UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

Form 10-Q

(Mark one)

ý
  
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

OR

o
  
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                              to                                            

Commission file number                  0-24230



FIBERSTARS, INC.
(Exact name of registrant as specified in its charter)


California
  
94-3021850
(State or other jurisdiction of incorporation or organization)
  
(I.R.S. Employer Identification No.)
     
44259 Nobel Drive, Fremont, CA
(Address of principal executive offices)
     
94538
(Zip Code)
(Registrant’s telephone number, including area code): (510) 490-0719

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
 
The number of outstanding shares of the registrants’ Common Stock, $0.0001 par value, as of July 31, 2005 was 7,834,534.



TABLE OF CONTENTS
 
Part I - FINANCIAL INFORMATION
       
Item 1
Financial Statements:
  
       
 
a.
Condensed Consolidated Balance Sheets at June 30, 2005 (unaudited) and December 31, 2004
3
       
 
b.
Condensed Consolidated Statements of Operations for the Three Months and Six Months Ended June 30, 2005 and 2004 (unaudited)
4
       
 
c.
Condensed Consolidated Statements of Comprehensive Operations for the Three Months and Six Months Ended June 30, 2005 and 2004 (unaudited)
5
       
 
d.
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004 (unaudited)
6
       
 
e.
Notes to Condensed Consolidated Financial Statements (unaudited)
7
       
Item 2
Management’s Discussion and Analysis of Financial Condition and Results of Operations 
 12
       
Item 3
Quantitative and Qualitative Disclosures About Market Risk
21
       
Item 4
Controls and Procedures
21
       
Part II - OTHER INFORMATION
       
       
       
Item 1
Legal Proceedings
22
       
Item 4
Submission of Matters to a Vote of Security Holders
22
       
Item 6
Exhibits
23
       
 
Signatures
24
 

Item 1. Financial Statements

FIBERSTARS, INC.
CONDENSED
CONSOLIDATED BALANCE SHEETS
(amounts in thousands)

   
June 30,
2005
  
December 31,
2004
  
   
(unaudited)
      
ASSETS
              
Current assets:
              
Cash and cash equivalents
  
$
3,349
  
$
3,609
  
Accounts receivable trade, net
    
6,201
    
7,224
  
Notes and other accounts receivable
    
79
    
152
  
Inventories, net
    
7,973
    
8,433
  
Prepaids and other current assets
    
526
    
455
  
Total current assets
    
18,128
    
19,873
  
               
Fixed assets, net
    
2,487
    
2,604
  
Goodwill, net
    
4,139
    
4,279
  
Intangibles, net
    
98
    
150
  
Other assets
    
118
    
112
  
Total assets
  
$
24,970
  
$
27,018
  
               
LIABILITIES
              
Current liabilities:
              
Accounts payable
  
$
1,688
  
$
2,920
  
Accrued liabilities
    
2,003
    
2,374
  
Short-term bank borrowings
    
194
    
38
  
Total current liabilities
    
3,885
    
5,332
  
Long-term bank borrowings
    
408
    
484
  
Total liabilities
    
4,293
    
5,816
  
               
Commitments and contingencies (Note 9)
              
               
SHAREHOLDERS’ EQUITY
              
Common stock
    
1
    
1
  
Additional paid-in capital
    
29,028
    
27,520
  
Unearned stock-based compensation
    
(407
)
  
(490
)
Accumulated other comprehensive income
    
358
    
661
  
Accumulated deficit
    
(8,303
)
  
(6,490
)
Total shareholders’ equity
    
20,677
    
21,202
  
Total liabilities and shareholders’ equity
  
$
24,970
  
$
27,018
  

The accompanying notes are an integral part of these financial statements
 
3
FIBERSTARS, INC.
CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands except per share amounts)
(unaudited)
 
   
Three months
ended June 30,
  
Six months
ended June 30,
  
   
2005
  
2004
  
2005
  
2004
  
Net sales
  
$
7,645
  
$
8,550
  
$
14,465
  
$
14,558
  
Cost of sales
    
4,723
    
4,983
    
9,000
    
8,890
  
Gross profit
    
2,922
    
3,567
    
5,465
    
5,668
  
Operating expenses:
                          
                           
Research and development
    
400
    
217
    
877
    
487
  
Sales and marketing
    
2,388
    
2,210
    
4,708
    
4,187
  
General and administrative
    
747
    
645
    
1,558
    
1,268
  
Restructure expense
    
197
    
---
    
197
    
---
  
Total operating expenses
    
3,732
    
3,072
    
7,340
    
5,942
  
Profit (loss) from operations
    
(810
)
  
495
    
(1,875
)
  
(274
)
Other income (expense):
                          
Other income/(expense)
    
37
    
1
    
40
    
1
  
Interest income (expense), net
    
(2
)
  
(29
)
  
(5
)
  
(23
)
                           
Profit (loss) before income taxes
    
(775
)
  
467
    
(1,840
)
  
(296
)
Benefit from (provision for) income taxes
    
12
    
(6
)
  
27
    
(7
)
Net income (loss)
  
$
(763
)
$
461
  
$
(1,813
)
$
(303
)
                           
Net income (loss) per share - basic
 
$
(0.10
)
$
0.06
  
$
(0.24
)
$
(0.04
)
                           
Shares used in computing net income per share - basic
    
7,585
    
7,219
    
7,783
    
7,135
  
                           
Net income (loss) per share - diluted
  
$
(0.10
)
$
0.06
  
$
(0.24
)
$
(0.04
)
                           
Shares used in computing net income per share - diluted
    
7,585
    
8,100
    
7,783
    
7,135
  
                           

The accompanying notes are an integral part of these financial statements
 
4
FIBERSTARS, INC.
CONDENSED
CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS
(amounts in thousands)
(unaudited)
 
   
Three Months Ended June 30,
  
Six months Ended June 30,
  
   
 2005
  
 2004
  
 2005
  
 2004
  
Net income (loss)
  
$
(763
)
$
461
  
$
(1,813
)
$
(303
)
                           
Other comprehensive income (loss), net of tax:
                          
Foreign currency translation adjustments
    
(316
)
  
(13
)
  
(481
)
  
22
  
Benefit (provision) for income taxes
    
117
    
5
    
178
    
(8
)
Comprehensive income (loss)
  
$
(962
)
$
453
  
$
(2,116
)
$
(289
)

The accompanying notes are an integral part of these financial statements

5
FIBERSTARS, INC.
CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)
(unaudited)
 
   
Six months Ended June 30,
  
   
2005
  
2004
  
Cash flows from operating activities:
          
Net loss
  
$
(1,813
)
$
(303
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
              
Depreciation and amortization
    
568
    
498
  
Non-cash stock option expense
    
235
        
Changes in assets and liabilities:
              
Accounts receivable
    
936
    
(989
)
Notes and other receivables
    
(1
)
  
23
  
Inventories
    
288
    
(794
)
Prepaids and other current assets
    
(25
)
  
(535
)
Other assets
    
(6
)
  
9
  
Accounts payable
    
(1,204
)
  
135
  
Accrued liabilities
    
(190
)
  
(348
)
Total adjustments
    
601
    
(2,001
)
Net cash from (used in) operating activities
    
(1,212
)
  
(2,304
)
               
Cash flows from investing activities:
              
Acquisition of fixed assets
    
(464
)
  
(352
)
Net cash used in investing activities
    
(464
)
  
(352
)
               
Cash flows from financing activities:
              
Cash proceeds from exercise of stock options
    
1,356
    
1,032
  
Collection of loan made to shareholder
    
¾
    
224
  
Proceeds from (repayment of) Short-term bank borrowings
    
¾
     88  
Other long-term liabilities
    
179
    
28
  
Net cash provided by financing activities
    
1,535
    
1,372
  
               
Effect of exchange rate changes on cash
    
(119
)
  
(13
)
               
Net increase (decrease) in cash and cash equivalents
    
(260
)
  
(1,297
)
Cash and cash equivalents, beginning of period
    
3,609
    
4,254
  
Cash and cash equivalents, end of period
  
$
3,349
  
$
2,957
  

The accompanying notes are an integral part of these financial statements

6
FIBERSTARS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)

1. Summary of Significant Accounting Policies

Interim Financial Statements (unaudited)
Although unaudited, the interim financial statements in this report reflect all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair statement of financial position, results of operations and cash flows for the interim periods covered and of the financial condition of Fiberstars, Inc. (the “Company”) at the interim balance sheet date. The results of operations for the interim periods presented are not necessarily indicative of the results expected for the entire year.
 
