**UNITED
      STATES****SECURITIES
      AND EXCHANGE COMMISSION****WASHINGTON,
      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 March 31,
  2005******
      **OR****[
      ] 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 incorporation or
      organization)**
    (**I.R.S.
      Employer identification No.)****91
      Cabot Court, Hauppauge, New York 11788****(Address
      of principal executive offices)****(631)
      434-1600****(Registrant’s
      telephone number, including area code
)**




1


**Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months (or for such shorter period that the
      registrant was required to file such reports), and (2) has been subject to
      such filing requirements for the past 90 days.****Yes  
         X**
    **No
      ___****Indicate
      by check mark whether the registrant is an accelerated filer (as defined
      in Rule 12b-2 of the Exchange Act)****Yes
      ____**
    **No  
      X********As
      of May 3, 2005, 9,493,011 shares of .01 par value Common Stock of the
      registrant were outstanding, not including treasury
      shares.**




2
 **INDEX**




**PART
      I.   FINANCIAL
INFORMATION**
 
 **Item
      1.   Financial Statements**
    **Page
      No.**




**Condensed
      Consolidated Balance Sheets -**
      **March
      31, 2005 (unaudited) and September 30, 2004
    (audited)**
    **5****Condensed
      Consolidated Statements of Income -**
      **Three
      Months ended March 31, 2005 (unaudited) and 2004
      (unaudited)**
    **6****Condensed
      Consolidated Statements of Income -**
      **Six
      Months ended March 31, 2005 (unaudited) and 2004
      (unaudited)**
    **7****Condensed
      Consolidated Statements of Other Comprehensive Income
      -**
      **Three
      and six months ended March 31, 2005 (unaudited) and 2004
      (unaudited)**
    **8****Condensed
      Consolidated Statements of Cash Flows -**
      **Six
      Months ended March 31, 2005 (unaudited) and 2004
      (unaudited)**
    **9****Notes
      to Condensed Consolidated Financial Statements**
      ****
    **10
      -17****Item
      2. Management's Discussion and Analysis of Financial Condition and Results
      of Operations**
    **18
      -37********Item
      3. Quantitative and Qualitative Disclosures about Market
      Risks**
    **38-39****Item
      4. Controls and Procedures**
    **39**


3
 **PART
      II. OTHER INFORMATION**
      ****
      ******Item
      2. Unregistered Sales of Equity Securities and Use of
      Proceeds**
    40**Item
      6. Exhibits**
    40**SIGNATURES**
    41


4


**PART
I. FINANCIAL INFORMATION**




**Item
      1.  Financial Statements**





**HAUPPAUGE
      DIGITAL, INC. AND SUBSIDIARIES****CONDENSED
      CONSOLIDATED BALANCE SHEETS**






**March**
      **31,****2005**
      **(unaudited)**
    
    
    **September**
      **30,**
      **2004**
      **(audited**
    ****
      ****
      **)****Assets:**
    
    
    ********Current
      Assets:**
    
    
    ****
    
    
    ******Cash
      and cash equivalents**
    
    **$**
    **8,976,708**
    
    **$**
    **8,661,589****Receivables,
      net of various allowances**
    
    
    **16,832,937**
    
    
    **13,593,907****Inventories**
    
    
    **8,359,476**
    
    
    **8,477,254****Prepaid
      expenses and other current assets**
    
    
    **1,117,222**
    
    
    **770,745****Total
      current assets**
    
    
    **35,286,343**
    
    
    **31,503,495****Property,
      plant and equipment, net**
    
    
    **525,800**
    
    
    **489,370****Security
      deposits and other non current assets**
    
    
    **77,952**
    
    
    **77,934******
    
    **$******
    ******35,890,095**
    
    **$******
    ******32,070,799****Liabilities
      and Stockholders’ Equity:******
    
    
    ******Current
      Liabilities:****Accounts
      payable**
    
    **$**
    **13,577,432**
    
    **$**
    **13,243,966****Accrued
      expenses**
    
    
    **4,650,351**
    
    
    **4,256,970****Income
      taxes payable**
    
    
    **263,871**
    
    
    **242,438****Total
      current liabilities**
    
    
    **18,491,654**
    
    
    **17,743,374******
    
    
    ****
    
    
    ******Stockholders'
      Equity:**
    
    
    ******Common
      stock $.01 par value; 25,000,000 shares authorized, 10,091,496 and
      9,759,465 issued, respectively**
    
