, compared to $24.9 million in
fiscal year 2003, and $21.6 million in fiscal year 2002.
Block licensing agreements totaling $9.4 million were
signed during fiscal year 2004, all of which was recognized as
revenue during the year. This is compared with block licensing
agreements of $19.5 million signed in fiscal year 2003, of
which approximately $13.6 million was recognized as revenue
during fiscal year 2003, with the remaining $5.9 million
being recognized in the five quarters following the end of
fiscal year 2003. The decrease in product licensing revenue in
fiscal year 2004 is mainly attributable to the decrease in
demand for the OEMs products containing the Companys
core monochrome technology. The increase in product licensing
revenue in fiscal year 2003 compared to fiscal year 2002 was
mainly attributable to an increase in sales of third party
technology addressing OEM requirements.

Engineering services and maintenance revenues
generated by the Company were $3.2 million in fiscal year
2004, compared to $5.0 million in fiscal year 2003, and
$6.1 million in fiscal year 2002. The fiscal year 2003 and
2004 decreases were primarily the result of a lack of design
wins for the Companys Peerless Sierra Technologies.
Revenue generated by ASIC sales were $2.1 million in fiscal
year 2004, compared $1.9 million in fiscal year 2003, and
$2.0 million in fiscal year 2002. Contract and maintenance
backlog at January 31, 2004 was approximately
$0.4 million, as compared with $1.4 million at
January 31, 2003.



| |                 
| | ----------------
| | Cost of Revenues

Cost of revenues for fiscal year 2004 was
$10.3 million, compared to $12.1 million in fiscal
year 2003, and $13.2 million in fiscal year 2002. Product
licensing costs were $6.3 million in fiscal year 2004,
compared to $8.3 million in fiscal year 2003, and
$6.3 million in fiscal year 2002. The decrease from fiscal
year 2003 to fiscal year 2004 was primarily due to decreased
product licensing revenues, offset by an additional accrual for
settlement of certain third party licensing costs totaling
$0.5 million. The increase from fiscal year 2002 to fiscal
year 2003 was primarily due to increased product licensing
revenues and higher levels of third party technology content in
the products licensed in those revenues. Engineering services
and maintenance costs

30



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##### Table of Contents



decreased 50% in fiscal year 2003 from fiscal
year 2002, due to lower levels of revenues and improved
performance.




| |             
| | ------------
| | Gross Margin

Gross margin as a percentage of total revenues
was 59% in fiscal year 2004, compared to 62% in fiscal year
2003, and 56% in fiscal year 2002. The decrease in fiscal year
2004 was largely due to higher levels of product licensing costs
for third party technology associated with certain of the
Companys licensing revenues. The increase in fiscal year
2003 was largely due to increased product licensing fees and
engineering services margins, which improved to 44% in fiscal
year 2003 from 7% in fiscal year 2002, due to reduced costs for
engineering services.



| |                   
| | ------------------
| | Operating Expenses

Operating expenses for fiscal year 2004 were
$20.7 million, compared to $19.4 million in fiscal
year 2003, and $26.5 million in fiscal year 2002.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Research and development expenses were
    $11.8 million in fiscal year 2004, compared to
    $9.8 million in fiscal year 2003, and $13.6 million in
    fiscal year 2002. The increase in fiscal year 2004 was primarily
    due to higher staffing and consulting costs associated with the
    continued development of the Companys Peerless Sierra
    Technologies. The decrease in fiscal year 2003 was
    primarily due to the divestiture of Netreon.                                                                                                                                                                                                                                                                                                                         
|
| |  | Sales and marketing expenses were
    $4.5 million in fiscal year 2004, compared to
    $4.6 million in fiscal year 2003, and $6.0 million in
    fiscal year 2002. The decrease from fiscal year 2002 to fiscal
    year 2003 was also primarily due to the divestiture of Netreon.
    The Company continued to focus on the future launch of
    Peerless Sierra Technologiesand on developing new OEM
    customers, attending industry trade shows, and evaluating other
    opportunities to promote the Companys core and new color
    imaging and network solutions.                                                                                                                                                                                                           
|
| |  | General and administrative expenses were
    $4.4 million in fiscal year 2004, compared to
    $5.1 million in fiscal year 2003, and $6.9 million in
    fiscal year 2002. The decrease in fiscal year 2004 was primarily
    due to the reduction of consulting costs. In addition, during
    fiscal year 2004, the Company received a $0.2 million
    insurance refund for costs associated with completed legal
    proceedings. The decrease in fiscal year 2003 was due in large
    part to a recovery and reduction of legal expenses, a result of
    the successful resolution of litigation matters. Also included
    in the fiscal year 2003 was a write-off of approximately
    $0.7 million for the reduction in office space located at
    the Companys headquarters.



| |                                                          
| | ---------------------------------------------------------
| | Interest Income, Other Income and Expenses,
    and Taxes

Interest income earned in all fiscal years was
attributable to interest and investment income earned on cash
and cash equivalents and investment balances. The decreases in
both fiscal years 2004 and 2003 in interest income were due to
lower yields on a lower level of the Companys investments
in government and corporate bonds.

Included in other income in fiscal year 2004 was
$1.0 million from the Companys sale of its remaining
interest in Netreon, Inc., announced on February 20, 2003.
In addition, the Company recorded a gain of $0.6 million
associated with the termination of a sublease of a portion of
its leased office space at its headquarters in El Segundo,
California. Additionally, the Company recorded a $121,000 loss
for a correction to fiscal year 2002 reported accrued interest.
In fiscal year 2002, the Company resolved a disputed claim
regarding the licensing of its intellectual property and
reported non-recurring other income of $2.3 million and
collected a $1.5 million receivable. In addition, the
Company recorded a $2.3 million loss in connection with the
divestiture of the Netreon storage management operations.

The provisions for income taxes for all fiscal
years were primarily the result of foreign income taxes paid. In
fiscal year 2004, the foreign income taxes paid were offset by
the release of certain long-term tax liabilities. In fiscal year
2003, the foreign income taxes paid were offset by the
Companys receipt of a tax benefit of

31



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$0.6 million as a result of a change in the
tax code that allowed the Company to carry back losses to obtain
a tax refund. The Company has provided a valuation allowance on
its net deferred tax assets because of the uncertainty with
respect to the Companys ability to generate future taxable
income to realize the deferred tax assets.




| |                        
| | -----------------------
| | Contractual Obligations

The following table summarizes the Companys
significant contractual obligations at January 31, 2004,
and the effect such obligations are expected to have on the
Companys liquidity and cash flows in future periods. This
table excludes amounts already recorded on the Companys
consolidated balance sheets at January 31, 2004.

|                            |       |                        |       |           |  |           |       |           |  |         |       |       |  |   |       |       |  |   |   |   | 
|--------------------------- | ----- | ---------------------- | ----- | --------- |  | --------- | ----- | --------- |  | ------- | ----- | ----- |  | - | ----- | ----- |  | - | - | - | 
|                            |       |                       
|                            |       | Payments Due by Period
|                            |       |                       
|                            |       |                        |       | Less than |  |           |       | More than
|                            |       | Total                  |       | 1 Year    |  | 1-3 Years |       | 3-5 Years |  | 5 Years
|                            |       |                        |       |           |  |           |       |           |  |        
|Operating lease obligations |       | $                      | 4,882 |           |  | $         | 1,213 |           |  | $       | 2,492 |       |  | $ | 1,177 |       |  | $ |  |  
|Outstanding purchase orders |       |                        | 199   |           |  |           | 199   |           |  |         |      |       |  |   |      |       |  |   |  |  
|                            |       |                        |       |           |  |           |       |           |  |         |       |       |  |   |       |       |  |   |   |  
|                            | Total |                        | $     | 5,081     |  |           | $     | 1,412     |  |         | $     | 2,492 |  |   | $     | 1,177 |  |   | $ |  | 
|                            |       |                        |       |           |  |           |       |           |  |         |       |       |  |   |       |       |  |   |   |  

Liquidity and Capital Resources

The Companys principal source of liquidity
is its cash and cash equivalents and investments, which, as of
January 31, 2004 were $9.4 million in the aggregate.
For the twelve month period ended January 31, 2004, the
Company experienced substantial negative cash flow, primarily
the result of the net loss incurred during the year, and the
timing of collections of accounts receivable.

Compared to January 31, 2003, total assets
at January 31, 2004 decreased 20% to $19.3 million and
stockholders equity decreased 27% to $11.8 million.
The Companys cash and short-term investment portfolio was
$9.4 million at January 31, 2004, a decrease of 41%
from January 31, 2003. The decrease in the value of the
Companys investment portfolio was primarily due to the
negative cash flow resulting from the operating loss during
fiscal year 2004. The ratio of current assets to current
liabilities was 2.3:1 compared to 2.9:1 last year. The Company
used $9.7 million in cash during the twelve month period
ended January 31, 2004 from operations as compared to
$3.7 million in cash provided by operations during the
twelve month period ended January 31, 2003. This decrease
in cash was primarily due to the Companys loss from
operations.

The Companys investing activities during
the fiscal year ended January 31, 2004 resulted in a net
use of cash of $37,000. It is the Companys policy to
invest the majority of its unused cash in low risk government
and commercial debt securities. The Company has not historically
purchased derivative instruments or entered into hedging
transactions. For the twelve month period ended January 31,
2004, the Company invested approximately $0.4 million in
property, equipment and leasehold improvements compared to
$0.2 million during the previous twelve month period.

During fiscal year 2004, $0.4 million was
provided by the issuance of common stock under the
Companys employee stock purchase plan and exercise of
stock options. Net cash provided by financing activities was
$0.4 million during fiscal year 2004 and $0.1 million
in fiscal year 2003.

During the twelve month period ended
January 31, 2004, cash and investments decreased by
$8.6 million compared to a $3.4 million increase in
the prior fiscal year. The decrease in fiscal year 2004 was
primarily due to operating losses during fiscal year 2004 and
the timing of licensing collections, and the increase in fiscal
year 2003 was primarily due to profitable operations and the
lowering of days sales outstanding due to the timing of license
collections.

At January 31, 2004, net trade receivables
were $4.1 million higher than at January 31, 2003, due
primarily to the timing of the signing of new licensing
agreements at the end of fiscal year 2004. In fiscal year 2003,
the Company increased its efforts to collect accounts receivable
in a timely manner. As a result of these increased efforts, the
Company had a $3.1 million reduction in current net trade
receivables.

32



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The Company does not have a credit facility;
however, it is exploring opportunities to obtain a line of
credit for short-term financing in order to provide for working
capital needs associated with the expected launch of its channel
product in the second quarter of fiscal year 2005 and to avoid
disruptions of its current investment levels.

The Company expects cash and investments will
decrease during fiscal year 2005 to approximately
$3.0 million by the end of this years third quarter.
Although the Company expects the cash position to increase
thereafter with the expected sales growth associated with the
Peerless Sierra Technologies, there can be no assurances
that the Company will experience the anticipated increase in the
Peerless Sierra Technologiessales in the fourth quarter
or at all. The Company expects to reduce operating expenses in
the second quarter as a result of completion of the majority of
the Peerless Sierra Technologiesdevelopment effort.
However, if the remaining development costs are higher than
expected or the anticipated level of Peerless Sierra
Technologiessales is lower than anticipated and the Company
is unable to further reduce its operating expenses, the Company
may need to take significant measures to preserve and maintain
continued business operations. In such event, the Company may
need to further reduce costs and may have to access to the
capital markets to raise additional funding. There is no
assurance that the Company would be successful in raising
capital at attractive terms or at all, and should the Company be
successful in raising capital, the financing may be dilutive to
current shareholders.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk

As of January 31, 2004, the Company does not
hold any positions in equity securities of other publicly traded
companies.

The Companys exposure to interest rate risk
relates primarily to the Companys non-equity investment
portfolio. The primary objectives of the Companys
investment activities are to preserve the principal while at the
same time maximizing yields without significantly increasing
risk. To achieve this objective, the Company from time to time
maintains a portfolio of cash equivalents, fixed rate debt
instruments of the federal, state, and local governments and
high-quality corporate issuers and short-term investments in
money market funds. As discussed in Note 3 of the Notes to
Consolidated Financial Statements in this Annual Report on
Form 10-K, as of January 31, 2004, the Company held
approximately $1.6 million in debt securities issued by the
federal, state, and local governments and $2.7 million in
corporate debt securities. Although the Company is subject to
interest rate risks in these investments, the Company believes
an effective increase or decrease of 10% in interest rate
percentages would not have a material adverse effect on its
results from operations. Consequently, the Companys
interest rate risk is minimal.

The Company has not entered into any derivative
financial instruments. Currently all of the Companys
contracts, including those involving foreign entities, are
denominated in U.S. dollars and as a result, the Company
has experienced no significant foreign exchange gains and losses
to date. The Company has not engaged in foreign currency hedging
activities to date, and has no intention of doing so.






|        |                                                             
|------- | ------------------------------------------------------------
|Item 8. | Consolidated Financial Statements and
    Supplementary Data

See Index to Financial Statements on page F-1.






|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with Accountants
    on Accounting and Financial Disclosure

None.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

The Company maintains disclosure controls and
procedures that are designed to ensure that information required
to be disclosed in the its Exchange Act reports is recorded,
processed, summarized and reported within the time periods
specified in the SECs rules and forms, and that such
information is accumulated and communicated to Peerless
management, including the Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions
regarding required disclosure. In designing and evaluating the
disclosure

33



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##### Table of Contents



controls and procedures, management recognized
that any controls and procedures, no matter how well designed
and operated, can provide only reasonable assurance of achieving
the desired control objectives, and management necessarily was
required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.


As required by Rule 13(a)-15(b) under the
Securities Exchange Act of 1934, the Company carried out an
evaluation, under the supervision and with the participation of
management, including the Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and
operation of the disclosure controls and procedures. Based on
the foregoing, the Chief Executive Officer and Chief Financial
Officer concluded that, as of end of the period covered by this
report, the Companys disclosure controls and procedures
were effective at the reasonable assurance level.

There have been no significant changes in the
Companys internal controls or in other factors that could
significantly affect the internal controls subsequent to the
date the Company completed its evaluation.

34



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##### Table of Contents






PART III






|         |                                 
|-------- | --------------------------------
|Item 10. | Directors and Executive Officers

The information required by this Item is
incorporated by reference to the Peerless Proxy Statement.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required by this Item is
incorporated by reference to the Peerless Proxy Statement.






|         |                                                                                                   
|-------- | --------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder Matters

The information required by this Item is
incorporated by reference to the Peerless Proxy Statement.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required by this Item is
incorporated by reference to the Peerless Proxy Statement.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accounting Fees and
    Services

The information required by this Item is
incorporated by reference to the Peerless Proxy Statement.

