**UNITEDSTATESSECURITIES 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 1, 2007** |
|                                              |   |                                                                                                    |
| **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**

**OVERLANDSTORAGE, INC.**

(Exact name of registrant as specified in its charter)

| **CALIFORNIA**                                                         | ** ** | **95-3535285**                     |
|------------------------------------------------------------------------|------------|------------------------------------|
| (State or other  jurisdiction of incorporation or organization)        | ** ** | (IRS Employer  Identification No.) |
| ** **                                                             | ** ** | ** **                         |
| **4820  Overland Avenue, San Diego, California**                       | ** ** | **92123**                          |
| (Address of  principal executive offices)                              | ** ** | (Zip Code)                         |
| ** **                                                             | ** ** | ** **                         |
| **(858)  571-5555**                                                    |
| (Registrant’s  telephone number, including area code)             |
|                                                                   |
| Securities  registered pursuant to Section 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 to Section 12(g) of the Act: **None** |
|---------------------------------------------------------------------------------|

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act. Yes  o   No  x

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. Yes  o   No  x

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes  x   No  o

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein,and will not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated 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 o | Non-accelerated  filer x |
|---------------------------|---------------------|--------------------------|

Indicate by check markwhether the registrant is a shell company (as defined by Rule 12b-2 of theAct). Yes  o   No x

Theaggregate market value of the voting stock held by non-affiliates of theregistrant as of December 31, 2006, the last business day of the registrant’ssecond fiscal quarter, was approximately $48,391,767 (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 10% 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.

Asof August 17, 2007, the number of outstanding shares of the registrant’s CommonStock was 12,756,466.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portionsof the proxy statement to be filed in connection with registrant’s AnnualMeeting of Shareholders to be held on November 13, 2007 (the “ProxyStatement”) are incorporated herein by reference into Part III of thisreport.

 

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### **PART I**

**ITEM 1. Business.**

*Thisreport contains certain statements of a forward-looking nature relating tofuture events or the future performance of our company. Words such as “expects,”“anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “currentlyscheduled” and similar expressions or variations of such words are intended toidentify forward-looking statements, but are not the only means of identifyingforward-looking statements. Prospective investors are cautioned that suchstatements are only predictions and actual events or results may differmaterially. In evaluating such statements, prospective investors shouldspecifically consider various factors identified in this report, including thematters set forth below under the caption “Risk Factors,” which could causeactual results to differ materially from those indicated by suchforward-looking statements.*

**Overview**

We are a market leader and innovative provider ofsmart, affordable data protection appliances that help small and medium-sizebusiness and distributed enterprises ensure their business-critical data is “constantlyprotected, readily available and always there.” Our range of award-winning data protection solutions include:

·                  the ULTAMUSSERIESTM of  nearline data protection appliances;

·                  the REO SERIES® of disk-based backup and recovery appliances;and

·                  the NEO SERIES® and ARCVaultTM familyof tape backup and archive appliances.

These solutionsspan all three tiers of data storage, making us the first company to offer cost-effective,end-to-end data protection solutions designed for mid-range environments.

For over 25 years, we have delivered data protectionsolutions designed for backup and recovery to ensure business continuity.Historically, we have focused on delivering a portfolio of tape automationsolutions including loader and library systems designed for small business andmid-range computing environments. In 2003, we expanded our product offerings toinclude a family of intelligent disk-based backup and recovery appliances tocomplement our tape solutions. In 2007, we introduced our line of nearline dataprotection appliances which we believe provide the advanced features,performance and flexibility necessary to make information technology (IT)departments as efficient and dynamic as the businesses they support.

One of the main market differentiators of many of ourproducts has been that we design them around a modular, scalable architecture.This feature enables customers to purchase storage as they need it, rather thanhaving to purchase larger monolithic devices with excess capacity. We enableour customers to purchase an initial module to meet their near-term needs, andlater increase speed and capacity by adding modules that can be interconnectedto function as a single system. Our solution provides a lower price entrypoint, investment protection, and an increased level of fault tolerance, aseach module is self-sufficient and will continue to function even if anotherwere to fail.

We also differentiate ourselves with our “go-to-market”approach. We are the only supplier in our market space that does not have adirect sales force. The majority of our sales have historically been generatedthrough private label arrangements with original equipment manufacturers(OEMs). The remainder of our sales are made through commercial distributors,direct market resellers (DMRs) and value-added resellers (VARs).

End-users of our products include small andmedium-size businesses, as well as distributed enterprise customers representedby divisions and operating units of large multi-national corporations,governmental organizations, universities and other non-profit institutions. Ourproducts are used in a broad range of industry sectors including financialservices, healthcare, retail, manufacturing, telecommunications, broadcasting,research and development and many others. Our products are sold world-wide inthe Americas, EMEA (Europe, Middle East, Africa) and Asia Pacific. For our 2007fiscal year, 57.6% of our revenue was generated internationally, primarily inEurope.

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We wereincorporated in California in 1980 as Overland Data, Inc. and changed our nameto Overland Storage, Inc. in 2002. Our headquarters are located at 4820Overland Avenue, San Diego, California 92123, and our telephone number is (858)571-5555.

#### **Our Direction and Strategy**

We currently offer our customers a complete portfolio of smart,affordable data protection appliances that help small and medium-sizedbusinesses and distributed enterprises ensure their data is “constantlyprotected, readily available and always there.” Our product strategy is to bring enterprise-class capabilities tomid-range customers through affordable and reliable solutions that reduce thebackup window, improve data recovery speed, simplify short and long-term dataretention and make cost-effective disaster recovery more readily available. Ourfocus will continue to be on solutions that can be easily sold worldwidethrough OEMs and our indirect network of distributors, retailers and resellers.

Historically, magnetic tape has been used for all forms of data backupand recovery because magnetic tape was, and still is, the only cost-effective, “removable,”high capacity storage media that can be taken off-site to ensure that data issafeguarded in case of disaster. For a number of years now, we have held amarket-leading position in mid-range tape automation with our flagship NEOTM products,and sales of tape automation appliances have represented approximately 75% ofour revenue for each of the last three fiscal years. In the fourth quarter offiscal 2005 we commenced development of ARCvault, a new tape automationplatform. The first two products in the ARCvault family were launched in July2006 and the final product was launched in April 2007. Although we expect thattape solutions will continue to be the anchor of the data protection strategyat most companies, tape backup is time consuming and often unreliable andinefficient. The process of recovering data from tape is also time consumingand inefficient. Ultimately, we expect that tape will be relegated to anarchival role for less-frequently accessed data.

Over the last few years, the advent of low-cost serial ATAdisk and iSCSI networking technology, together with greatly increasedregulatory compliance requirements and the continued growth of digital data,have driven businesses to use secondary storage disk-based backup appliances.One of the greatest benefits of disk-based backup is the speed of restoration.Studies show that approximately 90% of recovered data is two weeks old oryounger, or last accessed within that period. As a result, many IT managers areelecting to use disk-based appliances as an intermediate staging area, with thebackup data eventually moving to tape. Additionally, new software technologiessuch as replication and data deduplication are helping disk solutions overcomethe portability and capacity advantages of tape. We have enjoyed initialsuccess in the disk-based backup space with our REO® VTL-based appliance, and believe that REO canalso be a platform for data deduplication and data movement software that couldposition REO in the future as the most complete and capable family ofdisk-based appliances in the world marketplace. We are currently in developmentof a number of new REO solutions that we intend to deliver to market in thefirst half of fiscal 2008.

**Our Products and Services**

Our data storage products include nearline dataprotection appliances, disk backup and recovery, data protection software, andtape backup and archive.

*Nearline Data Protection Appliances*

In February 2007, we introduced our ULTAMUSTM RAIDnearline data protection appliances which provide small to medium-sized businesscustomers an affordable alternative to costly high-end network attached storage(NAS) and storage area network (SAN) solutions. The ULTAMUS RAID product familyfeatures cableless design and hot swap components and supports RAID (RedundantArray of Independent Disks) Levels 0, 1, 5, 6, 10 and 50, active/active RAIDcontrollers, and multiple 4 Gb/sec fibre channel host connections. OurULTAMUS product family currently consists of two products:

·                  *ULTAMUS RAID 1200* – ULTAMUS RAID 1200 provides the abilityto use 12 SAS (Serial Attached SCSI) disk drives and/or 12 SATA (SerialAdvanced Technology Attachment) disk drives within the same 2U rack-mountableenclosure. This product has a native storage capacity of up to 9.0 terabytes,and is expandable up to 60 drives and 45.0 terabytes.

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·                  *ULTAMUS RAID 4800* – ULTAMUS RAID 4800 leads the industry instorage rack efficiency by offering up to 48 SATA II disk drives in its 4Urack-mountable enclosure. This product has a native storage capacity of up to36.0 terabytes using SATA disk drives, and scales up to 72.0 terabytes using anadditional 4U expansion chassis.

*Disk Backup and Recovery*

We introduced our REO SERIES of disk backup andrecovery appliances in 2003. Powered by our embedded REO Protection OSTM software, these appliances are readilyconfigurable as virtual tape libraries (VTL), standalone virtual tape drives,and/or disk volumes (LUNs). See “Data Protection Software” below for moreinformation about REO Protection OS and our other add-on software modules. REOappliances are compatible with all popular open systems or Windows-based backupsoftware, physical tape drives or tape libraries. They also connect easily toEthernet (iSCSI) or fibre channel networks for seamless integration intoexisting backup environments.

Our REO product family currently consists of threeproducts:

·                  *REO 1500* – Our REO 1500 product has four disk drives and anative storage capacity of up to 3.0 terabytes.

·                  *REO 4500* – Our REO 4500 product has 12 disk drives and anative storage capacity of up to 9.0 terabytes; and our REO 4500 expansionarray can be added to an existing REO 4500 appliance to expand the totalstorage capacity of up to a maximum system capacity of 36.0 terabytes.

·                  *REO 9100*  – With 12 or24 disk drives and a native storage capacity of up to 18.0 terabytes, our REO9100 expansion array can be added to an existing REO 9000 appliance to expandthe total storage capacity of up to a maximum system capacity of 66.0terabytes.

*Data Protection Software*

Our embedded storage operating system software(Protection OS) and add-on software module PACs (Programmable AutomationControllers) provide data protection intelligence and advanced capabilitieswithin and across our appliances.

·                  *Protection OS* – Our Protection OS software deliversvirtualization, data protection, management, and connectivity features to ourREO appliances, and enables users to implement our appliances in almost anystorage or backup environment. Protection OS is compatible with all popularoperating systems and backup software along with Ethernet (iSCSI) and FibreChannel networks. In July 2006, we launched version 3.0 of our Protection OS,and in March 2007 we launched version 4.0.

·                  *REO Multi-Site PAC* – REO Multi-Site PAC® software makes it easy to add more advancedbackup and recovery capabilities to our REO appliances, including mirroring andconsolidation. This software is also available to protect remote data byfacilitating the transfer of data in virtual tape format from a remote REO to acentral REO for management and tape storage.

*Tape Backup and Archive*

Our automated tape libraries are devices capable ofmanaging multiple data cartridges. These libraries incorporate two or more tapedrives to provide unattended backup of large quantities of data, which tapedrives are supplied by other manufacturers based on the leading mid-range tapetechnologies, including LTO (Linear Tape Open) and SDLT (Super Digital LinearTape). Our NEO SERIES libraries have flexible configurations and featureredundant robotics, tape drives, power supplies, controller cards andinterfaces so that no single failure can disable the entire library. Our NEOTM productsand ARCVault libraries or autoloaders can be combined with our REO appliancesfor a complete disk-to-disk-to-tape solution.

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We offer three versions of our NEO product family:

·                  *NEO 2000* – Our NEO 2000 product accommodates up to two tape drives and 30 cartridges and scales up toeight modules high to create a system of 16 tape drives and 240 cartridges.

·                  *NEO 4000* – Our NEO 4000 product accommodates up to four tape drives and 60 cartridges and scales up tofour modules high to create a system of 16 tape drives and 240 cartridges.Customers can configure NEO systems with a combination of NEO 2000 and 4000modules.

·                  *NEO 8000* – Our NEO 8000 product consists of a base model with 100-cartridge capacity which canbe scaled up to 12 tape drives and 500 cartridges through a field-enabledsoftware key. Additionally, two NEO 8000 libraries can be interconnected toprovide up to 1,000 cartridge capacity and 24 tape drives.

Our new ARCVaultfamily of tape automation solutions is designed to deliver better value to aprice sensitive market. We offer three versions of our ARCVault family thatwere launched in fiscal 2007:

·                  *ARCVault 12* – OurARCVault 12 autoloader consists of one tape drive and accommodates up to 12cartridges.

·                  *ARCVault 24* – Our ARCVault 24 tape library accommodates up to two tape drives and 24 cartridges.

·                  *ARCVault 48* – Our ARCVault 48 tape library accommodates up to four tape drives and 48 cartridges.

*RelatedProducts and Services*

We also have avariety of products and services supporting our tape libraries 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; and

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

*VR**2**®** (Variable Rate Randomizer)*

VR2* *is our patented dataencoding technology. This technology,which is embedded in an Applications Specific Integrated Circuit (ASIC) chip,is capable of significantly increasing the native capacity and data transferrate performance of linear tape technologies without requiring any changes intape path design, recording heads and/or media. This performance isaccomplished 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, T9840 and T10000 drives and future tape drive products.

**Customers**

Our operating structure is designed for our mid-range strategy in thatour products do not require us to have a “direct” (to end-users) sales orservice force. We sell all of our products on an indirect basis,primarily through three channels or types of customers: (i) OEMs;(ii) distributors and (iii) VARs and DMRs. Regardless of the channelthrough which they are sold, all of our products are designed and manufacturedto meet OEM-level requirements and reliability standards.

·                  ***OEM Channel***– Historically, we have had a significant OEM supply agreement with HewlettPackard Company (HP), which incorporates our NEO products into its system offerings.In August 2005, we announced that HP had selected an 

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alternate supplierfor its next-generation mid-range tape automation products. HP began purchasingthe first product of this new line from the alternate supplier during the firstquarter of calendar year 2006. Although we believe that our sales to HP willcontinue to decline through fiscal 2008, HP has recently relaunched the tapeautomation products supplied by us with support for the new LTO4 tape drivesand this may slow the rate of replacement of our supplied products by thealternate supplier’s product.

Although we continually strive to win new OEM business, the OEM salescycle is often lengthy and uncertain. It typically consists of a generaltechnology evaluation, qualification of product specifications, verification ofproduct performance against these specifications, integration testing of theproduct within the customers’ systems, product announcement and volumeshipment.

As is customary in the industry, our OEM contracts have an initialthree-year term, provide for periodic price reviews and the customers are notrequired to purchase minimum quantities. Our existing contract with HP(initially signed in August 2003 and extended for up to three years inJuly 2006) also provides that title to inventory shipped from our warehouseinto various inventory hub locations remains with us until the products arepulled by HP to fulfill its customer’s orders. HP has been our largestcustomer, accounting for approximately 45.8%, 49.7% and 54.3% of sales infiscal 2007, 2006 and 2005, respectively. No other customer accounted for morethan 10% of sales in any year during the three-year period ended June 30, 2007.

·                  ***Distribution Channel*** – Our primarydistribution customers include Ingram Micro, Inc., Tech Data Corporationand Promark Technology in the United States and approximately eight technicaldistributors in Europe. Typically, these distributors sell our products tosmaller VARs and DMRs who in turn sell to end-users. The distribution agreementsinclude provisions for rights of return, stock rotation and price protection,common terms in the commercial distribution area. Because of these terms,revenue from shipments to these customers is not recognized until the relatedproducts are in turn sold by the distributor. We support these distributorsthrough a dedicated field sales force and provide further support through fieldsales personnel who work with the smaller VARs and catalogers to generateend-user sales and create the pull through its distribution customers.

·                  ***VAR Channel*** – Our VAR channelincludes systems integrators and larger VARs. Some of our VARs qualify topurchase products direct from us while others purchase through the distributionchannel. 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 RAID systems, to deliver acomplete storage subsystem. These customers also recommend our products asreplacement solutions when backup systems are upgraded, and bundle our productswith storage management software specific to the end-user’s system. We supportthis channel through our field sales representatives.

Our products are soldboth domestically and internationally and we have sales personnel located invarious cities throughout the world. We divide our sales into three geographicalregions: (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.

Sales to customers outside of the United States represent a significantportion of our sales. International sales are subject to various risks anduncertainties. See “Our international operations are important to our businessand involve unique risks” in Risk Factors below. Sales generated by ourEuropean channel generally show seasonal slowing during our first fiscalquarter (July through September), reflecting the summer holiday period inEurope.

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The following table sets forth certain foreign revenue(in thousands):

|                                                 | ** ** | **Fiscal Year** | ** ** |
|-------------------------------------------------|------------|----------------------|------------|
| ** **                                      | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Foreign revenue:                                |       |                 |       |   |   |   |   |
| United Kingdom                                  |       | $                    | 40,925     |   | $ | 47,914 |   | $ | 65,845 |   |
| Rest of Europe                                  |       | 25,613               |       | 29,098 |   | 28,464 |   |
| Singapore                                       |       | 15,247               |       | 22,940 |   | 21,822 |   |
| Other foreign  revenue                          |       | 10,678               |       | 18,674 |   | 22,400 |   |
|                                            |       | $                    | 92,463     |   | $ | 118,626 |   | $ | 138,531 |   |
| Foreign revenue as a  percentage of net revenue |       | 57.6                 | %          | 56.7 | % | 58.8 | % |

Our marketing efforts include support for both our OEM and brandedcustomers. Our branded channel partners are provided with a full range ofmarketing materials, including product specification literature and applicationnotes. In addition, we offer lead generation opportunities and marketdevelopment funds to our key channel partners. Our sales management andengineering personnel provide support to the channel partners and, in certaininstances, visit potential customer sites to explain and demonstrate thetechnical advantages of our products. We maintain press relations bothdomestically and in Europe, and participate in national and regional tradeshows in varying degrees both domestically and internationally.

**Customer Service and Support**

Our technicalsupport personnel are trained on our products, compatibility between multiplehardware platforms, operating systems and backup, data interchange and storagemanagement software and are equipped to respond to customer inquiries.Additionally, our application engineers are available to solve more complexcustomer problems. Customers that need service and support can contact usthrough our toll-free telephone lines, facsimile and Internet e-mail.Application notes and user manuals can be obtained directly from our website.

For most products, we offer a program calledXchangeNOW® as part of a return-to-factory warranty whichenables customers to receive an advance replacement unit or field replacementpart shipped within two business days after placing a service request. Thecustomer ships the defective unit back to us using the shipping materials fromthe replacement unit. In addition, we generally provide:

·                  three-yearadvance replacement return-to-factory limited warranty on our ULTAMUS RAID, REOSERIES, PowerLoader and LoaderXpress products;

·                  one year advancereplacement return-to-factory limited warranty for our ARCvault 12 and 24 products;and

·                  one year on-siteservice limited warranty on our NEO Seriesand ARCvault 48 products, for which we contract with third-party serviceproviders.

In May 2007 the warranty length for NEO SERIESproducts was reduced from three years to one year. The second and third year ofwarranty for those NEO SERIES products shipped prior to May 2007 will continueto be serviced under the three year advance replacement return-to-factorywarranty through no later than the fourth quarter of fiscal 2010. As of the endof third quarter of fiscal 2007, our PowerLoader and LoaderXpress products werereplaced by our new ARCvault product family. Our PowerLoader and LoaderXpressproducts will continue to be serviced under the three-year advance replacementreturn-to-factory warranty, but not later than the third quarter of fiscal2010.

**Research and Development**

We incurred research and development (R&D) costs of $15.0 million,$18.8 million and $10.7 million in fiscal 2007, 2006 and 2005, respectively,representing 9.4%, 9.0% and 4.5%, respectively, of net revenue. We currently employ 38 people in our R&Ddepartment, including electrical, mechanical, software, hardware and firmwareengineers who support our products. In fiscal 2006, our development effortswere focused on three projects: (1) our ARCvault tape automation platform;

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(2) anULTAMUS protected primary storage appliance based on acquired technology weobtained in the August 2005 acquisition of Zetta Systems (which projectwas abandoned in the first quarter of fiscal 2007); and (3) the additionof scalability to our current line of REO products. In fiscal 2007, wecompleted the development of the ARCvault tape automation products, new RoHScompliant platforms for all three of our REO products and Version 4.0 of ourREO Protection OS software. We also completed the sourcing and qualification ofour new ULTAMUS RAID products. We are currently developing both hardware andsoftware enhancements to our REO platforms which will incorporate bothcompression and data deduplication technologies. We expect R&Dexpenditures, which reached an all-time high as a percentage of net revenue infiscal 2006, to decline significantly in fiscal 2008, both absolutely and as apercentage of net revenue. None of our R&D expenditures arecustomer-sponsored.

#### **Manufacturing and Suppliers**

In September 2004, weannounced a plan to outsource all of our manufacturing to Sanmina – SCICorporation, a United States third party manufacturer. We completed thistransfer in August 2005. During fiscal 2006, however, we failed to achievethe customer service levels, product quality and cost reductions we expectedfrom the outsourcing. Additionally, we incurred a significant amount ofredundant costs to support the outsourcing, which eroded our gross marginsduring the year. Consequently, we decided to bring manufacturing back to ourSan Diego facility and entered into a transition agreement with Sanmina,effective September 2006. We completed the transfer of all production linesback to San Diego in February 2007. Our customer lead times have now beenreduced to target levels and we believe we have eliminated the quality andbacklog issues that occurred during the outsourced period. We are now workingto reduce costs, improve efficiencies and reduce inventory levels.

At our integrated factory in San Diego, California, weperform product assembly, integration and testing, while leaving component andpiece-part manufacturing to our supplier partners. Our products have a largenumber of components and subassemblies produced by outside suppliers. We dependgreatly on these suppliers for tape drives, printed circuit boards andintegrated circuits, which are essential to the manufacture of our products. Wework closely with a group of regional, national and international suppliers,which are carefully selected based on their ability to provide quality partsand components that meet our specifications, as well as meet present and futurevolume requirements. For certain items, we qualify only a single source, whichcan magnify the risk of shortages and decrease our ability to negotiate withour suppliers on the basis of price. From time to time in the past, we have notobtained as many drives as we have needed from various vendors due to driveshortages or quality issues.

