UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

FORM 10-Q

|                                                                                             | 
|-------------------------------------------------------------------------------------------- | 
|(Mark One)                                                                                  
|x QUARTERLY REPORT PURSUANT TO
  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|                                                                                             | 
|For the quarterly period ended June
  30, 2006                                              
|                                                                                             | 
|OR                                                                                          
|                                                                                             | 
|o TRANSITION REPORT PURSUANT TO
  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|                                                                                             | 
|For the transition period from
  _______ to ________                                        

Commission
file number 1-13550

|                                                        
|--------------------------------------------------------
|HAUPPAUGE DIGITAL, INC.                                 
|                                                        
|(Exact
  name of registrant as specified in its charter)

| |                                   |  |                       | 
| | --------------------------------- |  | --------------------- | 
| | Delaware                          |  | 11-3227864            | 
| |                                   |  |                       | 
| | (State
  or other jurisdiction of |  | (I.R.S.
  Employer    | 
| | incorporation
  or organization)  |  | Identification
  No.) | 

|                                                      
|------------------------------------------------------
|91
  Cabot Court, Hauppauge, New York 11788           
|                                                      
|(Address
  of principal executive offices)            
|                                                      
|(631)
  434-1600                                      
|                                                      
|(Registrants
  telephone number, including area code)

Indicate by check mark whether the registrant (1) has
filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.

xYESoNO

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

oLARGE
  ACCELERATED FILER oACCELERATED
  FILER xNON-ACCELERATED
  FILER

Indicate by check mark whether the registrant is a
shell company (as defined in Rule12b-2 of the Exchange act).

oYESxNO

As of July 31, 2006, 9,623,772 shares of .01 par
value Common Stock of the registrant were outstanding.

---



HAUPPAUGE
DIGITAL, INC. AND SUBSIDIARIES

INDEX

|                                                                                                                                               |  |         
|---------------------------------------------------------------------------------------------------------------------------------------------- |  | --------
|                                                                                                                                               |  | Page no.
|                                                                                                                                               |  |         
|PART I. FINANCIAL
  INFORMATION                                                                                                                |  |         
|                                                                                                                                               |  |         
|Item 1. Financial Statements                                                                                                                   |  |         
|                                                                                                                                               |  |         
|Condensed Consolidated Balance Sheets  June 30, 2006
  (unaudited) and September 30, 2005                                                     |  | 3       
|                                                                                                                                               |  |         
|Condensed Consolidated Statements of Income - Three Months ended
  June 30, 2006 (unaudited) and 2005 (unaudited)                              |  | 4       
|                                                                                                                                               |  |         
|Condensed Consolidated Statements of Income - Nine months ended
  June 30, 2006 (unaudited) and 2005 (unaudited)                               |  | 5       
|                                                                                                                                               |  |         
|Condensed Consolidated Statements of Other Comprehensive Income
  - Three and nine months ended June 30, 2006 (unaudited) and 2005 (unaudited) |  | 6       
|                                                                                                                                               |  |         
|Condensed Consolidated Statements of Cash Flows - Nine Months
  ended June 30 , 2006 (unaudited) and 2005 (unaudited)                          |  | 7       
|                                                                                                                                               |  |         
|Notes to Condensed Consolidated Financial Statements                                                                                           |  | 8-14    
|                                                                                                                                               |  |         
|Item 2. Managements Discussion and Analysis of Financial
  Condition and Results of Operations                                                |  | 15-24   
|                                                                                                                                               |  |         
|Item 3. Quantitative and Qualitative Disclosures about Market
  Risk                                                                           |  | 24      
|                                                                                                                                               |  |         
|Item 4. Controls and Procedures                                                                                                                |  | 24      
|                                                                                                                                               |  |         
|PART II. OTHER INFORMATION                                                                                                                     |  |         
|                                                                                                                                               |  |         
|Item 2. Unregistered Sales of Equity Securities and Use of Proceeds                                                                            |  | 26      
|                                                                                                                                               |  |         
|Item 6. Exhibits                                                                                                                               |  | 26      
|                                                                                                                                               |  |         
|Signatures                                                                                                                                     |  | 27      

2

---



PART
I. FINANCIAL INFORMATION

Item 1. Financial Statements

HAUPPAUGE
DIGITAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

|                                                                                                            |  |                             |            |                      |   |            |  
|----------------------------------------------------------------------------------------------------------- |  | --------------------------- | ---------- | -------------------- | - | ---------- | -
|                                                                                                            |  | June 30, 2006
  (unaudited) |            | September 30,
  2005 |  
|                                                                                                            |  |                             |           
|Assets:                                                                                                     |  |                             |            |                      |   |            |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Cash and cash
  equivalents                                                                                 |  | $                           | 7,339,775  |                      | $ | 7,567,393  |  
|Receivables,
  net of various allowances                                                                    |  |                             | 19,162,544 |                      |   | 13,048,076 |  
|Inventories                                                                                                 |  |                             | 12,661,114 |                      |   | 9,806,785  |  
|Prepaid
  expenses and other current assets                                                                 |  |                             | 920,508    |                      |   | 1,087,453  |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Total current assets                                                                                        |  |                             | 40,083,941 |                      |   | 31,509,707 |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Property,
  plant and equipment, net                                                                        |  |                             | 564,797    |                      |   | 525,108    |  
|Security
  deposits and other non current assets                                                            |  |                             | 83,239     |                      |   | 81,529     |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Total assets                                                                                                |  | $                           | 40,731,977 |                      | $ | 32,116,344 |  
|                                                                                                            |  |                             |            |                      |   |            |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Liabilities and Stockholders Equity :                                                                      |  |                             |            |                      |   |            |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Current Liabilities:                                                                                        |  |                             |            |                      |   |            |  
|Accounts
  payable                                                                                          |  | $                           | 16,681,672 |                      | $ | 10,750,560 |  
|Accrued
  expenses - fees                                                                                   |  |                             | 5,196,310  |                      |   | 4,126,506  |  
|Accrued
  expenses                                                                                          |  |                             | 849,938    |                      |   | 1,121,842  |  
|Income taxes
  payable                                                                                      |  |                             | 189,546    |                      |   | 175,944    |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Total current
  liabilities                                                                                 |  |                             | 22,917,466 |                      |   | 16,174,852 |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Stockholders
  Equity:                                                                                     |  |                             |            |                      |   |            |  
|                                                                                                           
|Common stock $.01 par value;
  25,000,000 shares authorized, 10,254,019 and 10,107,936 issued, respectively |  |                             | 102,541    |                      |   | 101,080    |  
|Additional
  paid-in capital                                                                                |  |                             | 14,107,060 |                      |   | 13,603,705 |  
|Retained
  earnings                                                                                         |  |                             | 5,670,580  |                      |   | 3,311,888  |  
|Accumulated
  other comprehensive (loss) income                                                             |  |                             | (307,719   | )                    |   | 682,770    |  
|Treasury
  Stock, at cost, 607,547 shares                                                                   |  |                             | (1,757,951 | )                    |   | (1,757,951 | )
|                                                                                                            |  |                             |            |                      |   |            |  
|Total
  stockholders equity                                                                                |  |                             | 17,814,511 |                      |   | 15,941,492 |  
|                                                                                                            |  |                             |            |                      |   |            |  
|Total
  liabilities and stockholders equity                                                                |  | $                           | 40,731,977 |                      | $ | 32,116,344 |  
|                                                                                                            |  |                             |            |                      |   |            |  

See accompanying
notes to condensed consolidated financial statements

3

---



HAUPPAUGE
DIGITAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

|                                             |  |                               |            |      |   |            | 
|-------------------------------------------- |  | ----------------------------- | ---------- | ---- | - | ---------- | 
|                                             |  | Three
  months ended June 30, |           
|                                             |  |                               |           
|                                             |  | 2006                          |            | 2005 |  
|                                             |  |                               |            |      |  
|                                             |  |                               |            |      |   |            | 
|Net sales                                    |  | $                             | 23,775,992 |      | $ | 19,372,783 | 
|Cost of sales                                |  |                               | 19,144,041 |      |   | 14,980,624 | 
|                                             |  |                               |            |      |   |            | 
|Gross profit                                 |  |                               | 4,631,951  |      |   | 4,392,159  | 
|                                             |  |                               |            |      |   |            | 
|Selling, general and administrative expenses |  |                               | 3,433,560  |      |   | 3,582,726  | 
|Research & development expenses              |  |                               | 747,973    |      |   | 655,588    | 
|                                             |  |                               |            |      |   |            | 
|Income from
  operations                     |  |                               | 450,418    |      |   | 153,845    | 
|                                             |  |                               |            |      |   |            | 
|Other income (expense):                      |  |                               |            |      |   |            | 
|Interest
  income                            |  |                               | 6,440      |      |   | 3,366      | 
|Foreign
  currency                           |  |                               | (17,146    | )    |   | 19,917     | 
|                                             |  |                               |            |      |   |            | 
|Other income (expense)                       |  |                               | (10,706    | )    |   | 23,283     | 
|                                             |  |                               |            |      |   |            | 
|Income before
  taxes on income              |  |                               | 439,712    |      |   | 177,128    | 
|Tax provision                                |  |                               | 59,371     |      |   | 17,156     | 
|                                             |  |                               |            |      |   |            | 
|Net income                                   |  | $                             | 380,341    |      | $ | 159,972    | 
|                                             |  |                               |            |      |   |            | 
|                                             |  |                               |            |      |   |            | 
|Net income per share:                        |  |                               |            |      |   |            | 
|Basic                                        |  | $                             | 0.04       |      | $ | 0.02       | 
|Diluted                                      |  | $                             | 0.04       |      | $ | 0.02       | 
|                                             |  |                               |            |      |   |            | 