35



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##### Table of Contents






PART IV






|         |                                                                    
|-------- | -------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K

(a)Documents filed as a part of this
Annual Report on Form 10-K:



| |                         
| | ------------------------
| | (1)Financial Statements:

|                                                      |  |      |     | 
|----------------------------------------------------- |  | ---- | --- | 
|                                                      |  | Page
|                                                      |  |     
|Report of Ernst & Young LLP, Independent
    Auditors |  |      | F-2 | 
|Consolidated Statements of Operations                 |  |      | F-3 | 
|Consolidated Balance Sheets                           |  |      | F-4 | 
|Consolidated Statements of Stockholders
    Equity   |  |      | F-5 | 
|Consolidated Statements of Cash Flows                 |  |      | F-6 | 
|Notes to Consolidated Financial Statements            |  |      | F-7 | 



| |                                  
| | ---------------------------------
| | (2)Financial Statement Schedules:

The following financial statement schedule of the
Company is filed as part of this Report and should be read in
conjunction with the Financial Statements of the Company.

|                                     |  |      |     | 
|------------------------------------ |  | ---- | --- | 
|Schedule                             |  | Page
|                                     |  |     
|II Valuation and Qualifying Accounts |  |      | S-1 | 

Schedules not listed above have been omitted
because they are not applicable or are not required or the
information required to be set forth therein is included in the
Financial Statements or Notes thereto.

(b)Reports on Form 8-K:

None.

(c)Exhibits:

The following exhibits are filed as part of, or
incorporated by reference into, this Annual Report on
Form 10-K:

|            |  |                                                                                                                                                                                                                              
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit     |  |                                                                                                                                                                                                                              
|Number      |  |                                                                                                                                                                                                                              
|            |  |                                                                                                                                                                                                                              
|3.1(1)      |  | Certificate of Incorporation of the Company.                                                                                                                                                                                 
|3.2(9)      |  | Amended and Restated Bylaws of the Company.                                                                                                                                                                                  
|4.1         |  | Instruments defining the rights of security
    holders. Reference is made to Exhibits 3.1 and 3.2.                                                                                                                          
|4.2(4)      |  | Rights Agreement, dated October 7, 1998,
    between the Company and Wells Fargo Shareowner Services, a
    division of Wells Fargo Bank Minnesota, N.A., formerly known as
    Norwest Shareowner Services, as Rights Agent.
|10.1(10)(2) |  | 1996 Equity Incentive Plan, as amended and form
    of stock option agreements thereunder.                                                                                                                                   
|10.2(11)(2) |  | 1996 Employee Stock Purchase Plan, as amended.                                                                                                                                                                               
|10.3(1)(3)  |  | Reference Post Appendix No. 2 to the
    Adobe Third Party License dated February 11, 1993.                                                                                                                                  
|10.4(1)     |  | Amendment No. 1 to the Adobe Third Party
    License dated November 29, 1993.                                                                                                                                                
|10.5(1)(3)  |  | PCL Development and License Agreement (the
    PCL License ) dated June 14, 1993, between the
    Registrant and Adobe.                                                                                                    
|10.6(1)(3)  |  | Amendment No. 1 to the PCL License dated
    October 31, 1993.                                                                                                                                                               
|10.7(1)(3)  |  | Letter Modification to the PCL License dated
    August 5, 1994.                                                                                                                                                             
|10.8(1)(3)  |  | Addendum No. 1 to the PCL License dated
    March 31, 1995.                                                                                                                                                                  
|10.9(1)(3)  |  | Letter Modification to the PCL License dated
    August 30, 1995.                                                                                                                                                            

36



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##### Table of Contents



|             |  |                                                                                                                                                                                                                             
|------------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit      |  |                                                                                                                                                                                                                             
|Number       |  |                                                                                                                                                                                                                             
|             |  |                                                                                                                                                                                                                             
|10.10(1)     |  | Lease Agreement between the Company and
    Continental Development Corporation dated February 6, 1992,
    and Addendum, dated February 6, 1992.                                                                           
|10.11(1)     |  | First Amendment to Office Lease dated
    December 1, 1995, between the Company and Continental
    Development Corporation.                                                                                                
|10.12(5)     |  | Second Amendment to Office Lease dated
    April 8, 1997, between the Company and Continental
    Development Corporation.                                                                                                  
|10.13(5)     |  | Third Amendment to Office Lease dated
    December 16, 1997, between the Company and Continental
    Development Corporation.                                                                                               
|10.14(6)     |  | Fourth Amendment to Office Lease dated
    April 22, 1998, between the Company and Continental
    Development Corporation.                                                                                                 
|10.15(7)     |  | Agreement and Plan of reorganization and Merger
    by and among Peerless Systems Corporation, Auco Merger and Auco,
    Inc. dated as of April 6, 1999.                                                                    
|10.16(8)     |  | Marubun Supplier/ Distribution Agreement dated
    December 14, 1999.                                                                                                                                                       
|10.17(8)     |  | Lease PSN McKelvy Family Trust (386 Main Street)
    Standard Industrial/ Commercial Single-Tenant dated
    March 14, 1997.                                                                                                
|10.18(8)     |  | Lease PSIP Kent Centennial Limited Partnership
    dated January 31, 1996.                                                                                                                                                  
|10.19(2)(12) |  | Form of Indemnification Agreement, effective as
    of March 12, 2001.                                                                                                                                                      
|10.20(13)    |  | Settlement Agreement and Mutual Release dated
    April 11, 2001 between Peerless Systems Corporation and
    Gordon L. Hanson.                                                                                             
|10.21(9)     |  | Settlement Agreement and Mutual Release,
    effective as of April 27, 2001, by and among the State of
    Wisconsin Investment Board, Peerless Systems Corporation and
    Edward A. Gavaldon.                             
|10.22(14)    |  | Series A Preferred Stock Purchase Agreement
    dated January 29, 2002 by and among Netreon, Inc., a
    Delaware corporation, Netreon, Inc., a California corporation
    and each of the several purchasers named therein.
|10.23(14)    |  | Series A Preferred Stock Contribution
    Agreement dated January 29, 2002 by and between Netreon,
    Inc., a Delaware corporation and Peerless Systems Corporation.                                                       
|10.24(3)(15) |  | Postscript Software Development License and
    Sublicense Agreement between Adobe Systems Incorporated and the
    Company effective as of July 23, 1999.                                                                  
|10.25(3)(15) |  | Custom Sales Agreement between the Company and
    International Business Machines effective as of April 23,
    2001.                                                                                                      
|10.26(3)(15) |  | Master Technology License Agreement dated
    January 16, 2000 between Konica Corporation and Peerless
    Systems Corporation.                                                                                             
|10.27(3)(15) |  | License Software Addendum #1 to Master
    Technology License Agreement by and between Konica Corporation
    and the Company effective as of January 16, 2000.                                                             
|10.28(3)(15) |  | License Software Addendum #2 to Master
    Technology License Agreement by and between Konica Corporation
    and the Company effective as of January 19, 2000.                                                             
|10.29(3)(15) |  | License Software Addendum #3 to Master
    Technology License Agreement by and between Konica Corporation
    and the Company effective as of July 21, 2000.                                                                
|10.30(3)(15) |  | License Software Addendum #4 to Master
    Technology License Agreement by and between Konica Corporation
    and the Company effective as of March 1, 2001.                                                                
|10.31(3)(15) |  | License Software Addendum #5 to Master
    Technology License Agreement by and between Konica Corporation
    and the Company effective as of July 1, 2001.                                                                 
|10.32(3)(15) |  | License Software Addendum #7 to Master
    Technology License Agreement by and between Konica Corporation
    and the Company effective as of January 1, 2002.                                                              
|10.33(3)(15) |  | License Software Addendum #8 to Master
    Technology License Agreement by and between Konica Corporation
    and the Company effective as of January 1, 2002.                                                              
|10.34(3)(15) |  | License Software Addendum #9 to Master
    Technology License Agreement by and between Konica Corporation
    and the Company effective as of January 1, 2002.                                                              

37



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##### Table of Contents



|             |  |                                                                                                                                                                                                    
|------------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit      |  |                                                                                                                                                                                                    
|Number       |  |                                                                                                                                                                                                    
|             |  |                                                                                                                                                                                                    
|10.35(15)    |  | Master Technology License Agreement dated
    April 1, 1997 between Kyocera Corporation and Peerless
    Systems Corporation.                                                                      
|10.36(3)(15) |  | Licensed Software Addendum #1 to Master
    Technology License Agreement by and between Kyocera Corporation
    and the Company effective as of December 28, 1999.                                 
|10.37(3)(15) |  | Amendment #3 to Licensed Software
    Addendum #1 to Master Technology License Agreement by and
    between Kyocera Corporation and the Company effective as of
    September 28, 2001.            
|10.38(3)(15) |  | Licensed Software Addendum #3 to Master
    Technology License Agreement by and between Kyocera Mita
    Corporation and the Company effective as of May 1, 2002.                                  
|10.39(3)(15) |  | Master Technology License Agreement between Oki
    Data Corporation and Peerless Systems Imaging Products, Inc.                                                                                   
|10.40(3)(15) |  | Licensed System Addendum No. 1 to Master
    Technology License Agreement between Oki Data Corporation and
    Peerless Systems Imaging Products, Inc.                                             
|10.41(3)(15) |  | Licensed System Addendum No. 2 to Master
    Technology License Agreement between Oki Data Corporation and
    Peerless Systems Imaging Products, Inc.                                             
|10.42(3)(15) |  | Licensed System Addendum No. 3 to Master
    Technology License Agreement between Oki Data Corporation and
    Peerless Systems Imaging Products, Inc. effective as of
    August 25, 2000.        
|10.43(3)(15) |  | Attachment #1 to Licensed System
    Addendum #3 by and between Oki Data Corporation and
    Peerless Systems Imaging Products, Inc. dated March 1, 2001.                                          
|10.44(3)(15) |  | Attachment #2 to Licensed System
    Addendum #3 by and between Oki Data Corporation and
    Peerless Systems Imaging Products, Inc. dated July 1, 2001.                                           
|10.45(3)(15) |  | Licensed System Addendum No. 4 to Master
    Technology License Agreement between Oki Data Corporation and
    Peerless Systems Imaging Products, Inc. effective as of
    February 1, 2002.       
|10.46(15)    |  | Master Technology License Agreement dated
    April 1, 2000 between Seiko Epson Corporation and Peerless
    Systems Imaging Products, Inc.                                                        
|10.47(3)(15) |  | Licensed System Addendum #1 to Master
    Technology License Agreement by and between Seiko Epson
    Corporation and Peerless Systems Imaging Products, Inc. dated
    April 1, 2000.             
|10.48(3)(15) |  | Licensed System Addendum #2 to Master
    Technology License Agreement by and between Seiko Epson
    Corporation and Peerless Systems Imaging Products, Inc.                                      
|10.49(3)(15) |  | Licensed System Addendum #3 to Master
    Technology License Agreement by and between Seiko Epson
    Corporation and Peerless Systems Imaging Products, Inc.                                      
|10.50(3)(15) |  | Attachment #1 to Licensed System
    Addendum #3 by and between Seiko Epson Corporation and
    Peerless Systems Imaging Products, Inc. dated May 1, 2001.                                         
|10.51(3)(15) |  | Attachment #2 to Licensed System
    Addendum #3 by and between Seiko Epson Corporation and
    Peerless Systems Imaging Products, Inc. dated July 23, 2001.                                       
|10.52(3)(15) |  | Licensed System Addendum #4 to Master
    Technology License Agreement by and between Seiko Epson
    Corporation and Peerless Systems Imaging Products, Inc.
    effective as of October 19, 2001.
|10.53(3)(15) |  | Licensed System Addendum #5 to Master
    Technology License Agreement by and between Seiko Epson
    Corporation and Peerless Systems Imaging Products, Inc.
    effective as of December 1, 2001.
|10.54(3)(15) |  | Licensed System Addendum #6 to Master
    Technology License Agreement by and between Seiko Epson
    Corporation and Peerless Systems Imaging Products, Inc.
    effective as of April 30, 2002.  
|10.55(3)(15) |  | Nest Office SDK Development and Reseller
    Agreement Statement of Work 8 to BDA No. N-A-1 between and
    Novell, Inc. and Peerless Systems Networking effective as of
    August 17, 1999.      

38



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|             |  |                                                                                                                                                                                                                                                               
|------------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit      |  |                                                                                                                                                                                                                                                               
|Number       |  |                                                                                                                                                                                                                                                               
|             |  |                                                                                                                                                                                                                                                               
|10.56(3)(15) |  | Amendment No. 1 to Nest Office SDK
    Development and Reseller Agreement Statement of Work 8 to BDA
    No. N-A-1 between and Novell, Inc. and Peerless Systems
    Networking effective as of August 17, 1999.                                              
|10.57(15)    |  | Business Development Agreement by and between
    Novell and Auco, Inc effective as of September 6, 1996.                                                                                                                                                     
|10.58(16)    |  | Amendment No. 4 to Licensed System Addendum
    No. 4 dated February 1, 2002 by and between Oki Data
    Corporation and Peerless Systems Imaging Products, Inc. dated
    September 1, 2002.(15)                                                             
|10.59(16)    |  | Amendment No. 3 to Postscript Software
    Development Agreement by and between Adobe Systems Incorporated
    and the Company dated October 25, 2002.                                                                                                        
|10.60(3)(17) |  | Amendment No. 1 to Licensed System Agreement
    No. 7 dated November 1, 2001 by and between Konica
    Corporation and Peerless Systems Corporation dated
    January 1, 2003.                                                                               
|10.61(3)(17) |  | Licensed System Agreement Addendum No. 10 to
    Master Technology License Agreement dated January 16, 2000
    by and between Konica Corporation and Peerless Systems
    Corporation dated January 17, 2003.                                                
|10.62(3)(17) |  | Licensed System Addendum #8 to Master
    Technology License Agreement dated April 1, 2000 by and
    between Seiko Epson Corporation and Peerless Systems Imaging
    Products, Inc. effective as of January 6, 2003.                                        
|10.63(3)(18) |  | Amendment No. 4 to the Postscript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of July 31, 2003.                                                       
|10.64(3)(18) |  | Amendment No. 10 to the Postscript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of July 31, 2003.                                                      
|10.65(3)(19) |  | Amendment No. 5 to Licensed System Addendum
    No. 4 between Oki Data Corporation and Peerless Systems
    Imaging Products, Inc. dated February 1, 2002.                                                                                                    
|10.66(3)(19) |  | Amendment No. 8 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of September 30, 2003.                                                  
|10.67(3)(19) |  | Amendment No. 9 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of September 15, 2003.                                                  
|10.68(3)(19) |  | Amendment No. 12 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of September 22, 2003.                                                 
|10.69(20)    |  | Licensed Software Addendum No. 14 to Master
    Technology License Agreements dated January 16, 2000 and
    June 12, 1997 by and between KonicaMinolta Business
    Technologies, Inc. and Peerless Systems Corporation, effective
    as of October 1, 2003.
|10.70(20)    |  | Amendment #2 to the LSA #9 by and
    between KonicaMinolta Business Technologies, Inc. and Peerless
    Systems Corporation, effective as of November 1, 2003.                                                                                               
|10.71(20)    |  | Amendment No. 5 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of December 16, 2003.                                                   
|10.72(20)    |  | Amendment No. 6 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of July 31, 2002.                                                       
|10.73        |  | Amendment No. 7 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of May 22, 2003.                                                        