In general, our branded products are not manufactureduntil an order is received. The typical lead-time for manufacturing products isthree days and backlog usually is not a significant factor to our business. AtJune 30, 2007, we had $1.2 million of firm backlog orders (a more typicallevel), compared to approximately $5.0 million at June 30, 2006 (resulting frominefficiencies related to our outsourced manufacturing). Our largest OEM customer,HP, requires that we maintain finished goods inventory on hand, known as bufferstock, at any given time sufficient to supply their forecasted requirements forthe next three weeks. They provide weekly forecast information that allows usto manage both raw material and finished goods inventories. The buffer stock isshipped into various distribution hubs around the world and we retain ownershipof that inventory until it is pulled by HP to fulfill customer orders, at whichtime we record the sale.

We occupied our current headquarters and manufacturingbuildings in March 2002. The buildings are subject to a 12-year lease with onefive-year extension option. We believe that we have the capacity to supportunit production levels several times greater than our current rate ofproduction. We maintain approximately 30% of our direct labor in the form oftemporary staffing to accommodate normal business fluctuations and control ourstaffing levels carefully to meet customer requirements at any specific time.

**Competition**

The worldwide storage market is intensely competitive and barriers toentry are relatively low. Our competitors vary in size from small start-ups tolarge multi-national corporations who have substantially greater financial,R&D and marketing resources. In the tape automation market, we believe ourprimary competition is Quantum Corporation, but we also face competition fromSun StorageTek in larger scale libraries. Key competitive factors includeproduct features, reliability, durability, scalability and price.

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Our disk-based productscurrently compete with products made by Quantum, DataDomain, Dell,Nexsan, FalconStor, InforTrend, EMC, Network Appliance, StorVault (a divisionof Network Appliance), Apple, IBM, Sepaton andnumerous small start-ups. We believe additional competitors are likely to enterthe market. Key competitive factors in these markets include performance,functionality, scalability, availability, interoperability, connectivity, timeto market enhancements and total value of ownership.

The markets for all of our products are characterized by significantprice competition, and we anticipate that our products will continue to faceincreasing price pressure.

**Proprietary Rights**

#### **General****–** We presently hold 17 United States patents and have five United Statespatents pending. In general, these patents have a 20-year term from the firsteffective filing date for each patent. We also hold a number of foreign patentsand patent applications for certain of our products and technologies. Theserights, however, may not prevent competitors from developing substantiallyequivalent or superior products to ours. In addition, our present and futurepatents may be challenged, invalidated or circumvented, reducing or eliminatingour proprietary protection.

**VR****2®**** Technology** – We have entered into variousintellectual property licensing agreements relating to our VR2 technology. These agreements require the paymentof royalty fees based on sales by licensees of products containing VR2. In certain instances, we sell to the licensee ASICchips embodying VR2 priced toinclude the cost of the chip plus an embedded royalty fee.

**Employees**

As of July 1,2007, we had 326 employees, including 108 in sales and marketing, 38 inresearch and development, 142 in manufacturing and operations and 38 infinance, information systems, human resources and other management. There areno collective bargaining contracts covering any of the employees and we believethat our relationship with our employees is good.

**Financial Information aboutSegments and Geographic Areas**

We operate ourbusiness in one reportable segment. For information about (1) our revenues fromexternal customers, measures of profits and losses and total assets, and (2)our revenues from external customers and long-lived assets broken down bygeographic area, see our consolidated financial statements and Note 1(Operations and Summary of Significant Accounting Policies – “Segment Data” and“Information about Geographic Areas”) thereto.

**Additional Information**

Our web site islocated at www.overlandstorage.com. We make available free of charge on our website our annual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and amendments to those reports filed pursuant to Section13(a) or 15(d) of the Securities Exchange Act as soon as reasonably practicableafter we electronically file such material with, or furnish it to, theSecurities and Exchange Commission. The contents of our web site are not a partof this report.

**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.*

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**We havea recent history of net losses. We expect to continue to incur net losses forsome time and we may not achieve or maintain profitability.**

We have incurredsignificant operating losses in recent periods and anticipate continued lossesduring fiscal 2008. At July 1, 2007 we had an accumulated deficit of $18.8million. We need to generate additional revenue and improve our gross profitmargins to be profitable in future periods. Our current plans indicate that,depending on sales, we may need additional capital to support our growth. Wemay generate a portion of these funds from operations. Principal factors thatcould affect the availability of our internally generated funds include:

·                                          our abilityto reduce and control spending;

·                                          introductionof new competing technologies;

·                                          product mixand effect on margins; and

·                                          acceptance ofour products in new and existing markets.

Our recent historyof net losses could cause current or potential customers to defer new orderswith us or select other vendors, and may cause suppliers to require terms thatare unfavorable to us. Failure to achieve profitability, or maintainprofitability if achieved, may require us to raise additional funding which (i)could have a material adverse effect on the market value of our common stock,(ii) we may not be able to obtain in the necessary time frame to avoiddisruptions to our business or on terms favorable to us, if at all, and (iii)may be inadequate to enable us to continue to conduct business. If it werenecessary for us to obtain additional funding by selling additional shares ofour capital stock or securities convertible into or exercisable for commonstock, the ownership interest of our shareholders would likely be diluted.

**Our business has been highlydependent on sales to large OEM customers and we are currently experiencing acustomer transition.**

Hewlett-Packard Company (HP), including theformer Compaq which HP acquired in May 2002, has been our largestcustomer, accounting for approximately 45.8% of net revenue in fiscal 2007,49.7% of net revenue in fiscal 2006 and 54.3% of net revenue in fiscal 2005. Noother customer accounted for more than 10% of net revenue in fiscal 2007.Neither HP nor any other customer is obligated to purchase a specific amount ofour products or provide binding forecasts of purchases for any period.

InAugust 2005, we announced that HP had selected an alternate supplier forits next-generation mid-range tape automation product. HP began purchasing thefirst product of this new line from the alternate supplier during the firstquarter of calendar year 2006. We expect HP to continue to purchase the tapeautomation products currently supplied by us for some time, but the new productwill eventually replace a significant portion of those purchases. We cannotpredict how quickly this transition will occur, but we believe the effect onour revenue during fiscal 2008 may be significant.

**Wecould incur charges for excess and obsolete inventory.**

The value of our inventory may be adversely affected by changes intechnology that affect our ability to sell the products in our inventory. If wedo not effectively forecast and manage our inventory, we may need to write offinventory as excess or obsolete, which in turn can adversely affect cost ofsales and gross profit. We have previously experienced, and may in the futureexperience, reductions in sales of older generation products as customers delayor defer purchases in anticipation of new product introductions. We currentlyhave established reserves for slow moving or obsolete inventory. The reserveswe have established for potential losses due to obsolete inventory may,however, prove to be inadequate and may give rise to additional charges forexcess or obsolete inventory.

**We rely on indirect saleschannels to market and sell our branded products. Therefore, the loss of ordeterioration in our relationship with one or more of our distributors orresellers could negatively affect our operating results.**

We sell all of ourbranded products through our network of distributors, value-added resellers orVARs, and direct 

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marketing resellers whoin turn sell our products to end users. The success of these partners is hard to predict, particularly overtime, and we have no purchase commitments or long-term orders from them thatassure us of any baseline sales through these channels.  Most of our partners carry competing productlines that they may promote over our products. A partner might not continue to purchase our products or market themeffectively, and each reseller determines the type and amount of our productsthat it will purchase from us and the pricing of the products that it sells toend user customers.  Our operatingresults could be adversely affected by any number of factors including:

·                           Achange in competitive strategy that adversely affects a partners’ willingnessor ability to distribute our products;

·                           Thereduction, delay or cancellation of orders or the return of a significantamount of product(s);

·                           Theloss of one or more of such partners; or

·                           Anyfinancial difficulties of such partners that result in their inability to payamounts owed to us.

**We plan to replace our ERP(Enterprise Resource Planning) System within the next several years, and thismay be disruptive to our business.**

OurERP system is approximately 10 years old, and we anticipate the need to replaceit within the next several years. Transition to a new ERP system will beexpensive and time consuming and, if problems occur in the transition, ourbusiness and results of operations may be materially and adversely affected. Inaddition, we have modified this system significantly during its term of use andit is possible that we would experience a significant system failure before wereplace the system. Any such failure also may materially and adversely affectour business and results of operations.

**Our financial results mayfluctuate substantially for many reasons, and past results should not be reliedon as indications of future performance.**

All of the markets that we serve are volatile andsubject to market shifts, which we may not be able to discern in advance. Aslowdown in the demand for workstations, mid-range computer systems, networksand servers could have a significant adverse effect on the demand for ourproducts in any given period. We have experienced delays in receipt of purchaseorders and, on occasion, anticipated purchase orders have been rescheduled orhave not materialized due to changes in customer requirements. Our customersmay cancel or delay purchase orders for a variety of reasons, including therescheduling of new product introductions, changes in their inventory practicesor forecasted demand, general economic conditions affecting our customers’markets, changes in our pricing or the pricing of our competitors, new productannouncements by us or others, quality or reliability problems related to ourproducts or selection of competitive products as alternate sources of supply.In particular, our ability to forecast sales to distributors, integrators andvalue-added resellers is especially limited as these customers typicallyprovide us with relatively short order lead times or are permitted to changeorders on short notice. Given that a large portion of our sales are generatedby our European channel, our first fiscal quarter (July through September)results of operations are commonly impacted by seasonally slow European orders,reflecting the summer holiday period in Europe. In addition, none of ourcustomers is obligated to purchase a specific amount of our products.

Our financial results have fluctuated and willcontinue to fluctuate quarterly and annually based on many other factors suchas:

·                  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

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·                  increases in thecost of or limitations on availability of materials.

Based on all of the foregoing, we believe thatour revenue and operating results will continue to fluctuate, andperiod-to-period comparisons are not necessarily meaningful and should not berelied on as indications of future performance. Furthermore, in some futurequarters, our revenue and operating results could be below the expectations ofpublic market analysts or investors, which could result in a material adverseeffect on the price of our common stock. In addition, portions of our expensesare fixed and difficult to reduce if revenue does not meet our expectations. Thesefixed expenses magnify the adverse effect of any revenue shortfall.

**The market price of our common stock may bevolatile***.*

The market price of our common stock hasexperienced significant fluctuations since it commenced trading inFebruary 1997. The market price of our common stock may continue tofluctuate significantly in the future. Many factors could cause the marketprice 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;

·                  quarterlyvariations in operating results;

·                  the introductionof new technologies or products;

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

·                  changes in generaleconomic conditions.

In addition, stock markets have experiencedextreme price and volume volatility in recent years. This volatility has had asubstantial effect on the market prices of securities of many smaller public companiesfor reasons frequently unrelated or disproportionate to the operatingperformance of the specific companies. These market fluctuations may adverselyaffect the market price of our common stock.

**We face intense competition andprice pressure, and many of our competitors have substantially greaterresources than we do.**

The worldwide storage market is intenselycompetitive as a number of manufacturers of tape automation solutions andstorage management software products compete for a limited number of customers.In addition, barriers to entry are relatively low in these markets. Wecurrently participate in the mid-range of the tape backup market. In thissegment, some of our competitors have substantially greater financial and otherresources, larger research and development staffs, and more experience andcapabilities in manufacturing, marketing and distributing products. The marketsfor our products are characterized by significant price competition, and weanticipate that our products will face increasing price pressure. This pressurecould result in significant price erosion, reduced profit margins and loss ofmarket share, any of which could have a material adverse effect on ourbusiness, liquidity, results of operation and financial position.

**Our business is highly dependenton the continued market acceptance and usage of tape-based systems for databackup and recovery.**

We have historically derived a majority of ourrevenue from products based on the use of magnetic tape drives for backup andrecovery of digital data. Ourtape-based storage solutions now compete directly with other storagetechnologies, such as hard disk drives, and may face competition in the futurefrom other emerging technologies. The prices of hard disk drives continue todecrease while capacity and performance have increased. We expect that ourtape-based products will face increased competition from these alternativetechnologies and come under increasing price pressure. If our strategy tocompete in disk-based markets does not succeed, our business, liquidity,results of operations and financial condition will be materially and adverselyaffected.

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**Our disk-based products involvemany significant risks and may fail to achieve or maintain market acceptance.**

The success of ourrecently introduced REO SERIES and ULTAMUS SERIES disk-based products isuncertain and subject to significant risks, any of which could have a materialadverse effect on our business, liquidity, results of operation and financialposition. We must commit significant resources to these new products and willcontinuously need to update and upgrade them to stay competitive. Any delay inthe commercial release of new or enhanced disk-based products could result in asignificant loss of potential revenue and may adversely impact the market priceof our common stock. Furthermore, if our disk-based products do not achievemarket acceptance 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 ourability to anticipate rapid technological changes and develop new and enhancedproducts.**

As an advanced technology company, we aresubject to numerous risks and uncertainties, generally characterized by rapidtechnological change and intense competition. In this environment, our futuresuccess will depend on our ability to anticipate changes in technology, todevelop new and enhanced products on a timely and cost-effective basis and tointroduce, manufacture and achieve market acceptance of these new and enhancedproducts.

Development schedules for high technologyproducts are inherently subject to uncertainty. We may not meet our productdevelopment schedules, including those for products based on our disk-basedtechnologies, and development costs could exceed budgeted amounts. Ourbusiness, liquidity, results of operations and financial position may bematerially and adversely affected if the products or product enhancements thatwe develop are delayed or not delivered due to developmental problems, qualityissues or component shortage problems, or if our products or productenhancements do not achieve market acceptance or are unreliable. Theintroduction, whether by us or our competitors, of new products embodying newtechnologies, such as new sequential or random access mass storage devices, andthe emergence of new industry standards could render existing products obsoleteor not marketable, which may have a material adverse effect on our business,liquidity, results of operations and financial position.

**Our international operations areimportant to our business and involve unique risks.**

Historically, sales to customers outside ofthe United States have represented a significant portion of our sales and weexpect them to continue representing a significant portion of sales. Sales tocustomers outside the United States are subject to various 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 withchanges in foreign standards in the future. Our inability to design productsthat comply with foreign standards could have a material adverse effect on ourbusiness, liquidity, results of operations and financial position.

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**We are subject to exchange rate riskin connection with our international operations.**

We do not currently engage in foreign currency hedgingactivities and therefore we are exposed to some level of currency risk. Ourwholly-owned subsidiaries in the United Kingdom, France and Germany incur costswhich are denominated in local currencies. As exchange rates vary, theseresults when translated into U.S. dollars may vary from expectations andadversely impact overall expected results. A weaker U.S. dollar would result inan increase to revenue and expenses upon consolidation, and a stronger U.S.dollar would result in a decrease to revenue and expenses upon consolidation.

**Our ability to compete effectively depends in parton our ability to protect our intellectual property rights effectively.**

We rely on a combination of patent, copyright,trademark, trade secret and other intellectual property laws to protect ourintellectual property rights. These rights may not however prevent competitorsfrom developing products that are substantially equivalent or superior to ourproducts. To the extent we have or obtain patents, such patents may notafford meaningful protection for our technology and products. Others maychallenge our patents and, as a result, our patents could be narrowed,invalidated or declared unenforceable. In addition, current or future patentapplications may not result in the issuance of patents in the United States orforeign countries. The laws of certain foreign countries may not protect our intellectualproperty to the same extent as U.S. laws. Furthermore, competitors mayindependently develop similar products, duplicate our products or, if patentsare issued to us, design around these patents.

In order toprotect or enforce our patent rights, we may initiate interference proceedings,oppositions, or patent litigation against third parties, such as infringementsuits. These lawsuits could be expensive, take significant time and divertmanagement’s attention from other business concerns. The patent position ofinformation technology firms generally is highly uncertain, involves complexlegal and factual questions, and has recently been the subject of muchlitigation. No consistent policy has emerged from the U.S. Patent and TrademarkOffice or the courts regarding the breadth of claims allowed or the degree ofprotection afforded under information technology patents.

**Oursuccess will depend partly on our ability to operate without infringing on ormisappropriating the proprietary rights of others.**

Our business issuch that we may at any time be sued for infringing the patent rights ormisappropriating the proprietary rights of others. For example, during fiscal2004 we settled a case alleging patent infringement. Intellectual propertylitigation is costly and, even if we prevail, the cost of such litigation couldadversely affect our business, liquidity, results of operations and financial condition.In addition, litigation is time consuming and diverts management attention andresources away from our business. If we do not prevail in any litigation, wecould be required to stop the infringing activity and/or pay substantialdamages. Under some circumstances in the United States, these damages could betriple the actual damages the patent holder incurs. If we have suppliedinfringing products to third parties for marketing or licensed third parties tomanufacture, use or market infringing products, we may be obligated toindemnify these third parties for any damages they may be required to pay tothe patent holder and for any losses the third parties may sustain themselvesas the result of lost sales or damages paid to the patent holder.

If a third partyholding rights under a patent successfully asserts an infringement claim withrespect to any of our products, we may be prevented from manufacturing ormarketing our infringing product in the country or countries covered by thepatent we infringe, unless we can obtain a license from the patent holder. Anyrequired license may not be available to us on acceptable terms, or at all.Some licenses may be non-exclusive, and therefore, our competitors may haveaccess to the same technology licensed to us. If we fail to obtain a requiredlicense or are unable to design around a patent, we may be unable to marketsome of our products, which could have a material adverse effect on ourbusiness, liquidity, financial condition and results of operations.

**We havemade a number of acquisitions in the past and may make acquisitions in thefuture. The failure to successfully integrate acquisitions and successfullycomplete product development and launch of the related products could harm ourbusiness, financial condition and operating results.**

We have in thepast and may in the future make acquisitions of complementary businesses,products or technologies as we implement our business strategy. Mergers andacquisitions involve numerous risks, including liabilities that we may 

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assume from the acquired company, difficulties incompletion of in-process product development and assimilation of the operationsand personnel of the acquired business, the diversion of management’s attentionfrom other business concerns, risks of entering markets in which we have nodirect prior experience, and the potential loss of key employees of theacquired business.

For example, in August 2005, we acquired ZettaSystems, whose data protection software was then incorporated into our ULTAMUSPro storage appliance that was launched in the first quarter of fiscal 2007.ULTAMUS Pro did not generate revenue subsequent to its launch, and wesubsequently discontinued the product and closed the related developmentfacility. We recognized an impairment loss of $8.4 million and a write-down of$350,000 in inventory in the first quarter of fiscal 2007 associated with thefailure of this acquisition.

Future mergers and acquisitions by us also mayresult in dilutive issuances of our equity securities and the incurrence ofdebt, amortization expenses and potential impairment charges related tointangible assets. Any of these factors could adversely affect our business,liquidity, results of operations and financial position.

**Our warranty reserves may not adequatelycover our warranty obligations.**

We have established reserves for the estimatedliability associated with our product warranties. However, we could experienceunforeseen circumstances where these or future reserves may not adequatelycover our warranty obligations. For example, the failure or inadequateperformance of product components that we purchase could increase our warrantyobligations beyond these reserves.

**The failure to attract, retain and motivate keypersonnel could have a significant adverse impact on our operations.**

We have experienced significant changes in our senior management. InAugust 2007, our board of directors appointed Vernon A. LoForti, who had servedas our chief financial officer since December 1995, as our new President andChief Executive Officer. Kurt L. Kalbfleisch, who had served in our financedepartment since December 1994, was appointed as our vice president of financein July 2007, and was appointed by our board of directors to the additionalposition of Interim Chief Financial Officer in August 2007. These changes maybe a distraction to other senior management, business operations, commercialpartners and customers. Additionally, we have experienced a prolonged period ofoperating losses and declines in our stock price and cash position which hasaffected and may continue to affect employee morale and retention. In April2007, we reduced our workforce by 14% worldwide. Further turnover, particularlyamong senior management, can also create distractions as we search forreplacement personnel, which could result in significant recruiting,relocation, training and other costs, and can cause operational inefficienciesas replacement personnel become familiar with our business and operations. Inaddition, manpower in certain areas may be constrained, which could lead todisruptions over time. We cannot guaranty that we will continue to successfullyattract or retain the management we need, or be able to maintain an optimalworkforce size. Any inability to attract, retain or motivate such personnel oraddress manpower constraints as needed could materially adversely affect ourfuture operating results and financial position. We do not currently maintainany key-man insurance for any of our employees.

**Item 1B. Unresolved Staff Comments.**

We have no unresolved comments from the SEC.

**Item 2. Properties.**

We own no real property and we currently lease allfacilities used in our business. Our headquarters are located in San Diego,California in a two-building light industrial complex comprising approximately160,000 square feet. The lease expires in February 2014 and can be renewedfor one additional five-year period. This San Diego facility houses all of ourresearch and development, and administrative functions, as well as a majorportion of sales, sales administration, marketing and customer support.

We lease a 17,000 square foot facility located inWokingham, England, which houses sales, technical support and repair services.The lease expires in January 2018. We also maintain small sales officeslocated close to Paris, France, Munich, Germany, Singapore and Korea and aresearch and development office located near Seattle, Washington.

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**Item 3. Legal Proceedings.**

We are from timeto time involved in various lawsuits, legal proceedings or claims that arise inthe ordinary course of business. We do not believe any such legal proceedingsor claims will have, individually or in the aggregate, a material adverseeffect on our business, liquidity, results of operations and financialcondition. However, litigation is subject to inherent uncertainties, and anadverse result in these or other matters may arise from time to time that mayharm our business.

**Item 4. Submission of Matters toa Vote of Security Holders.**

No matters were submitted to a vote of our securityholders during the fourth quarter of 2007.

**PART II**

**Item 5. Market for Registrant’sCommon Equity, Related Shareholder Matters and Issuer Purchases of EquitySecurities.**

Our common stocktrades on The NASDAQ Global Market under the symbol “OVRL.” As of August 17,2007, there were approximately 75 shareholders of record. We have not paid anycash dividends on our common stock and do not anticipate paying any cashdividends in the foreseeable future. The high and low sales prices of ourcommon stock from July 4, 2005 through July 1, 2007 were as follows:
|                   | ** ** | **Sales Prices** | ** ** |
|-------------------|------------|-----------------------|------------|
| ** **        | ** ** | **High**              | ** ** | **Low** | ** ** |
| Fiscal Year 2007: |       |                  |       |   |   |
| Fourth quarter    |       | $                     | 4.20       |   | $ | 2.51 |   |
| Third quarter     |       | 4.78                  |       | 3.90 |   |
| Second quarter    |       | 7.01                  |       | 3.63 |   |
| First quarter     |       | 7.76                  |       | 6.10 |   |
|              |       |                  |       |   |   |
| 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 |   |

 

The abovequotations reflect inter-dealer prices, without retail markup, markdown orcommission and may not necessarily represent actual transactions.

