UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington,
  D.C. 20549



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Form 10-Q



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(Mark
  One)

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

| | For
        the Quarter ended September 30, 2006
| | ------------------------------------------------

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

| | For
        the transition period from _______ to _______.
| | ----------------------------------------------------------

Commission
  File Number: 000-21240

NEOWARE,
  INC.

(Exact
  name of registrant as specified in its charter)



| | Delaware(State or other jurisdiction ofincorporation or organization) |  | 23-2705700(IRS Employer Identification No.) | 
| | --------------------------------------------------------------------- |  | ------------------------------------------- | 

3200
  Horizon Drive

King
  of Prussia, Pennsylvania 19406

(Address
  of principal executive offices)

(610)
  277-8300

(Registrants
  telephone number including area code)



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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.

YesNo

Indicate
  by check mark whether the registrant is a large accelerated filer, an accelerated
  filer, or a non-accelerated filer. See definition of accelerated filer
  and large accelerated filer in Rule 12b-2 of the Exchange Act.

Large
          Accelerated FilerAccelerated
          Filer

        Non-Accelerated Filer


Indicate
  by check mark whether the registrant is a shell company (as defined in Rule
  12b-2 of the Exchange Act).

(Check
  one):

YesNo

As
  of November 3, 2006, there were 19,945,266 outstanding shares of the Registrants
  Common Stock.






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NEOWARE, INC.

INDEX



PAGEPART
          I. FINANCIAL INFORMATIONItem
          1.
      
      Consolidated
          Financial Statements (unaudited)Condensed
          Consolidated Balance Sheets as of September 30, 2006 and June 30, 2006
      3Consolidated
          Statements of Operations for the Three Months Ended September 30, 2006
          and 2005
      4Consolidated
          Statements of Cash Flows for the Three Months Ended September 30, 2006
          and 2005
      5Notes
          to Consolidated Financial Statements
      6Item
          2.
      
      Managements
          Discussion and Analysis of Financial Condition and Results of Operations
      14Item
          3.
      
      Quantitative
          and Qualitative Disclosures About Market Risk
      24Item
          4.
      
      Controls
          and Procedures
      24PART
          II. OTHER INFORMATIONItem
          1A.
      
      Risk
          Factors
      25Item
          6.
      
      Exhibits
      37Signatures
      
      
      38




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NEOWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



September 30,2006


      

        June 30,2006ASSETSCurrent assets:Cash and cash equivalents

        

        $

        21,657

        

        $

        19,328Short-term investments

        

        

        88,756

        

        

        94,798Accounts receivable, net

        

        

        15,145

        

        

        16,877Inventories, net

        

        

        9,405

        

        

        7,734Prepaid income taxes

        

        

        2,848

        

        

        1,544Prepaid expenses and other

        

        

        2,489

        

        

        1,687Deferred income taxes

        

        

        1,866

        

        

        1,866Total current assets

        

        

        142,166

        

        

        143,834Property and equipment, net

        

        

        1,559

        

        

        1,586Goodwill

        

        

        38,093

        

        

        37,761Intangibles, net

        

        

        11,312

        

        

        12,175Deferred income taxes

        

        

        4,093

        

        

        4,156Other

        

        

        80

        

        

        61$

        197,303

        

        $

        199,573LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

        

        $

        4,942

        

        $

        8,989Accrued compensation and benefits

        

        

        1,768

        

        

        2,021Other accrued expenses

        

        

        5,059

        

        

        4,159Restructuring reserve

        

        

        545

        

        

        600Income taxes payable

        

        

        150

        

        

        158Deferred revenue

        

        

        1,038

        

        

        973Total current liabilities

        

        

        13,502

        

        

        16,900Deferred income taxes

        

        

        773

        

        

        755Deferred revenue

        

        

        316

        

        

        316Total liabilities

        

        

        14,591

        

        

        17,971Stockholders equity:Preferred stock

        

        

        

        

        

        Common stock

        

        

        20

        

        

        20Additional paid-in capital

        

        

        160,336

        

        

        158,671Treasury stock, 100,000 shares at cost

        

        

        (100

        )

        

        (100

        )Accumulated other comprehensive income

        

        

        1,053

        

        

        556Retained earnings

        

        

        21,403

        

        

        22,455Total stockholders equity

        

        

        182,712

        

        

        181,602$

        197,303

        

        $

        199,573


See accompanying notes to consolidated financial statements.

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NEOWARE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)



Three
          Months EndedSeptember 30,2006
      
      2005Net
          revenues
      
      $
      21,560
      
      $
      26,543Cost
          of revenuesCost
          of products (includes stock-based compensation expense of $26 and $19
          for the three months ended September 30, 2006 and 2005)
      
      
      14,038
      
      
      15,569Amortization
          of intangibles
      
      
      336
      
      
      273Total
          cost of revenues
      
      
      14,374
      
      
      15,842Gross
          profit
      
      
      7,186
      
      
      10,701Operating
          expensesSales
          and marketing
      
      
      4,412
      
      
      4,169Research
          and development
      
      
      1,774
      
      
      1,284General
          and administrative
      
      
      2,617
      
      
      2,298Amortization
          of intangibles
      
      
      589
      
      
      315Total
          operating expenses (includes stock-based compensation expense of $907
          and $701 for the three months ended September 30, 2006 and 2005)
      
      
      9,392
      
      
      8,066Operating
          income (loss)
      
      
      (2,206
      )
      
      2,635Foreign
          exchange gain (loss)
      
      
      (27
      )
      
      9Interest
          income, net
      
      
      981
      
      
      244Income
          (loss) before income taxes
      
      
      (1,252
      )
      
      2,888Income
          tax expense (benefit)
      
      
      (200
      )
      
      1,047Net
          income (loss)
      
      $
      (1,052
      )
      $
      1,841Earnings
          (loss) per share:Basic
      
      $
      (.05
      )
      $
      0.11Diluted
      
      $
      (.05
      )
      $
      0.11Weighted
          average number of common shares outstanding:Basic
      
      
      19,943
      
      
      16,271Diluted
      
      
      19,943
      
      
      16,434


See accompanying notes to consolidated financial statements.

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NEOWARE, INC.

CONSOLIDATED
  STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



Three Months EndedSeptember 30,2006


      

        2005Cash flows from operating activities:Net income (loss)

        

        $

        (1,052

        )

        $

        1,841Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities-Amortization of intangibles

        

        

        925

        

        

        588Depreciation

        

        

        138

        

        

        89Non-cash share-based compensation

        

        

        933

        

        

        720Deferred income taxes

        

        

        65

        

        

        Changes in operating assets and liabilities- net of effect from acquisition-Accounts receivable

        

        

        1,813

        

        

        (410

        )Inventories

        

        

        (1,671

        )

        

        (587

        )Prepaid expenses and other

        

        

        (2,122

        )

        

        605Accrued compensation and benefits

        

        

        (255

        )

        

        (953

        )Accounts payable

        

        

        (4,049

        )

        

        (132

        )Other accrued expenses

        

        

        834

        

        

        25Income taxes payable

        

        

        (8

        )

        

        (1,271

        )Deferred revenue

        

        

        59

        

        

        5Net cash provided by (used in) operating activities

        

        

        (4,390

        )

        

        520Cash flows from investing activities:Purchase of short-term investments

        

        

        (34,455

        )

        

        (900

        )Sales of short-term investments

        

        

        40,496

        

        

        4,250Purchases of property and equipment

        

        

        (110

        )

        

        (174

        )Net cash provided by investing activities

        

        

        5,931

        

        

        3,176Cash flows from financing activities:Expense incurred related to the issuance of common stock

        

        

        (3

        )

        

        Exercise of stock options

        

        

        36

        

        

        161Excess tax benefit from share-based payment arrangements

        

        

        699

        

        

        446Net cash provided by financing activities

        

        

        732

        

        

        607Effect of foreign exchange rate changes on cash

        

        

        56

        

        

        (38

        )Increase in cash and cash equivalents

        

        

        2,329

        

        

        4,265Cash and cash equivalents, beginning of period

        

        

        19,328

        

        

        8,285Cash and cash equivalents, end of period

        

        $

        21,657

        

        $

        12,550Supplemental disclosures:Cash paid for income taxes

        

        $

        309

        

        $

        2,647


See accompanying notes to consolidated financial statements.

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NEOWARE,
  INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note
  1. Basis of Presentation

The
  accompanying unaudited consolidated financial statements of Neoware, Inc. and
  Subsidiaries have been prepared in accordance with U.S. Generally Accepted Accounting
  Principles (GAAP) for interim financial statements. These statements, while
  unaudited, reflect all normal recurring adjustments, which are, in the opinion
  of management, necessary for a fair presentation of the consolidated financial
  statements. The results for the interim periods presented are not necessarily
  indicative of the results that may be expected for any future period. Certain
  information and footnote disclosures included in financial statements have been
  condensed or omitted pursuant to such rules and regulations relating to interim
  financial statements. The consolidated financial statements included in this
  Form 10-Q should be read in conjunction with the audited consolidated financial
  statements and notes thereto included in our Annual Report on Form 10-K for
  the year ended June 30, 2006, filed with the Securities and Exchange Commission
  on September 13, 2006.

Note
  2. Recent Accounting Pronouncements

In
  July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation
  No. 48,Accounting for Uncertainty
  in Income Taxesan interpretation of FASB Statement No. 109.Interpretation
  No. 48 clarifies the accounting for uncertainty in income taxes recognized in
  an entitys financial statements in accordance with FASB Statement No.
  109 and prescribes a recognition threshold and measurement attribute for financial
  statement disclosure of tax positions taken or expected to be taken on a tax
  return. Additionally, Interpretation No. 48 provides guidance on derecognition,
  classification, interest and penalties, accounting in interim periods, disclosure
  and transition. Interpretation No. 48 is effective for fiscal years beginning
  after December 15, 2006, with early adoption permitted. We are still evaluating
  the impact Interpretation No. 48 will have on our consolidated financial statements.

In
  June 2006, the Emerging Issues Task Force (EITF) issued EITF
  06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities
  Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation),
  to clarify diversity in practice on the presentation of different types of taxes
  in the financial statements. The Task Force concluded that, for taxes within
  the scope of the issue, a company may adopt a policy of presenting taxes either
  gross within revenue or net. That is, it may include charges to customers for
  taxes within revenues and the charge for the taxes from the taxing authority
  within cost of sales, or, alternatively, it may net the charge to the customer
  and the charge from the taxing authority. If taxes subject to EITF 06-3 are
  significant, a company is required to disclose its accounting policy for presenting
  taxes and the amounts of such taxes that are recognized on a gross basis. The
  guidance in this consensus is effective for the first interim reporting period
  beginning after December 15, 2006. The Company will adopt EITF 06-3 as
  of January 1, 2007. The adoption of EITF 06-3 is not expected to have an
  impact on our consolidated financial statements.

In
  September 2006 the FASB issued Statement No. 157,Fair
  Value Measurements, which establishes
  a framework for measuring fair value and expands disclosures about fair value
  measurements. Statement No 157 applies under other accounting pronouncements
  that require or permit fair value measurements and, accordingly, Statement No. 157
  does not require any new fair value measurements. Statement No. 157 is
  effective for financial statements issued for fiscal years beginning after November 15,
  2007, and interim periods within those fiscal years. We will adopt Statement
  No. 157 as of July 1, 2008. The adoption of Statement No. 157 is not expected
  to have a significant impact on our consolidated financial statements.

In
  September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108,Considering the Effects of Prior Year
  Misstatements when Quantifying Misstatements in Current Year Financial Statements,
  which provides interpretive guidance on how the effects of the carryover or
  reversal of prior year misstatements should be considered in quantifying a current
  year misstatement. The SEC staff believes that registrants should quantify errors
  using both a balance sheet and an income statement approach and evaluate whether
  either approach results in a misstatement that, when all relevant quantitative
  and qualitative factors are considered, is material and therefore must be quantified.
  We will adopt SAB No. 108 as of July 1, 2007. We have not determined the impact
  SAB No. 108 will have on our consolidated financial statements.

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Note 3. Equity-Based Compensation

Accounting
  for Employee Stock Award Plans

In July 2005, we adopted SFAS No. 123 (revised 2004),Share-Based Payment,(SFAS No.123R) which was issued in December 2004. SFAS No. 123R revised SFAS No. 123, Accounting for Stock Based Compensation, and superseded APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related interpretations. SFAS No. 123R requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period that the employee is required to perform the services in exchange for the award. SFAS No. 123R also requires measurement of
the cost of employee services received in exchange for an award based on the grant-date fair value of the award. SFAS No. 123R also amended SFAS No. 95, Statement of Cash Flows, to require that excess tax benefits be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows. We adopted SFAS No. 123R using the modified prospective method. Accordingly, prior period amounts have not been restated. Under this application, we are required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption.

Classification of Stock-Based Compensation Expense

Stock-based compensation is as follows (in thousands):



Three Months EndedSeptember 30,2006


      

        2005Cost of revenues


      


      $


      26


      


      $


      19Selling and marketing

        

        

        355

        

        

        250Research and development

        

        

        95

        

        

        105General and administrative

        

        

        457

        

        

        346$

        933

        

        $

        720


Tax Effect related to Stock-Based Compensation Expense

SFAS No. 123R provides that income tax effects of share-based payments are recognized in the financial statements for those awards that will normally result in tax deductions under existing tax law. Under current U.S. federal tax law, we would receive a compensation expense deduction related to non-qualified stock options only when those options are exercised and vested shares are received. Accordingly, the financial statement recognition of compensation cost for non-qualified stock options creates a deductible temporary difference which results in a deferred tax asset and a corresponding deferred tax benefit in the income statement. We do not recognize a tax benefit for compensation expense related to incentive stock options (ISOs) unless the underlying shares are disposed of in a disqualifying disposition. Accordingly, compensation expense related to ISOs is treated
as a non-deductible expense for income tax purposes.