See accompanying
notes to condensed consolidated financial statements

4

---



HAUPPAUGE
DIGITAL, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

|                                               |  |                              |            |      |   |            | 
|---------------------------------------------- |  | ---------------------------- | ---------- | ---- | - | ---------- | 
|                                               |  | Nine
  months ended June 30, |           
|                                               |  |                              |           
|                                               |  | 2006                         |            | 2005 |  
|                                               |  |                              |           
|                                               |  |                              |            |      |   |            | 
|Net sales                                      |  | $                            | 75,506,375 |      | $ | 63,095,518 | 
|Cost of sales                                  |  |                              | 60,461,107 |      |   | 48,572,102 | 
|                                               |  |                              |            |      |   |            | 
|Gross profit                                   |  |                              | 15,045,268 |      |   | 14,523,416 | 
|                                               |  |                              |            |      |   |            | 
|Selling,
  general and administrative expenses |  |                              | 10,272,747 |      |   | 10,336,596 | 
|Research
  & development expenses              |  |                              | 2,282,545  |      |   | 1,844,555  | 
|                                               |  |                              |            |      |   |            | 
|Income from
  operations                       |  |                              | 2,489,976  |      |   | 2,342,265  | 
|                                               |  |                              |            |      |   |            | 
|Other income
  (expense):                      |  |                              |            |      |   |            | 
|Interest
  income                              |  |                              | 17,921     |      |   | 15,699     | 
|Foreign
  currency                             |  |                              | (2,695     | )    |   | 11,317     | 
|                                               |  |                              |            |      |   |            | 
|Other income                                   |  |                              | 15,226     |      |   | 27,016     | 
|                                               |  |                              |            |      |   |            | 
|Income before
  taxes on income                |  |                              | 2,505,202  |      |   | 2,369,281  | 
|Tax provision                                  |  |                              | 146,510    |      |   | 118,156    | 
|                                               |  |                              |            |      |   |            | 
|Net income                                     |  | $                            | 2,358,692  |      | $ | 2,251,125  | 
|                                               |  |                              |            |      |   |            | 
|                                               |  |                              |            |      |   |            | 
|Net income
  per share:                        |  |                              |            |      |   |            | 
|Basic                                          |  | $                            | 0.25       |      | $ | 0.24       | 
|Diluted                                        |  | $                            | 0.24       |      | $ | 0.23       | 
|                                               |  |                              |            |      |   |            | 

See accompanying notes to condensed consolidated
financial statements

5

---



HAUPPAUGE
DIGITAL, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OTHER COMPREHENSIVE INCOME
(UNAUDITED)

|                                              |  |                               |         |      |   |          |  
|--------------------------------------------- |  | ----------------------------- | ------- | ---- | - | -------- | -
|                                              |  | Three
  months ended June 30, |        
|                                              |  |                               |        
|                                              |  | 2006                          |         | 2005 |  
|                                              |  |                               |        
|Net
  income                                  |  | $                             | 380,341 |      | $ | 159,972  |  
|Foreign
  currency translation (loss) gain    |  |                               | 120,891 |      |   | (528,645 | )
|Forward
  exchange contracts marked to market |  |                               | (48,792 | )    |   | 182,258  |  
|                                              |  |                               |         |      |   |          |  
|                                             
|Other
  comprehensive income                  |  | $                             | 452,440 |      | $ | (186,415 | )
|                                              |  |                               |         |      |   |          |  

|                                              |  |                              |           |      |   |           |  
|--------------------------------------------- |  | ---------------------------- | --------- | ---- | - | --------- | -
|                                              |  | Nine
  months ended June 30, |          
|                                              |  |                              |          
|                                              |  | 2006                         |           | 2005 |  
|                                              |  |                              |          
|Net
  income                                  |  | $                            | 2,358,692 |      | $ | 2,251,125 |  
|Foreign
  currency translation (loss)         |  |                              | (798,031  | )    |   | (181,845  | )
|Forward
  exchange contracts marked to market |  |                              | (192,458  | )    |   | 308,767   |  
|                                              |  |                              |           |      |   |           |  
|                                             
|Other
  comprehensive income                  |  | $                            | 1,368,203 |      | $ | 2,378,047 |  
|                                              |  |                              |           |      |   |           |  

See
accompanying notes to condensed consolidated financial statements

6

---



HAUPPAUGE
DIGITAL, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

|                                                                                |  |                              |            |      |   |            |  
|------------------------------------------------------------------------------- |  | ---------------------------- | ---------- | ---- | - | ---------- | -
|                                                                                |  | Nine months
  ended June 30, |           
|                                                                                |  |                              |           
|                                                                                |  | 2006                         |            | 2005 |  
|                                                                                |  |                              |            |      |  
|Net income                                                                      |  | $                            | 2,358,692  |      | $ | 2,251,125  |  
|                                                                                |  |                              |            |      |   |            |  
|Adjustments
  to reconcile net income to net cash used in operating activities: |  |                              |            |      |   |            |  
|Depreciation
  and amortization                                                 |  |                              | 136,780    |      |   | 163,362    |  
|Stock
  compensation expense                                                    |  |                              | 274,770    |      |   |           |  
|Other non
  cash items                                                          |  |                              | (1,710     | )    |   | (2,399     | )
|Changes in
  current assets and liabilities:                                    |  |                              |            |      |   |            |  
|Accounts
  receivable                                                           |  |                              | (6,114,468 | )    |   | 848,289    |  
|Inventories                                                                     |  |                              | (2,854,329 | )    |   | (3,106,657 | )
|Prepaid
  expenses and other current assets                                     |  |                              | 166,945    |      |   | (478,308   | )
|Accounts
  payable                                                              |  |                              | 5,931,112  |      |   | (1,899,975 | )
|Accrued
  expenses and other current liabilities                                |  |                              | 811,502    |      |   | 609,275    |  
|                                                                                |  |                              |            |      |   |            |  
|Total
  adjustments                                                             |  |                              | (1,649,398 | )    |   | (3,866,412 | )
|                                                                                |  |                              |            |      |   |            |  
|Net cash
  provided by (used in) operating activities                           |  |                              | 709,294    |      |   | (1,615,288 | )
|                                                                                |  |                              |            |      |   |            |  
|                                                                                |  |                              |            |      |   |            |  
|Cash Flows
  From Investing Activities:                                         |  |                              |            |      |   |            |  
|Purchases of
  property, plant and equipment                                    |  |                              | (176,469   | )    |   | (228,557   | )
|                                                                                |  |                              |            |      |   |            |  
|Net cash used
  in investing activities                                         |  |                              | (176,469   | )    |   | (228,557   | )
|                                                                                |  |                              |            |      |   |            |  
|                                                                                |  |                              |            |      |   |            |  
|Cash Flows
  From Financing Activities:                                         |  |                              |            |      |   |            |  
|Proceeds:
  exercise of stock options and employee stock purchases              |  |                              | 230,046    |      |   | 676,538    |  
|Purchase of
  treasury stock                                                    |  |                              |           |      |   | (172,589   | )
|                                                                                |  |                              |            |      |   |            |  
|Net cash
  provided by financing activities                                     |  |                              | 230,046    |      |   | 503,949    |  
|                                                                                |  |                              |            |      |   |            |  
|Effect of
  exchange rates on cash                                              |  |                              | (990,489   | )    |   | 126,922    |  
|Net decrease
  in cash and cash equivalents                                     |  |                              | (227,618   | )    |   | (1,212,974 | )
|Cash and cash
  equivalents, beginning of period                                |  |                              | 7,567,393  |      |   | 8,661,589  |  
|                                                                                |  |                              |            |      |   |            |  
|Cash and cash
  equivalents, end of period                                      |  | $                            | 7,339,775  |      | $ | 7,448,615  |  
|                                                                                |  |                              |            |      |   |            |  
|Supplemental
  disclosures:                                                     |  |                              |            |      |   |            |  
|Income taxes
  paid                                                             |  | $                            | 94,421     |      | $ | 171,027    |  
|                                                                                |  |                              |            |      |   |            |  

See
accompanying notes to condensed consolidated financial statements

7

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HAUPPAUGE
DIGITAL, INC. AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Note 1.
Basis of Presentation

The accompanying unaudited condensed consolidated
financial statements included herein have been prepared in accordance with
generally accepted accounting principles for interim period reporting in
conjunction with the instructions to Form 10-Q. Accordingly, these statements
do not include all of the information required by generally accepted accounting
principles for annual financial statements. In the opinion of management, all
known adjustments (consisting of normal recurring accruals and reserves)
necessary to present fairly the Companys consolidated financial position,
results of operations and cash flows as of and for the interim periods have
been included. It is suggested that these interim statements be read in
conjunction with the financial statements and related notes included in the
Companys September 30, 2005 Form 10-K.

The operating results for the three months and nine
months ended June 30, 2006 are not necessarily indicative of the results to be
expected for the September 30, 2006 year end.

Certain reclassifications have been made to the prior
condensed consolidated financial statements to conform to the current
presentation.

Note 2.
Receivables

Accounts and other receivables as of June 30, 2006 and
September 30, 2005 consisted of :

|                                       |  |          |            |               |   |            |  
|-------------------------------------- |  | -------- | ---------- | ------------- | - | ---------- | -
|                                       |  | June 30, |            | September 30, |  
|                                       |  | 2006     |            | 2005          |  
|                                       |  |          |            |               |  
|Trade receivables                      |  | $        | 16,261,826 |               | $ | 10,186,232 |  
|Receivable from contract manufacturers |  |          | 5,301,705  |               |   | 5,491,524  |  
|GST and VAT taxes receivables          |  |          | 807,795    |               |   | 567,820    |  
|Allowances and reserves                |  |          | (3,257,000 | )             |   | (3,257,000 | )
|Other                                  |  |          | 48,218     |               |   | 59,500     |  
|                                       |  |          |            |               |   |            |  
|                                       |  | $        | 19,162,544 |               | $ | 13,048,076 |  
|                                       |  |          |            |               |   |            |  

Note 3.
Derivative Financial Instruments

As of June 30, 2006, the Company had foreign currency
contracts outstanding of approximately $5,588,270 against the delivery of the
Euro. The contracts expire from July 2006 through October 2006. The Companys
accounting policies for these instruments designate such instruments as cash
flow hedging transactions. The Company does not enter into such contracts for speculative
purposes. The Company records all derivative gains and losses on the balance
sheet as a component of stockholders equity under the caption Accumulated
other comprehensive income (loss). The Company recorded a loss of $192,458 for
the nine months ended June 30, 2006 on its statement of other comprehensive
income. As of June 30, 2006, a deferred loss of $56,040, reflecting the
cumulative mark to market losses of the Companys derivatives, was recorded on
the Companys balance sheet as a component of accumulated other comprehensive
income (loss) in our equity section.

Beginning with the Companys third fiscal quarter
ended June 30, 2006, the Company began using the average prevailing spot rate
to translate Euro denominated sales into the Companys U.S. dollar denominated
sales. Prior to this, the Company used the average monthly forward contract
exchange rate to translate our Euro

8

---



denominated sales into the Companys U.S. dollar
reporting currency. The change in this accounting treatment did not have a
material effect on the Companys financial statements.