**Share Repurchases**

Neither we nor any affiliated purchasers repurchasedany shares of common stock or other equity securities in the fourth quarter offiscal 2007. In October 2006, our board of directors terminated our sharerepurchase program.

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**COMPARISONOF CUMULATIVE TOTAL RETURNAMONG OVERLAND STORAGE, THE NASDAQ COMPOSITE INDEX, ANDTHE NASDAQ COMPUTER MANUFACTURERS INDEX**

**Item 6. Selected Financial Data.**

The followingselected financial data has been derived from our audited consolidatedfinancial statements and related notes. This information should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and with our consolidated financial statements andrelated notes appearing elsewhere in this report.

The consolidatedstatement of operations data for the years ended June 30, 2007, 2006 and 2005,and the consolidated balance sheet data at June 30, 2007 and 2006, are derivedfrom our audited consolidated financial statements appearing elsewhere in thisreport. The consolidated statement of operations data for the years ended June30, 2004 and 2003, and the consolidated balance sheet data at June 30, 2005,2004 and 2003, are derived from our audited consolidated financial statementsthat are not included in this report. The historical results are notnecessarily indicative of the results to be expected in any future period.

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| ** **                                         | ** ** | **Fiscal Year**                                                  | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                         | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Consolidated Statement of  Operations Data:**    | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                                        |       | $                                                                     | 160,443    |   | $ | 209,038 |   | $ | 235,687 |   | $ | 238,139 |   | $ | 195,881 |   |
| Gross profit                                       |       | 24,343                                                                |       | 46,446 |   | 60,917 |   | 64,654 |   | 54,018 |   |
| (Loss) income from  operations                     |       | (44,845                                                               | )          | (25,931 | ) | 3,524 |   | 15,598 |   | 10,310 |   |
| (Loss) income before  income taxes                 |       | (43,836                                                               | )          | (23,311 | ) | 5,068 |   | 16,199 |   | 10,193 |   |
| Net (loss) income                                  |       | (44,111                                                               | )          | (19,486 | ) | 4,578 |   | 10,625 |   | 6,682 |   |
| Net (loss) income per  share (1):                  |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                                              |       | $                                                                     | (3.45      | ) | $ | (1.42 | ) | $ | 0.33 |   | $ | 0.79 |   | $ | 0.59 |   |
| Diluted                                            |       | $                                                                     | (3.45      | ) | $ | (1.42 | ) | $ | 0.32 |   | $ | 0.74 |   | $ | 0.54 |   |
|                                               |       |                                                                  |       |   |   |   |   |   |   |   |   |
| **Consolidated Balance Sheet  Data:**              | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash equivalents  and short-term investments |       | $                                                                     | 22,825     |   | $ | 62,512 |   | $ | 76,887 |   | $ | 69,657 |   | $ | 55,020 |   |
| Working capital                                    |       | 39,566                                                                |       | 76,381 |   | 110,363 |   | 103,244 |   | 84,326 |   |
| Total assets                                       |       | 88,053                                                                |       | 144,769 |   | 164,554 |   | 144,851 |   | 130,922 |   |
| Long-term debt,  inclusive of current portion      |       | —                                                                |       | — |   | — |   | — |   | 3,957 |   |
| Shareholders’ equity                          |       | 49,110                                                                |       | 95,438 |   | 121,494 |   | 113,514 |   | 93,264 |   |

 

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(1)          SeeNote 1 to our consolidated financial statements for an explanation of sharesused in computing net (loss) income per share.

**Item 7. Management’s Discussionand Analysis of Financial Condition and Results of Operation.**

*Thediscussion in this section contains statements of a forward-looking naturerelating to future events or our future performance. Words such as “expects,” “anticipates,”“intends,” “plans,” “believes,” “seeks,” “estimates” 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. Suchstatements are only predictions and actual events or results may differmaterially. In evaluating such statements, you should specifically considervarious factors identified in this report, including in particular the mattersset forth under the caption “Risk Factors”, in Part I, Item 1A of this report,which could cause actual results to differ materially from those indicated bysuch forward-looking statements.*

We are a market leader and innovative provider of dataprotection appliances that help small and medium-sized businesses anddistributed enterprises ensure their data is “constantly protected, readilyavailable and always there.”  Ourportfolio of data protection appliances includes the following:

·                  the ULTAMUSSERIES of nearline data protection appliances;

·                  the REO SERIESof disk-based backup and recovery appliances; and

·                  the NEO SERIESand ARCVault family of tape backup and archive appliances.

Our products spanall three tiers of data storage (nearline data protection appliances,disk-based backup and recovery and tape automation) and enable us to offer ourcustomers an end-to-end data protection solution. End-users of our productsinclude small and medium-size businesses, as well as distributed enterprisecustomers represented by divisions and operating units of large multi-nationalcorporations, governmental organizations, universities and other non-profitinstitutions operating in a broad range of industry sectors. See the “Business”section in Part I, Item 1 of this report for more information about ourbusiness, products and operations.

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**Overview**

This overview discussesmatters on which our management primarily focuses in evaluating our financialcondition and operating performance.

*Generation of revenue*. Wegenerate the vast majority of our revenue from sales of our data protectionappliances. The balance of our revenue is provided by selling spare parts,rendering services to our customers and earning royalties on our licensedtechnology. Historically, most of our product sales have been made throughprivate label arrangements with OEMs, and the remainder have been made throughcommercial distributors, DMRs and VARs in our branded channel. However, ourstrategy moving forward is to focus heavily on the delivery of new products toour branded channel, which historically has produced higher gross margins incomparison to OEM business.

*Declining sales to HP.*In August 2005,our largest OEM customer, Hewlett Packard Company (HP), notified us that it hadselected an alternate supplier for its next-generation mid-range tapeautomation products. HP began purchasing the first product of this new linefrom the alternate supplier during the first quarter of calendar year 2006.Although HP will continue to purchase the tape automation products currentlysupplied by us for some time, the alternate supplier’s product will eventuallyreplace a significant portion of those purchases. Although we believethat sales to HP will continue to decline through fiscal 2008, HP has recentlyrelaunched the tape automation products supplied by us with support for the newLTO4 tape drives and this may slow the rate of replacement of our suppliedproducts by the alternate supplier’s product.

*Recent setbacks.*During fiscal2007, we experienced significant setbacks related to the outsourcing of ourmanufacturing to Sanmina-SCI Corporation (Sanmina),our supply contract with Dell Computer (Dell), and the commercialization of thetechnology we acquired from Zetta Systems, Inc. (Zetta):

·                  In September 2004, we announced our plan tooutsource all of our manufacturing to Sanmina, a U.S. third party manufacturer.We completed this transfer in August 2005. During fiscal 2006, however, we failed toachieve the customer service levels, product quality and cost reductions weexpected from the outsourcing. Additionally, we incurred a significant amountof redundant costs to support the outsourcing, which eroded our gross marginsduring the year. Consequently, we decided to bring manufacturing back to ourSan Diego facility and entered into a transition agreement with Sanminaeffective September 2006. In February 2007, we completed the transfer of allproduction lines back to San Diego.

·                  In October 2006,we were notified by Dell of its intent to terminate the supply agreement underwhich we would supply it with our next generation tape library that was underdevelopment (ARCVault). Shipments of the tape libraries had not yet commencedbut were expected to begin shortly.

·                  In August 2006,after a year of development, we launched our ULTAMUS Pro product whichincorporated the technology we acquired from Zetta. We had planned tofacilitate our entry into the primary protected disk market with ULTAMUS Pro,but this product failed to achieve market acceptance. In October 2006, wediscontinued our research and development efforts on the Zetta technology, andrecorded an impairment charge of $8.4 million in the first quarter of fiscal2007.

Relatedin large part to the decline in HP revenue and the loss of the Dell agreement,for the fiscal year ended June 30, 2007, we reported net revenue of $160.4million compared with $209.0 million for the prior fiscal year. The decline innet revenue and the increases in costs related to manufacturing and researchand development resulted in a net loss for fiscal 2007 of $44.1 million, or$3.45 per share, compared with a net loss of $19.5 million, or $1.42 per share,a year earlier. These results also reflect lower than expected sales in ourbranded sales channel during fiscal 2007.

*Positive trends.*Despite the disappointing financial results infiscal 2007, we have recently achieved a number of financial and operationalobjectives which we believe will assist us in our efforts to regainprofitability:

·                  In the fourthquarter of fiscal 2007, our cash balance grew by $1.6 million to $22.8 millionfrom $21.2 million, which is the first time in eight quarters that we havereported positive cash flow.

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·                  Through acombination of cost reduction efforts and the completion of research anddevelopment cycles, in the fourth quarter of fiscal 2007, our operatingexpenses reached their lowest level in over three and a half years.Additionally, we projected we would reduce inventory levels by $4.0 million inthe fourth quarter of 2007, and exceeded that target by reducing inventorylevels by over $5.0 million. We continue to work to reduce costs, improveefficiencies and reduce inventory levels.

·                  In June 2007, welaunched three new products: ULTAMUS RAID 4800, REO 4500 and REO 9100. Dueto their introduction late in the fourth quarter, these products did notmaterially contribute to revenue in fiscal 2007. However, we expect these newproducts, together with additional new products we expect to launch in thefirst half of fiscal 2008, to improve results in our branded sales channelduring fiscal 2008. We have also been working to update all of our REOproducts with new hardware platforms that we believe will (i) boost the speedand performance of these products, and (ii) be compliant with the EuropeanUnion directive on the Restriction of the use of Certain Hazardous substancesin Electrical and Electronic Equipment (RoHS).

·                  Having completedthe transfer of manufacturing back to our headquarters in San Diego in February2007, we believe our customer lead times have been reduced to target levels andthat we have regained our reputation for timely delivery of quality products.We also believe we have eliminated the backlog issues that occurred during theoutsourced period.

*Liquidity and capital resources.*Historically, our primary source of liquidity has been cash generated fromoperations. However, in fiscal 2007, we incurred a net loss of $44.1 millionand the balance of cash, cash equivalents and short-term investments declinedby $39.7 million compared to the balance at June 30, 2006. At June 30, 2007, wehad $22.8 million of cash, cash equivalents and short-term investments,compared to $62.5 million at June 30, 2006. We have no other unused sources ofliquidity at this time. Although we reported positive cash flow in the fourthquarter of fiscal 2007, we expect to continue to incur losses during fiscal2008 as we introduce and market our new products. In fiscal 2008, cashmanagement and preservation will be a top priority.

*Industry trends.*Historically, magnetic tape has been used for allforms of data backup and recovery, because magnetic tape was, and still is, theonly cost-effective, “removable,” high capacity storage media that can be takenoff-site to ensure that data is safeguarded in case of disaster. For a numberof years now, we have held a market-leading position in mid-range tape automationwith our flagship NEO products, and sales of tape automation appliances haverepresented more than 75% of our revenue for each of the last three fiscalyears. In the fourth quarter of fiscal 2005, we commenced development ofARCVault, our new tape automation platform. The first two products in theARCVault family were launched in July 2006 with the final product launched inApril 2007. Although we expect that tape solutions will continue to be theanchor of the data protection strategy at most companies, tape backup is timeconsuming and often unreliable and inefficient. The process of recovering datafrom tape is also time consuming and inefficient. Ultimately, we expect thattape will be relegated to an archival role for less-frequently accessed data,and that companies will focus more on disk-based solutions moving forward.

**RecentDevelopments**

·                  InAugust 2007, our board of directors appointed Vernon A. LoForti as ourPresident and Chief Executive Officer, replacing Scott McClendon, who wasserving as Interim President and Chief Executive Officer. Upon therecommendation of our nominating and governance committee, Mr. LoForti was alsoappointed as a member of our board of directors. Mr. LoForti has served as ourVice President and Chief Financial Officer since joining us in December 1995.

·                  InAugust 2007, our board of directors appointed Kurt L. Kalbfleisch as ourInterim Chief Financial Officer, replacing Mr. LoForti as Chief FinancialOfficer. Mr. Kalbfleisch has been an employee of our company since December1993, and most recently has served as our Vice President of Finance since July2007, in which position he also continues to serve.

·                  Mr.McClendon remains as our Chairman of our Board. Because Mr. McClendon served asour Interim President and Chief Executive Officer for less than one year, ourboard of directors, after analysis and recommendation of our 

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nominating and governance committee, determined thatMr. McClendon qualifies as an independent director under Nasdaq MarketplaceRule 4200(a)(15)

**Critical Accounting Policies and Estimates**

Our discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America. The preparation of consolidated financialstatements requires that we make estimates and judgments that affect thereported 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 otherlong-lived assets, warranty obligations, income taxes and restructuringcharges. We base our estimates on historical experience and on various otherassumptions that we believe to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates under different assumptions orconditions.

We believe the following accounting policies affect our more significantjudgments and estimates used in the preparation of our consolidated financialstatements.

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

Revenue from salesof products is recognized when persuasive evidence of an arrangement exists,the price is fixed or determinable, collectibility is reasonably assured anddelivery has occurred. Under this policy, revenue on direct product sales(excluding sales to distributors and certain OEM customers) is recognized uponshipment of products to our customers. These customers are not entitled to anyspecific right of return or price protection, except for any defective productthat may be returned under our warranty policy. Title and risk of loss transferto the customer 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 forreturned 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. For products in which software is essential to functionality, werecognize revenue in accordance with Statement of Position (SOP) No. 97-2, *Software Revenue Recognition*.

When there are multiple elements 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 element(s) and the residual revenue is allocated tothe delivered element(s). Undelivered elements typically include services.Revenue from extended warranty and product service contracts is initiallydeferred and recognized as revenue ratably over the contract period.

We have variouslicensing agreements relating to our Variable Rate Randomizer (VR2) technology with thirdparties. As consideration for licensing our VR2 technology, the licensees pay us a royalty feefor sales of their products that incorporate our VR2 technology. On a periodic basis, the licenseesprovide us with reports that include the quantity of units, subject to royalty,sold to their end users. We record the royalty when reported to us by thelicensee, generally in the period during which the licensee ships the productscontaining VR2 technology. In certain instances, the customerhas elected to purchase from us the Applications Specific Integrated Circuit(ASIC) 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, whichunder our FOB origin terms is upon shipment, of the underlying ASIC chipincorporating the VR2 technology to the customer.

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

Share-based compensation expense can be significant to our results ofoperations, even though no cash is used for such expense. In determining periodexpense associated with unvested options, we estimate the fair value of eachoption at the date of grant. We use the Black-Scholes option pricing model todetermine the fair value of the award. This model requires the input of highlysubjective assumptions, including the expected volatility of our stock and theexpected term the average employee will hold the option prior to the date ofexercise. In addition, we estimate pre-vesting forfeitures for share-

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basedawards that are not expected to vest. We primarily use historical data todetermine 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.

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

We estimate our allowance for doubtful accounts based on an assessment ofthe collectibility of specific accounts and the overall condition of theaccounts receivable portfolio. When evaluating the adequacy of the allowancefor doubtful accounts, we analyze specific trade and other receivables,historical bad debts, customer credits, customer concentrations, customercredit-worthiness, current economic trends and changes in customers’ paymentterms and/or patterns. If the financial condition of our customers were todeteriorate, 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. We assess the valueof our inventories periodically based upon numerous factors including expectedproduct or material demand, current market conditions, technologicalobsolescence, current cost and net realizable value. If necessary, we adjustour inventory for obsolete or unmarketable inventory equal to the differencebetween the cost of the inventory and the estimated market value. 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***

Our businessacquisitions typically result in recognition of intangible assets (acquiredtechnology), which affect the amount of current and future period charges andamortization expenses, and in certain cases non-recurring charges associatedwith in-process research and development (IPR&D). 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.

The determinationof the value of these components of a business combination, as well asassociated asset useful lives, requires management to make various estimatesand assumptions. Critical estimates in valuing intangible assets may includebut are not limited to: future expected cash flows from product sales andservices, maintenance agreements, and acquired development technologies andpatents or trademarks; expected costs to develop the IPR&D intocommercially viable products and estimated cash flows from projects whencompleted; the acquired company’s brand awareness and market position, as wellas assumptions about the period of time the acquired products and services willcontinue to be used in our product portfolio; and discount rates. Management’sestimates of fair value and useful lives are based upon assumptions believed tobe reasonable, but which are inherently uncertain and unpredictable.Unanticipated events and circumstances may occur and assumptions may change.Estimates using different assumptions could also produce significantlydifferent results.

###### ***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. During the first quarter of fiscal 2007, we recorded an$8.4 million impairment charge related to acquired technology. See *Impairment of Acquired Technology* under the discussion of *Results of Operations* below. If the Company’s future results are significantly different thanforecasted, the Company may be required to further evaluate its long-livedassets for recoverability and such analysis could result in an impairmentcharge in a future period.

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 

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be required to record impairment charges for theseassets and future results of operations could be adversely affected.

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

TheCompany provides for estimated future costs of warranty obligationsin accordance with FASB Statement No. 5, *Accounting forContingencies,* and discloses those obligations as required by FASBInterpretation No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*.

Forreturn-to-factory and on-site warranties, we accrue for warranty costs at thetime revenue is recognized based on contractual rights and on the historicalrate of claims and costs to provide warranty services. If we experience anincrease in warranty claims above historical experience or our costs to providewarranty services increase, we may be required to increase our warrantyaccrual. The impact of theses unforeseen increases may have an adverse impacton our gross margins in subsequent periods.

###### ***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.

**Restructuring Charges**

In recent periods and over the past several years, werecorded restructuring charges related to the realignment and restructuring ofour business operations. These charges represent expenses incurred inconnection with certain cost reduction programs and acquisition integrationsthat we have implemented and consist of the cost of involuntary terminationbenefits, separation benefits and facilities charges.

The charges for severance and exit costs require theuse of estimates, primarily related to the amount of severance and relatedbenefits to be paid and the cost of exiting facilities.

We account for restructuring charges in accordancewith SFAS No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities*. SFAS No. 146requires that a liability for a cost associated with an exit or disposalactivity be recognized when the liability is incurred rather than at the dateof an entity’s commitment to an exit plan. SFAS No. 146 establishes fairvalue as the objective for initial measurement of the liability. Restructuringcharges we have incurred under SFAS No. 146 in recent years includeseverance and facilities charges.

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**Resultsof Operations**

The followingtables set forth certain financial data as a percentage of net revenue:
|                                            | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------|------------|----------------------|------------|
| ** **                                 | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                       |       |                 |       |   |   |   |   |
| Net revenue                                |       | 100.0                | %          | 100.0 | % | 100.0 | % |
| Cost of revenue                            |       | 84.8                 |       | 77.8 |   | 74.2 |   |
| Gross profit                               |       | 15.2                 |       | 22.2 |   | 25.8 |   |
| Operating  expenses:                       |       |                 |       |   |   |   |   |
| Sales and marketing                        |       | 20.2                 |       | 18.1 |   | 14.6 |   |
| Research and development                   |       | 9.4                  |       | 9.0 |   | 4.5 |   |
| General and administrative                 |       | 8.4                  |       | 7.0 |   | 5.2 |   |
| Impairment of acquired technology          |       | 5.2                  |       | — |   | — |   |
| In-process research and development        |       | —               |       | 0.5 |   | — |   |
|                                       |       | 43.2                 |       | 34.6 |   | 24.3 |   |
| (Loss) income from  operations             |       | (28.0                | )          | (12.4 | ) | 1.5 |   |
| Other income,  net                         |       | 0.7                  |       | 1.2 |   | 0.7 |   |
| (Loss) income  before income taxes         |       | (27.3                | )          | (11.2 | ) | 2.2 |   |
| Provision for  (benefit from) income taxes |       | 0.2                  |       | (1.9 | ) | 0.3 |   |
| Net (loss) income                          |       | (27.5                | )          | (9.3 | ) | 1.9 |   |

 

A summary of thesales mix by product follows:
|                       | ** ** | **Fiscal Year** | ** ** |
|-----------------------|------------|----------------------|------------|
| ** **            | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Tape based  products: |       |                 |       |   |   |   |   |
| NEO Series            |       | 66.2                 | %          | 68.8 | % | 75.0 | % |
| ARCvault              |       | 7.1                  |       | — |   | — |   |
| Others                |       | 1.2                  |       | 7.4 |   | 9.1 |   |
|                  |       | 74.5                 |       | 76.2 |   | 84.1 |   |
| Service               |       | 10.3                 |       | 5.1 |   | 2.0 |   |
| Spare parts and other |       | 8.0                  |       | 10.8 |   | 8.8 |   |
| Disk based (1)        |       | 6.4                  |       | 6.5 |   | 4.2 |   |
| VR2                   |       | 0.8                  |       | 1.4 |   | 0.9 |   |
|                  |       | 100.0                | %          | 100.0 | % | 100.0 | % |

 

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| (1) Includes RESO SERIES and  ULTAMUS SERIES products. |
|--------------------------------------------------------|

 

**Fiscal 2007 Compared to Fiscal2006**

***Net Revenue****.*Net revenue decreased to $160.4 million during fiscal 2007from $209.0 million during fiscal 2006, a decrease of approximately $48.6million, or 23.2%. The decline was primarily the result of lower sales to HP,but decreases in net revenue in our branded sales channel were also consistentthroughout all of the regions (Americas, EMEA and APAC), partially offset by anincrease in service revenue.

*ProductSales*

Net productrevenue decreased to $142.4 million during fiscal 2007 from $196.5 millionduring fiscal 2006, a decrease of $54.1 million, or 27.5%.

Net productrevenue from OEM customers decreased to $77.3 million during fiscal 2007 from$112.0 million during fiscal 2006. The decrease of $34.7 million, or 31.0%, isprimarily associated with declining sales to HP. Net revenue from HP 

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represented approximately45.8% of total net revenue during fiscal 2007 compared to 49.7% of total netrevenue during fiscal 2006.

Net productrevenue from Overland branded products, excluding service revenue, decreased to$65.3 million during fiscal 2007 from $83.4 million during fiscal 2006. Thedecrease of approximately $18.1 million, or 21.7%, was primarily associatedwith (i) a $13.1 million decrease in revenue due to the discontinuation of ourPowerLoader and LoaderXpress products, (ii) a $12.1 million decrease in our NEOproduct sales and (iii) a $3.9 million decrease in our REO product sales,primarily due to a limited supply of RoHS-compliant product which affectedsales in Europe. These decreases were partially offset by $11.4 million of netproduct revenue generated from sales of our new ARCvault product which weintroduced in early fiscal 2007.

