** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

##### **FORM 10-K**

**(MarkOne)**
| **x**      | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------|------------|---------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                    |
|       | ** ** | **For the  fiscal year ended: JULY 2, 2006**                                                       |
|       |       |                                                                                                    |
| ** ** | ** ** | **OR**                                                                                                  |
|       |       |                                                                                                    |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 or  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from            to            **

**Commission File Number:  000-22071**

**OVERLAND STORAGE, INC.**

(Exact name of registrant as specified in its charter)

| **CALIFORNIA**                                  |   | **95-3535285**                     |
|-------------------------------------------------|--------|------------------------------------|
| (State or other  jurisdiction of incorporation) |   | (IRS Employer  Identification No.) |

 

**4820Overland Avenue, San Diego, California 92123**

(Address of principal executive offices, including zipcode)

**(858)571-5555**

(Registrant’s telephone number, including area code)

Securities registered pursuant toSection 12(b) of the Act:
| Title of each class         | ** ** | **Name of each exchange on which registered** |
|-----------------------------|------------|-----------------------------------------------|
| Common Stock, no  par value |       | The NASDAQ  Global Market                     |

 

Securities registered pursuant toSection 12(g) of the Act: None

Indicate by check markwhether the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act. Yes  o   No  x

Indicate by check mark if the registrant is not required to file reportspursuant to Section 13 or Section 15(d) of the Act. Yes  o   No  x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes  x   No  o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, tothe best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition of  “accelerated filer and large acceleratedfiler” in Rule 12b-2 of the Exchange Act. (Check one):
| Large  accelerated filer o |   | Accelerated filer x |   | Non-accelerated filer o |
|----------------------------|--------|---------------------|--------|-------------------------|

 

Indicate by check mark whether the registrant is a shell company (asdefined by Rule 12b-2 of the Act). Yes  o   No ý

The aggregate market value of the voting stock held by non-affiliates ofthe registrant as of December 30, 2005, the last business day of the registrant’ssecond fiscal quarter, was approximately $71,875,048 (based on the closingprice reported on such date by The NASDAQ Global Market of the registrant’sCommon Stock). Shares of Common Stock held by officers and directors andholders of 5% or more of the outstanding Common Stock have been excluded fromthe calculation of this amount because such persons may be deemed to beaffiliates. This determination of affiliate status is not necessarily aconclusive determination for other purposes.

As of September 8, 2006, the number of outstanding shares of theregistrant’s Common Stock was 12,981,283.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portionsof the Proxy Statement to be filed in connection with registrant’s AnnualMeeting of Shareholders to be held on November 14, 2006 (the “ProxyStatement”) are incorporated herein by reference into Part III of thisReport.

 

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### **PART I**

**ITEM 1. Business.**

*This report contains certain statements of aforward-looking nature relating to future events or the future performance ofour company. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,”“seeks,” “estimates,” “currently scheduled” and similar expressions orvariations of such words are intended to identify forward-looking statements,but are not the only means of identifying forward-looking statements.Prospective investors are cautioned that such statements are only predictionsand that actual events or results may differ materially. In evaluating suchstatements, prospective investors should specifically consider various factorsidentified in this report, including the matters set forth below under thecaption “Risk Factors,” which could cause actual results to differ materiallyfrom those indicated by such forward-looking statements.*

#### **General**

Overland was originally foundedand incorporated as Overland Data, Inc. in California in 1980. InJune 2002, we changed our name to Overland Storage, Inc.

Our principal executive officesare located at 4820 Overland Avenue, San Diego, California 92123, and ourtelephone number is 858-571-5555. For over 25 years we have delivered dataprotection solutions designed for backup and recovery to ensure businesscontinuity. Historically, we have focused on delivering a portfolio of tapeautomation solutions including loader and library systems designed for smallbusiness and midrange computing environments. Beginning with the June 2003acquisition of Okapi Software, Inc. (Okapi or Okapi Software), aprivately-owned company based in San Diego, California, we expanded our product offerings to include a family of intelligentdisk-based backup and recovery appliances to complement our tape solutions. InAugust 2005, we acquired Zetta Systems, Inc. (Zetta or Zetta Systems), aprivately-owned company based in the Seattle, Washington area, and haveincorporated the Zetta technology into a new line of protected primarydisk-based storage appliances.

One of the main marketdifferentiators of many of our products has been that we design them around amodular, scalable architecture. This enables customers to purchase storage asthey need it, rather than having to purchase larger monolithic devices withexcess capacity. Customers can purchase an initial module to meet theirnear-term needs, and later increase speed and capacity by adding modules thatcan be interconnected to function as a single system. This provides a lowerprice entry point, investment protection, and an increased level of faulttolerance, as each module is self-sufficient and will continue to function evenif another were to fail.

We also differentiate ourselveswith our “go-to-market” approach. We are the only supplier in our market spacethat does not have a direct sales force. The majority of our sales havehistorically been generated through private label arrangements with originalequipment manufacturers (OEMs). The remainder of our sales are made throughcommercial distributors and value-added resellers (VARs).

End-users of our productsinclude small and midsize businesses, as well as divisions and operating unitsof large multi-national corporations, governmental organizations, universitiesand other non-profit institutions. Our products are used in a broad range ofindustry sectors including financial services, healthcare, retail,manufacturing, telecommunications, broadcasting, research and development andmany others. Our products are sold world-wide in the Americas, EMEA (Europe,Middle East, Africa) and Asia Pacific. Approximately 56.5% of our revenue isgenerated internationally, primarily in Europe.

Our Internet address is www.overlandstorage.com. Wemake available free of charge on our Internet website our annual report onForm 10-K, quarterly reports on Form 10-Q, current reports onForm 8-K, and amendments to those reports filed pursuant toSection 13(a) or 15(d) of the Securities Exchange Act as soon asreasonably practicable after we electronically file such material with, orfurnish it to, the Securities and Exchange Commission. The contents of ourwebsite are not a part of this report.

#### **OurDirection and Strategy**

Our strategy is to become amarket leader and innovative supplier of a complete portfolio of tiered datastorage solutions by providing intelligent storage appliances with embeddedprotection software designed to work together to ensure that information is “automaticallysafe, readily available and always there.” We intend to deliver products to address all three tiers of datastorage:  protected primary disk,secondary disk-based backup and tertiary automated tape libraries for archival.Our focus will continue to be on mid-range solutions that can be easily soldworldwide through OEMs and our indirect network of distributors and resellers.We intend to leverage our leadership position in mid-range tape automation intoa similar position in primary and secondary intelligent disk-based appliances.

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Historically, magnetic tape hasbeen used for all forms of data backup and recovery, because magnetic tape was,and still is, the only reliable, “removable”, high capacity storage media thatcan be taken off-site to ensure that data is safeguarded in case of disaster.For a number of years now, Overland has held a market-leading position inmid-range tape automation, and sales of tape automation appliances haverepresented more than 90% of our revenue for each of the last three fiscalyears.  In the fourth quarter of fiscal2005 we commenced development of ARCvaultTM, a new tape automation platform that will spawnseveral new price competitive products. The first of these products waslaunched in July 2006 with the others to be delivered to market during theremainder of fiscal 2007. Although we expect that tape solutions will continueto be the anchor of the data protection strategy at most companies, tape backupis time consuming and often unreliable and inefficient. The process ofrecovering data from tape is also time consuming and inefficient. Ultimately,we expect that tape will likely be relegated to an archival role forless-frequently accessed data.

Over thelast few years, the advent of low-cost serial ATA disk and iSCSI networkingtechnology, together with greatly increased regulatory compliance requirements andthe continued growth of digital data have driven businesses to use secondarystorage disk-based backup appliances. One of the greatest benefits ofdisk-based backup is the speed of restoration. Studies show that approximately90% of recovered data is two weeks old or younger, or last accessed within thatperiod. As a result, many IT managers are electing to use disk-based appliancesas an intermediate staging area, with the backup data eventually moving totape. We have enjoyed initial success in this relatively new market space withour REO disk-based backup solutions, and we believe there is significantpromise for future growth.

Inaddition to daily or periodic backup, companies are also looking for ways toprotect their data continuously. Software protection is being applied toprimary storage devices through a combination of features including file andblock-based replication, near instantaneous snapshotting and virtualization. Weare now using the technology developed by Zetta Systems, which we acquired inAugust 2005, as the basis for ULTAMUSTM, a line of protected primarystorage appliances recently introduced to the market. This product line will bemarketed and sold through our existing branded sales channel. It will betargeted to the mid-market with a goal of delivering enterprise-classavailability, built-in data protection and exceptional performance at anaffordable price. The primary storage market is currently many times largerthan the secondary and tertiary storage markets, and we anticipate that theprimary storage market could be the source of a significant portion of our longterm revenue growth.

Successin the primary and secondary disk-based appliance markets will require us tointroduce a steady stream of new products that are feature-rich andcompetitively priced.

**Products**

Our current products andother offerings include:

·                  *Tape Automation* - Automated tape libraries are devicescapable of managing multiple data cartridges and incorporate two or more tapedrives to provide unattended backup of large quantities of data. Our librariesincorporate tape drives supplied by other manufacturers based on the leadingmid-range tape technologies, including LTO (Linear Tape Open) and DLTtape. Wecurrently offer the following tape automation products:

·                  *Scalable NEO SERIES****®*** – Weoffer 3 versions of our NEOTM product family:

·                  NEO 2000 can accommodate up to 2 tape drivesand 30 cartridges and can scale up to 8 modules high with 16 tape drives and240 cartridges.

·                  NEO 4000 can accommodate up to four tapedrives and 60 cartridges and can scale up to 4 modules high to comprise asystem of 16 tape drives and 240 cartridges. Customers can configure NEOsystems with a combination of NEO 2000 and 4000 modules.

·                  NEO 8000 consists of a base modelwith 100-cartridge capacity which can be scaled up to 500 cartridges through afield-enabled software key. Additionally, two NEO 8000s can be interconnectedto provide up to 1,000 cartridge capacity.

·                  *ARCvault*–Overland’s newest family of tape automation solutions is designed to deliverbetter value to a price sensitive market. We ultimately intend to deliver four products to the marketplace.  The following two products were launched in July 2006:

·                  ARCvault 12 autoloader consists of one tapedrive and can accommodate up to 12 cartridges.

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·                  ARCvault 24 tape library can accommodate upto two tape drives and 24 cartridges.

·                  *Disk-based Backup Products* – In August 2003, we beganshipping our REO SERIES***®*** ofdisk-based products based on the technology we received in the Okapi Softwareacquisition. The REOTM product familycurrently consists of three products:

·                  REO1000 with 4 disk drives and a native capacity of up to 2.0 terabytes;

·                  REO4000 with 8 disk drives and a native capacity of up to 4.0 terabytes; and

·                  REO9000 with 12 or 24 disk drives and a native capacity of up to 12.0terabytes.  The REO 9000 expansion arraycan be added to expand the capacity of an existing REO 9000 in increments of4.0 terabytes up to a maximum system capacity of 44.0 terabytes.

The strength of theseintelligent appliances lies in the embedded Protection OSTM software which enables them to be configuredas virtual tape libraries, dynamic virtual tape drives and/or disk LUN volumes.The optional REO Multi-Site PACTM software is also available to protect remotedata by facilitating the transfer of data in virtual tape format from a remoteREO to a central REO for management and tape storage.

·                  *Protected Primary Storage* – In July 2006, we launchedULTAMUS ProTM 500 with Protection OS based on the technologywe obtained in the Zetta Systems acquisition. ULTAMUS Pro 500 can be expanded to a raw capacity of 32.0 terabytes andis designed to protect data through snapshotting, block-level remotereplication for disaster recovery and virtualization for simplified management.

·                  *Related Products and Services*– We have a variety of productsand services supporting our tape libraries, PowerLoaders and loaders. Wecurrently offer the following additional products and services:

·                  Desktopand internal upgrade tape drives.

·                  Spares,post warranty return-to-factory and on-site service.

·                  Media,including tape cartridges for SDLT and LTO formats.

·                  *VR**2***®*** *(Variable RateRandomizer) – VR2* *is our patented dataencoding technology. Thistechnology, which is embedded in an Applications Specific Integrated Circuit(ASIC) chip, is capable of significantly increasing the native capacity anddata transfer rate performance of linear tape technologies without requiringany changes in tape path design, recording heads and/or media. This performanceis accomplished by achieving encoding efficiency of greater than 99%. We havelicensed VR2 to TandbergData ASA for use in its Scalable Linear Recording (SLR) tape drives, to ImationCorporation as the owner of the Travan technology format, to QuantumCorporation for use in its Travan tape drive offerings, and to Sun Storage Tekfor use in its T9940 and T9840 drives and future tape drive products.

**Customers**

Our operating structure isoptimized for our mid-range strategy in that our products do not require us tohave a “direct” (to end-users) sales or service force. We sell all ourproducts on an indirect basis, primarily through three channels or types ofcustomers: (i) OEMs; (ii) distributors and (iii) VARs.Regardless of the channel through which they are sold, all of our products aredesigned and manufactured to meet OEM-level requirements and reliabilitystandards.

·                  ***OEM Channel*** - Our significant OEMsupply agreements have been with Hewlett Packard Company (HP) and InternationalBusiness Machine Corporation (IBM), both of which incorporate our NEO productsinto their system offerings. Fujitsu Limited and NEC Corporation also purchaseNEO products and sell them under their respective labels. However, we arerequired to sell to them through their appointed reseller, and consequently weclassify them as VAR customers rather than OEM customers.

In August 2005, weannounced that HP had selected an alternate supplier for its next-generationmid-range tape automation products. HP began purchasing the first product ofthis new line from the alternate supplier during the first quarter of calendaryear 2006. Although HP will continue to purchase the tape automation productscurrently supplied by Overland for some time, the alternate supplier’s productwill eventually replace the majority of those purchases. We cannot predict howquickly this transition will occur, but believe the effect on our revenue infiscal 2007 will be significant.

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In November 2005, weannounced that Overland had been selected by a new-tier one OEM customer tosupply it with Overland’s next generation tape library. We expect this businessto contribute significantly to our revenue over the three-year life of thecontract. Shipments to this OEM customer are currently scheduled to commence inthe first half of fiscal 2007.

Although we continuallystrive to win new OEM business, the OEM sales cycle is often lengthy anduncertain. It typically consists of a general technology evaluation,qualification of product specifications, verification of product performanceagainst these specifications, integration testing of the product within thecustomers’ systems, product announcement and volume shipment.

As is customary in theindustry, our OEM contracts have an initial three-year term, provide forperiodic price reviews and the customers are not required to purchase minimumquantities. Our existing contracts with HP (initially signed inAugust 2003 and extended for up to three years in July 2006) and IBM(initially signed in November 2002 and extended through November 2006)also provide that title to inventory shipped from our warehouse into variousinventory hub locations remains with us until the products are pulled by HP orIBM to fulfill their customer orders. HP, including the former Compaq that HPacquired in May 2002, has been our largest customer, accounting forapproximately 49.7%, 54.3% and 58.8% of sales in fiscal 2006, 2005 and 2004,respectively. No other customer accounted for more than 10% of sales in anyyear during the three-year period ended June 30, 2006.

·                  ***Distribution Channel*** - Our primarydistribution customers include Bell Microproducts, Inc., IngramMicro, Inc. and Tech Data Corporation in the United States andapproximately eight technical distributors in Europe. Typically, thesedistributors sell our products to smaller VARs and catalogers who in turn sellto end-users. The distribution agreements include provisions for rights ofreturn, stock rotation and price protection, common terms in the commercialdistribution area. Because of these terms, revenue from shipments to thesecustomers is not recognized until the related products are in turn sold by thedistributor. We support these distributors through a dedicated field salesforce and provide further support through field sales personnel who work withthe smaller VARs and catalogers to generate end-user sales and create the pullthrough its distribution customers.

·                  ***VAR Channel*** - Our VAR channelincludes systems integrators and larger VARs. Some of our VARs qualify topurchase products direct from Overland while others purchase through thedistribution channel. Some of these customers specialize in the insurance,banking, financial, geophysical or medical industries, and offer a variety ofvalue-added services relating to our products. Our products frequently arepackaged by these customers as part of a complete data processing system orcombined with other storage devices, such as redundant array of independentdisks (RAID) systems, to deliver a complete storage subsystem. These customersalso recommend our products as replacement solutions when backup systems areupgraded, and bundle our products with storage management software specific tothe end-user’s system. We support this channel through our field sales representatives.

Our products aresold both domestically and internationally and we have sales personnel locatedin various cities throughout the world. We divide our sales into threegeographical regions: (1) the Americas, consisting of North and South America;(2) Europe, Middle East and Africa (EMEA); and (3) Asia Pacific(APAC). Primary support for customers in the Americas is provided from our SanDiego headquarters office. EMEA is supported by our wholly-owned subsidiarieslocated in Wokingham, England; Paris, France; and Munich, Germany. Thesubsidiary in England provides sales, technical support and repair services,while the subsidiaries in France and Germany provide sales and technicalsupport. Our APAC customers are supported by our sales offices in Singapore andKorea. We assign to our international distributors the right to sell ourproducts in a country or group of countries. In addition, many domesticcustomers ship a portion of our products to their overseas customers. Ourforeign sales for fiscal 2006, 2005 and 2004 were approximately $118.2 million,$138.5 million and $116.5 million, respectively, representing 56.5%, 58.8% and48.9%, respectively, of our total net revenue. Foreign sales in the UnitedKingdom and Singapore, primarily in our OEM channel, were approximately $47.9million and $22.9 million, respectively, in fiscal 2006, $65.8 million and$21.8 million, respectively, in fiscal 2005 and $67.2 million and $9.4 million,respectively, in fiscal 2004.

Ourmarketing efforts include support for both our OEM and branded customers. Ourbranded channel partners are provided with a full range of marketing materials,including product specification literature, software connectivity informationand application notes. In addition, Overland offers lead generationopportunities and market development funds to our key channel partners. Oursales management and engineering personnel provide support to the channelpartners and, in certain instances, visit potential customer sites to explainand demonstrate the technical advantages of our products. We maintain pressrelations both domestically and in Europe, and participate in national andregional trade shows in varying degrees both domestically and internationally.

Sales to customers outside of the United Statesrepresent a significant portion of our sales. International sales are subjectto various risks and uncertainties. See “Our international operations areimportant to our business and involve unique risks” in Risk Factors below.Sales generated by our European channel generally show seasonal slowing duringour first fiscal quarter (July through

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September),reflecting the summer holiday period in Europe.

**CustomerService and Support**

Our technical support personnel are trained on ourproducts, compatibility between multiple hardware platforms, operating systemsand backup, data interchange and storage management software and are equippedto respond to customer inquiries. Additionally, our application engineers areavailable to solve more complex customer problems. Customers that need serviceand support can contact us through our toll-free telephone lines, facsimile andInternet e-mail. Application notes and user manuals can be obtained directlyfrom our website.

We generally provide a three-year advance replacementreturn-to-factory warranty on our NEO SERIES, REO SERIES, PowerLoader® and LoaderXpress® products. We also provide on-site service,where available, for the first warranty year of the NEO SERIES products forwhich we contract with third-party service providers. For our ARCvault product,we offer a one-year advance replacement return-to-factory warranty. For mostproducts, we offer a program called XchangeNOW® as part of our return-to-factory warrantywhich enables customers to receive an advance replacement unit shipped withintwo business days after placing a service request. The customer ships thedefective unit back to us using the shipping materials from the replacementunit. Separately priced extended on-site warranties are offered for sale tocustomers. We contract with outside vendors to provide service relating to allon-site warranties.

**Researchand Development**

We incurred research anddevelopment (R&D) costs of $18.8 million, $10.7 million and $7.3 million infiscal 2006, 2005 and 2004, respectively, representing 9.0%, 4.5% and 3.0%,respectively of net revenue. Wecurrently employ 89 people in our R&D department, including electrical,mechanical, software, hardware and firmware engineers who support our products.In fiscal 2006, our development efforts were focused on three projects:(1) our new ARCvault tape automation platform; (2) our new ULTAMUSprotected primary storage appliance based on the technology we obtained in theAugust 2005 acquisition of Zetta Systems; and (3) the addition ofscalability to our current line of REO disk based backup and recoveryappliances. In fiscal 2007, we expect to complete the development of theARCvault tape automation products, including distinct versions of the productsfor our new OEM customer.  We also planto develop next generation platforms and follow-on products of REO andULTAMUS.  We expect R&D expendituresto decline throughout fiscal 2007 as these developments are completed.

#### **Manufacturingand Suppliers**

Historically, we havemaintained a fully integrated factory in San Diego, California. However, inSeptember 2004, in order to reduce our cost structure, increase ourflexibility and improve our focus on product development, we announced plans tooutsource all of our manufacturing to Sanmina-SCI Corporation (Sanmina). Thetransition of the manufacturing of all of our products to Sanmina’s Rapid City,South Dakota plant was completed in August 2005.

Since then, we havepurchased completed products from Sanmina. Sanmina has generally been responsiblefor procuring all raw materials and producing the products to meet ourspecifications. However, we continue to purchase tape drives and certainprinted circuit boards (PCBs), which are incorporated into our tape automationproducts, and consign the drives and PCBs to Sanmina. Tape drives are the mostexpensive material component of these products and consignment enables us toavoid an additional markup from Sanmina. For a small portion of our tape driverequirements, we qualify only a single source, which can magnify the risk ofshortages and decrease our ability to negotiate with our suppliers on the basisof price. Fromtime to time in the past, we have not obtained as many drives as we have neededfrom various vendors due to drive shortages or quality issues.

During fiscal 2006, we failed to achieve thecustomer service levels, product quality and cost reductions we expected fromthe outsourcing.  Additionally, weincurred a significant amount of redundant costs to support the outsourcingwhich eroded our gross margins during the year. As a consequence, we have decided to bring manufacturing back to our SanDiego facility.  As of July 2006, we aremanufacturing our new ARCvault product in San Diego, and our plan calls for thetransition of all products back to San Diego by December 31, 2006.

In general,Overland-branded products are not manufactured until an order is received. Thetypical lead-time for manufacturing products is three to five days and backlogis generally not a significant factor to our business. Our two largest OEMcustomers, HP and IBM, have both required that we maintain inventory on hand,known as buffer stock, at any given time sufficient to supply their forecastedrequirements for the next three weeks. They provide weekly forecast informationthat allows us to manage both raw material and finished goods inventories. Thebuffer stock is shipped into various distribution hubs around the world and weretain ownership of that inventory until it is pulled by HP or IBM to fulfillcustomer orders, at which time revenue is recognized.

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**Competition**

The worldwide storage market isintensely competitive and barriers to entry are relatively low. However, nosignificant new entry has occurred in several years. Our competitors vary insize from small start-ups to large multi-national corporations who havesubstantially greater financial, R&D and marketing resources. In the tapeautomation market, our primary competition includes Quantum Corporation andAdvanced Digital Information Corporation (acquired by Quantum Corporation, in August2006) with limited competition fromSun Storage Tek in larger scale libraries. Key competitive factors includeproduct features, reliability, durability, scalability and price.

Our disk-based productscurrently compete with products made by IBM, HP, EMC Corporation, QuantumCorporation, Advanced Digital Information Corporation (acquired byQuantum Corporation in August 2006),Sun Storage Tek, Network Appliance, Inc. and numerous small startups. Webelieve additional competitors are likely to enter the market.  Key competitive factors in these marketsinclude performance, functionality, scalability, availability,interoperability, connectivity, time to market enhancements and total value ofownership.

The markets for all of ourproducts are characterized by significant price competition, and we anticipatethat our products will face increasing price pressure.

**ProprietaryRights**

#### **General**– In the tape automation space, we believe that patent, copyright, trademarkand trade secret protection are less significant than factors such as theknowledge, ability and experience of our personnel, new product introductionsand product enhancements. In the secondary disk-based appliance and primaryprotected storage spaces, we believe intellectual property protection will bean important competitive advantage, and we intend to secure a significantnumber of patents, copyrights and trademarks as quickly as possible to obtain aleadership position in these areas.