Use of Estimate:
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Estimates include, but are not limited to, the establishment of reserves for accounts receivable, sales returns, and warranty claims; the useful lives for property, equipment, and intangible assets, and stock-based compensation. Actual results could differ from those estimates.
 
Year-end Balance Sheet
The year-end balance sheet information was derived from audited financial statements but does not include all disclosures required by generally accepted accounting principles. These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended December 31, 2004, contained in the Company’s 2004 Annual Report on Form 10-K.

Foreign Currency Translation
The Company’s international subsidiaries use their local currency as their functional currency. For those subsidiaries, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expense accounts at average exchange rates during the year. Resulting translation adjustments are recorded to a separate component of shareholders’ equity.

Earnings Per Share
Basic earnings per share (“EPS”) is computed by dividing income available to shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS is computed by giving effect to all dilutive potential common shares that were outstanding during the period. Dilutive potential common shares consist of incremental shares upon exercise of stock options and warrants.

A reconciliation of the numerator and denominator of basic and diluted EPS is provided as follows (in thousands, except per share amounts):

   
Three months ended June 30,
  
Six months ended June 30,
  
   
2005
  
2004
  
2005
  
2004
  
Numerator - earnings ( loss )
  
$
(763
)
$
461
  
$
(1,813
)
$
(303
)
Denominator - Basic and Diluted EPS
                          
Weighted average shares outstanding
    
7,585
    
7,219
    
7,783
    
7,135
  
Basic earnings ( loss ) per share
  
$
(0.10
)
$
0.06
  
$
(0.24
)
$
(0.04
)
 
   
Three months ended June 30,
  
Six months ended June 30,
  
 
  
2005
  
2004
  
2005
  
2004
  
Numerator - earnings ( loss )
  
$
(763
)
$
461
  
$
(1,813
)
$
(303
)
Effect potentially of dilutive securities
                          
Stock options and warrants
    
—
    
881
    
—
    
—
  
Denominator - Basic and Diluted EPS
          
             
Weighted average shares outstanding (excluding anti-dilutive securities)
    
7,585
    
8,100
    
7,783
    
7,135
  
Diluted earnings ( loss ) per share
  
$
(0.10
)
$
0.06
  
$
(0.24
)
$
(0.04
)
 
7
For all periods presented the shares outstanding used for calculating basic and diluted EPS include 120,000 shares of common stock issuable for no cash consideration upon exercise of certain exchange provisions of warrants held by Advanced Lighting Technologies, Inc. ("ADLT").

At June 30, 2005, options and warrants to purchase 2,135,882 shares of common stock were outstanding, but were not included in the calculation of diluted EPS because their inclusion would have been antidilutive. Options to purchase 1,105,322 shares of common stock were outstanding at June 30, 2004, but were not included in the calculation of diluted EPS for the six months ended June 30, 2004 because their inclusion would have been antidilutive.
 
Stock- Based Compensation
The Company accounts for stock-based compensation plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The following table illustrates the effect on net income (loss) and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share amounts):
 
   
Three months ended
June 30,
 
Six months ended
June 30,
 
   
2005
  
2004
  
2005
  
2004
  
Net loss, as reported
  
$
(763
)
$
461
  
$
(1,813
)
$
(303
)
                           
Add: Stock-based employee compensation expense included in reported net income (loss), net of related tax effects
    
203
    
—
    
207
    
—
  
                           
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax related effects
    
(250
)
  
(78
)
  
(366
)
  
(133
)
                           
Net loss, pro forma
  
$
(810
)
  
383
  
$
(1,972
)
  
(436
)
                           
Basic and Diluted net loss per share—As reported
  
$
( 0.10
)
$
0.06
  
$
(0.24
)
$
(0.04
)
                           
Basic and Diluted net loss per share—Pro forma
  
$
(0.10
)
$
0.05
  
$
(0.26
)
$
(0.06
)


Product Warranties
The Company warrants finished goods against defects in material and workmanship under normal use and service for periods of one to three years for illuminators and fiber. A liability for the estimated future costs under product warranties is maintained for products outstanding under warranty (in thousands):

   
Six months ended
June 30,
 
   
2005
  
2004
  
Balance at the beginning of the period
  
$
430
  
$
330
  
Accruals for warranties issued during the period
    
479
    
297
  
Accruals related to pre-existing warranties (including changes in estimates)
     —    
45
  
Settlements made during the period (in cash or in kind)
    
(516
)
  
(297
)
Balance at the end of the period
  
$
393
  
$
375
  

8
2. Inventories

Inventories are stated at the lower of standard cost (which approximates actual cost determined using the first-in, first-out cost method) or market and consist of the following (in thousands):

   
June 30,
2005
  
December 31,
2004
  
           
Raw materials
  
$
6,380
  
$
6,441
  
Inventory Reserve
    
(571
)
  
(513
)
Finished goods
    
2,164
    
2,505
  
   
$
7,973
  
$
8,433
  
 
3. Bank Borrowings

The Company had a $5,000,000 Loan and Security Agreement (Accounts Receivable and Inventory) dated December 7, 2001, with Comerica Bank bearing interest equal to prime plus 0.25% per annum computed daily or a fixed rate term option of LIBOR plus 3%. Borrowings under this Loan and Security Agreement were collateralized by its assets and intellectual property. Specific borrowings were tied to accounts receivable and inventory balances, and the Company was required to comply with certain covenants with respect to effective net worth and financial ratios. The Company had no borrowings against this facility as of June 30, 2005 and December 31, 2004. The Company was not in conformity with the bank covenants of the Comerica Bank agreement as of June 30, 2005. The Company agreed to a new bank line of credit agreement with Silicon Valley Bank on August 15, 2005. This credit facility is for $5,000,000 and is secured by accounts receivable. It has a minimum tangible net worth covenant which the Company must meet going forward.

The Company also has available a $448,000 (in UK pounds sterling based on the exchange rate at June 30, 2005) bank overdraft agreement with Lloyds Bank Plc through its UK subsidiary. The Company had no borrowings against this facility as of June 30, 2005 and December 31, 2004. The facility is renewed annually on January 1 and bears an interest rate of 7%.

