---




Securities and Exchange Commission


Washington, DC 20549





REPORT ON FORM 10-Q





(Mark One)


|x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- |  | ---------------------------------------------------------------------------------------




For the quarterly period ended April 30, 2002





| ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- |  | ----------------------------------------------------------------------------------------




For the transition period from
 to





Commission file number 0-21053





PROCOM
TECHNOLOGY, INC.


(Exact name of registrant as specified in its charter)





California

33-0268063(State or other jurisdiction of

(IRS Employerincorporation or organization)

Identification No.)





58 Discovery, Irvine California

92618(Address of principal executive office)

(Zip Code)





(949) 852-1000


(Registrants telephone number, including area code)





(Former name, former address and former fiscal year, if changed since last report.)





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.    YesxNo  ̈





The number of shares of Common Stock, $.01 par value, outstanding on June 12, 2002 was 16,023,633.





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---




PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES





TABLE OF CONTENTS





PART 1FINANCIAL INFORMATION





PAGEItem 1.

Condensed Consolidated Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of April 30, 2002 and July 31, 2001

2Condensed Consolidated Statements of Operations for the three and nine month periods ended April 30, 2002 and
2001

3Condensed Consolidated Statements of Shareholders Equity for the nine month period ended April 30, 2002 and the
year ended July 31, 2001

4Condensed Consolidated Statements of Cash Flows for the nine month periods ended April 30, 2002 and 2001

5Notes to Condensed Consolidated Financial Statements

6Item 2.

Managements Discussion and Analysis of Financial Condition and Results of Operations

9Item 3.

Quantitative and Qualitative Disclosures About Market Risk

21SIGNATURES







1




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PART I


FINANCIAL INFORMATION





ITEM 1.    FINANCIAL STATEMENTS.





PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)





APRIL 30, 2002


JULY 31, 2001ASSETSCurrent assets:Cash and cash equivalents

$
11,141,000


$
25,419,000Accounts receivable, less allowances for doubtful accounts and sales returns of $11,793,000 and $6,412,000,
respectively


7,565,000



11,979,000Inventories


9,372,000



6,292,000Income tax receivable and deferred income taxes


4,437,000



Prepaid expenses


1,463,000



1,184,000Other current assets


276,000



310,000Total current assets


34,254,000



45,184,000Property and equipment, net


16,830,000



17,766,000Other assets


1,917,000



2,259,000Total assets

$
53,001,000


$
65,209,000LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Lines of credit

$
84,000


$
8,000Current portion of long-term debt


172,000



Accounts payable


3,535,000



4,151,000Flooring line obligation


496,000



531,000Accrued expenses and other current liabilities


2,549,000



2,052,000Accrued compensation


824,000



1,194,000Deferred service revenues


717,000



447,000Income taxes payable






33,000Convertible debenture






9,726,000Total current liabilities


8,377,000



18,142,000Long-term debt, net of current portion


8,520,000



Total liabilities


16,897,000



18,142,000Commitments and contingenciesShareholders equity:Preferred stock, no par value; 10,000,000 shares authorized, no shares issued and outstanding






Common stock, $.01 par value; 65,000,000 shares authorized, 16,023,633 and 15,993,564 shares issued and outstanding,
respectively


160,000



160,000Additional paid-in capital


58,700,000



58,575,000Accumulated deficit


(22,603,000
)


(11,343,000
)Accumulated other comprehensive loss


(153,000
)


(325,000
)Total shareholders equity


36,104,000



47,067,000Total liabilities and shareholders equity

$
53,001,000



65,209,000





See notes to condensed consolidated financial statements.




2




---




PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(UNAUDITED)





THREE MONTHS ENDED


NINE MONTHS ENDEDAPRIL 30, 2002


APRIL 30, 2001


APRIL 30, 2002


APRIL 30, 2001Net sales

$
4,356,000


$
8,002,000


$
20,443,000


$
32,988,000Cost of sales


2,599,000



4,829,000



11,286,000



20,319,000Gross profit


1,757,000



3,173,000



9,157,000



12,669,000Selling, general and administrative expenses


5,782,000



4,385,000



19,457,000



13,352,000Research and development expenses


1,462,000



1,472,000



4,697,000



4,925,000In-process research and development














4,262,000Total operating expenses


7,244,000



5,857,000



24,154,000



22,539,000Operating loss


(5,487,000
)


(2,684,000
)


(14,997,000
)


(9,870,000
)Interest income


83,000



139,000



418,000



597,000Interest expense


(203,000
)


(434,000
)


(1,154,000
)


(1,005,000
)Loss before income taxes


(5,607,000
)


(2,979,000
)


(15,733,000
)


(10,278,000
)Income tax provision (benefit)


(4,473,000
)


61,000



(4,473,000
)


(279,000
)Net loss

$
(1,134,000
)

$
(3,040,000
)

$
(11,260,000
)

$
(9,999,000
)Net loss per common share:Basic and diluted

$
(0.07
)

$
(0.25
)

$
(0.70
)

$
(0.84
)Weighted average number of common shares:Basic and diluted


16,024,000



12,139,000



16,009,000



11,835,000





See notes to condensed consolidated financial statements.




3




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PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY


(UNAUDITED)





COMMON STOCK

ADDITIONAL PAID IN
CAPITAL


RETAINED EARNINGS (ACCUMULATED DEFICIT)


ACC. OTHER COMPREHENSIVE GAIN (LOSS)


TOTALSHARES

AMOUNTBALANCE AT JULY 31, 2000

11,531,357

$
115,000

$
19,685,000


$
8,007,000


$
(251,000
)

$
27,556,000Comprehensive loss:Net loss











(19,350,000
)






(19,350,000
)Foreign currency translation adjustment















(74,000
)


(74,000
)Comprehensive loss



















(19,424,000
)Issuance of common stock through public offering, net of issuance costs of $2.7 million

3,800,000


38,000


31,453,000











31,491,000Acquisition of business

480,000


5,000


5,755,000











5,760,000Compensatory stock options







41,000











41,000Exercise of employee stock options

157,401


2,000


845,000











847,000Issuance of stock to employees

24,806





234,000











234,000Issuance of stock warrant to investor







562,000











562,000BALANCE AT JULY 31, 2001

15,993,564


160,000


58,575,000



(11,343,000
)


(325,000
)


47,067,000Comprehensive loss:Net loss











(11,260,000
)






(11,260,000
)Foreign currency translation adjustment















172,000



172,000Comprehensive loss



















(11,088,000
)Additional issuance costs relating to common stock public offering in fiscal 2001







(23,000
)










(23,000
)Compensatory stock options







55,000











55,000Issuance of stock to employees

25,569





70,000











70,000Exercise of employee stock options

4,500





23,000











23,000BALANCE AT APRIL 30, 2002

16,023,633

$
160,000

$
58,700,000


$
(22,603,000
)

$
(153,000
)

$
36,104,000





See notes to condensed consolidated financial statements.




4




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PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)





NINE MONTHS ENDED APRIL 30,2002


2001CASH FLOWS FROM OPERATING ACTIVITIES:Net loss

$
(11,260,000
)

$
(9,999,000
)Adjustments to reconcile net loss to netcash used in operating activities:Depreciation and amortization


1,451,000



1,014,000Amortization of debt issuance costs related to stock warrant


274,000



95,000Compensatory stock options


55,000



30,000In-process research and development






4,262,000Deferred income taxes






(310,000
)Changes in operating accounts:Accounts receivable


4,414,000



(6,838,000
)Inventories


(3,080,000
)


(1,358,000
)Income tax receivable and deferred income taxes


(4,470,000
)


2,673,000Prepaid expenses


(279,000
)


(1,289,000
)Other current assets


34,000



(71,000
)Other assets


(19,000
)


64,000Accounts payable


(616,000
)


(3,125,000
)Accrued expenses and compensation


127,000



460,000Deferred service revenues


270,000



(58,000
)Income taxes payable






115,000Net cash used in operating activities


(13,099,000
)


(14,335,000
)CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of property and equipment


(154,000
)


(1,860,000
)Acquisition of business, net of cash acquired






(250,000
)Net cash used in investing activities


(154,000
)


(2,110,000
)CASH FLOWS FROM FINANCING ACTIVITIES:Issuance of convertible debenture






15,000,000Repayments of convertible debenture


(10,000,000
)


Borrowings (repayments) of long term debt


8,692,000



(10,750,000
)Net borrowings on lines of credit


76,000



3,980,000Flooring line obligation


(35,000
)


(364,000
)Proceeds from exercise of stock options


23,000



671,000Common stock issuance costs


(23,000
)


Issuance of common stock to employees


70,000



145,000Net cash provided by (used in) financing activities


(1,197,000
)


8,682,000Effect of exchange rate changes


172,000



(67,000
)Decrease in cash and cash equivalents


(14,278,000
)


(7,830,000
)Cash and cash equivalents at beginning of period


25,419,000



15,515,000Cash and cash equivalents at end of period

$
11,141,000


$
7,685,000Supplemental disclosures of cash flow information:CASH PAID (RECEIVED) DURING THE PERIOD:Interest

$
694,000


$
235,000Income taxes

$



$
(2,759,000
)SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITIES:Common stock warrant issued to convertible debenture investor

$



$
562,000





See notes to condensed consolidated financial statements.




5




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PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1.    GENERAL.





The accompanying financial information is unaudited, but in the opinion of
management, reflects all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position of Procom Technology, Inc. and its consolidated subsidiaries (the Company) as of the dates
indicated and the results of operations and cash flows for the periods then ended. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the
United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. While the Company believes that the disclosures are adequate to make the information presented not misleading,
the financial information should be read in conjunction with the audited financial statements and notes thereto included in the Companys Report on Form 10-K for fiscal 2001. Results for the interim periods presented are not necessarily
indicative of the results for the entire year.





NOTE 2.    CRITICAL ACCOUNTING POLICIES AND ESTIMATES.





The preparation of the condensed consolidated financial statements requires the Company to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, the Company evaluates its estimates, including those related to product returns, bad
debts, inventories, and contingencies. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments
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.