#### We presentlyhold 16 UnitedStates patents and have seven UnitedStates patents pending. In general, these patents have a 20-year term from thefirst effective filing date for each patent. We also hold a number of foreignpatents and patent applications for certain of our products and technologies.These rights, however, may not prevent competitors from developingsubstantially equivalent or superior products to ours. In addition, our presentand future patents may be challenged, invalidated or circumvented, reducing oreliminating our proprietary protection.

**VR****2 Technology** –We have entered into various intellectual property licensing agreementsrelating to our VR2 technology. These agreements require thepayment of royalty fees based on sales by licensees of products containing VR2. In certain instances, we sellto the licensee ASIC chips embodying VR2 priced to include the cost of the chip plus an embeddedroyalty fee.

**Employees**

As of July 2, 2006, we had 360 employees, including143 in sales and marketing, 89 in research and development, 79 in manufacturingand operations and 49 in finance, information systems, human resources andother management. There are no collective bargaining contracts covering any ofthe employees and we believe that our relationship with our employees is good.

**ITEM 1A.Risk Factors**

*An investment in our company involvesa high degree of risk. In addition to the other information included in thisreport, you should carefully consider each of the following risk factors inevaluating our business and prospects as well as an investment in our company.**The risks and uncertainties described below are not the only ones weface. Additional risks and uncertainties not presently known to us or that wecurrently consider immaterial may also impair our business operations. If anyof the following risks actually occur, our business and financial results couldbe harmed. In that case the trading price of our common stock could decline.You should also refer to the other information included or incorporated by reference in thisreport.*

**Our business has been highly dependent on sales tolarge OEM customers and we are currently experiencing a customer transition.**

Hewlett-PackardCompany (HP), including the former Compaq which HP acquired in May 2002,has been our largest customer, accounting for approximately 49.7% of netrevenue in fiscal 2006, 54.3% of net revenue in fiscal 2005 and 58.8% of netrevenue in fiscal 2004. No other customer accounted for more than 10% of netrevenue in fiscal 2006. Neither HP nor any other customer is obligated topurchase a specific amount of our products or provide binding forecasts ofpurchases for any period.

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In August 2005, we announced that HP had selectedan alternate supplier for its next-generation mid-range tape automationproduct. HP began purchasing the first product of this new line from thealternate supplier during the first quarter of calendar year 2006. We expect HPto continue to purchase the tape automation products currently supplied by usfor some time, but the new product will eventually replace the majority ofthose purchases. We cannot predict how quickly this transition will occur, butwe believe the effect on our revenue during fiscal 2007 will be significant.

In addition, in November 2005, we announced thatOverland had been selected by a new tier one OEM customer to supply it withOverland’s next generation tape library. Although we expect shipments to thisOEM customer to commence in the first half of fiscal 2007, the actual launchdate is at the discretion of the customer and we cannot accurately predict thepace at which sales to this customer will accelerate. Once these sales occur,we believe our business will become dependent on sales to this customer. Thiscustomer will not be obligated to purchse a specific amount of our products orprovide binding forecasts of purchases for any period.

**We outsourced all of our manufacturing to Sanmina-SCICorporation (Sanmina), but now are in the process of returning manufacturing toour San Diego facility. If we are unable to complete the transitionefficiently, or obtain our products from Sanmina in a cost effective and timelymanner that meets our customers’ expectations our business, financial conditionand results of operations could be materially and adversely affected.**

In August 2005, we completed the outsourcing of allour manufacturing to Sanmina. During fiscal 2006, we failed to achieve thecustomer service levels, product quality and cost reductions expected from theoutsourcing.  We also incurred a significantamount of redundant costs to support the outsourcing which eroded our grossmargins during the year. As a consequence, we have decided to bringmanufacturing back to our San Diego facility.

We face a number of risks during this transition. Wemay continue to experience product quality issues and shortages fromSanmina.  We may experience difficultiesin re-establishing our production lines in San Diego that could also result inshortages and product quality issues. Additionally, our agreement with Sanmina commits us to purchase productsand materials based upon the forecast of customer demand that we provide. As aconsequence of the termination of this agreement, we will be obligated topurchase finished goods and component parts based on such forecasts.  If such forecasts prove to be higher thancurrent customer demand, we may experience higher than normal inventorycarrying costs and some of the inventory may become obsolete either of whichcould reduce our gross margins.

**Our internal controls and proceduresrelated to accounts payable cut-off need to be improved.**

Management is responsible for establishing andmaintaining adequate internal control over financial reporting. Our internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements in accordance with generally accepted accountingprinciples. In making this assessment, management used the criteria set forthin the framework issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO) entitled Internal Control–Integrated Framework.

As of July 2, 2006, the Company did not maintaineffective controls over the completeness and accuracy of accounts payable andaccrued expenses. Specifically, controls over cut-off and completeness ofaccounts payable and accrued expenses were insufficient to ensure that invoicesfrom certain vendors were properly evaluated at period end.  We believe the deficiency resulted primarilyfrom the departures of our controller and accounting manager in April and May2006, and the resulting reassignment of tasks until the positions were filledin June and July 2006.  This controldeficiency resulted in audit adjustments to the Company’s 2006 annualconsolidated financial statements and the interim consolidated financialstatements for the quarter ended July 2, 2006. Additionally, this controldeficiency could result in a misstatement of the Company’s accrued liabilities,cost of revenue, and operating expenses that would not be prevented ordetected. Accordingly, management has determined that this control deficiencyconstitutes a material weakness.

If we are unable to improve our internal controlsrelated to accounts payable and accrued expenses, our ability to report ourfinancial results on a timely and accurate basis will be adversely affected,which could in turn have a material adverse effect on our ability to operateour business and remain listed on the Nasdaq Global Market, and could result inlegal sanctions or private lawsuits filed against us or our management. Ourstock price could decline as a result of any of these occurrences.

Even if the remedial measures discussed in “Controlsand Procedures” below are effective at remediating the material weakness, ourinternal control over financial reporting may not prevent future errors orfraud, since any control system, no matter how well designed, can provide onlyreasonable and not absolute assurance that the objectives of the control systemwill be achieved.

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**We plan to replace our ERP System inseveral years, and this may be disruptive to our business.**

Our ERP system isapproximately 10 years old, and we anticipate the need to replace it in severalyears. Transition to a new ERP system will be expensive and time consuming and,if problems occur in the transition, our business and results of operations maybe materially and adversely affected. In addition, we have modified this systemsignificantly during its term of use and it is possible that we wouldexperience a significant system failure before we replace the system. Any suchfailure also may materially and adversely affect our business and results ofoperations.

**Our financial results may fluctuate substantiallyfor many reasons, and past results should not be relied on as indications offuture performance.**

Allof the markets that we serve are volatile and subject to market shifts, whichwe may not be able to discern in advance. A slowdown in the demand for workstations,mid-range computer systems, networks and servers could have a significantadverse effect on the demand for our products in any given period. We haveexperienced delays in receipt of purchase orders and, on occasion, anticipatedpurchase orders have been rescheduled or have not materialized due to changesin customer requirements. Our customers may cancel or delay purchase orders fora variety of reasons, including the rescheduling of new product introductions,changes in their inventory practices or forecasted demand, general economicconditions affecting our customers’ markets, changes in our pricing or thepricing of our competitors, new product announcements by us or others, qualityor reliability problems related to our products or selection of competitiveproducts as alternate sources of supply. In particular, our ability to forecastsales to distributors, integrators and value-added resellers is especiallylimited as these customers typically provide us with relatively short orderlead times or are permitted to change orders on short notice. Given that alarge portion of our sales are generated by our European channel, our firstfiscal quarter (July through September) is commonly impacted by seasonallyslow European orders, reflecting the summer holiday period in Europe. Inaddition, none of our customers is obligated to purchase a specific amount ofour products.

Ourfinancial results have fluctuated and will continue to fluctuate quarterly andannually based on many other factors such as:

·                  changes incustomer mix (e.g., OEM vs. branded);

·                  changes in productmix;

·                  fluctuations inaverage selling prices;

·                  currency exchangefluctuations;

·                  increases in costsand expenses associated with the introduction of new products; and

·                  increases in the costof or limitations on availability of materials.

Basedon all of the foregoing, we believe that our revenue and operating results willcontinue to fluctuate, and period-to-period comparisons are not necessarilymeaningful and should not be relied on as indications of future performance.Furthermore, in some future quarters, our revenue and operating results couldbe below the expectations of public market analysts or investors, which couldresult in a material adverse effect on the price of our common stock. Inaddition, portions of our expenses are fixed and difficult to reduce if revenuedoes not meet our expectations. These fixed expenses magnify the adverse effectof any revenue shortfall.

**The marketprice of our common stock may be volatile***.*

Themarket price of our common stock has experienced significant fluctuations sinceit commenced trading in February 1997. The market price of our commonstock may continue to fluctuate significantly in the future. Many factors couldcause the market price of our common stock to fluctuate, including:

·                  announcementsconcerning us, our competitors, our customers or our industry;

·                  changes inearnings estimates by analysts;

·                  purchasingdecisions of HP and other significant customers;

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·                  quarterlyvariations in operating results;

·                  the introductionof new technologies or products;

·                  changes in productpricing policies by us or our competitors; and

·                  changes in generaleconomic conditions.

Inaddition, stock markets have experienced extreme price and volume volatility inrecent years. This volatility has had a substantial effect on the market pricesof securities of many smaller public companies for reasons frequently unrelatedor disproportionate to the operating performance of the specific companies.These market fluctuations may adversely affect the market price of our commonstock.

**We face intense competition and price pressure,and many of our competitors have substantially greater resources than we do.**

Theworldwide storage market is intensely competitive as a number of manufacturersof tape automation solutions and storage management software products competefor a limited number of customers. In addition, barriers to entry arerelatively low in these markets. We currently participate in the mid-range ofthe tape backup market. In this segment, some of our competitors havesubstantially greater financial and other resources, larger research anddevelopment staffs, and more experience and capabilities in manufacturing,marketing and distributing products. The markets for our products arecharacterized by significant price competition, and we anticipate that ourproducts will face increasing price pressure. This pressure could result insignificant price erosion, reduced profit margins and loss of market share, anyof which could have a material adverse effect on our business, liquidity,results of operation and financial position.

**Our business is highly dependent on the continuedmarket acceptance and usage of tape-based systems for data backup and recovery.**

We have historicallyderived a majority of our revenue from products based on the use of magnetictape drives for backup and recovery of digital data. Our tape-based storage solutions now competedirectly with other storage technologies, such as hard disk drives, and mayface competition in the future from other emerging technologies. The prices ofhard disk drives continue to decrease while capacity and performance haveincreased. We expect that our tape-based products will face increasedcompetition from these alternative technologies and come under increasing pricepressure. If our strategy to compete in disk-based markets does not succeed,our business, liquidity, results of operations and financial condition will bematerially and adversely affected.

**Ourdisk-based products involve many significant risks.**

In August 2003, we began shipping our REO SERIESof secondary disk-based backup and recovery products based on technologyacquired from Okapi Software. In July 2006, we launched ULTAMUS Pro 500, adisk-based protected primary storage solution, with embedded Protection OSsoftware based on the technology obtained in August 2005 from Zetta Systems.

The success of these disk-based products is uncertainand subject to significant risks, any of which could have a material adverseeffect on our business, liquidity, results of operation and financial position.We must commit significant resources to these new products before determiningwhether they will succeed. If these new products are not adopted by customersor do not achieve anticipated sales levels, any related intangible assets wehave recorded may be impaired. Such impairment would result in a charge againstearnings in the period for which impairment is determined to exist, and reduceour assets and shareholders’ equity.

Before our acquisition of Okapi Software, we were notinvolved in the development, marketing and sale of disk-based products, andbefore our acquisition of Zetta Systems, we were not involved in the protectedprimary storage market. The protected primary storage area is still new to manyof our personnel. We will need to continuously update and upgrade theseproducts to stay competitive. Any delay in the commercial release of new orenhanced disk-based products could result in a significant loss of potentialrevenue and may adversely impact the market price of our common stock.

If our disk-based products do not achieve marketacceptance or success, then the association of our brand name with theseproducts may adversely affect our reputation and our sales of other products,as well as dilute the value of our brand name.

**Our success depends on our ability to anticipaterapid technological changes and develop new and enhanced products.**

Asan advanced technology company, we are subject to numerous risks anduncertainties, generally characterized by rapid

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technologicalchange and intense competition. In this environment, our future success willdepend on our ability to anticipate changes in technology, to develop new andenhanced products on a timely and cost-effective basis and to introduce,manufacture and achieve market acceptance of these new and enhanced products.

Developmentschedules for high technology products are inherently subject to uncertainty.We may not meet our product development schedules, including those for productsbased on our disk-based technologies, and development costs could exceedbudgeted amounts. Our business, liquidity, results of operations and financialposition may be materially and adversely affected if the products or productenhancements that we develop are delayed or not delivered due to developmentalproblems, quality issues or component shortage problems, or if our products orproduct enhancements do not achieve market acceptance or are unreliable. The introduction,whether by us or our competitors, of new products embodying new technologies,such as new sequential or random access mass storage devices, and the emergenceof new industry standards could render existing products obsolete or notmarketable, which may have a material adverse effect on our business,liquidity, results of operations and financial position.

**Our international operations are important to ourbusiness and involve unique risks.**

Historically,sales to customers outside of the United States have represented a significantportion of our sales and we expect them to continue representing a significantportion of sales. Sales to customers outside the United States are subject tovarious risks, including:

·                  the imposition ofgovernmental controls mandating compliance with various foreign and U.S. exportlaws;

·                  currency exchangefluctuations and weak economic conditions in foreign markets;

·                  political andeconomic instability;

·                  traderestrictions;

·                  changes in tariffsand taxes;

·                  longer paymentcycles (typically associated with international sales); and

·                  difficulties instaffing and managing international operations.

Furthermore,we may not be able to comply with changes in foreign standards in the future.Our inability to design products that comply with foreign standards could havea material adverse effect on our business, liquidity, results of operations andfinancial position.

**Weare subject to exchange rate risk in connection with our internationaloperations.**

We do notcurrently engage in foreign currency hedging activities and therefore we areexposed to some level of currency risk. Our wholly-owned subsidiaries in theUnited Kingdom, France and Germany incur costs which are denominated in localcurrencies. As exchange rates vary, these results when translated into U.S.dollars may vary from expectations and adversely impact overall expectedresults. A weaker U.S. dollar would result in an increase to revenue andexpenses upon consolidation, and a stronger U.S. dollar would result in a decreaseto revenue and expenses upon consolidation.

* ***Our ability to competeeffectively depends in part on our ability to protect our intellectual propertyrights effectively.**

Werely on a combination of patent, copyright, trademark, trade secret and otherintellectual property laws to protect our intellectual property rights. Theserights may not however prevent competitors from developing products that aresubstantially equivalent or superior to our products. To the extent wehave or obtain patents, such patents may not afford meaningful protection forour technology and products. Others may challenge our patents and, as a result,our patents could be narrowed, invalidated or declared unenforceable. Inaddition, current or future patent applications may not result in the issuanceof patents in the United States or foreign countries. The laws of certain foreign countries may notprotect our intellectual property to the same extent as U.S. laws. Furthermore,competitors may independently develop similar products, duplicate our productsor, if patents are issued to us, design around these patents.

In order to protect or enforce our patent rights, wemay initiate interference proceedings, oppositions, or patent litigation

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againstthird parties, such as infringement suits. These lawsuits could be expensive,take significant time and divert management’s attention from other businessconcerns. The patent position of information technology firms generally ishighly uncertain, involves complex legal and factual questions, and hasrecently been the subject of much litigation. No consistent policy has emergedfrom the U.S. Patent and Trademark Office or the courts regarding the breadthof claims allowed or the degree of protection afforded under informationtechnology patents.

**Our success will depend partly on ourability to operate without infringing on or misappropriating the proprietaryrights of others.**

Our business is such that we may at any time be suedfor infringing the patent rights or misappropriating the proprietary rights ofothers. For example, during fiscal 2004 we settled a case alleging patentinfringement. Intellectual property litigation is costly and, even if weprevail, the cost of such litigation could adversely affect our business,liquidity, results of operations and financial condition. In addition,litigation is time consuming and diverts management attention and resourcesaway from our business. If we do not prevail in any litigation, we could berequired to stop the infringing activity and/or pay substantial damages. Undersome circumstances in the United States, these damages could be triple theactual damages the patent holder incurs. If we have supplied infringingproducts to third parties for marketing or licensed third parties to manufacture,use or market infringing products, we may be obligated to indemnify these thirdparties for any damages they may be required to pay to the patent holder andfor any losses the third parties may sustain themselves as the result of lostsales or damages paid to the patent holder.

If a third party holding rights under a patentsuccessfully asserts an infringement claim with respect to any of our products,we may be prevented from manufacturing or marketing our infringing product inthe country or countries covered by the patent we infringe, unless we canobtain a license from the patent holder. Any required license may not beavailable to us on acceptable terms, or at all. Some licenses may benon-exclusive, and therefore, our competitors may have access to the sametechnology licensed to us. If we fail to obtain a required license or areunable to design around a patent, we may be unable to market some of ourproducts, which could have a material adverse effect on our business,liquidity, financial condition and results of operations.

**We have made a number of acquisitions in the past and maymake acquisitions in the future. The failure to successfully integrateacquisitions, could harm our business, financial condition and operatingresults.**

We have in the past and expect in the future to makeacquisitions of complementary businesses, products or technologies as weimplement our business strategy. Mergers and acquisitions involve numerous risks,including liabilities that we may assume from the acquired company,difficulties in the assimilation of the operations and personnel of theacquired business, the diversion of management’s attention from other businessconcerns, risks of entering markets in which we have no direct priorexperience, and the potential loss of key employees of the acquired business.

Futuremergers and acquisitions by us also may result in dilutive issuances of ourequity securities and the incurrence of debt, amortization expenses andpotential impairment charges related to intangible assets. Any of these factorscould adversely affect our business, liquidity, results of operations andfinancial position.

**Our warranty reserves may not adequately cover ourwarranty obligations.**

Wehave established reserves for the estimated liability associated with ourproduct warranties. However, we could experience unforeseen circumstances wherethese or future reserves may not adequately cover our warranty obligations. Forexample, the failure or inadequate performance of product components that wepurchase could increase our warranty obligations beyond these reserves.

**Oursuccess depends on our ability to attract, retain and motivate our executivesand other key personnel.**

Ourfuture success depends in large part on our ability to attract, retain andmotivate our executives and other key personnel, many of whom have beeninstrumental in developing new technologies and setting strategic plans. Ourgrowth also depends in large part on our continuing ability to hire, motivateand retain highly qualified management, technical, sales and marketing teammembers. Competition for qualified personnel is intense and there can be noassurance that we will retain existing personnel or attract additionalqualified personnel in the future.

**The WEEE and RoHS directives in Europemay impact the cost of our products and/or our ability to sell products inEurope.**

The European Union (EU) enacted Directive 2002/96/ECon Waste Electrical and Electronic Equipment (WEEE), which regulates thecollection, recovery and recycling of waste from electrical and electronicproducts, and Directive 2002/95/EC on the Restriction of the Use of CertainHazardous Substances in Electrical and Electronic Equipment (RoHS), which bansthe use of certain

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hazardous materials including lead, mercury, cadmium,chromium and halogenated flame-retardants. Detailed regulations on practices andprocedures related to WEEE and RoHS continue to evolve in member states and wehave yet to assess fully the ramifications to our products. In order to complywith the WEEE directive, we intend to join a consortium and contribute to thecost of collection, treatment, disposal and recycling of past and futurecovered products. We believe the costs to comply with WEEE will not be material.Compliance with the RoHS directive is a very significant effort that iscurrently underway. It requires us to source new compliant components forvirtually all of our hardware products either from existing or alternatesuppliers so that no electrical products failing to meet RoHS standards are puton the EU market. At this time we cannot provide assurance that compliance withRoHS will not have a material adverse effect on our business, liquidity,results of operations and financial condition.

**ITEM 1B. Unresolved Staff Comments.**

We have no unresolvedcomments from the SEC.

**ITEM 2.Properties.**

We own no real propertyand we currently lease all facilities used in our business. Our headquartersare located in San Diego, California in a two-building light industrial complexcomprising approximately 160,000 square feet. The lease expires inFebruary 2014 and can be renewed for one additional five-year period. ThisSan Diego facility houses all of our research and development, andadministrative functions, as well as a major portion of sales, sales administration,marketing and customer support.

We lease a 17,000 squarefoot facility located in Wokingham, England, which houses sales, technicalsupport and repair services. The lease expires in January 2018. We alsomaintain small sales offices located close to Paris, France, Munich, Germany,Singapore and Korea and a research and development office located near Seattle,Washington.

**ITEM 3.Legal Proceedings.**

We are from time to time involved in various lawsuits,legal proceedings or claims that arise in the ordinary course of business. Wedo not believe any such legal proceedings or claims will have, individually orin the aggregate, a material adverse effect on our business, liquidity, resultsof operations and financial condition. However, litigation is subject toinherent uncertainties, and an adverse result in these or other matters mayarise from time to time that may harm our business.

**ITEM 4.Submission of Matters to a Vote of Security Holders.**

None

**PART II**

**ITEM 5.Market for Registrant’s Common Equity, Related Shareholder Matters and IssuerPurchases of Equity Securities.**

Our common stock trades on The NASDAQ Global Marketunder the symbol “OVRL”. As of September 8, 2006, there were approximately 82shareholders of record. We have not paid any cash dividends on our common stockand do not anticipate paying any cash dividends in the foreseeable future. Thehigh and low sales prices of our common stock from June 28, 2004 through July2, 2006 were as follows:

|                    | ** ** | **Sales Prices** | ** ** |
|--------------------|------------|-----------------------|------------|
| ** **         | ** ** | **High**              | ** ** | **Low** | ** ** |
| Fiscal Year  2006: |       |                  |       |   |   |
| Fourth quarter     |       | $                     | 9.38       |   | $ | 6.61 |   |
| Third quarter      |       | 9.86                  |       | 8.04 |   |
| Second quarter     |       | 8.75                  |       | 7.49 |   |
| First quarter      |       | 10.38                 |       | 6.69 |   |
| Fiscal Year  2005: |       |                  |       |   |   |
| Fourth quarter     |       | $                     | 14.63      |   | $ | 9.44 |   |
| Third quarter      |       | 16.84                 |       | 14.28 |   |
| Second quarter     |       | 17.01                 |       | 13.72 |   |
| First quarter      |       | 14.42                 |       | 9.90 |   |

 

The above quotations reflect inter-dealer prices,without retail markup, markdown or commission and may not necessarily representactual transactions.