Valuation Assumptions for Options Granted during Fiscal 2007

The fair value of each stock option granted during fiscal 2007 was estimated at the date of grant using Black-Scholes, assuming no dividends and using the valuation assumptions noted in the following table. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected life (estimated period of time outstanding) of the stock options granted was estimated using the historical exercise behavior of employees. Expected volatility was based on historical volatility for a period equal to the stock options expected life, and calculated on a daily basis.



Expected term

        

        5.5 yearsExpected volatility

        

        76.7

        %Weighted average volatility

        

        76.7

        %Risk-free rate

        

        4.5% - 5.1

        %


The above assumptions were used to determine the weighted average per share fair value of $9.26 for stock options granted during fiscal 2007.

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Equity Compensation Plans

In
  December 2004, our stockholders approved the 2004 Equity Incentive Plan (the
  2004 Plan), and the 1995 Stock Option Plan and the 2002 Non-Qualified
  Stock Option Plan were terminated as to any shares then available for future
  grant. The 2004 Plan permits us to grant equity-based awards to our directors,
  executives and a broad-based category of employees. The 2004 Plan provides for
  the issuance of up to 1,500,000 shares of common stock plus all outstanding
  options which terminate, expire or are canceled under the terminated plans on
  or after December 1, 2004. Under the terms of the 2004 Plan, the exercise price
  of options granted cannot be less than the fair market value on the date of
  grant. Non-employee director options that are automatically granted upon the
  person first becoming a director vest and become exercisable six months after
  the date of grant and options granted annually vest and become exercisable for
  one-half the shares six months from the date of grant and for the balance of
  the grant one year from the date of grant. All options that have been granted
  expire ten years from the grant date, although the committee or board may define
  vesting and expiration dates for all options granted under the 2004 Plan, except
  for automatic grants of options to non-employee directors and provided that
  the term does not exceed 10 years, or five years for ISOs granted to optionees
  who are holders of 10% or more of our stock.

In May 2005, our Board of Directors approved the acceleration of the vesting of unvested stock options held by employees that had option exercise prices of greater than $14.00 per share. Our stock price had ranged from $6.30 to $12.23 over the previous twelve months. As a result of the acceleration, options to purchase 532,376 shares of our common stock became immediately exercisable. Of these options, approximately seventy percent were scheduled to vest within the next eighteen months. The decision to accelerate vesting of these stock options was made to avoid recognizing compensation cost in the Consolidated Statements of Operations in future financial statements upon our adoption of SFAS No. 123R on July 1, 2005 and because the Board believed that the incentive and retention value of these options was significantly lower than their valuation using the Black-Scholes
methodology. We estimate that the accelerated vesting of the stock options reduced stock-based compensation expense on a pre-tax  basis by approximately $2.9 million in fiscal 2007, based on valuation calculations using the Black Scholes methodology.

Currently, our primary type of stock-based compensation consists of stock options, generally vesting over four years. We fund shares issued upon exercise out of available authorized shares.

A summary of the status of our stock option plans as of September 30, 2006 is presented below:



Shares


      

        WeightedAverageExercise Price


      


      RemainingContractualTerm (years)


      

        IntrinsicValue(inthousands)Outstanding as of June 30, 2006


      


      1,956,568


      


      $


      12.75Granted

        

        258,500

        

        

        13.58Exercised

        

        (7,721

        )

        

        3.55Terminated

        

        (38,938

        )

        

        14.60Outstanding as of September 30, 2006

        

        2,168,409

        

        

        12.85

        

        8.0

        

        $

        27,866Options exercisable at September 30, 2006

        

        890,691

        

        $

        14.02

        

        6.9

        

        $

        12,489Options expected to vest at September 30, 2006

        

        909,224

        

        $

        12.03

        

        8.7

        

        $

        10,942Options available for future grants at September 30, 2006

        

        172,958


The total intrinsic value of options exercised in fiscal 2007 was $72,000. Upon exercise of stock options, we issue authorized, but unissued shares.

As
  of September 30, 2006, there was $7.6 million of total unrecognized compensation
  cost related to non-vested stock-based compensation arrangements related to
  stock options granted under our stock option plans. This cost is expected to
  be recognized over a weighted-average period of 2.3 years.

The
     2004 Plan permits us to grant restricted stock which may impose conditions,

  including continued employment or performance conditions. The terms and conditions
     applicable to a restricted stock issuance, including the vesting periods
    and
  conditions, and the form of consideration payable, if any, are determined by
     the Compensation and Stock Option Committee of the Board of Directors.The plan provides that restricted
  stock  will not vest in full in less than three years if vesting is based on
  continued
  employment and in not less than one year if vesting is based on the achievement
   of performance criteria, other than as determined by the Committee upon a
  change
  in control or upon the participants death or termination of service,
  other  than for cause.

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During
  fiscal 2007, we did not grant any restricted stock. Changes in our restricted
  stock for fiscal 2007 were as follows:



Shares

        

        WeightedAverage GrantDate Fair ValueUnvested as of June 30, 2006

        

        11,290

        

        $

        13.29Vested

        

        (4,596

        )

        

        10.88Unvested
          as of September 30, 2006

        

        6,694

        

        

        14.94


As of September 30, 2006, there was $77,000 of total unrecognized compensation cost related to non-vested stock-based compensation arrangements related to restricted stock granted under the Plan. This cost is expected to be recognized over a weighted-average period of 0.7 years.

Note
  4. Reclassification and Revision

The
  June 30, 2006 consolidated balance sheet has been revised to reflect a reclassification
  of $66.9 million from cash and cash equivalents to short-term investments. This
  revision did not impact the consolidated statement of operations for the year
  ended June 30, 2006. However, this revision increased cash flows used in investing
  activities from $11.3 million to $78.2 million and decreased the increase in
  cash and cash equivalents from $77.9 million to $11.0 million in the consolidated
  statement of cash flows for the year ended June 30, 2006. This revision did
  not impact the consolidated statement of operations or consolidated statement
  of cash flows for the three months ended September 30, 2005. The impact of this
  reclassification and revision on the previously issued consolidated balance
  sheet and statements of cash flows is as follows (in thousands):



June
          30, 2006
      
      As
          Reported
      
      Adjustment
      
      As
          AdjustedCash
          and cash equivalents
      
      $
      86,223
      
      $
      (66,895
      )
      $
      19,328Short-term
          investments
      
      
      27,903
      
      
      66,895
      
      
      94,798Net
          cash used in investing activities
      
      
      (11,257
      )
      
      (66,895
      )
      
      (78,152
      )Increase
          in cash and cash equivalents
      
      
      77,938
      
      
      (66,895
      )
      
      11,094


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Note
          5. Goodwill and Intangible Assets


The
  carrying amount of goodwill was $38.1 million and $37.8 million at September
  30, 2006 and June 30, 2006, respectively. Goodwill increased in fiscal 2007
  due to the impact of changes in foreign exchange rates.

Intangible
  assets with finite useful lives are amortized over their respective estimated
  useful lives. The following table provides a summary of our intangible assets
  (in thousands):



September 30, 2006Estimateduseful life


      

        GrossCarryingAmount


      

        AccumulatedAmortization


      

        Net CarryingAmountTradenames


      


      Indefinite


      


      $


      363


      


      $


      


      


      $


      363Non-compete agreements

        

        2-5
          years

        

        

        1,674

        

        

        544

        

        

        1,130Customer relationships

        

        2-5
          years

        

        

        7,379

        

        

        2,418

        

        

        4,961Distributor relationships

        

        5 years

        

        

        2,325

        

        

        2,180

        

        

        145Acquired technology

        

        5-10
          years

        

        

        7,328

        

        

        2,615

        

        

        4,713$

        19,069

        

        $

        7,757

        

        $

        11,312




June 30, 2006Estimateduseful life


      

        GrossCarryingAmount


      

        AccumulatedAmortization


      

        Net CarryingAmountTradenames


      


      Indefinite


      


      $


      360


      


      $


      


      


      $


      360Non-compete agreements

        

        2-5
          years

        

        

        1,700

        

        

        448

        

        

        1,252Customer relationships

        

        2-5
          years

        

        

        7,350

        

        

        2,031

        

        

        5,319Distributor relationships

        

        5 years

        

        

        2,325

        

        

        2,079

        

        

        246Acquired technology

        

        5-10
          years

        

        

        7,506

        

        

        2,508

        

        

        4,998$

        19,241

        

        $

        7,066

        

        $

        12,175


The weighted average remaining lives of the intangible assets as of September 30, 2006 are as follows:



Non-compete agreements


      

        2.5 yearsCustomer relationships

        

        3.7 yearsDistributor relationships

        

        0.9 yearsAcquired technology

        

        3.6 years


The
  amortization expense of intangible assets is set forth below (in thousands):



Three Months EndedSeptember 30,2006


      

        2005Non-compete agreements


      


      $


      128


      


      $


      35Customer relationships

        

        

        360

        

        

        179Distributor relationships

        

        

        101

        

        

        116Acquired technologies

        

        

        336

        

        

        258$

        925

        

        $

        588


Amortization
  expense for customer relationships and distributor relationships is included
  in sales and marketing expenses and amortization expense for acquired technologies
  is included in cost of revenues. Amortization expense for non-compete agreements
  is classified depending on the classification of the related employee. Intangible
  assets held by foreign subsidiaries whose functional currency is not the U.S.
  dollar fluctuate based on changes in foreign rates.

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The following table provides estimated future amortization expense related to intangible assets (assuming there is no write down associated with these intangible assets causing an acceleration of expense or changes in foreign currency exchange rates) (in thousands):



Year Ending June 30,


      

        FutureAmortizationRemainder of fiscal 2007


      


      $


      2,5662008

        

        

        3,2282009

        

        

        2,7962010

        

        

        1,8482011

        

        

        4862012

        

        

        25$

        10,949


Note 6. Comprehensive Income


Excluding
  net income, our sources of other comprehensive income (loss) are unrealized
  gains and losses relating to foreign exchange rate fluctuations. The following
  summarizes the components of comprehensive income (loss) (in thousands):



Three Months EndedSeptember 30,2006


      

        2005Net income (loss)


      


      $


      (1,052


      )


      $


      1,841Foreign currency translation adjustment

        

        

        497

        

        

        (311

        )Comprehensive income (loss)

        

        $

        (555

        )

        $

        1,530


Note
          7. Revenue Recognition


Net
  revenues include sales of thin client appliance systems, which include the appliance
  device and related software, and services. We follow AICPA Statement of Position
  No. 97-2, Software Revenue Recognition
  (SOP 97-2) for revenue recognition because the software component
  of the thin client appliance systems is more than incidental to the thin client
  appliance systems as a whole. Revenue is recognized on product sales when persuasive
  evidence of an arrangement exists, delivery of the product has occurred, the
  fee is fixed or determinable and collectibility is probable. To date, sale of
  standalone software products and services have not exceeded 10% of our consolidated
  revenue for any period.

Revenue related to post-contract support services is generally recognized with the initial product sale when the fee is included with the initial product fee, post-contract services are for one year or less, the estimated cost of providing such services during the arrangement is insignificant, and unspecified upgrades and enhancements offered during the period are expected to continue to be minimal and infrequent. Otherwise, revenue from extended warranty and post-contract support service contracts is recorded as deferred revenue and subsequently recognized over the term of the contract. Vendor specific objective evidence of these amounts is determined by the price charged when these elements are sold separately.

Stock rotation rights and price protection are provided to certain distributors. Stock rotation rights are generally limited to a maximum amount per quarter and require a corresponding order of equal or greater value at the time of the stock rotation. Price protection provides for a rebate in the event we reduce the price of products for which the distributors have yet to sell to end-users. We reserve for these arrangements based on a specific review of known issues, historical experience and the level of inventories in the distribution channel and reduces current period revenue accordingly.

Product warranty costs are accrued at the time the related revenues are recognized. We offer fixed-price support and maintenance contracts, including extended warranties, to its customers ranging from one to five years. Revenue from these transactions is recognized over the related term.

We record sales and value added taxes that are externally imposed on a revenue producing transaction between a seller and a customer on a net basis in the statements of operations.

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Note 8. Major Customers and Dependence on Suppliers

The
  following table sets forth sales to customers comprising 10% or more of our
  net revenue and accounts receivable balances:



|                           |  | Three Months EndedSeptember 30, |  
|-------------------------- |  | ------------------------------- | -
|                           |  |                                 |  
|                           |  | 2006                            |  
|                           |  |                                 |  
|Net revenues               |  |                                 |  
|North American distributor |  | 11                              | %
|Lenovo                     |  | 10                              | %
|Customer A                 |  | *                               |  
|Customer B                 |  | *                               |  



|                         |  | September 30,2006 |   | June 30,2006 |  
|------------------------ |  | ----------------- | - | ------------ | -
|                         |  |                   |   |              |  
|Accounts receivable      |  |                   |   |              |  
|European distributor     |  | 10                | % | *            |  
|Customer A               |  | *                 |   | 17           | %
|Billing agent for Lenovo |  | *                 |   | 11           | %

|(*) | Amounts do not exceed 10% for such period
|--- | -----------------------------------------

In
  April 2005, in connection with the sale of IBMs Personal Computing Division
  to Lenovo Group Limited, we entered into a mirror agreement with Lenovo, under
  which Lenovo can purchase our products under the same terms as IBM. Our agreement
  with IBM remains in effect.

Under the IBM and Lenovo agreements, IBM and Lenovo sell our branded products to their customers. During the sales process, our sales and integration personnel work directly with the end customers, along with the support of IBM and Lenovo salespeople, thereby developing ongoing relationships with the customers. The strategy of selling our branded products and developing ongoing relationships with the end customers was designed to mitigate the risk of customer concentration from sales through IBM and Lenovo.

IBM,
  Lenovo and our distributors resell our products to individual resellers and
  end-users. The percentage of revenue derived from IBM, Lenovo, individual distributors,
  resellers or end-users can vary significantly from period to period. In addition
  to our direct sales to IBM and Lenovo, IBM, Lenovo and their resellers can purchase
  our products through distributors. Furthermore, IBM and Lenovo can influence
  an end-users decision to purchase our products even though the end-user
  may not purchase our products through IBM or Lenovo. While it is difficult to
  quantify the net revenues associated with these purchases, we believe that these
  sales are significant and can vary significantly from quarter to quarter.