39



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|          |  |                                                                                                                                                                                                             
|--------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit   |  |                                                                                                                                                                                                             
|Number    |  |                                                                                                                                                                                                             
|          |  |                                                                                                                                                                                                             
|10.74(20) |  | Amendment No. 11 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of February 9, 2004. 
|10.75     |  | Amendment No. 14 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of December 16, 2003.
|10.76     |  | Amendment No. 15 to the PostScript Software
    Development License and Sublicense Agreement between Adobe
    Systems Incorporated and Peerless Systems Corporation, effective
    as of January 6, 2004.  
|10.77(2)  |  | Change in Control Agreement of Chief Executive
    Officer.                                                                                                                                                 
|10.78(2)  |  | Form of Change in Control Agreement of certain
    members of senior management.                                                                                                                            
|10.79(2)  |  | Form of Transaction Incentive Plan of certain
    members of senior management.                                                                                                                             
|21        |  | Registrants Wholly-Owned Subsidiaries.                                                                                                                                                                     
|23.1      |  | Consent of Ernst & Young LLP,
    Independent Auditors.                                                                                                                                                     
|24.1      |  | Power of Attorney. Reference is made to the
    signature page to this Annual Report on Form 10-K.                                                                                                          
|31.1      |  | Certification of Principal Executive Officer
    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                 
|31.2      |  | Certification of Principal Financial Officer
    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                 
|32        |  | Certifications of Principal Executive Officer and
    Principal Financial Officer Pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002.                                                            



---



|    |                                                                                                                                                        
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Previously filed in the Companys
    Registration Statement on Form S-1 (File
    No. 333-09357), as amended and incorporated herein by
    reference.
|   
|(2) | Management contract or compensatory plan or
    arrangement.                                                                                           
|   
|(3) | Subject to a Confidential Treatment Order.                                                                                                             
|   
|(4) | Previously filed in the Companys Current
    Report on Form 8-K, filed October 13, 1999, and
    incorporated herein by reference.                    
|   
|(5) | Previously filed in the Companys 1998
    Annual Report filed on Form 10-K, filed April 24,
    1998, and incorporated herein by reference.           
|   
|(6) | Previously filed in the Companys 1999
    Annual Report filed on Form 10-K, filed April 26,
    1999, and incorporated herein by reference.           
|   
|(7) | Previously filed in the Companys
    Registration Statement on Form S-4 (File
    No. 333-77049) as amended and incorporated herein by
    reference. 
|   
|(8) | Previously filed in the Companys 2000
    Annual Report filed on Form 10-K, filed April 28,
    2000, and incorporated herein by reference.           
|   
|(9) | Previously filed in the Companys Current
    Report on Form 8-K, filed July 2, 2001, and
    incorporated herein by reference.                        



|     |                                                                                                                                                                                         
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Previously filed in the Companys
    Registration Statement on Form S-8 (File
    No. 333-73562), filed November 16, 2001, and
    incorporated herein by reference.                   
|    
|(11) | Previously filed in the Companys
    Registration Statement on Form S-8 (File
    No. 333-57362), filed March 21, 2001, and incorporated
    herein by reference.                      
|    
|(12) | Previously filed in the Companys Amendment
    No. 4 to its Registration Statement on Form S-3 (File
    No. 333-60284), filed July 27, 2001, and incorporated
    herein by reference.
|    
|(13) | Previously filed in the Companys 2001
    Annual Report filed on Form 10-K, filed May 1, 2001,
    and incorporated herein by reference.                                               

40



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##### Table of Contents





|     |                                                                                                                                                                                                   
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(14) | Previously filed in the Companys 2002
    Annual Report on Form 10-K, filed May 1, 2002, and
    incorporated herein by reference.                                                               
|    
|(15) | Previously filed in the Companys Quarterly
    Report for the period ended July 31, 2002, filed
    September 16, 2002, and incorporated herein by reference.                                    
|    
|(16) | Previously filed in the Companys Quarterly
    Report for the period ended October 31, 2002, filed
    December 16, 2002, and incorporated herein by reference.                                  
|    
|(17) | Previously filed in the Companys 2003
    Annual Report on Form 10-K filed May 1, 2003, and
    incorporated herein by reference.                                                                
|    
|(18) | Previously filed in the Companys Quarterly
    Report for the period ended July 31, 2003, filed
    September 15, 2003, and incorporated herein by reference.                                    
|    
|(19) | Previously filed in the Companys Quarterly
    Report for the period ended October 31, 2003, filed
    December 15, 2003, and incorporated herein by reference.                                  
|    
|(20) | Confidential treatment has been requested with
    respect to the omitted portions of this Exhibit, which portions
    have been filed separately with the Securities and Exchange
    Commission.

41



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##### Table of Contents



SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, as amended, the
Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized, on the
30th day of April, 2004.



| |                             
| | ----------------------------
| | PEERLESS SYSTEMS CORPORATION



| |     |                    
| | --- | -------------------
| | By: | /s/ WILLIAM R. NEIL

| |                              
| | -----------------------------
| |                              
| | William R. Neil              
| | Vice President of Finance and
| | Chief Financial Officer      

KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints
Howard J. Nellor and William R. Neil, his/her attorneys-in-fact,
each with the power of substitution, for him/her in any and all
capacities, to sign any amendments to this Annual Report on
Form 10-K, and to file the same, with Exhibits thereto and
other documents in connection therewith with the Securities and
Exchange Commission, hereby ratifying and confirming all that
each of said attorneys-in-fact, or substitute or substitutes may
do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the
capacities and on the date indicated.

|                                       |  |                                                                                                        |  |                |  | 
|-------------------------------------- |  | ------------------------------------------------------------------------------------------------------ |  | -------------- |  | 
|                                       |  |                                                                                                        |  |               
|Signature                              |  | Title                                                                                                  |  | Date          
|                                       |  |                                                                                                        |  |               
|                                      
|/s/ HOWARD J. NELLORHoward J. Nellor   |  | Chief Executive Officer, President &
    Director (Principal Executive Officer)                        |  | April 30, 2004
|                                      
|/s/ ROBERT G. BARRETTRobert G. Barrett |  | Director                                                                                               |  | April 30, 2004
|                                      
|/s/ LOUIS C. COLELouis C. Cole         |  | Director                                                                                               |  | April 30, 2004
|                                      
|/s/ ROBERT L. NORTHRobert L. North     |  | Director                                                                                               |  | April 30, 2004
|                                      
|/s/ WILLIAM R. NEILWilliam R. Neil     |  | Vice President of Finance and Chief Financial
    Officer (Principal Financial and Accounting Officer) |  | April 30, 2004

42



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PEERLESS SYSTEMS CORPORATION

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                      |  |      |     | 
|----------------------------------------------------- |  | ---- | --- | 
|                                                      |  | Page
|                                                      |  |     
|Report of Ernst & Young LLP, Independent
    Auditors |  |      | F-2 | 
|Consolidated Statements of Operations                 |  |      | F-3 | 
|Consolidated Balance Sheets                           |  |      | F-4 | 
|Consolidated Statements of Stockholders
    Equity   |  |      | F-5 | 
|Consolidated Statements of Cash Flows                 |  |      | F-6 | 
|Notes to Consolidated Financial Statements            |  |      | F-7 | 

F-1



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##### Table of Contents



REPORT OF ERNST & YOUNG LLP,
INDEPENDENT AUDITORS

The Board of Directors and Stockholders of
Peerless Systems Corporation

We have audited the accompanying consolidated
balance sheets of Peerless Systems Corporation as of
January 31, 2004 and 2003, and the related consolidated
statements of operations, stockholders equity and cash
flows for each of the three years in the period ended
January 31, 2004. Our audits also included the financial
statement schedule listed in the Index at Item 15
(a) for each of the three years in the period ended
January 31, 2004. These financial statements and schedule
are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements and schedule based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the financial statements referred
to above present fairly, in all material respects, the
consolidated financial position of Peerless Systems Corporation
at January 31, 2004 and 2003 and the consolidated results
of its operations and its cash flows for each of the three years
in the period ended January 31, 2004 in conformity with
accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule
for each of the three years in the period ended January 31
2004, when considered in relation to the basic financial
statements take as a whole, presents fairly in all material
respects the information set forth therein.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Los Angeles, California

March 12, 2004


F-2



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PEERLESS SYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |        |         |  
|-------------------------------------------------------- | ------------------------------------ | ---------------------------------------- | ------ | ------ | ------ | ---- | ------ | ------ | ------ | - | ------ | ------ | ------- | -
|                                                         |                                      |                                         
|                                                         |                                      | Years Ended January 31,                 
|                                                         |                                      |                                         
|                                                         |                                      | 2004                                     |        | 2003   |        | 2002
|                                                         |                                      |                                          |        |        |        |     
|                                                         |                                      |                                         
|                                                         |                                      | (In thousands, except per share amounts)
|Revenues:                                                |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         | Product licensing                    |                                          | $      | 19,931 |        |      | $      | 24,856 |        |   | $      | 21,606 |        
|                                                         | Engineering services and maintenance |                                          |        | 3,178  |        |      |        | 5,047  |        |   |        | 6,132  |        
|                                                         | Other                                |                                          |        | 2,145  |        |      |        | 1,854  |        |   |        | 2,029  |        
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         |                                      | Total revenues                           |        |        | 25,254 |      |        |        | 31,757 |   |        |        | 29,767  |  
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Cost of revenues:                                        |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         | Product licensing                    |                                          |        | 6,333  |        |      |        | 8,251  |        |   |        | 6,309  |        
|                                                         | Engineering services and maintenance |                                          |        | 3,066  |        |      |        | 2,850  |        |   |        | 5,708  |        
|                                                         | Other                                |                                          |        | 937    |        |      |        | 971    |        |   |        | 1,206  |        
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         |                                      | Total cost of revenues                   |        |        | 10,336 |      |        |        | 12,072 |   |        |        | 13,223  |  
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         |                                      | Gross margin                             |        |        | 14,918 |      |        |        | 19,685 |   |        |        | 16,544  |  
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Operating expenses:                                      |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         | Research and development             |                                          |        | 11,771 |        |      |        | 9,766  |        |   |        | 13,634 |        
|                                                         | Sales and marketing                  |                                          |        | 4,540  |        |      |        | 4,552  |        |   |        | 6,001  |        
|                                                         | General and administrative           |                                          |        | 4,400  |        |      |        | 5,127  |        |   |        | 6,857  |        
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         |                                      | Total operating expenses                 |        |        | 20,711 |      |        |        | 19,445 |   |        |        | 26,492  |  
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Income (loss) from operations                            |                                      |                                          | (5,793 | )      |        |      | 240    |        |        |   | (9,948 | )     
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Interest income, net                                     |                                      |                                          | 138    |        |        |      | 374    |        |        |   | 743    |       
|Other income                                             |                                      |                                          | 1,490  |        |        |      |       |        |        |   | 2,320  |       
|Loss on divestiture of storage operations                |                                      |                                          |       |        |        |      |       |        |        |   | (2,303 | )     
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         |                                      | Total other income                       |        |        | 1,628  |      |        |        | 374    |   |        |        | 760     |  
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Income (loss) before provision for income taxes          |                                      |                                          | (4,165 | )      |        |      | 614    |        |        |   | (9,188 | )     
|Provision for income taxes                               |                                      |                                          | 696    |        |        |      | 490    |        |        |   | 1,809  |       
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|                                                         |                                      | Net income (loss)                        |        | $      | (4,861 | )    |        | $      | 124    |   |        | $      | (10,997 | )
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Basic earnings (loss) per share                          |                                      | $                                        | (0.31  | )      |        | $    | 0.01   |        |        | $ | (0.73  | )     
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Diluted earnings (loss) per share                        |                                      | $                                        | (0.31  | )      |        | $    | 0.01   |        |        | $ | (0.73  | )     
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Weighted average common shares
    outstanding  basic   |                                      |                                          | 15,575 |        |        |      | 15,282 |        |        |   | 15,062 |       
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       
|Weighted average common shares
    outstanding  diluted |                                      |                                          | 15,575 |        |        |      | 15,722 |        |        |   | 15,062 |       
|                                                         |                                      |                                          |        |        |        |      |        |        |        |   |        |       

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

F-3



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION

CONSOLIDATED BALANCE SHEETS

|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |         |        | 
|---------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | ------- | ------ |  | ----- | ------- | ------ | 
|                                         |                                                                                                                                                 |                                           
|                                         |                                                                                                                                                 | January 31,                               
|                                         |                                                                                                                                                 |                                           
|                                         |                                                                                                                                                 | 2004                                       |       | 2003   
|                                         |                                                                                                                                                 |                                            |       |        
|                                         |                                                                                                                                                 |                                           
|                                         |                                                                                                                                                 | (In thousands)                            
|ASSETS                                  
|Current assets:                          |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         | Cash and cash equivalents                                                                                                                       |                                            | $     | 5,069   |        |  | $     | 14,355  |       
|                                         | Short-term investments                                                                                                                          |                                            |       | 4,341   |        |  |       | 1,729   |       
|                                         | Trade accounts receivable, less allowance for
    doubtful accounts of $141 and $202 in 2004 and 2003, respectively                             |                                            |       | 6,146   |        |  |       | 2,015   |       
|                                         | Unbilled receivables                                                                                                                            |                                            |       |        |        |  |       | 88      |       
|                                         | Prepaid expenses and other current assets                                                                                                       |                                            |       | 622     |        |  |       | 817     |       
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         |                                                                                                                                                 | Total current assets                       |       |         | 16,178 |  |       |         | 19,004 | 
|Investments                              |                                                                                                                                                 |                                            |      |         |        |  | 1,945 |        
|Property and equipment, net              |                                                                                                                                                 |                                            | 1,981 |         |        |  | 2,205 |        
|Other assets                             |                                                                                                                                                 |                                            | 1,148 |         |        |  | 953   |        
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         |                                                                                                                                                 | Total assets                               |       | $       | 19,307 |  |       | $       | 24,107 | 
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                        
|LIABILITIES AND STOCKHOLDERS
    EQUITY
|Current liabilities:                     |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         | Accounts payable                                                                                                                                |                                            | $     | 897     |        |  | $     | 688     |       
|                                         | Accrued wages                                                                                                                                   |                                            |       | 384     |        |  |       | 1,091   |       
|                                         | Accrued compensated absences                                                                                                                    |                                            |       | 805     |        |  |       | 657     |       
|                                         | Accrued product licensing costs                                                                                                                 |                                            |       | 2,834   |        |  |       | 2,221   |       
|                                         | Income taxes payable                                                                                                                            |                                            |       | 469     |        |  |       | 121     |       
|                                         | Other current liabilities                                                                                                                       |                                            |       | 428     |        |  |       | 653     |       
|                                         | Deferred revenue                                                                                                                                |                                            |       | 1,323   |        |  |       | 1,081   |       
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         |                                                                                                                                                 | Total current liabilities                  |       |         | 7,140  |  |       |         | 6,512  | 
|Other tax liabilities                    |                                                                                                                                                 |                                            |      |         |        |  | 980   |        
|Other liabilities                        |                                                                                                                                                 |                                            | 366   |         |        |  | 404   |        
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         |                                                                                                                                                 | Total liabilities                          |       |         | 7,506  |  |       |         | 7,896  | 
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        
|Stockholders equity:                    |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         | Common stock, $.001 par value,
    30,000 shares authorized, 15,866 and 15,450 shares
    issued and outstanding in 2004 and 2003, respectively |                                            |       | 15      |        |  |       | 15      |       
|                                         | Additional paid-in capital                                                                                                                      |                                            |       | 49,295  |        |  |       | 48,882  |       
|                                         | Accumulated deficit                                                                                                                             |                                            |       | (37,434 | )      |  |       | (32,573 | )     
|                                         | Accumulated other comprehensive income                                                                                                          |                                            |       | 38      |        |  |       |        |       
|                                         | Treasury stock, 150 shares in 2004 and 2003                                                                                                     |                                            |       | (113    | )      |  |       | (113    | )     
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         |                                                                                                                                                 | Total stockholders equity                 |       |         | 11,801 |  |       |         | 16,211 | 
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        
|                                         |                                                                                                                                                 | Total liabilities and stockholders equity |       | $       | 19,307 |  |       | $       | 24,107 | 
|                                         |                                                                                                                                                 |                                            |       |         |        |  |       |        