The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its condensed
consolidated financial statements.





The Company sells NAS appliances primarily through direct sales channels and
resellers. Revenue is generally recorded upon product shipment. The Company maintains reserves, which are adjusted at each reporting date, to estimate anticipated returns based on historical rates of sales returns. In addition, the Company sells
service contracts for certain of its appliances that extend for a specified period of time, usually one to three years. Revenue from these service contracts is recorded ratably over the life of the service agreement. The Company sells its Legacy
products primarily through distributors. Revenue is recorded from these Legacy sales when the distributor receives the product. The agreements with the Companys distributors allow limited product returns, including stock balancing and price
protection privileges. The Company maintains reserves, which are adjusted at each financial reporting date, to estimate anticipated returns, including stock balancing and price protection claims, relating to each reporting period. The reserves are
based on historical rates of sales and returns, including stock balancing and price protection claims, and the level of the Companys product held by its customers in their inventory. If the Company were to experience a significant increase in
product sales returns, additional sales reserves may be required.





The Company maintains allowances for doubtful
accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Companys customers were to deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required.





The Company writes down its inventory for estimated obsolescence equal to
the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory
write-downs may be required.





NOTE 3.    INVENTORIES.





Inventories are summarized as follows:





April 30, 2002

July 31, 2001Raw materials

$
3,587,000

$
2,472,000Work in process


872,000


283,000Finished goods


4,913,000


3,537,000Total

$
9,372,000

$
6,292,000







6




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NOTE 4.    NET LOSS PER SHARE.





Basic net loss per share is computed using the weighted average number of shares of common stock outstanding during the period. Diluted
net loss per share is computed using the weighted average number of shares of common stock outstanding and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares consist of stock options and warrants.
For the periods presented, basic and diluted net loss per share was based on the weighted average number of shares of common stock outstanding during the period. As of April 30, 2002 and 2001, stock options and warrants to purchase 2,048,569 shares
and 1,000,871 shares, respectively of common stock were outstanding. The dilutive effect of these stock options and warrants were not included in the computation of net loss per share as the effect would have been antidilutive.





NOTE 5.    COMPREHENSIVE LOSS.





For the nine months ended April 30, 2002 and 2001, the only differences between reported net loss and comprehensive loss was a foreign currency translation adjustment of $172,000 and $(67,000),
respectively. For the three months ended April 30, 2002 and 2001, the only differences between reported net loss and comprehensive loss was a foreign currency translation adjustment of $147,000 and $(29,000), respectively.





NOTE 6.    BUSINESS SEGMENT INFORMATION.





The Company operates in one industry segment: The design, manufacture and marketing of data storage devices. The Company has two major distinct product families: network attached storage products
(NAS) and other data storage products (Legacy), which includes disk drive storage upgrade systems, CD/DVD-ROM servers and arrays and tape backup products. Net sales of NAS products represented 73.2% and 72.5% of total product
net sales for the three months ended April 30, 2002 and 2001, respectively, and 80.5% and 67.1% of total net sales for the nine months ended April 30, 2002 and 2001, respectively.





International sales as a percentage of net sales amounted to 3.3% and 50.0% for the three months ended April 30, 2002 and 2001, respectively, and 39.0% and 59.1% for the
nine months ended April 30, 2002 and 2001, respectively. International sales were primarily to European customers. Identifiable assets used in connection with the Companys foreign operations were $3.0 million at April 30, 2002 and $8.5 million
at July 31, 2001.





For the nine months ended April 30, 2002, no single customers accounted for more than 10.0% of
net sales, while two customers accounted for 13.4% of net sales for the nine months ended April 30, 2001. At April 30, 2002, one Italian reseller accounted for approximately 11.4% of total accounts receivable.





NOTE 7.    LINES OF CREDIT, CONVERTIBLE DEBENTURE AND LONG-TERM DEBT.





On October 10, 2000, the Company entered into a term loan agreement and a three-year working capital line of credit with The CIT Group/Business Credit (CIT).
The first term loan of $4.0 million, due and payable upon the Companys finalization of a long-term mortgage on its corporate headquarters or paid in 12 monthly installments commencing April 1, 2001, was fully repaid in May 2001. Another term
loan of $1.0 million, due and payable in 90 days, was fully repaid on November 1, 2000. The term loans under the agreement incurred interest at the lenders prime rate, plus .5%, with increases if the outstanding principal was not reduced
according to a fixed amortization schedule. The working capital line of credit allows for the Company to borrow, on a revolving basis, for a period of three years, a specified percentage of its eligible accounts receivable (approximately $2.8
million at April 30, 2002), up to a limit of $5.0 million. Amounts outstanding under the working capital line bear interest at the lenders prime rate plus .25%. At April 30, 2002, no amounts were outstanding under the various credit
arrangements. The lender charged approximately $130,000 for the credit facility which is being amortized as interest expense over the term of the credit agreement. The line of credit accrues various monthly maintenance, minimum usage and early
termination fees. The line of credit is collateralized by certain assets of the Company. The line of credit requires certain financial and other covenants, including the maintenance of a minimum EBITDA requirement for rolling 12-month periods ending
on each fiscal quarter. For the 12-month period ended on April 30, 2002, the Company was not in compliance with the minimum EBITDA requirement. The lender has not waived the Companys non-compliance with this covenant for this period and does
not intend to make advances under the line.





In addition to the CIT line of credit noted above, the Company has a
flooring line with IBM Credit, which has committed to make $2.0 million in flooring inventory commitments available to the Company. As of April 30, 2002 and July 31, 2001, the Company owed $496,000 and $531,000, respectively, under the flooring
line. The flooring line is collateralized by the specific inventory purchased pursuant to the flooring commitments. CIT and IBM Credit have entered into an intercreditor agreement which determines the level of priority of either lenders
security interest. The flooring line requires the maintenance by the Company of a minimum net worth of $16.0 million. The Company was in compliance with the terms of the flooring line at April 30, 2002. The flooring line also requires the Company
not to be in default of any covenants in the CIT agreement. IBM Credit has waived compliance with that requirement at April 30, 2002.










7




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On October 31, 2000, the Company issued a $15.0 million convertible unsecured
debenture to a private investor. The debenture carried interest at 6.0% per annum, and was repayable in full on October 31, 2003, unless otherwise converted into the common stock of the Company. In connection with the issuance of the debenture, the
Company issued to the investor a 5-year warrant to purchase up to 32,916 shares of its common stock at an initial exercise price of $32.55 per share, with the number of shares for which the warrant is exercisable and the exercise price subject to
antidilution adjustments. The value of the warrant of $562,000 was computed using the Black-Scholes model, with the following assumptions: Expected life  5 years, Risk free interest rate  6%, and Volatility  1.20. In the second
quarter of fiscal 2002, the Company paid the investor the remaining $10,000,000 principal amount of the debentures and expensed the remaining unamortized debt issuance and warrant costs of $274,000 to interest expense.





In June 2001, the Company completed the sale of 3,800,000 shares of common stock raising gross proceeds of approximately $34.2 million
before offering costs of $2.7 million. As a result of this offering, the exercise price of the warrant was adjusted to $27.95 and the number of shares issuable upon exercise of the warrant pursuant to anti-dilution provisions of the warrant were
adjusted to 38,333.





In December 2001, the Company borrowed $8.75 million under a financing arrangement secured by
the Companys corporate headquarters. The principal amount outstanding bears interest at prime plus 1.0% per annum, but not less than 7.0% per annum. Under certain conditions, the Company has the right to request that portions of the principal
amount outstanding under the note shall bear interest at a LIBOR based rate, but not less than 7.0%. As of April 30, 2002, the interest rate on the loan was 7.0%. Principal reduction payments of $14,400 plus accrued interest are due each month
beginning February 1, 2002 with the remaining principal balance and unpaid interest due at the maturity date of January 1, 2007. Debt issuance costs totaled $201,800 and are being amortized over the term of the loan. Up to an additional $1.0 million
may be borrowed under this financing arrangement to cover leasing costs and tenant improvements on the vacant, unimproved space within the corporate headquarters. As of April 30, 2002, the outstanding principal balance of the loan totaled $8.69
million.





In addition to the line of credit, our foreign subsidiaries in Germany, Italy and Switzerland have lines
of credit with banks in their respective countries that are utilized primarily for overdraft and short-term cash needs. At April 30, 2002, the amount outstanding under these lines was $84,000.





NOTE 8.    RECENT ACCOUNTING PRONOUNCEMENTS.





In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 141, all business
combinations initiated after June 30, 2001 must be accounted for using the purchase method. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are reviewed annually for impairment (or more frequently
if indicators of impairment arise). Separable intangible assets that are not deemed to have indefinite lives will continue to be amortized over their useful lives (but with no maximum life). The amortization provisions of SFAS No. 142 apply to
goodwill and intangible assets acquired after June 30, 2001. With respect to goodwill and intangible assets acquired prior to July 1, 2001, the Company is required to adopt SFAS No. 142 effective August 1, 2002.





As of the date of adoption, the Company expects to have unamortized goodwill in the amount of $1,140,000, and unamortized identifiable
intangible assets in the amount of $630,000, all of which will be subject to the transition provisions of SFAS 141 and 142. Amortization expense related to goodwill was $ 361,000 and $ 221,000 for the nine months ended April 30, 2002 and 2001,
respectively. Because of the extensive effort needed to comply with adopting SFAS 141 and 142, it is not practicable to reasonably estimate the impact of adopting these statements on the Companys financial statements at the date of this
report, including whether any transitional impairment losses will be required to be recognized as a cumulative effect of a change in accounting principle.





In October 2001, the FASB issued SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. SFAS 144 supersedes SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement is effective for fiscal years beginning after December 15,
2001. Adoption of this statement is not expected to have a material impact on the Companys consolidated financial position or results of operations.