Note 4.
Inventories

Inventories have been valued at the lower of average
cost or market on a first in first out basis. The components of inventory
consist of:

|                 |  |              |            |                     |   |           | 
|---------------- |  | ------------ | ---------- | ------------------- | - | --------- | 
|                 |  | June 30,2006 |            | September
  30,2005 |  
|                 |  |              |            |                     |  
|Component Parts  |  | $            | 6,430,757  |                     | $ | 4,131,732 | 
|Finished
  Goods |  |              | 6,230,357  |                     |   | 5,675,053 | 
|                 |  |              |            |                     |   |           | 
|                 |  | $            | 12,661,114 |                     | $ | 9,806,785 | 
|                 |  |              |            |                     |   |           | 

Note 5.
Net Income Per Share

Basic net income per share includes no dilution and is
computed by dividing net income by the weighted average number of shares of
common stock outstanding for the period. Diluted net income per share reflects,
in the periods in which they have a dilutive effect, the dilution which would
occur upon the exercise of stock options. A reconciliation of the shares used
in calculating basic and diluted net income per share is as follows:

|                                                                   |  |                                 |            |                                |  |           |  |      |            |  |  |           | 
|------------------------------------------------------------------ |  | ------------------------------- | ---------- | ------------------------------ |  | --------- |  | ---- | ---------- |  |  | --------- | 
|                                                                   |  | Three
  Months Ended
  June 30, |            | Nine months
  Ended
  June 30, | 
|                                                                   |  | 2006                            |            | 2005                           |  | 2006      |  | 2005 |           
|                                                                   |  |                                 |            |                                |  |           |  |      |           
|Weighted
  average shares outstanding-basic                        |  |                                 | 9,636,912  |                                |  | 9,489,843 |  |      | 9,573,594  |  |  | 9,408,827 | 
|Number of
  shares issued on the assumed exercise of stock options |  |                                 | 420,567    |                                |  | 477,669   |  |      | 430,385    |  |  | 581,228   | 
|                                                                   |  |                                 |            |                                |  |           |  |      |            |  |  |           | 
|Weighted
  average shares outstanding-diluted                      |  |                                 | 10,057,479 |                                |  | 9,967,512 |  |      | 10,003,979 |  |  | 9,990,055 | 
|                                                                   |  |                                 |            |                                |  |           |  |      |            |  |  |           | 

Options to purchase 223,204 and 174,122 shares of
common stock, at prices ranging $4.13 to $ 8.75 and $3.88 to $10.06, were
outstanding for the three months ended June 30, 2006 and 2005, respectively,
but were not included in the computation of diluted earnings per share because
they were anti-dilutive.

Options to purchase 208,391 and 112,026 shares of
common stock, at prices ranging $4.13 to $ 8.75 and $4.62 to $10.06, were
outstanding for the nine months ended June 30, 2006 and 2005, respectively, but
were not included in the computation of diluted earnings per share because they
were anti-dilutive.

Note 6. Accumulated other comprehensive income

As of June 30, 2006, appearing in the equity section
under Accumulated other comprehensive income (loss) was a loss of $307,719,
which consisted of a deferred translation loss of $251,679 and a deferred loss
of $56,040 due to the mark to market losses on the difference between the value
of the Companys open forward exchange contracts at the contract rates versus
the same contracts valued at the period ending forward rate.

Accumulated other comprehensive income (loss) consists
of two components: translation gains and losses and FAS 133 mark to market
gains and losses on our open foreign exchange contracts. The table below
details the gains and losses that make up the accumulated other comprehensive
loss of $307,719 recorded on our balance sheet as of June 30, 2006:

9

---



|                                                |  |                 |         |                     |   |                 |   |   |          |  
|----------------------------------------------- |  | --------------- | ------- | ------------------- | - | --------------- | - | - | -------- | -
|Accumulated Other Comprehensive
  Income (Loss) |  | Balance as
  of |         | Oct 05 to
  June 06 |   | Balance as
  of |  
|Fiscal 2006 activity                            |  | Sept 30 2005    |         | (losses)            |   | June 30 2006    |  
|                                                |  |                 |         |                     |   |                 |  
|Translation gains and losses                    |  | $               | 546,352 |                     | $ | (798,031        | ) | $ | (251,679 | )
|FAS 133 mark to market adjustment               |  |                 | 136,418 |                     |   | (192,458        | ) |   | (56,040  | )
|                                                |  |                 |         |                     |   |                 |   |   |          |  
|                                                |  | $               | 682,770 |                     | $ | (990,489        | ) | $ | (307,719 | )
|                                                |  |                 |         |                     |   |                 |   |   |          |  

Note 7.
Revenue Recognition

The Company sells through a sales channel which
consists of retailers, distributors and original equipment manufacturers
(OEMs). The Companys prices are fixed consistently over the entire sales
channel. The majority of the Companys customers are granted lines of credit.
The product is shipped on open account with the majority of the Companys
customers given 30 to 45 day payment terms. Those customers deemed as large
credit risks either pay in advance or issue us a letter of credit.

The Company requires the customer to submit a purchase
order to the Company. The price of the product and payment terms are fixed per
the terms of the purchase order. Upon shipment of the order to the customer,
the title to the goods is passed to the customer. The customer is legally
obligated to pay for the order within the payment terms stated on the
customers purchase order. The obligation to insure the products and the cost
of any pilferage while in the customers possession is the responsibility of
the customer. The Company sells analog, hybrid video recorders and digital
computer boards that are stocked on the shelves of retailers, and are subject
to the normal consumer traffic that retail stores attract. Aside from normal
store promotions such as end-caps and advertisements in the stores circular,
the Company has no further obligation to assist in the resale of the product.

The Company offers its customers a right of return.
The Companys accounting method complies with Statement of Financial Accounting
Standards No. 48, Revenue Recognition when Right of Return Exists as typically
at the end of every quarter the Company, based on historical data, evaluates its
sales reserve level based on the previous six months sales. Due to seasonal
nature of the business coupled with the changing economic environment,
management exercises some judgment with regard to the historical data to arrive
at the reserve.

Note 8.
Product segment and Geographic Information

The Company operates in one business segment, which is
the development, marketing and manufacturing of analog and digital TV receiver
products for the personal computer market. The products are similar in function
and share commonality of component parts and manufacturing processes. The
Companys products are either sold, or can be sold, by the same retailers and
distributors in our marketing channel. The Company also sells product directly
to OEM customers. The Company evaluates its product lines under the functional
categories of analog and digital products. Sales by functional category are as
follows:

|                   |  |                             |            |                            |   |            |  |      |            |  |   |            | 
|------------------ |  | --------------------------- | ---------- | -------------------------- | - | ---------- |  | ---- | ---------- |  | - | ---------- | 
|                   |  | Three months ended June 30, |            | Nine months ended June 30, |  
|                   |  | 2006                        |            | 2005                       |   | 2006       |  | 2005 |           
|                   |  |                             |            |                            |   |            |  |      |           
|Product line sales |  |                             |            |                            |   |            |  |      |            |  |   |            | 
|Analog sales       |  | $                           | 16,377,894 |                            | $ | 15,440,513 |  | $    | 51,325,967 |  | $ | 50,219,062 | 
|Digital sales      |  |                             | 7,398,098  |                            |   | 3,932,270  |  |      | 24,180,408 |  |   | 12,876,456 | 
|                   |  |                             |            |                            |   |            |  |      |            |  |   |            | 
|                   |  | $                           | 23,775,992 |                            | $ | 19,372,783 |  | $    | 75,506,375 |  | $ | 63,095,518 | 
|                   |  |                             |            |                            |   |            |  |      |            |  |   |            | 

The Company sells its products through an
international network of distributors and retailers. Sales percent by
geographic region are as follows:

10

---



|                                   |  |                             |  |                            |   |      |  |      |   |  |  |     |   |  |  |     |  
|---------------------------------- |  | --------------------------- |  | -------------------------- | - | ---- |  | ---- | - |  |  | --- | - |  |  | --- | -
|                                   |  | Three months ended June 30, |  | Nine months ended June 30, |  
|Sales percent by geographic region |  | 2006                        |  | 2005                       |   | 2006 |  | 2005 |  
|                                   |  |                             |  |                            |   |      |  |      |  
|United States                      |  |                             |  | 50                         | % |      |  | 51   | % |  |  | 47  | % |  |  | 46  | %
|Europe                             |  |                             |  | 47                         | % |      |  | 45   | % |  |  | 51  | % |  |  | 52  | %
|Asia                               |  |                             |  | 3                          | % |      |  | 4    | % |  |  | 2   | % |  |  | 2   | %
|                                   |  |                             |  |                            |   |      |  |      |   |  |  |     |   |  |  |     |  
|Total                              |  |                             |  | 100                        | % |      |  | 100  | % |  |  | 100 | % |  |  | 100 | %
|                                   |  |                             |  |                            |   |      |  |      |   |  |  |     |   |  |  |     |  

Note 9.
Stock-Based Compensation

Prior to October 1, 2005, the Company accounted for employee
stock option plans based on the intrinsic value method in accordance with
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related
Interpretations and had adopted the disclosure requirements of SFAS No. 123, Accounting for Stock-Based
Compensation
(SFAS No.123). Accordingly, compensation cost for stock options was measured as
the excess, if any, of the quoted market price of the Companys stock at the
grant date over the amount an employee must pay to acquire the stock. The
Company granted stock options with exercise prices equal to the market price of
the underlying stock on the date of grant, therefore, the Company did not
record stock-based compensation expense under APB Opinion No. 25.

Effective October 1, 2005, the Company adopted SFAS
No. 123R, Share-Based Payments using the modified prospective method, which
requires measurement of compensation cost for all stock-based awards at fair
value on date of grant and recognition of compensation over the service period
for awards expected to vest. Therefore, prior period financial statements have
not been restated. The fair value of stock options were determined using the
Black-Scholes valuation model, which is consistent with our valuation techniques
previously utilized for stock options in footnote disclosures required under
SFAS No. 123. Such fair value is recognized as expense over the service period,
net of estimated forfeitures. The adoption of SFAS No.123R resulted in an
immaterial cumulative change in accounting as of the date of adoption.