Through its German subsidiary, the Company maintains a credit facility under an agreement with Sparkasse Neumarkt Bank. This credit facility is in place to finance, and is secured by, its offices in Berching, Germany, owned and occupied by its German subsidiary. As of June 30, 2005, the Company had total borrowings of $408,000 against this credit facility (in Euros, based on the exchange rate at June 30, 2005). As of December 31, 2004, the Company had $477,000 in borrowings against this facility (in Euros, based on the exchange rate at December 31, 2004). Additionally, the Company has a revolving line of credit of $244,000 (in Euros, based on the exchange rate at June 30, 2005) with Sparkasse Neumarkt Bank. As of June 30, 2005, there was a total borrowing of $166,000 (in Euros, based on the exchange rate at June 30, 2005) against this facility, and the Company had no borrowings against this facility as of December 31, 2004. The facility is renewed annually on January 1 and bears an interest rate of 8.75%.

4. Comprehensive Operations

Comprehensive income (loss) is defined as net income (loss) plus sales, expenses, gains and losses that, under generally accepted accounting principles, are included in comprehensive income (loss) but excluded from net income (loss). A separate statement of comprehensive operations has been presented with this report.
 
5. Segments and Geographic Information

The Company operates in a single industry segment that manufactures, markets and sells fiber optic lighting products. The Company has two primary product lines: the pool and spa lighting product line and the commercial lighting product line, each of which markets and sells fiber optic lighting products. The Company markets its products for worldwide distribution primarily through independent sales representatives, distributors and swimming pool builders in North America, Europe and the Far East.

9
A summary of sales by geographic area is as follows (in thousands):

   
Three months ended June 30,
  
Six months ended June 30,
  
   
2005
  
2004
  
2005
  
2004
  
                   
United States$
   $ 5,847   $ 6,497  
$
10,734
  
$
10,509
  
Germany
     372     765    
1,412
    
1,765
  
United Kingdom
     1,325     1,089    
2,034
    
1,931
  
Other countries
     101     199    
285
    
353
  
      7,645     8,550  
$
14,465
  
$
14,558
  

Geographic sales are categorized based on the location of the customer to whom the sales are made.

A summary of sales by product line is as follows (in thousands):

   
Three months ended June 30,
  
Six months ended June 30,
  
   
2005
  
2004
  
2005
  
2004
  
                   
Pool and Spa Lighting
   $ 4,444     5,177  
$
8,132
  
$
8,235
  
Commercial Lighting
     3,201     3,373    
6,333
    
6,323
  
      7,645     8,550  
$
14,465
  
$
14,558
  
 
A summary of geographic fixed assets is as follows (in thousands):

   
June 30,
2005
  
December 31,
2004
  
   
(unaudited)
      
United States
  
$
1,713
  
$
1,624
  
Germany
    
667
    
843
  
Other Countries
    
107
    
137
  
   
$
2,487
  
$
2,604
  

6. Recent pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004) or SFAS 123R, “Share-Based Payments.” SFAS 123R requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments, such as stock options granted to employees. We will be required to apply SFAS 123R on a modified prospective method. Under this method, we are required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. In addition, we may elect to adopt SFAS 123R by restating previously issued financial statements, basing the amounts on the expense previously calculated and reported in their pro forma disclosures that had been required by SFAS 123. SFAS 123R is effective for the first fiscal year beginning after June 15, 2005. We have not completed our evaluation of the effect that SFAS 123R will have, but we believe that when adopted it will increase stock-based compensation expense and reduce earnings in a manner previously only presented as pro forma disclosure, with no or little impact on our overall financial position.

In December 2004, the FASB issued SFAS No.151, “Inventory Costs,” which amends part of ARB 43, “Inventory Pricing,” concerning the treatment of certain types of inventory costs. The provisions of ARB No. 43 provided that certain inventory-related costs, such as double freight, re-handling, might be “so abnormal” that they should be charged against current earnings rather than be included in the cost of inventory and, that is capitalized to future periods. As amended by SFAS No. 151, the “so-abnormal” criterion has been eliminated. Thus, all such (abnormal) costs are required to be treated as current-period charges under all circumstances. In addition, fixed production overhead should be allocated based on the normal capacity of the production facilities, with unallocated overhead charged to expense when incurred. SFAS 151 is required to be adopted for fiscal years beginning after June 15, 2005. We are assessing the impact of adopting SFAS No.151, but do not believe its adoption will have a material impact on our overall financial position. 
 
10
7. Goodwill and Acquired Intangibles

In February 2000, the Company purchased certain assets of Unison Fiber Optic Systems, Inc. and accounted for the acquisition as a purchase. Acquired intangible assets are being amortized using the straight-line method over the estimated useful life of the assets ranging from 3 to 7 years.

8. Income Taxes

A full valuation allowance is recorded against the Company’s U.S. deferred tax assets as management cannot conclude, based on available objective evidence, when the gross value of its deferred tax assets will be realized. The Company accrues foreign tax expenses or benefits as these are incurred.
 
9. Commitments and Contingencies

The Company is a third-party .defendant in a lawsuit pending in the Court of Common Pleas, Cuyahoga County, Ohio filed September 21, 2004. In that matter Sherwin-Williams Company, plaintiff, brought suit against defendant and third-party plaintiff, Wagner Electric Sign Company, or Wagner, for alleged breach of warranty and breach of contract in connection with an allegedly defective sign manufactured and sold by Wagner. The complaint alleges $141,739.06 in compensatory damages. Third-party plaintiff, Wagner, has cross-claimed against us requesting unspecified damages alleging that the signs’ failure, if any, arises from defective fiber optic lighting components, instructions and/or services purportedly supplied to it by us. The Company denies these allegations in our responsive pleadings and discovery proceeds on all claims. While the Company cannot predict as to the ultimate outcome of the litigation, the Company does not currently believe its outcome will have a material impact on our financial condition.

The Company is currently involved in a lawsuit brought by one of our competitors in the swimming pool and spa market, Pentair Water Pool and Spa, Inc. In a lawsuit filed against us on April 5, 2005 in the United States District Court, Northern District of California, Pentair alleges that the manufacture, use and sale of our FX Pool Light infringes three United States patents that Pentair claims to own relevant to certain synchronized light technology, U.S. Patent No. 6,379,025 B1, No. 6,002,216 and No. 6,811,286. In the lawsuit, Pentair is attempting to stop us from selling certain of our synchronized pool light products and to obtain compensatory and treble damages. The Company’s initial response to these allegations has not as yet been filed. Although the Company believes it may have defenses that are meritorious, litigation is unpredictable and the outcome of this matter cannot be determined at this time. If the Company does not prevail, the Company may be ordered to pay damages for past sales and an ongoing royalty for future sales of products found to infringe. The Company could also be ordered to stop selling the challenged FX Pool Light product. If found liable, the Company may or may not be able to redesign our products to avoid future infringement. Any public announcement concerning the litigation that is unfavorable to us may result in a decline in our stock price.

As the Pentair litigation is in its very early stages the Company also does not know how expensive or protracted it will be. The Company believes that this type of litigation often tends to be expensive and protracted. The Company also believes that our intellectual property position with regard to synchronized swimming pool and spa lights may be weakened were the litigation to result in an adverse ruling. Additionally, whether or not the Company is successful in this lawsuit, this litigation could consume substantial amounts of our financial resources and divert management’s attention away from our core business.

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Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Condensed Consolidated Financial Statements and related notes included elsewhere in this report and the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2004.