Net revenues from sales outside of the United States, primarily in Europe, Middle East and Africa (EMEA) represented approximately 41% and 27% of net revenues for the first quarter for fiscal 2007 and 2006, respectively. No single country accounted for more than 10% of net revenue in the first quarter for fiscal 2007 and 2006.

We depend upon a limited number of single source suppliers for the design and manufacture of its thin client devices and for several of the associated components. During fiscal 2005, we accommodated one of our suppliers by purchasing products for inventory in advance of our contractual obligations due to the suppliers cash liquidity constraints, which increased inventory and decreased cash balances. Additionally, a domestic supplier requires advances to fund production of our orders . At September 30, 2006, we had advanced $860,000 to this domestic supplier, which was recorded as a prepaid expense. Although we have identified alternative suppliers that could produce comparable products, it is likely there would be an interruption of supply during any transition, which would limit our ability to ship product to fully meet customer demand. If this were to happen, our revenue would
decline and its profitability would be adversely impacted.

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Note 9. Inventories

Inventories
  are stated at the lower of cost or market. Cost is determined by the first-in,
  first-out method and consists of the following (in thousands):



|                                       |  | September 30,2006 |       | June 30,2006 |  
|-------------------------------------- |  | ----------------- | ----- | ------------ | -
|                                       |  |                   |       |              |  
|Purchased components and subassemblies |  | $                 | 3,079 |              | $
|Finished goods                         |  |                   | 6,326 |              |  
|                                       |  |                   |       |              |  
|                                       |  | $                 | 9,405 |              | $
|                                       |  |                   |       |              |  

The first quarter of fiscal 2007 includes a $1.5 million write off of unfinished goods inventory and related purchase commitments for certain products acquired in an acquisition.

Note
  10. Income Taxes

We
  account for income taxes under the asset-and-liability method. Deferred tax
  assets and liabilities are recognized for the future tax consequences attributable
  to differences between the financial statement carrying amounts of existing
  assets and liabilities and the respective tax bases. Deferred tax assets and
  liabilities are measured using enacted tax rates expected to apply to taxable
  income in the years in which those temporary differences are expected to be
  recovered or settled. The effect on deferred tax assets and liabilities of a
  change in tax rates is recognized in income in the period that includes the
  enactment date.

Note
  11. Short-term Borrowings

In
  December 2004, we entered into an Offering Basis Loan Agreement with a bank
  under which we can request short-term loan advances up to an aggregate principal
  amount of $10.0 million. Upon such request, the bank would provide us with the
  interest rate, terms and conditions applicable to the requested loan advance.
  The funds would be committed upon agreement of such terms by both parties. Unless
  otherwise agreed to by the bank, the term for any advance cannot exceed 180
  days. There were no borrowings under the Offering Basis Loan Agreement in fiscal
  2007.

Note
  12. Earnings per Share

Basic
  EPS is computed by dividing net income by the weighted average number of common
  shares outstanding for the period. Diluted EPS reflects the potential dilution
  from the exercise or conversion of securities into common stock, such as stock
  options and warrants. The following table sets forth the computation of basic
  and diluted earnings per share (in thousands, except share and per share data):



|                                          |  | Three Months EndedSeptember 30, |       
|----------------------------------------- |  | ------------------------------- | ------
|                                          |  |                                 |       
|                                          |  | 2006                            |       
|                                          |  |                                 |       
|Net
        income (loss)                 |  | $                               | (1,052
|                                          |  |                                 |       
|Weighted average shares outstanding:      |  |                                 |       
|Basic                                     |  |                                 | 19,943
|Effect of dilutive employee stock options |  |                                 |      
|                                          |  |                                 |       
|Diluted                                   |  |                                 | 19,943
|                                          |  |                                 |       
|Earnings (loss) per common share:         |  |                                 |       
|Basic                                     |  | $                               | (0.05 
|                                          |  |                                 |       
|Diluted                                   |  | $                               | (0.05 
|                                          |  |                                 |       

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The following table sets forth the common shares issuable upon exercise of stock options that were excluded from the dilutive earnings per share computations (in thousands):



Three Months EndedSeptember 30,2006


      


      2005Employee stock options

        

        1,037

        

        1,177


Note
  13. Guarantees

Indemnifications

In
    the ordinary course of business, from time-to-time we enter into contractual
    arrangements under which it may agree to indemnify its customer for losses
    incurred
  by the customer or supplier arising from certain events as defined within the
    particular contract, which may include, for example, litigation or intellectual
    property infringement claims. The potential liability related to these indemnification
  provisions is insignificant.

Warranty

We
  provide for the estimated cost of product warranties at the time it recognizes
  revenue. We actively monitor and evaluate the quality of our component suppliers;
  however, ongoing product failure rates, material usage and service delivery
  costs incurred in correcting a product failure affect the estimated warranty
  obligation. If actual product failure rates, material usage or service delivery
  costs differ from estimates, revisions to the estimated warranty liability would
  be required. Our standard warranty service period ranges from one to three years.

The
  changes in our warranty liability, which is included in other accrued expenses,
  during fiscal 2007 are as  follows (in thousands):



Accrued warranty cost at June 30, 2006


      


      $


      1,177Expense incurred

        

        

        (174

        )Provisions for warranties

        

        

        105Accrued warranty cost at September 30, 2006

        

        $

        1,108


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

Overview

We
  are a leading global provider of thin client computing solutions. Our thin client
  software and devices enable organizations to enhance security, improve manageability,
  increase reliability and lower the up-front and ongoing cost of computing. Our
  software powers, secures and manages thin client devices and traditional personal
  computers, enabling these devices to run Windows® and web applications across
  a network, as well as to connect to mainframes, mid-range, UNIX and Linux systems.

We generate revenue primarily from sales of thin client devices, which includes the device and related software, and to a lesser extent from our software sold on a standalone basis for use on thin client devices, personal computers and servers and complementary services such as integration, training and maintenance utilizing our global integration and development centers. To date, sales of standalone software products and services have not exceeded 10% of our consolidated revenues for any period.

We offer a broad range of thin client computing solutions for enterprises of varying sizes and across diverse vertical markets, including the retail, financial services, healthcare, hospitality, transportation, manufacturing, and education industries and multiple levels of government. We sell our products worldwide through our alliances with IBM, Lenovo, NEC, and ClearCube, and other indirect channels such as distributors, resellers and systems integrators, and to a lesser extent through direct sales. Our customers, including those we serve through our alliance and distribution partners, include AutoZone, CVS, Daimler Chrysler, France Telecom, Lockheed Martin, Royal Bank of Canada and the VA Medical Centers. In addition to our principal headquarters in the United States, we maintain offices in Australia, Austria, China, France, Germany, and the United Kingdom. Sales from our
international locations are primarily made through distributors and are collectible primarily in US dollars, while the associated operating expenses are payable in foreign currencies.

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In April 2005, in connection with the sale of IBMs Personal Computing Division to Lenovo Group Limited, we entered into a mirror agreement with Lenovo under which Lenovo can purchase our products under the same terms as IBM. Lenovo sells our products primarily to IBM customers. Our agreement with IBM remains in effect.

Strategy

Our
  objective is to be the leading global provider of thin client solutions for
  enterprise customers by providing a secure, manageable, and cost-effective alternative
  to traditional PC architectures. Key elements of our strategy include the following:



        Continue to invest in technology development.We believe that we have developed and acquired the technology to enable a more powerful, secure and cost-effective thin computing architecture. We have a 15-year history of developing this technology and between our own expenditures and those of the companies we have acquired. We will continue to invest in technology development to maintain a global leadership position and drive market share growth.




        Focus on the enterprise.We believe the most significant market segment for the thin client solution is the enterprise customer. As a result, we have focused our development, sales and marketing efforts  on small,  medium and large enterprises across a diverse set of vertical markets. Our access to this highly attractive market is considerably enhanced by our relationships with our alliance and distribution partners. We are planning to make significant investments to attract additional enterprise customers and gain market share. These investments will include additions to the sales teams primarily in the United States and Europe, as well as additional marketing personnel and programs designed to stimulate thin client awareness and lead generation.




        Enhance channel partnerships. To expand our access to customers, we have developed relationships with third parties that we believe have strong market positions and customer relationships. We have developed alliances with IBM, Lenovo, NEC and ClearCube, all of which sell our products to their customers.




        Expand and deepen our geographic footprint.Our business was historically focused on the U.S. market. In fiscal year 2004, we determined to expand our global footprint as part of a strategic expansion of our development and integration organization through the acquisitions of Maxspeed, Mangrove, Qualystem and ThinTune, as well as through partnerships with global distributors such as NEC, ClearCube and local providers. As a result, we now have a global footprint, with operations primarily in the US and Europe. We believe that international markets will be a significant source of growth and we intend to continue to increase our presence by expanding our reseller relationships and through select acquisitions.




        Grow our business through strategic acquisitions.Our acquisition strategy has been focused on expanding our geographic reach, acquiring businesses with technologies that increase our ownership of core intellectual property, and with products that can be sold through our existing channels to the same end-user customers, leveraging our existing organization. We have also sought to augment our software development resources and add to our integration capability on a global basis. We intend to continue to pursue select strategic acquisitions in the future.




        Capitalize on the growing adoption of industry-standard and open-source technologies. We believe that many enterprise customers are seeking industry-standard technologies, not proprietary solutions that require them to use a single vendor. As a result, we integrate our products into industry-standard solutions, and utilize open-source and other industry-standard technologies. In our supply chain we leverage the high volumes of the PC industry and PC supply chain techniques to lower our costs. We believe our commitment to open-source, cross-platform and industry-standard software technologies, and our use of the high volume supply chain efficiencies of the PC industry, represent significant differentiators and competitive advantages for us.


Recent Acquisitions

In
  November 2005, we completed the acquisition of Maxspeed Corporation, a provider
  of thin client solutions, headquartered in the United States, with research,
  development and sales in China.

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In
  October 2005, we acquired the thin client business of TeleVideo, Inc., located
  in the United States, including a trademark license, product brands, customer
  lists, customer contracts and non-competition agreements.

In
  April 2005, we acquired all of the outstanding shares of Qualystem Technology
  S.A.S., located in France, a provider of software that streams Windows®
  and application components on-demand from a server to other servers, personal
  computers, and thin clients.

In
  March 2005, we acquired the ThinTune thin client business of eSeSIX Computer,
  located in Germany, which included customer lists, intellectual property and
  technology, and also entered into reseller, supplier and non-competition agreements,
  and acquired all of the outstanding shares of eSeSIX Tech, located in Austria,
  eSeSIX Computers development and engineering affiliate. eSeSIX Computer
  together with eSeSIX Tech are collectively referred to as the ThinTune thin
  client business.

In
  January 2005, we acquired all of the outstanding shares of Mangrove Systems
  S.A.S., located in France, a provider of Linux software solutions. As a result
  of the Mangrove acquisition, we acquired customer lists, intellectual property
  and technology and non-competition agreements.

In
  September 2004, we acquired the thin client business of Visara International,
  Inc, located in the United States, including customer lists, intellectual property
  and technology, and also entered into reseller, supplier and non-competition
  agreements.

Financial
  Highlights

Net
  revenue, gross profit margin, and earnings per share are key measurements of
  our financial results.



Three Months EndedSeptember 30,2006


      

        2005


      


      % ChangeNet revenues (in thousands)


      


      $


      21,560


      


      $


      26,543


      


      (19


      )%Gross profit margin

        

        

        33

        %

        

        40

        %Diluted earnings (loss) per share

        

        $

        (0.05

        )

        $

        0.11


Net
    revenues decreased in the first quarter of fiscal 2007 primarily due to lower
    sales of our products to two large enterprise customers that contributed
    $1.5 million in the first quarter of fiscal 2007 compared to $9.0 million
    in the first quarter of fiscal 2006. Offsetting this decrease was a 24% increase
    in international revenues and an 18% increase in our small and medium sized
    business and distribution groups.

The gross profit margin percentage decrease in the first quarter of fiscal 2007 was primarily the result of a $1.5 million write off of unfinished goods inventory and related purchase commitments for certain products acquired in an acquisition due to discontinued sales of this product to new customers which has resulted in excess inventory and a $350,000 write off of excess third party software licenses, offset by a 31% decrease in the average cost per unit. The decrease in the average cost per unit is due to a 89% decrease in the unit sales our e900 thin client products. This resulted in lower gross profit margin in the first quarter of fiscal 2006 because our e900 thin client products typically sell at lower gross margin than our other products.

Diluted earnings (loss) per share was $(0.05) for the first quarter of fiscal 2007, compared to $0.11 in the first quarter of fiscal 2006, as a result of a decline in revenues, the impact of $1,850,000 write off to cost of products relating to the write off of inventory and for software purchase commitments, increased operating expenses, and increased cost of amortization of acquired intangibles, as well as a larger number of fully diluted shares due to a stock offering completed in February 2006. Stock-based compensation expense included in these results was $26,000 and $19,000 in cost of products sold and $907,000 and $701,000 in operating expense for the first quarter of fiscal 2007 and 2006, respectively, and amortization of intangibles was $925,000 and $588,000 for the first quarter of fiscal 2007 and 2006, respectively.

As of September 30, 2006, our cash and cash equivalents and short- term investments were $110.4 million, compared to $114.1 million at June 30, 2006. We used $4.4 million in operations due primarily to our net loss, increases in inventory and prepaid expenses and decreases in accounts payable, offset by a decrease in accounts receivable, received $6.0 million from the net sales of short-term investment and received $735,000 of cash from the exercise of stock options and related excess tax benefits.

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Critical Accounting Policies and Estimates

We
  believe that there are several accounting policies that are critical to understanding
  our historical and future performance, as these policies affect the reported
  amounts of revenue and other significant areas that involve managements
  judgments and estimates. These critical accounting policies and estimates include:



        Revenue recognition




        Valuation of long-lived and intangible assets and goodwill




        Accounting for income taxes




        Stock-based compensation


These
  policies and estimates and our procedures related to these policies and estimates
  are described in detail below and under specific areas within the discussion
  and analysis of our financial condition and results of operations. Please refer
  to Note 1, Organization and Summary of Significant Accounting Policies
  in the Notes to Consolidated Financial Statements in our annual financial statements
  as of June 30, 2006 included in our Annual Report on Form 10-K for further discussion
  of our accounting policies and estimates.