*Service*

Net servicerevenue increased to $16.5 million during fiscal 2007 from $10.7 million duringfiscal 2006. The increase of $5.8 million or 54.2% is associated with (i) a$2.9 million increase associated with an increase in the number of servicecontracts sold due to increased focus in this area and (ii) a $3.0 millionincrease in of out-of warranty services provided, primarily to HP.

*RoyaltyFees*

Net royalty feesdecreased to $1.5 million during fiscal 2007 from $1.8 million during fiscal2006. The decrease of approximately $300,000 or 16.7% is primarily associatedwith lower VR2 royalties occurring in fiscal 2007, partiallyoffset by other royalty fees. VR2 royalties during fiscal 2007 totaledapproximately $1.4 million compared to $1.8 million during fiscal 2006.

***Gross Profit****.*****Overall grossprofit decreased to $24.3 million during fiscal 2007 from $46.4 million duringfiscal 2006, a decrease of approximately $22.1 million, or 47.6%.

*ProductSales*

Product grossprofit decreased to $16.4 million, or 11.5%, for fiscal 2007 compared to $40.2million, or 20.5%, for fiscal 2006. The increase in product gross profit is associatedprimarily with (i) significant under absorption of manufacturing costs arisingfrom the transition of manufacturing back to San Diego and (ii) a $2.6 millionincrease in reserves taken for obsolete inventory. These increases wereslightly offset by a $2.0 million decrease in amortization expense because ofthe impairment of the Zetta acquired technology. In addition, product grossprofit was affected by decreased sales across all channels, especially OEM.

*Service*

Service grossprofit for fiscal 2007 of $6.4 million increased from $4.4 million for fiscal2006. The increase in service gross profit of $2.0 million, or 46.0%, isprimarily associated with an increase in service revenue in fiscal 2007 fromfiscal 2006, as noted above and related increases in outside repair costs.

***Stock-BasedCompensation***. During fiscal 2007, we had a net reversal,or benefit, of $75,000 compared to $2.0 million of share-based compensationcharges in fiscal 2006. The net reversal in fiscal 2007 resulted fromsignificant pre-vesting forfeitures (in excess of amounts previously estimated)related to the forfeiture of options and restricted shares previously grantedto two executives and individuals terminated as part of the October 2006 andApril 2007 restructurings. The pre-vesting forfeitures resulted in the reversalof previously recognized share-based compensation expense and such reversalexceeded the amount of expense recorded for other awards during fiscal 2007.

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Share-basedcompensation was allocated as follows (in thousands): 
|                             | ** ** | **Fiscal Year** | ** ** |
|-----------------------------|------------|----------------------|------------|
| ** **                  | ** ** | **2007**             | ** ** | **2006** | ** ** | **Change** | ** ** |
|                        |       |                 |       |   |   |   |   |
| Cost of product revenue     |       | $                    | 6          |   | $ | 13 |   | $ | (7 | ) |
| Sales and marketing         |       | (251                 | )          | 621 |   | (872 | ) |
| Research and  development   |       | (99                  | )          | 206 |   | (305 | ) |
| General and  administrative |       | 269                  |       | 1,170 |   | (901 | ) |
|                        |       | $                    | (75        | ) | $ | 2,010 |   | $ | (2,085 | ) |

 

***Sales and Marketing Expense****.*Sales and marketing expense was $32.4million during fiscal 2007, compared to $37.9 million during fiscal 2006. Thedecrease of approximately $5.5 million, or 14.5%, is primarily due to (i) adecrease of approximately $4.4 million in employee and related expenses(including travel and sales commissions) associated with a decrease in averageheadcount by 26 employees associated with our fiscal 2007 restructurings andrealignment of our sales force, (ii) a $872,000 reduction in share-basedcompensation expense associated with a reversal of awards that canceled priorto vesting and a reduction of related expense under FIN No. 28 associated withour accelerated amortization methodology, (iii) a $667,000 decrease incontractor fees related to cost reduction initiatives and (iv) a $523,000reduction in public relations expenses related to reduced promotional spending.These reductions were partially offset by an increase of $1.1 million in severanceassociated with our fiscal 2007 restructurings and other severance recorded inthe first quarter of fiscal 2007.

***Research and Development Expense****.*Research and development (R&D)expense was $15.0 million during fiscal 2007, compared to $18.8 million duringfiscal 2006. The decrease of approximately $3.8 million, or 20.2%, is primarilydue to (i) a $3.0 million decrease in employee and related expenses associatedwith a decrease in average headcount by 27 employees primarily associated withthe closing of the office near Seattle, Washington, the April 2007 reduction inworkforce and completion of scheduled R&D projects, (ii) a net decrease of$508,000 in development materials and tooling and demonstration items as aresult of fewer continuing R&D projects, and (iii) a decrease of $305,000of share-based compensation expense associated with a reversal of awards thatcanceled prior to vesting and a reduction of related expense under FIN No. 28associated with our accelerated amortization methodology. These cost savingswere partially offset by a $290,000 increase in severance primarily associatedwith our fiscal 2007 restructurings.

***General and Administrative Expense****.*General and administrative expense was$13.4 million during fiscal 2007, compared to $14.6 million during fiscal2006. The decrease of approximately $1.2 million, or 8.2%, is primarilydue to (i) a $901,000 reduction in share-based compensation expense associatedwith a reversal of awards that canceled prior to vesting and a reduction of relatedexpense under FIN No. 28 associated with our accelerated amortizationmethodology, and (ii) a $761,000 net reduction in legal fees. Our legal fees infiscal 2006 were higher as a result of the accumulation of our shares by acompetitor and related issues. These expense reductions were offset by (i)increased severance expenses of approximately $449,000 primarily related to thetermination of our former president and chief executive officer, and (ii) a$198,000 increase in bad debt expense.

***Impairmentof Acquired Technology****.* In the firstquarter of fiscal 2007, we recorded an impairment charge of $8.4 millionrelated to the technology acquired from Zetta Systems, Inc. (Zetta) in August2005. As discussed in Note 2 to the consolidated financial statements, managementperformed an impairment analysis of the technology acquired from Zetta, inaccordance with SFAS No. 144, and concluded that the asset was not recoverableand that an impairment loss should be recognized as of September 30, 2006. Thefull amount of the remaining intangible asset balance as of September 30, 2006,or $8.4 million, was recorded as an impairment of acquired technology in thefirst quarter of fiscal 2007.

***In-ProcessResearch and Development***.****Duringfiscal 2006, a portion of the fair value of the assets acquired from Zetta wasassigned to in-process research and development. We had no similar transactionsin fiscal 2007.

***Interest Income, net****.*During fiscal 2007, we generated netinterest income of $1.7 million compared to $2.8 million during the same periodof the prior fiscal year. The decrease of approximately $1.1 million or 39.3%is due to lower cash and investment balances when compared to the same periodin fiscal 2006.

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***OtherIncome (Expense), net.***During fiscal 2007, we incurrednet other expense of $698,000 compared to $139,000 during fiscal 2006. Theincrease in other net expense is primarily associated with (i) an increase of$262,000 in realized losses on foreign currency transactions due to a weakeningof the dollar compared to the euro and the British pound, and (ii) an increasein realized losses on our short-term investments to $264,000 in fiscal 2007from $23,000 in fiscal 2006. Fiscal 2007 includes a $157,000 impairment chargeunder FSP FAS 115-1 and 124-1, with no comparable charge in fiscal 2006.

***Provisionfor (Benefit from) Income Taxes.*** We recorded income taxexpense of $275,000 during fiscal 2007 compared to an income tax benefit of$3.8 million during fiscal 2006. The change of approximately $4.1 million isprimarily due to tax benefit recorded in fiscal 2006 for losses that werecarried back to prior years’ tax returns for refund claims. Fiscal 2007 taxexpense is primarily due to tax expense related to earnings in our foreignoperations.

**Fiscal 2006 Compared to Fiscal2005**

***Net Revenue****.*Net revenue decreased to $209.0 million during fiscal 2006from $235.7 million during fiscal 2005, a decrease of approximately $26.7million, or 11.3%. The decline was primarily the result of lower sales to HP,offset by (i) a 0.9% increase in sales of branded products and (ii) an increasein service revenue. 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.

*ProductSales*

Net productrevenue decreased to $196.5 million during fiscal 2006 from $229.1 millionduring fiscal 2005, a decrease of $32.6 million, or 14.2%.

Net productrevenue from OEM customers decreased to $112.0 million during fiscal 2006 from$140.3 million during fiscal 2005. The decrease of $28.3 million, or 20.2%, wasprimarily due to the expected decline in shipments of our NEO products to HPand IBM as these customers begin to transition to alternate products sourcedfrom other suppliers. Net revenue from HP represented approximately 49.7% ofnet revenue in fiscal 2006 compared to 54.3% of net revenue for fiscal 2005.

Net productrevenue from Overland branded products, excluding service revenue, decreased to$83.4 million during fiscal 2006 from $88.6 million during fiscal 2005. Thedecrease of approximately $5.2 million, or 5.9%, was primarily associated witha 19.0% increase in sales of branded products in our APAC region offset by a12.5% decline in sales within our EMEA (Europe, Middle East and Africa) region.

*Service*

Net servicerevenue increased to $10.7 million during fiscal 2006 from $­­4.6 millionduring fiscal 2005. The increase of $6.1 million or 132.6% is associated with a$6.8 million increase in out-of warranty services provided, primarily to HP,partially offset by approximately a $700,000 decrease in the number of servicecontracts sold.

*RoyaltyFees*

Net royalty feesdecreased to $1.8 million during fiscal 2006 from $2.0 million during fiscal2005. The decrease of approximately $200,000 or 10.0% is associated with lowerVR2 royalties.

***GrossProfit.*** Gross profit decreased from $60.9 million duringfiscal 2005 to $46.4 million during fiscal 2006, a decrease of approximately$14.5 million or 23.8%.

*ProductSales*

Product grossprofit decreased to $40.2 million, or 20.5%, during of fiscal 2006 compared to$57.9 million, or 25.3%, during fiscal 2005 and was negatively affected by (i)redundant costs to support Sanmina and (ii) amortization 

27

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expense of $2.7 millionrelated to the technology acquired from Zetta. In addition, gross profit wasnegatively affected by increased materials and labor costs, partially offset bya decrease in other cost of product revenue.

*Service*

Service grossprofit increased to $4.4 million, or 41.1%, for fiscal 2006 from $1.1 million,or 23.3%, for fiscal 2005. The increase in gross profit of $3.3 million, or310.3%, showed significant improvement in material gross margins offset by aslight decrease in other cost of service revenue.

***Share-BasedCompensation*.** During fiscal 2006, we recorded $2.0million of share-based compensation charges associated with the adoption ofSFAS No. 123(R), of which $13,000 was allocated to cost of revenue,$621,000 was allocated to sales and marketing, $206,000 to research anddevelopment and $1.2 million to general and administrative expenses.

***Salesand Marketing Expense.*** Sales and marketing expensesincreased to $37.9 million during fiscal 2006 from $34.4 million during fiscal2005. The increase of approximately $3.5 million or 10.3% was primarilyassociated with increased compensation expense of approximately $3.1 millionassociated with an increase in headcount of 10 employees and $615,000 inshare-based compensation expense not included in fiscal 2005, partially offsetby reduced promotional spending of approximately $888,000.

***Researchand Development Expense.*** Research and developmentexpenses increased to $18.8 million during fiscal 2006 from $10.7 millionduring fiscal 2005. The increase of approximately $8.1 million or 75.5%was primarily due to a $5.7 million increase in compensation costs associatedwith (i) an increase in headcount resulting from the acquisition of the Zettadevelopment team and (ii) $1.6 million in costs related to development ofARCvault.

***Generaland Administrative Expense***. General and administrativeexpenses increased to $14.6 million during fiscal 2006 from $12.3 millionduring fiscal 2005. The increase of approximately $2.3 million or 18.2% wasprimarily due to (i) $1.1 million share-based compensation costs not includedin the prior year period, (ii) $902,000 in higher than expected legal fees dueto the accumulation of our shares in early fiscal 2006 by a competitor, (iii)$105,000 severance costs, and (iv) $197,000 in increased IT spending, partiallyoffset by a reduction in readiness costs associated with Section 404 of theSarbanes-Oxley Act of 2002.

***In-ProcessResearch and Development***. The purchase price of ouracquisition of Zetta was assigned to the fair value of the assets acquired,including in-process research and development. As of the acquisition date,technological feasibility of the in-process technology had not beenestablished. Therefore, the in-process research and development of $1.1 millionwas recorded as expense at the date of the acquisition.

The amount of thepurchase price allocated to in-process research and development was based onestablished valuation techniques used in the technology industry. The fairvalue 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.

***InterestIncome***. Interest income increased to $2.8 million duringfiscal 2006 from $1.6 million during fiscal 2005. The increase of approximately$1.2 million or 71.8% is due to higher average yields when compared to fiscal2005.

***(Benefitfrom) Provision for Income Taxes.*** We recorded an incometax benefit of $3.8 million for fiscal 2006 compared to income tax expense of$490,000 for fiscal 2005. The change of approximately $4.3 million is primarilydue to our loss in fiscal 2006 versus income in fiscal 2005, partially offsetby the impact of recording a full valuation allowance, against our net deferredtax assets, for fiscal 2006. The benefit of $3.8 million recorded in fiscal2006 represents the current benefit earned for losses that can be carried backto prior years’ tax returns for refund claims.

28

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**Liquidity and Capital Resources**

At June 30, 2007, we had $22.8 million of cash, cashequivalents and short-term investments,compared to $62.5 million at June 30, 2006. We have no other unusedsources of liquidity at this time.

Historically, our primary sourceof liquidity has been cash generated from operations. However, we have incurredlosses in recent periods and negative cash flows during the current fiscalyear. As of or for the year ended June 30, 2007, we had an accumulated deficitof $18.8 million, incurred a net loss of $44.1 million and the balance of cash,cash equivalents and short-term investments declined by $39.7 million comparedto the balance at June 30, 2006.  Weoperate in a highly competitive market characterized by rapidly changingtechnology. During fiscal 2008, we expect to continue to incur losses as weintroduce and market our new products. However, we expect to increase inventoryturns and further reduce our inventory levels. Management expects that thisreduction in inventory levels, our current balance of cash, cash equivalentsand short-term investments, and anticipated funds from operations willbe sufficient to fund our operations for the twelve months following thebalance sheet date. We need to generate additional revenue, improve our grossprofit margins and reduce operating expenses to be profitable in futureperiods. Our recent history of net losses could cause current or potentialcustomers to defer new orders with us or select other vendors, and may causesuppliers to require terms that are unfavorable to us. Failure to achieveprofitability, or maintain profitability if achieved, may require us to raiseadditional funding which (i) could have a material adverse effect on the marketvalue of our common stock, (ii) we may not be able to obtain in the necessarytime frame to avoid disruptions to our business or on terms favorable to us, ifat all, or (iii) may be inadequate to enable us to continue to conductbusiness. If needed, failure to raise such additional funding may adverselyaffect our ability to achieve our longer term business objectives.

During fiscal 2007, we used cashin operating activities of approximately $34.2 million compared to cashprovided from operating activities in fiscal 2006 and 2005 of $7.3 million and$8.3 million, respectively. Thechange from fiscal 2006 to 2007 of $41.5 million is primarily attributed to ourincreased net loss, offset by a non-cash impairment of acquired technology of$8.4 million. From fiscal 2005 to 2006, there was a change of $1.0 million incash provided by operating activities. This change was primarily the result ofour net loss in fiscal 2006 compared to net income in fiscal 2005.

During fiscal 2007and 2006, we generated cash from investing activities of $33.7 million and$16.0 million, respectively, compared to cash used in investing activities of$18.1 million during fiscal 2005. During fiscal 2007 and 2006 we liquidatedsome of our investments to support our operations. In fiscal 2006, we used $8.9million to acquire Zetta with no other similar acquisitions in fiscal 2007 or2005. During fiscal 2007, 2006 and 2005, capital expenditures totaled $3.2million, $4.0 million and $3.4 million, respectively. During fiscal 2007, suchexpenditures were primarily associated with computers, machinery and equipmentto support new product development and transitioning manufacturing in-house.During fiscal 2006 and 2005, capital expenditures were comprised primarily ofsoftware and tooling equipment.

We used cash inour financing activities of $­­2.6 million during fiscal 2007 compared to $8.5million during fiscal 2006 and cash provided by financing activities in fiscal2005 of $2.6 million. During fiscal 2007, 2006 and 2005 we used cash of $2.7million, $10.8 million and $309,000, respectively to repurchase 373,000 shares,1.3 million shares and 32,500 shares of our stock under our repurchase program.These uses of cash were offset by proceeds from the issuance of common stockunder our 1996 ESPP and 2006 ESPP and upon exercise of stock options forproceeds of $142,000, $2.3 million and $2.9 million in fiscal 2007, 2006 and2005, respectively. Proceeds from the issuance of common stock under our 1996ESPP and 2006 ESPP and upon exercise of stock options have decreased due to thedecrease in our stock price since fiscal 2005 and the change in the purchaseprice of our ESPP.

InOctober 2005, our board of directors expanded our share repurchase programto allow for the purchase of up to 2.5 million shares of our common stock onthe open market or through negotiated transactions. In October 2006, our boardof directors terminated our share repurchase program and there were no share repurchasesafter the first quarter of fiscal 2007. During fiscal 2007 and fiscal 2006, anaggregate of approximately 373,000 shares and 1.3 million shares wererepurchased at a cost of approximately $2.7 million and $10.8 million,respectively.

29

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**Off-BalanceSheet Arrangements**

We have no off-balance sheet arrangements orsignificant guarantees to third parties that are not fully recorded in ourconsolidated balance sheets or fully disclosed in the notes to our consolidatedfinancial statements.

**Contractual Obligations**

The followingschedule summarizes our contractual obligations to make future payments atJune 30, 2007 (in thousands)**:**
| Contractual Obligations     | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **After 5  years** | ** ** |
|----------------------------------|------------|-----------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-------------------------|------------|
| Operating lease  obligations (1) |       | $         | 24,945     |                            | $          | 3,496              |       | $                  | 6,896      |                    | $          | 7,106 |   | $ | 7,447 |   |
| Purchase  obligations (2)        |       | 9,270     |       | 8,506                           |       | 764                |       |               |       |                    |       |
| Total contractual  obligations   |       | $         | 34,215     |                            | $          | 12,002             |       | $                  | 7,660      |                    | $          | 7,106 |   | $ | 7,447 |   |

 

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(1)          Represents contractual lease obligationsunder non-cancellable operating leases on our San Diego; Wokingham England;Paris, France; and Singapore facilities

(2)          Represents purchase orders for inventoryand non-inventory items entered into prior to June 30, 2007, with purchasedates extending beyond July 1, 2007. The obligations are not necessarilynon-cancellable.

**Inflation**

Inflation has not had asignificant impact on our operations during the periods presented. Historicallywe have been able to pass on to our customers increases in raw material pricescaused by inflation. If at any time we cannot pass on such increases, ourmargins could suffer. Our exposure to the effects of inflation could bemagnified by the concentration of OEM business, where our margins tend to belower.

**Recently Issued AccountingPronouncements**

See Note 1 to ourconsolidated financial statements.

**Item 7A. Quantitative andQualitative Disclosures about Market Risk.**

Market risk represents the risk of loss that mayimpact our financial position, results of operations or cash flows due to adversechanges in financial and commodity market prices and rates. We are exposed tomarket risk in the areas of changes in U.S. interest rates and changes inforeign currency exchange rates as measured against the U.S. dollar. Theseexposures are directly related to our normal operating and funding activities.Historically, we have not used derivative instruments or engaged in hedgingactivities.

***Interest Rate Risk.***Allof our fixed income investments are classified as available-for-sale andtherefore reported on the balance sheet at market value. Changes in the overalllevel of interest rates affect our interest income that is generated from ourinvestments. For fiscal 2007, total interest income was $1.7 million withinvestments yielding an annual average of 5.1% on a worldwide basis. Theinterest rate level was up approximately 100 basis points from 4.1% in fiscal2006. If a comparable increase or decrease in overall interest rates (100 basispoints) were to occur in fiscal 2008, our interest income would increase ordecrease approximately $322,000, assuming consistent investment levels.

The table below presents the cash, cash equivalentsand short-term investment balances and related weighted-average interest ratesat the end of fiscal 2007. The cash, cash equivalents and short-term investmentbalances approximate fair value (inthousands):

30

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|                            | ** ** | **Approximate  Market Value** | ** ** | **Weighted-Average  Interest Rate** | ** ** |
|----------------------------|------------|------------------------------------|------------|------------------------------------------|------------|
| Cash and cash  equivalents |       | $                                  | 17,503     |                                     | 4.7        | % |
| Short-term  investments:   |       |                               |       |                                     |       |
| Less than 1 year           |       | —                             |       | —                                   |       |
| Due in 1 – 2 years    |       | —                             |       | —                                   |       |
| Due in 2-5 years           |       | 329                                |       | 4.0                                      | %          |
| Due after 5 years          |       | 4,993                              |       | 5.2                                      | %          |
|                       |       | $                                  | 22,825     |                                     | 4.8        | % |

 

The table above includes the U.S. dollar equivalent ofcash, cash equivalents and short-term investments, including $1.2 million and$318,000 equivalents denominated in the British pound and the euro,respectively.

***Foreign Currency Risk.***Weconduct business on a global basis and essentially all of our products sold ininternational markets are denominated in U.S. dollars. Historically, exportsales have represented a significant portion of our sales and are expected tocontinue to represent a significant portion of sales.

Our wholly-owned subsidiaries in the United Kingdom,France and Germany incur costs which are denominated in local currencies. Asexchange rates vary, these results when translated into U.S. dollars may varyfrom expectations and adversely impact overall expected results. The effect ofexchange rate fluctuations on our results during fiscal 2007 was not material.

**Item 8. Financial Statements andSupplementary Data.**

Our consolidatedfinancial statements and supplementary data required by this item are set forthat the pages indicated in Item 15(a)(1) and 15(a)(2), respectively.

**Item 9. Changes in andDisagreements with Accountants on Accounting and Financial Disclosure.**

Not applicable.

**Item 9A. Controls and Procedures.**

**Not applicable.**

**Item 9A(T). Controls andProcedures.**

**Disclosure Controls andProcedures**

Under thesupervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures, as such term is definedunder Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on thisevaluation, our principal executive officer and our principal financial officerconcluded that our disclosure controls and procedures were effective as of theend of the period covered by this annual report.