When used in this discussion, the words "expects," "anticipates," "estimates," ”plan,” and similar expressions are intended to identify forward-looking statements. These statements, which include statements as to our expected sales and gross profit margins, expected operating expenses and capital expenditure levels, our sales and marketing expenses, our general and administrative expenses, expected expenses related to compliance with the Sarbanes-Oxley Act of 2002, the adequacy of capital resources and necessity to raise additional funds, our critical accounting policies, expected restructuring charge related to our consolidation in Solon, Ohio, expected benefits from our consolidation, our reseaserch and development expenses, sources of revenue, our reliance on a limited number customers, our production of new products, increases in manufacturing,and statements regarding pending litigation are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, those risks discussed below, as well as our ability to manage expenses, our ability to reduce manufacturing overhead and general and administrative expenses as a percentage of sales, our ability to collect on doubtful accounts receivable, our ability to increase cash balances in future quarters, the cost of enforcing or defending intellectual property, unforeseen adverse competitive, economic or other factors that may impact our cash position, risks associated with raising additional funds, risk relating to developing and marketing new products, possible delays in release of products, and risks associated with our pending litigation; and the matters discussed in “Factors that May Affect Results.” These forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

RESULTS OF OPERATIONS

Net sales decreased 11% to $7,645,000 for the quarter ended June 30, 2005, as compared to the same quarter a year ago. The decrease was primarily the result of a 69% decrease in spa lighting sales and 36% decrease in Jazz lighting sales as a result of increased competition in these markets. Despite an increase in worldwide sales of EFO systems of $361,000, commercial lighting sales were also lower by 5% for the second quarter due to lower sales from international markets, particularly Germany. Net sales were $14,465,000 for the first six months of 2005, a decrease of $93,000 compared to the first six months of 2004. This marginal decrease was due to a decline in spa lighting sales for the pool lighting products and a decline in traditional commercial lighting sales in Germany and the U.S., partially offset by an increase in sales in-ground pool products and of EFO systems. We expect net sales to be up slightly in 2005 as a result of an increase in EFO sales offsetting a decline in pool and spa sales. However, the market for our products is highly dependent upon general economic conditions.

Gross profit was $2,922,000 in the second quarter of fiscal 2005, an 18% decrease compared to the same period in the prior year. The gross profit margin as a percentage of sales declined from 42% to 38% for the second quarter of fiscal 2005 as compared to 2004 due to the lower sales not recovering as much fixed manufacturing overhead costs. Gross profit margin declined in both the pool lighting and commercial lighting business because of changes in the product mix and due to increased competition requiring a reduction in prices. Gross profit for the first six months of 2005 was $5,465,000, down 4% from gross profit for the same period last year. Gross profit margin as a percentage of sales decreased slightly to 38% for the first six months of 2004 compared to 39% for the first six months of 2004. The decrease was primarily a result of competitive pricing in the pool and spa market. We expect gross profit margins for the full 2005 year, before any restructure charges, to be approximately the same as in 2004, assuming general economic conditions remain consistent.

Research and development expenses were $400,000 in the second quarter of fiscal 2005, an increase of $183,000 compared with the second quarter of fiscal 2004. Our research and development expense increased due to reduced credits received for achieving milestones under a development contract with the Defense Advanced Research Projects Agency, (“DARPA”), that was signed in February 2003, partially offset by lower personnel and project costs related to government contract work and improvements for existing products. The gross research and development spending along with credits from government contracts is shown in the table:

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Three months ended
June 30,
  
Six months ended
June 30,
  
   
(in thousands)
  
(in thousands)
  
   
2005
  
2004
  
2005
  
2004
  
                   
Gross expenses for research and development
  
$
723
  
$
923
  
$
1,661
  
$
1,802
  
                           
Deduct: credits from DARPA & DOE contracts
    
(380
)
  
(706
)
  
(784
)
  
(1,315
)
                           
Net research and development expense
  
$
400
  
$
217
  
$
877
  
$
487
  

We expect research and development expense to increase for the full year 2005 compared to 2004 due to reduced DARPA credits.

Sales and marketing expenses increased by 8% to $2,388,000 in the second quarter of fiscal 2005 as compared to $2,210,000 for the same period in fiscal 2004. This increase was largely due to an increase in personnel and associated costs. For the first six months of 2005, sales and marketing expenses were $4,708,000 compared to $4,187,000 for the same period in 2004, a 12% increase. The increase was due to higher expenditures for personnel, trade shows, literature and fluctuations in exchange rates. We expect sales and marketing expenses to increase for the full year 2005 as we anticipate increasing our sales and marketing efforts for our new products.

General and administrative costs were $747,000 in the second quarter of fiscal 2005, an increase of 16% compared to the second quarter of fiscal 2004. For the first six months of 2005, general and administrative costs increased by 23% to $1,558,000 compared to $1,268,000 for the same period in 2004. The increase was primarily due to higher accounting, investor conferences and legal fees. We currently do not qualify for accelerated filing status with the SEC as a result of measuring our market capitalization as of June 30, 2005. We will be required to comply with Section 404 of the Sarbanes-Oxley Act of 2002 beginning fiscal year ending December 31, 2006. Estimates of costs required in order to comply with Section 404 for a company of our size range in the order of $500,000 or higher, independent of additional audit fees. Some of these additional expenses will be incurred in the fiscal year 2005. We expect general and administrative expenses to increase in 2005 as compared to 2004 due to anticipated higher accounting fees and expenses associated with the impact of the Sarbanes- Oxley Act of 2002 and anticipated increased legal fees and costs associated with certain ongoing litigation.

In June 2005, we announced our plans to close our Fremont office and consolidate most of our operations in Solon, Ohio, where we have a local sales office and a manufacturing facility. The relocation will result in a one-time restructuring charge of approximately $3.5 million for severance payments, redundancy, lease and inventory write-offs; however, we expect to save approximately $2 million a year in lease and personnel costs compared with current costs. We recognized a $197,000 restructuring charge in the second quarter of fiscal 2005 for costs related to our former CEO’s retirement package. We expect operating expenses to increase this fiscal year as a result of the restructure charge related to our consolidation in Solon, Ohio, with of most of the estimated restructuring charge to be taken during the year 2005.

We recorded a net loss of $763,000 in the second quarter of fiscal 2005 as compared to a net profit of $461,000 in the second quarter of fiscal 2004. For the first six months of 2005, we had a net loss of $1,813,000 compared to a net loss of $303,000 for the same period in 2004. The net loss in 2005 was due primarily to lower gross profit margin and higher operating expenses, including a restructuring charge in the second quarter of 2005 compared to the second quarter of 2004.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents

At June 30, 2005, our cash and cash equivalents were $3,349,000 as compared to $3,609,000 at December 31, 2004, a net cash decrease of $260,000 during the first six months of 2005. This compares to a net cash decrease of $1,297,000 for the same period in 2004, and an ending cash balance of $2,957,000 as of June 30, 2004.

Cash decreased from operations during the first six months of 2005 principally due to a net loss of $1,813,000 and a decrease in accounts payable of $1,204,000. These uses of cash from operations were partially offset by depreciation and amortization of $568,000, a decrease in accounts receivable of $936,000 and a decrease in inventories of $288,000. After these and other adjustments our total net cash used in operating activities in the first half of 2005 was $1,212,000 compared to net cash used of $2,304,000 in the first half of 2004.

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Cash Used in Investing Activities

Investing activities used cash of $464,000 during the first six months of 2005, compared to a use of cash of $352,000 for the same period of 2004. During both periods, cash was used for the acquisition of fixed assets. The increase was due to additional fixed assets required in order to move forward with the DARPA and EFO projects.