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

F-4



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                           |                                       |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |        |        |      |   |   |     |    |   |   |         |         |        |   |    |   |    |   |        |         |        |  
|-------------------------- | ------------------------------------- | --------------------------------------- | ------ | -------------- | - | ---------- | -- | -------- | - | ----------- | ---- | ------------- | - | ------------- | ---- | ------ | - | ------ | ------ | ---- | - | - | --- | -- | - | - | ------- | ------- | ------ | - | -- | - | -- | - | ------ | ------- | ------ | -
|                           |                                       |                                         |        |                |   |            |    |          |   |             |      | Accumulated   |   |              
|                           |                                       | Common Stock                            |        | Treasury Stock |   | Additional |    |          |   |             |      | Other         |   | Total        
|                           |                                       |                                         |        |                |   | Paid-In    |    | Deferred |   | Accumulated |      | Comprehensive |   | Stockholders
|                           |                                       | Shares                                  |        | Amount         |   | Shares     |    | Amount   |   | Capital     |      | Comp.         |   | Deficit       |      | Income |   | Equity
|                           |                                       |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |       
|                           |                                       |                                        
|                           |                                       | (In thousands)                         
|Balances, January 31, 2001 |                                       |                                         | 14,909 |                |   | $          | 15 |          |   |             |     |               |   | $             |     |        |   | $      | 48,471 |      |   | $ | (58 | )  |   | $ | (21,700 | )       |        | $ |   |   |    | $ | 26,728 |        
|                           | Issuance of put options               |                                         |        |               |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        | (232 | ) |   |     |   |   |   |         |        |        |   |    |  |    |   |        | (232    | )     
|                           | Repurchase of common stock            |                                         |        |               |   |            |    |         |   |             |      | (150          | ) |               |      | (113   | ) |        |        | 113  |   |   |     |   |   |   |         |        |        |   |    |  |    |   |        |        |       
|                           | Expiration of put options             |                                         |        |               |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        | 209  |   |   |     |   |   |   |         |        |        |   |    |  |    |   |        | 209     |       
|                           | Issuance of common stock              |                                         |        | 406            |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        | 209  |   |   |     |   |   |   |         |        |        |   |    |  |    |   |        | 209     |       
|                           | Exercise of stock options             |                                         |        | 62             |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        | 19   |   |   |     |   |   |   |         |        |        |   |    |  |    |   |        | 19      |       
|                           | Amortization of deferred compensation |                                         |        |               |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        |     |   |   |     | 58 |   |   |         |        |        |   |    |  |    |   |        | 58      |       
|                           | Net loss                              |                                         |        |                |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        |     |   |   |     |   |   |   |         | (10,997 | )      |   |    |  |    |   |        | (10,997 | )     
|                           |                                       |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |        |        |      |   |   |     |    |   |   |         |         |        |   |    |   |    |   |        |        
|Balances, January 31, 2002 |                                       |                                         | 15,377 |                |   |            | 15 |          |   |             | (150 | )             |   |               | (113 | )      |   |        | 48,789 |      |   |   |    |    |   |   | (32,697 | )       |        |   |   |   |    |   | 15,994 |        
|                           | Issuance of common stock              |                                         |        |               |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        | 30   |   |   |     |   |   |   |         |        |        |   |    |  |    |   |        | 30      |       
|                           | Exercise of stock options             |                                         |        | 73             |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        | 63   |   |   |     |   |   |   |         |        |        |   |    |  |    |   |        | 63      |       
|                           | Net income                            |                                         |        |               |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        |     |   |   |     |   |   |   |         | 124     |        |   |    |  |    |   |        | 124     |       
|                           |                                       |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |        |        |      |   |   |     |    |   |   |         |         |        |   |    |   |    |   |        |        
|Balances, January 31, 2003 |                                       |                                         | 15,450 |                |   |            | 15 |          |   |             | (150 | )             |   |               | (113 | )      |   |        | 48,882 |      |   |   |    |    |   |   | (32,573 | )       |        |   |   |   |    |   | 16,211 |        
|                           | Issuance of common stock              |                                         |        | 294            |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        | 317  |   |   |     |   |   |   |         |        |        |   |    |  |    |   |        | 317     |       
|                           | Exercise of stock options             |                                         |        | 122            |   |            |    |         |   |             |      |              |   |               |      |       |   |        |        | 96   |   |   |     |   |   |   |         |        |        |   |    |  |    |   |        | 96      |       
|                           | Comprehensive loss:                   |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |        |        |      |   |   |     |    |   |   |         |         |        |   |    |   |    |   |        |         |       
|                           |                                       | Net loss                                |        |                |  |            |    |          |  |             |      |               |  |               |      |        |  |        |        |      |  |   |     |    |  |   |         |         | (4,861 | ) |    |   |   |   |        |         | (4,861 | )
|                           |                                       | Foreign currency translation adjustment |        |                |  |            |    |          |  |             |      |               |  |               |      |        |  |        |        |      |  |   |     |    |  |   |         |         |       |   |    |   | 38 |   |        |         | 38     |  
|                           |                                       |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |        |        |      |   |   |     |    |   |   |         |         |        |   |    |   |    |   |        |        
|                           | Total comprehensive loss              |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |        |        |      |   |   |     |    |   |   |         |         |        |   |    |   |    |   |        | (4,823  | )     
|                           |                                       |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |        |        |      |   |   |     |    |   |   |         |         |        |   |    |   |    |   |        |        
|Balances, January 31, 2004 |                                       |                                         | 15,866 |                |   | $          | 15 |          |   |             | (150 | )             |   | $             | (113 | )      |   | $      | 49,295 |      |   | $ |    |    |   | $ | (37,434 | )       |        | $ | 38 |   |    | $ | 11,801 |        
|                           |                                       |                                         |        |                |   |            |    |          |   |             |      |               |   |               |      |        |   |        |        |      |   |   |     |    |   |   |         |         |        |   |    |   |    |   |        |        

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

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##### Table of Contents



PEERLESS SYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |         |        |        |  
|------------------------------------------------- | -------------------------------------------------------------------------------------------------- | -------------------------------------------------- | -------------------------------------------------------- | ------- | ------ | ------ | ------ | ------ | ------ | ----- | ------ | ------- | ------ | ------ | -
|                                                  |                                                                                                    |                                                   
|                                                  |                                                                                                    | Years Ended January 31,                           
|                                                  |                                                                                                    |                                                   
|                                                  |                                                                                                    | 2004                                               |                                                          | 2003    |        | 2002  
|                                                  |                                                                                                    |                                                    |                                                          |         |        |       
|                                                  |                                                                                                    |                                                   
|                                                  |                                                                                                    | (In thousands)                                    
|Cash flows from operating activities:             |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|                                                  | Net income (loss)                                                                                  |                                                    | $                                                        | (4,861  | )      |        | $      | 124    |        |       | $      | (10,997 | )     
|                                                  | Adjustments to reconcile net income (loss) to net
    cash provided (used) by operating activities |                                                    |                                                          |         |        |        |        |        |        |       |        |         |       
|                                                  |                                                                                                    | Depreciation and amortization                      |                                                          |         | 1,375  |        |        |        | 1,510  |       |        |         | 2,126  |       
|                                                  |                                                                                                    | Net gain from sublease termination                 |                                                          |         | (938   | )      |        |        |       |       |        |         |       |       
|                                                  |                                                                                                    | Gain from Netreon sale                             |                                                          |         | (971   | )      |        |        |       |       |        |         |       |       
|                                                  |                                                                                                    | Loss on divestiture of storage operations          |                                                          |         |       |        |        |        |       |       |        |         | 2,303  |       
|                                                  |                                                                                                    | Loss from lease amendment                          |                                                          |         |       |        |        |        | 725    |       |        |         |       |       
|                                                  |                                                                                                    | Other                                              |                                                          |         | (54    | )      |        |        | 31     |       |        |         | 48     |       
|                                                  | Changes in operating assets and liabilities:                                                       |                                                    |                                                          |         |        |        |        |        |        |       |        |         |       
|                                                  |                                                                                                    | Trade accounts receivable and unbilled receivables |                                                          |         | (4,043 | )      |        |        | 3,215  |       |        |         | 1,269  |       
|                                                  |                                                                                                    | Prepaid expenses and other assets                  |                                                          |         | 245    |        |        |        | (885   | )     |        |         | (60    | )     
|                                                  |                                                                                                    | Long-term receivable                               |                                                          |         |       |        |        |        |       |       |        |         | 1,500  |       
|                                                  |                                                                                                    | Accounts payable                                   |                                                          |         | 209    |        |        |        | (54    | )     |        |         | (150   | )     
|                                                  |                                                                                                    | Accrued product licensing costs                    |                                                          |         | 613    |        |        |        | 1,337  |       |        |         | (1,073 | )     
|                                                  |                                                                                                    | Deferred revenue                                   |                                                          |         | 242    |        |        |        | (746   | )     |        |         | 1,001  |       
|                                                  |                                                                                                    | Other liabilities                                  |                                                          |         | (1,479 | )      |        |        | (1,581 | )     |        |         | (1,287 | )     
|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|                                                  |                                                                                                    |                                                    | Net cash provided (used) by operating
    activities     |         |        | (9,662 | )      |        |        | 3,676 |        |         |        | (5,320 | )
|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|Cash flows from investing activities:             |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|                                                  | Proceeds from sale of Netreon                                                                      |                                                    |                                                          | 971     |        |        |        |       |        |       |        |        |       
|                                                  | Proceeds from sublease termination                                                                 |                                                    |                                                          | 639     |        |        |        |       |        |       |        |        |       
|                                                  | Purchases of property and equipment                                                                |                                                    |                                                          | (388    | )      |        |        | (215   | )      |       |        | (914    | )     
|                                                  | Purchases of available-for-sale securities                                                         |                                                    |                                                          | (16,819 | )      |        |        | (2,488 | )      |       |        | (7,640  | )     
|                                                  | Proceeds from sales of available-for-sale
    securities                                           |                                                    |                                                          | 16,162  |        |        |        | 2,407  |        |       |        | 13,454  |       
|                                                  | Divestiture of storage operations                                                                  |                                                    |                                                          |        |        |        |        |       |        |       |        | (1,343  | )     
|                                                  | Purchases of software licenses                                                                     |                                                    |                                                          | (602    | )      |        |        | (128   | )      |       |        | (137    | )     
|                                                  | Restricted cash                                                                                    |                                                    |                                                          |        |        |        |        | (20    | )      |       |        | 742     |       
|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|                                                  |                                                                                                    |                                                    | Net cash provided (used) by investing
    activities     |         |        | (37    | )      |        |        | (444  | )      |         |        | 4,162  |  
|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|Cash flows from financing activities:             |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|                                                  | Proceeds from issuance of common stock                                                             |                                                    |                                                          | 317     |        |        |        | 30     |        |       |        | 209     |       
|                                                  | Proceeds from exercise of common stock options                                                     |                                                    |                                                          | 96      |        |        |        | 63     |        |       |        | 19      |       
|                                                  | Repurchase of common stock                                                                         |                                                    |                                                          |        |        |        |        |       |        |       |        | (113    | )     
|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|                                                  |                                                                                                    |                                                    | Net cash provided by financing activities                |         |        | 413    |        |        |        | 93    |        |         |        | 115    |  
|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|                                                  |                                                                                                    |                                                    | Net increase (decrease) in cash and cash
    equivalents |         |        | (9,286 | )      |        |        | 3,325 |        |         |        | (1,043 | )
|Cash and cash equivalents, beginning of period    |                                                                                                    |                                                    | 14,355                                                   |         |        |        | 11,030 |        |        |       | 12,073 |        
|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|Cash and cash equivalents, end of period          |                                                                                                    | $                                                  | 5,069                                                    |         |        | $      | 14,355 |        |        | $     | 11,030 |        
|                                                  |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|Supplemental disclosure of cash flow information: |                                                                                                    |                                                    |                                                          |         |        |        |        |        |        |       |        |        
|                                                  | Cash paid during the year for:                                                                     |                                                    |                                                          |         |        |        |        |        |        |       |        |         |       
|                                                  |                                                                                                    | Income taxes                                       |                                                          | $       | 1,325  |        |        | $      | 1,805  |       |        | $       | 1,629  |       
|                                                  |                                                                                                    | Interest                                           |                                                          | $       |       |        |        | $      |       |       |        | $       |       |       

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

F-6



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

(in thousands, except per share
amounts)




|   |                                                                           
|-- | --------------------------------------------------------------------------
|1. | Organization, Business and Summary of
    Significant Accounting Policies:

Organization and
Business:Peerless Systems Corporation
(Peerless or the Company) was
incorporated in the state of California in April 1982 and
reincorporated in the state of Delaware in September 1996.
Peerless develops and licenses software-based digital imaging
and networking systems and supporting electronic technologies
and provides custom engineering services to Original Equipment
Manufacturers (OEMs) of digital document products
located primarily in the United States and Japan. Digital
document products include printers, copiers, fax machines,
scanners and color products, as well as multifunction products
that perform a combination of these imaging functions. In order
to process digital text and graphics, digital document products
rely on a core set of imaging software and supporting
electronics, collectively known as a digital imaging system.
Network interfaces supply the core technologies to digital
document products that enable them to communicate over local
area networks and the Internet.

The Company has incurred losses from operations
and has reported negative operating cash flows. As of
January 31, 2004, the Company had an accumulated deficit of
$37.4 million and cash and short-term investments of
$9.4 million. The Company has no material financial
commitments other than those under operating lease agreements.
The Company believes that its existing cash and short-term
investments, and any cash generated from operations will be
sufficient to fund its working capital requirements, capital
expenditures and other obligations through the next
12 months. Long term, the Company may face significant
risks associated with the successful execution of its business
strategy and may need to raise additional capital in order to
fund more rapid expansion, to expand its marketing activities,
to develop new or enhance existing services or products, and to
respond to competitive pressures or to acquire complementary
services, businesses, or technologies. If the Company is not
successful in generating sufficient cash flow from operations,
it may need to raise additional capital through public or
private financing, strategic relationships, or other
arrangements.