NOTE 9.    SUBSEQUENT EVENTS





The Job Creation and
Workers Assistance Act of 2002, signed by the President in February 2002, permits the Company to carry back certain of its previously recorded losses for 5 years instead of only 2 years. The Company previously had not believed it would be able
to recover a tax benefit related to its prior year losses. As a result of the legislation, in April 2002, the Company filed amended tax returns for prior year losses, and in June 2002, the Company received a tax refund of $2.9 million. In addition,
the Company anticipates that it will be able to recover approximately $2.3 million in additional tax refunds when it files its fiscal 2002 tax return, and carries expected fiscal 2002 operating losses back to previous periods. The Company has
recorded in the current




8




---

quarter a tax benefit of $2.9 million plus a proportionate share of the anticipated additional refunds related to fiscal 2002.





In May 2002, the employment of three executives of the Company was terminated. Pursuant to agreements executed between the
Company and the executives at the time of termination, each executive will receive payments of $18,750 for 36 months, and each will be entitled to participate in the Companys employee benefit, health and other insurance plans for the 36 month
period. The Company anticipates that it will record a charge for the severance obligations of approximately $2.3 million in the quarter ended July 31, 2002.





ITEM 2.    MANAGMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.





We develop, manufacture and market NAS appliances and other storage devices for a wide range of computer networks and operating systems. Our NAS appliances, which consist of our DataFORCE and NetFORCE
product lines, provide end-users with faster access to data at a lower overall cost than other storage alternatives. We refer to these products collectively as our NAS appliances. In addition, we sell disk drive storage upgrade systems, CD/DVD-ROM
servers and arrays and tape backup products, which we refer to collectively as our Legacy products. Over the last four years, we have significantly increased our focus on the development and sale of NAS appliances. We continue to develop more
advanced NAS appliances and expect this business to be our principal business in the future. We are currently analyzing the market demands and opportunities for all of our Legacy products, and we hope to transition users of these products to our
growing line of more robust, generally higher margin NAS solutions.





Changing Business Mix.


We have experienced significantly reduced demand, revenues and gross margins for our Legacy products and, as a result, have discontinued some of these Legacy products.
The demand for our CD servers and arrays has declined and we have experienced increased pricing pressures on our disk drive storage upgrade systems, resulting in lower overall revenues and gross margins. Our gross margins vary significantly by
product line, and, therefore, our overall gross margin varies with the mix of products we sell. For example, our sales of CD servers and arrays have historically generated higher gross margins than those of our tape back-up and disk drive products.
In future periods, as sales of our higher margin NAS appliances continue to increase as a percentage of total sales, we expect our overall gross margins to be positively affected.





Our revenues and gross margins have been and may continue to be affected by a variety of factors including:





| |  |  | new product introductions and enhancements;
| | - |  | -------------------------------------------




| |  |  | competition;
| | - |  | ------------




| |  |  | direct versus indirect sales;
| | - |  | -----------------------------




| |  |  | the mix and average selling prices of products; and
| | - |  | ---------------------------------------------------




| |  |  | the cost of labor and components.
| | - |  | ---------------------------------




Revenue and Revenue Recognition.


We sell NAS appliances primarily through direct sales channels
and resellers. Revenue is generally recorded upon product shipment. We maintain reserves, which are adjusted at each reporting date, to estimate anticipated returns relating to each reporting period based on historical rates of sales returns. In
addition, we sell service contracts for certain of our appliances that extend for a specified period of time, usually one to three years. Revenue from these service contracts is recorded ratably over the life of the service agreement.





We sell Legacy products primarily through distributors. Revenue is recorded from these Legacy sales when the distributor
receives the product. Our agreements with our distributors allow limited product returns, including stock balancing and price protection privileges. We maintain reserves, which are adjusted at each financial reporting date, to estimate anticipated
returns, including stock balancing and price protection claims, relating to each reporting period. The reserves are based on historical rates of sales and returns, including price protection and stock balancing claims, and the level of our product
held by our customers in their inventory.





In addition, under a product evaluation program established by us, our
indirect channel partners and end-users generally are able to receive appliances on a trial basis and return the appliances within a specified period, generally 30-60 days, if they are not satisfied. The period may be extended if the customer needs
additional time to evaluate the product within the customers particular operating environment. The value of evaluation units at customer sites at a financial reporting date are included in inventory as




9




---

finished goods. At April 30, 2002 and July 31, 2001, inventory related to evaluation units was approximately $2.7 million and $2.2 million,
respectively. We do not record evaluation units as sales until the customer has notified us of acceptance of these units.





Cost of Sales.


Our cost of sales consists primarily of the cost of components produced by our suppliers, such as disk drives,
cabinets, power supplies, controllers and CPUs, our direct and indirect labor expenses and related overhead costs such as rent, utilities and manufacturing supplies and other expenses. In addition, cost of sales includes third party license fees,
warranty expenses and reserves for excess and obsolete inventory.





Selling, General and Administrative
Expenses.


Selling expenses consist primarily of costs directly associated with the selling process such as salaries and commissions of sales
personnel, marketing, direct and cooperative advertising and travel expenses. General and administrative expenses include our general corporate expenses, such as salaries and benefits, rent, utilities, bad debt expense, legal and other professional
fees and expenses, depreciation and amortization of goodwill. These costs are expensed as incurred.





Research
and Development Expenses.


Research and development expenses consist of the costs associated with software and hardware development. Specifically,
these costs include employee salaries and benefits, consulting fees for contract programmers, test supplies, employee training and other related expenses. The cost of developing new appliances and substantial enhancements to existing appliances are
expensed as incurred.





The following table sets forth consolidated statement of operations data as a percentage of
net sales for each of the periods indicated:





THREE MONTHS ENDED APRIL 30,


NINE MONTHS ENDED APRIL 30,2002


2001


2002


2001STATEMENT OF OPERATIONSNet sales

100.0
%

100.0
%

100.0
%

100.0
%Cost of sales

59.7


60.3


55.2


61.6Gross profit

40.3


39.7


44.8


38.4Operating expenses:Selling, general and administrative

132.7


54.8


95.2


40.5Research and development

33.6


18.4


23.0


14.9In-process research and development










12.9Total operating expenses

166.3


73.2


118.2


68.3Operating loss

(126.0
)

(33.5
)

(73.4
)

(29.9
)Interest expense, net

(2.7
)

(3.7
)

(3.6
)

(1.2
)Loss before income taxes

(128.7
)

(37.2
)

(77.0
)

(31.1
)Provision (benefit) for income taxes

(102.7
)

0.8


(21.9
)

(0.8
)Net loss

(26.0
)%

(38.0
)%

(55.1
)%

(30.3
)%





CRITICAL ACCOUNTING POLICIES AND ESTIMATES.





The discussion and analysis of our financial condition and results of operations are based upon our condensed 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 us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, and contingencies. We base our
estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments 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.





We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.





We sell NAS appliances primarily through direct sales channels and resellers. Revenue is generally recorded upon product shipment. We
maintain reserves, which are adjusted at each reporting date, to estimate anticipated returns based on historical rates of sales returns. In addition, we sell service contracts for certain of our appliances that extend for a specified period of
time, usually one to three years. Revenue from these service contracts is recorded ratably over the life of the service agreement. We sell our Legacy products primarily through distributors. Revenue from these Legacy sales is recorded when the
distributor receives the product. The agreements with our distributors allow limited product returns, including stock balancing and price protection




10




---

privileges. We maintain reserves, which are adjusted at each financial reporting date, to estimate anticipated returns, including stock
balancing and price protection claims, relating to each reporting period. The reserves are based on historical rates of sales and returns, including stock balancing and price protection claims, and the level of our product held by our customers in
their inventory. If we were to experience a significant increase in product sales returns, incremental sales reserves may be required.





We maintain allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be required.





We write down our inventory
for estimated obsolescence equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by
management, additional inventory write-downs may be required.





COMPARISON OF THREE AND NINE MONTHS ENDED APRIL 30, 2002 AND 2001





Net sales decreased by 45.0% to $4.4 million for the three months ended April 30, 2002, from $8.0 million for
the three months ended April 30, 2001. The decrease resulted from a decline in product sales in international markets for our NAS and Legacy products partially offset by a 47% increase in domestic NAS product sales in fiscal 2002. Net sales
decreased 38.1% to $20.4 million for the nine months ended April 30, 2002, from $33.0 million in the comparable period of fiscal 2001. The decrease was due to lower international sales of our NAS and Legacy products partially offset by an increase
in domestic NAS product sales in fiscal 2002.





Net sales of our NAS products decreased 44.8% to $3.2
million for the three months ended April 30, 2002, from $5.8 million for the comparable period in fiscal 2001. Net sales of our NAS products decreased 25.3% to $16.5 million for the nine months ended April 30, 2002, from $22.1 million for the prior
year. The decrease was due primarily to a decline in international NAS product sales partially offset by an increase in domestic NAS sales of 47% and 25% for the three and nine months ended April 30, 2002, respectively, compared to the comparable
periods in fiscal 2001. As a percentage of total net sales, NAS product sales increased to 73.1% from 72.4% and to 80.5% from 68.0% for the three and nine months ended April 30, 2002 and 2001, respectively.





International sales were $0.14 million, or 3.3% of our net sales, for the three months ended April 30, 2002, compared to $4.0 million, or
50.0% of our net sales, for the three months ended April 30, 2001. International sales were $8.0 million, or 39.0% of our net sales, for the nine months ended April 30, 2002, compared to $19.4 million, or 58.9% of net sales, for the comparable
period of fiscal 2001. The decrease was due primarily to lower overall sales of NAS and Legacy products to international customers, primarily in Asia and Europe, in fiscal 2002.





Gross profit decreased 43.7% to $1.8 million for the three months ended April 30, 2002, from $3.2 million for the three months ended April 30, 2001. Gross profit for the
nine month period ended April 30, 2002 decreased 27.5% to $9.2 million from $12.7 million for the same period the prior fiscal year. The decrease in gross profit for both periods was due primarily to lower overall sales. Gross margins increased to
40.3% and 44.8% of net sales for the three and nine months ended April 30, 2002 and for the comparable three and nine month periods in fiscal 2001, from 39.7% and 38.4% of net sales. The increase in gross margin was primarily the result of the
higher percentage of NAS sales, which have higher margins than non-NAS products.