The Company had as of June 30, 2006 options issued
from four incentive option plans and one non qualified option plan. These
options typically vest over a period of four to five years. Options granted
subsequent to the Companys October 1, 2005 adoption of SFAS 123R, have a
contract term of 10 years and the fair value for these options was estimated at
the date of grant using a Black-Scholes option pricing model with the following
weighted average assumptions based on historical data of the Companys stock:

| |   |                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------
| |  | Risk free interest rate-4.25%                                                                                                       
| |   |                                                                                                                                     
| |  | Expected volatility-50%                                                                                                             
| |   |                                                                                                                                     
| |  | Expected dividend yield-0%                                                                                                          
| |   |                                                                                                                                     
| |  | Weighted average expected life-5 to7 years,
  determined via the simplified method detailed in Staff Accounting Bulletin
  No. 107

11

---



Stock option activity for the nine months ended June
30, 2006 is as follows:

|                                        |  |         |           |                                     |   |                                                      |  |                               |      |  |   |           | 
|--------------------------------------- |  | ------- | --------- | ----------------------------------- | - | ---------------------------------------------------- |  | ----------------------------- | ---- |  | - | --------- | 
|                                        |  | Options |           | Weighted
  average
  exercise price |   | Weighted average
  remaining contract
  term (years) |  | Aggregate
  intrinsic
  Value |     
|                                        |  |         |           |                                     |   |                                                      |  |                               |     
|Outstanding as of October 1, 2005       |  |         | 1,427,094 |                                     | $ | 3.12                                                 |  |                               |      |  |   |           | 
|Options granted                         |  |         | 146,000   |                                     |   | 3.32                                                 |  |                               |      |  |   |           | 
|Options exercised                       |  |         | (105,397  | )                                   |   | 1.56                                                 |  |                               |      |  |   |           | 
|Options forfeited                       |  |         | (13,253   | )                                   |   | 1.46                                                 |  |                               |     |  |   |          | 
|                                        |  |         |           |                                     |   |                                                      |  |                               |      |  |   |           | 
|                                        | 
|Options outstanding as of June 30, 2006 |  |         | 1,454,444 |                                     | $ | 3.27                                                 |  |                               | 4.48 |  | $ | 4,757,290 | 
|                                        |  |         |           |                                     |   |                                                      |  |                               |      |  |   |           | 
|Options exercisable as of June 30, 2006 |  |         | 1,000,304 |                                     | $ | 2.80                                                 |  |                               | 3.97 |  | $ | 2,797,754 | 
|                                        |  |         |           |                                     |   |                                                      |  |                               |      |  |   |           | 

For the non vested options outstanding that were
granted prior to the Companys October 1, 2005 adoption of SFAS 123R, the fair
value for these options was estimated using a Black-Scholes option pricing
model on the date of grant. Options granted prior to October 1, 2005 were
accounted for based on the intrinsic value method in accordance with Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related
Interpretations. Additionally, the Company had adopted the disclosure
requirements of SFAS No. 123, Accounting
for Stock-Based Compensation (SFAS No.123).

Presented in the table below
are the options granted, weighted average fair value using a Black Sholes
pricing model and total compensation charges, net of estimated forfeitures.

|                                                            |  |                   |         |                                          |   |                       |  |   |           | 
|----------------------------------------------------------- |  | ----------------- | ------- | ---------------------------------------- | - | --------------------- |  | - | --------- | 
|                                                            |  | Options
  Granted |         | Weighted Average
  Black Scholes
  Value |   | Compensation
  Charge | 
|                                                            |  |                   |         |                                          |   |                       | 
|Options
  granted subsequent to adoption of SFAS 123R       |  |                   | 146,000 |                                          | $ | 2.1505                |  | $ | 313,975   | 
|Non vested
  options granted prior to adoption of SFAS 123R |  |                   | 393,690 |                                          |   | 1.8412                |  |   | 724,874   | 
|                                                            |  |                   |         |                                          |   |                       |  |   |           | 
|                                                            | 
|Total                                                       |  |                   | 539,690 |                                          | $ | 1.9249                |  | $ | 1,038,849 | 
|                                                            |  |                   |         |                                          |   |                       |  |   |           | 

Unrecognized stock
compensation charges, weighted average stock compensation amortization and
stock compensation expenses charged to operations for the quarter and nine
months ended June 30, 2006 are as follows:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | $1,038,849 of total unrecognized compensation cost,
  net of estimated forfeitures, related to non-vested share-based compensation
  arrangements and options granted subsequent to the October 1, 2005 adoption
  of SFAS 123R, was outstanding prior to the recognition of $274,770 of
  compensation charges in the nine months ended June 30, 2006                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Compensation cost is expected to be recognized over
  a weighted-average period of 3.50 years                                                                                                                                                                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Compensation costs charged to operations for the
  third quarter ended June 30, 2006 was $86,946, consisting of $20,945 for
  options granted during fiscal 2006 and $66,001 for non vested options granted prior to
  October 1, 2005. These costs have been recorded in SG&A and R&D
  expense. Expensing stock compensation costs against operations resulted in a
  $0.01 reduction in basic and diluted net income per share for the quarter
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Compensation costs charged to operations for the
  nine months ended June 30, 2006 was $274,770, consisting of $62,835 for
  options granted during fiscal 2006 and $211,935 for non vested options granted prior to
  October 1, 2005. These costs have been recorded in SG&A and R&D
  expense.                                                                                                                                                

12

---



| |  |                                                                                                                                                                          
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Expensing stock
  compensation costs against operations resulted in a $0.03 reduction in basic
  and diluted net income per share for the nine months ended June 30, 2006

In recognition that stock compensation is a non-cash
expense, the effect of expensing options had no affect on the Companys cash
flow. However, it was reflected in the Companys cash flow statement as a
non-cash add back in the determination of cash flows from operating activities.

A summary of our non-vested shares as of June 30, 2006
and changes during the nine months ended June 30, 2006 is presented below:

|                                   |  |        |         |                                            |   |      | 
|---------------------------------- |  | ------ | ------- | ------------------------------------------ | - | ---- | 
|                                   |  | Shares |         | Weighted average
  Grant date
  fair value |  
|                                   |  |        |         |                                            |  
|Non-vested
  as of October 1, 2005 |  |        | 393,690 |                                            | $ | 1.84 | 
|Granted                            |  |        | 146,000 |                                            |   | 2.15 | 
|Vested                             |  |        | (80,550 | )                                          |   | 0.63 | 
|Forfeited                          |  |        | (5,000  | )                                          |   | 0.43 | 
|                                   |  |        |         |                                            |   |      | 
|                                   | 
|Non-vested
  as of June 30, 2006   |  |        | 454,140 |                                            | $ | 2.16 | 
|                                   |  |        |         |                                            |   |      | 

The following table illustrates the effect on net
income and net income per share for the three and nine months ended June 30,
2005 as if the Company has consistently measured the compensation cost for the
Companys stock option programs under the fair value method adopted on October
1, 2005:

|                                                                                                                     |  |                                    |         |                                   |   |           |  
|-------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------- | ------- | --------------------------------- | - | --------- | -
|                                                                                                                     |  | Three months ended
  June 30, 2005 |         | Nine months ended
  June 30, 2005 |  
|Net income
  as reported                                                                                             |  | $                                  | 159,972 |                                   | $ | 2,251,125 |  
|Deduct:
  Total stock-based employee compensation expense determined under fair value
  method, net of related taxes |  |                                    | (8,924  | )                                 |   | (26,772   | )
|Pro forma
  net income                                                                                               |  | $                                  | 151,048 |                                   | $ | 2,224,353 |  
|                                                                                                                     |  |                                    |         |                                   |   |           |  
|Net income
  per share - as reported:                                                                                |  |                                    |         |                                   |   |           |  
|Basic                                                                                                                |  | $                                  | 0.02    |                                   | $ | 0.24      |  
|Diluted                                                                                                              |  | $                                  | 0.02    |                                   | $ | 0.23      |  
|Net income
  per share - pro forma:                                                                                  |  |                                    |         |                                   |   |           |  
|Basic                                                                                                                |  | $                                  | 0.02    |                                   | $ | 0.23      |  
|Diluted                                                                                                              |  | $                                  | 0.02    |                                   | $ | 0.22      |  

Note 10.
Arrangements with Off-Balance Sheet Risk - Guarantees

The Company occupies a facility located in Hauppauge New York
  which is used for its executive offices and for the testing, storage and shipping
  of the Companys products. Hauppauge Computer Works, Inc. ("HCW"),
  a wholly owned subsidiary of Hauppauge Digital Inc., leases this facility from
  Ladokk Realty, LLC, ("LADOKK") the members of which are Kenneth Plotkin,
  the Companys Chairman of the Board, Chief Executive Officer, President,
  Chief Operating Officer and Vice President of Marketing, Director and the holder
  of approximately 8.6% of the Companys Common Stock as of June 30, 2006,
  Dorothy Plotkin, the wife of Kenneth Plotkin and holder of approximately 5.8%
  of the Companys Common Stock as of June 30, 2006, and Laura Aupperle,
  believed by the Company to be the holder of approximately 10.4% of the Companys
  Common Stock, including Common Stock attributed to the Estate of Kenneth R.
  Aupperle.

13

---



On February 17, 2004, HCW entered into a new lease agreement with
  Ladokk (the 2004 Lease). The 2004 Lease is for five years and terminates
  on February 16, 2009. Annual rent under the 2004 Lease is $360,000, payable
  monthly. Concurrently with the new lease, Ladokk completed a refinancing of
  its mortgages, and the new lender did not require HCW to sign a guarantee. Accordingly,
  the Company no longer guarantees the landlords mortgages. The 2004 Lease
  replaced the 1990 Lease between HCW and Ladokk Realty Co., to which Ladokk is
  the successor, was due to expire on January 31, 2006 (the 1990 lease).
  The execution of the 2004 Lease provided an annual reduction in rent of nearly
  $100,000 compared to the 1990 lease and released the Company from its guarantee
  of the mortgages of the landlord.

The Audit Committee, under applicable laws, rules and regulations,
is required to review and approve the 2004 Lease because the landlord is
affiliated with (although not under the exclusive control of) the Companys
Chief Executive Officer. Shortly following the execution and delivery of the
2004 Lease, the Audit Committee engaged the services of an independent law firm
and an independent real estate appraiser to ascertain if the 2004 Lease was
within the current market range in our geographic area for the building the
Company occupies.

The real estate appraiser determined that the rent
provided in the 2004 Lease was somewhat above market value without giving
effect to, among other things, the costs and potential disruption of the
Companys operations that would be associated with any move to a new facility.
The Company and the landlord are negotiating the terms of a new lease to
replace the 2004 Lease. Although there can be no assurances, the Companys
expectation is that the 2004 Lease will be replaced with such new lease before
the end of our fiscal fourth quarter.