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**ShareRepurchase Authorization**

In October 2005, our board of directors expanded ourshare repurchase program to allow for the purchase of up to 2.5 million sharesof our common stock on the open market or through negotiated transactions. Thisrepurchase authority allows us to repurchase our common stock selectively fromtime to time in the open market, through block trades or otherwise, or inprivately negotiated transactions. Depending on market conditions and otherfactors, at any time or from time to time, the board may modify the program orcommence or suspend purchases without prior notice. There is no fixedtermination date for the repurchase program. During fiscal 2006 and 2005, anaggregate of approximately 1.3 million shares and 32,500 shares, respectively,were repurchased at a cost of approximately $10.8 million and $309,000,respectively, pursuant to the repurchase program. Repurchases during the fourthquarter of fiscal 2006 are summarized in the table below:

### **ISSUER PURCHASES OFEQUITY SECURITIES**

**UNDER SHARE REPURCHASE AUTHORIZATION**
| Period                                  | ** ** | **(a) Total Number  of Shares  Purchased** | ** ** | **(b)  Average  Price Paid  per Share** | ** ** | **(c) Total Number  of Shares  Purchased as Part  of Publicly  Announced Plans  or Programs** | ** ** | **(d) Maximum  Number of Shares that  May Yet Be  Purchased Under the  Plans or Programs** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| April 3 through  April 30, 2006    |       | —                                                    |       | $                                                 | —     |                                                                                                                                  | —     |                                                                                                                                         | 1,563,982  |   |
| May 1 through  May 28, 2006   |       | 293,600                                                   |       | $                                                 | 8.25       |                                                                                                                                  | 293,600    |                                                                                                                                         | 1,270,382  |   |
| May 29, through  July 2, 2006 |       | 105,300                                                   |       | $                                                 | 7.67       |                                                                                                                                  | 105,300    |                                                                                                                                         | 1,165,082  |   |
| Total                                   |       | 398,900                                                   |       | $                                                 | 8.10       |                                                                                                                                  | 398,900    |                                                                                                                                         | 1,165,082  |   |

 

**ITEM 6.Selected Financial Data.**

Thefollowing selected financial data has been derived from our auditedconsolidated financial statements and the related notes. This informationshould be read in conjunction with Item 7 of this report,  “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” and with our consolidatedfinancial statements and the related notes set forth at thepages indicated in Item 15(a)(1) of this Report.
| ** **                                         | ** ** | **Fiscal Year**                                                  | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                         | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Income Statement Data:**                         | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                                        |       | $                                                                     | 209,038    |   | $ | 235,687 |   | $ | 238,139 |   | $ | 195,881 |   | $ | 163,380 |   |
| Gross profit                                       |       | 46,446                                                                |       | 60,917 |   | 64,654 |   | 54,018 |   | 42,445 |   |
| (Loss) income from  operations                     |       | (25,931                                                               | )          | 3,524 |   | 15,598 |   | 10,310 |   | 6,516 |   |
| (Loss) income before  income taxes                 |       | (23,311                                                               | )          | 5,068 |   | 16,199 |   | 10,193 |   | 6,839 |   |
| Net (loss) income                                  |       | (19,486                                                               | )          | 4,578 |   | 10,625 |   | 6,682 |   | 4,493 |   |
| Net (loss) income per  share(1):                   |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                                              |       | $                                                                     | (1.42      | ) | $ | 0.33 |   | $ | 0.79 |   | $ | 0.59 |   | $ | 0.42 |   |
| Diluted                                            |       | $                                                                     | (1.42      | ) | $ | 0.32 |   | $ | 0.74 |   | $ | 0.54 |   | $ | 0.40 |   |
|                                               |       |                                                                  |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                            | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash equivalents  and short-term investments |       | $                                                                     | 62,512     |   | $ | 76,887 |   | $ | 69,657 |   | $ | 55,020 |   | $ | 26,884 |   |
| Working capital                                    |       | 76,381                                                                |       | 110,363 |   | 103,244 |   | 84,326 |   | 54,463 |   |
| Total assets                                       |       | 144,769                                                               |       | 164,554 |   | 144,851 |   | 130,922 |   | 81,003 |   |
| Long-term debt,  inclusive of current portion      |       | —                                                                |       | — |   | — |   | 3,957 |   | 4,655 |   |
| Shareholders’ equity                          |       | 95,438                                                                |       | 121,494 |   | 113,514 |   | 93,264 |   | 59,266 |   |

 

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(1)          See Note 1 of Notes to ConsolidatedFinancial Statements for an explanation of shares used in computing net incomeper share.

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**ITEM 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperation.**

*Thediscussion in this section contains certain statements of aforward-looking nature relating to future events or our future performance.Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,”“estimates” and similar expressions or variations of such words are intended toidentify forward-looking statements, but are not the only means of identifyingforward-looking statements. Such statements are only predictions and actualevents or results may differ materially. In evaluating such statements, youshould specifically consider various factors identified in this report,including the matters set forth under the caption “Risk Factors,” which couldcause actual results to differ materially from those indicated by suchforward-looking statements.*

**Overview**

Our strategy is to becomea market leader and innovative supplier of a complete portfolio of tiered datastorage solutions by providing intelligent storage appliances with embeddedprotection software designed to work together to ensure that information is “automaticallysafe, readily available and always there.” We intend to deliver products to address all three tiers of datastorage:  protected primary disk,secondary disk-based backup and tertiary automated tape libraries for archival.Our focus will continue to be on mid-range solutions that can be easily soldworldwide through OEMs and our indirect network of distributors and resellers.We intend to leverage our leadership position in mid-range tape automation toachieve a similar position in primary and secondary intelligent disk-based appliances.

Fiscal 2006 and 2007 aresignificant transition years for Overland. We are currently in the midst of amajor customer transition during which sales to our largest OEM customer aredeclining while sales to a new tier-one OEM customer have not yet commenced.Additionally, in fiscal 2006, we made the largest single year investment in newproduct development in the Company’s history, both as a percent of revenue andin actual dollars spent. This investment level will decline to a more typicallevel during fiscal 2007.  We areinvesting heavily in the development of ARCvault, our new line of tapeautomation products, expansion of REO, our disk-based backup products, and ourentry into the protected primary storage market through our August 2005 acquisitionof Zetta Systems (the acquisition of Zetta). After the acquisition of Zetta,the combined Overland and Zetta development teams incorporated the Zettatechnology into our new line of intelligent appliances called ULTAMUSTM.

In August 2005,Hewlett-Packard Company (HP) informed us of its decision not to purchase fromOverland its next-generation, mid-range tape automation product line. HP willcontinue to purchase the tape automation products currently supplied by us forsome time, however, the new product from an alternate supplier is expected toreplace the majority of those purchases eventually. We cannot predict howquickly this transition will occur, but we believe the affect on our revenue infiscal 2007 will be significant. Our original three-year contract with HPexpired in July 2006, but has been extended and will continue in effect untilJuly 2009 unless terminated earlier by either party.  The contract does not commit HP to buyspecific quantities of product at any time.

In October 2005,Overland entered into a contract with a new tier-one OEM customer to supply itwith Overland’s next generation tape library. The contract has a three-year term with automatic one-year renewalsthereafter, unless either party provides a non-renewal notice 180 days beforethe end of the then current term.  Weexpect this business to contribute significantly to our revenue over the lifeof the contract.  Shipments to this OEMcustomer are currently scheduled to commence in the first half of fiscal 2007.

The development of ournew ARCvault line of tape automation products began in April 2005 and welaunched the first two of four such products through our branded sales channelin July 2006. ARCvault is based on a new platform that was developed in-houseby our engineering team. The new products will replace our existing loader andpower-loader products and all are designed to be price competitive in themarketplace. We expect that these new products will result in some erosion ofour branded channel sales of existing NEO 2000; the NEO line of products hassignificantly greater enterprise-class features and we believe it will continueto have a market with enterprise customers.

In October 2005, weintroduced the REO 9000 Expansion Array. This array, developed in response tocustomer demand, enables our REO product line to scale from one terabyte up to38 terabytes. Shortly thereafter, we announced that we had signed a licenseagreement with HP, who had chosen our REO Protection OS software as the basisfor a disk-based virtual tape solution that HP launched in May 2006. Weanticipate that this license agreement could result in annual royalties andincremental gross profit contribution to Overland in the range of $2.0 millionto $4.0 million once the product has been fully deployed.

Wecompleted the transfer of all of our manufacturing operations to Sanmina-SCICorporation (Sanmina) in August 2005. In

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fiscal 2005, werecorded $2.1 million to cost of revenue in pretax charges for severance costsrelated to the outsourcing and other obligations. During the first threequarters of fiscal 2006, we recorded $770,000 in pretax charges to cost ofrevenue for other obligations related to the outsourcing, including a charge of$704,000 for the estimated fair value of the liability associated with leasedwarehouse space that we permanently ceased using in December 2005. In June2006, we decided to terminate the relationship with Sanmina and returnmanufacturing to San Diego. As a result, we recorded a pre-tax credit of$536,000 in the fourth quarter to reverse the remaining excess facilitiesliability previously recorded.

Duringthe fourth quarter of fiscal 2006, the Company recorded certain amountsrelating to prior 2006 quarters and prior years resulting in a reduction of itsnet loss by $313,000 ($0.03 per share) and $324,000 ($0.02 per share) for thequarter and year ended July 2, 2006, respectively. The Company concluded thatthe amounts were not material to any previously-reported annual or interimperiod nor was the cumulative amount material to the current fiscal year. Assuch, the amounts were recorded in the fourth quarter of fiscal 2006 and priorperiods were not restated.

**Critical Accounting Policies and Estimates**

Our discussion and analysis of our financial conditionand results of operations are based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of consolidatedfinancial statements requires that we make estimates and judgments that affectthe reported amounts of assets, liabilities, revenue and expenses, and relateddisclosure of contingent liabilities. On an on-going basis, we evaluate ourestimates, including, but not limited to, those related to revenue recognition,share-based compensation, bad debts, inventories, intangible and other long-livedassets, warranty obligations and income taxes. We base our estimates onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

We believe the following accounting policies affect ourmore significant judgments and estimates used in the preparation of ourconsolidated financial statements.

###### **Revenue Recognition**

Revenuefrom sales of products is recognized when persuasive evidence of an arrangementexists, the price is fixed or determinable, collectibility is reasonablyassured and delivery has occurred. Under this policy, revenue on direct productsales (excluding sales to distributors and certain OEM customers) is recognizedupon shipment of products to our customers. These customers are not entitled toany specific right of return or price protection, except for any defectiveproduct that may be returned under our warranty policy. Title and risk of losstransfer to the customer when the product leaves our dock. Product sales todistribution customers are subject to certain rights of return, stock rotationprivileges and price protection. Because we are unable to estimate our exposurefor returned product or price adjustments, revenue from shipments to thesecustomers is not recognized until the related products are in turn sold to theultimate customer by the distributor. As part of our existing agreements withcertain OEM customers, we ship products to various distribution hubs around theworld and retain ownership of that inventory until it is pulled by these OEMcustomers to fulfill their customer orders, at which time revenue isrecognized.

We have entered into various licensing agreementsrelating to our Variable Rate Randomizer (VR2) technology. These agreements typicallycall for royalty fees based on sales by licensees of products containing VR2. Royalties on sales bylicensees of products containing VR2 are recorded when earned, generally in theperiod during which the licensee ships the products containing VR2 technology. In certain instances, the customerhas elected to purchase from us the Applications Specific Integrated Circuit(ASIC) chips embodying VR2,which are priced to include the cost of the chip plus an embedded royalty fee;and revenue on ASIC chip sales is recorded as product revenue when earned,which is upon the shipment of the underlying ASIC chip incorporating the VR2 technology to the customer.

When elements suchas hardware and services are contained in an arrangement, we allocate revenueto the separate elements based on relative fair value, provided we have fairvalue for all elements of the arrangement. If in an arrangement we have fairvalue for undelivered elements but not the delivered element, we defer the fairvalue of the undelivered elements and the residual revenue is allocated to thedelivered elements.  Undelivered elements typically includeservices.  Revenue from extended warranty and product service contracts isinitially deferred and recognized as revenue ratably over the contract period.

###### **Share-Based Compensation**

Share-based compensation expense can be significant toour results of operations, even though no cash is used for such expense. Indetermining period expense associated with unvested options, we estimate thefair value of each option at the date of grant. We use the Black-Scholes optionpricing model to determine the fair value of the award. This model requires theinput of highly subjective assumptions, including the expected volatility ofour stock and the expected term the average employee will hold the option priorto the date of exercise. In addition, we estimate pre-vesting forfeitures forshare-based awards that are not expected to vest. We primarily use historicaldata to determine the inputs and assumptions to be used in the Black-Scholes pricingmodel. Changes in these inputs and assumptions could occur and could materiallyaffect the measure of estimated fair value and make it difficult to compare theresults in future periods to our current results.

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###### **Allowance for Doubtful Accounts**

We estimate our allowance for doubtful accounts based onan assessment of the collectibility of specific accounts and the overallcondition of the accounts receivable portfolio. When evaluating the adequacy ofthe allowance for doubtful accounts, we analyze specific trade and otherreceivables, historical bad debts, customer credits, customer concentrations,customer credit-worthiness, current economic trends and changes in customers’payment terms and/or patterns. If the financial condition of our customers wereto deteriorate, resulting in an impairment of their ability to make additionalpayments, then we may need to make additional allowances. Likewise, if wedetermine that we could realize more of our receivables in the future thanpreviously estimated, we would adjust the allowance to increase income in theperiod we made this determination. We review the allowance for doubtfulaccounts on a quarterly basis and record adjustments as considered necessary.

###### **Inventory Valuation**

We record inventories at the lower of cost or market. Weassess the value of our inventories periodically based upon numerous factorsincluding expected product or material demand, current market conditions,technological obsolescence, current cost and net realizable value. Ifnecessary, we adjust our inventory for obsolete or unmarketable inventory equalto the difference between the cost of the inventory and the estimated marketvalue. Likewise, we record an adverse purchase commitment liability whenanticipated market sales prices are lower than committed costs. If actualmarket conditions are less favorable than what we projected, we may need torecord additional inventory adjustments and adverse purchase commitments.

###### **Business Acquisitions and Intangible Assets**

Ourbusiness acquisitions typically result in recognition of intangible assets(acquired technology) and in certain cases non-recurring charges associatedwith in-process research and development (IPR&D), which affect the amountof current and future period charges and amortization expenses. We amortize ourdefinite-lived intangible assets using the straight-line method over theirestimated useful lives, while IPR&D is recorded as a non-recurring chargeon the acquisition date.

Thedetermination of the value of these components of a business combination andassociated asset useful lives require management to make various estimates andassumptions. Critical estimates in valuing intangible assets may include butare not limited to: future expected cash flows from product sales and services,maintenance agreements, and acquired development technologies and patents ortrademarks; expected costs to develop the IPR&D into commercially viableproducts and estimated cash flows from projects when completed; the acquiredcompany’s brand awareness and market position; assumptions about the period oftime the acquired products and services will continue to be used in our productportfolio; and discount rates. Management’s estimates of fair value and usefullives are based upon assumptions believed to be reasonable, but which areinherently uncertain and unpredictable. Unanticipated events and circumstancesmay occur and assumptions may change. Estimates using different assumptionscould also produce significantly different results.

Weassess potential impairments to intangible assets when there is evidence thatevents or changes in circumstances indicate that the carrying amount of anasset may not be recovered. Our judgments regarding the existence of impairmentindicators and future cash flows related to intangible assets are based onoperational performance or viability of the acquired assets, market conditionsand other factors. Although there are inherent uncertainties in this assessmentprocess, the estimates and assumptions we use are consistent with our internalplanning. If these estimates or their related assumptions change in the future,we may be required to record an impairment charge on all or a portion of ourintangible assets. Furthermore, we cannot predict the occurrence of futureimpairment-triggering events nor the impact such events might have on ourreported asset values. Future events could cause us to conclude that impairmentindicators exist and that intangible assets associated with our acquired assetsare impaired. Any resulting impairment loss could have an adverse impact on ourresults of operations. We periodically review the estimated remaining usefullives of our acquired intangible assets. A reduction in our estimate ofremaining useful lives, if any, could result in increased amortization expensein future periods.

###### **Impairment of Long-Lived Assets**

We test for recoverability of long-lived assetswhenever events or changes in circumstances indicate the carrying value may notbe recoverable. When the carrying value is not considered recoverable, animpairment loss, for the amount by which the carrying value of a long-livedasset exceeds its fair value, is recognized with an offsetting reduction in thecarrying value of the related asset(s). In such circumstances, we may incurmaterial charges relating to the impairment of such asset. Fair value isgenerally determined based on the estimated future discounted cash flows overthe remaining useful life of the asset or asset group using a discount ratedetermined by management to be commensurate with the risk inherent in ourcurrent business model. To date, we havenot recorded any material impairment losses.

The assumptions supporting the cash flows, includingthe discount rates, are determined using management’s best estimates as of thedate of the impairment review. If these estimates or their related assumptionschange in the future, we may be required to

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record impairment chargesfor these assets and future results of operations could be adversely affected.

###### **Warranty Obligations**

We generallyprovide a three-year advance replacement return-to-factory warranty on our NEOSERIES, REO SERIES, PowerLoader and LoaderXpress products. We also provideon-site service, where available, for the first warranty year of the NEO SERIESproducts for which we contract with third-party service providers. For ourARCvault product, we offer a one-year advance replacement return-to-factorywarranty. For most products, we offer a program called XchangeNOW as part ofour return-to-factory warranty which enables customers to receive an advancereplacement unit shipped within two business days after placing a servicerequest. The customer ships the defective unit back to us using the shippingmaterials from the replacement unit. We record a provision for estimated futurewarranty costs at the time of shipment for both the return-to-factory andon-site warranties. If future actual costs to repair were to differsignificantly from our estimates, we would record the impact of theseunforeseen costs or cost reductions in subsequent periods. 

Separatelypriced extended on-site warranties are offered for sale to customers. Wecontract with outside vendors to provide service relating to all on-sitewarranties. Extended warranty revenue and amounts paid in advance to outsideservice organizations are deferred and recognized as revenue and cost ofrevenue, respectively, over the period of the service agreement.

###### **Income Taxes**

The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes generally represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of our assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when a judgment is made that it is considered more likely than not that a tax benefit will not be realized. A decision to record a valuation allowance results in an increase in income tax expense or a decrease in income tax benefit (as we had in fiscal 2006). If the valuation allowance, recorded in fiscal 2006, is released in a future period, income tax expense will be reduced accordingly.

The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimates of whether, and the extent to which, additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result.

**Results of Operations**

Thefollowing tables set forth certain financial data as a percentage of netrevenue:
|                                            | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------|------------|----------------------|------------|
| ** **                                 | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                       |       |                 |       |   |   |   |   |
| Net revenue                                |       | 100.0                | %          | 100.0 | % | 100.0 | % |
| Cost of revenue                            |       | 77.8                 |       | 74.2 |   | 72.9 |   |
| Gross profit                               |       | 22.2                 |       | 25.8 |   | 27.1 |   |
| Operating  expenses:                       |       |                 |       |   |   |   |   |
| Sales and marketing                        |       | 18.1                 |       | 14.6 |   | 13.0 |   |
| Research and development                   |       | 9.0                  |       | 4.5 |   | 3.0 |   |
| General and administrative                 |       | 7.0                  |       | 5.2 |   | 4.6 |   |
| In-process research and development        |       | 0.5                  |       | — |   | — |   |
|                                       |       | 34.6                 |       | 24.3 |   | 20.6 |   |
| (Loss) income  from operations             |       | (12.4                | )          | 1.5 |   | 6.5 |   |
| Other income,  net                         |       | 1.2                  |       | 0.7 |   | 0.3 |   |
| (Loss) income  before income taxes         |       | (11.2                | )          | 2.2 |   | 6.8 |   |
| (Benefit from)  provision for income taxes |       | (1.9                 | )          | 0.3 |   | 2.3 |   |
| Net (loss) income                          |       | (9.3                 | )          | 1.9 |   | 4.5 |   |

 

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**Fiscal2006 Compared to Fiscal 2005**

***Net Revenue.*** Net revenue decreased from $235.7million during fiscal 2005 to $209.0 million during fiscal 2006. The decreaseof $26.7 million, or 11.3%, is due to a 20.1% decrease in revenue from OEMcustomers offset by a 0.9% increase in sales of branded products and a 72.9%increase in extended warranty service revenue associated with more warrantycontracts being sold. We finished the year with a $5.0 million backlog due toproduction and inventory problems at our outsourced manufacturer which delayedshipping of products, principally to HP and to one of our Asia Pacific (APAC)OEM customers.

Thedecrease in OEM revenue is primarly due to the expected decline in shipments ofour NEO products to HP and IBM as these customers begin to transition toalternate products sourced from other suppliers. Net revenue from HPrepresented approximately 49.7% of net revenue in fiscal 2006 compared to 54.3% of netrevenue for fiscal 2005.

Netrevenue from Overland branded products increased from $93.2 million duringfiscal 2005 to $94.1 million during fiscal 2006. The increase of approximately$900,000 was the result of a 19.0% increase in sales of branded products in ourAPAC region offset by a 12.5% decline in sales within our EMEA (Europe, MiddleEast and Africa) region.

VR2 revenue during fiscal 2006 of $2.9 million wascomprised of royalties of $1.8 million and chip sales of $1.1 million. VR2 revenue during fiscal 2005 of $2.2 million wascomprised of royalties of $1.9 million and $240,000 in chip sales.

A summary of the sales mix by product for the periodspresented in the Consolidated Statement of Operations follows:
|                             | ** ** | **Fiscal Year** | ** ** |
|-----------------------------|------------|----------------------|------------|
| ** **                  | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| LibraryXpress  products:    |       |                 |       |   |   |   |   |
| NEO Series                  |       | 62.8                 | %          | 68.0 | % | 68.8 | % |
| Loaders                     |       | 7.4                  |       | 8.9 |   | 10.3 |   |
|                        |       | 70.2                 |       | 76.9 |   | 79.1 |   |
| Spare parts,  drives, other |       | 21.9                 |       | 17.9 |   | 18.6 |   |
| Disk based                  |       | 6.5                  |       | 4.2 |   | 0.7 |   |
| VR2                         |       | 1.4                  |       | 1.0 |   | 1.6 |   |
|                        |       | 100.0                | %          | 100.0 | % | 100.0 | % |

 

***Gross Profit.*** Gross profit decreased from $60.9million during fiscal 2005 to $46.4 million during fiscal 2006. The decrease ofapproximately $14.5 million or 23.8% is primarily the result of the 11.3%decline in revenue, as well as amortization expense of $2.7 million related totechnology obtained in the Zetta acquisition. Additionally, we experienced (i)approximately a 4.5% increase in costs associated with all non- VR2and non-spares and other products (whichincreases were not passed on to our customers), (ii) a decrease in the numberof units sold within our branded channel and to our OEMs, and (iii) redundantcosts to support Sanmina, our outsourced manufacturer.

***Share-Based Compensation*.** During fiscal 2006, werecorded $2.0 million of share-based compensation charges associated with theadoption of SFAS No. 123(R), of which $13,000 was allocated to cost ofrevenue, $621,000 was allocated to sales and marketing, $206,000 to researchand development and $1.2 million to general and administrative expenses.

***Sales and Marketing Expense.*** Sales and marketingexpenses increased to $37.9 million during fiscal 2006 from $34.4 millionduring fiscal 2005. The increase of approximately $3.5 million or 10.3% isprimarily associated with increased compensation expense of approximately $3.1million associated with an increase in headcount of 10 employees and $615,000in share-based compensation expense not included in fiscal 2005, partiallyoffset by reduced promotional spending of approximately $888,000.

***Research and Development Expense.*** Research anddevelopment expenses increased to $18.8 million during fiscal 2006 from $10.7million during fiscal 2005. The increase of approximately $8.1 million or75.5% is primarily due to a $5.7 million increase in compensation costsassociated with an increase in headcount resulting from the acquisition of theZetta development team and $1.6 million in costs related to development of ournew tape library platform.

***General and Administrative Expense***. General andadministrative expenses increased to $14.6 million during fiscal 2006 from$12.3 million during fiscal 2005. The increase of approximately $2.3 million or18.2% is primarily due to (i) $1.1 million share-based compensation costs notincluded in the prior year period, (ii) $902,000 in higher than expected legalfees due to the accumulation of our shares in early fiscal 2006 by acompetitor, (iii) $105,000 severance costs and (iv) $197,000 in increased ITspending, partially offset by a reduction in readiness costs associated withSection 404 of the Sarbanes-Oxley Act of 2002.

***In-Process Research and Development***. The purchaseprice of our recent acquisition of Zetta was assigned to the fair value of theassets acquired, including in-process research and development. As of the acquisitiondate, technological feasibility of the in-process technology had not beenestablished. Therefore, the in-process research and development of $1.1 millionwas recorded as

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expense at thedate of the acquisition.

Theamount of the purchase price allocated to in-process research and developmentwas based on established valuation techniques used in the technology industry.The fair value assigned to the acquired in-process research and development wasdetermined using the income approach, which discounts projected future cashflows to present value. The key assumptions used in the valuation included,among others, expected completion date of the in-process projects identified asof the acquisition date, estimated costs to complete the projects, revenuecontributions and expense projections assuming the resulting product hasentered the market, and discount rate based on the risks associated with thedevelopment life cycle of the acquired in-process technology.