    
    **100,915**
    
    
    **97,595****Additional
      paid-in capital**
    
    
    **13,566,486**
    
    
    **12,913,497****Retained
      earnings**
    
    
    **4,016,290**
    
    
    **1,925,135****Accumulated
      other comprehensive income**
    
    
    **1,448,820**
    
    
    **975,511****Treasury
      Stock, at cost, 602,067 and 567,067 shares**
    
    
    **(1,734,070**
    **)**
    
    **(1,584,313**
    **)****Total
      stockholders' equity**
    
    
    **17,398,441**
    
    
    **14,327,425****$******
    ******35,890,095**
    
    **$******
    ******32,070,799**


** ***See
accompanying notes to condensed consolidated financial
statements***






5


**HAUPPAUGE
      DIGITAL, INC. AND SUBSIDIARIES****CONDENSED
      CONSOLIDATED STATEMENTS OF INCOME**


**(UNAUDITED)**




**Three
      months ended March 31,****2005**
    
    
    **2004****Net
      sales**
    
    **$**
    **20,362,293**
    
    **$**
    **16,804,283****Cost
      of sales**
    
    
    **15,542,399**
    
    
    **11,873,313****Gross
      profit**
    
    
    **4,819,894**
    
    
    **4,930,970******
    
    
    ******Selling,
      general and administrative expenses**
    
    
    **3,326,814**
    
    
    **3,223,769****Research
      & development expenses**
    
    
    **631,437**
    
    
    **444,390****Arbitration
      proceeding**
    
    
    **-**
    
    
    **206,250****Litigation
      proceeding**
    
    
    **-**
    
    
    **500,000****Income
      from operations**
    
    
    **861,643**
    
    
    **556,561******
    
    
    ******Other
      Income:**
    
    
    ****
    
    
    ******Interest
      income**
    
    
    **3,150**
    
    
    **1,397****Foreign
      currency**
    
    
    **7,672**
    
    
    **33,232****Other
      income**
    
    
    **10,822**
    
    
    **34,629****Income
      before taxes on income**
    
    
    **872,465**
    
    
    **591,190****Tax
      provision**
    
    
    **45,000**
    
    
    **46,800****Net
      income**
    
    **$**********
    ******827,465******
    
    **$******
    ******544,390******
    
    
    ******Net
      income per share:**
    
    
    ****
    
    
    ******Basic**
    
    **$**
    **0.09**
    
    **$**
    **0.06****Diluted**
    
    **$**
    **0.08**
    
    **$**
    **0.06**







***See
accompanying notes to condensed consolidated financial
statements***




6


**HAUPPAUGE
      DIGITAL, INC. AND SUBSIDIARIES****CONDENSED
      CONSOLIDATED STATEMENTS OF INCOME**


**(UNAUDITED)**






**Six
      months ended March 31,****2005**
    
    
    **2004****Net
      sales**
    
    **$**
    **43,722,736**
    
    **$**
    **35,034,581****Cost
      of sales**
    
    
    **33,591,477**
    
    
    **25,521,988****Gross
      profit**
    
    
    **10,131,259**
    
    
    **9,512,593******
    
    
    ******Selling,
      general and administrative expenses**
    
    
    **6,753,870**
    
    
    **6,344,385****Research
      & development expenses**
    
    
    **1,188,967**
    
    
    **854,664****Arbitration
      proceeding**
    
    
    **-**
    
    
    **206,250****Litigation
      proceeding**
    
    
    **-**
    
    
    **500,000****Income
      from operations**
    
    
    **2,188,422**
    
    
    **1,607,294******
    
    
    ******Other
      Income (expense):**
    
    
    ****
    
    
    ******Interest
      income**
    
    
    **4,661**
    
    
    **3,136****Foreign
      currency**
    
    