Note 11.
Recent Accounting Prouncements

On July 13, 2006, FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes -
An Interpretation of FASB Statement No. 109,
was issued. FIN 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprises financial statements in accordance with FASB
Statement No. 109, Accounting for
Income Taxes. FIN 48 also prescribes a recognition threshold and
measurement attribute for the financial statement recognition and measurement
of a tax position taken or expected to be taken in a tax return. The new FASB
standard also provides guidance on de-recognition, classification, interest and
penalties, accounting in interim periods, disclosure, and transition.

14

---



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
THREE MONTH PERIOD ENDED JUNE 30, 2006 COMPARED TO
JUNE 30, 2005

Results of operations for the three months ended June
30, 2006 compared to June 30, 2005 are as follows:

|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |   | 
|----------------------------------------------------- |  | ------------------------ | ---------- | ------------------------- | --------------------- | ---------- | - | ---- | --------- | ---------- |  | ------ | - |  | ------ | - |  |  | ----- | - | 
|                                                      |  | Three MonthsEnded6/30/06 |            | Three Months
Ended6/30/05 |                       |            |  
|                                                      |  |                          |            |                           | Percentage
  of sales |           
|                                                      |  |                          |            | Variance $                |                       | 2006       |   | 2005 |           | Variance % | 
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |  
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |  
|Net
  sales                                           |  | $                        | 23,775,992 |                           | $                     | 19,372,783 |   | $    | 4,403,209 |            |  | 100.00 | % |  | 100.00 | % |  |  |      |  
|Cost
  of sales                                       |  |                          | 19,144,041 |                           |                       | 14,980,624 |   |      | 4,163,417 |            |  | 80.52  | % |  | 77.33  | % |  |  | 3.19  | %
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |   | 
|Gross
  profit                                        |  |                          | 4,631,951  |                           |                       | 4,392,159  |   |      | 239,792   |            |  | 19.48  | % |  | 22.67  | % |  |  | -3.19 | %
|Gross
  profit %                                      |  |                          | 19.48      | %                         |                       | 22.67      | % |      | -3.19     | %          |  |        |   |  |        |   |  |  |       |   | 
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |   | 
|Expenses:                                             |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |  
|Sales
  & marketing                                   |  |                          | 2,320,786  |                           |                       | 2,606,705  |   |      | (285,919  | )          |  | 9.76   | % |  | 13.46  | % |  |  | -3.70 | %
|Technical
  support                                   |  |                          | 143,989    |                           |                       | 129,738    |   |      | 14,251    |            |  | 0.60   | % |  | 0.67   | % |  |  | -0.07 | %
|General
  & administrative                            |  |                          | 910,966    |                           |                       | 846,283    |   |      | 64,683    |            |  | 3.83   | % |  | 4.37   | % |  |  | -0.54 | %
|SG&A
  stock compensation expense                     |  |                          | 57,819     |                           |                       |           |   |      | 57,819    |            |  | 0.25   | % |  | 0.00   | % |  |  | 0.25  | %
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |  
|Total selling, general and
  administrative expenses  |  |                          | 3,433,560  |                           |                       | 3,582,726  |   |      | (149,166  | )          |  | 14.44  | % |  | 18.50  | % |  |  | -4.06 | %
|Research
  & development                              |  |                          | 718,846    |                           |                       | 655,588    |   |      | 63,258    |            |  | 3.02   | % |  | 3.38   | % |  |  | -0.36 | %
|Research and development stock
  compensation expense |  |                          | 29,127     |                           |                       |           |   |      | 29,127    |            |  | 0.12   | % |  | 0.00   | % |  |  | 0.12  | %
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |   | 
|Total
  operating expenses                            |  |                          | 4,181,533  |                           |                       | 4,238,314  |   |      | (56,781   | )          |  | 17.58  | % |  | 21.88  | % |  |  | -4.30 | %
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |   | 
|Net operating income                                  |  |                          | 450,418    |                           |                       | 153,845    |   |      | 296,573   |            |  | 1.90   | % |  | 0.79   | % |  |  | 1.11  | %
|Other
  income (expense)                              |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |   | 
|Interest
  income                                     |  |                          | 6,440      |                           |                       | 3,366      |   |      | 3,074     |            |  | 0.03   | % |  | 0.02   | % |  |  | 0.01  | %
|Foreign
  currency                                    |  |                          | (17,146    | )                         |                       | 19,917     |   |      | (37,063   | )          |  | -0.07  | % |  | 0.10   | % |  |  | -0.17 | %
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |  
|Total other income (expense)                          |  |                          | (10,706    | )                         |                       | 23,283     |   |      | (33,989   | )          |  | -0.04  | % |  | 0.12   | % |  |  | -0.16 | %
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |  
|Income
  before taxes                                 |  |                          | 439,712    |                           |                       | 177,128    |   |      | 262,584   |            |  | 1.86   | % |  | 0.91   | % |  |  | 0.95  | %
|Taxes
  on income                                     |  |                          | 59,371     |                           |                       | 17,156     |   |      | 42,215    |            |  | 0.25   | % |  | 0.09   | % |  |  | 0.16  | %
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |  
|Net
  income                                          |  | $                        | 380,341    |                           | $                     | 159,972    |   | $    | 220,369   |            |  | 1.61   | % |  | 0.82   | % |  |  | 0.79  | %
|                                                      |  |                          |            |                           |                       |            |   |      |           |            |  |        |   |  |        |   |  |  |       |  

15

---



Net sales for the three months ended June 30, 2006
increased $4,403,209 over the three months ended June 30, 2005 as shown in the
table below.

|         |  |                              |            |                              |   |                                   |  |      |           |   |                                |  |                     |    |   |  |     |   |  |     |  
|-------- |  | ---------------------------- | ---------- | ---------------------------- | - | --------------------------------- |  | ---- | --------- | - | ------------------------------ |  | ------------------- | -- | - |  | --- | - |  | --- | -
|         |  |                              |            |                              |   |                                   |  |      |           |   | Increase (Decrease) Variance % |  | Sales by Geographic |   
|         |  | Three Months Ended
  6/30/06 |            | Three Months Ended
  6/30/05 |   | Increase (Decrease)DollarVariance |  |      | region    |  
|Location |  |                              |            |                              |   | 2006                              |  | 2005 |          
|         |  |                              |            |                              |   |                                   |  |      |           |   |                                |  |                     |    |   |  |     |   |  |     |  
|Domestic |  | $                            | 11,795,292 |                              | $ | 9,925,638                         |  | $    | 1,869,654 |   |                                |  |                     | 19 | % |  | 50  | % |  | 51  | %
|Europe   |  |                              | 11,344,867 |                              |   | 8,750,299                         |  |      | 2,594,568 |   |                                |  |                     | 30 | % |  | 47  | % |  | 45  | %
|Asia     |  |                              | 635,833    |                              |   | 696,846                           |  |      | (61,013   | ) |                                |  |                     | -9 | % |  | 3   | % |  | 4   | %
|         |  |                              |            |                              |   |                                   |  |      |           |   |                                |  |                     |    |   |  |     |   |  |     |  
|Total    |  | $                            | 23,775,992 |                              | $ | 19,372,783                        |  | $    | 4,403,209 |   |                                |  |                     | 23 | % |  | 100 | % |  | 100 | %
|         |  |                              |            |                              |   |                                   |  |      |           |   |                                |  |                     |    |   |  |     |   |  |     |  

Net sales to domestic customers were 50% of net sales
for the three months ended June 30, 2006 compared to 51% for the three months
ended June 30, 2005. Net sales to European customers were 47% of net sales
compared to 45% for the same period of last year. Net sales to Asian customers
were 3% for the three months ended June 30, 2006 as opposed to 4% for the three
months ended June 30, 2005.

Gross profit increased $239,792 for the three months
ended June 30, 2006 compared to the prior years third quarter. The components
of increases and (decreases) in the gross profit are detailed below:

|                                         |  |                       |            |  
|---------------------------------------- |  | --------------------- | ---------- | -
|                                         |  | Increase
  (decrease) |           
|                                         |  |                       |           
|Due to
  increased sales                 |  | $                     | 1,459,306  |  
|Due to
  lower gross profit on sales mix |  |                       | (1,021,211 | )
|Due to
  increases in production costs   |  |                       | (198,303   | )
|                                         |  |                       |            |  
|Total increase in gross profit           |  | $                     | 239,792    |  
|                                         |  |                       |            |  

Gross profit percentage for the three months ended
June 30, 2006 was 19.48% compared to 22.67% for the three months ended June 30,
2005, a decrease of 3.19%. The components of increase (decreases) in the gross
profit percent are detailed below:

|                                  |  |                        |  |       |    | 
|--------------------------------- |  | ---------------------- |  | ----- | -- | 
|                                  |  | Increase 
  (decrease) | 
|                                  |  |                        | 
|Lower
  gross profit on sales mix |  |                        |  | (3.92 | )%
|Production
  costs                |  |                        |  | 0.73  | % 
|                                  |  |                        |  |       |   
|Net
  decrease in gross profit %  |  |                        |  | (3.19 | )%
|                                  |  |                        |  |       |   

The decrease in the gross profit percent of 3.19 % for
the three months ended June 30, 2006 compared to the three months ended June
30, 2005 was primarily due to:

| |   |                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------
| |  | A higher percentage in sales of lower gross profit
  margin products contributed to a 3.92% decrease in gross profit                      
| |   |                                                                                                                                           
| |  | Production and shipping decreases contributed to a
  0.73% increase in gross profit percent compared to three months ended June
  30, 2005