Cash Provided by Financing Activities

Financing activities contributed $1,535,000 to cash during the first six months of 2005. This net contribution was due primarily to the proceeds from the exercise of warrants and employee stock options for $1,356,000. For the same period in 2004, financing activities, from the exercise of warrants and employee stock options, were $1,032,000.

We had a $5,000,000 Loan and Security Agreement (Accounts Receivable and Inventory) dated December 7, 2001, with Comerica Bank bearing interest equal to prime plus 0.25% per annum computed daily or a fixed rate term option of LIBOR plus 3%. Borrowings under this Loan and Security Agreement were collateralized by our assets and intellectual property. Specific borrowings are tied to accounts receivable and inventory balances, and we were required to comply with certain covenants with respect to effective net worth and financial ratios. We had no borrowings against this facility as of June 30, 2005 and December 31, 2004. We were not in conformity with the bank covenants of the Comerica Bank agreement as of June 30, 2005. We agreed to a new bank line of credit agreement with Silicon Valley Bank on August 15, 2005. This credit facility is for $5,000,000 and is secured by accounts receivable. It has a minimum tangible net worth covenant which we must meet going forward.

We also have a $448,000 (in UK pounds sterling based on the exchange rate at June 30, 2005) bank overdraft agreement with Lloyds Bank Plc through its UK subsidiary. There were no borrowings against this facility as of June 30, 2005 and December 31, 2004. The facility is renewed annually on January 1 and bears an interest rate of 7%.

Through our German subsidiary, we maintain a credit facility under an agreement with Sparkasse Neumarkt Bank. This credit facility is in place to finance, and is secured by, our offices owned and occupied by our German subsidiary. As of June 30, 2005, we had total borrowings of $408,000 (in Euros, based on the exchange rate at June 30, 2005) against this credit facility. As of December 31, 2004, we had $477,000 (in Euros, based on the exchange rate at December 31, 2004) borrowed against this facility. Additionally, we have a revolving line of credit of $244,000 (in Euros, based on the exchange rate at June 30, 2005) with Sparkasse Neumarkt Bank. As of June 30, 2005, there was a total borrowing of $166,000 (in Euros, based on the exchange rate at June 30, 2005) against this facility, and there were no borrowings against this facility as of December 31, 2004. The facility is renewed annually on January 1 and bears an interest rate of 8.75%.

We believe that our existing cash balances and funds available to us through our bank lines of credit together with funds that we anticipate generating from our operations, will be sufficient to finance our currently anticipated working capital requirements and capital expenditure requirements for the next twelve months.  However, a sudden increase in product demand requiring a significant increase in manufacturing capability, or unforeseen adverse competitive, economic or other factors may impact our cash position, and thereby affect operations.  From time to time we may be required to raise additional funds through public or private financing, strategic relationships or other arrangements.  There can be no assurance that such funding, if needed, will be available on terms acceptable to us, or at all.  Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require that we relinquish rights to certain of our technologies or products.  Failure to generate sufficient revenues or to raise capital when needed could have an adverse impact on our business, operating results and financial condition, as well as our ability to achieve intended business objectives.

Recently Issued Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004) or SFAS 123R, “Share-Based Payments.” SFAS 123R requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments, such as stock options granted to employees. We will be required to apply SFAS 123R on a modified prospective method. Under this method, we are required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. In addition, we may elect to adopt SFAS 123R by restating previously issued financial statements, basing the amounts on the expense previously calculated and reported in their pro forma disclosures that had been required by SFAS 123. SFAS 123R is effective for the first fiscal year beginning after June 15, 2005. We have not completed our evaluation of the effect that SFAS 123R will have, but we believe that when adopted it will increase stock-based compensation expense and reduce earnings in a manner previously only presented as pro forma disclosure, with no or little impact on our overall financial position.

In December 2004, the FASB issued SFAS No.151, “Inventory Costs,” which amends part of ARB 43, “Inventory Pricing,” concerning the treatment of certain types of inventory costs. The provisions of ARB No. 43 provided that certain inventory-related costs, such as double freight, re-handling, might be “so abnormal” that they should be charged against current earnings rather than be included in the cost of inventory and, that is capitalized to future periods. As amended by SFAS No. 151, the “so-abnormal” criterion has been eliminated. Thus, all such (abnormal) costs are required to be treated as current-period charges under all circumstances. In addition, fixed production overhead should be allocated based on the normal capacity of the production facilities, with unallocated overhead charged to expense when incurred. SFAS 151 is required to be adopted for fiscal years beginning after June 15, 2005. We are assessing the impact of adopting SFAS No.151, but do not believe its adoption will have a material impact on our overall financial position. 

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Factors that May Affect Results

We may encounter difficulties, including higher than anticipated costs and the diversion of management’s attention, as a result of the restructuring of our business and the relocation of our headquarters from California to Ohio.

In June 2005, we announced a reorganization and restructuring of Fiberstars and our plan to relocate our headquarters to our facility in Solon, Ohio. We may incur higher than anticipated costs or delays in closing our Fremont, California facility, and this restructuring could result in the diversion of the efforts of our senior management and other key employees from our business operations. Our operating and financial results could be adversely affected by the risks associated with this relocation, including unanticipated delays, ineffective transition of responsibilities or systems, the retention of certain key employees and the hiring of accounting personnel in Ohio, which may affect our ability to maintain adequate disclosure controls and procedures during this period of restructuring. The relocation could negatively affect our relationship with our customers, suppliers and distributors, which could result in a loss of revenue. In addition, our planned manufacturing changes may not be successful and our anticipated cost savings may be unattainable or delayed.

In connection with the restructuring, we also made changes to our senior management, including the appointment of a new Chief Executive Officer and Chief Technology Officer. These changes could affect our relationship with our employees, customers, suppliers, distributors and strategic partners. Failure to effectively complete this restructuring could negatively impact our business or results of operations.

Our operating results are subject to fluctuations caused by many factors that could result in decreased revenues and a drop in the price of our common stock.

Our quarterly operating results can vary significantly depending upon a number of factors. It is difficult to predict the lighting market's acceptance of and demand for our products on a quarterly basis, and the level and timing of orders received can fluctuate substantially. Our sales volumes fluctuate, as does the relative volume of sales of our various products with significantly different product margins. Historically we have shipped a substantial portion of our quarterly sales in the last month of each of the second and fourth quarters of the year. Our product development and marketing expenditures may vary significantly from quarter to quarter and are made well in advance of potential resulting revenue. If we are not able to meet certain milestones in our DARPA contracts, research and development funding may be lost or delayed resulting in higher expenses. Significant portions of our expenses are relatively fixed in advance based upon our forecasts of future sales. If sales fall below our expectations in any given quarter, we will not be able to make any significant adjustment in our operating expenses, and our operating results will be adversely affected.

Our sales are dependent upon new construction levels and are subject to seasonal and general economic trends.

Sales of our pool and spa lighting products, which currently are available only with newly constructed pools and spas, depend substantially upon the level of new construction of pools. Sales of commercial lighting products also depend significantly upon the level of new building construction and renovation. Construction levels are affected by housing market trends, interest rates and the weather. Because of the seasonality of construction, our sales of swimming pool and commercial lighting products, and thus our overall revenues and income, have tended to be significantly lower in the first and the third quarter of each year. Various economic and other trends may alter these seasonal trends from year to year, and we cannot predict the extent to which these seasonal trends will continue.

15
We are subject to global economic or political conditions which may disrupt the general economy, reducing demand for our products.