Principles of Consolidation and Basis of
Presentation:The consolidated
financial statements include the accounts of the Company and its
subsidiaries. All significant intercompany accounts and
transactions have been eliminated. As a result of the Netreon
exchange transaction, the Companys Netreon subsidiary was
deconsolidated effective January 29, 2002. Although the
Company initially retained an equity interest in the business
formed as a result of the transaction, the Company did not
record a related investment and had no continuing obligation to
fund this business. In February 2003, the Company sold its
remaining interest in Netreon (see Note 2).

Use of Estimates:The preparation of financial statements in conformity with
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting
periods. Actual results could differ from those estimates.

The Company provides an accrual for estimated
product licensing costs owed to third party vendors whose
technology is included in the products sold by the Company. The
accrual is impacted by estimates of the mix of products shipped
under certain of the Companys block license agreements.
The estimates are based on historical data and available
information as provided by the Companys customers
concerning projected shipments. Should actual shipments under
these agreements vary from these estimates, adjustments to the
estimated accruals for product licensing costs may be required.

The Company grants credit terms in the normal
course of business to its customers. The Company continuously
monitors collections and payments from its customers and
maintains allowances for doubtful accounts for estimated losses
resulting from the inability of any customers to make required
payments. Estimated losses are based primarily on specifically
identified customer collection issues. If the financial

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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


condition of any of the Companys customers,
or the economy as a whole, were to deteriorate, resulting in an
impairment of their ability to make payments, additional
allowances may be required.

The Companys recurring product licensing
revenues are dependent, in part, on the timing and accuracy of
product sales reports received from the Companys OEM
customers. These reports are provided only on a calendar quarter
basis and, in any event, are subject to delay and potential
revision by the OEM. Therefore, the Company is required to
estimate all of the recurring product licensing revenues for the
last month of each fiscal quarter and to further estimate all of
its quarterly revenues from an OEM when the report from such OEM
is not received in a timely manner. In the event the Company is
unable to estimate such revenues accurately prior to reporting
financial results, the Company may be required to adjust
revenues in subsequent periods. Fiscal year 2004 revenues
subject to such estimates were minimal.

Cash and Cash
Equivalents:Cash and cash equivalents
represent cash and highly liquid investments which mature within
three months from date of purchase.

Investments:The
Companys investments at January 31, 2004 and 2003
consisted of available-for-sale U.S. government debt, state
and local government debt and corporate debt. Available-for-sale
securities are carried at fair value. Unrealized gains and
losses, if material, are reported as a separate component of
stockholders equity. Realized gains and losses and
declines in value judged to be other than temporary are included
in results of operations. Realized gains and losses are
calculated using the specific identification method and were not
material to the Companys results of operations in any
period presented.

Fair Value of Financial
Investments:Cash and cash
equivalents, accounts payable, and accrued liabilities are
carried at cost, which management believes approximates fair
value due to the short term maturity of these instruments.
Investments, which are available-for-sale securities, are
carried at fair value. Fair value of publicly traded investments
is based on quoted market rates.

Property and
Equipment:Property and equipment are
stated at cost, less accumulated depreciation. Depreciation on
property and equipment is calculated using the straight-line
method as follows:

|                        |  |                                     
|----------------------- |  | ------------------------------------
|Computers and equipment |  | 3 to 5 years                        
|Furniture               |  | 10 years                            
|Leasehold improvements  |  | Shorter of useful life or lease term

Maintenance and repairs are expensed as incurred,
while renewals and betterments are capitalized. Upon the sale or
retirement of property and equipment, the accounts are relieved
of the cost and the related accumulated depreciation, and any
resulting gain or loss is included in results of operations.

Long-Lived Assets:The Company currently evaluates long-lived assets, including
intangible assets, for impairment when events or changes
indicate, in managements judgment, that the carrying value
of such assets may not be recoverable. The determination of
whether an impairment has occurred is based upon
managements estimate of undiscounted future cash flows
attributable to the assets as compared to the carrying value of
the assets. If an impairment has occurred, the amount of the
impairment recognized is determined by estimating the fair value
of the assets and recording a write-down to reduce the related
asset to its estimated fair value.

Capitalization of Software Development
Costs:The Company follows the working
model approach to determine technological feasibility of its
products. Costs that are incurred subsequent to establishing
technological feasibility are immaterial and, therefore, the
Company expenses all costs associated with the development of
its products as such costs are incurred.

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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


Employee Stock-Based
Compensation:The Company accounts for
its stock option plans and employee stock purchase plan under
the recognition and measurement principles of Accounting
Principles Board Opinion (APB) No. 25,
Accounting for Stock Issued to Employees, and related
Interpretations. Under APB No. 25, no stock-based
compensation is reflected in net income (loss), as all options
granted under the plans had an exercise price equal to the
market value of the underlying common stock on the date of grant
and the related number of shares granted is fixed at that point
in time. The following table illustrates the effect on net
income (loss) and earnings (loss) per share if the Company had
applied the fair value recognition provisions of Statement of
Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-Based Compensation (see
Note 10, Stock Option and Purchase Plans):

|                                         |         |                        |        |       |   |      |        |       |   |   |         |       |  
|---------------------------------------- | ------- | ---------------------- | ------ | ----- | - | ---- | ------ | ----- | - | - | ------- | ----- | -
|                                         |         |                       
|                                         |         | Year Ended January 31,
|                                         |         |                       
|                                         |         | 2004                   |        | 2003  |   | 2002
|                                         |         |                        |        |       |   |     
|Net income (loss) as reported            |         | $                      | (4,861 | )     |   | $    | 124    |       |   | $ | (10,997 | )    
|Stock-based compensation, net of tax     |         |                        | (1,506 | )     |   |      | (3,275 | )     |   |   | (6,107  | )    
|                                         |         |                        |        |       |   |      |        |       |   |   |         |      
|Proforma net loss                        |         | $                      | (6,367 | )     |   | $    | (3,151 | )     |   | $ | (17,104 | )    
|                                         |         |                        |        |       |   |      |        |       |   |   |         |      
|Net income (loss) per share as reported: |         |                        |        |       |   |      |        |       |   |   |         |      
|                                         | Basic   |                        | $      | (0.31 | ) |      | $      | 0.01  |   |   | $       | (0.73 | )
|                                         |         |                        |        |       |   |      |        |       |   |   |         |      
|                                         | Diluted |                        | $      | (0.31 | ) |      | $      | 0.01  |   |   | $       | (0.73 | )
|                                         |         |                        |        |       |   |      |        |       |   |   |         |      
|Proforma net loss per share:             |         |                        |        |       |   |      |        |       |   |   |         |      
|                                         | Basic   |                        | $      | (0.41 | ) |      | $      | (2.06 | ) |   | $       | (1.14 | )
|                                         |         |                        |        |       |   |      |        |       |   |   |         |      
|                                         | Diluted |                        | $      | (0.41 | ) |      | $      | (2.00 | ) |   | $       | (1.14 | )
|                                         |         |                        |        |       |   |      |        |       |   |   |         |      

In determining the fair value, the Company used
the Black-Scholes model, assumed no dividend per year, used
expected lives ranging from 2 to 10 years, expected
volatility of 71.7%, 84.8%, and 130.6% for the years ended
January 31, 2004, 2003, and 2002, respectively, and risk
free interest rates of 2.97%, 3.71%, and 3.27% for the years
ended January 31, 2004, 2003, and 2002, respectively. The
weighted average per share fair value of options granted during
the year with exercise prices equal to market price on the date
of grant was $1.39, $0.82, and $0.80 per share for the
years ended January 31, 2004, 2003, and 2002, respectively.

Revenue Recognition:The Company recognizes revenues in accordance with Statement of
Position 97-2 Software Revenue Recognition as
amended by Statement of Position 98-9.

Development license revenues from the licensing
of source code or software development kits (SDKs)
for the Companys standard products are recognized upon
delivery to and acceptance by the customer of the software if no
significant modification or customization of the software is
required and collection of the resulting receivable is probable.
If modification or customization is essential to the
functionality of the software, the development license revenues
are recognized over the course of the modification work.

The Company also enters into engineering services
contracts with certain of its OEMs to provide a turnkey
solution, adapting the Companys software and supporting
electronics to specific OEM requirements. Revenues on such
contracts are recognized over the course of the engineering work
on a percentage-of-completion basis. Progress-to-completion
under percentage-of-completion is determined based on direct
costs, consisting primarily of labor and materials, expended on
the arrangement. The Company provides for any anticipated losses
on such contracts in the period in which such losses are first
determinable. At January 31, 2004 and 2003, the Company had
no on-going contract engineering work being accounted for under
a percentage-of-completion basis on which an accrual for losses
on contracts was required. The Company also

F-9



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


provides engineering support based on a
time-and-material basis. Revenues from this support are
recognized as the services are performed.

Recurring licensing revenues are derived from per
unit fees paid by the Companys customers upon
manufacturing and subsequent commercial shipment of products
incorporating Peerless technology and certain third party
technology, of which the Company is a sub-licensor. These
recurring licensing revenues are recognized on a per unit basis
as products are shipped commercially. In certain cases, the
Company may sell a block license, that is, a specific quantity
of licensed units that may be shipped in the future, or the
Company may require the customer to pay minimum royalty
commitments. Associated payments are typically made in one lump
sum or extend over a period of four or more quarters. The
Company generally recognizes revenues associated with block
licenses and minimum royalty commitments on delivery and
acceptance of software, when collection of the resulting
receivable is probable, when the fee is fixed and determinable,
and when the Company has no future obligations. In cases where
block licenses or minimum royalty commitments have extended
payment terms and the fees are not fixed and determinable,
revenue is recognized as payments become due. Further, when
earned royalties exceed minimum royalty commitments, revenues
are recognized on a per unit basis as products are shipped
commercially.

For fees on multiple element arrangements, values
are allocated among the elements based on vendor specific
objective evidence of fair value (VSOE). If VSOE
does not exist, all revenue for the arrangement is deferred
until the earlier of the point at which such VSOE does exist or
all elements of the arrangement have been delivered. If an
arrangement includes software and service elements, a
determination is made as to whether the service element can be
accounted for separately as services are performed.

Deferred revenue consists of prepayments of
licensing fees and payments billed to customers in advance of
revenue recognized on engineering services or support contracts.
Unbilled receivables arise when the revenue recognized on a
contract exceeds billings due to timing differences related to
billing milestones as specified in the contract.

Research and Development
Costs:Research and development costs
are generally expensed as incurred. Costs to purchase software
from third-parties for research and development that have
identifiable alternative future uses (in research and
development projects or otherwise) are capitalized as intangible
assets and amortized over their expected useful life (see
Note 5).

Advertising Costs:Advertising costs are expensed as incurred in accordance with
Statement of Position 93-7 Reporting on Advertising
Costs. Advertising expenses are recorded in sales and
marketing expense and were immaterial to the results of
operations for all periods presented.

Income Taxes:The
Company accounts for income taxes in accordance with
SFAS No. 109, Accounting for Income Taxes.
Under this method, deferred income taxes are recognized for the
tax consequences in future years resulting from differences
between the tax bases of assets and liabilities and their
financial reporting amounts at each year-end based on enacted
tax laws and statutory rates applicable to the periods in which
the differences are expected to reverse. Valuation allowances
are established, when necessary, to reduce deferred income tax
assets to the amount expected to be realized. Income tax
provision is the tax payable for the period and the change
during the period in net deferred income tax assets and
liabilities.

Comprehensive Loss:In accordance with SFAS No. 130, Reporting
Comprehensive Income, all components of comprehensive
loss, including net losses, are reported in the financial
statements in the period in which they are recognized.
Comprehensive loss is defined as the change in equity during a
period from transactions and other events and circumstances from
non-owner sources. The Companys other comprehensive income
for January 31, 2004 consisted of foreign currency
translation gains and is reported in stockholders equity.

F-10



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


Earnings Per Share:Basic earnings per share (basic EPS) is computed by
dividing net income (loss) available to common stockholders (the
numerator) by the weighted average number of common shares
outstanding (the denominator) during the period. The computation
of diluted earnings per share (diluted EPS) is
similar to the computation of basic EPS except that the
denominator is increased to include the number of additional
common shares that would have been outstanding if dilutive
potential common shares had been issued. Potential common shares
include outstanding options under the Companys employee
stock option plan (which are included under the treasury stock
method) and any outstanding convertible securities. A
reconciliation of basic EPS to diluted EPS is presented in
Note 8 to the Companys financial statements.

Reclassifications:Certain previously reported financial information has been
reclassified to conform to the fiscal 2004 presentation.

Foreign Currency
Translation:The financial statements
of the Companys non-U.S. subsidiary are translated
into U.S. dollars in accordance with SFAS No. 52,
Foreign Currency Translation. The assets and
liabilities of the Companys non-U.S. subsidiary whose
functional currencies are other than the
U.S. dollar are translated at current rates of exchange.
Revenue and expense items are translated at the average exchange
rate for the year. The resulting translated adjustments are
recorded directly into accumulated other comprehensive income
(loss). Transaction gains and losses are included in net income
in the period they occur. Foreign currency translation and
transaction gains and losses have not been significant in any
period presented.

Recent Accounting
Pronouncements:On December 17,
2003, the Staff of the Securities and Exchange Commission
(SEC or the Staff) issued Staff
Accounting Bulletin No. 104 (SAB 104),
Revenue Recognition, which supercedes SAB 101,
Revenue Recognition in Financial Statements.
SAB 104s primary purpose is to rescind accounting
guidance contained in SAB 101 related to multiple element
revenue arrangements, superceded as a result of the issuance of
EITF 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables. Additionally, SAB 104 rescinds
the SECs Revenue Recognition in Financial Statements
Frequently Asked Questions and Answers issued with
SAB 101 that had been codified in SEC Staff Accounting
Bulletin Topic 13, Revenue Recognition. While the
wording of SAB 104 has changed to reflect the issuance of
EITF 00-21, the revenue recognition principles of
SAB 101 remain largely unchanged by the issuance of
SAB 104. The adoption of SAB 104 did not have a
material effect on the Companys financial condition or
results of operations.



|   |                      
|-- | ---------------------
|2. | Divestiture and Sale:



| |                              
| | -----------------------------
| | Netreon Divestiture and Sale:

In January 2002, the Company exchanged all of the
outstanding capital stock of Netreon for 7,714 shares of
Series A Preferred Stock of Netreon, Inc., a Delaware
corporation (Newco), representing a 40.8% interest
in the voting shares of Newco stock. The remaining 59.2% of the
voting shares of Newco stock was held by parties external to the
Company, including a former executive officer of Netreon, who is
also a former member of the Companys board of directors.
The Company did not expect to realize the cost of the Netreon
capital stock exchanged or costs incurred which were direct and
incremental to the transaction. As a result, the Company did not
record an investment in Newco and recorded a $2.3 million
charge to loss on divestiture of storage operations. Among other
things, this included a $947 payment made to a landlord to
terminate the Companys obligations under one of
Netreons leases and a $420 accrual for other Netreon lease
obligations to be paid by the Company through fiscal year 2005.
The Company has no continuing obligation to provide funding in
any form to Newco.