16

---



The chart below illustrates the components of selling,
general and administrative expenses:

|                                  |  |                               |           |                       |   |           |  |   |            |   |  |       |   |  |       |   |            |       |  
|--------------------------------- |  | ----------------------------- | --------- | --------------------- | - | --------- |  | - | ---------- | - |  | ----- | - |  | ----- | - | ---------- | ----- | -
|                                  |  | Three
  months ended June 30, |          
|                                  |  |                               |          
|                                  |  | Dollar
  Costs                |           | Percentage
  of Sales |  
|                                  |  |                               |           |                       |  
|                                  |  |                               |           |                       |   |           |  |   | Increase   |   |  |       |   |  |       |   | Increase   |      
|                                  |  |                               | 2006      |                       |   | 2005      |  |   | (Decrease) |   |  | 2006  |   |  | 2005  |   | (Decrease) |      
|                                  |  |                               |           |                       |   |           |  |   |            |   |  |       |  
|                                  |  |                               |           |                       |   |           |  |   |            |   |  |       |   |  |       |   |            |       |  
|Sales and marketing               |  | $                             | 2,320,786 |                       | $ | 2,606,705 |  | $ | (285,919   | ) |  | 9.76  | % |  | 13.46 | % |            | -3.70 | %
|Technical support                 |  |                               | 143,989   |                       |   | 129,738   |  |   | 14,251     |   |  | 0.60  | % |  | 0.67  | % |            | -0.07 | %
|General and administrative        |  |                               | 910,966   |                       |   | 846,283   |  |   | 64,683     |   |  | 3.83  | % |  | 4.37  | % |            | -0.54 | %
|SG&A
  stock compensation expense |  |                               | 57,819    |                       |   |          |  |   | 57,819     |   |  | 0.25  | % |  | 0.00  | % |            | 0.25  | %
|                                  |  |                               |           |                       |   |           |  |   |            |   |  |       |   |  |       |   |            |       |  
|Total                             |  | $                             | 3,433,560 |                       | $ | 3,582,726 |  | $ | (149,166   | ) |  | 14.44 | % |  | 18.50 | % |            | -4.06 | %
|                                  |  |                               |           |                       |   |           |  |   |            |   |  |       |   |  |       |   |            |       |  

Selling, general and administrative expenses decreased
$149,166 from the prior years third quarter. As a percentage of sales,
selling, general and administrative expenses decreased by 4.06% when compared
to the three months ended June 30, 2005. The decrease in sales and marketing
expense of $285,919 was mainly due to lower advertising and promotional
expenses. The increases in technical support expense of $14,251 was mainly due
to compensation increases. The increase in general and administrative expenses
of $64,683 was primarily due to compensation increases for additional
managerial and support staff. Reflected in selling, general and administrative
expenses for the three months ended June 30, 2006 was $57,819 in stock
compensation expenses related to the issuance of stock options.

Research and development expenses increased $92,385.
The increase was mainly due to the hiring of additional engineering management
and staff personnel and increased program development costs due to a higher
volume of new product and product enhancement programs. Reflected in research
and development expenses for the three months ended June 30, 2006 was $29,127
in stock compensation expenses related to the issuance of stock options.

Other
income (expense)

Net other expense for the three months ended June 30,
2006 was $10,706 compared to net other income of $23,283 for the three months
ended June 30, 2005. The change was primarily driven by the foreign currency
transaction gains and losses.

Tax
provision

Our net tax provision for the three months ended June
30, 2006 and 2005 is as follows:

|                                         |  |                               |        |  |   |        | 
|---------------------------------------- |  | ----------------------------- | ------ |  | - | ------ | 
|                                         |  | Three
  months ended June 30, |       
|                                         |  |                               |       
|                                         |  |                               | 2006   |  |   | 2005   | 
|                                         |  |                               |        |  |  
|AMT
  Tax attributable to U.S operations |  | $                             | 25,000 |  | $ |       | 
|Tax
  expense European operations        |  |                               | 29,371 |  |   | 12,156 | 
|State
  taxes                            |  |                               | 5,000  |  |   | 5,000  | 
|                                         |  |                               |        |  |   |        | 
|Net
  tax provision                      |  | $                             | 59,371 |  | $ | 17,156 | 
|                                         |  |                               |        |  |   |        | 

The deferred tax assets and the offsetting tax
valuation allowance is attributable to the Companys domestic operations. For
four out of the last five fiscal years, the Companys domestic operation
incurred tax losses. Fiscal 2005 was the first year out of the last five years
in which the Companys domestic operations had pre tax income. As of June 30,
2006, we evaluated the future realization of our deferred tax assets and the
corresponding valuation allowance. The Company took into consideration:

17

---



| |   |                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the tax
  losses incurred by our domestic operations in four out of the last five years                                                          
| |   |                                                                                                                                                  
| |  | the seasonal
  nature and cyclical nature of the business, which makes it difficult to
  predict the future realization of the deferred tax asset
| |   |                                                                                                                                                  
| |  | the dynamic
  market and technological changes that occur in our industry                                                                        

After
evaluating the circumstances listed above, it was the Companys opinion that as
of June 30, 2006, the valuation allowance was still applicable.

As a result of
all of the above items mentioned in this Managements Discussion and Analysis
of Financial Condition and Results of Operations, we recorded net income of
$380,341, for the three months ended June 30, 2006, which resulted in basic and
diluted net income per share of $0.04 on weighted average basic and diluted
shares of 9,636,912 and 10,057,479, respectively, compared to a net income of
$159,972 for the three months ended June 30, 2005, which resulted in basic and
diluted net income per share of $0.02, respectively, on weighted average basic
and diluted shares of 9,489,843 and 9,967,512, respectively.

18

---



NINE MONTH PERIOD ENDED JUNE 30, 2006
COMPARED TO 
JUNE 30, 2005

Results of
operations for the nine months ended June 30, 2006 compared to June 30, 2005
are as follows:

|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|--------------------------------------------------- |  | --------------------- | ---------- | ------------------- | - | ---------- | - | --------------------- | ---------- | ---- |  | -------- | - |  | ------ | - |  | ----- | -
|                                                    |  | Nine
  Months
  Ended |            | Nine
  Months Ended |   | Variance   |   | Percentage
  of sales |           
|                                                    |  | 6/30/06               |            | 6/30/05             |   | $          |   | 2006                  |            | 2005 |  | Variance |  
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |  
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Net sales                                           |  | $                     | 75,506,375 |                     | $ | 63,095,518 |   | $                     | 12,410,857 |      |  | 100.00   | % |  | 100.00 | % |  |      |  
|Cost of sales                                       |  |                       | 60,461,107 |                     |   | 48,572,102 |   |                       | 11,889,005 |      |  | 80.07    | % |  | 76.98  | % |  | 3.09  | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Gross profit                                        |  |                       | 15,045,268 |                     |   | 14,523,416 |   |                       | 521,852    |      |  | 19.93    | % |  | 23.02  | % |  | -3.09 | %
|Gross profit%                                       |  |                       | 19.93      | %                   |   | 23.02      | % |                       | -3.09      | %    |  |          |   |  |        |   |  |       |  
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Expenses:                                           |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Sales & marketing                                   |  |                       | 6,992,771  |                     |   | 7,388,716  |   |                       | (395,945   | )    |  | 9.26     | % |  | 11.71  | % |  | -2.45 | %
|Technical support                                   |  |                       | 430,839    |                     |   | 374,480    |   |                       | 56,359     |      |  | 0.57     | % |  | 0.59   | % |  | -0.02 | %
|General & administrative                            |  |                       | 2,637,202  |                     |   | 2,573,400  |   |                       | 63,802     |      |  | 3.49     | % |  | 4.08   | % |  | -0.59 | %
|SG&A stock compensation expense                     |  |                       | 211,935    |                     |   |           |   |                       | 211,935    |      |  | 0.28     | % |  | 0.00   | % |  | 0.28  | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Total selling, general and administrative expenses  |  |                       | 10,272,747 |                     |   | 10,336,596 |   |                       | (63,849    | )    |  | 13.60    | % |  | 16.38  | % |  | -2.78 | %
|Research & development                              |  |                       | 2,219,710  |                     |   | 1,844,555  |   |                       | 375,155    |      |  | 2.94     | % |  | 2.92   | % |  | 0.02  | %
|Research and development stock compensation expense |  |                       | 62,835     |                     |   |           |   |                       | 62,835     |      |  | 0.08     | % |  | 0.00   | % |  | 0.08  | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Total operating expenses                            |  |                       | 12,555,292 |                     |   | 12,181,151 |   |                       | 374,141    |      |  | 16.62    | % |  | 19.30  | % |  | -2.68 | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Net operating income                                |  |                       | 2,489,976  |                     |   | 2,342,265  |   |                       | 147,711    |      |  | 3.31     | % |  | 3.72   | % |  | -0.41 | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Other income (expense)                              |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Interest income                                     |  |                       | 17,921     |                     |   | 15,699     |   |                       | 2,222      |      |  | 0.02     | % |  | 0.02   | % |  | 0.00  | %
|Foreign currency                                    |  |                       | (2,695     | )                   |   | 11,317     |   |                       | (14,012    | )    |  | 0.00     | % |  | 0.02   | % |  | -0.02 | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Total other income (expense)                        |  |                       | 15,226     |                     |   | 27,016     |   |                       | (11,790    | )    |  | 0.02     | % |  | 0.04   | % |  | -0.02 | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Income before taxes                                 |  |                       | 2,505,202  |                     |   | 2,369,281  |   |                       | 135,921    |      |  | 3.33     | % |  | 3.76   | % |  | -0.43 | %
|Taxes on income                                     |  |                       | 146,510    |                     |   | 118,156    |   |                       | 28,354     |      |  | 0.20     | % |  | 0.19   | % |  | 0.01  | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  
|Net income                                          |  | $                     | 2,358,692  |                     | $ | 2,251,125  |   | $                     | 107,567    |      |  | 3.13     | % |  | 3.57   | % |  | -0.44 | %
|                                                    |  |                       |            |                     |   |            |   |                       |            |      |  |          |   |  |        |   |  |       |  

Net sales for
the nine months ended June 30, 2006 increased $12,410,857 over the nine months
ended June 30, 2005 as shown in the table below.

|         |  |               |            |               |   |                     |  |                       |            |                               |  |      |   |  |     |   |  |     |  
|-------- |  | ------------- | ---------- | ------------- | - | ------------------- |  | --------------------- | ---------- | ----------------------------- |  | ---- | - |  | --- | - |  | --- | -
|         |  | Nine Months   |            | Nine Months   |   | Increase (Decrease) |  | Increase
  (Decrease) |            | Sales by Geographic 
  region | 
|Location |  | Ended 6/30/06 |            | Ended 6/30/05 |   | DollarVariance      |  | Variance %            |            | 2006                          |  | 2005 |  
|         |  |               |            |               |   |                     |  |                       |            |                               |  |      |  
|Domestic |  |               | 35,477,958 |               |   | 28,810,910          |  |                       | 6,667,048  |                               |  | 23   | % |  | 47  | % |  | 46  | %
|Europe   |  |               | 38,204,680 |               |   | 32,808,781          |  |                       | 5,395,899  |                               |  | 16   | % |  | 51  | % |  | 52  | %
|Asia     |  |               | 1,823,737  |               |   | 1,475,827           |  |                       | 347,910    |                               |  | 24   | % |  | 2   | % |  | 2   | %
|         |  |               |            |               |   |                     |  |                       |            |                               |  |      |   |  |     |   |  |     |  
|Total    |  | $             | 75,506,375 |               | $ | 63,095,518          |  | $                     | 12,410,857 |                               |  | 20   | % |  | 100 | % |  | 100 | %
|         |  |               |            |               |   |                     |  |                       |            |                               |  |      |   |  |     |   |  |     |  

Net sales to domestic customers
were 47% of net sales for the nine months ended June 30, 2006 compared to 46%
for the nine months ended June 30, 2005. Net sales to European customers were
51% of net sales compared to
52% for the same period of last year. Net sales to Asian customers were 2% for
the nine months ended June 30, 2006 and June 30, 2005.