Revenue
  Recognition

For each type of arrangement, we make judgments regarding: the fair value of multiple elements contained in our arrangements, whether fees are fixed or determinable, collectibility is probable, and accounting for potential distributor stock rotation rights and price protection. These judgments, and their effect on revenue recognition, are discussed below.

Multiple
  Element Arrangements

Net
  revenues include sales of thin client devices, which include the device and
  related software, maintenance and technical support as well as standalone software
  products and services. We follow AICPA Statement of Position No. 97-2,Software
  Revenue Recognition(SOP
  97-2) for revenue recognition. Revenue is recognized on product sales
  when persuasive evidence of an arrangement exists, delivery of the product has
  occurred, the fee is fixed or determinable and collectibility is probable.

Revenue
  related to post-contract support services is generally recognized with the initial
  product sale when the fee is included with the initial product fee, post-contract
  services are for one year or less, the estimated cost of providing such services
  during the arrangement is insignificant, and unspecified upgrades and enhancements
  offered during the period are expected to continue to be minimal and infrequent.
  Otherwise, revenue from extended warranty and post-contract support service
  contracts is recorded as deferred revenue and subsequently recognized over the
  term of the related support period. Vendor specific objective evidence (VSOE)
  of these amounts is determined by the price charged when these elements are
  sold separately.

The
  Fee is Fixed or Determinable

We
  make judgments at the outset of an arrangement regarding whether the fees are
  fixed or determinable. The majority of our payment terms are within 30 to 60
  days after invoice date. We review arrangements that have payment terms extending
  beyond 60 days on a case-by-case basis to determine if the fee is fixed or determinable.
  If we determine at the outset of an arrangement that the fees are not fixed
  or determinable, we recognize revenue as the fees become due and payable.

Collection
  is Probable

We
  make judgments at the outset of an arrangement regarding whether collection
  is probable. Probability of collection is assessed on a customer-by-customer
  basis. We typically sell to customers with whom we have had a history of successful
  collections. New customers are subjected to a credit review process to evaluate
  the customers financial position and ability to pay. If we determine at
  the outset of an arrangement that collection is not probable, revenue is recognized
  upon receipt of payment.

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Stock Rotation Rights and Price Protection

We
  provide certain distributors with stock rotation rights and price protection.
  Stock rotation rights are generally limited to a maximum amount per quarter
  and require a corresponding order of equal or greater value at the time of the
  stock rotation. We provide price protection as a rebate in the event that we
  reduce the price of products that our distributors have yet to sell to end-users.
  We estimate potential stock rotation and price protection claims based on historical
  experience and the level of inventories in the distribution channel and reduce
  current period revenue accordingly. If we cannot reasonably estimate claims
  related to stock rotations and price protection at the outset of an arrangement,
  we recognize revenue when the claims can be reasonably estimated.

Valuation of Long-Lived and Intangible Assets and Goodwill

In
  connection with acquisitions, we allocate portions of the purchase price to
  tangible and intangible assets, consisting of acquired technologies, distributor
  and customer relationships, tradenames and non-compete agreements based on independent
  appraisals received after each acquisition, with the remainder allocated to
  goodwill.

We
  assess the realizability of goodwill and intangible assets with indefinite useful
  lives pursuant to SFAS No. 142, Goodwill
  and Other Intangible Assets.
  We perform a SFAS No. 142 impairment test annually on June 30, or sooner if
  events or changes in circumstances indicate that the carrying amount may not
  be recoverable. We have determined that the reporting unit level is our sole
  operating segment. The test for goodwill is a two-step process:



        First, we compare the carrying amount of our reporting unit, which is the book value of the entire company, to the fair value of our reporting unit. If the carrying amount of our reporting unit exceeds its fair value, we have to perform the second step of the process. If not, no further testing is needed.




        If the second part of the analysis is required, we allocate the fair value of our reporting unit to all assets and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. We then compare the implied fair value of our reporting units goodwill to its carrying amount. If the carrying amount of our reporting units goodwill exceeds its fair value, we recognize an impairment loss in an amount equal to that excess.


We
  review our long-lived assets, including amortizable intangibles, for impairment
  when events indicate that their carrying amount may not be recoverable in accordance
  with SFAS No. 144, Accounting
  for the Impairment or Disposal of Long-Lived Assets.When we determine that one or more impairment indicators are present for an
  asset, we compare the carrying amount of the asset to net future undiscounted
  cash flows that the asset is expected to generate. If the carrying amount of
  the asset is greater than the net future undiscounted cash flows that the asset
  is expected to generate, we compare the fair value to the book value of the
  asset. If the fair value is less than the book value, we recognize an impairment
  loss. The impairment loss is the excess of the carrying amount of the asset
  over its fair value.

Some
  of the events that we consider as impairment indicators for our long-lived assets,
  including goodwill, are:



        Our net book value compared to our market capitalization;




        Significant adverse economic and industry trends;




        Significant decrease in the market value of the asset;




        The extent that we use an asset or changes in the manner that we use it; and




        Significant changes to the asset since we acquired it.


We
  have not recorded an impairment loss on goodwill or other long-lived assets.
  At September 30, 2006, goodwill and intangible assets were $38.1 million and
  $11.3 million, respectively. A decrease in the value of our business could trigger
  an impairment charge related to goodwill or amortizable intangible assets.

Accounting
  for Income Taxes

We
  are required to estimate our income taxes in each federal, state and international
  jurisdiction in which we operate. This process requires that we estimate the
  current tax expense as well as assess temporary differences between the accounting
  and tax treatment of assets and liabilities, including items such as accruals
  and allowances not currently deductible for tax purposes. The income tax effects
  of the differences we identify are classified as current or long-term deferred
  tax assets and liabilities in our consolidated balance sheets. Our judgments,
  assumptions and estimates relative to the current provision for income tax take
  into account current tax laws, our interpretation of current tax laws and possible
  outcomes of future audits conducted by foreign and domestic tax authorities.
  Changes in tax laws or our interpretation of tax laws and the resolution of
  future tax audits could significantly impact the amounts provided for income
  taxes in our balance sheet and results of operations. We must also assess the
  likelihood that deferred tax assets will be realized from future taxable income
  and, based on our assessment, establish a valuation allowance, if required.
  Deferred tax assets and liabilities are recognized for the estimated future
  tax consequences attributable to differences between the financial statement
  carrying amounts of existing assets and liabilities and their respective tax
  bases and operating losses. Deferred tax assets and liabilities are measured
  using enacted tax rates in effect for the year in which those temporary differences
  are expected to be recovered or settled. The effect on deferred tax assets and
  liabilities of a change in tax rates is recognized in the period that includes
  the enac tment date. We record a valuation allowance to reduce its deferred
  tax assets to the amount that is more likely than not to be realized. We have
  considered ongoing prudent and feasible tax planning strategies in assessing
  the need for a valuation allowance. In the event we were to determine that it
  would be able to realize all or a portion of these deferred tax assets, an adjustment
  to the valuation allowance would increase earnings in the period such determination
  was made. Likewise, should we determine that we would not be able to realize
  all or a portion of our remaining deferred tax assets in the future, an adjustment
  to the valuation allowance would be charged to earnings in the period such determination
  was made.

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Stock-Based
  Compensation

Prior
  to June 30, 2005, we accounted for employee stock option plans based on
  the intrinsic value method in accordance with Accounting Principles Board (APB)
  Opinion No. 25, Accounting
  for Stock Issued to Employees,and related Interpretations and had adopted the disclosure requirements of SFAS
  No. 123, Accounting for Stock-Based
  Compensation(SFAS No.123), as
  amended by SFAS No. 148, Accounting
  for Stock-Based Compensation - Transition and Disclosure
  (SFAS No. 148). Accordingly, compensation cost for stock options was measured
  as the excess, if any, of the quoted market price of our stock at the grant
  date over the amount an employee must pay to acquire the stock. We granted stock
  options with exercise prices equal to the market price of the underlying stock
  on the date of grant; therefore, we did not record stock-based compensation
  expense under APB Opinion No. 25.

In
  December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No.
  123R, Share-Based Payment,(SFAS No. 123R) to require that compensation cost relating to share-based payment
  arrangements be recognized in financial statements. As of July 1, 2005, we adopted
  SFAS No. 123R using the modified prospective method, which requires measurement
  of compensation cost for all stock-based awards at fair value on date of grant
  and recognition of compensation over the service period for awards expected
  to vest. The fair value of stock options are determined using the Black-Scholes
  valuation model, which is consistent with our valuation techniques previously
  utilized for stock options in footnote disclosures required under SFAS No. 123,
  as amended by SFAS No. 148. Such fair value is recognized as expense over the
  service period, net of estimated forfeitures. The adoption of SFAS No.123R resulted
  in no cumulative change in accounting as of the date of adoption.

On
  March 29, 2005, the Securities and Exchange Commission published Staff
  Accounting Bulletin No. 107 (SAB No. 107), which provides the Staffs
  views on a variety of matters relating to stock-based payments. SAB No. 107
  requires stock-based compensation to be classified in the same expense line
  items as cash compensation. Information about stock-based compensation included
  in the results of operations is as follows (in thousands):



Three Months EndedSeptember 30,2006


      

        2005Cost of revenues


      


      $


      26


      


      $


      19Selling and marketing

        

        

        355

        

        

        250Research and development

        

        

        95

        

        

        105General and administrative

        

        

        457

        

        

        346$

        933

        

        $

        720




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We
  expect stock-based compensation expense to be approximately $3.3 million for
  fiscal 2007 before income taxes, although this amount may increase if we hire
  additional executives or a significant number of other additional employees
  and grant options to them. This amount may also change as a result of additional
  grants to existing employees, forfeitures or differences between actual and
  estimated forfeitures, modifications to previously granted awards or other factors.
  SFAS No. 123R provides that income tax effects of share-based payments are recognized
  in the financial statements for those awards which will normally result in tax
  deductions under existing tax law. Under current U.S. federal and U.K.
  tax laws, we would receive a compensation expense deduction related to non-qualified
  stock options only when those options are exercised and vested shares are received. Accordingly,
  the financial statement recognition of compensation cost for non-qualified stock
  options creates a deductible temporary difference which results in a deferred
  tax asset and a corresponding deferred tax benefit in the income statement.
  We do not recognize a tax benefit for compensation expense related to incentive
  stock options (ISOs) unless the underlying shares are disposed of in a disqualifying
  disposition. Accordingly, compensation expense related to ISOs is treated as
  a permanent difference for income tax purposes which increases the effective
  tax rate.

For
  stock-based compensation arrangements we make judgments about the fair value
  of the awards, including the expected term of the award, volatility of the underlying
  stock and estimated forfeitures, which impact the amount of compensation expense
  recognized in the financial statements.

Results
  of Operations

Net
  Revenues(in thousands):



Three Months EndedSeptember 30,2006


      

        2005


      


      % ChangeNet revenues


      


      $


      21,560


      


      $


      26,543


      


      (19


      )%


We
  derive revenues primarily from the sale of thin client appliances, which include
  an appliance device and related software. Net revenues decreased in the first
  quarter of fiscal 2007 primarily due to lower sales of our products to two large
  enterprise customers that contributed $1.5 million in the first quarter of fiscal
  2007 compared to $9.0 million in the first quarter of fiscal 2006. This decision
  was partially offset by a 24% ($1.7 million) increase in international revenues
  and 18% ($670,000) increase in our small, medium business and distribution groups,
  for the first quarter of fiscal year 2007 as compared to the first quarter of
  fiscal year 2006. Unit sales of thin client devices in the first quarter of
  fiscal 2007 were comparable to the first quarter of fiscal 2006. Average selling
  prices decreased by 22% in the first quarter of fiscal 2007 due to decreased
  sales of our e900 thin client products, which carry significantly higher selling
  prices than our other thin client devices. Average selling prices will vary
  depending on product mix and competitive pricing situations.

The following table sets forth sales to customers comprising 10% or more of our net revenue:



Three Months EndedSeptember 30,2006


      


      2005Net revenuesNorth American Distributor

        

        11

        %

        *

        %Lenovo

        

        10

        %

        10Customer A

        

        *

        %

        22Customer B

        

        *

        %

        12


(*)

        Amounts do not exceed 10% for such period


Net revenues from sales outside of the United States, primarily in Europe, the Middle East and Africa (EMEA), based on the location of our customers, were as follows (in thousands):



Three Months EndedSeptember 30,2006


      


      2005


      


      % Change


International net revenues


      


      $


      8,909


      


      $


      7,206


      


      24


      %Percentage of net revenues


      


      


      41


      %


      


      27


      %


International
  net revenues increased in the first quarter of fiscal 2007 compared to the first
  quarter of fiscal 2006 due to an 8% increase in unit sales and a 7% increase
  in average selling price in EMEA.



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Cost of Revenues and Gross Profit Margin(in thousands):



Three Months EndedSeptember 30,2006


      

        2005


      


      % ChangeCost of products


      


      $


      14,038


      


      $


      15,569


      


      (10


      ) %Amortization of intangibles

        

        

        336

        

        

        273

        

        23

        %Total cost of revenues

        

        

        14,374

        

        

        15,842

        

        (9

        ) %Gross profit margin

        

        

        33

        %

        

        40

        %


Cost
  of revenues consists primarily of the cost of thin client devices, which include
  a device and related software, and, to a lesser extent, overhead including salaries
  and related benefits for personnel who fulfill product orders, delivery services,
  warranty obligations, amortization of intangibles related to acquisitions, and
  distribution costs.

The decrease in cost of products in the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006 was primarily the result of decreased unit sales of our e900 thin client products in fiscal 2006, which carries a higher unit cost, offset by a $1.5 million write off of acquired unfinished goods inventory and related purchase commitments for certain products acquired in an acquisition due to discontinued sales of this product to new customers which resulted in excess inventory and a $350,000 write off of excess third party software licenses.