Selling, general and
administrative expenses increased 31.8% to $5.8 million for the three months ended April 30, 2002, from $4.4 million for the three months ended April 30, 2001, and increased as a percentage of net sales to 132.7% from
54.8%.            In the third quarter of fiscal 2002, we increased our accounts receivable reserves $1.1 million to reflect the aging of certain accounts receivable from customers in
Europe and Asia. Excluding this additional provision, selling, general and administrative expenses for the third quarter of fiscal 2002 increased by $0.3 million over their levels for the third quarter of fiscal 2001 due primarily to increased sales
and administrative salaries and commissions in support of NAS sales, increased general administrative expenses partially offset by currency translation gains as the Euro and Swiss Franc strengthened against the U.S. dollar during the third quarter
of fiscal 2002.





For the nine months ended April 30, 2002, selling, general and administrative expenses increased
to $19.5 million from $13.4 million or 45.5% for the comparable period of fiscal 2001. In the first nine months of fiscal 2002, we increased our accounts receivable reserves by $4.9 million due to the financial instability of three of our
international customers and to reflect the aging of certain accounts receivable from customers in Europe and Asia referred to above. Excluding the additional provision for accounts receivable, selling, general and administrative expenses for the
nine months ended April 30, 2002 increased by $1.2 million from their levels for the comparable period of fiscal 2001, due primarily to increased sales and administrative salaries and commissions in support of NAS sales, increased general
administrative expenses partially offset by reduced advertising and marketing costs during




11




---

this nine month period. In addition, until our collection experience improves, beginning in the second quarter of fiscal 2002 we are recording
revenue from certain European countries on a cash basis.





Research and development expenses remained the same at
$1.5 million, or 33.5% of net sales in the third quarter of fiscal 2002 and 18.4% of net sales, for the comparable period of fiscal 2001. For the nine months ended April 30, 2002, research and development expenses decreased 4.0% to $4.7 million, or
23.0% of net sales, from $4.9 million, or 14.9% of net sales, in the same period in fiscal 2001. The dollar decrease was due primarily to reduced expenses for outside programmers slightly offset by increased compensation expense for additional NAS
software programmers and hardware developers.





In-process research and development relates to our December 2000
acquisition of the outstanding shares of Scofima Srl an Italian company engaged in software development. We employed an appraiser to value the assets of Scofima, and the appraiser assigned a value of approximately $4.3 million for the research and
development expenses relating to software being developed by Scofima which has not yet reached technological feasibility, and for which no alternative future use is available. We incurred this charge in the second quarter of fiscal 2001.





Interest income decreased 40.2% to $83,000 for the three months ended April 30, 2002, from $139,000 for the
comparable period of fiscal 2001. For the nine months ended April 30, 2002, interest income decreased 29.9% to $418,000 from $597,000 for the comparable period of fiscal 2001. The decrease for both periods was attributable to a decline in the
average interest rates earned on our invested cash balance.





Interest expense decreased 53.4% to $203,000 for the
three months ended April 30, 2002, from $434,000 for the comparable period of fiscal 2001. For the nine months ended April 30, 2002, interest expense increased 20% to $1.2 million from $1.0 million for the comparable period of fiscal 2001. The
increase was due primarily to the issuance of the $15.0 million convertible debenture on October 31, 2000 and the amortization of debt issuance costs.





Income tax provision (benefit). In the third quarter of fiscal 2002, we recorded a $4.5 million income tax benefit relating to recent changes in the tax laws. These changes allowed us to carry back net
operating losses generated in fiscal 2001 and and will allow us to carry back net operating losses generated in fiscal 2002 for five years, as opposed to the two years allowed under the tax law previously in effect.





LIQUIDITY AND CAPITAL RESOURCES





As of April 30, 2002, we had cash and cash equivalents totaling $11.1 million. Our cash and cash equivalents decreased by $14.3 million during the nine months ended April 30, 2002.





Net cash used in operating activities was $13.1 million for the nine months ended April 30, 2002 and $14.3 million for the nine
months ended April 30, 2001. Net cash used in operating activities in fiscal 2002 relates primarily to our net loss, an increase in our inventories and income tax receivable and a decrease in our accounts payable. These uses of cash were offset
partially by a decrease in our accounts receivable. Net cash used in operating activities in fiscal 2001 relates primarily to our net loss, increases in our accounts receivable and inventories and a decrease in our accounts payable. These uses of
cash were partially offset by a reduction of approximately $2.7 million in our income tax refund receivable.





Net
cash used in investing activities of $0.15 million for the nine months ended April 30, 2002 was the result of purchases of property and equipment. Net cash used in investing activities of $2.1 million for the nine months ended April 30, 2001 was
primarily the result of expenditures of $1.5 million to complete our corporate headquarters and $0.4 million for other property and equipment.





Net cash used by financing activities of $1.2 million for the nine months ended April 30, 2002 was primarily the result of a $10.0 million repayment of the convertible debenture, long-term borrowings
of $8.7 million under a financing arrangement secured by our corporate headquarters. Net cash provided by financing activities of $8.7 million for the nine months ended April 30, 2001 was the result of the issuance of a $15.0 million
convertible debenture, borrowings of approximately $4.0 million under the term loan line of credit agreement with The CIT Group/Business Credit and approximately $0.8 million in stock option exercises and employee stock purchases, reduced by the
repayment of approximately $10.8 million in loans previously secured by our commercial paper portfolio.





On
October 10, 2000, we entered into a term loan agreement and a three-year working capital line of credit with The CIT Group/Business Credit (CIT). The first term loan of $4.0 million, due and payable upon the finalization of a long-term
mortgage on our corporate headquarters or paid in 12 monthly installments commencing April 1, 2001, was fully repaid in May 2001. Another term loan of $1.0 million, due and payable in 90 days, was fully repaid on November 1, 2000. The term loans
under the agreement incurred interest at the lenders prime rate, plus .5%, with increases if the outstanding principal was not reduced according to a fixed amortization schedule. The working capital line of credit allows us to borrow, on a
revolving basis, for a period of three years, a







12




---




specified percentage of our eligible accounts receivable (approximately $2.8 million at April 30, 2002),
up to a limit of $5.0 million. Amounts outstanding under the working capital line bear interest at the lenders prime rate plus .25%. At April 30, 2002, no amounts other than loan fees were outstanding under the various credit arrangements. The
lender charged approximately $130,000 for the credit facility, which is being amortized as interest expense over the term of the credit agreement. The line of credit accrues various monthly maintenance, minimum usage and early termination fees. The
line of credit is collateralized by certain of our assets. The line of credit requires certain financial and other covenants, including the maintenance of a minimum EBITDA requirement for rolling 12-month periods ending on each fiscal quarter. For
the 12-month periods ended on April 30, 2002, we were not in compliance with the minimum EBITDA requirement. The lender has not waived our non-compliance with this covenant for this period and does not intend to make advances under the line.





In addition to the CIT line of credit noted above, we have a flooring line of credit with IBM Credit, which has
committed to make $2.0 million in flooring inventory commitments available to us. As of April 30, 2002, we owed $496,000 under the flooring line. The flooring line is collateralized by the specific inventory purchased pursuant to the flooring
commitments. CIT and IBM Credit have entered into an intercreditor agreement which determines the level of priority of either lenders security interest. The flooring line requires the maintenance of a minimum net worth of $16.0 million, and we
were in compliance with this covenant at April 30, 2002. The flooring line also requires us not to be in default of any covenants in the CIT agreement. IBM Credit has waived compliance with that requirement at April 30, 2002.





On October 31, 2000, we issued a $15.0 million convertible unsecured debenture to a private investor. The debenture carried
interest at 6.0% per annum, and was repayable in full on October 31, 2003, unless otherwise converted into our common stock. In connection with the issuance of the debenture, we issued to the investor a 5-year warrant to purchase up to 32,916 shares
of our common stock at an initial exercise price of $32.55 per share, with the number of shares for which the warrant is exercisable and the exercise price subject to antidilution adjustments. The value of the warrant of $562,000 was computed using
the Black-Scholes model, with the following assumptions: Expected life  5 years, Risk free interest rate  6%, and Volatility  1.20. In the second quarter of fiscal 2002, we paid the investor the remaining $10,000,000 principal
amount of the debentures and expensed the remaining unamortized debt issuance and warrant costs of $274,000 to interest expense.





In June 2001, we completed the sale of 3,800,000 shares of common stock raising gross proceeds of approximately $34.2 million before offering costs of $2.7 million. As a result of this offering, the exercise price of the warrant was
adjusted to $27.95 and the number of shares issuable upon exercise of the warrant pursuant to anti-dilution provisions of the warrant were adjusted to 38,333.





In December 2001, we borrowed $8.75 million under a financing arrangement secured by our corporate headquarters. The principal amount outstanding bears interest at prime plus 1.0% per annum, but not
less than 7.0% per annum. Under certain conditions, we have the right to request that portions of the principal amount outstanding under the note shall bear interest at a LIBOR based rate, but not less than 7.0%. As of April 30, 2002, the interest
rate on the loan was 7.0%. Principal reduction payments of $14,400 plus accrued interest are due each month beginning February 1, 2002 with the remaining principal balance and unpaid interest due at the maturity date of January 1, 2007. Debt
issuance costs totaled $201,800 and are being amortized over the term of the loan. Up to an additional $1.0 million may be borrowed under this financing arrangement to cover leasing costs and tenant improvements on the vacant, unimproved space
within the corporate headquarters. As of April 30, 2002, the outstanding principal balance of the loan totaled $8.69 million.





In addition to the line of credit, our foreign subsidiaries in Germany, Italy and Switzerland have lines of credit with banks in their respective countries that are utilized primarily for overdraft and short-term cash needs. At April
30, 2002, amounts outstanding under these lines was $84,000.