Assumptionsunderlying the valuation of acquired in-process research and development fromZetta included the following (in thousands, except percentages):
| Project names                                          | ** ** | **Non-High Availability Version** | ** ** | **High Availability Version** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------|------------|
|                                                        |       |                                        |       |                                    |       |
| Estimated costs  to complete technology at acquisition date |       | $                                           | 164        |                                    | $          | 153 |   |
| Percent  completed as of acquisition date                   |       | 57.0                                        | %          | 19.5                                    | %          |
| Risk-adjusted  discount rate                                |       | 37.8                                        | %          | 37.8                                    | %          |
| First period of  expected revenue                           |       | Third quarter FY 06                         |       | Fourth quarter FY 06                    |       |
|                                                             |            |                                             |            |                                         |            |  |  |

 

Incomparison to our original expectations at the time of purchase, we haveexperienced a two-quarter delay in both projects.  The non-high availability version of theproduct, referred to as ULTAMUS Pro 500, was launched in the first quarter offiscal year 2007, and the high availability version is still underdevelopment.  As a consequence, we haveincurred more development expense than originally expected, and there has beena delay in generating the return on our investment.  Despite this, we continue to believe that theproduct will ultimately be successful and the value of the capitalizedintangible assets will be recovered.

***Interest Income***. Interest income increased to$2.8 million during fiscal 2006 from $1.6 million during fiscal 2005. Theincrease of approximately $1.2 million or 71.8% is due to higher average yieldswhen compared to fiscal 2005.

***(Benefit from) Provision for Income Taxes.*** Werecorded an income tax benefit of $3.8 million for fiscal 2006 compared toincome tax expense of $490,000 for fiscal 2005. The change of approximately$4.3 million is primarily due to our loss in fiscal 2006 versus income infiscal 2005, partially offset by the impact of recording a full valuationallowance, against our net deferred tax assets, for fiscal 2006. The benefit of$3.8 million recorded in fiscal 2006 represents the current benefit earned forlosses that can be carried back to prior years’ tax returns for refund claims.

**Fiscal2005 Compared to Fiscal 2004**

***Net Revenue.*** Net revenue decreased from $238.1million in fiscal 2004 to $235.7 million in fiscal 2005. The decrease of $2.4million or 1.0% is primarily due to a 9.5% decrease in revenue from OEMcustomers. This decrease is primarily a result of declining sales to HP. Netrevenue from HP represented approximately 54.3% of net revenue in fiscal 2005compared to approximately 58.8% in fiscal 2004.

Netrevenue from Overland branded products increased from $79.4 million in fiscal2004 to $93.2 million in fiscal 2005. The increase of $13.8 million or 17.3%was primarily the result of an increase in sales of REO disk-based products anda $4.0 million increase in revenue from Europe, Middle East and Africa (EMEA)related to shipments under a large contract with a European governmentalagency. Fiscal 2004 product sales represent less than an entire year of REOsales as we began shipping the first REO product in August 2003. Inaddition, in October 2004, we introduced a new REO product which resultedin sales of approximately $7.1 million for fiscal 2005.

VR2 revenue in fiscal 2005 decreased from $3.8million in fiscal 2004 to $2.2 million in fiscal 2005. This decrease of $1.6million or 42.1% was the result of declining chip sales. In fiscal 2005,royalties represented $1.9 million of VR2 revenue compared to $1.7 million in fiscal 2004. Duringfiscal 2005 chip sales decreased to $240,000 from $2.0 million in fiscal 2004.

***Gross Profit.*** Gross profit decreased from $64.7million in fiscal 2004 to $60.9 million in fiscal 2005. The decrease ofapproximately $3.8 million or 5.8% is primarily due to the decrease in netrevenue of $2.4 million, and an increase of $2.1 million in cost of revenueassociated with the outsourcing of our manufacturing activities. In addition,during fiscal 2005 warranty costs increased by $2.6 million as a result of moreproducts under warranty compared to the prior year. These cost increases werepartially offset by favorable product mix within our branded channel and alarger concentration of higher margin sales of branded products versus lowermargin OEM products.

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***Sales and Marketing Expenses.*** Sales and marketingexpenses increased to $34.4 million in fiscal 2005 from $30.8 million in fiscal2004. The increase of approximately $3.6 million or 11.5% is primarilyassociated with an expansion of our branded sales force.

***Research and Development Expenses.*** Research anddevelopment expenses increased to $10.7 million in fiscal 2005 from $7.3million in fiscal 2004. The increase of approximately $3.4 million or 47.2% isprimarily due to an increase of approximately $1.4 million associated with anincrease in headcount for further development of REO and other new products,and a related increase in development costs of approximately $1.2 million.

***General and Administrative Expenses***. General andadministrative expenses increased to $12.3 million in fiscal 2005 from $10.9million in fiscal 2004. The increase of approximately $1.4 million or 12.6% isprimarily due to a $1.3 million increase in consulting and auditing feesassociated with compliance with Section 404 of the Sarbanes-Oxley Act of2002, and an increase of approximately $555,000 associated with an increase ingeneral operating activities during fiscal 2005. These increases were offset bya $639,000 decrease in legal fees in fiscal 2005, which primarily resulted fromthe settlement of the Raytheon patent infringement lawsuit in April 2004.

***Interest Income***. Interest income increased to$1.5 million in fiscal 2005 from $533,000 in fiscal 2004. The increase ofapproximately $1.0 million or 181.4% is due to higher average cash balances combinedwith higher average yields when compared to fiscal 2004.

***Provision for Income Taxes.*** Provision for incometaxes decreased from $5.6 million in fiscal 2004 to $490,000 in fiscal 2005.The decrease of approximately $5.1 million or 91.2% is primarily the result of the decrease in fiscal 2005 earnings compared to fiscal 2004 andchanges in prior year estimates due to the favorable settlement of IRS auditsand statute expirations.

**Liquidityand Capital Resources**

At June 30, 2006, our sources of liquidity were $62.5million of cash, cash equivalents and short-term investments and our unusedcredit facility of $10.0 million. We believe that these resources togetherwith anticipated cash from operations will be sufficient to fund our operationsand to provide for our growth for the next twelve months and into theforeseeable future.

Our primary source of liquidity has historically beencash generated from operations. During fiscal 2006, 2005 and 2004, we generated$7.3 million, $8.3 million and $14.6 million, respectively, from operations.

Infiscal 2006, investing activities resulted in $16.0 million cash inflowcompared to cash used in investing activities of $18.1 million and $59.2million for fiscal 2005 and 2004, respectively. The increase in cash providedby investing activities is primarily the result of a net decrease of $28.9million in purchases of short-term investments, offset by the acquisition ofZetta Systems for $8.9 million. During fiscal 2005, we purchased short-terminvestments, net of maturities and sales, of $14.7 million compared to a netpurchase of short-term investments of $57.1 million in fiscal 2004. Capitalexpenditures during fiscal 2006, 2005 and 2004, were approximately $4.0million, $3.4 million and $2.1 million, respectively. During fiscal 2006,capital expenditures consisted primarily of software and tooling equipment tobe used for our new products. In fiscal 2005 and 2004 capital expendituresconsisted primarily of purchases of computers and related equipment.

Infiscal 2006, we used $8.5 million in cash related to financing activities,compared to cash provided by financing activities of $2.6 million and $2.3million in fiscal 2005 and 2004, respectively. During fiscal 2006, we used cashto repurchase approximately $10.8 million of our common stock which was offsetby cash proceeds of approximately $2.3 million (i) from our employee’s purchaseof common stock through our Employee Stock Purchase Plan (ESPP) and (ii) theexercise of stock options. In fiscal 2005, cash provided by financingactivities consisted of $2.9 million in proceeds from the issuance of commonstock under our ESPP and upon exercise of stock options, offset by $309,000used to repurchase shares of our common stock on the open market under ourshare repurchase authorization plan. Proceeds from the issuance of common stockunder our ESPP and the exercise of stock options were $6.3 million in fiscal2004.

AtJune 30, 2006, we had a credit facility consisting of a $10.0 million revolvingline of credit for working capital purposes that expires on November 30,2006. The line of credit is secured by certain assets. Interest on the line ofcredit is set at the bank’s prime rate (8.25% at June 30, 2006) in effect fromtime to time minus 0.25% or, at our option, a rate equal to LIBOR plus 2.25%.The loan agreement that governs the credit facility contains certain financial((i) quick assets to current liabilities of not less than 2.00:1.00 and (ii)total liabilities to tangible net worth of less than 1.00:to1.00) and non-financialcovenants (i.e. reporting, etc). As of June 30, 2006, we were in compliancewith all covenants and no amounts were outstanding under the line of credit.

In October 2005, our board of directors expandedour share repurchase program to allow for the purchase of up to 2.5 millionshares of our common stock on the open market or through negotiatedtransactions. This repurchase authority allows us to repurchase

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our common stockselectively from time to time in the open market, through block trades orotherwise, or in privately negotiated transactions. Depending on marketconditions and other factors, at any time or from time to time, the board maymodify the program or commence or suspend purchases without prior notice. Thereis no fixed termination date for the repurchase program. During fiscal 2006 and2005, an aggregate of approximately 1.3 million shares and 32,500 shares,respectively, were repurchased at a cost of approximately $10.8 million and$309,000, respectively, pursuant to the repurchase program.

**Off-BalanceSheet Arrangements**

We have no off-balance sheet arrangements orsignificant guarantees to third parties not fully recorded in our ConsolidatedBalance Sheets or fully disclosed in our Notes to Consolidated FinancialStatements.

**ContractualObligations**

The followingschedule summarizes our contractual obligations to make future payments(in thousands)**:**
| Contractual Obligations   | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **After 5  years** | ** ** |
|--------------------------------|------------|-----------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-------------------------|------------|
| Operating lease  obligations   |       | $         | 27,630     |                            | $          | 3,300              |       | $                  | 6,614      |                    | $          | 6,890 |   | $ | 10,826 |   |
| Purchase  obligations          |       | 15,367    |       | 15,359                          |       | 8                  |       | —             |       | —                  |       |
| Total contractual  obligations |       | $         | 42,997     |                            | $          | 18,659             |       | $                  | 6,622      |                    | $          | 6,890 |   | $ | 10,826 |   |

 

**Inflation**

Inflationhas not had a significant impact on our operations during the periodspresented. Historically, we have been able to pass on to our customersincreases in raw material prices caused by inflation. If at any time we cannotpass on such increases, our margins could suffer. Our exposure to the effectsof inflation could be magnified by the concentration of OEM business.

**RecentlyIssued Accounting Pronouncements**

SeeNote 1 to Consolidated Financial Statements.

**ITEM 7A.Quantitative and Qualitative Disclosures about Market Risk.**

Market risk representsthe risk of loss that may impact our financial position, results of operationsor cash flows due to adverse changes in financial and commodity market pricesand rates. We are exposed to market risk in the areas of changes in UnitedStates interest rates and changes in foreign currency exchange rates asmeasured against the U.S. dollar. These exposures are directly related to ournormal operating and funding activities. Historically, we have not usedderivative instruments or engaged in hedging activities.

***InterestRate Risk.***All of our fixed income investments areclassified as available-for-sale and therefore reported on the balance sheet atmarket value. Changes in the overall level of interest rates affect ourinterest income that is generated from our investments. For fiscal 2006, totalinterest income was $2.8 million with investments yielding an annual average of4.1% on a worldwide basis. The interest rate level was up approximately 190basis points from 2.2% in fiscal 2005. If a comparable increase or decrease in overallinterest rates (190 basis points) were to occur in fiscal 2007, our interestincome would increase or decrease approximately $1.3 million, assumingconsistent investment levels.

The table below presentsthe cash, cash equivalents and short-term investment balances and relatedweighted-average interest rates at the end of fiscal 2006. The cash, cashequivalents and short-term investment balances approximate fair value (in thousands):
|                            | ** ** | **Approximate  Market Value** | ** ** | **Weighted-Average  Interest Rate** | ** ** |
|----------------------------|------------|------------------------------------|------------|------------------------------------------|------------|
| Cash and cash  equivalents |       | $                                  | 20,315     |                                     | 5.2        | % |
| Short-term  investments:   |       |                               |       |                                     |       |
| Less than 1 year           |       | —                             |       |                                     |       |
| Due in 1 – 2 years    |       | 2,600                              |       | 5.2                                      | %          |
| Due in 2-5 years           |       | 1,919                              |       | 4.1                                      | %          |
| Due after 5 years          |       | 37,678                             |       | 5.0                                      | %          |
|                       |       | $                                  | 62,512     |                                     | 5.1        | % |

 

22

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125

The table above includesthe United States dollar equivalent of cash, cash equivalents and short-terminvestments, including $221,000 and $201,000 equivalents denominated in theBritish Pound Sterling and the Euro, respectively.

***ForeignCurrency Risk.***We conduct business on a global basis andessentially all of our products sold in international markets are denominatedin U.S. dollars. Historically, export sales have represented a significantportion of our sales and are expected to continue to represent a significantportion of sales.

Our wholly-ownedsubsidiaries in the United Kingdom, France and Germany incur costs which aredenominated in local currencies. As exchange rates vary, these results whentranslated into U.S. dollars may vary from expectations and adversely impactoverall expected results. The effect of exchange rate fluctuations on ourresults during fiscal 2006 was not material.

**ITEM 8.Financial Statements and Supplementary Data.**

Ourconsolidated financial statements and supplementary data required by this itemare set forth at the pages indicated in Item 15(a)(1) and 15(a)(2),respectively.

**ITEM 9.Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure.**

None.

**ITEM 9A.Controls and Procedures.**

**Disclosure Controls andProcedures**

Under the supervision and with the participation ofour management, including our principal executive officer and principalfinancial officer, we conducted an evaluation of our disclosure controls andprocedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) underthe Exchange Act. Based on this evaluation, our principal executive officer andour principal financial officer concluded that our disclosure controls andprocedures were not effective as of the end of the period covered by thisannual report as a result of the material weakness described below.  Notwithstanding the material weakness, ourmanagement concluded that the financial statements included in this annualreport fairly present, in all material respects, our financial position,results of operations and cash flows for the periods presented in conformitywith generally accepted accounting principles.

**Management’s Report onInternal Control Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of1934. A company’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that(i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of the company’s assets that could have amaterial effect on the financial statements.

Under the supervision and with the participation ofmanagement, including our principal executive officer and principal financialofficer, management conducted an assessment of the effectiveness of ourinternal control over financial reporting as of July 2, 2006. In making thisassessment, management used the criteria established in the framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission (COSO)entitled *Internal Control—Integrated Framework*.

As of July 2, 2006, the Company did not maintaineffective controls over the completeness and accuracy of accounts payable andaccrued expenses. Specifically, controls over cut-off and completeness ofaccounts payable and accrued expenses were insufficient to ensure that invoicesfrom certain vendors were properly evaluated at period end.  This control deficiency resulted in auditadjustments to the Company’s 2006 annual consolidated financial statements andthe interim consolidated financial statements for the quarter ended July 2,2006. Additionally, this control deficiency could result in a misstatement ofthe Company’s accounts payable and accrued liabilities, cost of revenue, andoperating expenses that would not be prevented or detected. Accordingly,management has determined that this control deficiency constitutes a materialweakness.

23

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Because of this material weaknesses, management hasconcluded that we did not maintain effective internal control over financialreporting as of July 2, 2006, based on the criteria established in *Internal Control—Integrated Framework*issued by the COSO.

Management’s assessment of the effectiveness of ourinternal control over financial reporting as of July 2, 2006 has been auditedby PricewaterhouseCoopers LLP, an independent registered public accountingfirm, as stated in their report which appears herein.

**Plan for Remediation ofMaterial Weaknesses**

Management has identified an internal controldeficiency and reviewed this internal control deficiency with the auditcommittee and has advised the audit committee that the deficiency represents amaterial weakness in our internal control over financial reporting. We believethe deficiency resulted primarily from the departures of our controller andaccounting manager in April and May 2006, and the resulting reassignment oftasks until the positions were filled in June and July 2006.

Management and the audit committee have adoptedremedial measures that are designed to address the material weaknesses.  The remedial measures include the following:

·              Recruitment of a new controllerand accounting manager in June and July 2006 to replace departed personnel, andthe reassignment of tasks to the new personnel consistent with our historicalpractices.

·              Revisions to our controlsconcerning cut-offs and accruals in September 2006 to better assurecompleteness, valuation and existence of accounts payable and accured expenses.

At the direction of, and in consultation with, theaudit committee, management is currently implementing the remedial measuresdiscussed above.

**Changes in InternalControl over Financial Reporting**

Except as set forth above, there were no changes inour internal control over financial reporting during our fiscal quarter endedJuly 2, 2006 that have materially affected, or are reasonably likely tomaterially effect, our internal controls over financial reporting.

**ITEM 9B.Other Information.**

June 19, 2006, we entered into an Addendum to ProductPurchase Agreement with Hewlett-Packard Company (HP) under which we agreed toextend to July 30, 2007 the term of the original Product Purchase Agreementwith HP dated July 30, 2003.  After July30, 2007, the agreement will continue until July 30, 2009 unless terminatedearlier pursuant to the terms of the original agreement.

This disclosure is provided in lieu of disclosureunder Item 1.01 of Form 8-K.

**PART III**

**ITEM 10.Directors and Executive Officers of the Registrant.**

Theinformation required by this item is included under the captions entitled “Electionof Directors”, “Executive Officers”, and “Section 16(a) Beneficial OwnershipReporting Compliance” in our Proxy Statement to be filed for our 2006 AnnualMeeting of Shareholders and is incorporated herein by reference.

Wehave adopted the Overland Storage, Inc. Code of Business Conduct andEthics, a Code that applies to our directors, officers and employees. A copy ofthe Code of Business Conduct and Ethics is publicly available on our website atwww.overlandstorage.com. If we make any substantive amendments to the Code ofBusiness Conduct and Ethics or grant any waiver from a provision of the codeapplying to our principal executive officer or our principal financial oraccounting officer, we will disclose the nature of such amendment or waiver onour website or in a report on Form 8-K.

24

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**ITEM11.  Executive Compensation.**

Theinformation required by this item is included under the caption entitled “Compensationof Executive Officers”, “Non-Employee Director Compensation” and “Report of theCompensation Committee of the Board of Directors on Executive Compensation” inour Proxy Statement to be filed for our 2006 Annual Meeting of Shareholders andis incorporated herein by reference.

**ITEM12.  Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters.**

The information required by this item is includedunder the caption entitled “Security Ownership of Certain Beneficial Owners andManagement” in our Proxy Statement to be filed for our 2006 Annual Meeting ofShareholders and is incorporated herein by reference.

**ITEM13.  Certain Relationships and RelatedTransactions.**

Theinformation required by this item is included under the caption entitled “CertainRelationships and Related Transactions” in our Proxy Statement to be filed forour 2006 Annual Meeting of Shareholders and is incorporated herein byreference.

**ITEM14.  Principal Accounting Fees andServices.**

Theinformation required by this item is included under the caption entitled “PrincipalAccountant Fees and Services” in our Proxy Statement to be filed for our 2006Annual Meeting of Shareholders and is incorporated herein by reference.

**PART IV**

**ITEM15.  Exhibits, Financial StatementSchedules.**

(a)(1) **Financial Statements**.The following Consolidated Financial Statements of Overland Storage, Inc.and Report of Independent Registered Public Accounting Firm are included in aseparate section of this Report at the page numbers so indicated:
| Report of Independent  Registered Public Accounting Firm                                                                               |   |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated  Balance Sheets as of June 30, 2006 and 2005                                                                         |   |
| Consolidated Statements of Operations for the Years  Ended June 30, 2006, 2005 and 2004                                           |   |
| Consolidated Statements of Shareholders’ Equity and Comprehensive  Income (Loss) for YearsEnded June 30, 2006, 2005 and 2004 |   |
| Consolidated Statements of Cash Flows for the Years  Ended June 30, 2006, 2005 and 2004                                           |   |
| Notes to Consolidated Financial Statements                                                                                             |   |

 

(a)(2) **Financial Statement Schedule.**

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

(a)(3)  **Exhibits**
| 2.1    |   | Agreement and Plan of Merger dated June 20,  2003 among Overland, Okapi Acquisition Co., Inc. and Okapi  Software, Inc. (incorporated by reference to the Company’s  Form 10-K filed September 26, 2003). ++ |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                       |
| 2.2    |   | Agreement and Plan of Merger dated August 8,  2005 among Overland, Zeppole Acquisition Corp. and Zetta Systems, Inc.  (incorporated by reference to the Company’s Form 10K filed September 15,  2005). ++                   |
|   |   |                                                                                                                                                                                                                                       |
| 3.1    |   | Amended and Restated Articles of Incorporation  (incorporated by reference to the Company’s Form 10-K filed  September 27, 2002).                                                                                           |
|   |   |                                                                                                                                                                                                                                       |
| 3.2    |   | Certificate of Amendment of Articles of  Incorporation (incorporated by reference to the Company’s Form 10-Q filed  February 10, 2006).                                                                                               |

 

25

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| 3.3    |   | Amended and Restated Bylaws (incorporated by  reference to the Company’s Form 8-K filed August 26, 2005).                                                                                                                     |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                         |
| 4.1    |   | Specimen stock certificate (incorporated by  reference to the Company’s Form 10-K filed September 27, 2002).                                                                                                                  |
|   |   |                                                                                                                                                                                                                                         |
| 4.2    |   | Shareholder Rights Agreement dated August 22,  2005 between Overland and Wells Fargo Bank, N.A., as Transfer Agent  (incorporated by reference to the Company’s Form 8-K filed  August 26, 2005).                        |
|   |   |                                                                                                                                                                                                                                         |
| 10.1   |   | Build-to-Suit Single Tenant Lease dated  October 12, 2000 between Overland and LBA-VIF One, LLC (incorporated by  reference to the Company’s Form 10-Q filed February 14, 2001).                                         |
|   |   |                                                                                                                                                                                                                                         |
| 10.2   |   | First Amendment to Lease dated January 18, 2001  between Overland and LBA Overland, LLC, as successor-in-interest to LBA-VIF One,  LLC (incorporated by reference to the Company’s Form 10-K filed  September 28, 2001). |
|   |   |                                                                                                                                                                                                                                         |
| 10.3   |   | Second Amendment to Lease dated March 8, 2001  between Overland and LBA Overland, LLC (incorporated by reference to the  Company’s Form 10-K filed September 28, 2001).                                                  |
|   |   |                                                                                                                                                                                                                                         |
| 10.4   |   | Business Loan Agreement dated November 28, 2001  between Overland and Comerica Bank-California (incorporated by reference to  the Company’s Form 10-Q filed February 13, 2002).                                          |
|   |   |                                                                                                                                                                                                                                         |
| 10.5   |   | Security Agreement dated November 28, 2001  between Overland and Comerica Bank-California (incorporated by reference to  the Company’s Form 10-Q filed February 13, 2002).                                               |
|   |   |                                                                                                                                                                                                                                         |
| 10.6   |   | Master Revolving Note dated November 28, 2001  between Overland and Comerica Bank-California (incorporated by reference to  the Company’s Form 10-Q filed February 13, 2002).                                            |
|   |   |                                                                                                                                                                                                                                         |
| 10.7   |   | Variable Rate-Single Payment Note dated  November 28, 2001 between Overland and Comerica Bank-California  (incorporated by reference to the Company’s Form 10-Q filed  February 13, 2002).                               |
|   |   |                                                                                                                                                                                                                                         |
| 10.8   |   | First Modification to Business Loan Agreement dated  August 13, 2002 between Overland and Comerica Bank-California  (incorporated by reference to the Company’s Form 10-Q filed  November 13, 2002).                     |
|   |   |                                                                                                                                                                                                                                         |
| 10.9   |   | Loan Modification to Business Loan Agreement dated  August 30, 2002 between Overland and Comerica Bank-California  (incorporated by reference to the Company’s Form 10-K filed  September 10, 2004).                     |
|   |   |                                                                                                                                                                                                                                         |
| 10.10  |   | Second Modification to Business Loan Agreement and  Addendum A dated September 10, 2003 between Overland and Comerica  Bank-California (incorporated by reference to the Company’s Form 10-Q  filed February 10, 2004).  |
|   |   |                                                                                                                                                                                                                                         |
| 10.11  |   | Loan Revision/Extension Agreement dated  September 10, 2003 between Overland and Comerica Bank-California  (incorporated by reference to the Company’s Form 10-Q filed  February 10, 2004).                              |
|   |   |                                                                                                                                                                                                                                         |
| 10.12  |   | Third Modification to Business Loan Agreement dated  October 25, 2004 between Overland and Comerica Bank-California  (incorporated by reference to the Company’s Form 10-Q filed  February 11, 2005).                    |
|   |   |                                                                                                                                                                                                                                         |
| 10.13  |   | Loan Revision/Extension Agreement dated  October 22, 2004 between Overland and Comerica Bank-California  (incorporated by reference to the Company’s Form 10-Q filed  February 11, 2005).                                |
|   |   |                                                                                                                                                                                                                                         |
| 10.14  |   | Fourth Modification to Business Loan Agreement dated  November 8, 2005 between Overland and Comerica Bank (incorporated by  reference to the Company’s Form 10-Q filed February 10, 2006).                                              |
|   |   |                                                                                                                                                                                                                                         |
| 10.15  |   | VR2 Technology  License Agreement dated April 27, 2000 between Overland and Storage  Technology Corp. (incorporated by reference to the Company’s Form 8-K  filed July 25, 2000). +                            |
|   |   |                                                                                                                                                                                                                                         |
| 10.16  |   | Amendment to VR2 Technology License Agreement dated  June 18, 2002 between Overland and Storage Technology Corp.  (incorporated by reference to the Company’s Form 10-K filed September 27,  2002). +               |
|   |   |                                                                                                                                                                                                                                         |
| 10.17  |   | Second Amendment to VR2 Technology License Agreement dated  November 7, 2003 between Overland and Storage Technology Corp.  (incorporated by reference to the Company’s Form 10-Q filed  February 10, 2004). +      |