The
  gross profit margin percentage decrease was primarily the result of a $1.5 million
  write off of unfinished goods inventory and related purchase commitments for
  certain products acquired in an acquisition and a $350,000 write off of excess
  third party software licenses, offset by a 31% decrease in the average cost
  per unit. The decrease in the average cost per unit is due to a 89% decrease
  in the unit sales our e900 thin client products.
  This resulted in lower gross profit margin in the first quarter of fiscal 2006
  because our e900 thin client products typically sell at lower gross margin than
  our other products.

Gross
  margins for the remainder of fiscal 2007 are expected to be approximately 40%,
  but will fluctuate due to changes in product mix, reduction in sales prices
  due to increased sales to large enterprise customers and increased price competition,
  the percentage of revenues derived from thin client devices and software, and
  changes in the cost of thin client devices, flash memory, DRAM and other components.

Selling
  and Marketing(in thousands):



Three Months EndedSeptember 30,2006


      

        2005Selling and marketing


      


      $


      4,412


      


      $


      4,169As a percentage of revenue

        

        

        20

        %

        

        16

        %


Sales
  and marketing expenses consist primarily of salaries, related benefits, commissions,
  advertising, direct marketing, the cost of trade shows, stock-based compensation
  expense, and other costs associated with our sales and marketing efforts.

The increase in sales and marketing expenses in the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006, was due to a $105,000 increase in stock-based compensation expense, and an increase in employment resulting in an additional $164,000 of employee compensation cost and accrued severance of $100,000, offset by a $126,000 decrease in the expenses related to our annual sales meetings.

We expect selling and marketing expenses to increase in absolute dollars for the remainder of 2007. Spending levels in any one quarter will vary depending upon the timing of individual marketing initiatives.

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Research and Development(in thousands):



Three Months Ended September 30,2006


      

        2005


      


      % ChangeResearch and development


      


      $


      1,774


      


      $


      1,284


      


      38


      %As a percentage of revenue

        

        

        8

        %

        

        5

        %


Research and development expenses consist primarily of salaries, related benefits, stock-based compensation expense, and other engineering related costs.

The increase in research and development in the first quarter of fiscal 2007 is primarily the result of an increase in employment primarily from acquisitions resulting in an additional $371,000 of employee compensation costs and $162,000 related to severance.

We believe that a significant level of research and development investment is required to remain competitive and expect research and development expenses to increase in absolute dollars for the balance of fiscal 2007.

General and Administrative(in thousands):



Three Months Ended September 30,2006


      

        2005


      


      % ChangeGeneral and administrative


      


      $


      2,617


      


      $


      2,298


      


      14


      %As a percentage of revenue

        

        

        12

        %

        

        9

        %


General and administrative expenses consist primarily of salaries, related benefits, corporate insurance, such as director and officer liability insurance, fees related to the cost of being a public company and fees for legal, audit and tax services, and stock-based compensation expense.

The increase in general and administrative expenses in the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006 is primarily the result of a $111,000 increase in stock-based compensation expense, a $142,000 increase in franchise and capital stock taxes due to revenue and asset growth, $48,000 in higher facility costs due to the relocation into a new facility and increased costs related to managing a larger world-wide organization, as well as increased legal and accounting fees.

We expect general and administrative expenses to increase in absolute dollars for the remainder of fiscal 2007, including a $860,000 cash charge to be recorded in the second quarter of fiscal 2007 related to a severance agreement entered into in October 2006 between us and our  former Chief Executive Officer. We also expect an additional expense related to the modification of stock options previously granted to our former Chief Executive Officer.

Amortization of Intangibles(in thousands):



Three Months Ended September 30,2006


      

        2005


      


      % ChangeAmortization of intangibles


      


      $


      589


      


      $


      315


      


      87


      %As a percentage of revenue

        

        

        3

        %

        

        1

        %


The increase in amortization of intangibles in the first quarter of fiscal 2007 due to an increase in amortization expense related to intangible assets acquired in fiscal 2006. As of September 30, 2006, we had unamortized intangible assets in the net amount of $11.3 million. We expect amortization of acquired intangible assets to increase slightly in fiscal 2007 compared to fiscal 2006.

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Interest Income(in thousands):



Three Months Ended September 30,2006


      

        2005


      


      % ChangeInterest income


      


      $


      981


      


      $


      244


      


      302


      %As a percentage of revenue

        

        

        5

        %

        

        1

        %


Interest income is generated on cash, cash equivalent and short-term investments, primarily invested in tax-free, short-term instruments. Interest income increased in the first quarter of fiscal 2007 due to earnings on increased average balances of cash, cash equivalent and short-term investments, generated primarily from the common stock offering completed in February 2006.

Income Tax Expense (Benefit)(in thousands):



Three Months Ended September 30,2006


      

        2005


      


      % ChangeIncome tax expense (benefit)


      


      $


      (200


      )


      $


      1,047


      


      (117


      )%Effective tax rate

        

        

        16

        %

        

        36

        %


Our
     effective tax rate in the first quarter of fiscal 2007 differed from the
    combined
  federal and state statutory rates primarily due to federal tax free investment
     income, the Extraterritorial Income Exclusion (EIE), the manufacturing
      deduction for the Jobs Creation Act, foreign income taxes in lower tax
     rate
  countries, partially offset by the non-deductible portion of stock-based
   compensation expense associated with incentive stock options. The decrease
  in
  the effective tax rate is primarily due to a decline in pretax income due to
  a $3.1 million increase in to federal tax  free investment income, offset by
  a $763,000 increase in non-deductible stock-based
   compensation and expense associated with incentive stock options and a $400,000

  decrease in the EIE.

Liquidity
  and Capital Resources

As
     of September 30, 2006, we had net working capital of $128.7 million compared

  to $126.9 million at June 30, 2006. Our principal sources of liquidity include
     $110.4 million of cash and cash equivalents and short-term investments and
    an
  Offering Basis Loan Agreement with a bank under which we can request short-term
     loan advances up to an aggregate principal amount of $10.0 million. Upon
    such
  request, the bank would provide us with the interest rate, terms and conditions
     applicable to the requested loan advance. The funds would be committed upon

  agreement of such terms by both parties. Unless otherwise agreed to by the
    bank,  the term for any advance cannot exceed 180 days. There were no borrowings
    under
  the Offering Basis Loan Agreement during the first quarter of fiscal 2007.

Cash
  and cash equivalents increased by $2.3 million during the first quarter of fiscal
  2007, primarily as a result of $6.0 million from the net sales of short-term
  investments and $735,000 of cash from the exercise of stock options and related
  excess tax benefits, offset by $4.4 million used in operations.

Cash
        flows provided by (used in) operating activities:Cash
        flows used in operating activities in the first quarter of 2007 was $4.4
        million primarily as the result of a net loss of $1.1 million, adjusted
        for, among other items, depreciation of $138,000, amortization of intangibles
        of $925,000, stock-based compensation of $933,000, a $1.7 million increase
        in inventory, a $1.8 million decrease in accounts receivable due to lower
        revenue, a $2.1 million increase in prepaid expenses primarily related
        to income taxes, a $4.0 million reduction in accounts payable due primarily
        to payment of obligations for inventory purchases, and a net $950,000
        offset related to other working capital items.

Cash flows provided by investing activities:Cash flows from investing activities in the first quarter of fiscal 2007 and fiscal 2006 include the purchases and sales of short-term investments and purchases of property and equipment.

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Cash flows provided by financing activities:Cash flows from financing activities in the first quarter of fiscal 2007 and fiscal 2006 primarily included proceeds from the exercise of employee stock options and related excess tax benefits.

Contractual Obligations

The following is a summary of our contractual obligations as of September 30, 2006 (in thousands):



Total


      

        Remainder of 2007


      

        2008 and 2009


      

        2010 and 2011


      

        2012 and thereafterProduct purchase obligations


      


      $


      16,402


      


      $


      16,402


      


      $


      


      


      $


      


      


      $


      Operating leases

        

        

        3,664

        

        

        758

        

        

        1,439

        

        

        900

        

        

        567Other purchase obligations

        

        

        486

        

        

        486

        

        

        

        

        

        

        

        

        $

        20,552

        

        $

        17,646

        

        $

        1,439

        

        $

        900

        

        $

        567


The above table excludes contingent amounts payable pursuant to arrangements with executive officers which provide for severance obligations of up to an aggregate of $2.7 million.

In
    connection with our acquisition of Maxspeed, we recorded a restructuring
    reserve of $1.4 million as of the acquisition date. As of September 30, 2006
    we have incurred $855,000 of costs related to the termination of employees
    and lease restructuring which were recorded against this restructuring reserve.
    Any unused amounts after twelve months post closing of the reserve are payable
    to the Maxspeed shareholders.

We expect to fund current operations and other cash expenditures through the use of available cash, cash from operations, funds that may be available under our Offering Basis Loan Agreement and, potentially, new debt or equity financings. Management believes that we will have sufficient funds from current cash, operations and available financing to fund operations and cash expenditures for the foreseeable future. However, we may seek additional sources of funding in order to fund acquisitions.

Off Balance Sheet

Our guaranteed agreements are discussed in Note 13 to the consolidated financial statements.

Forward-Looking Statements

This quarterly report on Form 10-Q contains statements   that are forward-looking statements within the meaning of the Private Securities   Litigation Reform Act of 1995, such as statements regarding: our expectations   regarding gross margins, selling and marketing expenses, research and   development expenses, and general and administrative expenses for the balance of   fiscal 2007; our acquisition of businesses and technologies; future strategic   partnerships; our expectation of stock-based compensation fiscal 2007; the   availability of cash or other financing sources to fund future operations; cash   expenditures and acquisitions, and our potential issuance of debt and equity   securities. These forward-looking statements involve risks and uncertainties.   The factors set forth below, and those contained in “Item 1A., Risk Factors”,   and set forth elsewhere in this report, could cause actual results to differ   materially from those predicted in any such forward-looking statement. Factors   that could affect our actual results include: our success in implementing our   expanded marketing, sales and product development initiatives within our planned   timeframe; higher than expected severance payments; additional write offs of   inventory; our success in increasing sales to the targeted customers and our   continued dependence on enterprise customers; our inability to manage our   expanded organization; our inability to successfully integrate our recent   acquisitions; the timing and receipt of future orders; our timely development   and customers’ acceptance of our products; pricing pressures; rapid   technological changes in the industry; growth of overall thin client sales; our   ability to maintain our partnerships; our dependence on our   suppliers and distributors; increased competition; our continued ability to sell   our products through Lenovo to IBM's customers; our ability to attract and   retain qualified personnel; adverse changes in customer order patterns; our   ability to identify and successfully consummate and integrate future   acquisitions; adverse changes in general economic conditions in the U. S. and   internationally; risks associated with foreign operations; and political and   economic uncertainties associated with current world events.

Item
3. Quantitative and Qualitative Disclosures About Market Risk

We
  earn interest income from our balances of cash, cash equivalents and short-term
  investments. This interest income is subject to market risk related to changes
  in interest rates that primarily affects our investment portfolio. We invest
  in instruments that meet high credit quality standards, as specified in our
  investment policy.

As
  of September 30, 2006 and June 30, 2006, cash equivalents and short-term investments
  consisted primarily of corporate notes and government securities, certificates
  of deposit, auction rate securities and other specific money market instruments
  of similar liquidity and credit quality. Due to the conservative nature of our
  investment portfolio, a sudden change in interest rates would not have a material
  effect on the value of the portfolio.

We
  have operations in the United Kingdom, Germany, France, Austria, Sweden, Australia
  and China that are subject to foreign currency fluctuations. As currency rates
  change, translation of the foreign entities statements of operations from
  local currencies to U.S. dollars affects year-to-year comparability of operating
  results. Additionally, we have investments in each of these countries for which
  we recognize unrealized gains and losses through other comprehensive income
  within stockholders equity for foreign currency fluctuations.

Item
  4. Controls and Procedures

Under
  the supervision and with the participation of the Companys Chief Executive
  Officer and Chief Financial Officer, we carried out an evaluation of the effectiveness
  of our disclosure controls and procedures, as such term is defined in Rules
  13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of September
  30, 2006 (the Evaluation Date). Based on the evaluation performed,
  our Chief Executive Officer and Chief Financial Officer have concluded that,
  as of the Evaluation Date, the Companys disclosure controls and procedures
  were effective in recording, processing, summarizing and reporting in the periods
  specified in the SECs rules and forms the information required to be disclosed
  by the Company in its reports filed or furnished under the Exchange Act.

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There have not been any changes in our internal control over financial reporting during the quarter ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PARTII
  OTHER INFORMATION

Item
  1A. Risk Factors

Our
  future results may be affected by industry trends and specific risks in our
  business. Some of the factors that could materially affect our future results
  include those described below. Operating results for a particular future period
  are difficult to predict and, therefore, prior results are not necessarily indicative
  of results to be expected in future periods. Factors that could have a material
  adverse effect on our business, results of operations, and financial condition
  include, but are not limited to, the following:

The
  success of our strategy depends on our ability to attract, retain and grow our
  business with large enterprise customers, and the long sales cycle with these
  customers makes planning and inventory management difficult and future financial
  results less predictable.

We
  must retain and continue to expand our ability to reach and sell enterprise
  customers by implementing our sales and marketing initiatives, adding effective
  channel partners and expanding our integration services. Our inability to attract
  and retain enterprise customers could have a material adverse effect on our
  business, results of operations and financial condition. Large enterprise customers
  usually request special pricing and generally have longer sales cycles, which
  could negatively impact our revenues, and longer sales cycles could affect our
  ability to predict our revenues for any particular period. Additionally, as
  we implement our new sales and marketing initiatives in an attempt to attract
  and penetrate enterprise customers, we will need to increase our operating expenses.
  These efforts may not proportionally increase our operating revenues and could
  reduce our profits.