**Internal Control OverFinancial Reporting**

As our fiscal yearended before December 15, 2007 and we are not an “accelerated filer” or “largeaccelerated filer” (as those terms are defined in Rule 12b-2 under theSecurities Exchange Act of 1934, as amended), this annual report does notinclude a report of management’s assessment of the effectiveness of ourinternal control over financial reporting or an attestation report of ourindependent registered public accounting firm, as permitted by temporary rulesestablished by the Securities and Exchange Commission.

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**Changes in Internal Control overFinancial Reporting**

As of the end offiscal 2006, and through the first three quarters of fiscal 2007, we reported amaterial weakness in internal control over financial reporting related to thecompleteness and accuracy of accounts payable and accrued expenses. Through theimplementation of new processes and procedures, management believes thepreviously reported material weakness has been remediated as of the end of theperiod covered by this annual report.

As discussed abovewith respect to the remediation of the material weaknesses, there were changesin our internal control over financial reporting during the fiscal quarterended July 1, 2007 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

**Item 9B. Other Information.**

Not applicable.

**PART III**

**Item 10. Directors, ExecutiveOfficers and Corporate Governance.**

The informationrequired by this item is included under the captions entitled “Election ofDirectors,” “Executive Officers,” and “Section 16(a) BeneficialOwnership Reporting Compliance” in our proxy statement to be filed for our 2007Annual Meeting of Shareholders and is incorporated herein by reference.

We have adoptedthe Overland Storage, Inc. Code of Business Conduct and Ethics, a Codethat applies to our directors, officers and employees. A copy of the Code ofBusiness 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.

**Item 11. Executive Compensation.**

The informationrequired by this item will be contained in our proxy statement to be filed forour 2007 Annual Meeting of Shareholders and is incorporated herein byreference.

**Item 12. Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters.**

The information required by this item will becontained in our proxy statement to be filed for our 2007 Annual Meeting ofShareholders and is incorporated herein by reference.

**Item 13. Certain Relationshipsand Related Transactions, and Director Independence.**

The informationrequired by this item will be contained in our proxy statement to be filed forour 2007 Annual Meeting of Shareholders and is incorporated herein by reference.

**Item 14. Principal AccountingFees and Services.**

The informationrequired by this item will be contained in our proxy statement to be filed forour 2007 Annual Meeting of Shareholders and is incorporated herein byreference.

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**PART IV**

**Item 15. Exhibits, FinancialStatement Schedules.**

(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, 2007  and 2006                                                                          |
| Consolidated Statements of Operations for the Years  Ended June 30, 2007, 2006 and 2005                                            |
| Consolidated Statements of Shareholders’ Equity and  Comprehensive Income (Loss) for Years Ended June 30, 2007, 2006 and 2005 |
| Consolidated Statements of Cash Flows for the Years  Ended June 30, 2007, 2006 and 2005                                            |
| Notes to Consolidated Financial Statements                                                                                              |

 

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

Schedules notlisted 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).                                                                                                 |
|   |                                                                                                                                                                                                                                         |
| 3.3    | Amended and Restated Bylaws (incorporated by  reference to the Company’s Form 8-K filed August 26, 2005).                                                                                                                     |
|   |                                                                                                                                                                                                                                         |
| 3.4    | Certificate of Amendment of Bylaws (incorporated by  reference to the Company’s Form 8-K filed April 30, 2007).                                                                                                                         |
|   |                                                                                                                                                                                                                                         |
| 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   | San Diego Headquarters Facility 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).                                                  |

 

33

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| 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  | 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). +                       |
|   |                                                                                                                                                                                                                                                 |
| 10.16  | Addendum to Product Purchase Agreement No. 1585-042103 effective July  30, 2006 between Overland and Hewlett Packard Company (incorporated by  reference to the Company’s Form 10-K filed September 15, 2006).                             |
|   |                                                                                                                                                                                                                                                 |
| 10.17  | 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).  +         |
|   |                                                                                                                                                                                                                                                 |
| 10.18  | 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). + |
|   |                                                                                                                                                                                                                                                 |
| 10.19  | Transition Amendment dated September 29, 2006  between Overland Storage, Inc. and Sanmina-SCI Corporation (incorporated by  reference to the Company’s Form 10-Q filed November 8, 2006).+                                                      |
|   |                                                                                                                                                                                                                                                 |
| 10.20* | 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).                                         |
|   |                                                                                                                                                                                                                                                 |
| 10.21* | 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).                                                  |

 

34

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| 10.22* | 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).                                                                      |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                        |
| 10.23* | Separation Agreement, General Release and Consulting  Agreement with Christopher P. Calisi dated November 6, 2006 (incorporated by  reference to the Company’s Form 8-K filed November 7, 2006).                                       |
|   |                                                                                                                                                                                                                                        |
| 10.24* | 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).                                                    |
|   |                                                                                                                                                                                                                                        |
| 10.25* | 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).                                                       |
|   |                                                                                                                                                                                                                                        |
| 10.26* | 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).                                                          |
|   |                                                                                                                                                                                                                                        |
| 10.27* | 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).                                                  |
|   |                                                                                                                                                                                                                                        |
| 10.28* | 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).                                                 |
|   |                                                                                                                                                                                                                                        |
| 10.29* | 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).                                        |
|   |                                                                                                                                                                                                                                        |
| 10.30* | 2000 Stock Option Plan, as amended and restated  (incorporated by reference to the Company’s Form 10-K filed  September 27, 2002).                                                                                           |
|   |                                                                                                                                                                                                                                        |
| 10.31* | Form of Notice of Stock Option Award and Stock  Option Award Agreement for options granted under 2000 Stock Option Plan  (incorporated by reference to the Company’s Form 10-Q filed May 15,  2001).                    |
|   |                                                                                                                                                                                                                                        |
| 10.32* | 2001 Supplemental Stock Option Plan (incorporated by  reference to the Company’s Form S-8 Registration Statement  No. (333-75060) filed December 13, 2001).                                                             |
|   |                                                                                                                                                                                                                                        |
| 10.33* | 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). |
|   |                                                                                                                                                                                                                                        |
| 10.34* | 2003 Equity Incentive Plan, as amended (incorporated  by reference to the Company’s Form 10-Q filed February 11, 2005).                                                                                                      |
|   |                                                                                                                                                                                                                                        |
| 10.35* | 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).                            |
|   |                                                                                                                                                                                                                                        |
| 10.36* | 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).                          |
|   |                                                                                                                                                                                                                                        |
| 10.37* | 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).                                      |
|   |                                                                                                                                                                                                                                        |
| 10.38* | 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).                                            |
|   |                                                                                                                                                                                                                                        |
| 10.39* | 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).                                                                     |

 

35

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| 10.40* | 2006 Employee Stock Purchase Plan (incorporated by  reference to the Company’s Form S-8 Registration Statement  No. (333-139064) filed December 1, 2006).                                                                                                                            |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                |
| 10.41* | 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).                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                |
| 10.42* | Summary Sheet of Director and Executive Officer Compensation.                                                                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                |
| 21.1   | Subsidiaries of the Company.                                                                                                                                                                                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                |
| 23.1   | Consent of PricewaterhouseCoopers LLP, Independent  Registered Public Accounting Firm.                                                                                                                                                                                                              |
|   |                                                                                                                                                                                                                                                                                                |
| 24.1   | Power of Attorney (included on signature page).                                                                                                                                                                                                                                                     |
|   |                                                                                                                                                                                                                                                                                                |
| 31.1   | Certification of Vernon A. LoForti, 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 Kurt L. Kalbfleisch, Vice President  of Finance and Interim 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 Vernon A. LoForti, President and  Chief Executive Officer, and Kurt L. Kalbfleisch, Vice President of Finance  and Interim 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.                                                                                                                                                                          |

 

36

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.
|                             | OVERLAND STORAGE, INC.                |
|-----------------------------|---------------------------------------|
|                        |                                  |
| Dated: August 23, 2007 | By:                                   | /s/ VERNON A. LoFORTI |   |
|                        | Vernon A. LoForti                     |
|                        | President and Chief Executive Officer |

 

### **POWER OF ATTORNEY**

Each person whose signature appears below constitutesand appoints Vernon A. LoForti and Kurt L. Kalbfleisch, jointly and severally,as his attorney-in-fact, each with the power of substitution, for him in anyand all capacities, to sign any amendments to this annual report onForm 10-K and to file the same, with exhibits thereto and other documentsin connection therewith, with the Securities and Exchange Commission, herebyratifying and confirming all that each of said attorneys-in-fact, or hissubstitute or substitutes, may do or cause to be done by virtue hereof.Pursuant to the requirements of the Securities Exchange Act of 1934, thisreport has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.
| Signature                | ** ** | **Title**                             | ** ** | **Date**        |
|--------------------------|------------|---------------------------------------|------------|-----------------|
|                     |       |                                  |       |            |
| /s/ VERNON A.  LoFORTI   |       | President, Chief Executive Officer    |       | August 23, 2007 |
| Vernon A.  LoForti       |       | and Director                          |       |            |
|                     |       | (Principal Executive Officer)         |       |            |
|                     |       |                                  |       |            |
| /s/ KURT L.  KALBFLEISCH |       | Vice President of Finance and Interim |       | August 23, 2007 |
| Kurt L.  Kalbfleisch     |       | Chief Financial Officer               |       |            |
|                     |       | (Principal Financial                  |       |            |
|                     |       | and Accounting Officer)               |       |            |
|                     |       |                                  |       |            |
| /s/ ROBERT A.  DEGAN     |       | Director                              |       | August 23, 2007 |
| Robert A. Degan          |       |                                  |       |            |
|                     |       |                                  |       |            |
| /s/ SCOTT  McCLENDON     |       | Chairman of the Board                 |       | August 23, 2007 |
| Scott McClendon          |       |                                  |       |            |
|                     |       |                                  |       |            |
| /s/ WILLIAM  MILLER      |       | Director                              |       | August 23, 2007 |
| William Miller           |       |                                  |       |            |
|                     |       |                                  |       |            |
| /s/ MICHAEL  NORKUS      |       | Director                              |       | August 23, 2007 |
| Michael Norkus           |       |                                  |       |            |

 

37

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### **Report of Independent RegisteredPublic Accounting Firm**

To the Board of Directorsand Shareholders of Overland Storage, Inc.

In our opinion, theconsolidated financial statements listed in the index appearing under Item 15(a)(1)present fairly, in all material respects, the financial position of OverlandStorage, Inc. and its subsidiaries at July 1, 2007 and July 2, 2006, and theresults of their operations and their cash flows for each of the three years inthe period ended July 1, 2007****in conformitywith accounting principles generally accepted in the United States of America.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits. We conducted our audits of these statements in accordance withthe standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

As discussed in Note 1 tothe consolidated financial statements, the Company changed its method ofaccounting for share-based payments during the year ended July 2, 2006.
| PricewaterhouseCoopers LLP |
|----------------------------|
| San Diego,  California     |
| August 20, 2007            |

 

38

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**OVERLAND STORAGE, INC.**

**CONSOLIDATEDBALANCE SHEETS**

(in thousands)
| ** **                                                                                                                                          | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                                                                                          | ** ** | **2007**          | ** ** | **2006** | ** ** |
| **Assets**                                                                                                                                          |       |              |       |   |   |
| Current assets:                                                                                                                                     |       |              |       |   |   |
| Cash and cash  equivalents                                                                                                                          |       | $                 | 17,503     |   | $ | 20,315 |   |
| Short-term  investments                                                                                                                             |       | 5,322             |       | 42,197 |   |
| Accounts  receivable, less allowance for doubtful accounts of $374 and $436 as of June  30, 2007 and 2006, respectively                             |       | 22,572            |       | 30,321 |   |
| Inventories                                                                                                                                         |       | 20,556            |       | 14,978 |   |
| Deferred tax  assets                                                                                                                                |       | 185               |       | 2,147 |   |
| Other current  assets                                                                                                                               |       | 6,953             |       | 9,114 |   |
| Total current  assets                                                                                                                               |       | 73,091            |       | 119,072 |   |
|                                                                                                                                                |       |              |       |   |   |
| Property and equipment,  net                                                                                                                        |       | 11,052            |       | 11,026 |   |
| Intangible assets, net                                                                                                                              |       | 1,731             |       | 12,615 |   |
| Other assets                                                                                                                                        |       | 2,179             |       | 2,056 |   |
| Total assets                                                                                                                                        |       | $                 | 88,053     |   | $ | 144,769 |   |
|                                                                                                                                                |       |              |       |   |   |
| **Liabilities and Shareholders’  Equity**                                                                                                      |       |              |       |   |   |
| Current liabilities:                                                                                                                                |       |              |       |   |   |
| Accounts payable                                                                                                                                    |       | $                 | 8,094      |   | $ | 17,399 |   |
| Accrued  liabilities                                                                                                                                |       | 15,773            |       | 15,330 |   |
| Accrued payroll  and employee compensation                                                                                                          |       | 3,122             |       | 4,277 |   |
| Income taxes  payable                                                                                                                               |       | 402               |       | 278 |   |
| Accrued warranty                                                                                                                                    |       | 6,134             |       | 5,407 |   |
| Total current  liabilities                                                                                                                          |       | 33,525            |       | 42,691 |   |
|                                                                                                                                                |       |              |       |   |   |
| Deferred tax  liabilities                                                                                                                           |       | 185               |       | 2,147 |   |
| Other long-term  liabilities                                                                                                                        |       | 5,233             |       | 4,493 |   |
| Total  liabilities                                                                                                                                  |       | 38,943            |       | 49,331 |   |
|                                                                                                                                                |       |              |       |   |   |
| Commitments and  contingencies (Note 12)                                                                                                            |       |              |       |   |   |
|                                                                                                                                                |       |              |       |   |   |
| Shareholders’ equity:                                                                                                                          |       |              |       |   |   |
| Common stock, no  par value, 45,000 shares authorized; 12,748 and 13,230 shares issued and outstanding,  as of June 30, 2007 and 2006, respectively |       | 67,841            |       | 70,496 |   |
| Accumulated  other comprehensive income (loss)                                                                                                      |       | 91                |       | (347 | ) |
| (Accumulated  deficit) retained earnings                                                                                                            |       | (18,822           | )          | 25,289 |   |
| Total  shareholders’ equity                                                                                                                    |       | 49,110            |       | 95,438 |   |
| Total liabilities and  shareholders’ equity                                                                                                    |       | $                 | 88,053     |   | $ | 144,769 |   |

 

See accompanyingnotes to consolidated financial statements.

39

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**OVERLAND STORAGE, INC.**

##### **CONSOLIDATED STATEMENTS OF OPERATIONS**

(in thousands, except per share amounts)
| ** **                                             | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------------|------------|----------------------|------------|
| ** **                                             | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net revenue:                                           |       |                 |       |   |   |   |   |
| Product revenue                                        |       | $                    | 142,416    |   | $ | 196,527 |   | $ | 229,103 |   |
| Service revenue                                        |       | 16,501               |       | 10,680 |   | 4,592 |   |
| Royalty fees                                           |       | 1,526                |       | 1,831 |   | 1,992 |   |
|                                                   |       | 160,443              |       | 209,038 |   | 235,687 |   |
| Cost of product  revenue                               |       | 126,003              |       | 156,298 |   | 171,247 |   |
| Cost of service  revenue                               |       | 10,097               |       | 6,294 |   | 3,523 |   |
| Gross profit                                           |       | 24,343               |       | 46,446 |   | 60,917 |   |
|                                                   |       |                 |       |   |   |   |   |
| Operating  expenses:                                   |       |                 |       |   |   |   |   |
| Sales and marketing                                    |       | 32,391               |       | 37,940 |   | 34,382 |   |
| Research and development                               |       | 14,999               |       | 18,752 |   | 10,687 |   |
| General and administrative                             |       | 13,387               |       | 14,564 |   | 12,324 |   |
| Impairment of acquired technology                      |       | 8,411                |       | — |   | — |   |
| In-process research and development                    |       | —               |       | 1,121 |   | — |   |
|                                                   |       | 69,188               |       | 72,377 |   | 57,393 |   |
| (Loss) income  from operations                         |       | (44,845              | )          | (25,931 | ) | 3,524 |   |
|                                                   |       |                 |       |   |   |   |   |
| Other income  (expense):                               |       |                 |       |   |   |   |   |
| Interest income                                        |       | 1,709                |       | 2,771 |   | 1,613 |   |
| Interest expense                                       |       | (2                   | )          | (12 | ) | (76 | ) |
| Other (expense) income, net                            |       | (698                 | )          | (139 | ) | 7 |   |
| (Loss) income  before income taxes                     |       | (43,836              | )          | (23,311 | ) | 5,068 |   |
| Provision for  (benefit from) income taxes             |       | 275                  |       | (3,825 | ) | 490 |   |
| Net (loss)  income                                     |       | $                    | (44,111    | ) | $ | (19,486 | ) | $ | 4,578 |   |
|                                                   |       |                 |       |   |   |   |   |
| Net (loss)  income per share:                          |       |                 |       |   |   |   |   |
| Basic                                                  |       | $                    | (3.45      | ) | $ | (1.42 | ) | $ | 0.33 |   |
| Diluted                                                |       | $                    | (3.45      | ) | $ | (1.42 | ) | $ | 0.32 |   |
|                                                   |       |                 |       |   |   |   |   |
| Shares used in  computing net (loss) income per share: |       |                 |       |   |   |   |   |
| Basic                                                  |       | 12,799               |       | 13,716 |   | 13,899 |   |
| Diluted                                                |       | 12,799               |       | 13,716 |   | 14,429 |   |

 

See accompanyingnotes to consolidated financial statements.

40

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**OVERLAND STORAGE, INC.**

**CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE (LOSS) INCOME**

(in thousands)
| ** **                                                                        | ** ** | **Common Stock** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Deferred**           | ** ** | **(Accumulated   Deficit)   Retained** | ** ** | **Total  Shareholders’** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|------------------------|------------|--------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                        | ** ** | **Shares**            | ** ** | **Amount**                            | ** ** | **(Loss) Income** | ** ** | **Compensation**                                 | ** ** | **Earnings**                  | ** ** | **Equity** | ** ** |
| 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 |   |
| Stock option and  purchase plans                                                  |       | 26                    |       | 142                                   |       | —                 |       | —                                           |       | —                        |       | 142 |   |
| Cancellation of  restricted stock                                                 |       | (135                  | )          | —                                |       | —                 |       | —                                           |       | —                        |       | — |   |
| Repurchase of  common stock                                                       |       | (373                  | )          | (2,722                                | )          | —                 |       | —                                           |       | —                        |       | (2,722 | ) |
| Share-based  compensation benefit                                                 |       | —                |       | (75                                   | )          | —                 |       | —                                           |       | —                        |       | (75 | ) |
| Comprehensive  loss:                                                              |       |                  |       |                                  |       |                   |       |                                             |       |                          |       |   |   |
| Net loss                                                                          |       | —                |       | —                                |       | —                 |       | —                                           |       | (44,111                       | )          | (44,111 | ) |
| Foreign currency translation                                                      |       | —                |       | —                                |       | 154                    |       | —                                           |       | —                        |       | 154 |   |
| Reclassification adjustment for unrealized loss on  available-for-sale securities |       | —                |       | —                                |       | 284                    |       | —                                           |       | —                        |       | 284 |   |
| Total  comprehensive loss                                                         |       | —                |       | —                                |       | —                 |       | —                                           |       | —                        |       | (43,673 | ) |
| Balance at  June 30, 2007                                                    |       | 12,748                |       | $                                     | 67,841     |                   | $          | 91                                               |       | $                             | —     |   | $ | (18,822 | ) | $ | 49,110 |   |

 

See accompanyingnotes to consolidated financial statements.

41

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**OVERLAND STORAGE, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(in thousands)
| ** **                                                                                                     | ** ** | **Fiscal Year** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                     | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Operating  activities:**                                                                                     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net (loss)  income                                                                                             |       | $                    | (44,111    | ) | $ | (19,486 | ) | $ | 4,578 |   |
| Adjustments to  reconcile net (loss) income to cash (used in) provided by operating  activities:               |       |                 |       |   |   |   |   |
| Impairment of acquired technology                                                                              |       | 8,411                |       | — |   | — |   |
| Depreciation and amortization                                                                                  |       | 5,630                |       | 6,884 |   | 4,289 |   |
| Deferred tax provision                                                                                         |       | (146                 | )          | (1,429 | ) | (1,071 | ) |
| Provision for losses on accounts receivable                                                                    |       | 368                  |       | 159 |   | 97 |   |
| Acquired in-process research and development                                                                   |       | —               |       | 1,121 |   | — |   |
| Tax benefits from exercise of stock options                                                                    |       | —               |       | — |   | 715 |   |
| Share-based compensation                                                                                       |       | (75                  | )          | 2,011 |   | 109 |   |
| Realized loss (gain) on short-term investments                                                                 |       | 264                  |       | 23 |   | (2 | ) |
| Amortization of discount on short-term investments                                                             |       | 28                   |       | 122 |   | 147 |   |
| Loss on disposal of property and equipment                                                                     |       | 19                   |       | 17 |   | 35 |   |
| Changes in operating assets and liabilities, net of  effects of acquisition:                                   |       |                 |       |   |   |   |   |
| Accounts receivable                                                                                            |       | 7,381                |       | 7,223 |   | (4,006 | ) |
| Inventories                                                                                                    |       | (5,578               | )          | 4,130 |   | (3,982 | ) |
| Accounts payable and accrued liabilities                                                                       |       | (8,135               | )          | 3,324 |   | 11,650 |   |
| Accrued payroll and employee compensation                                                                      |       | (1,155               | )          | 282 |   | 866 |   |
| Other assets and liabilities, net                                                                              |       | 2,902                |       | 2,875 |   | (5,172 | ) |
| Net cash (used in) provided by operating activities                                                            |       | (34,197              | )          | 7,256 |   | 8,253 |   |
|                                                                                                           |       |                 |       |   |   |   |   |
| **Investing  activities:**                                                                                     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of short-term investments                                                                            |       | (48,525              | )          | (69,878 | ) | (114,218 | ) |
| Proceeds from maturities of short-term investments                                                             |       | 77,754               |       | 95,922 |   | 95,252 |   |
| Proceeds from sales of short-term investments                                                                  |       | 7,709                |       | 2,832 |   | 4,316 |   |
| Capital expenditures                                                                                           |       | (3,202               | )          | (3,972 | ) | (3,406 | ) |
| Net cash payments to acquire the stock of Zetta  Systems, Inc                                             |       | —               |       | (8,857 | ) | — |   |
| Net cash provided by (used in) investing activities                                                            |       | 33,736               |       | 16,047 |   | (18,056 | ) |
|                                                                                                           |       |                 |       |   |   |   |   |
| **Financing  activities:**                                                                                     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from the exercise of stock options and the  sale of stock under the 1996 employee stock purchase plan |       | 142                  |       | 2,258 |   | 2,943 |   |
| Repurchase of common stock                                                                                     |       | (2,722               | )          | (10,804 | ) | (309 | ) |
| Net cash (used in) provided by financing activities                                                            |       | (2,580               | )          | (8,546 | ) | 2,634 |   |
| Effect of  exchange rate changes on cash                                                                       |       | 229                  |       | 60 |   | 24 |   |
| Net (decrease) increase  in cash and cash equivalents                                                          |       | (2,812               | )          | 14,817 |   | (7,145 | ) |
| Cash and cash  equivalents, beginning of year                                                                  |       | 20,315               |       | 5,498 |   | 12,643 |   |
| Cash and cash  equivalents, end of year                                                                        |       | $                    | 17,503     |   | $ | 20,315 |   | $ | 5,498 |   |
|                                                                                                           |       |                 |       |   |   |   |   |
| **Supplemental  disclosure of cash flow information:**                                                         | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for income taxes                                                                                     |       | $                    | 355        |   | $ | 735 |   | $ | 2,555 |   |
| Cash paid for interest                                                                                         |       | $                    | 2          |   | $ | 9 |   | $ | — |   |
| **Non-cash  investing activities:**                                                                            | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Change in net unrealized loss on short-term  investments                                                       |       | $                    | 355        |   | $ | 171 |   | $ | 80 |   |
| Capital  expenditures received not paid as of year end                                                         |       | $                    | —     |   | $ | 709 |   | $ | — |   |

 

See accompanyingnotes to consolidated financial statements

42

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**OVERLANDSTORAGE, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1 – OPERATIONS AND SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

**General**

OverlandStorage, Inc. (We, Overland or the Company) was incorporated onSeptember 8, 1980, under the laws of the State of California. For more than 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 smalland medium-sized business computing environments.