 

26

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| 10.18  |   | Amendment Three to VR2 Technology License Agreement dated  March 29, 2004 between Overland and Storage Technology Corp.  (incorporated by reference to the Company’s Form 10-K filed  September 10, 2004). +                   |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                    |
| 10.19  |   | Base Agreement #4902RL1317 dated November 1,  2002 between Overland and International Business Machines Corporation  (incorporated by reference to the Company’s Form 10-Q filed  February 10, 2004). +                             |
|   |   |                                                                                                                                                                                                                                                    |
| 10.20  |   | Amendment dated October 6, 2005 to Statement of Work  #4902RL1340 to Base Agreement #4902RL1317 between Overland and International  Business Machines Corporation (incorporated by reference to the Company’s  Form 10-Q filed February 10, 2006). |
|   |   |                                                                                                                                                                                                                                                    |
| 10.21  |   | Product Purchase Agreement No. 1585-042103  dated July 31, 2003 between Overland and Hewlett Packard Company  (incorporated by reference to the Company’s Form 10-Q filed  February 10, 2004). +                          |
|   |   |                                                                                                                                                                                                                                                    |
| 10.22  |   | Addendum to Product Purchase Agreement  No. 1585-042103 effective July 30, 2006 between Overland and Hewlett  Packard Company.                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                    |
| 10.23  |   | Manufacturing Services Agreement between Overland  Storage, Inc. and Sanmina-SCI Corporation effective as of  November 23, 2004 (incorporated by reference to the Company’s  Form 10-Q filed February 11, 2005). +             |
|   |   |                                                                                                                                                                                                                                                    |
| 10.24  |   | Amendment No. 1 to Manufacturing Services  Agreement between Overland Storage, Inc. and Sanmina-SCI Corporation  effective as of May 30, 2005 (incorporated by reference to the Company’s  Form 10K filed September 15, 2005). +    |
|   |   |                                                                                                                                                                                                                                                    |
| 10.25* |   | Form of Indemnification Agreement entered into  between Overland and each of its directors and officers (incorporated by  reference to the Company’s Form 10-Q filed February 13, 2002).                                            |
|   |   |                                                                                                                                                                                                                                                    |
| 10.26* |   | Form of Retention Agreement entered into  between Overland and each of its executive officers (incorporated by reference  to the Company’s Form 10-K filed September 28, 2001).                                                     |
|   |   |                                                                                                                                                                                                                                                    |
| 10.27* |   | Employment Agreement dated March 12, 2001  between Overland and Christopher Calisi (incorporated by reference to the  Company’s Form 10-Q filed February 14, 2001).                                                                 |
|   |   |                                                                                                                                                                                                                                                    |
| 10.28* |   | Letter Agreement dated November 22, 2005 between  Overland and Christopher Calisi (incorporated by reference to the Company’s  Form 8-K filed November 29, 2005).                                                                                  |
|   |   |                                                                                                                                                                                                                                                    |
| 10.29* |   | Employment Agreement dated December 4, 2000  between Overland and Vernon A. LoForti (incorporated by reference to the  Company’s Form 10-Q filed February 14, 2001).                                                                |
|   |   |                                                                                                                                                                                                                                                    |
| 10.30* |   | Offer Letter dated June 27, 2005 between  Overland and George Karabatsos (incorporated by reference to the Company’s  Form 8-K filed August 12, 2005).                                                                              |
|   |   |                                                                                                                                                                                                                                                    |
| 10.31* |   | Separation and General Release Agreement dated July  24, 2006 between Overland and George Karabatsos (incorporated by reference to  the Company’s Form 8-K filed July 24, 2006).                                                                   |
|   |   |                                                                                                                                                                                                                                                    |
| 10.32* |   | Second Amendment to 1995 Stock Option Plan  (incorporated by reference to the Company’s Form S-8 Registration  Statement No. (333-41754) filed July 19, 2000).                                                                      |
|   |   |                                                                                                                                                                                                                                                    |
| 10.33* |   | Form of Stock Option Agreement for options  granted under the 1995 Stock Option Plan (incorporated by reference to the  Company’s Form 10-K filed September 28, 2001).                                                              |
|   |   |                                                                                                                                                                                                                                                    |
| 10.34* |   | First Amendment to 1997 Executive Stock Option Plan  (incorporated by reference to the Company’s Form S-8 Registration  Statement No. (333-41754) filed July 19, 2000).                                                             |
|   |   |                                                                                                                                                                                                                                                    |
| 10.35* |   | Form of Stock Option Agreement for options  granted under the 1997 Executive Stock Option Plan (incorporated by reference  to the Company’s Form 10-K filed September 28, 2001).                                                    |
|   |   |                                                                                                                                                                                                                                                    |
| 10.36* |   | 2000 Stock Option Plan, as amended and restated  (incorporated by reference to the Company’s Form 10-K filed  September 27, 2002).                                                                                                       |
|   |   |                                                                                                                                                                                                                                                    |
| 10.37* |   | Form of Notice of Stock Option Award and Stock  Option Award Agreement for options granted under 2000 Stock Option                                                                                                                                 |

 

27

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|        |   | Plan (incorporated by reference to the Company’s  Form 10-Q filed May 15, 2001).                                                                                                                                                                                 |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                            |
| 10.38* |   | 2001 Supplemental Stock Option Plan (incorporated by  reference to the Company’s Form S-8 Registration Statement  No. (333-75060) filed December 13, 2001).                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.39* |   | Form of Notice of Stock Option Award and Stock  Option Award Agreement for options granted under 2001 Supplemental Stock  Option Plan (incorporated by reference to the Company’s Form 10-K filed  September 27, 2002).                                     |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.40* |   | 2003 Equity Incentive Plan, as amended (incorporated  by reference to the Company’s Form 10-Q filed February 11, 2005).                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.41* |   | Form of Stock Option Agreement for options  granted to senior officers under the 2003 Equity Incentive Plan (incorporated  by reference to the Company’s Form 10-Q filed February 10, 2004).                                                                |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.42* |   | Form of Stock Option Agreement for options granted  to outside directors under the 2003 Equity Incentive Plan (incorporated by  reference to the Company’s Form 10-Q filed February 10, 2004).                                                              |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.43* |   | Form of Standard Stock Option Agreement for  options granted under the 2003 Equity Incentive Plan (incorporated by  reference to the Company’s Form 10-Q filed February 10, 2004).                                                                          |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.44* |   | Form of Restricted Stock Agreement for  restricted stock granted under the 2003 Equity Incentive Plan (incorporated  by reference to the Company’s Form 10K filed September 15, 2005).                                                                                |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.45* |   | Amended and Restated 1996 Employee Stock Purchase  Plan as amended August 22, 2005 (incorporated by reference to the Company’s  Form 10Q filed November 14, 2005).                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.46* |   | Employment Agreement dated May 16, 2005 between  Overland and W. Michael Gawarecki (incorporated by reference to the Company’s  Form 10K filed September 15, 2005).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.47* |   | Separation and General Release Agreement dated March  31, 2006 between Overland and Diane Gallo (incorporated by reference to the  Company’s Form 8-K filed March 22, 2006).                                                                                               |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.48* |   | Summary Sheet of Director and Executive Officer  Compensation.                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                            |
| 14.1   |   | Code of Business Conduct and Ethics (incorporated by  reference to the Company’s Form 10-K filed September 10, 2004).                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                            |
| 21.1   |   | Subsidiaries of the Registrant.                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                            |
| 23.1   |   | Consent of PricewaterhouseCoopers LLP, Independent  Registered Public Accounting Firm.                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                            |
| 24.1   |   | Power of Attorney (included on signature page).                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                            |
| 31.1   |   | Certification of Christopher Calisi, President and  Chief Executive Officer, pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities and Exchange Act of 1934, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                    |
|   |   |                                                                                                                                                                                                                                                                            |
| 31.2   |   | Certification of Vernon A. LoForti, Vice President  and Chief Financial Officer, pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities and Exchange Act of 1934, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                |
|   |   |                                                                                                                                                                                                                                                                            |
| 32.1   |   | Certification pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, executed by Christopher Calisi, President and  Chief Executive Officer, and Vernon A. LoForti, Vice President and Chief  Financial Officer. |

 

----

|        |   |                                                                                                                                                                                                                               |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| +      |   | The Company has requested confidential treatment for  certain portions of this Exhibit.                                                                                                                                            |
|   |   |                                                                                                                                                                                                                               |
| ++     |   | Certain schedules and similar attachments have been  omitted pursuant to Item 601(b)(2) of Regulation S-K. A copy of the  omitted schedules and similar attachments will be provided supplementally to  the SEC upon request. |
|   |   |                                                                                                                                                                                                                               |
| *      |   | Management contract or compensation plan or  arrangement.                                                                                                                                                                          |

 

28

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.
|                           | OVERLAND STORAGE, INC.                |                   |
|---------------------------|---------------------------------------|------------------------|
|                      |                                  |
| Dated: September 15, 2006 | By:                                   | /s/ CHRISTOPHER CALISI |   |
|                      | Christopher Calisi                    |
|                      | President and Chief Executive Officer |                   |
|                           |                                       |                        |  |  |

 

### **POWER OF ATTORNEY**

KNOW ALL MEN BY THESEPRESENTS, that each person whose signature appears below constitutes andappoints Christopher Calisi and Vernon A. LoForti, jointly and severally, ashis attorney-in-fact, each with the power of substitution, for him in any andall capacities, to sign any amendments to this Annual Report on Form 10-Kand to file the same, with exhibits thereto and other documents in connectiontherewith, with the Securities and Exchange Commission, hereby ratifying andconfirming all that each of said attorneys-in-fact, or his substitute orsubstitutes, may do or cause to be done by virtue hereof. Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
| Signature               | ** ** | **Title**                      | ** **                 | **Date** |
|-------------------------|------------|--------------------------------|----------------------------|----------|
|                    |       |                           |                       |     |
| /s/ CHRISTOPHER  CALISI |       |                           | President, Chief Executive |     | September 15, 2006 |
| Christopher  Calisi     |       | Officer and Director           |                       |     |
|                    |       | (Principal Executive Officer)  |                       |     |
|                    |       |                           |                       |     |
| /s/ VERNON A.  LoFORTI  |       |                           | Vice President, Chief      |     | September 15, 2006 |
| Vernon A.  LoForti      |       | Financial Officer and          |                       |     |
|                    |       | Secretary (Principal Financial |                       |     |
|                    |       | and Accounting Officer)        |                       |     |
|                    |       |                           |                       |     |
| /s/ MARK  BARRENECHEA   |       |                           | Director                   |     | September 15, 2006 |
| Mark Barrenechea        |       |                           |                       |     |
|                    |       |                           |                       |     |
| /s/ ROBERT A.  DEGAN    |       |                           | Director                   |     | September 15, 2006 |
| Robert A. Degan         |       |                           |                       |     |
|                    |       |                           |                       |     |
| /s/ SCOTT McCLENDON     |       |                           | Chairman of the Board      |     | September 15, 2006 |
| Scott McClendon         |       |                           |                       |     |
|                    |       |                           |                       |     |
| /s/ WILLIAM  MILLER     |       |                           | Director                   |     | September 15, 2006 |
| William Miller          |       |                           |                       |     |
|                    |       |                           |                       |     |
| /s/ MICHAEL  NORKUS     |       |                           | Director                   |     | September 15, 2006 |
| Michael Norkus          |       |                           |                       |     |
|                         |            |                                |                            |          |  |  |  |  |  |  |

 

29

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### **Reportof Independent Registered Public Accounting Firm**

To the Board ofDirectors and Shareholders of Overland Storage, Inc.

We have completedintegrated audits of Overland Storage, Inc.’s 2006 and 2005 consolidatedfinancial statements and of its internal control over financial reporting as ofJuly 2, 2006 and an audit of its 2004 consolidated financial statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Our opinions, based on our audits, are presented below.

Consolidated financial statements

In our opinion, the consolidated financial statements listed inthe index appearing under Item 15(a)(1)present fairly, in all material respects, the financial position of OverlandStorage, Inc. and its subsidiaries at July 2, 2006 and July 3, 2005, and theresults of their operations and their cash flows for each of the three years inthe period ended July 2, 2006 in conformity with accounting principlesgenerally accepted in the United States of America.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.  We conducted our audits of these statementsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit of financial statements includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

Asdiscussed in Note 1 to the consolidated financial statements, the Companychanged its method of accounting for share-based payments during the year endedJuly 2, 2006.

Internal controlover financial reporting

Also, we haveaudited management’s assessment, included in Management’s Report on InternalControl Over Financial Reporting appearing under Item 9A, that OverlandStorage, Inc. did not maintain effective internal control over financialreporting as of July 2, 2006, because the Company did not maintain effective controls over the completenessand cutoff of accounts payable and accrued expenses, based on criteria established in *InternalControl - Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting.  Ourresponsibility is to express opinions on management’s assessment and on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted ouraudit of internal control over financial reporting in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  An audit of internalcontrol over financial reporting includes obtaining an understanding ofinternal control over financial reporting, evaluating management’s assessment,testing and evaluating the design and operating effectiveness of internalcontrol, and performing such other procedures as we consider necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinions.

A company’sinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (i) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the

30

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company;(ii) provide reasonable assurance that transactions are recorded asnecessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expenditures ofthe company are being made only in accordance with authorizations of managementand directors of the company; and (iii) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use, ordisposition of the company’s assets that could have a material effect on thefinancial statements.

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

A materialweakness is a control deficiency, or combination of control deficiencies, thatresults in more than a remote likelihood that a material misstatement of theannual or interim financial statements will not be prevented or detected. Thefollowing material weakness has been identified and included in management’sassessment. As of July 2, 2006, the Company did not maintain effective controlsover the completeness and accuracy of accounts payable and accrued expenses.Specifically, controls over cut-off and completeness of accounts payable andaccrued expenses were insufficient to ensure that invoices from certain vendorswere properly evaluated at period end. This control deficiency resulted in audit adjustments to the Company’s2006 annual consolidated financial statements and the interim consolidatedfinancial statements for the quarter ended July 2, 2006. Additionally, thiscontrol deficiency could result in a misstatement of the Company’s accountspayable and accrued liabilities, cost of revenue, and operating expenses thatwould not be prevented or detected. Accordingly, management has determined thatthis control deficiency constitutes a material weakness. This material weaknesswas considered in determining the nature, timing, and extent of audit testsapplied in our audit of the 2006 consolidated financial statements, and ouropinion regarding the effectiveness of the Company’s internal control overfinancial reporting does not affect our opinion on those consolidated financialstatements.

In our opinion,management’s assessment that Overland Storage, Inc. did not maintain effectiveinternal control over financial reporting as of July 2, 2006, is fairly stated,in all material respects, based on criteria established in *InternalControl – Integrated Framework* issued by the COSO. Also, in ouropinion, because of the effect of the material weakness described above on theachievement of the objectives of the control criteria, Overland Storage, Inc.has not maintained effective internal control over financial reporting as ofJuly 2, 2006, based on criteria established in *InternalControl – Integrated Framework* issued by the COSO.

PricewaterhouseCoopersLLP

San Diego, California

September 13, 2006

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**OVERLAND STORAGE, INC.**

**CONSOLIDATED BALANCE SHEETS**

(in thousands)
| ** **                                                                                                            | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                                                            | ** ** | **2006**          | ** ** | **2005** | ** ** |
| **Assets**                                                                                                            |       |              |       |   |   |
| Current assets:                                                                                                       |       |              |       |   |   |
| Cash and cash  equivalents                                                                                            |       | $                 | 20,315     |   | $ | 5,498 |   |
| Short-term  investments                                                                                               |       | 42,197            |       | 71,389 |   |
| Accounts  receivable, less allowance for doubtful accounts of $436 and $298,  respectively                            |       | 30,321            |       | 37,703 |   |
| Inventories                                                                                                           |       | 14,978            |       | 19,108 |   |
| Deferred tax  assets                                                                                                  |       | 2,147             |       | 3,741 |   |
| Other current  assets                                                                                                 |       | 9,114             |       | 11,456 |   |
| Total current  assets                                                                                                 |       | 119,072           |       | 148,895 |   |
|                                                                                                                  |       |              |       |   |   |
| Property and equipment,  net                                                                                          |       | 11,026            |       | 8,758 |   |
| Intangible assets, net                                                                                                |       | 12,615            |       | 5,193 |   |
| Other assets                                                                                                          |       | 2,056             |       | 1,708 |   |
| Total assets                                                                                                          |       | $                 | 144,769    |   | $ | 164,554 |   |
|                                                                                                                  |       |              |       |   |   |
| **Liabilities and Shareholders’  Equity**                                                                        |       |              |       |   |   |
| Current liabilities:                                                                                                  |       |              |       |   |   |
| Accounts payable                                                                                                      |       | $                 | 17,399     |   | $ | 17,015 |   |
| Accrued  liabilities                                                                                                  |       | 15,330            |       | 12,460 |   |
| Accrued payroll  and employee compensation                                                                            |       | 4,277             |       | 3,973 |   |
| Income taxes  payable                                                                                                 |       | 278               |       | 926 |   |
| Accrued warranty                                                                                                      |       | 5,407             |       | 4,158 |   |
| Total current  liabilities                                                                                            |       | 42,691            |       | 38,532 |   |
|                                                                                                                  |       |              |       |   |   |
| Deferred tax  liabilities                                                                                             |       | 2,147             |       | 1,454 |   |
| Other liabilities                                                                                                     |       | 4,493             |       | 3,074 |   |
| Total  liabilities                                                                                                    |       | 49,331            |       | 43,060 |   |
|                                                                                                                  |       |              |       |   |   |
| Commitments and  contingencies (Note 12)                                                                              |       |              |       |   |   |
|                                                                                                                  |       |              |       |   |   |
| Shareholders’ equity:                                                                                            |       |              |       |   |   |
| Common stock, no  par value, 45,000 shares authorized; 13,230 and 14,123 shares issued and  outstanding, respectively |       | 70,496            |       | 77,494 |   |
| Accumulated  other comprehensive loss                                                                                 |       | (347              | )          | (312 | ) |
| Deferred  compensation                                                                                                |       | —            |       | (463 | ) |
| Retained  earnings                                                                                                    |       | 25,289            |       | 44,775 |   |
| Total  shareholders’ equity                                                                                      |       | 95,438            |       | 121,494 |   |
| Total liabilities and  shareholders’ equity                                                                      |       | $                 | 144,769    |   | $ | 164,554 |   |

 

See accompanying notes to consolidated financialstatements.

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**OVERLAND STORAGE, INC.**

##### **CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(in thousands, except pershare amounts)
| ** **                                             | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------------|------------|----------------------|------------|
| ** **                                             | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net revenue:                                           |       |                 |       |   |   |   |   |
| Product revenues                                       |       | $                    | 207,207    |   | $ | 233,695 |   | $ | 236,341 |   |
| Royalty fees                                           |       | 1,831                |       | 1,992 |   | 1,798 |   |
|                                                   |       | 209,038              |       | 235,687 |   | 238,139 |   |
| Cost of revenue                                        |       | 162,592              |       | 174,770 |   | 173,485 |   |
| Gross profit                                           |       | 46,446               |       | 60,917 |   | 64,654 |   |
|                                                   |       |                 |       |   |   |   |   |
| Operating  expenses:                                   |       |                 |       |   |   |   |   |
| Sales and marketing                                    |       | 37,940               |       | 34,382 |   | 30,848 |   |
| Research and development                               |       | 18,752               |       | 10,687 |   | 7,259 |   |
| General and administrative                             |       | 14,564               |       | 12,324 |   | 10,949 |   |
| In-process research and development                    |       | 1,121                |       | — |   | — |   |
|                                                   |       | 72,377               |       | 57,393 |   | 49,056 |   |
| (Loss) income  from operations                         |       | (25,931              | )          | 3,524 |   | 15,598 |   |
|                                                   |       |                 |       |   |   |   |   |
| Other income  (expense):                               |       |                 |       |   |   |   |   |
| Interest income                                        |       | 2,771                |       | 1,613 |   | 601 |   |
| Interest expense                                       |       | (12                  | )          | (76 | ) | (68 | ) |
| Other income (expense), net                            |       | (139                 | )          | 7 |   | 68 |   |
| (Loss) income  before income taxes                     |       | (23,311              | )          | 5,068 |   | 16,199 |   |
| (Benefit from)  provision for income taxes             |       | (3,825               | )          | 490 |   | 5,574 |   |
| Net (loss)  income                                     |       | $                    | (19,486    | ) | $ | 4,578 |   | $ | 10,625 |   |
|                                                   |       |                 |       |   |   |   |   |
| Net (loss)  income per share:                          |       |                 |       |   |   |   |   |
| Basic                                                  |       | $                    | (1.42      | ) | $ | 0.33 |   | $ | 0.79 |   |
| Diluted                                                |       | $                    | (1.42      | ) | $ | 0.32 |   | $ | 0.74 |   |
|                                                   |       |                 |       |   |   |   |   |
| Shares used in  computing net (loss) income per share: |       |                 |       |   |   |   |   |
| Basic                                                  |       | 13,716               |       | 13,899 |   | 13,384 |   |
| Diluted                                                |       | 13,716               |       | 14,429 |   | 14,404 |   |

 

See accompanying notes to consolidated financialstatements.