We are contingently liable at April 30, 2002 under
the terms of repurchase agreements with several financial institutions providing inventory financing for dealers of our products. Under these agreements, dealers purchase our products, and the financial institutions agree to pay us for those
purchases, less a pre-set financing charge, within an agreed payment term. Two of these institutions, Finova and IBM Credit Corporation, have also provided us with vendor inventory financing. The contingent liability under these agreements
approximates the amount financed, reduced by the resale value of any appliances that may be repurchased, and the risk of loss is spread over several dealers and financial institutions. At April 30, 2002, we were contingently liable for purchases
made under these agreements of approximately $0.1 million.





The Job Creation and Workers Assistance Act of
2002 signed by the President in February 2002, permits us to carry back certain of our previously recorded losses for 5 years instead of only 2 years. We previously had not believed we would be able to recover a tax benefit related to prior year
losses. As a result of the legislation, in April 2002, we filed amended tax returns for prior year losses, and in June 2002, received a tax refund of $2.9 million. In addition, we expect to be able to recover approximately $2.3 million in additional
tax refunds when we file our fiscal 2002 tax return, and carry expected fiscal 2002 operating losses back to previous periods. We have recorded a tax benefit in the current quarter of $2.9 million plus a proportionate share of the anticipated
additional refunds related to fiscal 2002.







13




---




In May 2002, the employment of three of our executives was terminated. Under the
agreements, the executives will receive payments of $18,750 for 36 months, and each will be entitled to participate in our employee benefit, health and other insurance plans of the 36 month period. We anticipate that we will record a charge for the
severance obligations of approximately $2.3 million in the quarter ended July 31, 2002.





We expect to have
sufficient cash generated from operations, our income tax refunds for fiscal 2001 and 2002, and, if necessary, the sale or refinancing of our headquarters building, to meet our anticipated cash requirements for the next twelve months. We cannot be,
certain, however we would be able to sell or refinance our building, if necessary, or otherwise obtain any additional financing, on favorable or any terms.





Contractual Cash Obligations:

Total

Less than 1
year

1 to 3 years

4 to 5 years

After 5 yearsLong Term Debt

$
8,693,000

$
172,000

$
345,000

$
8,176,000

$
Operating Leases


716,000


281,000


227,000


94,000


114,000Executive Severance


2,281,000


697,000


1,521,000


63,000


Total

$
11,690,000

$
1,150,000

$
2,093,000

$
8,333,000

$
114,000





NEW ACCOUNTING STANDARDS





In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible
Assets. Under SFAS No. 141, all business combinations initiated after June 30, 2001 must be accounted for using the purchase method. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are
reviewed annually for impairment (or more frequently if indicators of impairment arise). Separable intangible assets that are not deemed to have indefinite lives will continue to be amortized over their useful lives (but with no maximum life). The
amortization provisions of SFAS No. 142 apply to goodwill and intangible assets acquired after June 30, 2001. With respect to goodwill and intangible assets acquired prior to July 1, 2001, the Company is required to adopt SFAS No. 142 effective
August 1, 2002.





As of the date of adoption, the Company expects to have unamortized goodwill in the amount of
$1,140,000, and unamortized identifiable intangible assets in the amount of $630,000, all of which will be subject to the transition provisions of SFAS 141 and 142. Amortization expense related to goodwill was $361,000 and $262,000 for the nine
months ended April 30, 2002 and 2001, respectively. Because of the extensive effort needed to comply with adopting SFAS 141 and 142, it is not practicable to reasonably estimate the impact of adopting these statements on the Companys financial
statements at the date of this report, including whether any transitional impairment losses will be required to be recognized as a cumulative effect of a change in accounting principle.





In October 2001, the FASB issued SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. SFAS 144 supersedes SFAS No. 121, Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement is effective for fiscal years beginning
after December 15, 2001. Adoption of this statement is not expected to have a material impact on our consolidated financial position or results of operations.





RISK FACTORS





Before investing in our common stock, you
should be aware that there are risks inherent in our business, including those indicated below. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the
following risks actually occurs, our business could be harmed. In that case, the trading price of our common stock could decline, and you might lose part or all of your investment. You should carefully consider the following risk factors as well as
the other information in this Report on Form 10-Q.





COMPETING DATA STORAGE TECHNOLOGIES MAY EMERGE AS A STANDARD FOR DATA STORAGE
SOLUTIONS WHICH COULD CAUSE GROWTH IN THE NAS MARKET NOT TO MEET OUR EXPECTATIONS AND DEPRESS OUR STOCK PRICE.





The market for data storage is rapidly evolving. There are other storage technologies in use, including storage area network technology, which provide an alternative to network attached storage. We are not able to predict how the
data storage market will evolve. For example, it is not clear whether usage of a number of different solutions will grow and co-exist in the marketplace or whether one or a small number of solutions will be dominant and displace the others. It is
also not clear whether network attached storage technology will emerge as a dominant or even prevalent solution. Whether NAS becomes an accepted standard will be due to factors outside our control. If a solution other than network attached storage
emerges as the standard in the data storage market, growth in the network attached storage market may not meet our expectations. In such event, our growth and the price of our stock would suffer.







14




---




IF GROWTH IN THE NAS MARKET DOES NOT MEET OUR EXPECTATIONS, OUR FUTURE FINANCIAL PERFORMANCE COULD
SUFFER.





We believe our future financial performance will depend in large part upon the future growth in the
NAS market and on emerging standards in this market. We intend for NAS products to be our primary business. The market for NAS products, however, may not continue to grow. Long-term trends in storage technology remain unclear and some analysts have
questioned whether competing technologies, such as storage area networks, may emerge as the preferred storage solution. If the NAS market grows more slowly than anticipated, or if NAS products based on emerging standards other than those adopted by
us become increasingly accepted by the market, our operating results could be harmed.





THE REVENUE AND PROFIT POTENTIAL OF NAS
PRODUCTS IS UNPROVEN, AND WE MAY BE UNABLE TO ATTAIN REVENUE GROWTH OR PROFITABILITY FOR OUR NAS PRODUCT LINES.





NAS technology is relatively recent, and our ability to be successful in the NAS market may be negatively affected by not only a lack of growth of the NAS market but also the lack of market acceptance of our NAS products.
Additionally, we may be unable to achieve profitability as we transition to a greater emphasis on NAS products.





IF WE FAIL TO
SUCCESSFULLY MANAGE OUR TRANSITION TO A FOCUS ON NAS PRODUCTS, OUR BUSINESS AND PROSPECTS WOULD BE HARMED.





We
began developing NAS products in 1997. Since then, we have focused our efforts and resources on our NAS business, and we intend to continue to do so. We expect to continue to wind down our Legacy product development and marketing efforts. In the
interim, we expect to continue to rely in part upon sales of Legacy products to fund operating and development expenses. Net sales of our Legacy products have been declining in amount and as a percentage of our overall net sales, and we expect these
declines to continue. If the decline in net sales of our Legacy products varies significantly from our expectations, or the decline in net sales of our Legacy products is not substantially offset by increases in sales of our NAS products, we may not
be able to generate sufficient cash flow to fund our operations or to develop our NAS business.





We also expect
our transition to a NAS-focused business to require us to continue:





| |  |  | engaging in significant marketing and sales efforts to achieve market awareness as a NAS vendor;
| | - |  | ------------------------------------------------------------------------------------------------




| |  |  | reallocating resources in product development and service and support of our NAS appliances; and
| | - |  | ------------------------------------------------------------------------------------------------




| |  |  | modifying existing and entering into new channel partner relationships to include sales of our NAS appliances.
| | - |  | --------------------------------------------------------------------------------------------------------------




In addition, we may face unanticipated challenges in implementing our transition to a NAS-focused company. We may not be successful in
managing any anticipated or unanticipated challenges associated with this transition. Moreover, we expect to continue to incur costs in addressing these challenges, and there is no assurance that we will be able to generate sufficient revenues to
cover these costs. If we fail to successfully implement our transition to a NAS-focused company, our business and prospects would be harmed.





IF WE ARE UNABLE TO MANAGE OUR INTERNATIONAL OPERATIONS EFFECTIVELY, OUR OPERATING RESULTS COULD BE MATERIALLY ADVERSELY AFFECTED.





Net sales to our international customers, including export sales from the United States, accounted for approximately 33%, 41% and 56% of our net sales for the years ended July 31, 1999, 2000, 2001,
respectively, and approximately 39.0% of our net sales in the nine months ended April 30, 2002. We have committed significant operational resources to drive our international growth. Our international operations will expose us to operational
challenges that we would not otherwise face if we conducted our operations only in the United States. These include:





| |  |  | currency exchange rate fluctuations, particularly when we sell our products in currencies other than U.S. dollars;
| | - |  | ------------------------------------------------------------------------------------------------------------------




| |  |  | difficulties in collecting accounts receivable and longer accounts receivable payment cycles;
| | - |  | ---------------------------------------------------------------------------------------------




| |  |  | reduced protection for intellectual property rights in some countries, particularly in Asia;
| | - |  | --------------------------------------------------------------------------------------------




| |  |  | legal uncertainties regarding tariffs, export controls and other trade barriers;
| | - |  | --------------------------------------------------------------------------------




| |  |  | the burdens of complying with a wide variety of foreign laws and regulations; and
| | - |  | ---------------------------------------------------------------------------------






15




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| |  |  | seasonal fluctuations in purchasing patterns in other countries, particularly in Europe.
| | - |  | ----------------------------------------------------------------------------------------




Any of these factors could have an adverse impact on our existing international operations and business or impair our ability to continue
expanding into international markets. For example, our reported sales can be affected by changes in the currency rates in effect during any particular period. The effects of currency fluctuations were evident in our results of operations for the
fiscal year 2001 and the first nine months of fiscal 2002. During this period, the Euro and two currencies whose values are pegged to the Euro, fluctuated significantly against the U.S. dollar. As a result, we incurred a foreign currency loss of
approximately $54,000 in fiscal 2001 and a foreign currency gain of $53,000 in the first nine months of fiscal 2002. Also, these currency fluctuations can cause us to report higher or lower sales by virtue of the translation of the subsidiarys
sales into U.S. dollars at an average rate in effect throughout the fiscal year. In addition, we have funded operational losses of our subsidiaries of approximately $3.5 million between the date of purchase and April 30, 2002, and if our
subsidiaries continue to incur operational losses, our cash and liquidity would be negatively impacted.