The Company operates and reports using a 52-53 weekfiscal year with each quarter ending on the Sunday closest to the calendarquarter. For ease of presentation, the Company’s last fiscal year is consideredto end on June 30, 2007. For example, references to fiscal 2007, 2006 and2005 refer to the fiscal year ended July 1, 2007, July 2, 2006 and July 3,2005, respectively. Fiscal 2007, 2006 and 2005 contained 52 weeks, 52 weeks and53 weeks, respectively.

During the fourthquarter of fiscal 2006, the Company recorded certain amounts relating to prior2006 quarters and prior years resulting in a reduction of its net loss by$313,000 ($0.03 per share) and $324,000 ($0.02 per share) for the quarter andyear ended July 2, 2006, respectively. The Company concluded that the amountswere not material to any previously-reported annual or interim period nor wasthe cumulative amount material to the current fiscal year. As such, the amountswere recorded in the fourth quarter of fiscal 2006 and prior periods were notrestated.

We have incurred losses inrecent periods and negative cash flows during the current fiscal year. As of orfor the year ended June 30, 2007, we had an accumulated deficit of $18.8million, incurred a net loss of $44.1 million and the balance of cash, cashequivalents and short-term investments declined by $39.7 million compared tothe balance at June 30, 2006. We operate in a highly competitive marketcharacterized by rapidly changing technology. Total cash, cash equivalents andshort-term investments as of June 30, 2007 was $22.8 million. We have noother unused sources of liquidity at this time. During fiscal 2008, we expect to continue to incur losses as we introduceand market our new products. However, we expect to increase inventory turns andfurther reduce our inventory levels. Although there can be no assurance,management expects that this reduction in inventory levels, our current balanceof cash and short-term investments, and anticipated funds from operations willbe sufficient to fund our operations for the twelve months following thebalance sheet date. We need to generate additional revenue, improve our grossprofit margins and reduce operating expenses to be profitable in futureperiods. Our recent history of net losses could cause current or potentialcustomers to defer new orders with us or select other vendors, and may causesuppliers to require terms that are unfavorable to us. Failure to achieveprofitability, or maintain profitability if achieved, may require us to raiseadditional funding which (i) could have a material adverse effect on the marketvalue of our common stock, (ii) we may not be able to obtain in the necessarytime frame to avoid disruptions to our business or on terms favorable to us, ifat all, or (iii) may be inadequate to enable us to continue to conductbusiness. If needed, failure to raise such additional funding may adverselyaffect our ability to achieve our longer term business objectives.

**Reclassification**

Duringthe third quarter of fiscal 2007, service revenue exceeded 10.0% of total netrevenue and as such the Company is now required to separately disclose servicerevenue on the face of its consolidated statements of operations. Therefore,prior year revenue has been reclassified for consistency with current periodpresentation. These reclassifications had no impact on reported results ofoperations, financial position or cash flows.

**Principles of Consolidation**

The consolidatedfinancial statements include the accounts of the Company and its wholly-ownedsubsidiaries, Overland Storage (Europe) Ltd., Overland Storage SARL, OverlandStorage GmbH, Okapi Acquisition Co., Inc. (dissolved effective July 5, 2007),Zetta Systems, Inc., and Overland Storage Export Limited (dissolved effectiveJuly 3, 2007). All significant intercompany accounts and transactions have beeneliminated.

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**Management Estimates andAssumptions**

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and reported amounts ofrevenue and expenses during the reporting period. Estimates have been preparedon the basis of the most current and best available information and actualresults could differ from those estimates. Significant estimates made bymanagement include share-based compensation, allowance for doubtful accounts,inventory valuation, valuation of intangible assets, impairment of long-livedassets, warranty accrual and the valuation allowance on deferred tax assets,among others.

**Revenue Recognition**

Revenue from salesof products is recognized when persuasive evidence of an arrangement exists,the price is fixed or determinable, collectibility is reasonably assured anddelivery has occurred. Under this policy, revenue on direct product sales(excluding sales to distributors and certain OEM customers) is recognized uponshipment of products to our customers. These customers are not entitled to anyspecific right of return or price protection, except for any defective productthat may be returned under our warranty policy. Title and risk of loss transferto the customer 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 forreturned 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. For products where software is essential to the functionality ofour products, we recognize revenue in accordance with Statement of Position (SOP)No. 97-2, *Software Revenue Recognition*.

When there are multiple elements 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 we have fair value forundelivered elements but not the delivered element in an arrangement, we deferthe fair value of the undelivered element(s) and the residual revenue isallocated to the delivered element(s). Undelivered elements typically includeservices. Revenue from extended warranty and product service contracts isinitially deferred and recognized as revenue ratably over the contract period.

We have various licensing agreements relating to our Variable RateRandomizer (VR2)technology with third parties. As consideration for licensing our VR2 technology, the licensees pay us a royalty feefor sales or their products that incorporate our VR2 technology. On a periodic basis, the licenseesprovide us with reports that include the quantity of units, subject to royalty,sold to their end users. We record the royalty when reported to us by thelicensee, generally in the period during which the licensee ships the productscontaining VR2 technology. In certain instances, the customerhas elected to purchase from us the Applications Specific Integrated Circuit(ASIC) 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, whichunder our FOB origin terms is upon shipment of the underlying ASIC chipincorporating the VR2 technology to the customer.

**Warrantyand Extended Warranty**

TheCompany records a provision for estimated future warranty costs for both thereturn-to-factory and on-site warranties. If future actual costs to repair wereto differ significantly from estimates, the impact of these unforeseen costs orcost reductions would be recorded in subsequent periods.

Separatelypriced extended on-site warranties are offered for sale to customers of all productlines. The Company contracts with third-party service providers to provideservice relating to all on-site warranties. Extended warranty revenue andamounts paid in advance to outside service organizations are deferred andrecognized as service revenue and cost of service, respectively, over theperiod of the service agreement.

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Changes in theliability for product warranty and deferred revenue associated with extendedwarranties were as follows (in thousands):
|                                                              | ** ** | **Product  Warranty** | ** ** | **Deferred  Revenue** | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| 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                 |       |
| Settlements made  during the period                          |       | (1,810                | )          | (9,709                | )          |
| Change in  liability for warranties issued during the period |       | 2,731                 |       | 12,337                |       |
| Change in  liability for preexisting warranties              |       | (194                  | )          | 3                     |       |
| Liability at June 30,  2007                                  |       | $                     | 6,134      |                  | $          | 11,453 |   |

 

#### **Shipping and Handling**

Amounts billed tocustomers for shipping and handling are included in product sales and costsincurred related to shipping and handling are included in cost of revenue.

#### **Advertising Costs**

Advertising costs are expensed as incurred.Advertising expenses for fiscal 2007, 2006 and 2005 were $1.1 million, $1.4million and $1.5 million, respectively.

**Research and Development Costs**

Research anddevelopment costs are expensed as incurred. Software development costs areexpensed until technological feasibility has been established, at which timeany additional costs are capitalized in accordance with Financial AccountingStandards Board (FASB) Statement of Financial Standards (SFAS) No. 86, *Accounting for the Costs of Software to be Sold, Leased or OtherwiseMarketed*. Because we believe our current process for developingsoftware is essentially completed concurrently with the establishment oftechnological feasibility, which occurs upon the completion of a working model,no costs were capitalized during fiscal 2006 and 2005. Amounts capitalized infiscal 2007 were not material.

**SegmentData**

The Companyreports segment data based on the management approach. The management approachdesignates the internal reporting that is used by management for makingoperating and investment decisions and evaluating performance as the source ofthe Company’s reportable segments. The Company uses one measurement ofprofitability and does not disaggregate its business for internal reporting.Based on the criteria of SFAS No. 131, *Disclosures about Segmentsof an Enterprise and Related Information*, the Company has determinedthat it operates in one segment providing data storage solutions for mid-rangecomputer networks. The Company discloses information about products andservices, geographic areas and major customers.

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#### **Information about Products and Services**

The followingtable summarizes net revenue by product, in thousands:
|                          | ** ** | **Fiscal Year** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Tape based  products:    |       |                 |       |   |   |   |   |
| NEO Series               |       | $                    | 106,129    |   | $ | 143,745 |   | $ | 176,678 |   |
| ARCvault family          |       | 11,430               |       | 3 |   | — |   |
| Other (1)                |       | 1,909                |       | 15,435 |   | 21,518 |   |
|                     |       | 119,468              |       | 159,183 |   | 198,196 |   |
| Service                  |       | 16,501               |       | 10,680 |   | 4,592 |   |
| Spare parts and  other   |       | 12,887               |       | 22,628 |   | 20,772 |   |
| Disk based products  (2) |       | 10,228               |       | 13,603 |   | 9,895 |   |
| VR2                      |       | 1,359                |       | 2,944 |   | 2,232 |   |
|                     |       | $                    | 160,443    |   | $ | 209,038 |   | $ | 235,687 |   |

 

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(1)          Fiscal 2006 and 2005include revenue associated with our PowerLoader and LoaderXpress productsdiscontinued in fiscal 2007.

(2)          Includes REO Series andULTAMUS Series.

#### ** Informationabout Geographic Areas**

The Companymarkets its products domestically and internationally, with its principalinternational market being Europe. The tables below contain information aboutthe geographical areas in which the Company operates. Revenue is attributed tothe location to which the product was shipped. Long-lived assets are based onlocation of domicile.
|                          | ** ** | **Net Revenue**    | ** ** | **Long-Lived  Assets** | ** ** |
|--------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **               | ** ** | **(in thousands)** | ** ** |
| **Fiscal  2007**         |       |                    |       |                   |       |
| United States            |       | $                       | 67,980     |                   | $          | 12,065 |   |
| United Kingdom           |       | 40,925                  |       | 707                    |       |
| Rest of Europe           |       | 25,613                  |       | 11                     |       |
| Singapore                |       | 15,247                  |       | —                 |       |
| Other foreign  countries |       | 10,678                  |       | —                 |       |
|                     |       | $                       | 160,443    |                   | $          | 12,783 |   |
| **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 |   |

 

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**Cash Equivalents and Short-TermInvestments**

Highly liquidinvestments with insignificant interest rate risk and original maturities ofthree months or less, when purchased, are classified as cash equivalents. Cashequivalents are comprised of money market funds. The carrying amountsapproximate fair value due to the short maturities of these instruments.

Investments withmaturities greater than three months, when purchased, are classified as short-terminvestments. The Company manages its cash equivalents and short-terminvestments as a single portfolio of highly marketable securities, all of whichare intended to be available for the Company’s current operations. As such, allof the Company’s short-term investments are classified as available-for-saleand are reported at fair value, generally as determined by quoted marketprices, with any unrealized gains and losses (see Note 4), net of tax, recordedas a separate component of accumulated other comprehensive income (loss) inshareholders’ equity. The cost of securities sold is based on the specificidentification method. Investments in auction rate securities are recorded, inshort-term investments, at cost, which approximates fair value due to theirvariable interest rates, which typically reset every 27 to 34 days, and,despite the long-term nature of their stated contractual maturities, theCompany has the ability to quickly liquidate these securities.

**Accounts Receivable and Allowancefor Doubtful Accounts**

The Companyrecords accounts receivable at invoice amount and does not charge interestthereon. The Company estimates itsallowance for doubtful accounts based on an assessment of the collectibility ofspecific accounts and the overall condition of the accounts receivableportfolio. When evaluating the adequacy of the allowance for doubtful accounts,the Company analyzes specific trade and other receivables, historical baddebts, customer credits, customer concentrations, customer credit-worthiness,current economic trends and changes in customers’ payment terms and/orpatterns. The Company reviews the allowance for doubtful accounts on aquarterly basis and records adjustments as considered necessary. Customeraccounts are written-off against the allowance for doubtful accounts when anaccount is considered uncollectible.

**Inventories**

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

#### **Property and Equipment**

Property andequipment are recorded at cost. The Company also capitalizes qualifyinginternal use software costs incurred during the application development stage.Depreciation expense is computed using the straight-line method. Leaseholdimprovements are depreciated over the shorter of the estimated useful life ofthe asset or the term of the lease. Estimated useful lives are as follows:
| Machinery and equipment          |   | 3-5  years |   |
|----------------------------------|--------|------------|--------|
| Furniture and  fixtures          |   | 5  years   |   |
| Computer equipment and  software |   | 1-5 years  |   |

 

Expenditures fornormal maintenance and repair are charged to expense as incurred, andimprovements are capitalized. Upon the sale or retirement of property orequipment, the asset cost and related accumulated depreciation are removed fromthe respective accounts and any gain or loss is included in the results ofoperations.

#### **Long-Lived Assets**

TheCompany evaluates the recoverability of long-lived assets, including propertyand equipment and certain identifiable intangible assets, in accordance withSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets.*  The Company tests for recoverability whenever events or changes incircumstances indicate the carrying value may not be recoverable. We considersuch events or changes, as potential triggers of non-recoverability:

·                  significantunderperformance relative to historical or projected future operating results;

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·                  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 the carrying value is not considered recoverable,an impairment 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). The Company recorded an impairmentcharge of $8.4 million in the first quarter of fiscal 2007. If the Company’sfuture results are significantly different than forecasted, the Company may berequired to further evaluate its long-lived assets for recoverability and suchanalysis could result in an impairment charge in a future period.

Fair value is generally determined based on theestimated future discounted cash flows over the remaining useful life of theasset using a discount rate determined by management to be commensurate withthe risk inherent in the Company’s current business model.

#### **Deferred Rent**

Rent expense is recorded on a straight-line basis overthe term of the lease. The difference between rent expense and amounts paidunder the lease agreements is recorded in other liabilities in the accompanyingconsolidated balance sheets.

**Foreign Currency Translation**

The financial statements of foreign subsidiaries, forwhich the functional currency is the local currency, are translated into U.S.dollars using the exchange rate at the balance sheet date for assets andliabilities and a weighted-average exchange rate during the year for revenue,expenses, gains and losses. Translation adjustments are recorded as accumulatedother comprehensive income within shareholders’ equity. Gains or losses fromforeign currency transactions are recognized currently in income. Suchtransactions resulted in a loss of $448,000, a loss of $186,000 and a gain of$62,000 for fiscal 2007, 2006 and 2005, respectively.

#### **Income Taxes**

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.

#### **Accumulated Other Comprehensive Income (Loss)**

Comprehensiveincome (loss) for the Company includes net (loss) income, foreign currencytranslation adjustments and unrealized losses on available-for-sale securities,which are charged or credited to accumulated other comprehensive 

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income withinshareholders’ equity. For fiscal 2007, 2006 and 2005, the components ofaccumulated other comprehensive loss were as follows (in thousands):
| ** **                                            | ** ** | **Fiscal Year** | ** ** |
|-------------------------------------------------------|------------|----------------------|------------|
| ** **                                            | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Foreign currency  translation adjustments, net of tax |       | $                    | 91         |   | $ | (63 | ) | $ | (199 | ) |
| Unrealized loss  on short-term investments (Note 4)   |       | —               |       | (284 | ) | (113 | ) |
| Total accumulated other  comprehensive income (loss)  |       | $                    | 91         |   | $ | (347 | ) | $ | (312 | ) |

 

#### **Concentration of Credit Risks**

Financial instruments which potentially subject the Company toconcentrations of credit risk consist primarily of cash equivalents, short-terminvestments and trade accounts receivable, which are generally notcollateralized. The Company limits its exposure to credit loss by placing itscash equivalents and short-term investments with high quality financialinstitutions and investing in high quality short-term debt instruments. TheCompany performs ongoing credit evaluations of its customers, generallyrequires no collateral and maintains allowances for potential credit losses andsales returns.

The Company’s largest single customer accounted for approximately45.8%, 49.7% and 54.3% of sales in fiscal 2007, 2006 and 2005, respectively,and approximately 39.5%, 36.8% and 48.9% of accounts receivable as of the endof fiscal 2007, 2006 and 2005, respectively. No other customer accounted for 10.0%or more of sales in any of the three years presented.

#### **Fair Value of Financial Instruments**

The Company’s financial instruments consist of cashand cash equivalents, short-term investments, accounts receivable and accountspayable. Investments in debt securities are recorded at fair value based onquoted market prices for those securities. The carrying amounts of otherinstruments approximate fair value because of their short-term maturities.

**Net (Loss) Income per Share**

Basic net (loss)income per share is computed based on the weighted-average number of shares ofcommon stock outstanding during the period. Diluted net (loss) income per shareis computed based on the weighted-average number of shares of common stockoutstanding during the period increased by the weighted-average number ofdilutive common stock equivalents outstanding during the period, using thetreasury stock method. Dilutive securities are comprised of options granted andrestricted stock awards issued under the Company’s stock option plans and ESPPshare purchase rights.

A reconciliation of the calculation of basic and diluted earnings pershare is as follows:
|                                                             | ** ** | **Fiscal Year**                                                  | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **2007**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                  | ** ** | **(in thousands, except per share amounts)** | ** ** |
| ** **                                                  | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic weighted-average number of common shares  outstanding |       | 12,799                                                                |       | 13,716 |   | 13,899 |   |
| Common stock equivalents using the treasury stock  method   |       | —                                                                |       | — |   | 530 |   |
| Shares used in  computing diluted net income per share      |       | 12,799                                                                |       | 13,716 |   | 14,429 |   |

 

Anti-dilutivecommon stock equivalents excluded from the computation of diluted net (loss)income per share were as follows:
|                                      | ** ** | **Fiscal Year**    | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2007**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **(in thousands)** | ** ** |
|                                 |       |                    |       |   |   |   |   |
| Options  outstanding and ESPP shares |       | 2,044                   |       | 2,632 |   | 1,287 |   |
| Restricted stock awards  outstanding |       | 21                      |       | 144 |   | — |   |

 

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**Change in Accounting Principleand Share-Based Compensation**

The Company adopted SFAS No. 123 (revised 2004)(123(R)), *Share-Based Payment*, on July 4,2005. Upon adoption of SFAS No. 123(R), deferred compensation previouslyrecognized in the balance sheet for fiscal 2005 was reversed in fiscal 2006with the offsetting decrease in common stock. Compensation costs associatedwith the deferred compensation were recorded to expense over the requisiteservice period associated with the restricted stock.

The Company’sshare-based compensation plans are described in Note 10. Prior to the adoptionof SFAS No. 123(R) on July 4, 2005, the Company accounted forshare-based awards issued to employees, directors and officers under thoseplans under the recognition and measurement principles of Accounting PrinciplesBoard (APB) No. 25, *Accounting for StockIssued to Employees*, and related interpretations. Generally, noshare-based employee compensation expense was recognized for stock optiongrants, as all options granted under those plans had an exercise price equal tothe fair market value of the underlying common stock at the date of grant.Similarly, no compensation expense had been recognized for purchase rightsunder the Company’s Employee Stock Purchase Plans (ESPP).****Compensationexpense related to issuances of restricted stock awards with service conditionswas generally recognized based on the fair value less amounts paid byemployees, if any. Compensation expense related to restricted stock awards withmarket conditions was recognized when satisfaction of the market condition wasdeemed probable by management. The Company accounts for stock option grants andsimilar equity instruments granted to non-employees under the fair valuemethod, in accordance with Emerging Issues Task Force (EITF) IssueNo. 96-18, *Accounting for Equity Instruments That areIssued to Other Than Employees for Acquiring, or in Conjunction with Selling,Goods or Services*and SFAS No. 123(R).

As noted above, inthe first quarter of fiscal 2006, the Company adopted SFAS No. 123(R),which requires companies to measure the cost of employee services received inexchange for an award of an equity instrument based on the grant-date fairvalue of the award, using the modified prospective method. The Company uses theBlack-Scholes option pricing model to determine the fair value of its optionson the measurement date. The cost is recognized over the requisite serviceperiod (usually the vesting period) for the estimated number of instrumentswhere service is expected to be rendered. The Company elected the alternativetransition method described in FASB Staff Position No. FAS 123(R)-3, *Transition Election Related to Accounting for the Tax Effects ofShare-Based Payment Awards*, for purposes of calculating the pool ofexcess tax benefits available to absorb tax short falls recognized subsequentto adoption of SFAS No. 123(R).