33

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**OVERLAND STORAGE, INC.**

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITYAND COMPREHENSIVE INCOME (LOSS)**

(in thousands)
| ** **                                                      | ** ** | **Common Stock** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Deferred** | ** ** | **Retained**     | ** ** | **Total  Shareholders’** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|--------------|------------|------------------|------------|-------------------------------|------------|
| ** **                                                      | ** ** | **Shares**            | ** ** | **Amount**                            | ** ** | **Loss**     | ** ** | **Compensation** | ** ** | **Earnings**                  | ** ** | **Equity** | ** ** |
| Balance at  June 30, 2003                                  |       | 12,959                |       | $                                     | 63,884     |         | $          | (192             | )          | $                             | —     |   | $ | 29,572 |   | $ | 93,264 |   |
| Stock option and  purchase plans                                |       | 735                   |       | 6,251                                 |       | —       |       | —           |       | —                        |       | 6,251 |   |
| Tax benefits  from exercise of stock options                    |       | —                |       | 3,438                                 |       | —       |       | —           |       | —                        |       | 3,438 |   |
| Comprehensive  income:                                          |       |                  |       |                                  |       |         |       |             |       |                          |       |   |   |
| Net income                                                      |       | —                |       | —                                |       | —       |       | —           |       | 10,625                        |       | 10,625 |   |
| Foreign currency translation                                    |       | —                |       | —                                |       | (31          | )          | —           |       | —                        |       | (31 | ) |
| Unrealized loss on short-term investments                       |       | —                |       | —                                |       | (33          | )          | —           |       | —                        |       | (33 | ) |
| Total comprehensive income                                      |       | —                |       | —                                |       | —       |       | —           |       | —                        |       | 10,561 |   |
| Balance at  June 30, 2004                                  |       | 13,694                |       | 73,573                                |       | (256         | )          | —           |       | 40,197                        |       | 113,514 |   |
| Stock option and  purchase plans                                |       | 362                   |       | 2,972                                 |       | —       |       | —           |       | —                        |       | 2,972 |   |
| Issuance of  restricted stock                                   |       | 100                   |       | —                                |       | —       |       | —           |       | —                        |       | — |   |
| Deferred  compensation                                          |       | —                |       | 543                                   |       | —       |       | (463             | )          | —                        |       | 80 |   |
| Repurchase of  common stock                                     |       | (33                   | )          | (309                                  | )          | —       |       | —           |       | —                        |       | (309 | ) |
| Tax benefits  from exercise of stock options                    |       | —                |       | 715                                   |       | —       |       | —           |       | —                        |       | 715 |   |
| Comprehensive  income:                                          |       |                  |       |                                  |       |         |       |             |       |                          |       |   |   |
| Net income                                                      |       | —                |       | —                                |       | —       |       | —           |       | 4,578                         |       | 4,578 |   |
| Foreign currency translation                                    |       | —                |       | —                                |       | 24           |       | —           |       | —                        |       | 24 |   |
| Unrealized loss on short-term investments                       |       | —                |       | —                                |       | (80          | )          | —           |       | —                        |       | (80 | ) |
| Total comprehensive income                                      |       | —                |       | —                                |       | —       |       | —           |       | —                        |       | 4,522 |   |
| Balance at  June 30, 2005                                  |       | 14,123                |       | 77,494                                |       | (312         | )          | (463             | )          | 44,775                        |       | 121,494 |   |
| Reverse deferred  compensation upon adoption of SFAS No. 123(R) |       | —                |       | (463                                  | )          | —       |       | 463              |       | —                        |       | — |   |
| Stock option and  purchase plans                                |       | 349                   |       | 2,258                                 |       | —       |       | —           |       | —                        |       | 2,258 |   |
| Issuance of  restricted stock, net                              |       | 61                    |       | —                                |       | —       |       | —           |       | —                        |       | — |   |
| Repurchase of  common stock                                     |       | (1,303                | )          | (10,804                               | )          | —       |       | —           |       | —                        |       | (10,804 | ) |
| Share-based  compensation expense                               |       | —                |       | 2,011                                 |       | —       |       | —           |       | —                        |       | 2,011 |   |
| Comprehensive  loss:                                            |       |                  |       |                                  |       |         |       |             |       |                          |       |   |   |
| Net loss                                                        |       | —                |       | —                                |       | —       |       | —           |       | (19,486                       | )          | (19,486 | ) |
| Foreign currency translation                                    |       | —                |       | —                                |       | 136          |       | —           |       | —                        |       | 136 |   |
| Unrealized loss on short-term investments                       |       | —                |       | —                                |       | (171         | )          | —           |       | —                        |       | (171 | ) |
| Total comprehensive loss                                        |       | —                |       | —                                |       | —       |       | —           |       | —                        |       | (19,521 | ) |
| Balance at  June 30, 2006                                  |       | 13,230                |       | $                                     | 70,496     |         | $          | (347             | )          | $                             | —     |   | $ | 25,289 |   | $ | 95,438 |   |

 

See accompanying notes to consolidated financialstatements.

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**OVERLAND STORAGE, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(in thousands)
| ** **                                                                                                | ** ** | **Fiscal Year** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating  activities:**                                                                                | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net (loss)  income                                                                                        |       | $                    | (19,486    | ) | $ | 4,578 |   | $ | 10,625 |   |
| Adjustments to  reconcile net (loss) income to cash provided by operating activities:                     |       |                 |       |   |   |   |   |
| Depreciation and amortization                                                                             |       | 6,884                |       | 4,289 |   | 4,164 |   |
| Deferred tax provision                                                                                    |       | (1,429               | )          | (1,071 | ) | (885 | ) |
| Provision for losses on accounts receivable                                                               |       | 159                  |       | 97 |   | 10 |   |
| Acquired in-process research and development                                                              |       | 1,121                |       | — |   | — |   |
| Tax benefits from exercise of stock options                                                               |       | —               |       | 715 |   | 3,438 |   |
| Share-based compensation                                                                                  |       | 2,011                |       | 109 |   | — |   |
| Realized loss (gain) on short-term investments                                                            |       | 23                   |       | (2 | ) | — |   |
| Amortization of discount on short-term investments                                                        |       | 122                  |       | 147 |   | 29 |   |
| Loss on disposal of property and equipment                                                                |       | 17                   |       | 35 |   | — |   |
| Changes in operating assets and liabilities, net of  effects of acquisition:                              |       |                 |       |   |   |   |   |
| Accounts receivable                                                                                       |       | 7,223                |       | (4,006 | ) | (1,954 | ) |
| Inventories                                                                                               |       | 4,130                |       | (3,982 | ) | 4,136 |   |
| Accounts payable and accrued liabilities                                                                  |       | 3,324                |       | 11,650 |   | (218 | ) |
| Accrued payroll and employee compensation                                                                 |       | 282                  |       | 866 |   | (87 | ) |
| Other assets and liabilities, net                                                                         |       | 2,875                |       | (5,172 | ) | (4,660 | ) |
| Net cash provided by operating activities                                                                 |       | 7,256                |       | 8,253 |   | 14,598 |   |
|                                                                                                      |       |                 |       |   |   |   |   |
| **Investing  activities:**                                                                                | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of short-term investments                                                                       |       | (69,878              | )          | (114,218 | ) | (132,666 | ) |
| Proceeds from maturities of short-term investments                                                        |       | 95,922               |       | 95,252 |   | 75,569 |   |
| Proceeds from sales of short-term investments                                                             |       | 2,832                |       | 4,316 |   | — |   |
| Capital expenditures                                                                                      |       | (3,972               | )          | (3,406 | ) | (2,141 | ) |
| Net cash payments to acquire the stock of Zetta  Systems, Inc                                        |       | (8,857               | )          | — |   | — |   |
| Net cash provided by (used in) investing activities                                                       |       | 16,047               |       | (18,056 | ) | (59,238 | ) |
|                                                                                                      |       |                 |       |   |   |   |   |
| **Financing  activities:**                                                                                | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Payments on long-term debt                                                                                |       | —               |       | — |   | (3,957 | ) |
| Proceeds from the exercise of stock options and the  sale of stock under the employee stock purchase plan |       | 2,258                |       | 2,943 |   | 6,251 |   |
| Repurchase of common stock                                                                                |       | (10,804              | )          | (309 | ) | — |   |
| Net cash (used in) provided by financing activities                                                       |       | (8,546               | )          | 2,634 |   | 2,294 |   |
| Effect of  exchange rate changes on cash                                                                  |       | 60                   |       | 24 |   | (31 | ) |
| Net increase  (decrease) in cash and cash equivalents                                                     |       | 14,817               |       | (7,145 | ) | (42,377 | ) |
| Cash and cash  equivalents, beginning of year                                                             |       | 5,498                |       | 12,643 |   | 55,020 |   |
| Cash and cash  equivalents, end of year                                                                   |       | $                    | 20,315     |   | $ | 5,498 |   | $ | 12,643 |   |
|                                                                                                      |       |                 |       |   |   |   |   |
| **Supplemental  disclosure of cash flow information:**                                                    | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for income taxes                                                                                |       | $                    | 735        |   | $ | 2,555 |   | $ | 4,590 |   |
| Cash paid for interest                                                                                    |       | $                    | 9          |   | $ | — |   | $ | 75 |   |
| **Non-cash  investing activities:**                                                                       | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Change in net  unrealized loss on short-term investments                                                  |       | $                    | 171        |   | $ | 80 |   | $ | 33 |   |
| Capital  expenditures received not paid as of year end                                                    |       | $                    | 709        |   | $ | — |   | $ | — |   |

 

See accompanying notes to consolidated financialstatements

35

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**OVERLAND STORAGE, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1 -OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

**General**

Overland Storage, Inc. (We, Overland or theCompany) was incorporated on September 8, 1980, under the laws of the Stateof California. For more than 25 years wehave delivered data protection solutions designed for backup and recovery toensure business continuity. Historically, we have focused on delivering aportfolio of tape automation solutions including loader and library systemsdesigned for small business and midrange computing environments.

The Companyoperates and reports using a 52-53 week fiscal year with each quarter ending onthe Sunday closest to the calendar quarter. For ease of presentation, theCompany’s last fiscal year is considered to end on June 30, 2006. Forexample, references to fiscal 2006, 2005 and 2004 refer to the fiscal yearended July 2, 2006, July 3, 2005 and June 28, 2004, respectively. Fiscal2006, 2005 and 2004 contained 52 weeks, 53 weeks and 52 weeks, respectively.

Certain prior year amounts have been reclassified toconform to the current year presentation.

During the fourth quarter of fiscal 2006, the Companyrecorded certain amounts relating to prior 2006 quarters and prior years resultingin a reduction of its net loss by $313,000 ($0.03 per share) and $324,000($0.02 per share) for the quarter and year ended July 2, 2006, respectively.The Company concluded that the amounts were not material to anypreviously-reported annual or interim period nor was the cumulative amountmaterial to the current fiscal year. As such, the amounts were recorded in thefourth quarter of fiscal 2006 and prior periods were not restated.

**Principlesof Consolidation**

The consolidated financial statements include theaccounts of the Company and its wholly owned subsidiaries, Overland Storage(Europe) Ltd., Overland Storage SARL, Overland Storage GmbH, Okapi AcquisitionCo., Inc., Zetta Systems, Inc., and Overland Storage Export Limited, aforeign sales corporation. All significant intercompany accounts andtransactions have been eliminated.

**ManagementEstimates and Assumptions**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and reported amounts of revenue and expenses during the reportingperiod. Estimates have been prepared on the basis of the most current and bestavailable information and actual results could differ from those estimates.Significant estimates made by management include revenue recognition, share-basedcompensation, allowance for doubtful accounts, inventory valuation, warrantyaccrual, valuation of intangible assets, long-lived assets and the valuationallowance on deferred tax assets, among others.

**RevenueRecognition**

Revenue from sales of products is recognized whenpersuasive evidence of an arrangement exists, the price is fixed ordeterminable, collectibility is reasonably assured and delivery has occurred.Under this policy, revenue on direct product sales (excluding sales todistributors and certain OEM customers) is recognized upon shipment of productsto our customers. These customers are not entitled to any specific right ofreturn or price protection, except for any defective product that may bereturned under our warranty policy. Title and risk of loss transfer to thecustomer when the product leaves our dock. Product sales to distributioncustomers are subject to certain rights of return, stock rotation privilegesand price protection. Because we are unable to estimate our exposure for returnedproduct or price adjustments, revenue from shipments to these customers is notrecognized until the related products are in turn sold to the ultimate customerby the distributor. As part of our existing agreements with certain OEMcustomers, we ship products to various distribution hubs around the world andretain ownership of that inventory until it is pulled by these OEM customers tofulfill their customer orders, at which time revenue is recognized.

We have entered intovarious licensing agreements relating to our Variable Rate Randomizer (VR2) technology. These agreementstypically call for royalty fees based on sales by licensees of productscontaining VR2. Royaltieson sales by licensees of products containing VR2 arerecorded when earned, generally in the period during which the licensee shipsthe products containing VR2 technology. In certain instances, the customerhas elected to purchase from us the Applications Specific Integrated Circuit(ASIC)

36

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chips embodying VR2, whichare priced to include the cost of the chip plus an embedded royalty fee; andrevenue on ASIC chip sales is recorded as product revenue when earned, which isupon the shipment of the underlying ASIC chip incorporating the VR2 technology to the customer.

When elements such ashardware and services are contained in an arrangement, we allocate revenue tothe separate elements based on relative fair value, provided we have fair valuefor all elements of the arrangement. If in an arrangement we have fair valuefor undelivered elements but not the delivered element, we defer the fair valueof the undelivered elements and the residual revenue is allocated to thedelivered elements.  Undelivered elements typically includeservices.  Revenue from extended warranty and product service contracts isinitially deferred and recognized as revenue ratably over the contract period.

**Warrantyand Extended Warranty**

We generally provide a three-year advance replacementreturn-to-factory warranty on our NEO SERIES®, REO SERIES®, PowerLoader® and LoaderXpress® products. We also provide on-site service,where available, for the first warranty year of the NEO SERIES products forwhich we contract with third-party service providers. For most products, weoffer a program called XchangeNOW® as part of ourreturn-to-factory warranty which enables customers to receive an advancereplacement unit shipped within two business days after placing a servicerequest. The customer ships the defective unit back to us using the shippingmaterials from the replacement unit. We record a provision for estimated futurewarranty costs for both the return-to-factory and on-site warranties. If futureactual costs to repair were to differ significantly from our estimates, wewould record the impact of these unforeseen costs or cost reductions insubsequent periods. 

Separately priced extended on-site warranties are offered forsale to customers of other product lines. We contract with outside vendors toprovide service relating to all on-site warranties. Extended warranty revenueand amounts paid in advance to outside service organizations are deferred andrecognized as revenue and cost of revenue, respectively, over the period of theservice agreement.

Changes in the liability for product warranty anddeferred revenue associated with extended warranties were as follows (inthousands):
|                                                              | ** ** | **Product  Warranty** | ** ** | **Deferred  Revenue** | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| Liability at  June 30, 2004                                  |       | $                     | 2,594      |                  | $          | 3,091 |   |
| Settlements made  during the period                          |       | (1,852                | )          | (3,975                | )          |
| Change in  liability for warranties issued during the period |       | 3,047                 |       | 6,311                 |       |
| Change in  liability for preexisting warranties              |       | 369                   |       | 35                    |       |
| Liability at  June 30, 2005                                  |       | 4,158                 |       | 5,462                 |       |
| Settlements made  during the period                          |       | (1,908                | )          | (6,871                | )          |
| Change in  liability for warranties issued during the period |       | 3,417                 |       | 10,256                |       |
| Change in  liability for preexisting warranties              |       | (260                  | )          | (25                   | )          |
| Liability at June 30,  2006                                  |       | $                     | 5,407      |                  | $          | 8,822 |   |

 

#### **Shippingand Handling**

Amounts billed to customers for shipping and handlingare included in product sales and costs incurred related to shipping andhandling are included in cost of revenue.

#### **AdvertisingCosts**

Advertising costs areexpensed as incurred. Advertising expenses for fiscal 2006, 2005 and 2004 were$1.4 million, $1.5 million and $1.7 million, respectively.

**Researchand Development Costs**

Research and development costs are expensed asincurred. Software development costs are expensed until technologicalfeasibility has been established, at which time any additional costs would becapitalized in accordance with Financial Accounting Standards Board (FASB)Statement of Financial Standards (SFAS) No. 86, *Accountingfor the Costs of Software to be Sold, Leased or Otherwise Marketed*.Because we believe our current process for developing software is essentiallycompleted concurrently with the establishment of technological feasibility,which occurs upon the completion of a working model, no costs have beencapitalized for any of the periods presented.

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**Segment Data**

The Company reports segment data based on themanagement approach. The management approach designates the internal reportingthat is used by management for making operating and investment decisions andevaluating performance as the source of the Company’s reportable segments. TheCompany uses one measurement of profitability and does not disaggregate itsbusiness for internal reporting. Based on the criteria of SFAS No. 131, *Disclosures about Segments of an Enterprise and Related Information*,the Company has determined that it operates in one segment providing datastorage solutions for mid-range computer networks. The Company disclosesinformation about products and services, geographic areas and major customers.

#### **Informationabout Products and Services**

The following table summarizes net revenue by product,in thousands:
|                             | ** ** | **Fiscal Year** | ** ** |
|-----------------------------|------------|----------------------|------------|
| ** **                  | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| LibraryXpress  products:    |       |                 |       |   |   |   |   |
| NEO Series                  |       | $                    | 131,371    |   | $ | 160,343 |   | $ | 163,795 |   |
| Loaders                     |       | 15,434               |       | 20,914 |   | 24,442 |   |
|                        |       | 146,805              |       | 181,257 |   | 188,237 |   |
| Spare parts,  drives, other |       | 45,686               |       | 42,303 |   | 44,405 |   |
| Disk based                  |       | 13,603               |       | 9,895 |   | 1,719 |   |
| VR2                         |       | 2,944                |       | 2,232 |   | 3,778 |   |
|                        |       | $                    | 209,038    |   | $ | 235,687 |   | $ | 238,139 |   |

 

#### ** Information about Geographic Areas**

The Company markets its products domestically andinternationally, with its principal international market being Europe. Thetables below contain information about the geographical areas in which theCompany operates. Revenue is attributed to the location to which the productwas shipped. Long-lived assets are based on location of domicile.
|                          | ** ** | **Net Revenue**    | ** ** | **Long-Lived  Assets** | ** ** |
|--------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **               | ** ** | **(in thousands)** | ** ** |
| **Fiscal  2006**         |       |                    |       |                   |       |
| United States            |       | $                       | 90,412     |                   | $          | 22,933 |   |
| United Kingdom           |       | 47,914                  |       | 689                    |       |
| Rest of Europe           |       | 29,098                  |       | 19                     |       |
| Singapore                |       | 22,940                  |       | —                 |       |
| Other foreign  countries |       | 18,674                  |       | —                 |       |
|                     |       | $                       | 209,038    |                   | $          | 23,641 |   |
| **Fiscal  2005**         |       |                    |       |                   |       |
| United States            |       | $                       | 97,156     |                   | $          | 13,276 |   |
| United Kingdom           |       | 65,845                  |       | 667                    |       |
| Rest of Europe           |       | 28,464                  |       | 8                      |       |
| Singapore                |       | 21,822                  |       | —                 |       |
| Other foreign  countries |       | 22,400                  |       | —                 |       |
|                     |       | $                       | 235,687    |                   | $          | 13,951 |   |
| **Fiscal  2004**         |       |                    |       |                   |       |
| United States            |       | $                       | 121,641    |                   | $          | 14,048 |   |
| United Kingdom           |       | 67,209                  |       | 821                    |       |
| Rest of Europe           |       | 24,355                  |       | —                 |       |
| Singapore                |       | 9,415                   |       | —                 |       |
| Other foreign  countries |       | 15,519                  |       | —                 |       |
|                     |       | $                       | 238,139    |                   | $          | 14,869 |   |

 

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**CashEquivalents and Short-Term Investments**

Highly liquid investments with insignificant interestrate risk and original maturities of three months or less, when purchased, areclassified as cash equivalents. Cash equivalents are comprised of money marketfunds. The carrying amounts approximate fair value due to the short maturitiesof these instruments.

Investments with maturities greater than three monthsare classified as short-term investments. The Company manages its cashequivalents and short-term investments as a single portfolio of highlymarketable securities, all of which are intended to be available for theCompany’s current operations. As such, all of the Company’s short-terminvestments are classified as available-for-sale and are reported at fairvalue, generally as determined by quoted market prices, with any unrealizedgains and losses, net of tax, recorded as a separate component of accumulatedother comprehensive income (loss) in shareholders’ equity. The cost ofsecurities sold is based on the specific identification method. Investments inauction rate securities are recorded, in short-term investments, at cost, whichapproximates fair value due to their variable interest rates, which typicallyreset every 27 to 34 days, and, despite the long-term nature of their statedcontractual maturities, the Company has the ability to quickly liquidate thesesecurities.

**AccountsReceivable and Allowance for Doubtful Accounts**

The Company records accounts receivable at invoiceamount and does not charge interest thereon. The Company estimates its allowance for doubtful accountsbased on an assessment of the collectibility of specific accounts and theoverall condition of the accounts receivable portfolio. When evaluating theadequacy of the allowance for doubtful accounts, the Company analyzes specifictrade and other receivables, historical bad debts, customer credits, customerconcentrations, customer credit-worthiness, current economic trends and changesin customers’ payment terms and/or patterns. The Company reviews the allowancefor doubtful accounts on a quarterly basis and records adjustments asconsidered necessary. Customer accounts are written-off against the allowancefor doubtful accounts when an account is considered uncollectible.

**Inventories**

Inventories are stated atthe lower of cost (first-in-first-out method) or market.

#### **Propertyand Equipment**

Property and equipment are recorded at cost. TheCompany also capitalizes qualifying internal use software costs incurred duringthe application development stage. Depreciation expense is computed using thestraight-line method. Leasehold improvements are depreciated over the shorter ofthe estimated useful life of the asset or the term of the lease. Estimateduseful lives are as follows:
| Machinery and equipment          |   | 3-5 years |
|----------------------------------|--------|-----------|
| Furniture and  fixtures          |   | 5 years   |
| Computer  equipment and software |   | 1-5 years |

 

Expenditures for normal maintenance and repair arecharged to expense as incurred, and improvements are capitalized. Upon the saleor retirement of property or equipment, the asset cost and related accumulateddepreciation are removed from the respective accounts and any gain or loss isincluded in the results of operations.

#### **Long-LivedAssets**

The Company evaluates therecoverability of long-lived assets, including property and equipment andcertain identifiable intangible assets, in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets.*The Company tests for recoverabilitywhenever events or changes in circumstances indicate the carrying value may notbe recoverable. We consider such events or changes, as potential triggersof non-recoverability:

·                  significantunderperformance relative to historical or projected future operating results;

·                  significantchanges in the manner of use of the assets or the strategy for our overallbusiness;

·                  significantdecrease in the market value of the assets; and

·                  significantnegative industry or economic trends.

When thecarrying value is not considered recoverable, an impairment loss, for theamount by which the carrying value of a long-lived asset exceeds its fairvalue, is recognized with an offsetting reduction in the carrying value of therelated asset(s).

Fair value is generallydetermined based on the estimated future discounted cash flows over theremaining useful life of the

39

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asset using adiscount rate determined by management to be commensurate with the riskinherent in the Company’s current business model.

#### **DeferredRent**

Rent expense is recordedon a straight-line basis over the term of the lease. The difference betweenrent expense and amounts paid under the lease agreements is recorded in otherliabilities in the accompanying balance sheets.

**ForeignCurrency Translation**

The financial statementsof foreign subsidiaries, for which the functional currency is the localcurrency, are translated into U.S. dollars using the exchange rate at the balancesheet date for assets and liabilities and a weighted-average exchange rateduring the year for revenue, expenses, gains and losses. Translationadjustments are recorded as accumulated other comprehensive income withinshareholders’ equity. Gains or losses from foreign currency transactions arerecognized currently in income. Such transactions resulted in a loss of$186,000, a gain of $62,000 and a gain of $69,000 for fiscal 2006, 2005 and2004, respectively.

#### **IncomeTaxes**

The Company provides for income taxes utilizing the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes generally represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of the Company’s assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when a judgment is made that it is considered more likely than not that a tax benefit will not be realized. A decision to record a valuation allowance results in an increase in income tax expense or a decrease in income tax benefit (as we had in fiscal 2006). If the valuation allowance, recorded in fiscal 2006, is released in a future period, income tax expense will be reduced accordingly.

The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on the Company’s estimate of whether, and the extent to which, additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when the liabilities are no longer determined to be necessary. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result.

#### **AccumulatedOther Comprehensive Loss**

Comprehensive (loss)income for the Company includes net (loss) income, foreign currency translationadjustments and unrealized losses on available-for-sale securities, which arecharged or credited to accumulated other comprehensive income withinshareholders’ equity. For fiscal 2006, 2005 and 2004, the components ofaccumulated other comprehensive loss were as follow (in thousands):
| ** **                                  | ** ** | **Fiscal Year** | ** ** |
|---------------------------------------------|------------|----------------------|------------|
| ** **                                  | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Foreign currency  translation adjustments   |       | $                    | (63        | ) | $ | (199 | ) | $ | (223 | ) |
| Unrealized loss  on short-term investments  |       | (284                 | )          | (113 | ) | (33 | ) |
| Total accumulated other  comprehensive loss |       | $                    | (347       | ) | $ | (312 | ) | $ | (256 | ) |

 

#### **Concentrationof Credit Risks**

Financial instrumentswhich potentially subject the Company to concentrations of credit risk consistprimarily of cash equivalents, short-term investments and trade accountsreceivable, which are generally not collateralized. The Company limits itsexposure to credit loss by placing its cash equivalents and short-terminvestment with high quality financial institutions and investing in high qualityshort-term debt instruments. The Company performs ongoing credit evaluations ofits customers, generally requires no collateral and maintains allowances forpotential credit losses and sales returns.