    **(928**
    **)**
    
    **21,899****Other
      Income**
    
    
    **3,733**
    
    
    **25,035****Income
      before taxes on income**
    
    
    **2,192,155**
    
    
    **1,632,329****Tax
      provision**
    
    
    **101,000**
    
    
    **95,079****Net
      income**
    
    **$**********
    ******2,091,155******
    
    **$**********
    ******1,537,250**********
    
    
    ******Net
      income per share:**
    
    
    ****
    
    
    ******Basic**
    
    **$**
    **0.22**
    
    **$**
    **0.17****Diluted**
    
    **$**
    **0.21**
    
    **$**
    **0.16**





***See
accompanying notes to condensed consolidated financial
statements***




7


**HAUPPAUGE
      DIGITAL, INC. AND SUBSIDIARIES****CONDENSED
      CONSOLIDATED STATEMENTS OF OTHER COMPREHENSIVE
    INCOME**


**(UNAUDITED)**






**Three
      months ended March 31,****2005**
    
    
    **2004****Net
      income**
    
    **$**
    **827,465**
    
    **$**
    **544,390****Forward
      exchange contracts marked to market**
    
    
    **406,300**
    
    
    **(16,483**
    **)****Foreign
      currency translation (loss)**
    
    
    **(237,461**
    **)**
    
    **(142,087**
    **)****Other
      comprehensive income**
    
    **$******
    ******996,304**
    
    **$******
    ******385,820**
   **Six
      months ended March 31,****2005**
    
    
    **2004****Net
      income**
    
    **$**
    **2,091,155**
    
    **$**
    **1,537,250****Forward
      exchange contracts marked to market**
    
    
    **126,509**
    
    
    **187,978****Foreign
      currency translation gain**
    
    
    **346,800**
    
    
    **707,882****Other
      comprehensive income**
    
    **$******
    ******2,564,464**
    
    **$******
    ******2,433,110**


******
 ***See
accompanying notes to condensed consolidated financial
statements***




8


**HAUPPAUGE
      DIGITAL, INC. AND SUBSIDIARIES****CONDENSED
      CONSOLIDATED STATEMENTS OF CASH
FLOWS**


**(UNAUDITED)**







**Six
      months ended March 31,**********
    
    
    **2005**
    
    
    **2004****Net
      income**
    
    **$**
    **2,091,155**
    
    **$**
    **1,537,250****Adjustments
      to reconcile net income to net cash used in operating
      activities:****Depreciation
      and amortization**
    
    
    **109,084**
    
    
    **121,054****Other
      non cash items**
    
    
    **-**
    
    
    **12,667****Changes
      in current assets and liabilities:****Accounts
      receivable**
    
    
    **(2,765,721**
    **)**
    
    **360,712****Inventories**
    
    
    **117,778**
    
    
    **(4,083,229**
    **)****Prepaid
      expenses and other current assets**
    
    
    **(346,477**
    **)**
    
    **(133,175**
    **)****Accounts
      payable and other current liabilities**
    
    
    **748,262**
    
    
    **2,831,962****Total
      adjustments**
    
    
    **(2,137,074**
    **)**
    
    **(890,009**
    **)****Net
      cash (used in) provided by operating activities**
    
    
    **(45,919**
    **)**
    
    **647,241******
    
    
    ****
    
    
    ******Cash
      Flows From Investing Activities:**
    
    
    ****
    
    
    ******Purchases
      of property, plant and equipment**
    
    
    **(145,514**
    **)**
    
    **(46,848**
    **)****Net
      cash used in investing activities**
    
    
    **(145,514**
    **)**
    
    **(46,848**
    **)******
    
    
    ****
    
    
    ******Cash
      Flows From Financing Activities:**
    
    
    
    
    