Our
  sales cycle for large-scale deployments to large enterprise customers makes
  it difficult to predict when these sales will occur, and we may not be able
  to sustain these sales on a predictable basis. We often have a long sales cycle
  for these large enterprise sales because:



        our sales personnel generally need to explain and demonstrate the benefits of a large-scale deployment of our products to potential and existing customers prior to sale;




        our technical personnel typically spend a significant amount of time assisting potential customers in their testing and evaluation of our products and services and in integrating the products to suit their needs;




        our large-scale customers are typically large and medium size organizations that carefully research their technology needs and the many potential projects prior to making capital expenditures for IT infrastructure; and




        before making a purchase, our potential customers usually must obtain approvals from various levels of decision makers within their organizations, and this process can be lengthy.


The
  long sales cycle and our lack of visibility into when these sales to enterprise
  customers could occur may make it difficult to predict the timing of sales, as whether they will be completed.
  Delays in sales could cause significant variability in our revenue and operating
  results for any particular period. This uneven sales pattern also will affect
  our inventory management and logistics costs. If predicted demand is substantially
  greater than orders, as it was in the quarters ended June 30, and September
  30, 2006, there will be an increase in inventory, which could make it necessary
  for us to reduce our prices or write down inventory resulting in lower gross
  margins and less cash. Alternatively, if orders substantially exceed predicted
  demand, we may not be able to fulfill all of the orders received.

Our success may depend on our ability to attract, retain and grow our business with small and medium sized customers.

In order to successfully attract new customer segments and expand our existing relationships with enterprise customers, we must reach and retain small- and medium-sized customers and smaller project initiatives within our large enterprise customers. We have begun a sales and marketing initiative to reach these customers. We cannot guarantee that our small- and medium-sized customer sales and marketing initiatives will be successful. Our failure to attract and retain small- and medium-sized customers and smaller project initiatives within our large enterprise customers could have a material adverse effect on our business, results of operations and financial condition. Additionally, as we implement our sales and marketing initiatives in our attempt to attract and retain small- and medium-sized customers and smaller project initiatives within our large enterprise customers, we
will need to increase our operating expenses. These efforts may not proportionally increase our operating revenues and could reduce our profits.

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Because we rely on resellers and distributors, including IBM and Lenovo, to sell our products, our revenues could be negatively impacted if these companies do not continue to purchase products from us.

We
  cannot be certain that we will be able to attract or retain resellers or distributors
  to market our products effectively. None of our current resellers or distributors,
  including IBM and Lenovo, are obligated to continue selling our products or
  to sell our new products, and none are precluded from selling competing products.
  We cannot be certain that any resellers or distributors will continue to represent
  our products or that our resellers or distributors will devote a sufficient
  amount of effort and resources to selling our products. We need to expand our
  indirect sales channels, and if we fail to do so, our growth could be limited.
  A number of our distributors resell to their own networks of channel partners
  with whom we have no direct relationship. Our distribution channel could be
  affected by disruptions in the relationships of and with our channel partners
  and their networks.

We
  derive a significant portion of our revenue from sales made directly to IBM
  customers through Lenovo and through our other distributors. A significant portion
  of our other revenue is derived from sales to resellers. If Lenovo or our other
  distributors were to discontinue sales of our products or reduce their sales
  efforts, or if IBM salespeople were to reduce their attention to our products,
  it could adversely affect our operating results. In addition, the continued
  viability and financial condition of our distributors could deteriorate and
  may not be able to withstand changes in business conditions, including economic
  weakness, which could lead to significant delays in their payments to us or
  defaults on their payment obligations. Additionally, we could experience disruptions
  in the distribution of our products if our distributors financial conditions
  or operations weaken. Any significant delays, defaults or disruptions could
  have a material adverse effect on our business, results of operations and financial
  condition. For example, during the fourth quarter of fiscal 2006, one of our
  German distributors experienced significant financial difficulties and has since
  declared insolvency, which caused us to reverse revenues in the amount of $675,000
  invoiced in April through June 2006 and to add $385,000 to our reserve for doubtful
  accounts in the quarter ended June 30, 2006..

As
  a result of our alliances with IBM and Lenovo, we rely on those parties for
  distribution of our products to their customers. Sales directly to Lenovo accounted
  for 10% of our net sales during the quarter ended September 30, 2006. IBM and
  Lenovo are under no obligation to continue to actively market our products.
  In addition to our direct sales to IBM and Lenovo, IBM and Lenovo can purchase
  our products through individual distributors and/or resellers. Furthermore,
  IBM can influence an end-users decisions to purchase our products even
  though the end-user may not purchase our products through IBM or Lenovo. While
  it is difficult to quantify the net revenues associated with these purchases,
  we believe that these sales could be significant and can vary significantly
  from quarter to quarter.

Our business could be adversely affected if we are unable to expand and diversify our distribution channels.

We currently intend to continue to expand our distribution channels by expanding our sales with resellers, distributors and systems integrators. In addition, an integral part of our strategy is to expand and diversify our base of channel relationships by adding more channel partners with abilities to reach large enterprise customers and to sell our newer products. This will require additional resources, as we will need to expand our internal sales and service coverage of these customers and our marketing personnel. If we fail in these efforts and cannot expand or diversify our distribution channels, our revenues and profits could be adversely affected. In addition to this expansion and diversification of our base, we will need to maintain channel partners who cater to smaller customers. We may need to add distribution partners to maintain customer satisfaction and a steady or
increasing adoption rate of our products, which could increase our operating expenses. We intend to invest significant resources to develop these channels, which could reduce our profits if our efforts do not result in significant increases in our revenues.

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If we are unable to continue generating substantial revenues from international sales and effectively managing our international operations our business could be adversely affected.

We
  derive a substantial portion of our revenue from international sales primarily
  in Europe, Middle East and Africa (EMEA),and we recently began marketing and
  selling activities in China and other parts of Asia. Our international activities,
  primarily in EMEA, accounted for approximately 41% of revenues during the quarter
  ended September 30, 2006. In addition, a portion of our operations consists
  of manufacturing, software and product development, and sales activities outside
  of the U.S. Our ability to sell our products and conduct our operations internationally
  is subject to a number of risks. General economic and political conditions and
  the imposition of governmental controls in each country,including governmental restrictions
  on the transfer of funds to us from our operations outside the United States,including restrictions in China, could adversely affect our operations and demand
  for our products and services in these markets. We may also experience reduced
  intellectual property and contract rights protection as a result of different
  business practices in certain countries, which could have an adverse effect
  on our business and financial results. Although most of our international sales
  are denominated in U.S. Dollars, currency exchange rate fluctuations could result
  in lower demand for our products or lower pricing resulting in reduced revenue
  and margins, as well as currency translation losses. In addition, a weakening
  Dollar has resulted in increased costs for our international operations (which
  are mostly determined in local currencies), and could result in greater costs
  for our international operations in the future. In addition, concerns about
  terrorism or an outbreak of epidemic diseases such as avian influenza or severe
  acute respiratory syndrome, could have a negative effect on travel and our business
  operations, and could result in adverse consequences on our international operations.

Changes
  to and compliance with a variety of foreign laws and regulations may increase
  our cost of doing business in these jurisdictions. We incur additional legal
  compliance costs associated with our international operations and could become
  subject to legal penalties in foreign countries if we do not comply with local
  laws and regulations which may be substantially different from those in the
  United States. In many foreign countries, particularly those with developing
  economies, it is common to engage in business practices that are prohibited
  by United States regulations applicable to us, such as the Foreign Corrupt Practices
  Act, and any violations of such laws by our employees or contractors could have
  a material adverse effect on our business. Trade protection measures and import
  and export licensing requirements subject us to additional regulation and may
  prevent us from shipping products to a particular market, and increase our operating
  costs. In addition, our future results could be adversely affected by difficulties
  in staffing, and coordinating communications among and managing our international
  operations, which have significantly expanded and become more complex as a result
  of the European acquisitions completed in fiscal 2006 and 2005.

While
  we sell our products worldwide, one component of our strategy is to expand our
  sales efforts in China, India and other countries with large populations and
  propensities for adopting new technologies. We have limited experience with
  sales and marketing in some of these countries. There can be no assurance that
  we will be successful in marketing and selling our products in all of our targeted
  international markets. If our international efforts are not successful, our
  business growth and results of operations could be adversely impacted.

Our
  business is dependent on customer adoption of thin client devices as an alternative
  to personal computers, and a decrease in their rates of adoption could adversely
  affect our ability to increase our revenues.

We are dependent on the growing use of thin client devices to increase our revenues. If thin client devices are not accepted by corporations as an alternative to personal computers, the result would be slower than anticipated revenue growth or even a decline in our revenues.

Thin client devices have historically represented a very small percentage of the overall PC market, and, if sales do not grow as a percentage of the PC market, or if the overall PC market were to decline, our revenues might not grow or might decline. Alternatively, if the market were to grow faster than expected, it could lead PC manufacturers to the thin client device segment of the PC market, which would increase competition and could adversely impact our results.

Our
  acquisition and alliance activities could disrupt our ongoing business, and
  we may not be able to successfully complete and integrate future acquisitions
  we may complete, which may materially adversely affect our growth and our operating
  results.

As
  part of our business strategy, we frequently engage in discussions with third
  parties regarding, and enter into agreements relating to, possible acquisitions,
  strategic alliances and outsourcing transactions in order to further our business
  objectives. In order to pursue this strategy successfully, we must identify
  suitable candidates for these transactions, complete these transactions, some
  of which may be large andcomplex,
  and manage post-closing issues such as the integration of acquired companies
  or employees. We may, in order to integrate acquired businesses or employees,
  incur significant integration and restructuring costs, both one-time and on
  a recurring basis. Integration and other risks of acquisitions, strategic alliances
  and outsourcing transactions can be more pronounced for larger and more complicated
  transactions, or if multiple transactions are pursued simultaneously. However,
  if we fail to identify and successfully complete transactions that further our
  strategic objectives, we may be required to expend resources to develop products
  and technology internally, we may be at a competitive disadvantage or we may
  be adversely affected by negative market perceptions, any of which may have
  a material adverse effect on our revenue and selling, general and administrative
  expenses.

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Since
  June 2001, we have completed ten acquisitions and entered into alliances with
  IBMandLenovo, and we plan to make additional
  acquisitions, some of which may be large and complex, as part of our growth
  strategy. There is no assurance that we will derive benefits from the three
  European acquisitions we completed in the third and fourth quarters of fiscal
  2005, the Visara, TeleVideo or Maxspeed acquisitions we completed in the first
  half of fiscal 2006 or future acquisitions we pursue. We may be unable to retain
  key employees or key business relationships of the acquired businesses, consolidate
  IT infrastructures, integrate accounting controls, policies and procedures,
  manage supply chain integration, combine administrative, research and development
  and other operations, eliminate duplicative facilities and personnel, which
  could result in significant costs and expenses, and combine product offerings,
  and integration of the businesses may divert the attention and resources of
  our management. Our failure to successfully integrate acquired businesses into
  our operations could have a material adverse effect on our business, operating
  results and financial condition. Even if such acquisitions are successfully
  integrated, we may not receive the expected benefits of the transactions if
  we find that the acquired business does not further our business strategy or
  that we paid more than what the business was worth. Managing the completion
  and integration of acquisitions and alliances requires management resources,
  which may divert our attention from other business operations. In addition,
  we may lack experience operating in the geographic market of the business acquired.
  As a result, the effects of any completed or future transactions on financial
  results may differ from our expectations. These transactions may result in significant
  costs and expenses, including severance payments and additional compensation
  to executives and other key personnel, charges related to the elimination of
  duplicative facilities, assumed liabilities, and legal, accounting and financial
  advisory fees. In connection with completing acquisitions, we may issue shares
  of our common stock, potentially creating dilution for our existing stockholders.
  During fiscal 2004, we spent approximately $1.6 million pursuing acquisitions
  that we did not complete. We intend to continue to pursue acquisitions, and
  if we do not complete them, the cost of pursuing acquisitions will impact our
  profitability.

Because we depend on sole source, limited source and foreign source suppliers for the design and manufacture of our thin client products and for key components in our thin client products, we are susceptible to supply shortages that could prevent us from shipping customer orders on time, if at all, and result in lost sales. In addition, our outsourcing activities for other functions may fail to reduce costs and may disrupt operations.

We
  depend upon single source suppliers for the design and manufacture of our thin
  client device products and for several of the associated components. We also
  depend on limited sources to supply several other industry standard components.
  The third party designers and manufacturers of our thin client products have
  access to our intellectual property which increases the risk of infringement
  or misappropriation of this intellectual property.

We
  primarily rely on foreign suppliers, which subjects us to risks associated with
  foreign operations such as the imposition of unfavorable governmental controls
  or other trade restrictions, changes in tariffs, political instability and currency
  fluctuations. A weakening dollar could result in greater costs to us for our
  components. Severe acute respiratory syndrome, avian influenza and similar medical
  crises could also disrupt manufacturing processes and result in quarantines
  being imposed in the future.

We
  have in the past experienced and may in the future experience shortages of,
  or difficulties in acquiring, certain components. A significant portion of our
  revenues is derived from the sale of thin client devices that are bundled with
  our software. Third parties design and produce these thin client devices for
  us, and we typically do not have long-term supply contracts with them obligating
  them to continue producing products for us. The absence of such agreements means
  that, with little or no notice, these suppliers could refuse to continue to
  manufacture all or some of our products that we require or change the terms
  under which they manufacture our products. If our suppliers were to stop manufacturing
  our products, we might be unable to replace the lost manufacturing capacity
  on a timely basis. If we experience shortages of these products, or of their
  components, we may not be able to deliver our products to our customers, and
  our revenues would decline. If these suppliers were to change the terms under
  which they manufacture for us, our manufacturing costs could increase and our
  cost of revenues could increase, resulting in a decline in gross margins. If
  we were unable to adequately address the supply issues, we might have to reengineer
  some products resulting in further costs and delays. In addition, a failure
  of our suppliers to maintain their viability and financial condition could result
  in changes in payment and other terms of our relationships and their inability
  to produce and deliver our products on time and in sufficient quantities. During
  fiscal 2005, we accommodated one of our suppliers by purchasing products for
  inventory in advance of our contractual obligations due to the suppliers
  cash liquidity constraints, which increased inventory and decreased cash balances.
  Additionally, a domestic supplier that we added in fiscal 2005 required an advance
  payment of $1.1 million at June 30, 2005, and $860,000 at September 30, 2006, which were recorded as a prepaid expenses,
  to fund a portion of the initial and continued production of our orders. In
  the event of increased inventory levels, as at September 30, 2006, we would
  reduce our purchase of inventory in the short term, which could adversely affect
  the financial condition of our suppliers and jeopardize the continued supply
  of our products. Finally, if one of our suppliers failed to maintain viability,
  we would likely be required to honor warranties granted by them to our customers
  for products sold by us, which would increase our costs.