19

---



Gross profit
increased $521,852 for the nine months ended June 30, 2006 compared to the
prior year. The components of increases and (decreases) in the gross profit are
detailed below:

|                                     |  |            |            |  
|------------------------------------ |  | ---------- | ---------- | -
|                                     |  | Increase   |           
|                                     |  | (decrease) |           
|                                     |  |            |           
|Increased sales                      |  | $          | 3,915,147  |  
|Lower gross profit on sales mix      |  |            | (2,375,735 | )
|Due to increases in production costs |  |            | (1,017,560 | )
|                                     |  |            |            |  
|Total increase in gross profit       |  | $          | 521,852    |  
|                                     |  |            |            |  

Gross profit
percentage for the nine months ended June 30, 2006 was 19.93% compared to
23.02% for the prior year, a decrease of 3.09%.

The increases
and (decreases) in the gross profit percent are detailed below:

|                                     |  |            |       |   
|------------------------------------ |  | ---------- | ----- | --
|                                     |  | Increase   |      
|                                     |  | (decrease) |      
|Lower gross profit on sales mix      |  |            | (3.02 | )%
|Due to increases in production costs |  |            | (0.07 | )%
|                                     |  |            |       |   
|Net decrease in gross profit%        |  |            | (3.09 | )%

The decrease
in the gross profit percent of 3.09 % for the nine months ended June 30, 2006
compared to the nine months ended June 30, 2005 was primarily due to:

| |   |                                                                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | A higher
  percentage of lower gross profit margin products contributed to a 3.02%
  decrease in gross profit                                                                                
| |   |                                                                                                                                                                                              
| |  | Production
  and shipping increases contributed to a 0.07% decrease in gross profit
  percent. The increase in net sales was about 20% while the increase in
  production costs was about 20%

The chart
below illustrates the components of selling, general and administrative
expenses:

|                                |  |                              |            |                     |   |            |  |      |          |      |  |            |   |  |       |   |  |       |  
|------------------------------- |  | ---------------------------- | ---------- | ------------------- | - | ---------- |  | ---- | -------- | ---- |  | ---------- | - |  | ----- | - |  | ----- | -
|                                |  | Nine months
  ended June 30, |           
|                                |  |                              |           
|                                |  | Dollar Costs                 |            | Percentage of Sales |   |            | 
|                                |  |                              |            |                     |  
|                                |  |                              |            |                     |   | Increase   |  |      |          |      |  | Increase   |  
|                                |  | 2006                         |            | 2005                |   | (Decrease) |  | 2006 |          | 2005 |  | (Decrease) |  
|                                |  |                              |            |                     |   |            |  |      |          |      |  |            |  
|Sales and marketing             |  | $                            | 6,992,771  |                     | $ | 7,388,716  |  | $    | (395,945 | )    |  | 9.26       | % |  | 11.71 | % |  | -2.45 | %
|Technical support               |  |                              | 430,839    |                     |   | 374,480    |  |      | 56,359   |      |  | 0.57       | % |  | 0.59  | % |  | -0.02 | %
|General and administrative      |  |                              | 2,637,202  |                     |   | 2,573,400  |  |      | 63,802   |      |  | 3.49       | % |  | 4.08  | % |  | -0.59 | %
|SG&A stock compensation expense |  |                              | 211,935    |                     |   |           |  |      | 211,935  |      |  | 0.28       | % |  | 0.00  | % |  | 0.28  | %
|                                |  |                              |            |                     |   |            |  |      |          |      |  |            |   |  |       |   |  |       |  
|Total                           |  | $                            | 10,272,747 |                     | $ | 10,336,596 |  | $    | (63,849  | )    |  | 13.60      | % |  | 16.38 | % |  | -2.78 | %
|                                |  |                              |            |                     |   |            |  |      |          |      |  |            |   |  |       |   |  |       |  

Selling,
general and administrative expenses deceased $63,849 from the prior year. As a
percentage of sales, selling, general and administrative expenses decreased by
2.78% when compared to the nine months ended June 30, 2005. The decrease in
sales and marketing expense of $395,945 was mainly due to lower advertising and
promotional expenses offset by increased compensation expenses due to higher
sales commissions and mid year incentives. The increase in technical support
expenses of $56,359 was primarily due to increased personnel
required to handle increased phone volume due to expanding sales. The increase
in general and administrative expenses of $63,802 was primarily due to
compensation increases for additional managerial

20

---



staff offset by lower legal
fees of as a result of lower non recurring fees. Reflected in selling, general
and administrative expenses for the nine months ended June 30, 2006 was
$211,935 in stock compensation expenses related to the issuance of stock
options.

Research and
development expenses increased $437,990. The increase was mainly due to higher
compensation costs of due to the hiring of additional engineering management
and staff personnel and increased program development costs of due to higher
volume of new product and product enhancement programs. Reflected in research
and development expenses for the nine months ended June 30, 2006 was $62,835 in
stock compensation expenses related to the issuance of stock options.

Other income (expense)

Net other
income for the nine months ended June 30, 2006 was $15,226 compared to net
other income of $27,016 for the nine months ended June 30, 2005. The change was
primarily driven by the foreign currency transactions gains and losses.

Accumulated other comprehensive income (loss)

As of June 30,
2006, appearing in the equity section under Accumulated other comprehensive
income (loss) was a loss of $307,719, which consisted of a deferred
translation loss of $251,679 and a deferred loss of $56,040 due to the mark to
market losses on the difference between the value of the Companys open forward
exchange contracts at the contract rates versus the same contracts valued at
the period ending forward rate.

Accumulated
other comprehensive income (loss) consists of two components: translation gains
and losses and FAS 133 mark to market gains and losses on our open foreign
exchange contracts. The table below details the gains and losses that make up
the accumulated other comprehensive loss of $307,719 recorded on our balance
sheet as of June 30, 2006:

|                                                |  |               |         |                   |   |               |   |   |          |  
|----------------------------------------------- |  | ------------- | ------- | ----------------- | - | ------------- | - | - | -------- | -
|Accumulated Other Comprehensive
  Income (Loss) |  | Balance as of |         | Oct 05 to June 06 |   | Balance as of |  
|Fiscal 2006 activity                            |  | Sept 30 2005  |         | (losses)          |   | June 30 2006  |  
|                                                |  |               |         |                   |   |               |  
|Translation gains and losses                    |  | $             | 546,352 |                   | $ | (798,031      | ) | $ | (251,679 | )
|FAS 133 mark to market adjustment               |  |               | 136,418 |                   |   | (192,458      | ) |   | (56,040  | )
|                                                |  |               |         |                   |   |               |   |   |          |  
|                                                |  | $             | 682,770 |                   | $ | (990,489      | ) | $ | (307,719 | )
|                                                |  |               |         |                   |   |               |   |   |          |  

Tax provision

Our net tax
provision for the nine months ended June 30, 2006 and 2005 is as follows:

|                                       |  |                            |         |      |   |         | 
|-------------------------------------- |  | -------------------------- | ------- | ---- | - | ------- | 
|                                       |  | Nine months ended June 30, |        
|                                       |  |                            |        
|                                       |  | 2006                       |         | 2005 |  
|                                       |  |                            |         |      |  
|AMT Tax attributable to U.S operations |  | $                          | 55,000  |      | $ | 20,000  | 
|Tax expense European operations        |  |                            | 76,510  |      |   | 83,156  | 
|State taxes                            |  |                            | 15,000  |      |   | 15,000  | 
|                                       |  |                            |         |      |   |         | 
|Net tax provision                      |  | $                          | 146,510 |      | $ | 118,156 | 
|                                       |  |                            |         |      |   |         | 

The deferred
tax assets and the offsetting tax valuation allowance is attributable to the
Companys domestic operations. For four out of the last five fiscal years, the
Companys domestic operation incurred tax losses. Fiscal 2005 was the first
year out of the last five years in which the Companys domestic operations had
pre tax income. As of June 30, 2006, we evaluated the
future realization of our deferred tax assets and the corresponding valuation
allowance. The Company took into consideration:

21

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| |   |                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the tax losses incurred by our domestic operations
  in four out of the last five years                                                          
| |   |                                                                                                                                                  
| |  | the seasonal nature and cyclical nature of the
  business, which makes it difficult to predict the future realization of the
  deferred tax asset
| |   |                                                                                                                                                  
| |  | the dynamic market and technological changes that
  occur in our industry                                                                        

After evaluating the
circumstances listed above, it was the Companys opinion that as of June 30,
2006, the valuation allowance was still applicable.

As a result of all of the above items mentioned in
this Managements Discussion and Analysis of Financial Condition and Results of
Operations, we recorded net income of $2,358,692 for the nine months ended June
30, 2006, which resulted in basic net income per share of $0.25 and diluted net
income per share of $0.24 on weighted average basic and diluted shares of
9,573,594 and 10,003,979, respectively, compared to a net income of $2,251,125
for the nine months ended June 30, 2005, which resulted in basic net income per
share of $0.24 and diluted net income per share of $0.23 on weighted average
basic and diluted shares of 9,408,827 and 9,990,055, respectively.

Seasonality

As our sales are primarily to the consumer market, we
have experienced certain seasonal revenue trends. Our peak sales quarter, due
to holiday season sales of computer equipment, is our first fiscal quarter
(October to December), followed by our fourth fiscal quarter (July to
September). In addition, our international sales, mostly in the European,
market, were 54%, 66% and 68% of sales for the years ended September 30, 2005,
2004 and 2003, respectively. Our fiscal fourth quarter sales (July to
September) can be potentially impacted by the reduction of activity experienced
in Europe during the July and August summer holiday period.

To offset the above cycles, we target a wide range of
customer types in order to moderate the seasonal nature of our retail sales.