On-going terrorist threats and actual terrorist attacks have increased the uncertainty in both the United States and European economy, which are primary markets for our products, and may negatively impact general economic conditions in those markets. Economic conditions may also be negatively affected by social unrest, health epidemics or natural disasters. Because the markets for our products tend to be highly dependent upon general economic conditions, a decline in general economic conditions would likely harm our operating results.

If we are not able to timely and successfully develop, manufacture, market and sell our new products, our operating results will decline.

We expect to introduce additional new products in each year in the pool and spa lighting and/or commercial Lighting markets. Delivery of these products may cause us to incur additional unexpected research and development expenses. We could have difficulties manufacturing these new products as a result of our inexperience with them or the costs could be higher than expected. Any delays in the introduction of these new products could result in lost sales, loss of customer confidence and loss of market share. Also, it is difficult to predict whether the market will accept these new products. If any of these new products fails to meet expectations, our operating results will be adversely affected.

We operate in markets that are intensely and increasingly competitive.

Competition is increasing in a number of our markets. A number of companies offer directly competitive products, including compact metal halide products for downlighting and color halogen lighting for swimming pools. We are also experiencing competition from light emitting diode, or LED, products in water lighting and in neon and other lighted signs. Our competitors include some very large and well-established companies such as Philips, Schott, 3M, Bridgestone, Pentair, Mitsubishi and Osram/Siemens. All of these companies have substantially greater financial, technical and marketing resources than we do. We may not be able to adequately respond to fluctuations in competitive pricing. We anticipate that any future growth in fiber optic lighting will be accompanied by continuing increases in competition, which could adversely affect our operating results if we cannot compete effectively.

We are involved in what may be costly intellectual property litigation with Pentair that could harm our competitive position in the swimming pool and spa market and may prevent us from selling our FX Pool Light product.
 
We are currently involved in a lawsuit brought by a larger publi company competitor, Pentair Water Pool and Spa, Inc., which alleges that the manufacture, use and sale of our FX Pool Light product infringes three patents that it claims to own. In the lawsuit, Pentair is attempting to stop us from selling certain of our synchronized pool light products and to obtain compensatory and treble damages. This litigation is in its very early stages and we have not as yet filed our initial responsive pleading. Although we believe we may well have defenses that are meritorious, litigation is unpredictable and the outcome of this matter cannot be determined at this time. If we do not prevail, we may be ordered to pay damages for past sales and an ongoing royalty for future sales of products found to infringe. Wecould also be ordered to stop selling the challenged FX Pool Light product. If found liable, we may or may not be able to redesign our products to avoid future infringement. Any public announcement concerning the litigation that is unfavorable to us may result in a decline in our stock price. Additionally, this type of litigation tends to be expensive and protracted, and our intellectual property position may be weakened as a result of an adverse ruling. Whether or not we are successful in this lawsuit, this litigation may consume substantial amounts of our financial resources and divert management’s attention away from our core business.
 
We rely on intellectual property and other proprietary information that may not be protected and that may be expensive to protect.

16
We currently hold 41 patents. There can be no assurance, however, that our issued patents are valid or that any patents applied for will be issued. We have a policy of seeking to protect our intellectual property through, among other things, the prosecution of patents with respect to certain of our technologies. There are many issued patents and pending patent applications in the field of fiber optic technology, and certain of our competitors hold and have applied for patents related to fiber optic and non-fiber optic lighting. As with Pentair, we have in the past received communications from third parties asserting rights in our patents or that our technology infringes intellectual property rights held by such third parties. Based on information currently available to us, we do not believe that any such claims involving our technology or patents are meritorious. However, litigation to determine the validity of any third party claims or claims by us against such third party, whether or not determined in our favor, could result in significant expense and divert the efforts of our technical and management personnel, regardless of the outcome of such litigation. In addition, we do not know whether our competitors will in the future apply for and obtain patents that will prevent, limit or interfere with our ability to make, use, sell or import our products. Although we may seek to resolve any potential future claims or actions, we may not be able to do so on reasonable terms, or at all. If, following a successful third-party action for infringement, we cannot obtain a license or redesign our products, we may have to stop manufacturing and marketing our products, and our business would suffer as a result.

We rely on distributors for a significant portion of our sales and terms and conditions of sales are subject to change with very little notice.

Most of our products are sold through distributors, and we do not have long-term contracts with our distributors. Some of these distributors are quite large, particularly in the pool products market. If these distributors significantly change their terms with us or change their historical pattern of ordering products from us, there could be a significant impact on our net sales and operating results.

The loss of a key sales representative could have a negative impact on our net sales and operating results.

We rely on key sales representatives and outside sales agents for a significant portion of our sales. These sales representatives and outside sales agents have unique relationships with our customers and would be difficult to replace. The loss of a key sales representative or outside sales agent could interfere with our ability to maintain customer relationships and result in declines in our net sales and operating results.

We depend on key employees in a competitive market for skilled personnel, and the loss of the services of any of our key employees could materially affect our business.

Our future success will depend to a large extent on the continued contributions of certain employees, many of whom would be difficult to replace. Our future success will also depend on our ability to attract and retain qualified technical, sales, marketing and management personnel, for whom competition is intense. The loss of or failure to attract and retain any such persons could delay product development cycles, disrupt our operations or otherwise harm our business or results of operations.

We depend on a limited number of suppliers from whom we do not have a guarantee to adequate supplies, increasing the risk that loss of or problems with a single supplier could result in impaired margins, reduced production volumes, strained customer relations and loss of business.

Mitsubishi is the sole supplier of our stranded fiber, which is used extensively in our fiber pool and spa lighting products. We also rely on a sole source for certain lamps, reflectors, remote control devices and power supplies. The loss of one or more of our suppliers could result in delays in the shipment of products, additional expense associated with redesigning products, impaired margins, reduced production volumes, strained customer relations and loss of business or could otherwise harm our results of operations.

We depend on Advanced Lighting Technologies, Inc., or ADLT, for a number of components for our products and for certain of our manufacturing facilities.

ADLT supplies us with certain lamps, power supplies, reflectors and coatings. We have identified alternative suppliers for these components, but there could be an interruption of supply and increased costs if a transition to a new supplier were required. We could lose current or prospective customers as a result of supply interruptions. Increased costs would negatively impact our gross profit margin and results of operations. We also lease our facility in Solon, Ohio from ADLT. In the event the ADLT lease is not renewed in a timely manner, we may experience some disruption of our large core fiber production while new facilities are found and prepared to support fiber manufacturing.

17
We are becoming increasingly dependent on foreign sources of supply for many of our components and in some cases complete assemblies, which due to distance or political events may result in a lack of timely deliveries.

In order to control costs, we are continually seeking offshore supply of components and assemblies. This results in longer lead times for deliveries which can mean less responsiveness to sudden changes in market demand for the products involved. Some of the countries where components are sourced may be less stable politically than the United States or may be subject to natural disasters or diseases, and this could lead to an interruption of the delivery of key components. Delays in the delivery of key components could result in delays in product shipments, additional expenses associated with locating alternative component sources or redesigning products, impaired margins, reduced production volumes, strained customer relations and loss of customers, any of which could harm our results of operations.

We are subject to manufacturing risks, including fluctuations in the costs of purchased components and raw materials due to market demand, shortages and other factors.

We depend on various components and raw materials for use in the manufacturing of our products. We may not be able to successfully manage price fluctuations due to market demand or shortages. In addition to risks associated with sole and foreign suppliers, significant increases in the costs of or sustained interruptions in our receipt of adequate amounts of necessary components and raw materials could harm our margins, result in manufacturing halts, harm our reputation and relationship with our customers and negatively impact our results of operations.