In order
to successfully expand our international sales, we must strengthen foreign operations and recruit additional international distributors and resellers. Expanding internationally and managing the financial and business operations of our foreign
subsidiaries will also require significant management attention and financial resources. For example, our foreign subsidiaries in Europe have incurred operational losses. To the extent that we are unable to address these concerns in a timely manner,
our growth, if any, in international sales will be limited, and our operating results could be materially adversely affected. In addition, we may not be able to maintain or increase international market demand for our products.





IF THE AGING OF OUR ACCOUNTS RECEIVABLE CONTINUE TO INCREASE OR IF WE EXPERIENCE A SIGNIFICANT INCREASE IN SALES RETURNS, WE MAY NEED TO RECORD
ADDITIONAL RESERVES WHICH WOULD ADVERSELY AFFECT OUR OPERATING RESULTS.





At April 30, 2002, our net accounts
receivable totaled $7.6 million, which is net of reserves for bad debts of $9.2 million and sales returns of $2.6 million. Approximately $1.5 million, or 20%, of our net accounts receivable were past due greater than 90 days.Although management
believes that these accounts are collectible, if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, or if our receivable aging continued to lengthen for some of our European
and any other customers, we may be required to record additional bad debt reserves which would adversely affect our operating results.





Net sales for the nine months ended April 30, 2002 and 2001 were $20.4 million and $33.0 million, respectively. We recognize revenue on NAS product sales, sold through direct sales channels and resellers, generally upon
shipment of the product. In addition, we sell service contracts for certain of our appliances that require service for a specified period of time, usually one to three years. Revenue from these contracts is billed to customers at the time of sale,
but earned ratably over the life of the service agreement. Revenue is recognized on sales of our Legacy products, which are sold primarily through distributors, when the distributor receives the product. We maintain sales reserves for estimated
reductions to revenue for anticipated returns, including stock balancing and price protection claims, based on historical rates of sales returns. If we were to experience a significant increase in product sales returns, incremental sales reserves
may be required.





OUR STOCK MAY BE DE-LISTED FROM NASDAQ





The closing price of our common stock on June 13, 2002 was $0.86 per share. The NASDAQ National Market generally requires listed issuers to maintain a minimum bid price of
$1.00, and may delist an issuer whose share price falls below that threshold for an extended period of time. If we are unable to meet the minimum listing requirements, we may be subject to delisting from the NASDAQ National Market, which will have a
material adverse effect on our common stock and would severely restrict our ability to raise additional capital.





THE RECENT TERRORIST
ATTACKS MAY HAVE AN ADVERSE EFFECT ON OUR BUSINESS.





The terrorist attacks in New York and Washington, D.C. on
September 11, 2001 appear to be having an adverse effect on business, financial and general economic conditions. These effects may, in turn, have an adverse effect on our business and results of operations. At this time, however, we are not able to
predict the nature, extent and duration of these effects on overall economic conditions or on our business and operating results.





DUE
TO DETERIORATING U.S. AND WORLD ECONOMIC CONDITIONS, INFORMATION TECHNOLOGY SPENDING ON DATA STORAGE AND OTHER CAPITAL EQUIPMENT HAS DECLINED. IF TECHNOLOGY SPENDING CONTINUES TO DECLINE, OUR SALES AND OPERATING RESULTS COULD BE HARMED.





Many of our customers are affected by economic conditions in the United States and throughout the world. Many
companies have announced that they will reduce their spending on data storage and other capital equipment. If spending on data storage




16




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technology products is reduced further by customers and potential customers, our sales could be harmed,
and we may experience greater pressures on our gross margins. If economic conditions do not improve, or if our customers continue to reduce their overall information technology purchases, our sales, gross profits and operating results may be
reduced.





IF WE FAIL TO INCREASE THE NUMBER OF INDIRECT SALES CHANNELS FOR OUR NAS PRODUCTS, OUR ABILITY TO INCREASE NET SALES MAY BE
LIMITED.





In order to grow our business, we will need to increase market awareness and sales of our NAS
products. To achieve these objectives, we plan to expand revenues from our indirect sales channels, including resellers and systems integrators. To do this, we will need to modify and expand our existing relationships with these indirect channel
partners, as well as enter into new indirect sales channel relationships. We may not be successful in accomplishing these objectives. If we are unable to expand our direct or indirect sales channels, our ability to increase revenues may be limited.





BECAUSE WE DO NOT HAVE EXCLUSIVE RELATIONSHIPS WITH OUR DISTRIBUTORS FOR OUR LEGACY PRODUCTS, THESE CUSTOMERS MAY GIVE HIGHER
PRIORITY TO PRODUCTS OF COMPETITORS, WHICH COULD HARM OUR OPERATING RESULTS.





Our distributors generally offer
products of several different companies, including products of our competitors. Accordingly, these distributors may give higher priority to products of our competitors, which could harm our operating results. In addition, our distributors often
demand additional significant selling concessions and inventory rights, such as limited return rights and price protection. We cannot assure you that sales to our distributors will continue, or that these sales will be profitable.





BECAUSE WE HAVE ONLY APPROXIMATELY FOUR YEARS OF OPERATING HISTORY IN THE NAS MARKET, WHICH IS NEW AND RAPIDLY EVOLVING, OUR HISTORICAL FINANCIAL
INFORMATION IS OF LIMITED VALUE IN PROJECTING OUR FUTURE OPERATING RESULTS OR PROSPECTS.





We have been
manufacturing and selling our NAS products for only approximately four years. For the years ended July 31, 1999, 2000 and 2001, these products accounted for approximately 8%, 28% and 68% of our total net sales, respectively. For the nine months
ended April 30, 2002, these products accounted for approximately 39% of our total net sales. We expect sales of our NAS products to represent an increasing percentage of our net sales in the future. Because our operating history in the NAS product
market is only approximately four years, as well as the rapidly evolving nature of the NAS market, it is difficult to evaluate our business or our prospects. In particular, our historical financial information is of limited value in projecting our
future operating results.





MARKETS FOR BOTH OUR NAS APPLIANCES AND OUR LEGACY PRODUCTS ARE INTENSELY COMPETITIVE, AND IF WE ARE UNABLE
TO COMPETE EFFECTIVELY, WE MAY LOSE MARKET SHARE OR BE REQUIRED TO REDUCE PRICES.





The markets in which we
operate are intensely competitive and characterized by rapidly changing technology. Increased competition could result in price reductions, reduced gross margins or loss of market share, any of which could harm our operating results. We compete with
other NAS companies, direct-selling storage providers and smaller vendors that provide storage solutions to end-users. In our Legacy markets, we compete with computer manufacturers that provide storage upgrades for their own products, as well as
with manufacturers of hard drives, CD servers and arrays and storage upgrade products. Many of our current and potential competitors have longer operating histories, greater name recognition, larger customer bases and greater financial, technical,
marketing and other resources than we do. As a result, they may be able to respond more quickly to new or emerging technologies and changes in customer requirements, devote greater resources to the development, promotion, sale and support of their
products, and reduce prices to increase market share. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties. Accordingly, it is possible that new competitors
or alliances among competitors may emerge and rapidly acquire significant market share. We may not be able to compete successfully against current or future competitors. In addition, new technologies may increase competitive pressures.





WE DEPEND ON A FEW CUSTOMERS, INCLUDING DISTRIBUTORS AND SPECIALIZED END-USERS, FOR A SUBSTANTIAL PORTION OF OUR NET SALES, AND CHANGES IN THE
TIMING AND SIZE OF THESE CUSTOMERS ORDERS MAY CAUSE OUR OPERATING RESULTS TO FLUCTUATE.





For the nine
months ended April 30, 2002, no single customer accounted for more than 10.0% of our net sales, while two customers accounted for 13.4% of our net sales for the nine months ended April 30, 2001. Unless and until we diversify and expand our customer
base for NAS products, our future success will depend to a large extent on the timing and size of future purchase orders, if any, from these customers. In addition, we may receive from single site purchasers of large installations of our NAS
products large volume purchases of our NAS products over relatively short periods of time. This may cause our sales to be highly concentrated and significantly dependent on one or only a few customers. If we lose a major customer, or if one of our
customers significantly reduces its purchasing volume or experiences financial difficulties and is unable to or does not pay amounts owed to us,







17




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our results of operations would be adversely affected. In fiscal 2001, we sold our Legacy products
principally to distributors. We cannot be certain that customers that have accounted for significant revenues in past periods will continue to purchase our products or fully pay for products they purchase in future periods.





OUR GROSS MARGINS OF OUR VARIOUS PRODUCT LINES HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST AND MAY CONTINUE TO FLUCTUATE SIGNIFICANTLY. FOR EXAMPLE, WE MAY NOT
EXPERIENCE INCREASED SALES OF OUR NAS APPLIANCES.





Historically, our gross margins have fluctuated
significantly. Our gross margins vary significantly by product line and distribution channel, and, therefore, our overall gross margin varies with the mix of products we sell. Our markets are characterized by intense competition and declining
average unit selling prices over the course of the relatively short life cycles of individual products. For example, we derive a significant portion of our sales from NAS products. The market for these products is highly competitive and subject to
intense pricing pressures. If we fail to increase sales of our NAS appliances, or if demand, sales or gross margins for our Legacy products decline rapidly, we believe our overall gross margins may continue to decline.





Our gross margins have been and may continue to be affected by a variety of other factors, including:





| |  |  | new product introductions and enhancements;
| | - |  | -------------------------------------------




| |  |  | competition;
| | - |  | ------------




| |  |  | changes in the distribution channels we use;
| | - |  | --------------------------------------------




| |  |  | the mix and average selling prices of products; and
| | - |  | ---------------------------------------------------




| |  |  | the cost and availability of components and manufacturing labor.
| | - |  | ----------------------------------------------------------------




IF WE ARE UNABLE TO TIMELY INTRODUCE COST-EFFECTIVE HARDWARE OR SOFTWARE SOLUTIONS FOR NAS ENVIRONMENTS, OR IF OUR PRODUCTS FAIL TO KEEP PACE WITH TECHNOLOGICAL CHANGES IN THE MARKETS WE SERVE, OUR
OPERATING RESULTS COULD BE MATERIALLY ADVERSELY AFFECTED.