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In
  addition to using third party suppliers for the manufacture of our products
  and supply of our components, to achieve additional cost savings or operational
  benefits, we have expanded, and may in the future expand, our outsourcing activities
  where we believe a third party may be able to provide those services in a more
  efficient manner. In fiscal 2006, we entered into a relationship with a third-party
  company that provides CRM software and services to us on an outsourced basis.
  To the extent that we rely on partners or third party service providers for
  the provision of software development services and key business process functions,
  we may incur increased business continuity risks. We may no longer be able to
  exercise control over some aspects of software development and the development,
  support or maintenance of operations and processes, including the internal controls
  associated with our business operations and processes, which could adversely
  affect our business.If
  we are unable to effectively develop and implement our outsourcing strategy,
  we may not realize cost structure efficiencies and our operating and financial
  results could be materially adversely affected. In addition, if our third party
  service providers experience business difficulties or are unable to provide
  the services as anticipated, we may need to seek alternative service providers
  or resume providing such services internally which could be costly and time
  consuming and have an adverse material effect on our operating and financial
  results.

Our ability to accurately forecast our quarterly sales is limited, although our costs are relatively fixed in the short term, and we expect our business to be affected by rapid technological change, which may adversely affect our quarterly operating results.

Our
  ability to accurately forecast our quarterly sales is limited, which makes it
  difficult to predict the quarterly revenues that we will recognize. In addition,
  most of our operating expenses are for personnel and facilities, which are relatively
  fixed in the short term. If we have a shortfall in revenues in relation to our
  expenses, we may be unable to reduce our operating expenses quickly enough to
  avoid losses. As a result, our quarterly operating results could fluctuate.

Future
  operating results will continue to be subject to quarterly fluctuations based
  on a wide variety of factors, including:



        Linearity - Our quarterly sales have historically reflected a pattern in which a disproportionate percentage of sales occur in the last month of the quarter due to typical customer buying patterns in the IT industry. This pattern makes prediction of revenues and earnings for each financial period especially difficult and uncertain and increases the risk of unanticipated variations in quarterly results and financial condition;




        Significant Orders - We are subject to variances in our quarterly operating results because of the fluctuations in the timing of our receipt of large orders. If even a small number of large orders are delayed until after a quarter ends, or do not materialize, our operating results could vary substantially from quarter to quarter and net income could be substantially less than expected. Conversely, if even a small number of large orders are completed in an earlier quarter than that which was anticipated, our revenues and net income could be substantially higher than expected, making it possible that sales and net income in future periods may decline sequentially. Further, if orders substantially exceed predicted demand, we may not be able to fulfill all of the orders received in the last few weeks of the quarter;




        Seasonality  We have experienced seasonal reductions in business activity in some quarters based upon customer activity and based upon our partners seasonality. This pattern has generally resulted in lower sales in our first and third quarters than in the prior sequential quarters; and





      Stock-based
          compensation expense - Starting in the quarter ended, September 30, 2005,
          we began recording stock-based compensation expense as calculated under
          SFAS No. 123R. The non-cash impact of stock-based
          compensation expense during fiscal 2006 was $3.4 million and is expected
          to be $3.3 million in fiscal 2007. Such amounts may change as a result
          of additional grants, forfeitures, modifications in assumptions and
          other factors.


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There
  are factors that may affect the market acceptance of our products, some of which
  are beyond our control, including the following:



        the growth and changing requirements of the thin client segment of the PC market;




        the quality, price, performance and total cost of ownership of our products compared to personal computers;




        the availability, price, quality and performance of competing products and technologies; and




        the successful development of our relationships with software providers, original equipment manufacturers and existing and potential channel partners.


We
  may not succeed in developing and marketing our software and thin client device
  products and our operating results may decline as a result. Additionally, we
  plan to increase our sales and marketing expenses for our products and these
  efforts may not proportionately increase our sales, resulting in reduced profitability.

Our inventory management is complex as we sell a significant mix of products and our revenues and gross margins could suffer if we fail to manage the issues properly.

We must manage inventory effectively, which involves forecasting demand and pricing issues. Demand is difficult to forecast since it depends on many factors, including pricing, changes in customer buying patterns and changes in competition. Significant unanticipated fluctuations in demand, the timing and disclosure of new product releases or the timing of key sales orders could result in costly excess inventories or the inability to secure sufficient quantities of our products to satisfy customer demand. To the extent we manufacture products in anticipation of future demand that does not materialize, or in the event a customer cancels or reduces outstanding orders, we could experience an unanticipated increase in our inventory as occurred in the first quarter of fisical 2007 and which we expect will continue through December 2006. This could adversely impact our revenues, gross margins and financial condition.
Our use of indirect distribution methods may reduce visibility to demand and pricing issues, and therefore make forecasting more difficult. If we have excess or obsolete inventory, we may have to reduce our prices or write down inventory to market value.

Our gross margins can vary significantly, based upon a variety of factors. If we are unable to sustain adequate gross margins we may be unable to reduce operating expenses in the short term, resulting in losses.

Our
     gross margins can vary significantly from quarter to quarter depending on
    average
  selling prices, fixed costs in relation to revenue levels and the mix of our
     business, including the percentage of revenues derived from variousthin client device models, software, third party products
   and consulting services. Our gross profit margin also varies in response to

  competitive market conditions as well as periodic fluctuations in the cost
  of  memory and other significant components. The PC market in which we compete
  remains
  very competitive, and although we intend to continue our efforts to reduce
  the  cost of our products, there can be no certainty that we will not be required

  to reduce prices of our products without compensating reductions in the cost
   to produce our products in order to maintain or increase our market share
  or
  to meet competitors price reductions. Our marketing strategy is targeted
   at increasing the size of the thin client segment of the PC industry, in part

  by lowering prices to make thin clients more competitive with personal computers,
   and in addition by selling a larger percentage of products to large enterprise

  customers, who typically demand lower prices because of their volume purchases.
   This strategy has resulted in, and the implementation of our new sales and
  marketing
  initiatives may in the future result in, a decline in our gross margin. Additionally,
   we have certain products, including our e900 thin client product line, which

  has higher average selling prices but lower gross margin percentages than our
   traditional products.If our
    sales do not continue to increase as a result of these strategies, our profitability

  will decline, and we may experience losses. Finally, our gross margins may
   decline  if it is necessary for us to reduce the prices of our products as
   a result of
  excess inventory.

During the past several years, we have increased operating expenses significantly as a foundation for us to stimulate our growth and growth in our market, and we expect to increase our operating expenses during fiscal 2007, including increases needed to implement our new sales and marketing initiatives. If we do not increase revenues or appropriately manage further increases in operating expenses, our profitability will suffer.

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Our
  business has grown through both internal expansion and business acquisitions,
  and, as a result, we have significantly increased our operating expenses. If
  our revenues fail to increase as we increase our operating expenses, our profits
  may decline. Additionally, this growth has put pressure on our infrastructure,
  internal systems and managerial resources. The number of our employees increased
  from 140 full-time employees at August 31, 2005 to 179 full-time employees at
  August 31, 2006. Our new employees include a number of senior executive officers
  and other key managerial, technical, sales and marketing personnel, as well
  as international employees, and we intend to hire a significant number of additional
  sales and marketing personnel during fiscal 2007. To manage our growth effectively,
  we must continue to improve and expand our infrastructure, including operating
  and administrative systems and controls, and continue managing and integrating
  our personnel in an efficient manner. Our business may be adversely affected
  if we do not integrate and train our new employees quickly and effectively and
  coordinate among our executive, engineering, finance, marketing, sales, operations
  and customer support organizations. In addition, because of the growth of our
  international operations, we now have facilities located in multiple countries,
  and we have limited experience coordinating a geographically separated organization.
  If we are unable to effectively manage our growth, our business and operating
  results could be adversely affected.

We may not generate sufficient future taxable income to allow us to realize our deferred tax assets.

We have a significant amount of U.S. Federal tax loss carryforwards that will be available to reduce the taxes we would otherwise owe in the future. We have recognized the value of these future tax deductions in our consolidated balance sheets. The realization of our deferred tax assets is dependent upon our generation of future taxable income during the periods in which we are permitted, by law, to use those assets. We exercise judgment in evaluating our ability to realize the recorded value of these assets, and consider a variety of factors, including the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Our evaluation of the realizability of deferred tax assets must consider both positive and negative evidence, and the weight given to the potential effects of positive and negative evidence is based on the
extent to which the evidence can be verified objectively. While we believe that sufficient positive evidence exists to support our determination that the realization of our deferred tax assets is more likely than not, we cannot guarantee profitable U.S operations in the future that will allow us to fully realize those assets.

Our business may suffer if it is alleged or found that we have infringed the intellectual property rights of others.

In
  the course of our business, we receive notices from third parties claiming that
  we are infringing upon their intellectual property rights. We evaluate the validity
  of the claims and determine whether we will negotiate licenses to use the technology.
  Even if we believe that the claims are without merit, responding to such claims
  can be time consuming, result in costly litigation, divert managements
  attention and resources and cause us to incur significant expenses. There is
  no assurance, in the event of such claims, that we would be able to enter into
  a licensing arrangement on acceptable terms or that litigation would not occur.
  In the event that there were a temporary or permanent injunction entered prohibiting
  us from marketing or selling certain of our products, or a successful claim
  of infringement against us requiring us to pay royalties to a third party, and
  we failed to develop or license a substitute technology, our business, results
  of operations or financial condition could be materially adversely affected.

In
  addition, certain products or technologies developed by us, including for example
  the Linux-based products, may incorporate so-called open source
  software. Open source software is typically licensed for use at no initial charge,
  but certain open source software licenses impose on the licensee of the applicable
  open source software certain requirements to license or make available to others
  both the open source software as well as the software that relates to, or interacts
  with, the open source software. Our ability to commercialize products or technologies
  incorporating open source software may be restricted as a result of using such
  open source software because, among other reasons:



        open source license terms may be ambiguous and may result in being subject to unanticipated obligations regarding our products and technologies;




        competitors may have improved access to information that may help them develop competitive products;





      open
          source software cannot be protected under trade secret law; and




        it may be difficult for us to accurately determine the origin of the open source code and whether the open source software in fact infringes third party intellectual property rights.


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Thin
  client device products, like personal computers, are subject to rapid technological
  change due to changing operating system software and network hardware and software
  configurations, and our products could be rendered obsolete by new technologies.

The
  PC market is characterized by rapid technological change, frequent new product
  introductions, uncertain product life cycles, changes in customer demands and
  evolving industry standards. Our products could be rendered obsolete if products
  based on new technologies are introduced or new industry standards emerge.

If we are unable to rapidly and successfully develop and introduce new products and manage our inventory, we will not be able to satisfy customer demand.

We operate in a highly competitive, quickly changing environment, and our future success depends on our ability to develop and introduce new products that our customers choose to buy. If we are unable to develop new products, our business and operating results could be adversely affected. We must quickly develop, introduce and deliver new software and hardware products. If we fail to accurately anticipate our customers needs and technological trends, or are otherwise unable to complete the development of a product on a timely basis, we will be unable to introduce new products into the market on a timely basis, if at all, and our business and operating results would be materially and adversely affected.

Once we have developed a new product, we must be able to manufacture new products in sufficient volumes so that we can have an adequate supply of new products to meet customer demand. Forecasting demand requires us to predict order volumes, the correct mix of our products and the correct configurations of these products. We must manage new product introductions and transitions to minimize the impact of customer-delayed purchases of existing products in anticipation of new product releases. We must also try to reduce the levels of older product and component inventories to minimize inventory write-offs. If we have excess inventory, due to discontinued sales of specific products to new customers as we had at September 30, 2006, it may be necessary to reduce our prices or write down inventory, which could result in lower gross margins.  Additionally, our customers may delay orders for existing products in anticipation of new product introductions, such as may be the case with the introductions of Microsofts Vistro operating systems. As a result,
we may decide to adjust prices of our existing products during this process to try to increase customer demand for these products. Our future operating results would be materially and adversely affected if such pricing adjustments were to occur and we were unable to mitigate the resulting margin pressure by maintaining a favorable mix of hardware, software and services, or if we were unsuccessful in achieving cost reductions, operating efficiencies and increasing sales volumes.

We
  may not be able to preserve the value of our products intellectual property
  because other vendors could challenge our intellectual property rights.

Our
  products are differentiated from those of our competitors by our internally
  developed technology that is incorporated into our products. We rely upon patent,
  copyright, trademark and trade secret laws in the United States and similar
  laws in other countries, and agreements with our employees, customers, suppliers
  and other parties, to establish and maintain our intellectual property rights.
  However, any of our intellectual property rights could be challenged, invalidated
  or circumvented, which could result in costly product redesign efforts, discontinuance
  of certain product offerings or other competitive harm. Further, the laws of
  certain countries do not protect our proprietary rights to the same extent as
  do the laws of the United States. Therefore, in certain jurisdictions in which
  we operate or in which we have outsourced operations we may be unable to protect
  our proprietary technology adequately against unauthorized third-party copying
  or use, which could adversely affect our competitive position and cause us to
  incur substantial legal fees. If we are unable to protect our intellectual property,
  other vendors could sell products with features similar to ours, and this could
  reduce demand for our products, which would harm our operating results.

We
  may not be able to effectively compete against PC and thin client providers
  as a result of their greater financial resources and brand awareness.