The Company’s largestsingle customer accounted for approximately 49.7%, 54.3% and 58.8% of sales infiscal 2006, 2005 and 2004, respectively, and approximately 36.8%, 48.9% and44.2% of accounts receivable as of the end of fiscal 2006, 2005 and 2004,respectively. No other customer accounted for 10% or more of sales in any ofthe three years presented.

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#### **FairValue of Financial Instruments**

The Company’s financialinstruments consist of cash and cash equivalents, short-term investments,accounts receivable and accounts payable. Investments in debt securities arerecorded at fair value based on quoted market prices for these securities. Thecarrying amounts of other instruments approximate fair value because of theirshort-term maturities.

**Net(Loss) Income per Share**

Basic net (loss) income per share is computed based onthe weighted-average number of shares of common stock outstanding during theperiod. Diluted net (loss) income per share is computed based on theweighted-average number of shares of common stock outstanding during the periodincreased by the weighted-average number of dilutive common stock equivalentsoutstanding during the period, using the treasury stock method. Dilutivesecurities are comprised of options granted and restricted stock awards issuedunder the Company’s stock option plans and ESPP share purchase rights.

A reconciliation of thecalculation of basic and diluted earnings per share is as follows:
|                                                           | ** ** | **Fiscal Year**                                                  | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                | ** ** | **(in thousands, except per share amounts)** | ** ** |
| ** **                                                | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net (loss)  income                                        |       | $                                                                     | (19,486    | ) | $ | 4,578 |   | $ | 10,625 |   |
| Basic:                                                    |       |                                                                  |       |   |   |   |   |
| Weighted-average number of common shares outstanding      |       | 13,716                                                                |       | 13,899 |   | 13,384 |   |
| Basic net (loss) income per share                         |       | $                                                                     | (1.42      | ) | $ | 0.33 |   | $ | 0.79 |   |
|                                                      |       |                                                                  |       |   |   |   |   |
| Diluted:                                                  |       |                                                                  |       |   |   |   |   |
| Weighted-average number of common shares outstanding      |       | 13,716                                                                |       | 13,899 |   | 13,384 |   |
| Common stock equivalents using the treasury stock  method |       | —                                                                |       | 530 |   | 1,020 |   |
| Shares used in computing diluted net income per  share    |       | 13,716                                                                |       | 14,429 |   | 14,404 |   |
| Diluted net  (loss) income per share                      |       | $                                                                     | (1.42      | ) | $ | 0.32 |   | $ | 0.74 |   |

 

Anti-dilutive common stock equivalents excluded fromthe computation of diluted net (loss) income per share were as follows:
|                                      | ** ** | **Fiscal Year**    | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **(in thousands)** | ** ** |
| ** **                           | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Options  outstanding                 |       | 2,632                   |       | 1,287 |   | 512 |   |
| Restricted stock awards  outstanding |       | 144                     |       | — |   | — |   |

 

**Change inAccounting Principle and Share-Based Compensation**

The Companyadopted SFAS No. 123 (revised 2004) (123(R)), *Share-BasedPayment*, on July 4, 2005. Upon adoption of SFASNo. 123(R), deferred compensation previously recognized in the balancesheet for fiscal 2005 was reversed with the offsetting decrease in commonstock. Compensation costs associated with the deferred compensation will berecorded to expense over the requisite service period associated with therestricted stock.

The Company’s share-based compensation plans aredescribed in Note 9. Prior to the adoption of SFAS No. 123(R) onJuly 4, 2005, the Company accounted for share-based awards issued toemployees, directors and officers under those plans under the recognition andmeasurement principles of Accounting Principles Board (APB) No. 25, *Accounting for Stock Issued to Employees*, and relatedinterpretations. Generally, no share-based employee compensation expense wasrecognized for stock option grants, as all options granted under those planshad an exercise price equal to the fair market value of the underlying commonstock at the date of grant. Similarly, no compensation expense had beenrecognized for purchase rights under the Company’s Employee Stock Purchase Plan(ESPP).****Compensation expense related toissuances of service based restricted stock awards was generally recognizedbased on the fair value less amounts paid by employees, if any. Compensationexpense related to market based restricted stock awards was recognized whensatisfaction of the market condition was deemed probable by management. TheCompany accounts for stock option grants and similar equity instruments grantedto non-employees under the fair value method, in accordance with EmergingIssues Task Force (EITF) Issue No. 96-18, *Accountingfor Equity Instruments That are Issued to Other Than Employees for Acquiring,or in*

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*Conjunctionwith Selling, Goods or Services*and SFAS No. 123(R).

As noted above, in the first quarter of fiscal 2006,the Company adopted SFAS No. 123(R), which requires companies to measurethe cost of employee services received in exchange for an award of an equityinstrument based on the grant-date fair value of the award, using the modifiedprospective method. The Company uses the Black-Scholes option pricing model todetermine the fair value of its options on the measurement date. The cost isrecognized over the requisite service period (usually the vesting period) forthe estimated number of instruments where service is expected to be rendered. TheCompany has elected the alternative transition method described in FASB StaffPosition No. FAS 123(R)-3, *Transition ElectionRelated to Accounting for the Tax Effects of Share-Based Payment Awards*,for purposes of calculating the pool of excess tax benefits available to absorbtax short falls recognized subsequent to adoption of SFAS No. 123(R). Refer toNote 9 for additional information.

The fair value of service based restricted stockawards is equal to the fair value of the stock on the date of issuance. Thefair value of market based restricted stock awards is determined through use ofa lattice model. Compensation expense related to issuances of service basedrestricted stock awards is recorded at fair value less amounts paid byemployees, if any, and application of an estimated forfeiture rate.Compensation expense related to issuances of market based restricted stockawards is recorded at estimated fair value for the number of employees expectedto complete the requisite service period.

Compensation expense associated with option andrestricted stock awards with graded vesting is recognized in accordance withFASB Interpretation (FIN) No. 28, **Accounting for Stock Appreciation Rights andOther Variable Stock Option or Award Plans—an interpretation of APB OpinionsNo. 15 and 25****.**

In accordance with APB No. 25, the Companypreviously measured compensation expense for its share-based employeecompensation plans using the intrinsic value method and provided pro formadisclosures of net income and income per share as if the fair value-basedmethod had been applied in measuring compensation expense. As a result of theadoption of SFAS No. 123(R), during fiscal 2006, the Company recordedshare-based compensation expense of approximately $2.0 million, in theaccompanying Consolidated Statement of Operations. During fiscal 2005 and 2004,had compensation expense for the Company’s employee share-based compensationawards, including the Company’s ESPP, been determined based on the fair valueat the grant date, the Company’s net income and income per share would havebeen reduced to the pro forma amounts indicated below:

|                                                                                                                                         | ** ** | **Fiscal Year**                                                  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2005**                                                              | ** ** | **2004** | ** ** |
| ** **                                                                                                                              | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net income, as  reported                                                                                                                |       | $                                                                     | 4,578      |   | $ | 10,625 |   |
| Deduct:  Share-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (8,293                                                                | )          | (4,941 | ) |
| Pro forma net  (loss) income                                                                                                            |       | $                                                                     | (3,715     | ) | $ | 5,684 |   |
|                                                                                                                                    |       |                                                                  |       |   |   |
| Earnings (loss)  per share:                                                                                                             |       |                                                                  |       |   |   |
| Basic – as reported                                                                                                                |       | $                                                                     | 0.33       |   | $ | 0.79 |   |
| Basic – pro forma                                                                                                                  |       | $                                                                     | (0.27      | ) | $ | 0.42 |   |
|                                                                                                                                    |       |                                                                  |       |   |   |
| Diluted – as reported                                                                                                              |       | $                                                                     | 0. 32      |   | $ | 0.74 |   |
| Diluted – pro  forma                                                                                                               |       | $                                                                     | (0.27      | ) | $ | 0.39 |   |

 

On July 1, 2005, the Company’s Board of Directorsapproved the accelerated vesting of all unvested stock options held by theCompany’s officers and employees with an exercise price at or above $12.00 pershare, effective July 3, 2005. The stock option acceleration program did notapply to stock options held by the Company’s non-employee directors. Theaccelerated options were issued under the 2000 Stock Option Plan, the 2001Supplemental Stock Option Plan and the 2003 Equity Incentive Plan. Thisaccelerated vesting affected options to purchase up to an aggregate of 509,192shares of the Company’s common stock, held by 147 employees, all of whichbecame exercisable immediately. In connection with the acceleration of vestingof options held by the Company’s executive officers, each executive officeragreed not to sell or transfer any shares subject to accelerated vesting untilthe original vesting date would have occurred based on the original vestingschedule (without giving effect to any future termination of service). Theprimary purpose of the accelerated vesting was to eliminate future share-basedemployee compensation expense of approximately $4.5 million, net of estimatedforfeitures; the Company would otherwise have to record in the statement ofoperations over a period of three years beginning in fiscal year 2006 pursuantto the Company’s adoption of SFAS No. 123(R). For fiscal 2005, the Company’spro forma net loss includes a pro forma charge of $4.1 million, net ofstatutory taxes of $723,000, related to this acceleration.

**RecentlyIssued Accounting Pronouncements**

In June 2006,the FASB issued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes* (FIN 48). FIN 48 clarifies the accounting foruncertainty in income taxes recognized in financial statements in accordancewith Statement of Financial

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Accounting Standard(SFAS) No. 109, *Accounting for IncomeTaxes*. This Interpretation prescribes a recognition threshold andmeasurement attribute of tax positions taken or expected to be taken on a taxreturn. This Interpretation is effective for the first fiscal year beginningafter December 15, 2006; our fiscal 2008. Management is currentlyevaluating the impact FIN 48 will have on our financial position and results ofoperations.

**NOTE 2 –ACQUISITION OF CERTAIN ASSETS**

On August 8, 2005, the Company acquired all ofthe outstanding stock of Zetta Systems, Inc. (Zetta), a Washingtoncorporation, for total consideration of approximately $9.2 million in cash,including $154,000 in direct acquisition costs. Zetta developed data protectionsoftware that was incorporated into the Company’s ULTAMUSTM product and is expected by management tocontribute to product sales in fiscal 2007. The acquisition was madeprincipally to enable the Company’s entry into the primary data storage market.

The Company evaluated the business combinationcriteria within SFAS No. 141, *Business Combinations*,and after consideration of these criteria and the criteria included with EITFNo. 98-3, *Determining Whether a NonmonetaryTransaction Involves Receipt of Productive Assets or of a Business*,determined that the purchase of Zetta represented a purchase of assets ratherthan a business combination. Accordingly, the tangible and intangible assetsacquired and liabilities assumed**were recordedat their estimated fair values at the date of acquisition and no goodwill wasrecorded. The Company used available cash and cash equivalents to consummatethis acquisition, which was accounted for under the provisions of SFASNo. 142, *Goodwill and Other Intangible Assets*.A portion of the purchase price was allocated to existing technology andacquired in-process research and development. The assets were identified andvalued through analysis of data concerning developmental projects, their stageof development, the time and resources needed to complete them, their expectedincome generating ability, target markets and associated risks, among others.

The purchase consideration was allocated as follows(in thousands):
| Current assets                                              |   | $      | 252    |   |
|-------------------------------------------------------------|--------|--------|--------|--------|
| Non-current  assets                                         |   | 757    |   |
| Acquired technology                                         |   | 11,874 |   |
| Acquired  in-process research and development               |   | 1,121  |   |
| Current  liabilities                                        |   | (94    | )      |
| Deferred tax  liabilities and other non-current liabilities |   | (4,756 | )      |
| Total consideration                                         |   | $      | 9,154  |   |

 

The acquired technology has an estimated useful lifeof approximately four years and the cost allocated to it is being amortizedusing the straight-line method over the estimated useful life. The results ofoperations of Zetta are included in our consolidated results of operationsbeginning August 8, 2005.

**NOTE 3 –SHORT-TERM INVESTMENTS**

The following table summarizes short-term investmentsby security type (in thousands):

**June 30,2006**
|                                 | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|---------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| Asset-backed securities         |       | $                   | 14,653     |                         | $          | —                        |       | $                              | 356        |   | $ | 14,297 |   |
| Corporate bonds                 |       | 2,600               |       | —                       |       | —                        |       | 2,600                          |       |
| State and  municipal securities |       | 25,300              |       | —                       |       | —                        |       | 25,300                         |       |
|                            |       | $                   | 42,553     |                         | $          | —                        |       | $                              | 356        |   | $ | 42,197 |   |

 

**June 30,2005**
|                                                 | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|-------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|----------------------------|------------|
| Asset-backed  securities                        |       | $                   | 18,208     |                         | $          | —                        |       | $                          | 155        |   | $ | 18,053 |   |
| United States  government and agency securities |       | 2,000               |       | —                       |       | 22                            |       | 1,978                      |       |
| State and  municipal securities                 |       | 51,365              |       | 1                            |       | 8                             |       | 51,358                     |       |
|                                            |       | $                   | 71,573     |                         | $          | 1                             |       | $                          | 185        |   | $ | 71,389 |   |

 

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The following table summarizes the contractualmaturities of the Company’s short-term investments (in thousands):
|                           | ** ** | **June 30,** | ** ** |
|---------------------------|------------|-------------------|------------|
| ** **                | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Less than one  year       |       | $                 | —     |   | $ | 2,937 |   |
| Due in one to  two years  |       | 2,600             |       | 749 |   |
| Due in two to  five years |       | 1,919             |       | 1,931 |   |
| Due after five  years     |       | 37,678            |       | 65,772 |   |
|                      |       | $                 | 42,197     |   | $ | 71,389 |   |

 

Asset-backed securities have been allocated within thecontractual maturities table based upon the set maturity date of the security.Realized gains and losses on short-term investments are included in otherincome (expense), net, in the accompanying Consolidated Statement ofOperations. In fiscal 2006, the Company recorded realized gains and realizedlosses of approximately $1,000 and $24,000, respectively, on its short-terminvestments. In fiscal 2005, the Company recorded realized gains and realizedlosses of approximately $2,000 and $0, respectively, on its short-terminvestments.

As of June 30, 2006, the Company had 32 individualsecurities in an unrealized loss position. The following table shows the grossunrealized losses and the fair value of the Company’s investments withunrealized losses that are not deemed to be other-than-temporarily impaired (inthousands), aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position atJune 30, 2006.
| ** **                              | ** ** | **Less Than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**       | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|-----------------|------------|
| **Description of Securities** | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Losses**                  | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
|                                    |       |                                   |       |                                    |       |            |       |   |   |   |   |   |   |
| Asset-backed securities                 |       | $                                      | 5,076      |                                    | $          | 147             |       | $ | 7,582 |   | $ | 209 |   | $ | 12,658 |   | $ | 356 |   |
|                                         |            |                                        |            |                                         |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Unrealized losses on the Company’s investments inmortgage-backed securities guaranteed by a federal agency orgovernment-sponsored enterprise were caused by interest rate increases. Thecontractual cash flows of those investments are either guaranteed by an agencyof the U.S. government or entities with a line of credit to the U.S. Treasury.Accordingly, it is expected that the securities would not be settled at a priceless than the amortized cost of the Company’s investment. Because the declinein market value is attributable to changes in interest rates and not creditquality and because the Company has the ability and the intent to hold thoseinvestments until a recovery of fair value, which may be maturity, theCompany does not consider those investments to be other-than-temporarilyimpaired at June 30, 2006.

**NOTE 4 - COMPOSITION OF CERTAIN FINANCIALSTATEMENT CAPTIONS**

The following table summarizesinventories (in thousands):
|                 | ** ** | **June 30,** | ** ** |
|-----------------|------------|-------------------|------------|
| ** **      | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Raw materials   |       | $                 | 8,202      |   | $ | 8,550 |   |
| Work in process |       | 1,332             |       | 1,997 |   |
| Finished goods  |       | 5,444             |       | 8,561 |   |
|            |       | $                 | 14,978     |   | $ | 19,108 |   |

 

Thefollowing table summarizes other current assets (in thousands):
|                                       | ** ** | **June 30,** | ** ** |
|---------------------------------------|------------|-------------------|------------|
| ** **                            | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Prepaid  third-party service contract |       | $                 | 3,687      |   | $ | 2,896 |   |
| Income tax  receivable                |       | 3,480             |       | 4,177 |   |
| Prepaid  insurance and services       |       | 1,087             |       | 1,213 |   |
| Non-trade  accounts receivable        |       | 490               |       | 3,071 |   |
| Other                                 |       | 370               |       | 99 |   |
|                                  |       | $                 | 9,114      |   | $ | 11,456 |   |

 

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The following tablesummarizes property and equipment (in thousands):
|                                            | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Computer  equipment                        |       | $                 | 11,594     |   | $ | 9,414 |   |
| Machinery and  equipment                   |       | 7,333             |       | 6,368 |   |
| Leasehold  improvements                    |       | 3,925             |       | 3,814 |   |
| Furniture and fixtures                     |       | 1,398             |       | 1,309 |   |
|                                       |       | 24,250            |       | 20,905 |   |
| Accumulated  depreciation and amortization |       | (13,224           | )          | (12,147 | ) |
|                                       |       | $                 | 11,026     |   | $ | 8,758 |   |

 

Depreciation andamortization expense, for property and equipment, was $2.4 million, $2.6million and $2.4 million in fiscal 2006, 2005 and 2004, respectively.

 The following table summarizes accruedliabilities (in thousands):

|                                            | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Deferred revenue  – Service contracts |       | $                 | 5,773      |   | $ | 3,484 |   |
| Accrued expenses                           |       | 5,106             |       | 3,838 |   |
| Third-party  service contracts payable     |       | 1,316             |       | 2,262 |   |
| Deferred revenue  – Distributors      |       | 2,005             |       | 1,186 |   |
| Accrued market  development funds          |       | 853               |       | 621 |   |
| VAT &  sales taxes payable        |       | 207               |       | 251 |   |
| Other                                      |       | 70                |       | 818 |   |
|                                       |       | $                 | 15,330     |   | $ | 12,460 |   |

 

Thefollowing table summarizes other liabilities (in thousands):
|                                            | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Deferred revenue  – Service contracts |       | $                 | 3,049      |   | $ | 1,978 |   |
| Deferred rent                              |       | 1,164             |       | 990 |   |
| Other                                      |       | 280               |       | 106 |   |
|                                       |       | $                 | 4,493      |   | $ | 3,074 |   |

 

Asof fiscal 2006 and 2005, the accounts receivable balances consist entirely ofaccounts receivable trade balances, net of allowance for doubtful accounts. Thefollowing table summarizes the changes in allowance for doubtful accounts (inthousands):
| **Fiscal year** | ** ** | **Balance at  Beginning of  Year** | ** ** | **Additions  Charged to  Income** | ** ** | **Write-offs,  Net of  Recoveries** | ** ** | **Deductions  Credited to  Income** | ** ** | **Balance  at End  of Year** | ** ** |
|----------------------|------------|----------------------------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| 2006                 |       | $                                            | 298        |                                   | $          | 159                                      |       | $                                        | 21         |                                   | $          | — |   | $ | 436 |   |
| 2005                 |       | 296                                          |       | 97                                     |       | 95                                       |       | —                                   |       | 298                                    |       |
| 2004                 |       | 413                                          |       | 114                                    |       | 126                                      |       | 105                                      |       | 296                                    |       |
|                      |            |                                              |            |                                        |            |                                          |            |                                          |            |                                        |            |  |  |  |  |  |

 

**NOTE 5 –INTANGIBLE ASSETS**

Intangibleassets consist of the following (in thousands):
|                           | ** ** | **June 30,** | ** ** |
|---------------------------|------------|-------------------|------------|
| ** **                | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Acquired  technology      |       | $                 | 20,594     |   | $ | 8,720 |   |
| Accumulated  amortization |       | (7,979            | )          | (3,527 | ) |
|                      |       | $                 | 12,615     |   | $ | 5,193 |   |

 

Amortization expense of intangible assets was $4.5million, $1.7 million and $1.8 million during fiscal 2006, 2005 and 2004,respectively. The technology acquired from Okapi Software, Inc. and Zetta isbeing amortized over five years and four years, respectively. Estimatedamortization expense for intangible assets will be approximately $4.7 million,$4.7 million, $3.0 million and

45

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$247,000in fiscal 2007, 2008, 2009 and 2010, respectively.

**NOTE 6 -CREDIT FACILITY**

The Company has a creditfacility consisting of a $10.0 million revolving line of credit for workingcapital purposes that expires on November 30, 2006. The line of credit iscollateralized by substantially all of the Company’s assets. Interest on theline of credit is set at the bank’s prime rate (8.25% on June 30, 2006) ineffect from time to time minus 0.25% or, at the Company’s option, a rate equalto LIBOR plus 2.25%. The loan agreement that governs the credit facilitycontains certain financial and non-financial covenants. As of June 30, 2006 and2005, no amounts were outstanding under the credit facility.

**NOTE 7 -INCOME TAXES**

The components of (loss)income before income taxes were as follows (in thousands):
|            | ** ** | **Fiscal Year** | ** ** |
|------------|------------|----------------------|------------|
| ** ** | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Domestic   |       | $                    | (24,417    | ) | $ | 3,493 |   | $ | 15,003 |   |
| Foreign    |       | 1,106                |       | 1,575 |   | 1,196 |   |
|       |       | $                    | (23,311    | ) | $ | 5,068 |   | $ | 16,199 |   |

 

The (benefit from)provision for income taxes includes the following (in thousands):
|                                                  | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------|------------|----------------------|------------|
| ** **                                       | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:                                         |       |                 |       |   |   |   |   |
| Federal                                          |       | $                    | (2,718     | ) | $ | 131 |   | $ | 5,293 |   |
| State                                            |       | (143                 | )          | 115 |   | 1,171 |   |
| Foreign                                          |       | 224                  |       | 713 |   | 377 |   |
| Total current                                    |       | (2,637               | )          | 959 |   | 6,841 |   |
|                                             |       |                 |       |   |   |   |   |
| Deferred                                         |       |                 |       |   |   |   |   |
| Federal                                          |       | (961                 | )          | (366 | ) | (1,054 | ) |
| State                                            |       | (227                 | )          | (59 | ) | (213 | ) |
| Foreign                                          |       | —               |       | (44 | ) | — |   |
| Total deferred                                   |       | (1,188               | )          | (469 | ) | (1,267 | ) |
| Total (benefit from)  provision for income taxes |       | $                    | (3,825     | ) | $ | 490 |   | $ | 5,574 |   |

 

A reconciliation ofincome taxes computed by applying the federal statutory income tax rate of34.0%****to income before income taxes to thetotal income tax (benefit) provision reported in the Consolidated Statements ofOperations is as follows (in thousands):
|                                                   | ** ** | **Fiscal Year** | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| U.S. Federal income  tax at statutory rate        |       | $                    | (7,926     | ) | $ | 1,723 |   | $ | 5,493 |   |
| State income  taxes, net of federal benefit       |       | (1,231               | )          | 37 |   | 633 |   |
| Increase in  valuation allowance                  |       | 5,114                |       | — |   | — |   |
| In-process  research and development              |       | 381                  |       | — |   | — |   |
| Share-based  compensation expense                 |       | 120                  |       | — |   | — |   |
| Extraterritorial  income exclusion benefit        |       | (238                 | )          | (503 | ) | (374 | ) |
| Tax exempt  interest                              |       | (65                  | )          | (363 | ) | (68 | ) |
| Favorable IRS  settlement and statute expirations |       | (51                  | )          | (345 | ) | — |   |
| Federal R&D  tax credit                       |       | (111                 | )          | (136 | ) | — |   |
| Permanent  differences                            |       | 92                   |       | 43 |   | 53 |   |
| Other, net                                        |       | 90                   |       | 34 |   | (163 | ) |
| Total (benefit  from) provision for income taxes  |       | $                    | (3,825     | ) | $ | 490 |   | $ | 5,574 |   |

 

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Deferred income taxes comprised (in thousands):

|                                              | ** ** | **June 30,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Deferred tax assets:                         |       |              |       |   |   |
| Inventory                                    |       | $                 | 2,009      |   | $ | 1,152 |   |
| Net operating  loss carryforward             |       | 2,935             |       | — |   |
| Warranty  reserves                           |       | 2,244             |       | 1,951 |   |
| Tax credits                                  |       | 1,330             |       | 573 |   |
| Share-based  compensation and options        |       | 618               |       | — |   |
| Vacation and  deferred compensation          |       | 601               |       | 608 |   |
| State income  taxes                          |       | —            |       | 8 |   |
| Restructuring  accrual                       |       | —            |       | 243 |   |
| Allowance for  doubtful accounts             |       | 162               |       | 114 |   |
| Other                                        |       | 280               |       | 144 |   |
| Gross deferred  tax asset                    |       | 10,179            |       | 4,793 |   |
|                                         |       |              |       |   |   |
| Deferred tax  liabilities:                   |       |              |       |   |   |
| Purchased  intangible assets                 |       | (4,702            | )          | (1,975 | ) |
| Property and  equipment depreciation         |       | (363              | )          | (531 | ) |
| Gross deferred  tax liability                |       | (5,065            | )          | (2,506 | ) |
| Valuation  allowance for deferred tax assets |       | (5,114            | )          | — |   |
| Net deferred tax asset                       |       | $                 | —     |   | $ | 2,287 |   |

 

As of June 30,2006, the Company performed an assessment of its net deferred tax assets. Inprior years, the Company had relied principally on its ability to generatefuture taxable income in its assessment of the realizability of its netdeferred tax assets. However, SFAS No. 109, *Accounting for IncomeTaxes*, considers recent losses to be significant negative evidencethat is difficult to overcome by forecasts of future taxable income to supportthe realization of deferred tax assets. Accordingly, the Company recorded anon-cash charge in fiscal 2006 of $5.1 million to establish a full-valuationallowance against its net deferred tax assets as realization of such assets isuncertain. This non-cash charge significantly reduced the deferred tax benefitassociated with an increase in the Company’s net deferred tax assets. TheCompany recognized a current tax benefit in fiscal 2006 related principally toits ability to carry back a portion of the current year net operating losses.