Our future growth will depend in large part upon
our ability to successfully develop and introduce new hardware and software for the NAS market. Due to the complexity of products such as ours, we face significant challenges in developing and introducing new products. The development of new
products requires significant research and development expense and effort. We may not have the financial resources to fund the research and development efforts necessary to develop new NAS products, and we may be unable to introduce new products on
a timely basis or at all. If we are unable to introduce new products in a timely manner, our operating results could be harmed.





Even if we are successful in introducing new products, we may be unable to keep pace with technological changes in our markets and our products may not gain any meaningful market acceptance. The markets we serve are characterized by
rapid technological change, evolving industry standards, and frequent new product introductions and enhancements that could render our products obsolete and less competitive. As a result, our position in these markets could erode rapidly due to
changes in features and functions of competing products or price reductions by our competitors. In order to avoid product obsolescence, we will have to keep pace with rapid technological developments and emerging industry standards. We may not have
the financial resources to do so or otherwise be successful in doing so, and if we fail in this regard, our operating results could be harmed.





WE RELY UPON A LIMITED NUMBER OF SUPPLIERS FOR SEVERAL KEY COMPONENTS USED IN OUR PRODUCTS, INCLUDING DISK DRIVES, COMPUTER BOARDS, POWER SUPPLIES, MICROPROCESSORS AND OTHER COMPONENTS, AND ANY DISRUPTION OR TERMINATION OF THESE
SUPPLY ARRANGEMENTS COULD DELAY SHIPMENT OF OUR PRODUCTS AND HARM OUR OPERATING RESULTS.





We rely upon a
limited number of suppliers of several key components used in our products, including disk drives, computer boards, power supplies and microprocessors. In the past, we have experienced periodic shortages, selective supply allocations and increased
prices for these and other components. We may experience similar supply issues in the future. Even if we are able to obtain component supplies, the quality of these components may not meet our requirements. For example, in order to meet our product
performance requirements, we must obtain disk drives of extremely high quality and capacity. Even a small deviation from our requirements could render any of the disk drives we receive unusable by us. In the event of a reduction or interruption in
the supply or a degradation in quality of any of our components, we may not be able to complete the assembly of our products on a timely basis or at all, which could force us to delay or reduce shipments of our products. If we were forced to delay
or reduce product shipments, our operating results could be harmed. In addition, product shipment delays could adversely affect our relationships with our channel partners and current or future end-users.







18




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UNDETECTED DEFECTS OR ERRORS FOUND IN OUR PRODUCTS, OR THE FAILURE OF OUR PRODUCTS TO PROPERLY
INTERFACE WITH THE PRODUCTS OF OTHER VENDORS, MAY RESULT IN DELAYS, INCREASED COSTS OR FAILURE TO ACHIEVE MARKET ACCEPTANCE, WHICH COULD MATERIALLY ADVERSELY AFFECT OUR OPERATING RESULTS.





Complex products such as those we develop and offer may contain defects or errors, or may fail to properly interface with the products of other vendors, when first
introduced or as new versions are released. Despite internal testing and testing by our customers or potential customers, we do, from time to time, and may in the future encounter these problems in our existing or future products. Any of these
problems may:





| |  |  | cause delays in product introductions and shipments;
| | - |  | ----------------------------------------------------




| |  |  | result in increased costs and diversion of development resources;
| | - |  | -----------------------------------------------------------------




| |  |  | require design modifications; or
| | - |  | --------------------------------




| |  |  | decrease market acceptance or customer satisfaction with these products, which could result in product returns.
| | - |  | ---------------------------------------------------------------------------------------------------------------




In addition, we may not find errors or failures in our products until after commencement of commercial shipments, resulting in loss of or
delay in market acceptance, which could significantly harm our operating results. Our current or potential customers might seek or succeed in recovering from us any losses resulting from errors or failures in our products.





OUR PROPRIETARY SOFTWARE RELIES ON OUR INTELLECTUAL PROPERTY, AND ANY FAILURE BY US TO PROTECT OUR INTELLECTUAL PROPERTY COULD ENABLE OUR COMPETITORS TO
MARKET PRODUCTS WITH SIMILAR FEATURES THAT MAY REDUCE DEMAND FOR OUR PRODUCTS, WHICH WOULD ADVERSELY AFFECT OUR NET SALES.





Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our proprietary software or technology. We believe the protection of our proprietary technology is important
to our business. If we are unable to protect our intellectual property rights, our business could be materially adversely affected. We currently rely on a combination of copyright and trademark laws and trade secrets to protect our proprietary
rights. In addition, we generally enter into confidentiality agreements with our employees and license agreements with end-users and control access to our source code and other intellectual property. We have applied for the registration of some, but
not all, of our trademarks. We have applied for U.S. patents with respect to the design and operation of our NetFORCE product, and we anticipate that we may apply for additional patents. It is possible that no patents will issue from our currently
pending applications. New patent applications may not result in issued patents and may not provide us with any competitive advantages over, or may be challenged by, third parties. Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries, and the enforcement of those laws, do not protect proprietary rights to as great an
extent as do the laws of the United States. We cannot assure you that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology, duplicate our products or design around
any patent issued to us or other intellectual property rights of ours.





In addition, we may initiate claims or
litigation against third parties for infringement of our proprietary rights to establish the validity of our proprietary rights. This litigation, whether or not it is resolved in our favor, could result in significant expense to us and divert the
efforts of our technical and management personnel.





WE MAY FROM TIME TO TIME BE SUBJECT TO CLAIMS OF INFRINGEMENT OF OTHER
PARTIES PROPRIETARY RIGHTS OR CLAIMS THAT OUR OWN TRADEMARKS, PATENTS OR OTHER INTELLECTUAL PROPERTY RIGHTS ARE INVALID, AND IF WE WERE TO SUBSEQUENTLY LOSE OUR INTELLECTUAL PROPERTY RIGHTS, OUR BUSINESS WOULD BE MATERIALLY ADVERSELY AFFECTED.





We may from time to time receive claims that we are infringing third parties intellectual property
rights or claims that our own trademarks, patents or other intellectual property rights are invalid. For example, we have been notified by Intel Corporation that our products may infringe some of the intellectual property rights of Intel. In its
notification, Intel offered us a non-exclusive license for patents in their portfolio. We are investigating whether our products infringe the patents of Intel, and we have had discussions with Intel regarding this matter. We do not believe that we
infringe the patents of Intel, but our discussions and our investigation are ongoing, and we expect we will continue discussions with Intel. We cannot assure you that Intel would not be successful in asserting a successful claim of infringement, or
if we were to seek a license from Intel regarding its patents, that Intel would continue to offer us a non-exclusive license on any terms. We expect that companies in our markets will increasingly be subject to infringement claims as the number of
products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. The resolution of any claims of this nature, with or without merit, could be time-consuming, result in costly
litigation, cause product shipment delays, require us to redesign our products or require us to enter into royalty or licensing




19




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agreements, any of which could harm our operating results. Royalty or licensing agreements, if required, might not be available on terms
acceptable to us or at all. The loss of access to any key intellectual property right could harm our business.





OUR NET SALES AND
OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY, AND ANY FLUCTUATIONS COULD CAUSE THE MARKET PRICE OF OUR COMMON STOCK TO DECLINE.





We have experienced significant declines in net sales and gross profit and incurred operating losses, causing our quarterly operating results to vary significantly. If we fail to meet the expectations of investors or
securities analysts, as well as our internal operating goals, as a result of any future fluctuations in our quarterly operating results, the market price of our common stock could decline significantly. Our net sales and quarterly operating results
are likely to fluctuate significantly in the future due to a number of factors. These factors include:





| |  |  | market acceptance of our new products and product enhancements or those of our competitors;
| | - |  | -------------------------------------------------------------------------------------------




| |  |  | the level of competition in our target product markets;
| | - |  | -------------------------------------------------------




| |  |  | delays in our introduction of new products;
| | - |  | -------------------------------------------




| |  |  | changes in sales volumes through our reseller and distribution channels, which have varying commission and sales discount structures;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------




| |  |  | changing technological needs within our target product markets;
| | - |  | ---------------------------------------------------------------




| |  |  | the impact of price competition on the selling prices for our products;
| | - |  | -----------------------------------------------------------------------




| |  |  | the availability and pricing of our product components;
| | - |  | -------------------------------------------------------




| |  |  | our expenditures on research and development and the cost to expand our sales and marketing programs; and
| | - |  | ---------------------------------------------------------------------------------------------------------




| |  |  | the volume, mix and timing of orders received.
| | - |  | ----------------------------------------------




Due to these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indicators of future performance. In
addition, it is difficult for us to forecast accurately our future net sales. This difficulty results from our limited operating history in the emerging NAS market, as well as the fact that product sales in any quarter are generally booked and
shipped in that quarter. Because we incur expenses, many of which are fixed, based in part on our expectations of future sales, our operating results may be disproportionately affected if sales levels are below our expectations.





Our revenues in any quarter may also be affected by product returns and any warranty obligations in that quarter. Many of our
distributors have limited product return rights. In addition, we generally extend warranties to our customers that correspond to the warranties provided by our suppliers. If returns exceed applicable reserves or if a supplier were to fail to meet
its warranty obligations, we could incur significant losses. In the first nine months of fiscal 2002 and 2001, we experienced product return rates of approximately 16.7% and 14.0%, respectively. This rate may vary significantly in the future, and we
cannot assure you that our reserves for product returns will be adequate in any future period.





IF WE ARE UNABLE TO ATTRACT QUALIFIED
PERSONNEL OR RETAIN OUR EXECUTIVE OFFICERS AND OTHER KEY PERSONNEL, WE MAY NOT BE ABLE TO COMPETE SUCCESSFULLY.