The fair value ofrestricted stock awards with service conditions is equal to the fair value ofthe stock on the date of issuance. The fair value of restricted stock awardswith market conditions is determined through use of a lattice model.Compensation expense related to issuances of restricted stock awards withservice conditions is recorded at fair value less amounts paid by employees, ifany, and application of an estimated forfeiture rate. Compensation expenserelated to issuances of restricted stock awards with market conditions isrecorded at estimated fair value for the number of employees expected tocomplete the requisite service period.

Compensationexpense associated with option and restricted stock awards with graded vestingis recognized in accordance with FASB Interpretation (FIN) No. 28, **Accounting forStock Appreciation Rights and Other Variable Stock Option or Award Plans—aninterpretation of APB Opinions No. 15 and 25****.**

In accordance withAPB No. 25, the Company previously measured compensation expense for itsshare-based employee compensation plans using the intrinsic value method andprovided pro forma disclosures of net income and income per share as if thefair value-based method had been applied in measuring compensation expense.During fiscal 2007, the Company recorded a net benefit of $75,000 inshare-based compensation associated with awards cancelling prior to theirvesting in excess of the amount previously estimated. During fiscal 2006, theCompany recorded share-based compensation expense of approximately $2.0million, in the accompanying consolidated statement of operations. Duringfiscal 2005, had compensation expense for the Company’s employee share-basedcompensation awards, including the Company’s ESPPs, been determined based onthe fair value at the grant date, the Company’s net income and income per sharewould have been reduced to the pro forma amounts indicated below (in thousands,except per share amounts):

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| Net income, as reported                                                                                                                 |   | $      | 4,578  |   |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Deduct:  Share-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |   | (8,293 | )      |
| Pro forma net loss                                                                                                                      |   | $      | (3,715 | )      |
|                                                                                                                                    |   |   |   |
| Earnings (loss)  per share:                                                                                                             |   |   |   |
| Basic – as reported                                                                                                                |   | $      | 0.33   |   |
| Basic – pro forma                                                                                                                  |   | $      | (0.27  | )      |
|                                                                                                                                    |   |   |   |
| Diluted – as reported                                                                                                              |   | $      | 0. 32  |   |
| Diluted – pro  forma                                                                                                               |   | $      | (0.27  | )      |

In July 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. The stock option acceleration program did not apply to stock optionsheld by the Company’s non-employee directors. The accelerated options wereissued under the 2000 Stock Option Plan, the 2001 Supplemental Stock OptionPlan and the 2003 Equity Incentive Plan. This accelerated vesting affectedoptions to purchase up to an aggregate of 509,192 shares of the Company’scommon stock, held by 147 employees, all of which became exercisable immediately.In connection with the acceleration of vesting of options held by the Company’sexecutive officers, each executive officer agreed not to sell or transfer anyshares subject to accelerated vesting until the original vesting date wouldhave occurred based on the original vesting schedule (without givingeffect to any future termination of service). The primary purpose of theaccelerated vesting was to eliminate future share-based employee compensationexpense of approximately $4.5 million, net of estimated forfeitures, theCompany would otherwise have to record in the statement of operations over aperiod of three years beginning in fiscal year 2006 pursuant to the Company’sadoption of SFAS No. 123(R). For fiscal 2005, the Company’s pro forma netloss includes a pro forma charge of $4.1 million, net of statutory taxes of$723,000, related to this acceleration.

**Recently Issued AccountingPronouncements**

In June 2006,the FASB issued Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (FIN No. 48). FIN No. 48 clarifiesthe accounting for uncertainty in income taxes recognized in financialstatements in accordance with SFAS No. 109, *Accounting for Income Taxes*. FIN No. 48prescribes a recognition threshold and measurement attribute of tax positionstaken or expected to be taken on a tax return and is effective starting thefirst fiscal year beginning after December 15, 2006 (fiscal 2008 for theCompany). Management is currently evaluating the impact, if any, FIN No. 48will have on its consolidated financial position, results of operations andcash flows.

In September 2006,the FASB issued SFAS No. 157, *Fair ValueMeasurements*, which defines fair value, establishes a framework formeasuring fair value in accounting principles generally accepted in the UnitedStates of America and expands disclosure about fair value measurements. SFASNo. 157 is effective for fiscal years beginning after November 15, 2007 (fiscal2009 for the Company). Management is currently evaluating the impact, if any, SFASNo. 157 will have on its consolidated financial position, results of operationsand cash flows.

InFebruary 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities including an amendment of FASB Statement No. 115,*whichpermits an entity to choose to elect irrevocably fair value on acontract-by-contract basis as the initial and subsequent measurement attributefor many financial assets and liabilities and certain other items includinginsurance contracts. Entities electing the fair value option would be requiredto recognize changes in fair value in earnings and to expense upfront cost andfees associated with the item for which the fair value option is elected. Theprovisions of SFAS No. 159 are effective for fiscal yearsbeginning after November 15, 2007 (fiscal 2009 for the Company). Early adoptionis permitted as of the beginning of a fiscal year that begins on or beforeNovember 15, 2007, provided the entity also elects to apply the provisions ofSFAS No. 157. Management is currently evaluating the impact, if any, SFAS No.159 will have on its consolidated financial position, results of operations andcash flows.

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From time to time, new accounting pronouncements are issued by the FASBthat are adopted by the Company as of the specified effective date. Unlessotherwise discussed, management believes that the impact of recently issuedstandards, which are not yet effective, will not have a material impact on theCompany’s consolidated financial statements upon adoption.

**NOTE 2 — ASSET IMPAIRMENT ANDCOMPANY RESTRUCTURINGS**

***Asset Impairment***

InAugust 2005, the Company acquired all of the outstanding stock of ZettaSystems, Inc. (Zetta). Zetta developed data protection software that wasincorporated into the Company’s ULTAMUSTM Pro storage appliance which was launched in the firstquarter of fiscal 2007. ULTAMUS Pro did not generate revenue subsequent to itslaunch. On October 25, 2006, the Company’s Board of Directors approved theclosure of the Zetta-related software development office near Seattle,Washington and the elimination of the ULTAMUS Pro product from future forecastsand sales commission goals.

Inaccordance with Statement of Financial Accounting Standards (SFAS) No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*, the Company evaluated the acquired technologyintangible asset for impairment as of September 30, 2006, due to thesignificant underperformance of the ULTAMUS Pro product subsequent to itslaunch. Based on the Company’s revised forecasts, the Company concluded thatthe carrying amount of the asset was not recoverable and an impairment lossshould be recognized. An impairment charge equal to the remaining intangibleasset balance of $8.4 million was recorded in the first quarter of 2007, as theacquired technology was not considered to have any remaining value. Inaddition, in the first quarter of 2007, the Company recorded a write-down of$350,000 to cost of product sales against specific inventory associated withthe ULTAMUS Pro product because it can no longer be used in production.

***Restructurings***

*Outsource of ManufacturingOperations*

In September 2004, in order to enhance its strategic competitivenessand increase its flexibility, the Company announced a plan to outsource all ofits manufacturing to Sanmina-SCI Corporation (Sanmina), a U.S. third partymanufacturer. In November 2004, the contract with Sanmina was finalizedand all manufacturing employees were notified of termination dates andbenefits. Under the restructuring plan, the Company terminated 82 employees.

The Companycompleted the transfer of all of its manufacturing operations inAugust 2005. In fiscal 2005, the Company recorded $2.1 million to cost ofrevenue in pre-tax charges for severance costs related to the outsourcing andother obligations. In fiscal 2006, the Company recorded $770,000 in pre-taxcharges to cost of revenue for other obligations related to the outsourcing,including a charge of $704,000 for the estimated fair value of the liabilityassociated with leased warehouse space that the Company permanently ceasedusing in December 2005. In June 2006, the Company decided to terminate therelationship Sanmina and return manufacturing to San Diego. As a result, theCompany recorded a pre-tax credit of $536,000, in the fourth quarter, toreverse the remaining excess facilities liability previously recorded.

*October 2006 Reduction ofWorkforce*

In the secondquarter of fiscal 2007, the Company recorded $962,000 in severance for thetermination of 28 employees in connection with an October 2006 reduction inworkforce. In the third quarter of fiscal 2007, the Company recorded a netadjustment of $36,000 to severance for foreign employees whose settlements wereestimated at the end of the second quarter of fiscal 2007. As of June 30, 2007,all severance was paid. Severance charges are included in sales and marketingexpense and research and development expense in the accompanying consolidatedstatements of operations.

The October 2006reduction in workforce included a closure of the Company’s leased softwaredevelopment facility near Seattle, Washington, which lease expires on October31, 2007. In the third quarter of fiscal 2007, the Company recorded a charge of$42,000 to research and development expense for the estimated fair value of theliability associated with this location that the Company ceased using in March2007.

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*April 2007 Cost Reductions andRestructuring of Workforce*

In April 2007, theCompany announced that it reduced its employee workforce by 14% worldwide, or54 employees, in accordance with the Company’s initiatives to reduce costs andrestructure its workforce. Severance related to the terminated employees was$758,000 of which approximately $53,000 remained unpaid as of June 30,2007  Severance charges are included insales and marketing expense, research and development expense and general andadministrative expense in the accompanying consolidated statements ofoperations.

The followingtable summarizes the activity and balances of accrued restructuring chargesthrough fiscal 2007 (in thousands):
|                                | ** ** | **Employee  Related** | ** ** | **Facilities** | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------|------------|-----------------------|------------|----------------|------------|-----------|------------|-----------|------------|
|                           |       |                  |       |           |       |      |       |      |       |
| 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      |       | —                |       | —         |       | —    |       | —    |       |
| Accrued  restructuring charges |       | 1,720                 |       | 42             |       | —    |       | 1,762     |       |
| Cash payments                  |       | (1,631                | )          | (18            | )          | —    |       | (1,649    | )          |
| Adjustment                     |       | (36                   | )          | —         |       | —    |       | (36       | )          |
| Balance at June 30,  2007      |       | $                     | 53         |           | $          | 24        |       | $         | —     |   | $ | 77 |   |
|                                |            |                       |            |                |            |           |            |           |            |  |  |  |  |

 

**NOTE 3 – ACQUISITION OF CERTAINASSETS**

InAugust 2005, the Company acquired all of the outstanding stock of Zettafor total consideration of approximately $9.2 million in cash, including$154,000 in direct acquisition costs. The acquisition was made principally toenable the Company’s entry into the primary data storage market. The results ofoperations of Zetta were included in our consolidated results of operationsbeginning August 2005.

In the firstquarter of fiscal 2007, the Company recorded an impairment charge of $8.4million related to the unamortized Zetta acquired technology as of September30, 2007 (see Note 2) and closed the Washington office.

The purchaseconsideration 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  |   |

 

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**NOTE 4 – SHORT-TERM INVESTMENTS**

The followingtable summarizes short-term investments by security type (in thousands):

**June 30, 2007**
| ** **                      | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|---------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| Asset-backed securities         |       | $                   | 4,322      |                         | $          | —                        |       | $                              | —     |   | $ | 4,322 |   |
| State and municipal  securities |       | 1,000               |       | —                       |       | —                        |       | 1,000                          |       |
|                            |       | $                   | 5,322      |                         | $          | —                        |       | $                              | —     |   | $ | 5,322 |   |

 

**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 |   |

 

The followingtable summarizes the contractual maturities of the Company’s short-terminvestments (in thousands):
|                           | ** ** | **June 30,** | ** ** |
|---------------------------|------------|-------------------|------------|
| ** **                | ** ** | **2007**          | ** ** | **2006** | ** ** |
| Less than one  year       |       | $                 | —     |   | $ | — |   |
| Due in one to  two years  |       | —            |       | 2,600 |   |
| Due in two to  five years |       | 329               |       | 1,919 |   |
| Due after five  years     |       | 4,993             |       | 37,678 |   |
|                      |       | $                 | 5,322      |   | $ | 42,197 |   |

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.

The followingtable summarizes gross realized gains and gross realized losses on the Company’sshort-term investments (in thousands):
|                                              | ** ** | **Fiscal Year** | ** ** |
|----------------------------------------------|------------|----------------------|------------|
| ** **                                   | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Realized gains                               |       | $                    | —     |   | $ | 1 |   | $ | 2 |   |
| Realized losses                              |       |                 |       |   |   |   |   |
| Realized from sale of short-term investments |       | (107                 | )          | (24 | ) | — |   |
| Impairment under SFAS No. 115-1 and 124-1    |       | (157                 | )          | — |   | — |   |
|                                         |       | $                    | (264       | ) | $ | (23 | ) | $ | 2 |   |

In accordance with FASB Staff Position (FSP) FAS 115-1and 124-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments,* the Company performed areview of its investments that were in an unrealized loss position at the endof its third and fourth quarters of fiscal 2007. Based upon this review,management determined the losses to be other-than-temporary and recordedimpairment losses of approximately $157,000, pre-tax, on its investments,during fiscal 2007. This impairment is recorded in other income (expense), net,in the accompanying consolidated statements of operations.

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**NOTE 5 –COMPOSITION OF CERTAIN FINANCIAL STATEMENT CAPTIONS**

The following table summarizes inventories (in thousands):
|                 | ** ** | **June 30,** | ** ** |
|-----------------|------------|-------------------|------------|
| ** **      | ** ** | **2007**          | ** ** | **2006** | ** ** |
| Raw materials   |       | $                 | 11,539     |   | $ | 8,202 |   |
| Work in process |       | 1,134             |       | 1,332 |   |
| Finished goods  |       | 7,883             |       | 5,444 |   |
|            |       | $                 | 20,556     |   | $ | 14,978 |   |

 

The following tablesummarizes other current assets (in thousands):
|                                        | ** ** | **June 30,** | ** ** |
|----------------------------------------|------------|-------------------|------------|
| ** **                             | ** ** | **2007**          | ** ** | **2006** | ** ** |
| Prepaid  third-party service contracts |       | $                 | 4,760      |   | $ | 3,687 |   |
| Income tax  receivable                 |       | 613               |       | 3,480 |   |
| Prepaid  insurance and services        |       | 1,108             |       | 1,087 |   |
| Non-trade  accounts receivable         |       | 158               |       | 490 |   |
| Other                                  |       | 314               |       | 370 |   |
|                                   |       | $                 | 6,953      |   | $ | 9,114 |   |

 

The following table summarizes property and equipment (in thousands):
|                                            | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2007**          | ** ** | **2006** | ** ** |
| Computer equipment                         |       | $                 | 12,945     |   | $ | 11,594 |   |
| Machinery and  equipment                   |       | 7,930             |       | 7,333 |   |
| Leasehold  improvements                    |       | 4,167             |       | 3,925 |   |
| Furniture and  fixtures                    |       | 1,466             |       | 1,398 |   |
|                                       |       | 26,508            |       | 24,250 |   |
| Accumulated  depreciation and amortization |       | (15,456           | )          | (13,224 | ) |
|                                       |       | $                 | 11,052     |   | $ | 11,026 |   |

 

Depreciation and amortization expense, for propertyand equipment, was $3.2 million, $2.4 million and $2.6 million, in fiscal 2007,2006 and 2005, respectively.

 The following table summarizes accruedliabilities (in thousands):
|                                            | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2007**          | ** ** | **2006** | ** ** |
| Deferred revenue  – Service contracts |       | $                 | 7,752      |   | $ | 5,773 |   |
| Accrued expenses                           |       | 4,338             |       | 5,106 |   |
| Third-party  service contracts payable     |       | 1,879             |       | 1,316 |   |
| Deferred revenue  – Distributors      |       | 1,047             |       | 2,005 |   |
| Accrued market  development funds          |       | 575               |       | 853 |   |
| VAT &  sales taxes payable        |       | 165               |       | 207 |   |
| Other                                      |       | 17                |       | 70 |   |
|                                       |       | $                 | 15,773     |   | $ | 15,330 |   |

 

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The following tablesummarizes other long-term liabilities (in thousands):
|                                            | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2007**          | ** ** | **2006** | ** ** |
| Deferred revenue  – Service contracts |       | $                 | 3,701      |   | $ | 3,049 |   |
| Deferred rent                              |       | 1,245             |       | 1,164 |   |
| Other                                      |       | 287               |       | 280 |   |
|                                       |       | $                 | 5,233      |   | $ | 4,493 |   |

 

As of fiscal 2007 and 2006, the accounts receivablebalances consist entirely of accounts receivable trade balances, net ofallowance for doubtful accounts. The following table summarizes the changes inallowance for doubtful accounts (in thousands):
| **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** | ** ** |
|----------------------|------------|----------------------------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| 2007                 |       | $                                            | 436        |                                   | $          | 368                                      |       | $                                        | 430        |                                   | $          | — |   | $ | 374 |   |
| 2006                 |       | 298                                          |       | 159                                    |       | 21                                       |       | —                                   |       | 436                                    |       |
| 2005                 |       | 296                                          |       | 97                                     |       | 95                                       |       | —                                   |       | 298                                    |       |
|                      |            |                                              |            |                                        |            |                                          |            |                                          |            |                                        |            |  |  |  |  |  |

 

**NOTE 6 – INTANGIBLE ASSETS**

Intangible assets consistof the following (in thousands):
|                                          | ** ** | **June 30,** | ** ** |
|------------------------------------------|------------|-------------------|------------|
| ** **                               | ** ** | **2007**          | ** ** | **2006** | ** ** |
|                                     |       |              |       |   |   |
| Acquired  technology                     |       | $                 | 20,594     |   | $ | 20,594 |   |
| Impairment of  Zetta acquired technology |       | (8,411            | )          | — |   |
| Adjusted cost  basis                     |       | 12,183            |       | 20,594 |   |
| Accumulated  amortization                |       | (10,452           | )          | (7,979 | ) |
|                                     |       | $                 | 1,731      |   | $ | 12,615 |   |

As a result of the impairment of the Zetta technology,intangible assets at June 30, 2007 consist solely of the remaining unamortizedbalance of the technology acquired in the June 2003 acquisition of OkapiSoftware, Inc. (Okapi). Amortization expense of intangible assets was $2.5million, $4.5 million and $1.7 million during fiscal 2007, 2006 and 2005,respectively. The technology acquired from Okapi is being amortized over fiveyears. The technology acquired fromZetta was being amortized over four years before its impairment in the firstquarter of fiscal 2007. Estimated amortization expense for intangibleassets will be approximately $1.7 million in fiscal 2008 at which point theintangible asset will be fully amortized.

**NOTE 7 – CREDIT FACILITY**

On November 30,2006, the Company’s $10.0 million revolving line of credit expired in accordancewith its terms.

**NOTE 8 – INCOME TAXES**

The components of (loss) income before income taxes were as follows (inthousands):
|            | ** ** | **Fiscal Year** | ** ** |
|------------|------------|----------------------|------------|
| ** ** | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Domestic   |       | $                    | (44,806    | ) | $ | (24,417 | ) | $ | 3,493 |   |
| Foreign    |       | 970                  |       | 1,106 |   | 1,575 |   |
|       |       | $                    | (43,836    | ) | $ | (23,311 | ) | $ | 5,068 |   |

 

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The provision for (benefit from) income taxes includesthe following (in thousands):
|                                                  | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------|------------|----------------------|------------|
| ** **                                       | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Current:                                         |       |                 |       |   |   |   |   |
| Federal                                          |       | $                    | 132        |   | $ | (2,718 | ) | $ | 131 |   |
| State                                            |       | (55                  | )          | (143 | ) | 115 |   |
| Foreign                                          |       | 345                  |       | 224 |   | 713 |   |
| Total current                                    |       | 422                  |       | (2,637 | ) | 959 |   |
|                                             |       |                 |       |   |   |   |   |
| Deferred                                         |       |                 |       |   |   |   |   |
| Federal                                          |       | (134                 | )          | (961 | ) | (366 | ) |
| State                                            |       | (13                  | )          | (227 | ) | (59 | ) |
| Foreign                                          |       | —               |       | — |   | (44 | ) |
| Total deferred                                   |       | (147                 | )          | (1,188 | ) | (469 | ) |
| Total provision  for (benefit from) income taxes |       | $                    | 275        |   | $ | (3,825 | ) | $ | 490 |   |

 

A reconciliation of income taxes computed by applyingthe federal statutory income tax rate of 34.0%****to(loss) income before income taxes to the total income tax provision (benefit) reportedin the consolidated statements of operations is as follows (in thousands):
|                                                   | ** ** | **Fiscal Year** | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| U.S. federal  income tax at statutory rate        |       | $                    | (14,904    | ) | $ | (7,926 | ) | $ | 1,723 |   |
| State income  taxes, net of federal benefit       |       | (1,902               | )          | (1,231 | ) | 37 |   |
| Increase in  valuation allowance                  |       | 17,214               |       | 5,114 |   | — |   |
| In-process  research and development              |       | —               |       | 381 |   | — |   |
| Share-based  compensation expense                 |       | (30                  | )          | 120 |   | — |   |
| Extraterritorial  income exclusion benefit        |       | —               |       | (238 | ) | (503 | ) |
| Tax exempt  interest                              |       | —               |       | (65 | ) | (363 | ) |
| Favorable IRS  settlement and statute expirations |       | (82                  | )          | (51 | ) | (345 | ) |
| Federal R&D  tax credit                       |       | (178                 | )          | (111 | ) | (136 | ) |
| Permanent  differences                            |       | 72                   |       | 92 |   | 43 |   |
| Other, net                                        |       | 85                   |       | 90 |   | 34 |   |
| Total provision  for (benefit from) income taxes  |       | $                    | 275        |   | $ | (3,825 | ) | $ | 490 |   |

 

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Deferred incometaxes comprised (in thousands):
|                                             | ** ** | **June 30,** | ** ** |
|---------------------------------------------|------------|-------------------|------------|
| ** **                                  | ** ** | **2007**          | ** ** | **2006** | ** ** |
| Deferred tax  assets:                       |       |              |       |   |   |
| Net operating loss carryforward             |       | $                 | 14,396     |   | $ | 2,935 |   |
| Inventory                                   |       | 1,936             |       | 2,009 |   |
| Warranty reserves                           |       | 3,120             |       | 2,244 |   |
| Tax credits                                 |       | 2,292             |       | 1,330 |   |
| Share-based compensation                    |       | 622               |       | 618 |   |
| Vacation and deferred compensation          |       | 414               |       | 601 |   |
| Intangible assets                           |       | 139               |       | — |   |
| Restructuring accrual                       |       | 158               |       | — |   |
| Allowance for doubtful accounts             |       | 140               |       | 162 |   |
| Other                                       |       | 54                |       | 280 |   |
| Gross deferred tax asset                    |       | 23,271            |       | 10,179 |   |
|                                        |       |              |       |   |   |
| Deferred tax  liabilities:                  |       |              |       |   |   |
| Purchased intangible assets                 |       | (647              | )          | (4,702 | ) |
| Property and equipment depreciation         |       | (297              | )          | (363 | ) |
| Gross deferred tax liability                |       | (944              | )          | (5,065 | ) |
| Valuation allowance for deferred tax assets |       | (22,327           | )          | (5,114 | ) |
| Net deferred tax  asset                     |       | $                 | —     |   | $ | — |   |

 

The ultimate realization of the net deferred tax asset is dependentupon the generation of future taxable income during the periods in which thosetemporary differences become deductible. SFAS No. 109, *Accountingfor Income Taxes*, considers recent losses to be significant negativeevidence that is difficult to overcome by forecasts of future taxable income tosupport the realization of deferred tax assets. The Company is required torecord a valuation allowance to reduce its net deferred tax asset to the amountthat management believes is more likely than not to be realized. As of June 30,2006, the Company performed an assessment of its deferred tax assets anddetermined that it was appropriate to establish a full-valuation allowanceagainst its net deferred tax asset. The Company continues to maintain a fullvaluation allowance at June 30, 2007 against its net deferred tax asset.