F-11



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


In February, 2003, the Company sold its remaining
interest in Netreon. As a result of the sale, the Company
recorded in other income a gain of $971, net of expenses,
associated with this transaction in the first quarter of fiscal
year 2004 (see Note 15).



|   |             
|-- | ------------
|3. | Investments:

Investments available-for-sale at January 31
consisted of the following:

|                               |                                               |                                            |       |      |       |   |       |   |       | 
|------------------------------ | --------------------------------------------- | ------------------------------------------ | ----- | ---- | ----- | - | ----- | - | ----- | 
|                               |                                               | 2004                                       |       | 2003
|                               |                                               |                                            |       |     
|Available-for-sale securities: |                                               |                                            |       |      |       |   |       |  
|                               | Maturities within one year:                   |                                            |       |      |       |   |       |   |      
|                               |                                               | Corporate debt securities                  |       | $    | 499   |   |       | $ |      | 
|                               |                                               | State and local government debt securities |       |      | 403   |   |       |   | 816   | 
|                               |                                               | U.S. government debt securities            |       |      |      |   |       |   | 913   | 
|                               |                                               |                                            |       |      |       |   |       |  
|                               |                                               |                                            | 902   |      |       |   | 1,729 |  
|                               |                                               |                                            |       |      |       |   |       |  
|                               | Maturities after one year through five years: |                                            |       |      |       |   |       |   |      
|                               |                                               | Corporate debt securities                  |       |      | 2,218 |   |       |   |      | 
|                               |                                               | State and local government debt securities |       |      | 421   |   |       |   | 417   | 
|                               |                                               | U.S. government debt securities            |       |      | 400   |   |       |   | 1,228 | 
|                               |                                               |                                            |       |      |       |   |       |  
|                               |                                               |                                            | 3,039 |      |       |   | 1,645 |  
|                               |                                               |                                            |       |      |       |   |       |  
|                               | Maturities after ten years:                   |                                            |       |      |       |   |       |   |      
|                               |                                               | U.S. government debt securities            |       |      | 400   |   |       |   |      | 
|                               |                                               | Corporate debt securities                  |       |      |      |   |       |   | 300   | 
|                               |                                               |                                            |       |      |       |   |       |  
|                               |                                               |                                            | 400   |      |       |   | 300   |  
|                               |                                               |                                            |       |      |       |   |       |  
|Total investments              |                                               | $                                          | 4,341 |      |       | $ | 3,674 |  
|                               |                                               |                                            |       |      |       |   |       |  

The above available-for-sale securities include
$3.4 million of investments with contractual maturities
greater than one year which are classified on the consolidated
balance sheets as current investments, based on the
Companys intention to use these investments to fund
current operations, if necessary.

The fair value of available-for-sale securities
at January 31, 2004 and 2003 approximated their carrying
value (amortized cost). Unrealized gains or losses on
available-for-sale securities were immaterial for all periods
presented.

F-12



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)




|   |                        
|-- | -----------------------
|4. | Property and Equipment:

Property and equipment at January 31
consisted of the following:

|                                                |  |      |        |      |  |   |        |  
|----------------------------------------------- |  | ---- | ------ | ---- |  | - | ------ | -
|                                                |  | 2004 |        | 2003
|                                                |  |      |        |     
|Computers and other equipment                   |  | $    | 8,036  |      |  | $ | 7,698  |  
|Furniture                                       |  |      | 479    |      |  |   | 464    |  
|Leasehold improvements                          |  |      | 2,378  |      |  |   | 2,105  |  
|Construction-in-progress                        |  |      |       |      |  |   | 10     |  
|                                                |  |      |        |      |  |   |        |  
|                                                |  |      | 10,893 |      |  |   | 10,277 |  
|Less, accumulated depreciation and amortization |  |      | (8,912 | )    |  |   | (8,072 | )
|                                                |  |      |        |      |  |   |        |  
|                                                |  | $    | 1,981  |      |  | $ | 2,205  |  
|                                                |  |      |        |      |  |   |        |  

Depreciation and amortization for the years ended
January 31, 2004, 2003, and 2002 was $1,018, $1,321, and
$1,930, respectively.

During fiscal year 2003, the Company amended the
building lease of its headquarters in California, resulting in a
reduction of office space. The Company recorded charges of
approximately $0.7 million for costs associated with the
amendment of the lease and the write-off of certain leasehold
improvements.

In February 2003, a sublessee terminated a
sublease that involved approximately 9,000 square feet of
the Companys California headquarters. As a result of the
termination, the Company received $639 in cash and a forfeited
deposit, which is included in other income. In addition, the
Company received $299 in net fixed assets returned to the
Company, which was classified as operating expenses, the same
classification used in a prior period when a loss was recognized
for the disposal of these same assets. The assets were recorded
at fair market value. The total gain from the sublease
termination was $938.



|   |              
|-- | -------------
|5. | Other Assets:

In fiscal year 2004, the Company converted a
royalty-bearing perpetual license to a fully paid up perpetual
license to use certain third party color technology to be
incorporated into the Companys high performance color
architecture and products. The licensed technology is presently
being applied in several of the Companys research and
development projects and will be incorporated into the
Companys new products. The Company determined this license
has alternate future uses and has capitalized the cost as an
intangible asset, included in other assets. The cost of $1,100
for this license is being amortized over a two-year period
during its use on such projects and products. Accumulated
amortization from the acquired prepaid licenses totaled $229 at
January 31, 2004. As of January 31, 2004, the Company
anticipates that total charges to be recognized in future
periods from the amortization of the acquired technology will be
approximately $550 and $321 in fiscal years 2005 and 2006,
respectively.

F-13



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)




|   |                  
|-- | -----------------
|6. | Deferred Revenues

The Company may bill or receive payments from its
customers for fees associated with product licensing,
engineering services, or maintenance agreements in advance of
the Companys completion of its contractual obligations.
Such billings or payments, in accordance with the Companys
revenue recognition policies, are deferred, and are recognized
as revenue when the Company has performed its contractual
obligations related to the billings or payments.

Deferred revenues consisted of the following at
January 31:

|                                     |  |      |       |      |  |   |       | 
|------------------------------------ |  | ---- | ----- | ---- |  | - | ----- | 
|                                     |  | 2004 |       | 2003
|                                     |  |      |       |     
|Product licensing                    |  | $    | 63    |      |  | $ | 25    | 
|Engineering services and maintenance |  |      | 1,260 |      |  |   | 1,056 | 
|                                     |  |      |       |      |  |   |       | 
|                                     |  | $    | 1,323 |      |  | $ | 1,081 | 
|                                     |  |      |       |      |  |   |       | 



|   |              
|-- | -------------
|7. | Income Taxes:

The income tax provision for the years ended
January 31 consisted of:

|         |         |      |     |       |   |      |     |        |   |   |       |       |  
|-------- | ------- | ---- | --- | ----- | - | ---- | --- | ------ | - | - | ----- | ----- | -
|         |         | 2004 |     | 2003  |   | 2002
|         |         |      |     |       |   |     
|Current: |         |      |     |       |   |      |     |        |   |   |       |      
|         | Federal |      | $   | (980  | ) |      | $   | (1,621 | ) |   | $     | (200  | )
|         | State   |      |     | 1     |   |      |     | 1      |   |   |       | 2     |  
|         | Foreign |      |     | 1,675 |   |      |     | 2,110  |   |   |       | 2,007 |  
|         |         |      |     |       |   |      |     |        |   |   |       |      
|         |         | $    | 696 |       |   | $    | 490 |        |   | $ | 1,809 |      
|         |         |      |     |       |   |      |     |        |   |   |       |      

The foreign tax provision was comprised of
foreign withholding taxes on license fees and royalty payments.

The Companys current income tax provision
was benefited by approximately $980 and $1,080 for fiscal years
2004 and 2003, respectively, for the elimination of certain
pending income tax matters and related liabilities. At
January 31, 2004, the Company has no remaining liabilities
related to these matters.

Temporary differences that give rise to the
deferred tax provision for the years ended January 31,
consisted of:

|                     |                                  |                           |   |       |        |  |   |       |       | 
|-------------------- | -------------------------------- | ------------------------- | - | ----- | ------ |  | - | ----- | ----- | 
|                     |                                  | 2004                      |   | 2003 
|                     |                                  |                           |   |      
|Deferred tax assets: |                                  |                           |   |       |        |  |   |      
|                     | Net operating loss carryforwards |                           | $ | 2,735 |        |  | $ | 776   |      
|                     | Accrued liabilities              |                           |   | 326   |        |  |   | 268   |      
|                     | Allowance for doubtful accounts  |                           |   | 56    |        |  |   | 79    |      
|                     | Property and equipment           |                           |   | 119   |        |  |   | 90    |      
|                     | Deferred expenses                |                           |   | 171   |        |  |   | 177   |      
|                     | Tax credit carryforwards         |                           |   | 6,862 |        |  |   | 7,767 |      
|                     | Other                            |                           |   | 20    |        |  |   | 76    |      
|                     |                                  |                           |   |       |        |  |   |      
|                     |                                  | Total deferred tax assets |   |       | 10,289 |  |   |       | 9,233 | 
|                     |                                  |                           |   |       |        |  |   |      

F-14



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


|                         |             |                                |         |        |    |   |        |       |    |  
|------------------------ | ----------- | ------------------------------ | ------- | ------ | -- | - | ------ | ----- | -- | -
|                         |             | 2004                           |         | 2003  
|                         |             |                                |         |       
|Deferred tax liabilities |             |                                |         |        |    |   |        |      
|                         | State taxes |                                |         | (1     | )  |   |        | (1    | ) 
|                         | Other       |                                |         |       |    |   |        | (5    | ) 
|                         |             |                                |         |        |    |   |        |      
|                         |             | Total deferred tax liabilities |         |        | (1 | ) |        |       | (6 | )
|                         |             |                                |         |        |    |   |        |      
|                         | Subtotal    |                                |         | 10,288 |    |   |        | 9,227 |   
|Valuation allowance      |             |                                | (10,288 | )      |    |   | (9,227 | )    
|                         |             |                                |         |        |    |   |        |      
|                         |             | Net deferred income tax asset  |         | $      |   |   |        | $     |   |  
|                         |             |                                |         |        |    |   |        |      

The Company provided a valuation allowance on its
net deferred tax assets because of the uncertainty with respect
to the Companys ability to generate future taxable income
to realize the deferred tax assets. As a result of the Netreon
divestiture (see Note 2), the Company will no longer file a
consolidated return with Netreon. The deferred tax assets and
liabilities, including net operating losses, have been adjusted
to reflect this change in ownership.

A portion of the valuation allowance is related
to stock option compensation deductions incurred in the
Companys net operating loss carryforwards. If and when the
Company reduces any portion of the valuation allowance related
to stock option compensation deduction, the benefit will be
added to stockholders equity, rather than being shown as a
reduction of future income tax expense.

The provision for income taxes for the years
ended January 31, differed from the amount that would
result from applying the federal statutory rate as follows:

|                                  |                            |      |       |      |   |      |        |      |   |  |       |      |  
|--------------------------------- | -------------------------- | ---- | ----- | ---- | - | ---- | ------ | ---- | - |  | ----- | ---- | -
|                                  |                            | 2004 |       | 2003 |   | 2002
|                                  |                            |      |       |      |   |     
|Statutory federal income tax rate |                            |      | (34.0 | )%   |   |      | 34.0   | %    |   |  | (34.0 | )%  
|Foreign provision                 |                            |      | 40.2  |      |   |      | 353.9  |      |   |  | 21.9  |     
|Divestiture of Netreon            |                            |      |      |      |   |      |       |      |   |  | 8.5   |     
|Other nondeductible expenses      |                            |      | 0.5   |      |   |      | 2.5    |      |   |  | 0.5   |     
|State tax                         |                            |      | (4.2  | )    |   |      | 5.8    |      |   |  | (1.0  | )   
|Change in valuation allowance     |                            |      | 25.5  |      |   |      | (137.4 | )    |   |  | 26.0  |     
|Preacquisition reserves           |                            |      |      |      |   |      |       |      |   |  | (2.2  | )   
|Other                             |                            |      | (11.3 | )    |   |      | (176.9 | )    |   |  |      |     
|                                  |                            |      |       |      |   |      |        |      |   |  |       |     
|                                  | Provision for income taxes |      |       | 16.7 | % |      |        | 81.9 | % |  |       | 19.7 | %
|                                  |                            |      |       |      |   |      |        |      |   |  |       |     

As of January 31, 2004, the Company had net
operating loss carryforwards available to reduce future federal
and state income of approximately $6,954 and $6,358,
respectively, which expire through the periods ending in fiscal
years 2022 for federal and 2013 for state. In addition, as of
January 31, 2004, the Company had tax credit carryforwards
available to reduce future income tax liabilities of
approximately $6,862, which expire between fiscal years 2004 and
2023. Utilization of the net operating loss and tax
carryforwards will be subject to an annual limitation if a
change in the Companys ownership should occur as defined
by Section 382 and Section 383 of the Internal Revenue
Code.