Liquidity
and Capital Resources

Our cash, working capital and stockholders equity
position as of June 30, 2006 and September 30, 2005 is set forth below:

|                     |  |               |            |                    |   |            | 
|-------------------- |  | ------------- | ---------- | ------------------ | - | ---------- | 
|                     |  | June 30, 2006 |            | September 30, 2005 |  
|                     |  |               |            |                    |  
|Cash                 |  | $             | 7,339,775  |                    | $ | 7,567,393  | 
|Working Capital      |  |               | 17,166,475 |                    |   | 15,334,855 | 
|Stockholders Equity |  |               | 17,814,511 |                    |   | 15,941,492 | 

We had cash and cash
equivalents as of June 30, 2006 of $7,339,775, a decrease of $227,618 from
September 30, 2005.

The decrease in cash was due to:

|                                                      |  |   |            |  
|----------------------------------------------------- |  | - | ---------- | -
|Sources of cash:                                      |  |   |           
|Net income adjusted for non cash items                |  | $ | 2,768,532  |  
|Increase in accounts payable and accrued expenses     |  |   | 6,742,614  |  
|Proceeds from employee stock purchases                |  |   | 230,046    |  
|Decrease in prepaid expenses and other current assets |  |   | 166,945    |  
|Less cash used for:                                   |  |   |            |  
|Increase in account receivables                       |  |   | (6,114,468 | )
|Increase in inventories                               |  |   | (2,854,329 | )
|Effect of exchange rates on cash                      |  |   | (990,489   | )
|Capital equipment purchases                           |  |   | (176,469   | )
|                                                      |  |   |            |  
|                                                     
|Net cash decrease                                     |  | $ | (227,618   | )
|                                                      |  |   |            |  

22

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Net cash of $709,294 provided by operating activities
was primarily due to increases in accounts payable and accrued expenses of
$6,742,614, as was used to finance the growth in accounts receivable and
inventory to fund the increase in sales and a decrease in prepaid expenses and
other current assets of $166,945. Net income adjusted for non cash items of
$2,768,532 provided another source of cash. Somewhat offsetting these sources
of cash were increases in accounts receivable and inventory of $6,114,468 and
$2,854,329 respectively, required to fund the 54% increase in sales between the
last quarter of fiscal 2005 and the third quarter of fiscal 2006.

Cash of $176,469 was used to purchase fixed assets.
Proceeds from the stock purchased by employees through the exercise of options
and the employee stock purchase plan provided cash of $230,046 and the effect
of exchange rate changes used cash of $990,489.

On November 8, 1996, we approved a stock repurchase
program. The program, as amended, authorizes us to repurchase up to 850,000
shares of our own stock. We intend to use the repurchased shares for certain
employee benefit programs. On December 17, 1997, the stock repurchase program
was extended by a resolution of our Board of Directors. As of June 30, 2006, we
held 607,547 treasury shares purchased for $1,757,951 at an average purchase
price of approximately $2.89 per share.

Line of
Credit

On December 1, 2005, Hauppauge Computer Works, Inc.
(HCW), a wholly-owned subsidiary of Hauppauge Digital, Inc. (the Company),
entered into a $3,000,000 line of credit borrowing facility with the JP Morgan
Chase Bank, N.A. (the Bank). The line of credit is subject to renewal on
March 31, 2006. On March 17, 2006, the bank renewed our line of credit through
March 31, 2007. The Company, at its option, may borrow money at the Prime Rate
minus one percent (1.0%) or the adjusted Eurodollar Rate plus one and 85/100
percent (1.85%). In accordance with the terms of the line, the Company has entered
into a Guaranty with the Bank and has entered into a Share Pledge Agreement
among the Company, the Bank and Hauppauge Digital Europe S.àr.l., a wholly
owned subsidiary of the Company.

Pursuant to the Guaranty, the Company guarantees to
the Bank the payment of all liabilities of HCW to the Bank, secured by a
continuing lien and right of set-off for the amount of the liabilities of HCW
to the Bank upon any and all monies, securities, property, deposits and credits
of the Company with the Bank, J.P. Morgan Securities Inc. or any other
affiliate of the Bank.

Pursuant to the Share Pledge Agreement, the Company
granted a first priority right of pledge on approximately two-thirds of the
outstanding capital shares of Hauppauge Digital Europe in favor of the Bank as
security for the payment under the Note or the Share Pledge Agreement.

There were no borrowings outstanding as of the filing
date of this Quarterly Report on Form 10-Q.

We believe that our cash and cash equivalents as of
June 30, 2006, our internally generated cash flow and the line of credit we
entered into on December 1, 2005 will provide us with sufficient liquidity to
meet our currently foreseeable short-term and long-term capital needs.

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Future
Contractual Obligations

The following table shows our contractual obligations
related to lease obligations as of June 30, 2006:

|                              |  |                          |           |                    |   |           |  |                |         |  |   |         | 
|----------------------------- |  | ------------------------ | --------- | ------------------ | - | --------- |  | -------------- | ------- |  | - | ------- | 
|                              |  | Payments
  due by period |          
|                              |  | Total                    |           | Less than
  1 year |   | 1-3 years |  | 3 to 5
  years |        
|                              |  |                          |           |                    |   |           |  |                |        
|Operating
  lease obligations |  | $                        | 1,595,086 |                    | $ | 573,423   |  | $              | 898,466 |  | $ | 123,197 | 
|                              |  |                          |           |                    |   |           |  |                |         |  |   |         | 

Inflation

While inflation has not had a material effect on our
operations in the past, there can be no assurance that we will be able to
continue to offset the effects of inflation on the costs of our products or
services through price increases to our customers without experiencing a
reduction in the demand for our products; or that inflation will not have an
overall effect on the computer equipment market that would have a material
affect on us.

Item
3. Quantitative and Qualitative Disclosures about Market Risks

Sales for the Companys European subsidiary are
primarily invoiced and
collected in Euros. On the supply side the Company predominantly deals
with North American and Asian suppliers and contract manufacturers. Due to
this, a large percentage of the inventory required to support the Companys
European sales are purchased and paid in U.S. Dollars.

The combination of sales billed in Euros supported by
inventory purchased in U.S. dollars results in an absence of a natural local
currency hedge, subjecting the Company to market risks resulting from the
fluctuations in the Euro to U.S. Dollar exchange rates. The Company attempts to
reduce the risks by entering into foreign exchange forward contracts with
financial institutions. The purpose of these forward contracts is to hedge the
foreign currency market exposures underlying the Companys U.S. Dollar
denominated inventory purchases.

As of June 30, 2006, the Company had foreign currency
contracts outstanding of approximately $5,588,270 against the delivery of the
Euro. The contracts expire from July 2006 through October 2006. The Companys
accounting policies for these instruments designate such instruments as cash
flow hedging transactions. The Company does not enter into such contracts for
speculative purposes. The Company records all derivative gains and losses on
the balance sheet as a component of stockholders equity under the caption
Accumulated other comprehensive income (loss). The Company recorded a loss of
$192,458 for the nine months ended June 30, 2006 on its statement of other
comprehensive income. As of June 30, 2006, a deferred loss of $56,040,
reflecting the cumulative mark to market losses of the Companys derivatives,
was recorded on the Companys balance sheet as a component of accumulated other
comprehensive income (loss) in our equity section.

Item
4. Controls andProcedures

Our Chief Executive Officer and Chief Financial
Officer conducted an evaluation of the effectiveness of our disclosure controls
and procedures. Based on this evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures were
effective as of June 30, 2006 in alerting them in a timely manner to material
information required to be included in our SEC reports. In addition, no change
in our internal control over financial reporting occurred during the fiscal
quarter ended June 30, 2006 that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.

24

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Special Note Regarding Forward Looking
Statements

This Quarterly
Report contains forward-looking statements as that term is defined in the
federal securities laws. The events described in forward-looking statements
contained in this Quarterly Report may not occur. Generally these statements
relate to business plans or strategies, projected or anticipated benefits or
other consequences of our plans or strategies, projected or anticipated
benefits from acquisitions to be made by us, or projections involving
anticipated revenues, earnings or other aspects of our operating results. The
words may, will, expect, believe, anticipated, project,
plan,
intend, estimate, and continue, and their opposites and similar
expressions are intended to identify forward-looking statements. We caution you
that these statements are not guarantees of future performance or events and
are subject to a number of uncertainties, risks and other influences
(including, but not limited to, those set forth in our Annual Report on Form
10-K for the year ended September 30, 2005), many of which are beyond our
control, that may influence the accuracy of the statements and the projections
upon which the statements are based. Any one or more of these uncertainties,
risks and other influences could materially affect our results of operations
and whether forward looking statements made by us ultimately prove to be
accurate. Our actual results, performance and achievements could differ
materially from those expressed or implied in these forward-looking statements.
We undertake no obligation to publicly update or revise any forward-looking
statements, whether from new information, future events or otherwise. All
cautionary statements made in this Quarterly Report should be read as being
applicable to all related forward-looking statements wherever they appear.

25

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PART II. OTHER INFORMATION

Item 2. Unregistered Sales of Equity
Securities and Use of Proceeds

On November 8,
1996, we approved a stock repurchase program. The program authorizes us to
repurchase up to 850,000 shares of our own stock. The stock repurchase program
was extended by a resolution of our Board of Directors on December 17, 1997.

The Company
did not repurchase any of its common stock our stock repurchase program during
the quarter ended June 30, 2006.

Item 6. Exhibits

(c) Exhibits

31.1
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule
15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2
Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) or Rule
15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32
Certification of Chief Executive Officer and Chief Financial Officer pursuant
to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002

26

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SIGNATURES

Pursuant to the requirements
of the Securities Exchange Act of 1934, the registrant has duly caused this
report to be signed on its behalf by the undersigned thereunto duly authorized.

|                      |                                                        |                       | 
|--------------------- | ------------------------------------------------------ | --------------------- | 
|                      | HAUPPAUGE DIGITAL INC.                                
|                      | Registrant                                            
|                      |                                                       
|Date: August 14, 2006 | By                                                     | /s/
  Kenneth Plotkin | 
|                      |                                                        |                       | 
|                      | KENNETH PLOTKIN                                       
|                      | Chief Executive Officer,
  Chairman of the Board,     
|                      | President (Principal
  Executive Officer) and Director
|                      |                                                       
|                      |                                                       
|Date: August 14, 2006 | By                                                     | /s/ Gerald Tucciarone | 
|                      |                                                        |                       | 
|                      | GERALD TUCCIARONE                                     
|                      | Treasurer, Chief Financial
  Officer,                 
|                      | (Principal Accounting
  officer) and Secretary        

27

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