At June 30, 2007, the Company has federal and state net operating losscarryforwards of approximately $39.4 million and $29.5 million, respectively.These amounts include stock option deductions of approximately $950,000 whichwill be recorded to contributed capital when realized. The remaining federalnet operating loss will begin expiring in 2023, unless previously utilized.State net operating loss carryforwards generally begin to expire in 2016,unless previously utilized.

At June 30, 2007, the Company had federal and California researchand development tax credit carryforwards totaling approximately $570,000 and$1.5 million, respectively. The California research credit may be carriedforward indefinitely. The federal research credit will begin expiring in 2025,unless previously utilized. In addition, the Company has foreign tax creditcarryforwards totaling approximately $507,000, which will begin expiring in2015, unless previously utilized. The Company has federal alternative minimumtax credit carryforwards totaling $197,000 that can be carried forwardindefinitely.

**NOTE 9 –COMMON STOCK**

***Sharerepurchase program***

InOctober 2005, the Company’s Board of Directors expanded the Company’sshare repurchase program to allow for the purchase of up to 2.5 million sharesof its common stock with no fixed dollar amount. In October 2006, the Company’sBoard of Directors terminated the share repurchase program. There were no sharerepurchases after the first quarter of fiscal 2007. During fiscal 2007, anaggregate of approximately 373,000 shares were repurchased at a cost ofapproximately $2.7 million pursuant to the repurchase program. During fiscal2006, an aggregate of 1.3 million shares were repurchased at a cost ofapproximately $10.8 million pursuant to the repurchase program.

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**NOTE 10 –SHARE-BASED COMPENSATION**

***StockOption Plans***

The Company has six active stock option plans, each administered by aCommittee of the Board of Directors, which provide for the issuance of optionsto employees, officers, directors and consultants. As of June 30, 2007, theCompany had reserved an aggregate of 8.1 million shares of common stock forissuance under the 1993 Stock Option Plan, 1995 Stock Option Plan, 1997Executive Stock Option Plan, 2000 Stock Option Plan, 2001 Supplemental StockOption Plan (2001 Plan) and the 2003 Equity Incentive Plan (2003 Plan)(collectively, the Option Plans). The Option Plans provide for the granting ofstock options. In addition, the 2003 Plan provides for the granting ofrestricted stock and stock appreciation rights (collectively, stock awards).The Option Plans have been approved by shareholders with the exception of the2001 Plan. Currently, the Company may grant new awards only from the 2003 Plan.The Company’s 2003 Plan provides for an automatic annual grant to non-employeedirectors of non-statutory options to purchase 18,000 shares of common stock.

Certain options issued under selected plans allow for 100% vesting ofoutstanding options upon a change of control of the Company (if replacementoptions are not issued) or upon death or disability of the optionee. Optionsgranted generally vest over a three-year period. Options generally expire aftera period not to exceed ten years, except in the event of termination, whereuponvested shares must be exercised generally within three months under the 2003Plan and within 30 days under the other Option Plans, or upon death ordisability, where an extended six- or twelve-month exercise period isspecified. As of June 30, 2007, approximately 1.8 million shares were reservedfor issuance upon exercise of outstanding options and approximately 1.6 millionshares were available for grant under the Option Plans.

The fair value ofeach option award is estimated on the date of grant using the Black-Scholesoption pricing model which uses the weighted-average assumptions noted in thefollowing table. Beginning in the fourth quarter of fiscal 2005, separategroups of employees that have similar historical exercise behavior are beingconsidered separately in determining certain valuation assumptions. Expectedvolatilities are based on the historical volatility (using daily pricing) ofthe Company’s stock. Upon adoption of SFAS No. 123(R), the Company nowapplies a forfeiture rate, based upon historical pre-vesting optioncancellations. The expected term of options granted is estimated based on anumber of factors, including but not limited to the vesting term of the award,historical employee exercise behavior (for both options that have run theircourse and outstanding options), the expected volatility of the Company’s stockand an employee’s average length of service. The risk-free interest rate isdetermined based upon a U.S. constant rate Treasury Security with a contractuallife which approximates the expected term of the option award. Weighted-averageranges below result from certain groups of employees exhibiting differentbehavior:
|                           | ** ** | **Fiscal Year** | ** ** |
|---------------------------|------------|----------------------|------------|
| ** **                | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
|                      |       |                 |       |   |   |   |   |
| Expected  volatility      |       | 63.6-65.9            | %          | 72.2-74.1 | % | 76.9-77.3 | % |
| Risk-free  interest rate  |       | 4.6-4.8              | %          | 4.3-4.4 | % | 3.6-3.7 | % |
| Dividend yield            |       | —               |       | — |   | — |   |
| Expected term (in  years) |       | 5.5-6.36             |       | 5.6-5.9 |   | 5.0-6.0 |   |

 

The stock optionactivity is summarized below (shares and aggregate intrinsic value inthousands):
|                                            | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------|------------|------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------|------------|
|                                       |       |       |       |                                    |       |                                                              |       |                            |       |
| Options  outstanding at June 30, 2006 |       | 2,632      |       | $                                       | 11.44      |                                                              |       |                            |       |   |
| Granted                                    |       | 267        |       | 4.82                                    |       |                                                              |       |                            |       |
| Exercised                                  |       | (3         | )          | 5.31                                    |       |                                                              |       |                            |       |
| Canceled/forfeited                         |       | (1,110     | )          | 10.59                                   |       |                                                              |       |                            |       |
| Options  outstanding at June 30, 2007      |       | 1,786      |       | 10.63                                   |       | 5.8                                                               |       | $                               | —     |   |
| Exercisable outstanding  at June 30, 2007  |       | 1,680      |       | 10.94                                   |       | 5.6                                                               |       | $                               | —     |   |
|                                            |            |            |            |                                         |            |                                                                   |            |                                 |            |  |  |

 

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During fiscal 2007, 2006 and 2005, the Company recorded share-basedcompensation associated with outstanding stock option grants of approximately$285,000, $1.4 million and $0, respectively. As of June 30, 2007, there was$147,000 of total unrecognized compensation expense related to non-vested stockoptions granted under the Option Plans. This expense is expected to berecognized over a weighted-average period of 1.23 years. The following tablesummarizes information about stock options for fiscal 2007, 2006 and 2005 (inthousands, except per share amounts):
|                                                                                            | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                 | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                       |       |                 |       |   |   |   |   |
| Weighted-average  grant date fair value per share of options granted with exercise prices: |       |                 |       |   |   |   |   |
| Less than fair value                                                                       |       | $                    | —     |   | $ | — |   | $ | — |   |
| Equal to fair value                                                                        |       | 3.07                 |       | 5.49 |   | 8.92 |   |
| Greater than fair value                                                                    |       | 3.90                 |       | — |   | 8.18 |   |
| Intrinsic value  of options exercised                                                      |       | 6                    |       | 502 |   | 1,915 |   |
| Cash received  upon exercise of stock options                                              |       | 16                   |       | 1,918 |   | 2,269 |   |
| Actual tax  benefit realized for the tax deductions from option exercise                   |       | —               |       | — |   | 715 |   |
| 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.

***RestrictedStock Awards***

InApril 2005, the Company issued two restricted stock awards for 50,000shares each to its former CEO. At June 30, 2007, 16,667 shares were vested,83,333 shares were canceled and no shares were subject to repurchase. Theawards are described separately below.

The first award(the Service Award) vested as follows: 16,667 shares, 16,667 shares and 16,666shares on January 1, 2006, 2007 and 2008, respectively. In accordance withAPB No. 25, the Service Award was a fixed award and, as such, compensationexpense was recorded for the fair value of the Company’s common stock less anyamounts paid by the employee. The fair value of the Service Award was $10.86per share (the market value of the stock on the date of issuance) or $543,000,which was recorded as deferred compensation under APB No. 25. In November 2006,in connection with the termination of the CEO, the unvested shares revertedback to the Company and the Company reversed $170,000 of share-basedcompensation expense previously recognized associated with shares canceledprior to vesting. Compensation expense recorded during fiscal 2006 (under SFASNo. 123(R)) and fiscal 2005 (under APB No. 25) totaled approximately $300,000and $80,000, respectively. See Note 1, *Change in AccountingPrinciple and Accounting for Share-Based Compensation*.

The second award(the Market Award) vested as follows: 12,500 shares, 12,500 shares and 25,000shares, if the volume weighted daily average stock price of the Company for tenconsecutive trading days were to reach $20.00, $25.00 and $30.00 (collectively,the target stock price), respectively, on or before January 1, 2008. Basedupon the market values of the Company’s common stock through June 30, 2005,satisfaction of the vesting conditions were not considered probable bymanagement and therefore no compensation expense was recorded under APBNo. 25. Upon adoption of SFAS No. 123(R), the Company began recognizingcompensation expense associated with this award. The weighted-average grantdate fair value of this restricted stock award was estimated at $5.73, using atrinomial option pricing model based on the following assumptions: expectedvolatility of 54.2%, risk-free interest rate of 3.8%, dividend yield of 0.0%and an expected term of 978 days. Commencing with the adoption of SFASNo. 123(R), expense was being recognized in the consolidated statement ofoperations with offsetting credits to common stock. In November 2006, inconnection with the termination of the CEO, the unvested shares reverted backto the Company and the Company reversed all previously recorded share-basedcompensation expense of $77,000 as all shares comprising the Market awardcanceled prior to vesting. Compensation expense recorded during fiscal 2006totaled approximately $77,000.

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InAugust 2005, the Company issued an aggregate of 64,625 restricted sharesof common stock to new hires, 15,000 shares of which vested annually over aperiod of three years in equal increments and 49,625 shares of which vestedannually over a period of five years in equal increments, in each case subjectto continuing service by the recipient of the restricted stock. The fair valueof the restricted stock was $7.84 per share (the market value of the stock onthe date of issuance) or $506,660 and was to be recorded to compensationexpense, net of related forfeitures, over the requisite service periods of theawards. In fiscal 2007, $113,000 of share-based compensation expense previouslyrecorded was reversed due to the cancellation of shares prior to vesting inexcess of the amount previously estimated. Compensation expense recorded duringfiscal 2006 was approximately $183,000. At June 30, 2007, 9,075 shares werevested, 55,550 shares were canceled and no shares were subject to repurchase.

The following table summarizes information about non-vested restrictedstock awards as of June 30, 2007 and changes during fiscal 2007 (shares andaggregate unrecognized compensation expense in thousands):
|                                   | ** ** | **Shares** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** | **Weighted-  Average  Remaining  Service  Period** | ** ** | **Aggregate  Unrecognized  Compensation  Expense** | ** ** |
|-----------------------------------|------------|------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
|                              |       |       |       |                                                |       |                                               |       |                                               |       |
| Non-vested at  June 30, 2006 |       | 144        |       | $                                                   | 7.81       |                                               |       |                                               |       |   |
| Granted                           |       | —     |       | —                                              |       |                                               |       |                                               |       |
| Vested                            |       | (9         | )          | 7.84                                                |       |                                               |       |                                               |       |
| Canceled                          |       | (135       | )          | 7.80                                                |       |                                               |       |                                               |       |
| Non-vested at June 30,  2007      |       | —     |       | —                                              |       | —                                             |       | $                                                  | —     |   |
|                                   |            |            |            |                                                     |            |                                                    |            |                                                    |            |  |  |

 

The following table summarizes information about restricted stockawards vested during the fiscal 2007, 2006 and 2005 (in thousands):
|                                               | ** ** | **Fiscal Year** | ** ** |
|-----------------------------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **2007**             | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                          |       |                 |       |   |   |   |   |
| Fair value of vested  restricted stock awards |       | $                    | 62         |   | $ | 134 |   | $ | — |   |
|                                               |            |                      |            |  |  |  |  |  |  |  |

 

***1996and 2006 Employee Stock Purchase Plans***

In February 1997, the Company adopted the 1996Employee Stock Purchase Plan (1996 ESPP), which expired January 31, 2007. The2006 Employee Stock Purchase Plan (2006 ESPP) replaced the 1996 ESPP effectiveFebruary 1, 2007. A total of 500,000 shares of common stock have been reservedunder the 2006 ESPP for issuance and purchase by employees of the Company toassist them in acquiring a stock ownership interest in the Company and toencourage them to remain employees of the Company. The 2006 ESPP is qualifiedunder Section 423 of the Internal Revenue Code and permits eligibleemployees to purchase common stock at a discount through payroll deductionsduring specified six-month offering periods. No employee may purchase more than$25,000 worth of stock in any calendar year or 1,500 shares in any one offeringperiod.

Effective with the offering period beginning inAugust 2005, the purchase price of common stock under the 1996 ESPP wasdetermined as either (i) a percentage not less than 85.0% (the DesignatedPercentage), subject to the Compensation Committee’s discretion of the fairmarket value of the common stock on the last day of the offering period or(ii) the lower of (a) the Designated Percentage of the fair marketvalue 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. In August 2005, the Compensation Committeeof the Board of Directors determined the purchase price to be 95.0% of the fairmarket value of the common stock on the last day of each offering period,beginning with the August 2005 offering. As a result, commencing with theAugust 2005 offering period, the 1996 ESPP will no longer be compensatoryunder SFAS No. 123(R). Expense prior to this date was not significant. The 2006ESPP uses the same designated percentage as the 1996 ESPP.

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The fair value of each compensatory share purchaseright is estimated on the date of grant using the Black-Scholes option pricingmodel. The following assumptions were used in estimating the fair value of thepurchase rights during fiscal 2005:
| Expected volatility       |   | 38.4   | %      |
|---------------------------|--------|--------|--------|
| Risk-free  interest rate  |   | 1.9    | %      |
| Dividend yield            |   | — |   |
| Expected term (in  years) |   | 0.5    |   |

 

Theweighted-average estimated fair value of each compensatory share purchase rightissued during fiscal 2005 was $3.24.

During fiscal 2007, 2006 and 2005, approximately23,000, 54,000 and 74,000 shares, respectively, were issued under the 1996 ESPPfor combined proceeds of approximately $127,000, $338,000 and $673,000,respectively. As of June 30, 2007, approximately 500,000 shares were availableunder the 2006 ESPP.

#### **NOTE 11 – 401(k) PLAN**

The Company maintains an employee savings and retirement plan (the401(k) Plan) covering all of the Company’s employees. The 401(k) Plan permitsbut does not require matching contributions by the Company on behalf ofparticipants. The Company matches employee contributions at 75%, up to 6% of anemployee’s pretax income. The totals of these employer contributions were$714,000, $777,000 and $819,000 in fiscal 2007, 2006 and 2005, respectively.

**NOTE 12 – COMMITMENTS ANDCONTINGENCIES**

**Leases**

The Company leasesits office, production and sales facilities under non-cancelable operatingleases, which expire in various years through fiscal year 2018. The leasesprovide 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):
|             | ** ** | **Minimum  Lease  Payments** | ** ** |
|-------------|------------|------------------------------|------------|
|        |       |                         |       |
| Fiscal 2008 |       | $                            | 3,496      |   |
| Fiscal 2009 |       | 3,471                        |       |
| Fiscal 2010 |       | 3,425                        |       |
| Fiscal 2011 |       | 3,526                        |       |
| Fiscal 2012 |       | 3,580                        |       |
| Thereafter  |       | 7,447                        |       |
|        |       | $                            | 24,945     |   |

Rental expense is recognized on a straight-line basisover the respective lease terms and approximated $4.1 million, $4.0 million and$3.8 million in fiscal 2007, 2006 and 2005, respectively.

**Litigation**

From time to time,the Company may be involved in various lawsuits, legal proceedings or claimsthat arise in the ordinary course of business. Management does not believe anylegal proceedings or claims pending at June 30, 2007 will have, individually orin the aggregate, a material adverse effect on its business, liquidity,financial position or results of 

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operations. Litigation,however, is subject to inherent uncertainties, and an adverse result in theseor other matters may arise from time to time that may harm the Company’sbusiness.

**Purchase Commitment**

The Company’sManufacturing Service Agreement (MSA) with Sanmina committed the Company topurchase finished goods and component parts from them based upon the Company’sforecast of customer demand. At June 30, 2007, after the completion of thetransfer of manufacturing back to the Company’s San Diego facility,approximately $2.0 million of component parts inventories remained in thepossession of Sanmina. On June 29, 2007, the Company entered into a settlementagreement with Sanmina which defined how and when these inventories were to bepurchased and the appropriate disposition for each item.  The Company agreed to purchase $507,000 ofobsolete components and commit to issue purchase orders of approximately $1.5million for active components to be purchased by September 30, 2007. TheCompany does not expect the purchase commitments to have a material adverseeffect on its future results of operations.

In addition, theCompany terminated discussions with a Sanmina subsidiary regarding an unrelatedprogram for which the Sanmina subsidiary asserted it was owed liquidateddamages. The Company believes that no agreement was formed between the partiesand there is no basis for such claim.

**NOTE 13 – SELECTED QUARTERLYFINANCIAL DATA (UNAUDITED)**

The followingtable presents selected quarterly financial information for the periodsindicated. This information has been derived from the Company’s unauditedquarterly consolidated condensed financial statements, which in the opinion ofmanagement include all adjustments (consisting only of normal recurringadjustments) necessary for a fair statement of such information. The quarterlyper share amounts presented below were calculated separately and may not sum tothe annual figures presented in the consolidated statements of operations.These operating results are also not necessarily indicative of results for anyfuture period.
|                           | ** ** | **Fiscal 2007**                                                  | ** ** |
|---------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                | ** ** | **Q1**                                                                | ** ** | **Q2** | ** ** | **Q3** | ** ** | **Q4** | ** ** | **Total** | ** ** |
| ** **                | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net revenue               |       | $                                                                     | 41,827     |   | $ | 46,760 |   | $ | 37,798 |   | $ | 34,058 |   | $ | 160,443 |   |
| Gross profit              |       | 5,298                                                                 |       | 7,859 |   | 5,032 |   | 6,154 |   | 24,343 |   |
| Loss from operations      |       | (20,587                                                               | )          | (9,215 | ) | (9,203 | ) | (5,840 | ) | (44,845 | ) |
| Loss before income  taxes |       | (19,985                                                               | )          | (8,960 | ) | (9,066 | ) | (5,825 | ) | (43,836 | ) |
| Net loss                  |       | (19,997                                                               | )          | (8,889 | ) | (9,203 | ) | (6,022 | ) | (44,111 | ) |
|                      |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Net loss per share:       |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic and diluted         |       | $                                                                     | (1.54      | ) | $ | (0.70 | ) | $ | (0.72 | ) | $ | (0.47 | ) | $ | (3.45 | ) |

 
|                           | ** ** | **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 and diluted         |       | $                                                                     | (0.21      | ) | $ | (0.19 | ) | $ | (0.52 | ) | $ | (0.52 | ) | $ | (1.42 | ) |

 

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**NOTE 14 – SUBSEQUENT EVENTS**

*Appointmentof President and Chief Executive Officer and Director*

In August 2007,our board of directors appointed Vernon A. LoForti as our President and ChiefExecutive Officer, replacing Scott McClendon, who was serving as InterimPresident and Chief Executive Officer. Upon the recommendation of ournominating and governance committee, Mr. LoForti was also appointed as a memberof our board of directors. Mr. LoForti has served as our Vice President andChief Financial Officer since joining us in December 1995.

In connection withhis appointment as President and Chief Executive Officer, Mr. LoForti wasgranted an option to purchase 250,000 shares of our common stock pursuant toour 2003 Equity Incentive Plan. The option has a three-year contractual termand an exercise price based on the closing price of our common stock on Monday,August 13, 2007 ($1.62 per share). The option vests over one year in equalmonthly installments.

Mr. McClendonremains the Chairman of our Board and has resumed receiving the customary feespaid to our non-employee directors and the fee paid to our Chairman of theBoard.

*Appointmentof Interim Chief Financial Officer*

In August 2007,our board of directors appointed Kurt L. Kalbfleisch as our Interim ChiefFinancial Officer, replacing Mr. LoForti as Chief Financial Officer. Inconnection with his appointment as Interim Chief Financial Officer, Mr.Kalbfleisch was granted an option to purchase 75,000 shares of our common stockpursuant to our 2003 Equity Incentive Plan. The option has a three-yearcontractual term and an exercise price based on the closing price of our commonstock on Monday, August 13, 2007 ($1.62 per share). The option vests overone year in equal monthly installments.

*OtherStock Option Grants*

* Named Executive Officers*

On August 7, 2007,our compensation committee granted options to Robert J. Scroop, our VicePresident, New Product Delivery, and W. Michael Gawarecki, our Vice President,Operations, to purchase 75,000 and 100,000 shares, respectively, of our commonstock pursuant to our 2003 Equity Incentive Plan. Each option has a three-yearcontractual term and an exercise price based on the closing price of our commonstock on Monday, August 13, 2007 ($1.62 per share). Each option vests over oneyear in equal monthly installments.

*OtherEmployees*

On August 7, 2007,our compensation committee granted options to other non-named executiveofficers and other non-executive employees to purchase 985,000 shares of ourcommon stock pursuant to our 2003 Equity Incentive Plan. Each option has athree-year contractual term and an exercise price based on the closing price ofour common stock on Monday, August 13, 2007 ($1.62 per share). Each optionvests over one year in equal monthly installments.

As of August 15,2007, approximately 3.1 million shares were reserved for issuance upon exerciseof outstanding options and approximately 211,000 shares were available forgrant under the Option Plans.

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