F-15



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)




|   |                           
|-- | --------------------------
|8. | Earnings (Loss) Per Share:

Earnings (loss) per share for the years ended
January 31, is calculated as follows:

|                                                                              |  |      |        |        |  |        |        |        |  |        |       |        |  |      |     |        |  |        |        |  |  |   |      |  |  |   |         |   |  |  |        |  |  |   |       |  
|----------------------------------------------------------------------------- |  | ---- | ------ | ------ |  | ------ | ------ | ------ |  | ------ | ----- | ------ |  | ---- | --- | ------ |  | ------ | ------ |  |  | - | ---- |  |  | - | ------- | - |  |  | ------ |  |  | - | ----- | -
|                                                                              |  |      |        |        |  |       
|                                                                              |  | 2004 |        | 2003   |  | 2002  
|                                                                              |  |      |        |        |  |       
|                                                                              |  |      |        | Per    |  |        |        | Per    |  |        |       | Per   
|                                                                              |  | Net  |        |        |  | Share  |        | Net    |  |        |       | Share  |  | Net  |     |        |  | Share 
|                                                                              |  | Loss |        | Shares |  | Amount |        | Income |  | Shares |       | Amount |  | Loss |     | Shares |  | Amount
|                                                                              |  |      |        |        |  |        |        |        |  |        |       |        |  |      |     |        |  |       
|Basic EPS                                                                     |  |      |        |        |  |        |        |        |  |        |       |        |  |      |     |        |  |        |        |  |  |   |      |  |  |   |         |   |  |  |        |  |  |   |       |  
|Earnings (loss) available to common stock holders                             |  | $    | (4,861 | )      |  |        | 15,575 |        |  | $      | (0.31 | )      |  | $    | 124 |        |  |        | 15,282 |  |  | $ | 0.01 |  |  | $ | (10,997 | ) |  |  | 15,062 |  |  | $ | (0.73 | )
|                                                                              |  |      |        |        |  |        |        |        |  |        |       |        |  |      |     |        |  |        |        |  |  |   |      |  |  |   |         |   |  |  |        |  |  |   |       |  
|Effect of Dilutive Securities                                                 |  |      |        |        |  |        |        |        |  |        |       |        |  |      |     |        |  |        |        |  |  |   |      |  |  |   |         |   |  |  |        |  |  |   |       |  
|Options                                                                       |  |      |        |        |  |        |        |        |  |        |       |        |  |      |    |        |  |        | 440    |  |  |   |      |  |  |   |         |   |  |  |        |  |  |   |       |  
|                                                                              |  |      |        |        |  |        |        |        |  |        |       |        |  |      |     |        |  |        |        |  |  |   |      |  |  |   |         |   |  |  |        |  |  |   |       |  
|Diluted EPS                                                                   |  |      |        |        |  |        |        |        |  |        |       |        |  |      |     |        |  |        |        |  |  |   |      |  |  |   |         |   |  |  |        |  |  |   |       |  
|Earnings (loss) available to common stockholders
    with assumed conversions |  | $    | (4,861 | )      |  |        | 15,575 |        |  | $      | (0.31 | )      |  | $    | 124 |        |  |        | 15,722 |  |  | $ | 0.01 |  |  | $ | (10,997 | ) |  |  | 15,062 |  |  | $ | (0.73 | )
|                                                                              |  |      |        |        |  |        |        |        |  |        |       |        |  |      |     |        |  |        |        |  |  |   |      |  |  |   |         |   |  |  |        |  |  |   |       |  

The Company has certain common stock options that
are not included in the calculation of diluted earnings (loss)
per share in fiscal years 2004 and 2002 because the effects are
antidilutive. The stock options are described in Notes 1
and 10.



|   |                                 
|-- | --------------------------------
|9. | Issuance and Purchase of Shares:

In April 2001, the Company entered into a
settlement agreement with one of the former owners of HDE,
relating to a lawsuit filed by the Company against the former
owners of HDE in July 2000. Pursuant to the settlement, the
Company issued 429 put options with a strike price of
$0.75 per share. The put options entitled the holder to
sell shares of Peerless common stock to the Company at the
strike price before the expiration of the put options in October
2001. Prior to the formal settlement, at January 31, 2001,
the Company accrued $90, representing the deemed fair value of
the put options as determined by the difference between the put
option purchase price and the fair market value of the
Companys stock on the date of the settlement agreement.
Upon issuance of the put options in fiscal year 2002, the
potential obligation under the outstanding put options was
transferred from stockholders equity to common stock
subject to put options. During fiscal year 2002, the
Company repurchased 150 shares for $113 as the result of
the exercise of put options. The remaining obligation under the
outstanding put options, which expired in October 2001, has been
transferred back to stockholders equity.



|    |                                 
|--- | --------------------------------
|10. | Stock Option and Purchase Plans:

1992 Stock Option
Plan:During 1992, the Board of
Directors authorized the 1992 Stock Option Plan for the purpose
of granting options to purchase the Companys common stock
to employees, directors and consultants. The Board of Directors
determines the form, term, option price and conditions under
which each option becomes exercisable. Options to purchase a
total of 1,055 shares of common stock have been authorized
by the Board under this plan.

F-16



---



##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


The following represents option activity for the
years ended January 31 under the 1992 Stock Option Plan:

|                                                                           |  |           |              |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|-------------------------------------------------------------------------- |  | --------- | ------------ | --------- |  | --------- | ---- | --------- |  | --------- | -- | --------- |  | - | ---- |  |  |  | ---- | - |  | - | ---- | 
|                                                                           |  |           |              |           |  |          
|                                                                           |  | 2004      |              | 2003      |  | 2002     
|                                                                           |  |           |              |           |  |          
|                                                                           |  |           |              | Weighted  |  |           |      | Weighted  |  |           |    | Weighted 
|                                                                           |  |           |              | Average   |  |           |      | Average   |  |           |    | Average  
|                                                                           |  |           |              | Per Share |  |           |      | Per Share |  |           |    | Per Share
|                                                                           |  | Number of |              | Exercise  |  | Number of |      | Exercise  |  | Number of |    | Exercise 
|                                                                           |  | Options   |              | Price     |  | Options   |      | Price     |  | Options   |    | Price    
|                                                                           |  |           |              |           |  |           |      |           |  |           |    |          
|Options outstanding at beginning of year                                   |  |           | 22           |           |  | $         | 1.51 |           |  |           | 29 |           |  | $ | 1.29 |  |  |  | 152  |   |  | $ | 1.45 | 
|Options granted                                                            |  |           |             |           |  |           |      |           |  |           |   |           |  |   |      |  |  |  |     |   |  |   |      | 
|Options exercised                                                          |  |           | (1           | )         |  | $         | 0.53 |           |  |           | (7 | )         |  | $ | 0.53 |  |  |  | (1   | ) |  | $ | 0.53 | 
|Options forfeited                                                          |  |           |             |           |  |           |     |           |  |           |   |           |  |   |      |  |  |  | (122 | ) |  | $ | 1.43 | 
|                                                                           |  |           |              |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|Options outstanding at year-end                                            |  |           | 21           |           |  | $         | 1.56 |           |  |           | 22 |           |  | $ | 1.51 |  |  |  | 29   |   |  | $ | 1.29 | 
|                                                                           |  |           |              |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|Options exercisable at year-end                                            |  |           | 21           |           |  | $         | 1.56 |           |  |           | 22 |           |  | $ | 1.51 |  |  |  | 29   |   |  | $ | 1.29 | 
|                                                                           |  |           |              |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|Options available for future grant                                         |  |           |             |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|                                                                           |  |           |              |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|Weighted average remaining contractual life in
    years                   |  |           | 1.7          |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|                                                                           |  |           |              |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|Range of per share exercise prices for options
    outstanding at year-end |  | $         | 1.42 - $1.65 |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 
|                                                                           |  |           |              |           |  |           |      |           |  |           |    |           |  |   |      |  |  |  |      |   |  |   |      | 

Incentive Plan:In
May 1996, the Board adopted the Companys 1996 Stock Option
Plan. The Companys 1996 Equity Incentive Plan (the
Incentive Plan) was adopted by the Board of
Directors in July 1996 as an amendment and restatement of the
Companys 1996 Plan. At that time, the Board had authorized
and reserved an aggregate of 1,267 shares of common stock
for issuance under the Incentive Plan. Additional shares of
common stock were authorized and reserved for issuance under the
Incentive Plan in June 1998, June 1999, June 2001, and June 2003
in the amounts of 1,200, 750, 750, and 700 shares,
respectively.

The Incentive Plan provides for the grant of
incentive stock options to employees and nonstatutory stock
options, restricted stock purchase awards and stock bonuses to
employees, directors and consultants. The terms of stock options
granted under the Incentive Plan generally may not exceed
10 years. The exercise price of options granted under the
Incentive Plan is determined by the Board of Directors, provided
that the exercise price for an incentive stock option cannot be
less than 100% of the fair market value of the common stock on
the date of the option grant and the exercise price for a
nonstatutory stock option cannot be less than 85% of the fair
market value of the common stock on the date of the option
grant. Options granted under the Incentive Plan vest at the rate
specified in each optionees option agreement.

During 1994, the Auco, Inc. Board of Directors
authorized the 1994 Stock Option Plan. The terms and conditions
of this plan were generally the same as those of the Peerless
Incentive Plan except options issued under the Auco plan were
exercisable immediately subject to repurchase rights held by
Auco. In June 1999, upon completion of the merger between
Peerless and Auco, the Auco options were converted to options
under the Companys Incentive Plan.

F-17



---



##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


The following represents option activity under
the Incentive Plan for the years ended January 31:

|                                                                           |  |           |                |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|-------------------------------------------------------------------------- |  | --------- | -------------- | --------- |  | --------- | ---- | --------- |  | --------- | ----- | --------- |  | - | ---- |  |  |  | ------ | - |  | - | ---- | 
|                                                                           |  |           |                |           |  |          
|                                                                           |  | 2004      |                | 2003      |  | 2002     
|                                                                           |  |           |                |           |  |          
|                                                                           |  |           |                | Weighted  |  |           |      | Weighted  |  |           |       | Weighted 
|                                                                           |  |           |                | Average   |  |           |      | Average   |  |           |       | Average  
|                                                                           |  |           |                | Per Share |  |           |      | Per Share |  |           |       | Per Share
|                                                                           |  | Number of |                | Exercise  |  | Number of |      | Exercise  |  | Number of |       | Exercise 
|                                                                           |  | Options   |                | Price     |  | Options   |      | Price     |  | Options   |       | Price    
|                                                                           |  |           |                |           |  |           |      |           |  |           |       |          
|Options outstanding at beginning of year                                   |  |           | 3,121          |           |  | $         | 2.82 |           |  |           | 2,735 |           |  | $ | 3.68 |  |  |  | 2,457  |   |  | $ | 6.19 | 
|Options granted                                                            |  |           | 266            |           |  | $         | 2.34 |           |  |           | 794   |           |  | $ | 1.23 |  |  |  | 1,523  |   |  | $ | 0.92 | 
|Options exercised                                                          |  |           | (121           | )         |  | $         | 0.78 |           |  |           | (66   | )         |  | $ | 0.89 |  |  |  | (61    | ) |  | $ | 0.31 | 
|Options forfeited                                                          |  |           | (185           | )         |  | $         | 1.65 |           |  |           | (342  | )         |  | $ | 3.12 |  |  |  | (1,184 | ) |  | $ | 4.49 | 
|                                                                           |  |           |                |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|Options outstanding at year-end                                            |  |           | 3,081          |           |  | $         | 2.70 |           |  |           | 3,121 |           |  | $ | 2.82 |  |  |  | 2,735  |   |  | $ | 3.68 | 
|                                                                           |  |           |                |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|Options exercisable at year-end                                            |  |           | 1,849          |           |  | $         | 3.60 |           |  |           | 1,532 |           |  | $ | 4.32 |  |  |  | 1,193  |   |  | $ | 5.70 | 
|                                                                           |  |           |                |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|Options available for future grant                                         |  |           | 1,050          |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|                                                                           |  |           |                |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|Weighted average remaining contractual life in
    years                   |  |           | 7.2            |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|                                                                           |  |           |                |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|Range of per share exercise prices for options
    outstanding at year-end |  |           | $0.39 - $22.38 |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 
|                                                                           |  |           |                |           |  |           |      |           |  |           |       |           |  |   |      |  |  |  |        |   |  |   |      | 

For various price ranges, weighted average
characteristics of outstanding stock options under the Incentive
Plan at January 31, 2004 were as follows:

|                 |       |                     |       |                     |  |           |     |        |  |           |       |  |  |  |       |       |  |   |       |  | 
|---------------- | ----- | ------------------- | ----- | ------------------- |  | --------- | --- | ------ |  | --------- | ----- |  |  |  | ----- | ----- |  | - | ----- |  | 
|                 |       |                     |       |                    
|                 |       | Outstanding Options |       | Exercisable Options
|                 |       |                     |       |                    
|                 |       |                     |       | Weighted            |  | Weighted  |     |        |  | Weighted 
|                 |       |                     |       | Average             |  | Average   |     |        |  | Average  
|                 |       | Shares              |       | Remaining           |  | Per Share |     | Shares |  | Per Share
|                 |       | Under               |       | Life                |  | Exercise  |     | Under  |  | Exercise 
|                 |       | Option              |       | (Years)             |  | Price     |     | Option |  | Price    
|                 |       |                     |       |                     |  |           |     |        |  |          
|$0.00 to $2.31   |       |                     | 2,332 |                     |  |           | 7.1 |        |  | $         | 1.22  |  |  |  | 1,212 |       |  | $ | 1.25  | 
|$2.31 to $4.63   |       |                     | 342   |                     |  |           | 6.9 |        |  | $         | 3.31  |  |  |  | 235   |       |  | $ | 3.53  | 
|$4.63 to $6.94   |       |                     | 85    |                     |  |           | 5.1 |        |  | $         | 5.09  |  |  |  | 80    |       |  | $ | 5.09  | 
|$6.94 to $9.25   |       |                     | 97    |                     |  |           | 4.5 |        |  | $         | 8.48  |  |  |  | 97    |       |  | $ | 8.48  | 
|$9.25 to $11.56  |       |                     | 52    |                     |  |           | 3.5 |        |  | $         | 10.86 |  |  |  | 52    |       |  | $ | 10.86 | 
|$11.56 to $13.88 |       |                     | 76    |                     |  |           | 5.4 |        |  | $         | 12.99 |  |  |  | 76    |       |  | $ | 12.99 | 
|$13.88 to $16.19 |       |                     | 67    |                     |  |           | 4.2 |        |  | $         | 14.13 |  |  |  | 67    |       |  | $ | 14.13 | 
|$16.19 to $18.50 |       |                     | 14    |                     |  |           | 3.7 |        |  | $         | 17.14 |  |  |  | 14    |       |  | $ | 17.14 | 
|$18.50 to $20.81 |       |                     | 1     |                     |  |           | 4.3 |        |  | $         | 19.75 |  |  |  | 1     |       |  | $ | 19.75 | 
|$20.81 to $22.38 |       |                     | 15    |                     |  |           | 4.4 |        |  | $         | 22.15 |  |  |  | 15    |       |  | $ | 22.15 | 
|                 |       |                     |       |                     |  |           |     |        |  |           |       |  |  |  |       |       |  |   |       | 
|                 | Total |                     |       | 3,081               |  |           |     |        |  |           |       |  |  |  |       | 1,849 |  |   |       |  | 
|                 |       |                     |       |                     |  |           |     |        |  |           |       |  |  |  |       |       |  |   |       | 

Deferred
Compensation:During the year ended
January 31, 1997, the Company recorded deferred
compensation costs of $452 for the difference between the
exercise price and the deemed fair value of the Companys
common stock at the date of grant for options issued under the
Incentive Plan. Of the total deferred expense, the Company
recognized $58 as compensation expense during the year ended
January 31, 2002.

F-18



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


Employee Stock Purchase
Plan:In July 1996, the Companys
Board of Directors approved the Employee Stock Purchase Plan
(the Purchase Plan) covering an aggregate of
300 shares of the Companys common stock. An
additional 500 shares were approved by the stockholders in
June 2000. Under the Purchase Plan, the Board of Directors may
authorize participation by eligible employees, including
officers, in periodic offerings following the adoption of the
Purchase Plan. The offering period for any offering will be no
more than 27 months. Plan offering periods have been six
months since the inception of the plan. Employees are eligible
to participate if they are employed by the Company or an
affiliate of the Company designated by the Board of Directors
and meet eligibility standards established by the Board of
Directors. Employees who participate in an offering can have up
to 15% of their earnings withheld pursuant to the Purchase Plan
and applied, on specified dates determined by the Board of
Directors, to the purchase of shares of common stock. The price
of common stock purchased under the Purchase Plan will be equal
to 85% of the lower of the fair market value of the common stock
on the commencement date or the purchase date of each offering
period. Employees may end their participation in the offering at
any time during the offering period, and participation ends
automatically on termination of employment with the Company and
its affiliates. The Purchase Plan will terminate at the Board of
Directors discretion.