    ******Proceeds
      from employee stock purchases**
    
    
    **656,309**
    
    
    **96,569****Purchase
      of treasury stock**
    
    
    **(149,757**
    **)**
    
    **-****Net
      cash provided by financing activities**
    
    
    **506,552**
    
    
    **96,569****Net
      increase in cash and cash equivalents**
    
    
    **315,119**
    
    
    **696,962****Cash
      and cash equivalents, beginning of period**
    
    
    **8,661,589**
    
    
    **5,838,160****Cash
      and cash equivalents, end of period**
    
    **$******
    ******8,976,708**
    
    **$******
    ******6,535,122****Supplemental
      disclosures:**
    
    
    
    
    
    ******Income
      taxes paid**
    
    **$******
    ******171,027**
    
    **$******
    ******81,616**




***See
accompanying notes to condensed consolidated financial
statements*** ****




9


**HAUPPAUGE
      DIGITAL, INC. AND SUBSIDIARIES**
      **NOTES
      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, 2004 Form
10-K.





The
operating results for the three month and six months period ended March 31, 2005
are not necessarily indicative of the results to be expected for the September
30, 2005 year end.




**Note
      2.**
    **Receivables**


Accounts
and other receivables as of March 31, 2005 and September 30, 2004 consisted
of:





**March
      31,**
    
    
    **September
      30,****2005**
    
    
    **2004****Trade
      receivables**
    
    **$**
    **11,294,094**
    
    **$**
    **9,584,650****Receivable
      from contract manufacturers**
    
    
    **7,895,471**
    
    
    **6,568,968****GST
      and VAT taxes receivables**
    
    
    **1,057,858**
    
    
    **575,750****Allowances
      and reserves**
    
    
    **(3,538,000**
    **)**
    
    **(3,254,940**
    **)****Other**
    
    
    **123,514**
    
    
    **119,479****$**
    **16,832,937**
    
    **$**
    **13,593,907**




**Note
      3.**
    **Derivative
      Financial Instruments**


For each
of the past three fiscal years, over 60 % of the Company’s sales were generated
by our European subsidiary and were:


·
    Invoiced
      in local currency-primarily the Euro


·
    Collected
      in local currency-primarily the Euro






10


**NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)**




**Note
      3.**
    **Derivative
      Financial Instruments - continued**


On the
supply side, since the Company predominantly deals with North American and Asian
suppliers and contract manufacturers, approximately 75% of the Company’s
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. Consequently,
the Company’s financial results are subject to market risks resulting from the
fluctuations in the Euro to U.S. Dollar exchange rates.





The
Company attempts to reduce these 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 U.S. Dollar
denominated inventory purchases required to support the Company’s European
sales.





The
Company does not try to hedge against all possible foreign currency exposures
because of the inherent difficulty in estimating the volatility of the Euro. The
contracts the Company procures are specifically entered into to as a hedge
against forecasted or existing or foreign currency exposure. The Company does
not enter into contracts for speculative purposes. Although the Company
maintains these programs to reduce the short term impact of changes in currency
exchange rates, long term strengthening or weakening of the U.S. dollar against
the Euro impacts the Company’s sales, gross profit, operating income and
retained earnings. Factors that could impact the effectiveness of the Company’s
hedging program are:




·
    volatility
      of the currency markets




·
    availability
      of hedging instruments




·
    accuracy
      of our inventory forecasts




Additionally,
there is the risk that foreign exchange fluctuations will make our products less
competitive in foreign markets, which would substantially reduce our
sales.





As of
March 31, 2005, the Company had foreign currency contracts outstanding of
approximately $7,052,000 against the delivery of the Euro. The contracts expire
through August 2005. 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 deferred gain of $406,300 and $126,509 for the three and six
months ended March 31, 2005. As of March 31, 2005,




11
 **NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)**




**Note
      3.**
    **Derivative
      Financial Instruments - continued**





a
deferred gain of $27,110 reflecting the cumulative mark to market loss of the
Company’s derivatives, was recorded on the Company’s balance sheet as a
component of accumulated other comprehensive income in our equity section.