Our future success is highly dependent on the successful adoption of Efficient Fiber Optics, or EFO, products by the lighting market.

EFO is a new type of lighting that may not achieve acceptance by lighting designers or other customers of lighting products. EFO products include components that are difficult to manufacture and/or procure in large quantities in the short term. These components include lamps and optical and electronic components. While we plan to increase our manufacturing capabilities to meet an increase in demand, if the increase is greater than expected or larger quantities are needed in a shorter time frame than anticipated, we may not be able to meet customers’ requirements and our ability to market the product may be adversely affected.

We use plants in Mexico and India to manufacture and assemble many of our products. The supply of these finished goods may be impacted by local political or social conditions as well as the financial strength of the companies with which we do business.

As we attempt to reduce manufacturing expenses, we are becoming increasingly dependent upon offshore companies for the manufacturing and final assembly of many of our products. To do so, we must advance certain raw materials, inventory and production costs to these off-shore manufacturers. The supply of finished goods from these companies, and the raw materials, inventory and funds which we advance to them may be at risk depending upon the varying degrees of stability of the local political, economic and social environments in which they operate, and the financial strength of the manufacturing companies themselves.

Because we depend on a limited number of significant customers for our net sales, the loss of a significant customer, reduction in order size, or the effects of volume discounts granted to significant customers from time to time could harm our operating results.

Our business is currently dependent on a limited number of significant customers, and we anticipate that we will continue to rely on a limited number of customers. The loss of any significant customer would harm our net sales and operating results. Customer purchase deferrals, cancellations, reduced order volumes or non-renewals from any particular customer could cause our quarterly operating results to fluctuate or decline and harm our business. In addition, volume discounts granted to significant customers from time to time could lead to reduced profit margins, and negatively impact our operating results.

Our components and products could have design, defects or compatibility issues, which could be costly to correct and could result in the rejection of our products and damage to our reputation, as well as lost sales, diverted development resources and increased warranty reserves and manufacturing costs.

18
We cannot be assured that we will not experience defects or compatibility issues in components or products in the future. Errors or defects in our products may arise in the future, and, if significant or perceived to be significant, could result in rejection of our products, product returns or recalls, damage to our reputation, lost revenues, diverted development resources and increased customer service and support costs and warranty claims. Errors or defects in our products could also result in product liability claims. We estimate warranty and other returns and accrue reserves for such costs at the time of sale. Any estimates, reserves or accruals may be insufficient to cover sharp increases in product returns, and such returns may harm our operating results. In addition, customers may require design changes in our products in order to suit their needs. Losses, delays or damage to our reputation due to design or defect issues would likely harm our business, financial condition and results of operations.

If we are unable to predict market demand for our products and focus our inventories and development efforts to meet market demand, we could lose sales opportunities and experience a decline in sales.

In order to arrange for the manufacture of sufficient quantities of products and avoid excess inventory we need to accurately predict market demand for each of our products. Significant unanticipated fluctuations in demand could cause problems in our operations. We may not be able to accurately predict market demand in order to properly allocate our manufacturing and distribution resources among our products. As a result we may experience declines in sales and lose, or fail to gain, market share. Conversely, if we overbuild inventories we run a risk of having inventory write-offs due to obsolescence.

We depend on collaboration with third parties, who are not subject to material contractual commitments, to augment our research and development efforts.

Our research and development efforts include collaboration with third parties. Many of these third parties are not bound by any material contractual commitment leaving them free to end their collaborative efforts at will. Loss of these collaborative efforts would adversely affect our research and development efforts and could have a negative effect on our competitive position in the market. In addition, arrangements for joint development efforts may require us to make royalty payments on sales of resultant products or enter into licensing agreements for the technology developed, which could increase our costs and negatively impact our results of operations.

We have experienced negative cash flow from operations and may continue to do so in the future. We may need to raise additional capital in the near future, but our ability to do so may be limited.

While we have historically been able to fund cash needs from operations, from bank lines of credit or from capital markets, due to competitive, economic or other factors there can be no assurance that we will continue to be able to do so. If our capital resources are insufficient to satisfy our liquidity requirements and overall business objectives we may seek to sell additional equity securities or obtain debt financing. Adverse business conditions due to a weak economic environment or a weak market for our products have led to and may lead to continued negative cash flow from operations, which may require us to raise additional financing, including equity financing. Any equity financing may be dilutive to shareholders, and debt financing, if available, will increase expenses and may involve restrictive covenants. We may be required to raise additional capital, at times and in amounts, which are uncertain, especially under the current capital market conditions. Under these circumstances, if we are unable to acquire additional capital or are required to raise it on terms that are less satisfactory than desired, it may have a material adverse effect on our financial condition, which could require us to curtail our operations significantly, sell significant assets, seek arrangements with strategic partners or other parties that may require us to relinquish significant rights to products, technologies or markets, or explore other strategic alternatives including a merger or sale of our company.

Compliance with changing regulation of corporate governance and public disclosure may result in additional costs.

Changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and new rules and regulations of the Securities and Exchange Commission and the Nasdaq National Market are creating new duties and requirements for us and our executives, directors, attorneys and independent accountants. In order to comply with these new rules, we expect to continue to incur additional costs for personnel and use additional outside legal, accounting and advisory services, which we expect will increase our operating expenses. Management time associated with these compliance efforts necessarily reduces time available for other operating activities, which could adversely affect operating results. Estimates of our costs, independent of additional audit fees, required to comply with Section 404 of the Sarbanes-Oxley Act of 2002 are in the range of $500,000 or higher. While we expect these costs to increase our operating expenses significantly, we cannot predict or estimate the amount of future additional costs we may incur or the timing of such costs.
 
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We are exposed to risks from recent legislation requiring companies to evaluate their internal controls.
 
Section 404 of the Sarbanes-Oxley Act of 2002 will require our management to report on, and our independent auditors to attest to, the effectiveness of our internal control structure and procedures for financial reporting. We have an ongoing program to perform the system and process evaluation and testing necessary to comply with these requirements. This legislation is relatively new and neither companies nor accounting firms have significant experience in complying with its requirements. As a result, we expect to incur increased expense and to devote additional management resources to Section 404 compliance. In the event that our chief executive officer, chief financial officer or independent registered public accounting firm determine that our internal controls over financial reporting are not effective as defined under Section 404, investor perceptions of our company may be adversely affected and could cause a decline in the market price of our stock.
 
 
Changes to financial accounting standards may affect our results of operations and cause us to change our business practices.
 
We prepare our financial statements to conform with generally accepted accounting principles, or GAAP, in the United States. These accounting principles are subject to interpretation by the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. Changes to those rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, accounting policies affecting many aspects of our business, including rules relating to employee stock option grants, have recently been revised or are under review. The Financial Accounting Standards Board and other agencies have finalized changes to U.S. generally accepted accounting principles that will require us, starting in our third quarter of 2005, to record a charge to earnings for employee stock option grants and other equity incentives. We may have significant and ongoing accounting charges resulting from option grant and other equity incentive expensing that could reduce our overall net income. In addition, since we historically have used equity-related compensation as a component of our total employee compensation program, the accounting change could make the use of equity-related compensation less attractive to us and therefore make it more difficult to attract and retain employees.

Our stock price has been and will likely continue to be volatile and you may be unable to resell your shares at or above the price you paid.