Under the Purchase Plan, during the years ended
January 31, 2004 and 2002, employees purchased 294 and
406 shares of common stock at weighted average per share
prices of $1.09 and $4.57, respectively. No purchases were made
by employees during fiscal year 2003.



|    |                         
|--- | ------------------------
|11. | Shareholder Rights Plan:

In October 1998, the Board of Directors of the
Company adopted a stockholder rights plan, as set forth in the
Rights Agreement, dated as of October 7, 1998, by and
between the Company and Wells Fargo Shareowner Services, a
division of Wells Fargo Bank Minnesota, N.A., formerly known as
Norwest Shareowner Services, as rights agent. Pursuant to the
Rights Agreement, one right was issued for each share of the
Companys 11,037 outstanding shares of common stock as of
October 15, 1998. Each of the Rights entitles the
registered holder to purchase, from the Company, one
one-thousandth of a share of Series A Junior Participating
Preferred Stock at a price of $35.50 per one one-thousandth
of a share. The Rights generally will not become exercisable
unless and until, among other things, any person or group not
approved by the Board of Directors acquires beneficial ownership
of 15% or more of the Companys outstanding common stock or
commences a tender offer or exchange offer which would result in
a person or group beneficially owning 15% or more of the
Companys outstanding common stock. Upon the occurrence of
certain events, each holder of a Right, other than such person
or group, would thereafter have the right to purchase, for the
then exercise price of the Right, shares of common stock of the
Company or a corporation or other entity acquiring the Company,
having a value equal to two times the exercise price of the
Right. The Rights are redeemable by the Company under certain
circumstances at $0.01 per Right and will expire, unless
earlier redeemed or extended, on October 15, 2008.



|    |                       
|--- | ----------------------
|12. | Employee Savings Plan:

The Company maintains an employee savings plan
that qualifies under Section 401(k) of the Internal Revenue
Code (the Code) for all of the Peerless full-time
employees. The plan allows employees to make specified
percentage pretax contributions up to the maximum dollar
limitation prescribed by the Code. The Company has the option to
contribute to the plan up to a maximum of $2,000 per
employee per year. Company contributions to the plan during the
years ended January 31, 2004, 2003, and 2002 were $176,
$151, and $219, respectively.

F-19



---



##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)




|    |                          
|--- | -------------------------
|13. | International Operations:

The Companys long-lived assets are located
principally in the United States. The Companys revenues
for the years ended January 31, which are transacted in
U.S. dollars, are derived based on sales to customers in
the following geographic regions:

|              |  |                         |        |      |  |      |        |  |  |   |        | 
|------------- |  | ----------------------- | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|              |  |                        
|              |  | Years Ended January 31,
|              |  |                        
|              |  | 2004                    |        | 2003 |  | 2002
|              |  |                         |        |      |  |     
|United States |  | $                       | 3,255  |      |  | $    | 3,599  |  |  | $ | 3,826  | 
|Japan         |  |                         | 21,912 |      |  |      | 27,584 |  |  |   | 25,856 | 
|Other         |  |                         | 87     |      |  |      | 574    |  |  |   | 85     | 
|              |  |                         |        |      |  |      |        |  |  |   |        | 
|              |  | $                       | 25,254 |      |  | $    | 31,757 |  |  | $ | 29,767 | 
|              |  |                         |        |      |  |      |        |  |  |   |        | 



|    |                   
|--- | ------------------
|14. | Segment Reporting:

Peerless provides software-based digital imaging
and networking technology for digital document products and
provides directory and management software for networked storage
devices and integrates proprietary software into enterprise
networks of original equipment manufacturers.

On January 29, 2002, the Company divested
itself of the Netreon storage management operations. As a result
of this divestiture, in fiscal year 2003, the Company is solely
engaged in Imaging operations. Prior to the divestiture, the
Company viewed its operations as two segments: Imaging and
Storage. The factors that management used to identify the
separate segments included customer base, products and
technology. The factors used to measure the performance of the
two segments included revenues, operating profit and staffing.

A description of the products and services
provided by each segment is as follows:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Imaging provides to OEM customers imaging
    systems, page description languages, drivers, application
    specific integrated circuits, engineering services to modify
    products for specific applications and maintenance for digital
    document products. Products can be purchased in source code form
    or can be modified using the Companys engineering services
    to adapt for a specific application. License fees are charged
    for the utilization of imaging technology.                         
|
| |  | Storage provides OEM storage customers Network
    Attached Storage software development kits that allow NAS OEMs
    to provide NetWare or Windows 2000 compatibility for their
    products. Storage is currently developing comparable products
    for the Storage Area Networks. Products can be purchased in
    source code form or can be modified using the Storage
    engineering services to adapt for a specific application.
    License fees are charged for the utilization of the Storage
    technology.

The segment information presented below for
fiscal year 2002 as to revenues, operating loss, depreciation
and amortization, and capital expenditures is reported for the
storage segment through the period ending January 29, 2002,
the effective date of the Companys announced divestiture
of its storage operations. No information as to assets is given,
as the storage operation was not part of the Company as of
January 31, 2002.

The accounting policies used to derive reportable
segments results are generally the same as those described in
Note 1. Inter-segment transactions are not material. The
Companys selling, general and administrative expenses are
not identified by segments or accumulated in this manner due to,
among other things, shared management and cross-utilization of
personnel. For fiscal year 2002, such expenses related to the
Companys Netreon, Inc. subsidiary are attributed to the
Storage segment; all other such expenses incurred by the Company
are allocated to the Imaging segment.

F-20



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


The table below presents segment information for
fiscal year ended January 31:

|                              |  |         |        |         |  |                |        |   |  |   |        |  
|----------------------------- |  | ------- | ------ | ------- |  | -------------- | ------ | - |  | - | ------ | -
|                              |  | Imaging |        | Storage |  | Total Segments
|                              |  |         |        |         |  |               
|2004                          |  |         |        |         |  |                |        |   |  |   |        |  
|Revenues                      |  | $       | 25,254 |         |  | $              | N/A    |   |  | $ | 25,254 |  
|Operating loss                |  | $       | (5,793 | )       |  | $              | N/A    |   |  | $ | (5,793 | )
|Depreciation and amortization |  | $       | 1,375  |         |  | $              | N/A    |   |  | $ | 1,375  |  
|Capital expenditures          |  | $       | 388    |         |  | $              | N/A    |   |  | $ | 388    |  
|2003                          |  |         |        |         |  |                |        |   |  |   |        |  
|Revenues                      |  | $       | 31,757 |         |  | $              | N/A    |   |  | $ | 31,757 |  
|Operating income              |  | $       | 240    |         |  | $              | N/A    |   |  | $ | 240    |  
|Depreciation and amortization |  | $       | 1,510  |         |  | $              | N/A    |   |  | $ | 1,510  |  
|Capital expenditures          |  | $       | 215    |         |  | $              | N/A    |   |  | $ | 215    |  
|2002                          |  |         |        |         |  |                |        |   |  |   |        |  
|Revenues                      |  | $       | 29,654 |         |  | $              | 113    |   |  | $ | 29,767 |  
|Operating loss                |  | $       | (742   | )       |  | $              | (9,206 | ) |  | $ | (9,948 | )
|Depreciation and amortization |  | $       | 1,788  |         |  | $              | 338    |   |  | $ | 2,126  |  
|Capital expenditures          |  | $       | 369    |         |  | $              | 545    |   |  | $ | 914    |  



|    |              
|--- | -------------
|15. | Other Income:

On February 20, 2003, the Company sold its
remaining interest in Netreon. As a result of the sale, the
Company recorded in other income a gain of $971, net of
expenses, associated with this transaction in the first quarter
of fiscal year 2004.

On February 28, 2003, a sublessee terminated
a sublease that involved approximately 9,000 square feet of
the Companys El Segundo, California headquarters. As
a result of the sublease termination, the Company recorded in
other income a gain of $639 for cash and a forfeited deposit
associated with this transaction in the first quarter of fiscal
year 2004.

The Company resolved a disputed claim regarding
the licensing of its intellectual property and reported
non-recurring other income of $2.3 million and collected a
$1.5 million receivable during fiscal year 2002.

F-21



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)




|    |             
|--- | ------------
|16. | Commitments:

Operating Leases:The Company leases its offices and certain operating equipment
under operating leases that expire through fiscal year 2008. The
principal operating leases covering the Companys office
space contain certain predetermined rent increases calculated at
the inception of the lease based on the lessors estimate
of expected increases in the fair market value of the leased
space. These leases provide for renewal options of one to five
years, at then fair rental value. Future minimum rental payments
under long-term operating leases for the years ending
January 31 are as follows:

|     |  |           |       | 
|---- |  | --------- | ----- | 
|     |  | Operating
|     |  | Leases   
|     |  |          
|2005 |  | $         | 1,213 | 
|2006 |  |           | 1,218 | 
|2007 |  |           | 1,274 | 
|2008 |  |           | 1,177 | 
|     |  |           |       | 
|     |  | $         | 4,882 | 
|     |  |           |       | 

Total rental expense, net of sublease income, was
$1,372, $1,226, and $2,460 for the years ended January 31,
2004, 2003, and 2002, respectively.

The Company has outstanding purchase orders of
approximately $199 for materials and services at the end of
fiscal year 2004.



|    |                         
|--- | ------------------------
|17. | Risks and Uncertainties:

Concentration of Credit
Risk:The Company had cash and
certificates of deposit on deposit at banks at certain times
throughout the year that was in excess of federally insured
limits.

The Companys credit risk in accounts
receivable, which are generally not collateralized, is
concentrated with customers which are OEMs of laser printers and
printer peripheral technologies. The financial loss, should a
customer be unable to meet its obligation to the Company, would
be equal to the recorded accounts receivable. At
January 31, 2004, four customers collectively represented
86% of total trade accounts receivable and at January 31,
2003, three customers collectively represented 65%. For the
years ended January 31 the following customers, not
necessarily the same from year to year, represented greater than
ten percent of total revenues:

|           |  |      |        |      |  |      |    |   |  |   |        |  |  |  |    |   |  |   |        |  |  |  |    |  
|---------- |  | ---- | ------ | ---- |  | ---- | -- | - |  | - | ------ |  |  |  | -- | - |  | - | ------ |  |  |  | -- | -
|           |  |      |        |      |  |      |    |   |  |  
|           |  | 2004 |        |      |  |      |    |   |  |  
|           |  |      |        |      |  |      |    |   |  |  
|           |  |      |        |      |  |      |    |  
|           |  |      |        | 2003 |  |      |    |  
|           |  |      |        |      |  |      |    |  
|           |  |      |        |      |  |     
|           |  |      |        |      |  | 2002
|           |  |      |        |      |  |     
|Customer A |  | $    | 7,688  |      |  |      | 30 | % |  | $ | 7,458  |  |  |  | 24 | % |  | $ | 7,405  |  |  |  | 25 | %
|Customer B |  |      | 4,666  |      |  |      | 19 | % |  |   | 7,448  |  |  |  | 23 | % |  |   | 4,856  |  |  |  | 16 | %
|Customer C |  |      | 2,946  |      |  |      | 12 | % |  |   |       |  |  |  |    |   |  |   | 4,306  |  |  |  | 15 | %
|           |  |      |        |      |  |      |    |   |  |   |        |  |  |  |    |   |  |   |        |  |  |  |    |  
|           |  | $    | 15,300 |      |  |      | 61 | % |  | $ | 14,906 |  |  |  | 47 | % |  | $ | 16,567 |  |  |  | 56 | %
|           |  |      |        |      |  |      |    |   |  |   |        |  |  |  |    |   |  |   |        |  |  |  |    |  

A significant portion of the Companys
revenue is generated from the sale of block licenses. Block
license revenue represented 63%, 65%, 58% of total revenue for
the fiscal years 2004, 2003 and 2002.

Litigation:The
Company is involved from time to time in various claims and
legal actions incident to its operations, either as plaintiff or
defendant. In the opinion of management, after consulting with
legal counsel, no claims are currently expected to have a
material adverse effect on the Companys financial
position, operating results, or cash flows.

F-22



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##### Table of Contents



PEERLESS SYSTEMS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(in thousands, except per share
amounts)


Contingency:The
Company has come to a tentative agreement to resolve a dispute
with one of its licensors regarding contractual language with
respect to certain licensing rates. Although the agreement has
not yet been signed, the Company is confident that it will
successfully resolve the matter without a change to its accrued
product licensing costs; however, if the Company is unable to
successfully resolve this matter, this could potentially result
in a material increase in cost of sales.

F-23



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##### Table of Contents



SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

|                                                   |                                                  |                |   |            |  |               |   |            |   |  |   |      |   |  |   |     | 
|-------------------------------------------------- | ------------------------------------------------ | -------------- | - | ---------- |  | ------------- | - | ---------- | - |  | - | ---- | - |  | - | --- | 
|                                                   |                                                  |                |   | Additions  |  |               |   |           
|                                                   |                                                  | Balance at     |   | Charged to |  |               |   | Balance at
|                                                   |                                                  | Beginning      |   | Costs and  |  |               |   | End of    
|                                                   |                                                  | of Period      |   | Expenses   |  | Deductions(a) |   | Period    
|                                                   |                                                  |                |   |            |  |               |   |           
|                                                   |                                                  |               
|                                                   |                                                  | (In thousands)
|Year Ended January 31, 2002                        |                                                  |                |   |            |  |               |   |            |   |  |   |      |   |  |   |    
|Reserves deducted from assets to which they apply: |                                                  |                |   |            |  |               |   |            |   |  |   |      |   |  |   |    
|                                                   | Allowances for uncollectible accounts receivable |                | $ | 755        |  |               | $ | (150       | ) |  | $ | (505 | ) |  | $ | 100 | 
|Year Ended January 31, 2003                        |                                                  |                |   |            |  |               |   |            |   |  |   |      |   |  |   |    
|Reserves deducted from assets to which they apply: |                                                  |                |   |            |  |               |   |            |   |  |   |      |   |  |   |    
|                                                   | Allowances for uncollectible accounts receivable |                | $ | 100        |  |               | $ | 110        |   |  | $ | (8   | ) |  | $ | 202 | 
|Year Ended January 31, 2004                        |                                                  |                |   |            |  |               |   |            |   |  |   |      |   |  |   |    
|Reserves deducted from assets to which they apply: |                                                  |                |   |            |  |               |   |            |   |  |   |      |   |  |   |    
|                                                   | Allowances for uncollectible accounts receivable |                | $ | 202        |  |               | $ | (61        | ) |  | $ |     |   |  | $ | 141 | 



---



|    |  |                                         
|--- |  | ----------------------------------------
|(a) |  | Accounts written off, net of recoveries.

S-1