In
  the desktop PC market, we face significant competition from makers of traditional
  personal computers, many of which are larger companies that have greater name
  recognition than we have. In addition, we face significant competition from
  thin client providers, including Hewlett Packard, Wyse Technology and other,
  smaller companies. Increased competition may negatively affect our business
  and future operating results by leading to price reductions, higher selling
  expenses or a reduction in our market share. Our strategy to seek to increase
  our share of the overall PC market by targeting our core markets may create
  increased pressure, including pricing pressure, on certain of our thin client
  device products. While we believe that this will enable us to increase our revenues,
  there is no assurance that we will be successful in this approach. In fact,
  our implementation of this strategy may result in reductions in gross and operating
  margins as we compete to attract business. Our inability to successfully implement
  this strategy could have an adverse impact on our revenues.

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Our
  future competitive performance depends on a number of factors, including our
  ability to:



        continually develop and introduce new products and services with better prices and performance than offered by our competitors in the PC market;





      offer a wide range of products; and





      offer high-quality products and services.


If
  we are unable to offer products and services that compete successfully with
  the products and services offered by our competitors in the PC market, our business
  and our operating results would be harmed. In addition, if in responding to
  competitive pressures, we are forced to lower the prices of our products and
  services and we are unable to reduce our costs, our business and operating results
  would be harmed.

As the market for our products and services continues to develop, additional companies, including companies with significant market presence in the computer software, hardware and networking industries, could enter the market in which we compete and further intensify competition. In addition, we believe that price competition could become a more significant competitive factor in the future. As a result, we may not be able to maintain our historic prices and margins, which could adversely affect our business, results of operations and financial condition.

Actions taken by the SCO Group (SCO) could impact the sale of our Linux products, negatively affecting sales of some of our products.

SCO
  has taken legal action against IBM and certain other corporations, and sent
  letters to Linux customers alleging that certain Linux kernels infringe on SCOs
  Unix intellectual property and other rights, and that SCO intends to aggressively
  protect those rights. While we are not a party to any legal proceeding with
  SCO, since some of our products use Linux as their operating system, SCOs
  allegations, regardless of merit, could adversely affect sales of such products.
  SCO has brought claims against certain end user customers of the Linux operating
  system and threatened to bring claims against other end-users of Linux for copyright
  violations arising out of the facts alleged in SCOs lawsuit against IBM.
  Some of these claims could be indemnified under indemnities we have given or
  may give to certain customers. In the event that claims for indemnification
  are brought against the customers that we have indemnified, we could incur expenses
  reimbursing the customers for their costs, and if the claims were successful,
  for damages.

In
  order to continue to grow our revenues, we may need to hire additional executives
  and personnel.

In
  order to continue to develop and market our line of thin client devices, we
  may need to hire additionalexecutives
  and other personnel, including the additional sales and marketing employees
  we plan to hire to help implement our sales and marketing initiatives. Competition
  for employees is significant and we may experience difficulty in attracting
  qualified people.

Future
  growth that we may experience will place a significant strain on our management,
  systems and resources. To manage the anticipated growth of our operations, we
  may be required to:


      improve
          existing and implement new operational, financial and management information
          controls, reporting systems and procedures;



      hire,
          train and manage additional qualified personnel; and



      establish
          relationships with additional suppliers and partners while maintaining
          our existing relationships.


We
  rely on the services of certain key personnel, and those persons knowledge
  of our business and technical expertise would be difficult to replace.

Our
  products, technologies and operations are complex and we are substantially dependent
  upon the continued service of our existing personnel. The loss of any of our
  key employees could adversely affect our business and profits and slow our product
  development processes. We generally do not have employment contracts, including
  non-competition agreements, with our key employees. Further, we do not maintain
  key person life insurance on any of our employees.

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If
  we determine that any of our goodwill or intangible assets, including technology
  purchased in acquisitions, are impaired, we would be required to take a charge
  to earnings, which could have a material adverse effect on our results of operations.

As
  a result of our completed and potential future acquisitions, we anticipate that
  we may have a significant amount of goodwill and other intangible assets, such
  as product and core technology, related to these acquisitions. We periodically
  evaluate our intangible assets, including goodwill, for impairment. As of September
  30, 2006, we had $38.1 million of goodwill and $11.3 million of intangible assets.
  We review for impairment annually, or sooner if events or changes in circumstances
  indicate that the carrying amount could exceed fair value. Fair values are based
  on discounted cash flows using a discount rate determined by our management
  to be consistent with industry discount rates and the risks inherent in our
  current business model. Due to uncertain market conditions and potential changes
  in our strategy and product portfolio, it is possible that the forecasts we
  use to support our goodwill could change in the future, which could result in
  non-cash charges that would adversely affect our results of operations and financial
  condition. If impairment is deemed to exist, we would write down the recorded
  value of these intangible assets to their fair values and our stock price and
  operating results could be materially adversely affected.

We might repatriate cash from our foreign subsidiaries, which could result in additional income taxes that could negatively impact our results of operations and financial position. In addition, if foreign countries currency policies limit our ability to repatriate the needed funds, our business and results of operations could be adversely impacted.

One
  or more of our foreign subsidiaries may hold a portion of our cash and cash
  equivalents. Although our intention is to reinvest the earnings of our international
  subsidiaries permanently, if we need additional cash to acquire assets or technology,
  or to support our operations in the United States, and if the currency policies
  of these foreign countries allow us, we might repatriate some of our cash from
  these foreign subsidiaries to the United States. Depending on our financial
  results and the financial results of our subsidiaries at the time that the cash
  is repatriated, we may incur additional income taxes from the repatriation,
  which could negatively affect our results of operations and financial position.
  In addition, if the currency policies of these foreign countries prohibit or
  limit our ability to repatriate the needed funds, our business and results of
  operations could be adversely impacted.

Although
  we have generated operating profits for the past five fiscal years, we have
  a prior history of losses and may experience losses in the future, which could
  result in the market price of our common stock declining.

Although
  we have generated operating profits in the past five fiscal years, we incurred
  net losses in prior periods and in the quarter ended September 30, 2006. We expect
  to continue to incur significant operating expenses. Our operating expenses
  are expected to increase in the future reflecting the hiring of additional key
  personnel as we continue to implement our growth strategy and our planned investment
  in continuing to commercialize the technologies we have acquired. As a result,
  we will need to generate significant revenues and gross profit margin to maintain
  profitability. If we do not maintain profitability, the market price for our
  common stock may decline.

Our
  financial resources may not be enough for our capital and corporate development
  needs, and we may not be able to obtain additional financing. A failure to maintain
  and increase our revenues would likely cause us to incur losses and negatively
  impact the price of our common stock.

Because some of our products use embedded versions of Microsoft Windows as their operating system, an inability to license these operating systems on favorable terms could impair our ability to introduce new products and maintain market share.

We
  may not be able to introduce new products on a timely basis because some of
  our products use embedded versions of Microsoft Windows as their operating system.
  Microsoft provides Windows to us, and we do not have access to the source code
  for certain versions of the Windows operating system. If Microsoft fails to
  continue to enhance and develop its embedded operating systems, or if we are
  unable to license these operating systems on favorable terms, or at all, our
  operations may suffer.

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Because some of our products use Linux as their operating system as well as other open source technologies, the failure of open source developers to enhance and develop open source software that we use could impair our ability to release new products and maintain market share.

We may not be able to release new products on a timely basis because some of our products use Linux as their operating system and include other open source software. Much of the open source software we use is maintained by third parties. If this group of developers fails to further develop the software, we would have to either rely on other parties to further develop this software or develop it ourselves, which would increase our costs and slow our development efforts.

If our contracts with Citrix and other vendors of software applications were terminated, our business would be materially adversely affected.

Our thin client devices include our own software, plus software from other companies. We depend on third-party suppliers to provide us with key software applications in connection with our business. If such contracts and relationships were terminated, our revenues would be negatively affected.

Unforeseen environmental costs could impact our future earnings.

The European Union (EU) has adopted a directive to facilitate the recycling of electrical and electronic equipment sold in the EU. The Waste Electrical and Electronic Equipment (WEEE) directive directs EU member states to enact laws, regulations and administrative provisions to ensure that producers of electrical and electronic equipment are financially responsible for specified collection, recycling, treatment, and environmentally sound disposal of products placed on the market after August 13, 2005, and from products in use prior to that date that are being replaced. The EU has also adopted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (RoHS) directive. The RoHS directive restricts the use of lead, mercury, and certain other substances in electrical and electronic products placed on the
market in the European Union after July 1, 2006. As a result of these obligations, our product distribution costs may increase and may adversely impact our financial condition. We have implemented these directives during fiscal 2006. Similar legislation has been or may be proposed or enacted in other areas, including in the United States and China, the cumulative impact of which could be significant if we are unable to recover our costs to comply with these laws in the price of our products.

Recent and proposed regulations related to equity compensation could adversely affect our ability to attract and retain key personnel and affect our operating results.

We have historically used stock options as a key component of our employee compensation program. We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value, and, through the use of vesting, encourage employee retention and allow us to provide competitive compensation packages, although in recent periods many of our employee stock options have had exercise prices in excess of our stock price, which could affect our ability to retain or attract present and prospective employees. The adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R) requires all share-based payments to employees, including grants of stock options, to be recognized in the financial statements based on their fair values beginning with the first annual period
beginning after June 15, 2005. We adopted SFAS No. 123R in the first quarter of fiscal 2006 and it has had a material impact on our financial statements. In addition, rules implemented by The NASDAQ Global Market requiring stockholder approval for all stock option plans, as well as regulations implemented by the New York Stock Exchange prohibiting NYSE member organizations from voting on equity-compensation plans unless the beneficial owner of the shares has given voting instructions, could make it more difficult for us to grant options to employees in the future. As a result of these regulations, we may change our equity compensation strategy, which may make it more difficult to attract, retain and motivate employees, each of which could materially and adversely affect our business.

In the event we are unable to satisfy regulatory requirements relating to internal controls over financial reporting, or if these internal controls are not effective, our business and financial results may suffer.

The Sarbanes-Oxley Act of 2002 and newly enacted rules and regulations of the Securities and Exchange Commission and the National Association of Securities Dealers impose new duties on us and our executives, directors, attorneys and independent registered public accountants. In order to comply with the Sarbanes-Oxley Act and such new rules and regulations, we have recently completed our evaluation of our internal control over financial reporting to allow management to report on, and our independent registered public accounting firm to attest to, our internal control over financial reporting. As a result, we have incurred additional expenses and diversion of managements time, which increased our operating expenses and accordingly reduced our net income. While our evaluation resulted in our conclusion that as of June 30, 2006 our internal control over financial reporting
was effective, we cannot be certain as to the outcome of our testing in future periods. If we do not maintain effective internal control over financial reporting, it could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which ultimately could negatively impact the market price of our shares.

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Errors in our products could harm our business and our operating results.

Because our software and thin client device products are complex, they could contain errors or bugs that can be detected at any point in a products life cycle. Although many of these errors may prove to be immaterial, any of these errors could be significant. Detection of any significant errors may result in:



        the loss of or delay in market acceptance and sales of our products;




        diversion of development resources;




        injury to our reputation; or




        increased maintenance and warranty costs.


These problems could harm our business and future operating results. Occasionally, we have warranted that our products will operate in accordance with specified customer requirements. If our products fail to conform to these specifications, customers could demand a refund for the purchase price or assert claims for damages.

Moreover, because our products are used in connection with critical distributed computing systems services, we may receive significant liability claims if our products do not work properly. Our agreements with customers typically contain provisions intended to limit our exposure to liability claims. However, these limitations may not preclude all potential claims and, from time-to-time, we enter into contractual arrangements under which we agree to indemnify a customer for certain losses it may incur. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. Any such claims, whether or not successful, could seriously damage our reputation and our business.

Our stock price can be volatile.

Our stock price, like that of other technology companies, can be volatile. For example, our stock price can be affected by many factors such as: quarterly increases or decreases in our revenues or earnings, changes in revenues or earnings estimates or publication of research reports by analysts; speculation in the investment community about,or actual changes in, our executive team, our financial condition or results of operations and changes in revenue or earnings estimates; the announcement of new products, technological developments, alliances, acquisitions or divestitures by us or one of our competitors. In addition, general macroeconomic and market conditions unrelated to our financial performance may also affect our stock price.

The issuance of additional equity securities may have a dilutive effect on our existing stockholders and could lead to a decline in the price of our common stock.

Any additional issuance of equity securities, including for acquisitions, may have a dilutive effect on our existing stockholders. In addition, the perceived risk associated with the possible sale of a large number of shares could cause some of our stockholders to sell their stock, thus causing the price of our stock to decline. Subsequent sales of our common stock in the open market or the private placement of our common stock or securities convertible into common stock could also have an adverse effect on the market price of the shares. If our stock price declines, it may be more difficult or we may be unable to raise additional capital.

Provisions in our charter documents and Delaware law may delay or prevent acquisition of us, which could decrease the value of your shares.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. These provisions include advance notice procedures with respect to stockholder proposals and the nomination of candidates for election as directors. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock.

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Item
          6.

        Exhibits


The following exhibits are being filed as part of this quarterly report on Form 10-Q:



Exhibit

        Number

        

        Description10.1

        

        Employment
    Offer Letter between the Company and Michael Kantrowitz dated October 18,
    2005.10.2

        

        Separation Agreement and General Release of All Claims between the Company and Roy Zatcoff dated September 21, 2006.10.3

        

        Termination and Service Agreement between the Company and Michael Kantrowitz dated October 30, 2006.10.4

        

        Employment
    Offer Letter for the position of Chief Executive Officer between the Company
    and Klaus P. Besier dated October 30, 2005.31.1

        

        Certification of Klaus Besier as President and Chief Executive Officer of Neoware, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2

        

        Certification of Keith D. Schneck as Executive Vice President and Chief Financial Officer of Neoware, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1

        

        Certification of Klaus Besier as President and Chief Executive Officer of Neoware, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2

        

        Certification Keith D. Schneck as Executive Vice President and Chief Financial Officer of Neoware, Inc pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


---



        Management contract or arrangement.


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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 thereunder duly authorized.



NEOWARE, INC.Date:  November 9, 2006

        

        

        By: /s/ KLAUS BESIERKlaus BesierPresident and Chief Executive Officer




Date:  November 9, 2006

        

        

        By: /s/ KEITH D. SCHNECKKeith D. SchneckExecutive Vice President and Chief Financial Officer


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