The
Company uses the average monthly forward contract exchange rate to translate our
Euro denominated sales into the Company’s U.S. dollar reporting currency. For
the three month and six month periods ended March 31, 2005, the use of the
monthly average spot rate instead of the average monthly forward contract
exchange rate to value Euro denominated sales would have resulted in an
increase in sales of $337,699 and $978,484, respectively. This sales
increase is related to contracts that closed during these periods and the
changes in the fair value of our derivative contracts.  For the three month
and six month periods ended March 31, 2004, the use of the monthly average spot
rate instead of the average monthly forward contract exchange rate to value
Euro  denominated
sales would have resulted in a sales increase of $103,835 and $909,368,
respectively.




**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:





**March
      31,**
      **2005**
    
    
    **September
      30,**
      **2004****Component
      Parts**
    
    **$**
    **2,924,801**
    
    **$**
    **3,522,974****Finished
      Goods**
    
    
    **5,434,675**
    
    
    **4,954,280****$**
    **8,359,476**
    
    **$**
    **8,477,254**


**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: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**
      **March
      31,**
    **Six
      months Ended**
      **March
      31****2005**
    
    
    **2004**
    
    
    **2005**
    
    
    **2004****Weighted
      average shares outstanding-basic**
    
    
    **9,460,702**
    
    
    **8,901,734**
    
    
    **9,368,428**
    
    
    **8,891,135****Number
      of shares issued on the assumed exercise of stock
      options**
    
    
    **640,468**
    
    
    **848,173**
    
    
    **630,977**
    
    
    **684,964****Weighted
      average shares outstanding-diluted**
    
    
    **10,101,170**
    
    
    **9,749,907**
    
    
    **9,999,405**
    
    
    **9,576,099**
  12
 **NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)**




**Note
      5.**
    **Net
      Income Per Share - continued**


Options
to purchase 88,109 and 120,513 shares of common stock, at prices ranging $5.25
to $ 10.06, were outstanding for the three month periods ending March 31, 2005
and 2004, respectively, but were not included in the computation of diluted
earnings per share because they were anti-dilutive.





Options
to purchase 91,878 and 228,905 shares of common stock, at prices ranging $5.25
to $ 10.06 and $3.88 to $10.06, respectively, were outstanding for the six month
periods ending March 31, 2005 and 2004, respectively, but were not included in
the computation of diluted earnings per share because they were anti-dilutive.







**Note
      6.**
    **Accumulated
      other comprehensive income**


The Euro
is the functional currency of the Company’s European subsidiary, Hauppauge
Digital Europe Sarl . Assets
and liabilities of this subsidiary are translated to U.S. Dollars at the spot
exchange rate in effect at the end of each reporting period, while equity
accounts are translated to U.S. Dollars at the historical rate in effect at the
date of the contribution. Operating results are translated to U.S. Dollars at
the average prevailing exchange rate for the period, with the exception of
sales, which are translated to U.S. Dollars at the average monthly forward
exchange contract rate. The use of translating accounts at the spot, historical
and average exchange rates results in foreign currency translation gains or
losses. These translation gains or losses are recorded on the balance sheet
under accumulated other comprehensive income.





The
Company uses forward exchange contracts to reduce its exposure to fluctuations
in foreign currencies. Mark to market gains and losses on these open contracts
result from the difference between the USD value of the open foreign currency
forward contracts at the average contract rate as opposed to the same contracts
translated at the month end spot rate. The Company qualifies for cash flow hedge
accounting as prescribed under FAS 133, which allows the Company to record the
mark to market gains and losses in the equity section of the Company’s balance
sheet under accumulated other comprehensive income.





As of
March 31, 2005, appearing in the equity section under “ Accumulated other
comprehensive income” was a deferred gain of $1,448,820, which consisted of a
deferred translation gain of $1,421,710 and a deferred gain of $27,110 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.





The
Company’s Asian subsidiary reports its financial position and results of
operations in the reporting currency of the Company .