At June 30, 2006,the Company has federal and state net operating loss carryforwards net ofamounts eligible for carryback of approximately $8.9 million and $11.0 million,respectively. These amounts include stock option deductions of approximately$950,000 which will be recorded to contributed capital when realized. Theremaining federal net operating loss will begin expiring in 2023, unless previouslyutilized. State net operating loss carryfowards generally begin to expire in2016, unless previously utilized.

At June 30,2006, the Company had federal and California research and development taxcredit carryforwards totaling approximately $297,000 and $824,000,respectively. The California research credit may be carried forwardindefinitely. In addition, the Company has foreign tax credit carryforwardstotaling approximately $308,000, which will begin expiring in 2015, unlesspreviously utilized. Also, the Company has federal alternative minimum taxcredit carryforwards totaling $197,000 that can be carried forwardindefinitely.

**NOTE 8 - COMMON STOCK**

On October 16, 2005, the Company’s Board ofDirectors expanded the Company’s share repurchase program to allow for thepurchase of up to 2.5 million shares of its common stock with no fixed dollaramount. This repurchase authority allows the Company to repurchase its commonstock selectively from time to time in the open market, through block trades orotherwise, or in privately negotiated transactions. Depending on marketconditions and other factors, at any time or from time to time, without priornotice, the Company’s Board of Directors may modify the program or commence orsuspend purchases. There is no fixed termination date for the repurchaseprogram. During fiscal 2006 and fiscal 2005, an aggregate of approximately 1.3million and 32,500 shares, respectively, were repurchased at a cost ofapproximately $10.8 million and $309,000, respectively, pursuant to therepurchase program.

47

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**NOTE 9 – SHARE-BASED COMPENSATION**

***Stock Option Plans***

The Company has sixactive stock option plans, each administered by a Committee of the Board ofDirectors, which provide for the issuance of options to employees, officers,directors and consultants. As of June 30, 2006, the Company had reserved anaggregate of 7.3 million shares of common stock for issuance under the 1993Stock Option Plan, 1995 Stock Option Plan, 1997 Executive Stock Option Plan,2000 Stock Option Plan, 2001 Supplemental Stock Option Plan (2001 Plan) and the2003 Equity Incentive Plan (2003 Plan) (collectively, the Option Plans). TheOption Plans provide for the granting of stock options. In addition, the 2003Plan provides for the granting of restricted stock and stock appreciationrights (collectively, stock awards). The Option Plans have been approved byshareholders with the exception of the 2001 Plan. Currently, the Company maygrant new awards only from the 2003 Plan. The Company’s 2003 Plan provides forthe automatic grant of non-statutory options to purchase shares of common stockto non-employee directors.

Certain options issuedunder selected plans allow for 100% vesting of outstanding options upon achange of control of the Company (if replacement options are not issued) orupon death or disability of the optionee. Options granted generally vest over athree-year period. Options generally expire after a period not to exceed tenyears, except in the event of termination, whereupon vested shares must beexercised generally within three months under the 2003 Plan and within 30 daysunder the other Option Plans, or upon death or disability, where an extendedsix- or twelve-month exercise period is specified. As of June 30, 2006,approximately 2.6 million shares were reserved for issuance upon exercise ofoutstanding options and approximately 517,000 shares were available for grantunder the Option Plans.

The fair value of each option award is estimated onthe date of grant using the Black-Scholes-Merton option pricing model whichuses the weighted-average assumptions noted in the following table. Beginningin the fourth quarter of fiscal 2005, separate groups of employees that havesimilar historical exercise behavior are being considered separately indetermining certain valuation assumptions. Expected volatilities are based onthe historical volatility (using daily pricing) of the Company’s stock. Uponadoption of SFAS No. 123(R), the Company now applies a forfeiture rate,based upon historical pre-vesting option cancellations. The expected term ofoptions granted is estimated based on a number of factors, including but notlimited to the vesting term of the award, historical employee exercise behavior(for both options that have run their course and outstanding options), theexpected volatility of the Company’s stock and an employee’s average length ofservice. The risk-free interest rate is determined based upon a U.S. constantrate Treasury Security with a contractual life which approximates the expectedterm of the option award. Weighted-average ranges below result from certaingroups of employees exhibiting different behavior:

|                          | ** ** | **Fiscal Year** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                     |       |                 |       |   |   |   |   |
| Expected volatility      |       | 72.2-74.1            | %          | 76.9-77.3 | % | 79.0 | % |
| Risk-free interest rate  |       | 4.3-4.4              | %          | 3.6-3.7 | % | 4.2 | % |
| Dividend yield           |       | —               |       | — |   | — |   |
| Expected term (in years) |       | 5.6-5.9              |       | 5.0-6.0 |   | 7.0 |   |

 

The stock option activity is summarized below (sharesand aggregate intrinsic value in thousands):
|                                            | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------|------------|------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------|------------|
|                                       |       |       |       |                                    |       |                                                              |       |                            |       |
| Options outstanding at  June 30, 2005 |       | 3,113      |       | $                                       | 11.54      |                                                              |       |                            |       |   |
| Granted                                    |       | 224        |       | 8.17                                    |       |                                                              |       |                            |       |
| Exercised                                  |       | (294       | )          | 6.52                                    |       |                                                              |       |                            |       |
| Canceled/forfeited                         |       | (411       | )          | 15.47                                   |       |                                                              |       |                            |       |
| Options outstanding at  June 30, 2006      |       | 2,632      |       | 11.20                                   |       | 6.24                                                              |       | $                               | 165        |   |
| Exercisable outstanding at June 30, 2006   |       | 2,380      |       | 11.44                                   |       | 5.94                                                              |       | $                               | 165        |   |
|                                            |            |            |            |                                         |            |                                                                   |            |                                 |            |  |  |

 

During fiscal 2006, 2005and 2004, the Company recorded share-based compensation associated withoutstanding stock option grants of approximately $1.4 million, $0 and $0,respectively. As of June 30, 2006, there was $620,000 of total unrecognizedcompensation expense related to non-vested stock options granted under theOption Plans. This expense is expected to be recognized over a weighted-averageperiod of 1.43 years. The following table summarizes information about stockoptions for fiscal 2006, 2005 and 2004 (in thousands, except per shareamounts):

48

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|                                                                                             | ** ** | **Fiscal Year** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                  | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                        |       |                 |       |   |   |   |   |
| Weighted-averaged grant  date fair value per share of options granted with exercise prices: |       |                 |       |   |   |   |   |
| Less than fair  value                                                                       |       | $                    | —     |   | $ | — |   | $ | — |   |
| Equal to fair  value                                                                        |       | 5.49                 |       | 8.92 |   | 13.76 |   |
| Greater than  fair value                                                                    |       | —               |       | 8.18 |   | — |   |
| Intrinsic value of  options exercised                                                       |       | 502                  |       | 1,915 |   | 7,668 |   |
| Cash received upon  exercise of stock options                                               |       | 1,918                |       | 2,269 |   | 5,592 |   |
| Actual tax benefit  realized for the tax deductions from option exercise                    |       | —               |       | 715 |   | 3,438 |   |
| Total income tax benefit recognized in the statement of operations                          |       | —               |       | — |   | — |   |
|                                                                                             |            |                      |            |  |  |  |  |  |  |  |

 

In November 2005, the Company’s Board of Directorsextended the term of 97,000 fully vested options held by a former director. Asa result of that modification, the Company recognized additional compensationexpense of approximately $47,000 during the second quarter of fiscal 2006.

***Restricted Stock Awards***

In April 2005, the Company issued two restrictedstock awards for 50,000 shares each to its CEO. At June 30, 2006, 16,667 shareswere vested and 83,333 shares were subject to repurchase. The awards aredescribed separately below.

The first award (the Service Award) vests as follows:16,667 shares, 16,667 shares and 16,666 shares on January 1, 2006, 2007and 2008, respectively. In accordance with APB No. 25, the Service Awardwas a fixed award and, as such, compensation expense was recorded for the fairvalue of the Company’s common stock less any amounts paid by the employee. Thefair value of the Service Award is $10.86 per share (the market value of thestock on the date of issuance) or $543,000, which was recorded as deferredcompensation under APB No. 25. Compensation expense recorded during fiscal 2006(under SFAS No. 123(R)) and fiscal 2005 (under APB No. 25) totaledapproximately $300,000 and $80,000, respectively. See Note 1, *Change in Accounting Principle and Accounting for Share-BasedCompensation,*above, and *Effect of SFASNo. 123(R) Adoption*, below, for further discussion.

The second award (the Market Award) vests as follows:12,500 shares, 12,500 shares and 25,000 shares, if the volume weighted dailyaverage stock price of the Company for ten consecutive trading days reaches$20.00, $25.00 and $30.00 (collectively, the target stock price), respectively,on or before January 1, 2008. Based upon the market values of the Company’scommon stock through June 30, 2005, satisfaction of the vesting conditions werenot deemed probable by management and therefore no compensation expense wasrecorded under APB No. 25. Upon adoption of SFAS No. 123(R), the Companybegan recognizing compensation expense associated with this award. Thecompensation expense will be recognized through the remaining service period.The weighted-average grant date fair value of this restricted stock award wasestimated at $5.73, using a trinomial option pricing model based on thefollowing assumptions: expected volatility of 54.2%, risk-free interest rate of3.8%, dividend yield of 0.0% and an expected term of 978 days. Commencing withthe adoption of SFAS No. 123(R), this expense is being recognized in thestatement of operations with offsetting credits to common stock. Compensationexpense recorded during fiscal 2006 totaled approximately $77,000.

On August 8, 2005, the Company issued anaggregate of 64,625 restricted shares of common stock to new hires, 15,000shares of which vest annually over a period of three years in equal incrementsand 49,625 shares of which vest annually over a period of five years in equalincrements, in each case subject to continuing service by the recipient of therestricted stock. The fair value of the restricted stock is $7.84 per share(the market value of the stock on the date of issuance) or $506,660 and will berecorded to compensation expense, net of related forfeitures, over therequisite service periods of the awards. Compensation expense recorded duringfiscal 2006 was approximately $183,000. At June 30, 2006, no shares were vestedand 60,875 shares were subject to repurchase.

49

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The following tablesummarizes information about non-vested restricted stock awards as of June 30,2006 and changes during fiscal 2006 (shares and aggregate unrecognizedcompensation expense in thousands):
|                                   | ** ** | **Shares** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** | **Weighted-  Average  Remaining  Service  Period** | ** ** | **Aggregate  Unrecognized  Compensation  Expense** | ** ** |
|-----------------------------------|------------|------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
|                              |       |       |       |                                                |       |                                               |       |                                               |       |
| Non-vested at  June 30, 2005 |       | 100        |       | $                                                   | 8.29       |                                               |       |                                               |       |   |
| Granted                           |       | 65         |       | 7.84                                                |       |                                               |       |                                               |       |
| Vested                            |       | (17        | )          | 10.86                                               |       |                                               |       |                                               |       |
| Canceled                          |       | (4         | )          | 7.84                                                |       |                                               |       |                                               |       |
| Non-vested at June 30, 2006       |       | 144        |       | 7.81                                                |       | 2.39                                               |       | $                                                  | 413        |   |
|                                   |            |            |            |                                                     |            |                                                    |            |                                                    |            |  |  |

 

The following tablesummarizes information about restricted stock awards vested during the fiscal2006, 2005 and 2004 (in thousands):
|                                              | ** ** | **Fiscal Year** | ** ** |
|----------------------------------------------|------------|----------------------|------------|
| ** **                                   | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                         |       |                 |       |   |   |   |   |
| Fair value of vested restricted stock awards |       | $                    | 134        |   | $ | — |   | $ | — |   |
|                                              |            |                      |            |  |  |  |  |  |  |  |

 

***1996 Employee Stock Purchase Plan***

In February 1997,the Company adopted the 1996 Employee Stock Purchase Plan (ESPP), which is dueto expire January 31, 2007. A total of 600,000 shares of common stock have beenreserved under the ESPP, as amended, for issuance and purchase by employees ofthe Company to assist them in acquiring a stock ownership interest in theCompany and to encourage them to remain employees of the Company. The ESPP isqualified under Section 423 of the Internal Revenue Code and permitseligible employees to purchase common stock at a discount through payrolldeductions during specified six-month offering periods. No employee maypurchase more than $25,000 worth of stock in any calendar year or 1,500 sharesin any one offering period.

In August 2005, theBoard of Directors amended the ESPP so that, effective with the offering periodbeginning in August 2005, the purchase price of common stock under theESPP shall be determined as either (i) a percentage not less than 85.0%(the Designated Percentage), subject to the Compensation Committee’s discretionof the fair market value of the common stock on the last day of the offeringperiod or (ii) the lower of (a) the Designated Percentage of the fairmarket value of the common stock on the first day of the offering period or(b) the Designated Percentage of the fair market value of the common stockon the last day of the offering period. On August 10,2005, the CompensationCommittee of the Board of Director’s determined the purchase price to be 95.0%of the fair market value of the common stock on the last day of each offeringperiod, beginning with the August 2005 offering. As a result, commencingwith the August 2005 offering period, the ESPP will no longer becompensatory under SFAS No. 123(R). Expense prior to this date was notsignificant.

The fair value of eachcompensatory share purchase right is estimated on the date of grant using theBlack-Scholes-Merton option pricing model. The following assumptions were usedin estimating the fair value of the purchase rights during fiscal 2005 and2004:

|                          | ** ** | **Fiscal Year** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **2005**             | ** ** | **2004** | ** ** |
|                     |       |                 |       |   |   |
| Expected volatility      |       | 38.4                 | %          | 57.0 | % |
| Risk-free interest rate  |       | 1.9                  | %          | 3.7 | % |
| Dividend yield           |       | —               |       | — |   |
| Expected term (in years) |       | 0.5                  |       | 0.5 |   |

 

The weighted-average estimated fair value of eachcompensatory share purchase right issued during fiscal 2005 and 2004 was $3.24and $4.71 per share, respectively.

During fiscal 2006, 2005and 2004, approximately 54,000, 74,000 and 52,000 shares, respectively, wereissued under the ESPP for combined proceeds of approximately $338,000, $673,000and $658,000, respectively. As of June 30, 2006, approximately 28,000 shareswere available under the ESPP.

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***Effectof SFAS No. 123(R) Adoption***

The effect of theadoption of SFAS No. 123(R) on the Consolidated Balance Sheet atJune 30, 2005 is as follows (in thousands):
|                       | ** ** | **Without  SFAS No.  123(R)** | ** ** | **SFAS No.  123(R)  Impact** | ** ** | **With SFAS  No. 123(R)** | ** ** |
|-----------------------|------------|------------------------------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** **            | ** ** | **(as reported)**             | ** ** | ** **                        | ** ** | ** **                          | ** ** |
|                  |       |                               |       |                              |       |                                |       |
| Common stock          |       | $                                  | 77,494     |                              | $          | (463                                | )          | $ | 77,031 |   |
| Deferred compensation |       | (463                               | )          | 463                               |       | —                              |       |
|                       |            |                                    |            |                                   |            |                                     |            |  |  |  |

 

#### **NOTE10 - 401(k) PLAN**

In January 1994, theCompany adopted an employee savings and retirement plan (the 401(k) Plan)covering all of the Company’s employees. The 401(k) Plan permits but does notrequire matching contributions by the Company on behalf of participants. TheCompany matches employee contributions at 75%, up to 6% of an employee’s pretaxincome. The totals of these employer contributions were $777,000, $819,000 and$660,000 in fiscal 2006, 2005 and 2004, respectively.

**NOTE 11 – ACCRUED RESTRUCTURING CHARGES**

*Outsourceof Manufacturing*Operations

In September 2004, in orderto enhance its strategic competitiveness and increase its flexibility, theCompany announced a plan to outsource all of its manufacturing to a U.S. thirdparty manufacturer. In November 2004, the contract with the outsourcemanufacturer was finalized and all manufacturing employees were notified oftermination dates and benefits. Under the restructuring plan, the Companyterminated 82 employees.

The Company completed the transfer of all of itsmanufacturing operations in August 2005. In fiscal 2005, the Companyrecorded $2.1 million to cost of revenue in pre-tax charges for severance costsrelated to the outsourcing and other obligations. In fiscal 2006, the Companyrecorded $770,000 in pre-tax charges to cost of revenue for other obligationsrelated to the outsourcing, including a charge of $704,000 for the estimatedfair value of the liability associated with leased warehouse space that theCompany permanently ceased using in December 2005. In June 2006, theCompany decided to terminate the relationship Sanmina and return manufacturingto San Diego. As a result, the Company recorded a pre-tax credit of $536,000,in the fourth quarter, to reverse the remaining excess facilities liabilitypreviously recorded.

The following tablesummarizes the activity and balances of the accrued restructuring chargesthrough fiscal 2006 (in thousands):

|                                | ** ** | **Employee  Related** | ** ** | **Facilities** | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------|------------|-----------------------|------------|----------------|------------|-----------|------------|-----------|------------|
|                           |       |                  |       |           |       |      |       |      |       |
| Accrued restructuring  charges |       | $                     | 1,532      |           | $          | —    |       | $         | 523        |   | $ | 2,055 |   |
| Cash payments                  |       | (1,009                | )          | —         |       | (523      | )          | (1,532    | )          |
| Balance at  June 30, 2005 |       | 523                   |       | —         |       | —    |       | 523       |       |
| Accrued restructuring  charges |       | —                |       | 704            |       | 66        |       | 770       |       |
| Adjustment                     |       | (37                   | )          | (536           | )          | —    |       | (573      | )          |
| Cash payments                  |       | (486                  | )          | (168           | )          | (66       | )          | (720      | )          |
| Balance at June 30, 2006       |       | $                     | —     |           | $          | —    |       | $         | —     |   | $ | — |   |

 

**NOTE 12 -COMMITMENTS AND CONTINGENCIES**

**Leases**

TheCompany leases its office, production and sales facilities under non-cancelableoperating leases, which expire in various years through fiscal year 2018. Theleases provide for biennial or annual rent escalations intended to approximateincreases in cost of living indices, and certain of the leases provide for rentabatement. The Company has a one five-year option to renew its lease on its SanDiego headquarters facility. Future minimum lease payments under thesearrangements are as follows (in thousands):

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|             | ** ** | **Minimum  Lease  Payments** | ** ** |
|-------------|------------|------------------------------|------------|
|        |       |                         |       |
| Fiscal 2007 |       | $                            | 3,300      |   |
| Fiscal 2008 |       | 3,270                        |       |
| Fiscal 2009 |       | 3,344                        |       |
| Fiscal 2010 |       | 3,394                        |       |
| Fiscal 2011 |       | 3,496                        |       |
| Thereafter  |       | 10,826                       |       |
|        |       | $                            | 27,630     |   |

Rentalexpense is recognized on a straight-line basis over the respective lease termsand approximated $4.0 million, $3.8 million and $3.8 million in fiscal 2006,2005 and 2004, respectively.

**Litigation**

The Company is from time to time involved in variouslawsuits, claims and legal proceedings that arise in the ordinary course ofbusiness. In the opinion of management, the amount of any ultimate liabilitywith respect to these ordinary course actions will not materially affect theCompany’s financial condition or results of operations.

**NOTE 13 –SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)**

The following table presents selected quarterlyfinancial information for the periods indicated. This information has beenderived from the Company’s unaudited quarterly consolidated condensed financialstatements, which in the opinion of management include all adjustments(consisting only of normal recurring adjustments) necessary for a fairstatement of such information. The quarterly per share amounts presented belowwere calculated separately and may not sum to the annual figures presented inthe Consolidated Statements of Operations. These operating results are also notnecessarily indicative of results for any future period.

|                           | ** ** | **Fiscal 2006**                                                  | ** ** |
|---------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                | ** ** | **Q1**                                                                | ** ** | **Q2** | ** ** | **Q3** | ** ** | **Q4** | ** ** | **Total** | ** ** |
| ** **                | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net revenue               |       | $                                                                     | 58,502     |   | $ | 60,638 |   | $ | 48,153 |   | $ | 41,745 |   | $ | 209,038 |   |
| Gross profit              |       | 13,419                                                                |       | 13,387 |   | 10,336 |   | 9,304 |   | 46,446 |   |
| Loss from operations      |       | (5,498                                                                | )          | (4,554 | ) | (6,810 | ) | (9,069 | ) | (25,931 | ) |
| Loss before income  taxes |       | (4,984                                                                | )          | (3,807 | ) | (6,150 | ) | (8,370 | ) | (23,311 | ) |
| Net loss                  |       | (2,900                                                                | )          | (2,713 | ) | (7,038 | ) | (6,835 | ) | (19,486 | ) |
|                      |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Net loss per share:       |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                     |       | $                                                                     | (0.21      | ) | $ | (0.19 | ) | $ | (0.52 | ) | $ | (0.52 | ) | $ | (1.42 | ) |
| Diluted                   |       | (0.21                                                                 | )          | (0.19 | ) | (0.52 | ) | (0.52 | ) | (1.42 | ) |

 

|                                    | ** ** | **Fiscal 2005**                                                  | ** ** |
|------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                         | ** ** | **Q1**                                                                | ** ** | **Q2** | ** ** | **Q3** | ** ** | **Q4** | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net revenue                        |       | $                                                                     | 59,526     |   | $ | 62,525 |   | $ | 58,282 |   | $ | 55,354 |   | $ | 235,687 |   |
| Gross profit                       |       | 16,017                                                                |       | 17,818 |   | 14,886 |   | 12,196 |   | 60,917 |   |
| Income (loss) from  operations     |       | 2,664                                                                 |       | 3,544 |   | 952 |   | (3,636 | ) | 3,524 |   |
| Income (loss) before  income taxes |       | 3,007                                                                 |       | 3,921 |   | 1,389 |   | (3,249 | ) | 5,068 |   |
| Net income (loss)                  |       | 1,900                                                                 |       | 2,603 |   | 1,357 |   | (1,282 | ) | 4,578 |   |
|                               |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Net income (loss) per  share:      |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                              |       | $                                                                     | 0.14       |   | $ | 0.19 |   | $ | 0.10 |   | $ | (0.09 | ) | $ | 0.33 |   |
| Diluted                            |       | 0.13                                                                  |       | 0.18 |   | 0.09 |   | (0.09 | ) | 0.32 |   |

 

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