Our continued success depends, in part, on our ability to identify, attract, motivate and retain qualified technical and sales personnel. Competition for qualified engineers and sales personnel, particularly in Orange County,
California, is intense, and we may not be able to compete effectively to retain and attract qualified, experienced employees. Should we lose the services of a significant number of our engineers or sales people, we may not be able to compete
successfully in our targeted markets and our business would be harmed.





We believe that our success will depend on
the continued services of our executive officers and other key employees. The loss of any of these key executive officers or other key employees could harm our business.





WE MAY NOT BE ABLE TO ACHIEVE OR SUSTAIN PROFITABILITY, AND OUR FAILURE TO DO SO COULD REQUIRE US TO SEEK ADDITIONAL FINANCING, WHICH MAY NOT BE AVAILABLE TO US ON FAVORABLE OR ANY TERMS.




20




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In recent periods, we have experienced significant declines in net sales and
gross profit, and we have incurred operating losses. We incurred operating losses of $5.2 million for fiscal 1999, $12.1 million for fiscal 2000, $16.6 million (including a charge for in-process research and development) in fiscal year 2001 and
$15.7 million for the nine months ended April 30, 2002. We will need to increase our revenues from our NAS products to achieve and maintain profitability. The revenue and profit potential of these products is unproven. We may not be able to generate
significant or any revenues from our NAS products or achieve or sustain profitability in the future. If we are unable to achieve or sustain profitability in the future, we may have to seek additional financing in the future, which may not be
available to us on favorable or any terms.





CONTROL BY OUR EXISTING SHAREHOLDERS COULD DISCOURAGE POTENTIAL ACQUISITIONS OF OUR
BUSINESS THAT OTHER SHAREHOLDERS MAY CONSIDER FAVORABLE.





As of April 30, 2002, our executive officers and
directors beneficially owned approximately 5,970,000 shares, or approximately 37.0% of the outstanding shares of common stock. Acting together, these shareholders would be able to exert substantial influence on matters requiring approval by
shareholders, including the election of directors. This concentration of ownership could have the effect of delaying or preventing a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which
could in turn have an adverse effect on the market price of our common stock or prevent our shareholders from realizing a premium over the market price for their shares of common stock.





THE MARKET PRICE FOR OUR COMMON STOCK HAS FLUCTUATED SIGNIFICANTLY IN THE PAST AND WILL LIKELY CONTINUE TO DO SO IN THE FUTURE, WHICH COULD RESULT IN A DECLINE IN YOUR INVESTMENTS
VALUE.





The market price for our common stock has been volatile in the past, and particularly volatile in the
last twelve months, and may continue to fluctuate substantially in the future. The value of your investment in our common stock could decline due to the impact of any of the above or of the following factors upon the market price of our common
stock:





| |  |  | fluctuations in our operating results;
| | - |  | --------------------------------------




| |  |  | fluctuations in the valuation of companies perceived by investors to be comparable to us;
| | - |  | -----------------------------------------------------------------------------------------




| |  |  | a shortfall in net sales or operating results compared to securities analysts expectations;
| | - |  | --------------------------------------------------------------------------------------------




| |  |  | changes in analysts recommendations or projections;
| | - |  | ----------------------------------------------------




| |  |  | announcements of new products, applications or product enhancements by us or our competitors; and
| | - |  | -------------------------------------------------------------------------------------------------




| |  |  | changes in our relationships with our suppliers or customers, including failures by customers to pay amounts owed to us.
| | - |  | ------------------------------------------------------------------------------------------------------------------------




WE MAY ISSUE ADDITIONAL SHARES, WHICH WOULD REDUCE YOUR OWNERSHIP PERCENTAGE AND DILUTE THE VALUE OF YOUR SHARES.





Events over which you have no control could result in the issuance of additional shares of our common stock, which would dilute your
ownership percentage. Our issuance of 480,000 shares in connection with the acquisition of Scofima Software S.r.l. is an example of an issuance of additional shares to finance an acquisition that may dilute your ownership. Also in June 2001, we
completed the sale of 3.8 million shares of our common stock in an offering. In the future, we may issue additional shares of common stock or preferred stock to raise additional capital or finance acquisitions, upon the exercise or conversion of
outstanding options, warrants and shares of convertible preferred stock, or in lieu of cash payment of dividends. Our issuance of additional shares would dilute your shares.





SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS.





This
Report on Form 10-Q contains forward-looking statements, including, without limitation, the statements under the captions Risk Factors, and Managements Discussion and Analysis of Financial Condition and Results of
Operations, You can identify these statements by the use of words like may, will, could, should, project, believe, anticipate, expect,
plan, estimate, forecast, potential, intend, continue, and variations of these words or comparable words. In addition, all of the non-historical information in this Report on
Form 10-Q is forward-looking. Forward-looking statements do not guarantee future performance and involve risks and uncertainties. Actual results may and probably will differ substantially from the results that the forward-looking statements suggest
for various reasons, including those discussed under Risk Factors. These forward-looking statements are made only as of the date of this Report on Form 10-Q. We do not undertake to update or revise the forward-looking statements, whether
as a result of new information, future events or otherwise.





ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURE
ABOUT MARKET RISKS







21




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INTEREST RATE RISK





Our exposure to market risk for changes in interest rates relates primarily to the increase or decrease in the amount of interest income we can earn on our investment
portfolio as well as the fluctuation in interest rates on our various borrowing arrangements. We do not use derivative financial instruments in our investment portfolio. We invest in high-credit quality issuers and, by policy, we limit the amount of
credit exposure to any one issuer. As stated in our policy, we ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in safe and
high-credit quality securities and by constantly positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer, guarantor or depository. The portfolio includes only marketable securities
with active secondary or resale markets to help ensure reasonable portfolio liquidity.





Since October 31, 2000, we
have entered into a line of credit and term loan agreements pursuant to which amounts outstanding bear interest at the lenders prime rate plus up to .50%. Accordingly, if we were to borrow funds under such agreements, we expect that we will
experience interest rate risk on our debt.





In December 2001, we borrowed $8.75 million under a financing
arrangement. The principal amount outstanding bears interest at prime plus 1.0%, although at a minimum of 7%. Accordingly, if the prime rate were to fluctuate above 6%, we would experience interest rate risk on our debt.





FOREIGN CURRENCY EXCHANGE RATE RISK





We transact business in various foreign countries, but we only have significant assets deployed outside the United States in Europe. We have effected intercompany advances and sold goods to our German subsidiary, as well as
our subsidiaries in Italy and Switzerland, denominated in U.S. dollars, and those amounts are subject to currency fluctuation and require constant revaluation on our financial statements. In the nine months ended April 30, 2002 and 2001, we
incurred a foreign currency gain of $53,000 and a loss of $38,000 respectively which are included in our selling, general and administrative expenses. We do not operate a hedging program to mitigate the effect of a significant rapid change in the
value of the Euro or the Swiss franc compared to the U.S. dollar. If such a change did occur, we would have to take into account a currency exchange gain or loss in the amount of the change in the U.S. dollar denominated balance of the amounts
outstanding at the time of such change. Our net sales can also be affected by a change in the exchange rate because we translate sales of our subsidiaries at the average rate in effect during a financial reporting period. At April 30, 2002,
approximately $11.2 million in current intercompany advances and accounts receivable from our foreign subsidiaries were outstanding. We can not assure you that we will not sustain a significant loss if a rapid or unpredicted change in value of the
Euro or related European currencies should occur. We can not assure you that such a loss would not have an adverse material effect on our results of operations or financial condition.





PART II





SIGNATURES





Pursuant to the requirements 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, in the City of Irvine, County of Orange, State of California, on the 14th of June, 2002.





PROCOM TECHNOLOGY, INC.





By:

/s/    Alex RazmjooAlex Razmjoo Chairman, President
and Chief Executive Officer





Pursuant to the requirements of the Securities Exchange Act of
1934, as amended, this Report on Form 10-Q has been signed below by the following persons in the capacities and on the dates indicated.










22




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SIGNATURES

TITLE

DATE/s/    Alex
Razmjoo

Chairman of the Board, President

June 14, 2002and Chief Executive OfficerAlex Razmjoo

(Principal Executive Officer)/s/    Edward
Kirnbauer Edward
Kirnbauer

Controller and acting Chief Financial Officer

June 14, 2002







23




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INDEX TO EXHIBITS





EXHIBIT NUMBER

DESCRIPTION3.1

Amended and Restated Articles of Incorporation of the Company (incorporated by reference to Exhibit 3.1 in the Form S-1A filed on November 14,
1996)3.2

Amended and Restated Bylaws of the Company (incorporated by reference to Exhibit 3.2 in the Form S-1A filed on November 14, 1996)4.1

Form of Convertible Debenture dated October 31, 2000 (incorporated by reference to Exhibit 4.1 in the Registration Statement on Form S-3 filed on November
22, 2000)4.1.1

Amendment to Convertible Debenture (incorporated by reference to Exhibit 4.1.1 in the Form S-3 filed on April 25, 2001)4.2

Form of Common Stock Purchase Warrant dated October 31, 2000 (incorporated by reference to Exhibit 4.2 in the Report on Form 8-K filed on November 3,
2000)4.3

Securities Purchase Agreement dated October 31, 2000 (incorporated by reference to Exhibit 4.3 in the Report on Form 8-K filed on November 3,
2000)4.4

Registration Rights Agreement dated October 31, 2000 by and between the Registrant and Montrose Investments, Ltd. (incorporated by reference to Exhibit 4.4
in the Report on Form 8-K filed on November 3, 2000)4.5

Subordination Agreement dated October 31, 2000 by and between the Registrant, Montrose Investments, Ltd. and CIT Group/Business Credit, Inc. (incorporated by
reference to Exhibit 4.5 in the Report on Form 8-K filed on November 3, 2000)10.1

Loan Agreement dated November 28, 2001 by and between the Registrant and First Bank & Trust10.2

Agreement dated May 24, 2002 between the Registrant and Alex Aydin10.3

Agreement dated May 24, 2002 between the Registrant and Nick Shahrestany10.4

Agreement dated May 24, 2002 between the Registrant and Frank Alaghband




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