13


**NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**




**Note
      7.**
    **Revenue
      Recognition**





The
Company sells through a sales channel which consist of retailers, distributors
and original equipment manufacturers (OEM’s). The Company’s prices are fixed
consistently over the entire sales channel. The product is shipped on open
account with the majority of the Company’s customers given 30 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’s retail products
are typically stocked on the shelves of retailers, and is 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 it customers a right of return, but does not offer stock
balancing. The Company’s accounting method complies with SFAS 48 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 offers several types of analog products. The Company’s WinTV® analog TV
receivers allow PC users to watch television on their PC screen in a resizable
window, and also enable recording of TV shows to a hard disk. The Company’s
WinTV®-PVR TV personal video recorder products include hardware MPEG encoders,
which improve the performance of TV recording and add instant replay and program
pause functions, plus also enable the ‘burning’ of TV recordings onto DVD or CD
media. The Company’s EskapeTM Labs products allow users of Apple®Macintosh®
computers to watch television on their computer screen.





The
Company offers three types of digital TV receivers. The Company’s WinTV® digital
receivers can receive digital TV transmissions and display the digital TV show
in a re-sizeable window on a user’s PC screen. The Company’s Digital
Entertainment Center products (“DEC”) allow users to receive digital TV
broadcasts and display the digital TV on either a




14


**NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**





TV set or
a PC screen. Our MediaMVPTM product was designed to allow PC users to play
digital media such as digital music, digital pictures and digital videos on a TV
set via a home network. The Company’s products are either sold, or can be sold,
by the same retailers and distributors in the Company’s 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 March 31,**
    **Six
      months ended March 31,****2005**
    
    
    **2004**
    
    
    
    
    
    **2005**
    
    
    **2004****Product
      line sales****Analog
      sales**
    
    **$**
    **16,362,392**
    
    **$**
    **13,724,007**
    
    
    
    
    **$**
    **34,753,380**
    
    **$**
    **28,153,235****Digital
      sales**
    
    
    **3,999,901**
    
    
    **3,080,276**
    
    
    
    
    
    **8,969,356**
    
    
    **6,881,346****$**
    **20,362,293**
    
    **$**
    **16,804,283**
    
    
    
    
    **$**
    **43,722,736**
    
    **$**
    **35,034,581**
 
 The
Company sells its products through an international network of distributors and
retailers. Sales percent by geographic region are as follows:
 
 **Three
      months ended March 31,**
    **Six
      months ended March 31,****Sales
      percent by geographic region**
    **2005**
    **2004**
    **2005**
    **2004****United
      States**
    **49%**
    **33%**
    **43%**
    **29%****Europe**
    **49%**
    **65%**
    **55%**
    **70%****Asia**
    **2%**
    **2%**
    **2%**
    **1%****Total**
    **100%**
    **100%**
    **100%**
    **100%**


**Note
      9.**
    **Stock-Based
      Compensation**


The
Company applies Accounting Principles Board Opinion No. 25, “Accounting for
Stock Issued to Employees”, (“APB 25”), and related interpretations in
accounting for its employee stock options. Under APB 25, no compensation expense
is recorded so long as the quoted market price of the stock at the date of the
grant is equal to the exercise price.





Pro forma
information regarding net income and earnings per share has been determined as
if the Company had accounted for its employee stock options under the fair value
method of Financial Accounting Standards Board Statement No. 123 “Accounting for
Stock-Based Compensation”, (“FAS 123”). The weighted average fair value of
options outstanding during the three and six months ended March 31, 2005 and
March 31, 2004 was $1.15 to $1.39 and $0.43, respectively. 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 for the three and
six months ended March 31, 2005 and March 31, 2004: risk-free interest rates of
4.25%, volatility factor of the expected market price of the Company’s Common
Stock of 35%, assumed dividend yield of 0%, and a weighted-average expected life
of the option of 5 years.