Our stock price has been and is likely to be highly volatile, particularly due to our relatively limited trading volume. Our stock price could fluctuate significantly due to a number of factors, including:

 
•
variations in our anticipated or actual operating results;

 
•
sales of substantial amounts of our stock;

 
•
dilution as a result of additional equity financing by us;

 
•
announcements about us or about our competitors, including technological innovation or new products or services;

 
•
conditions in the fiber optic lighting industry;

 
•
governmental regulation and legislation; and

 
•
changes in securities analysts’ estimates of our performance, or our failure to meet analysts’ expectations.

Many of these factors are beyond our control.

In addition, the stock markets in general, and the Nasdaq National Market and the market for fiber optic lighting and technology companies in particular, have experienced extreme price and volume fluctuations recently. These fluctuations often have been unrelated or disproportionate to the operating performance of these companies. These broad market and industry factors may adversely affect the market price of our common stock, regardless of our actual operating performance.

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In the past, companies that have experienced volatility in the market prices of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of management’s attention and resources.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

As of June 30, 2005, we had $744,000 in cash held in foreign currencies based on the exchange rates at June 30, 2005. The balances for cash held overseas in foreign currencies are subject to exchange rate risk. We have a policy of maintaining cash balances in local currencies unless an amount of cash is occasionally transferred in order to repay inter-company debts.

As of June 30, 2005, we had a total borrowing of $407,000 (in Euros, based on the exchange rate at June 30, 2005) against a credit facility secured by real property owned by our German subsidiary. As of December 31, 2004, we had $477,000 (in Euros, based on the exchange rate at December 31, 2004) borrowed against this credit facility.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures.
 
We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet, and management believes they meet, reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
 
Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.
 
 (b) Changes in internal control over financial reporting.
 
There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION
 
Item 1. Legal Proceedings

We are a third-party .defendant in a lawsuit pending in the Court of Common Pleas, Cuyahoga County, Ohio filed September 21, 2004. In that matter Sherwin-Williams Company, plaintiff, brought suit against defendant and third-party plaintiff, Wagner Electric Sign Company, or Wagner, for alleged breach of warranty and breach of contract in connection with an allegedly defective sign manufactured and sold by Wagner. The complaint alleges $141,739.06 in compensatory damages. Third-party plaintiff, Wagner, has cross-claimed against us requesting unspecified damages alleging that the signs’ failure, if any, arises from defective fiber optic lighting components, instructions and/or services purportedly supplied to it by us. We deny these allegations in our responsive pleadings and discovery proceeds on all claims. While we cannot predict as to the ultimate outcome of the litigation, we do not currently believe its outcome will have a material impact on our financial condition.

We are currently involved in a lawsuit brought by one of our competitors in the swimming pool and spa market, Pentair Water Pool and Spa, Inc. In a lawsuit filed against us on April 5, 2005 in the United States District Court, Northern District of California, Pentair alleges that the manufacture, use and sale of our FX Pool Light infringes three United States patents that Pentair claims to own relevant to certain synchronized light technology, U.S. Patent No. 6,379,025 B1, No. 6,002,216 and No. 6,811,286. In the lawsuit, Pentair is attempting to stop us from selling certain of our synchronized pool light products and to obtain compensatory and treble damages. Our initial response to these allegations has not as yet been filed. Although we believe we may well have defenses that are meritorious, litigation is unpredictable and the outcome of this matter cannot be determined at this time. If we do not prevail, we may be ordered to pay damages for past sales and an ongoing royalty for future sales of products found to infringe. We could also be ordered to stop selling the challenged FX Pool Light product. If found liable, we may or may not be able to redesign our products to avoid future infringement. Any public announcement concerning the litigation that is unfavorable to us may result in a decline in our stock price.

As the Pentair litigation is in its very early stages we do not know how expensive or protracted it will be. We believe, however, that this type of litigation often tends to be expensive and protracted. We also believe that our intellectual property position with regard to synchronized swimming pool and spa lights may be weakened were the litigation to result in an adverse ruling. Additionally, whether or not we are successful in this lawsuit, this litigation could consume substantial amounts of our financial resources and divert management’s attention away from our core business.

Item 4. Submission of Matter to a Vote of Security Holders

We held an Annual Meeting of our Shareholders on June 22, 2005, at which the following occurred:

ELECTION OF DIRECTORS TO THE BOARD OF DIRECTORS: The shareholders elected David N. Ruckert, John B. Stuppin, Jeffrey H. Brite, Michael Kasper, Paul von Paumgartten and Philip Wolfson as Directors. The votes on the matters were as follows:
 
David N. Ruckert
  
FOR
5,895,150
WITHHELD
82,549
   
John B. Stuppin
  
FOR
5,895,837
WITHHELD
81,862
   
Jeffrey H. Brite
  
FOR
5,926,447
WITHHELD
51,252
   
Michael Kasper
  
FOR
5,918,487
WITHHELD
59,212
   
Paul von Paumgartten
  
FOR
5,966,674
WITHHELD
11,025
   
Philip Wolfson
  
FOR
5,831,697
WITHHELD
146,002

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RATIFICATION OF THE SELECTION BY THE AUDIT COMMITTEE OF THE BOARD OF DIRECTORS OF GRANT THORNTON LLP AS OUR INDEPENDENT REGISTERED PUBLIC ACCOUNTANTS: The shareholders ratified the selection by the Audit Committee of the Board of Directors of Grant Thornton LLP as our independent registered public accountants for the 2005 fiscal year. The vote on the matter was as follows:

FOR
5,953,749
WITHHELD
1,935
ABSTAIN
22,015

 
Item 6. Exhibits and Reports on Form 8-K
 
Exhibit
Number
  
Description of Documents
3(ii)
  
Certificate of Amendment of Bylaws dated April 27, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed on April 27, 2005).
10.1
  
Fourth Amended to Loan and Security Agreement (Accounts and Inventory) and Amended and Restated Inventory Rider (Revolving Advances) dated April 27, 2005, by and between the Registrant and Comerica Bank (incorporated by reference to the Registrant’s Current Report on Form 8-K filed on May 10, 2005).
31.1
  
Rule 13a-14(a) Certification of Chief Executive Officer.
31.2
  
Rule 13a-14(a) Certification of Chief Financial Officer.
32.1**
  
Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).
32.2**
  
Statement of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).
   
** In accordance with item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986, Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
     
 
FIBERSTARS, INC.
 
 		  
 		  
 
Date: August 15, 2005
 By:   /s/ John M. Davenport
 
  John M. Davenport
  Chief Executive Officer
     
 
 		  
 		  
 
  By:   /s/ Robert A. Connors
 
  Robert A. Connors
  Chief Financial Officer
  (Principal Financial and Accounting Officer)

Exhibit Index
 
Exhibit
Number
  
Description of Documents
3(ii)
  
Certificate of Amendment of Bylaws dated April 27, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed on April 27, 2005).
10.1
 
  
Fourth Amended to Loan and Security Agreement (Accounts and Inventory) and Amended and Restated Inventory Rider (Revolving Advances) dated April 27, 2005, by and between the Registrant and Comerica Bank (incorporated by reference to the Registrant’s Current Report on Form 8-K filed on May 10, 2005).
31.1
  
Rule 13a-14(a) Certification of Chief Executive Officer.
31.2
  
Rule 13a-14(a) Certification of Chief Financial Officer.
32.1**
  
Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).
32.2**
  
Statement of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).
     
** In accordance with item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986, Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.
 
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