15
 **NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)**





Under the
accounting provisions of FAS 123, the Company’s net income and net income per
share would have been adjusted to the pro forma amounts indicated
below:




**Three
      Months ended**
    **Six
      Months ended****March
      31,**
    **March
      31****2005**
    **2004**
    **2005**
    **2004****Net
      income as reported**
    **$
      827,465**
    **$
      544,390**
    **$
      2,091,155**
    **$
      1,537,250****Deduct:
      Total stock-based employee compensation expense****determined
      under fair value method, net of related taxes**
    **(8,924)**
    **(24,788)**
    **(17,848)**
    **(49,576)****Pro
      forma net income**
    **$
      818,541**
    **$
      519,602**
    **$
      2,073,307**
    **$
      1,487,674****Net
      income per share - as reported:****Basic**
    **$
      0.09**
    **$
      0.06**
    **$
      0.22**
    **$
      0.17****Diluted**
    **$
      0.08**
    **$
      0.06**
    **$
      0.21**
    **$
      0.16****Net
      income per share - pro forma:****Basic**
    **$
      0.09**
    **$
      0.06**
    **$
      0.22**
    **$
      0.17****Diluted**
    **$
      0.08**
    **$
      0.06**
    **$
      0.21**
    **$
      0.16**


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





FASB
Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of the Indebtedness
of Others, clarified the requirements of SFAS No. 5, Accounting for
Contingencies, relating to a guarantor’s accounting for and disclosures of
certain guarantees issued. FIN 45 requires enhanced disclosures for certain
guarantees. It also requires certain guarantees that are issued or modified
after December 31, 2002, including certain third-party guarantees, to be
initially recorded on the balance sheet at fair value. For guarantees issued on
or before December 31, 2002, liabilities are recorded when and if payments
become probable and estimable. FIN 45 has the general effect of delaying
recognition for a portion of the revenue for product sales that are accompanied
by certain third-party guarantees. The financial statement recognition
provisions became effective prospectively beginning January 1, 2003. The Company
has not entered into any new guarantees and the Company has been released from
the one guarantee it was subject to prior to February 17, 2004.





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. In February 1990, Hauppauge Computer Works, Inc., a wholly-owned
subsidiary of the Company (“HCW”), entered into a lease (the “1990 Lease”), with
Ladokk Realty Co., a real estate




16
 **NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)**





partnership
which is principally owned by Kenneth Plotkin, the Company’s Chairman of the
Board, Chief Executive Officer, President, Chief Operating Officer and Vice
President of Marketing and the holder of approximately 8.8% of the Company’s
Common Shares as of March 31, 2005, Dorothy Plotkin, the wife of Kenneth
Plotkin, holder of approximately 5.9% of the Company’s Common Shares as of March
31, 2005 and Laura Aupperle, believed by the Company to be the holder of
approximately 10.6% of the Compnay’s Common Shares, including Common Shares
attributed to the Estate of Kenneth R. Aupperle. Ladokk Realty Co., LLC is the
successor to Ladokk Realty Co. As of February 2004, the 1990 Lease provided for
annual rent of approximately $454,000, payable monthly, and subject to 5% annual
increases effective February 1 st of each
year. The Company was also obligated to pay real estate taxes and operating
costs of maintaining the premises subject to the 1990 Lease. Until February 17,
2004, the premises subject to such lease were subject to two mortgages
guaranteed by us.





On
February 17, 2004, HCW and Ladokk terminated the 1990 Lease and HCW entered into
a new lease agreement with Ladokk Realty Co., LLC (the “2004 Lease”). The 2004
Lease term is for five years and terminates on February 16, 2009. The annual
rent under the 2004 Lease is $360,000, payable monthly. The Company was also
obligated to pay real estate taxes and operating costs of maintaining the
premises subject to such lease. 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 guarantee the landlord’s
mortgages.





The
Company’s Audit Committee is in the process of evaluating the 2004
Lease.




17


Item
      2.
    **Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations**
      **Three
      Month Period ended March 31, 2005 Compared to March 31,
      2004**








Results
of operations for the three months ended March 31, 2005 compared to March 31,
2004 are as follows:





**Three**
    
    
    **Three******
    
    
    **Months**
    
    
    **Months******
    
    
    **Ended**
    
    
    **Ended**
    
    
    **Variance**
    
    **Percentage
      of sales******
    
    
    **3/31/05**
    
    
    **3/31/04**
    
    
    **$**
    
    
    **2005**
    
    
    **2004**
    
    
    **Variance****Net
      sales**
    
    **$**
    **20,362,293**
    
    **$**
    **16,804,283**
    
    **$**
    **3,558,010**
    
    
    **100.0**
    **%**
    
    **100.0**
    **%**
    
    **-****Cost
      of sales**
    
    
    **15,542,399**
    
    
    **11,873,313**
    
    
    **3,669,086**
    
    
    **76.33**
    **%**
    
    **70.66**
    **%**
    
    **5.67**
    **%****Gross
      profit**
    
    
    **4,819,894**
    
    
    **4,930,970**
    
    
    **(111,076**
    **)**
    
    **23.67**
    **%**
    
    **29.34**
    **%**
    
    **-
      5.67**
    **%****Gross
      profit %**
    
    
    **23.67**
    **%**
    
    **29.34**
    **%**
    
    **-5.67**
    **%******
    
    
    ******Costs:**
    
    
    
    
    
    
    
    
    
    
    
    ****
    
    
    ****
    
    
    ******Sales
      & marketing**
    
    
    **2,350,422**
    
    
    **2,041,614**
    
    
    **308,808**
    
    
    **11.54**
    **%**
    
    **12.15**
    **%**
    
    **-0.61**
    **%****Technical
      support**
    
    
    **124,417**
    
    
    **107,489**
    
    
    **16,928**
    
    
    **0.61**
    **%**
    
    **0.64**
    **%**
    
    **-0.03**
    **%****General
      & administrative**
    
    
    **851,975**
    
    
    **1,074,666**
    
    
    **(222,691**
    **)**
    
    **4.18**
    **%**
    
    **6.40**
    **%**
    
    **-2.22**
    **%****Total
      selling, general and administrative costs**
    
    
    **3,326,814**
    
    
    **3,223,769**
    
    
    **103,045**
    
    
    **16.33**
    **%**
    
    **19.19**
    **%**
    
    **-2.86**
    **%****Research
      & development**
    
    
    **631,437**
    
    
    **444,390**
    
    
    **187,047**
    
    
    **3.10**
    **%**
    
    **2.64**
    **%**
    
    **0.46**
    **%****Total
      operating costs**
    
    
    **3,958,251**
    
    
    **3,668,159**
    
    
    **290,092**
    
    
    **19.43**
    **%**
    
    **21.83**
    **%**
    
    **-2.40**
    **%****Net
      operating income before litigation and
arbitration**
    
    
    **861,643**
    
    
    **1,262,811**
    
    
    **(401,168**
    **)**
    
    **4.24**
    **%**
    
    **7.51**
    **%**
    
    **-3.27**
    **%****Arbitration
      and litigation items:****Arbitration
      proceeding**
    
    
    **-**
    
    
    **206,250**
    
    
    **(206,250**
    **)**
    
    **0.00**
    **%**
    
    **1.23**
    **%**
    
    **-1.23**
    **%****Litigation
      proceeding**
    
    
    **-**
    
    
    **500,000**
    
    
    **(500,000**
    **)**
    
    **0.00**
    **%**
    
    **2.98**
    **%**
    
    **-2.98**
    **%****Net
      operating income**
    
    
    **861,643**
    
    
    **556,561**
    
    
    **305,082**
    
    
    **4.24**
    **%**
    
    **3.30**
    **%**
    
    **0.94**
    **%****Other
      income****Interest
      income**
    
    
    **3,150**
    
    
    **1,397**
    
    
    **1,753**
    
    
    **0.02**
    **%**
    
    **0.01**
    **%**
    
    **0.01**
    **%****Foreign
      currency**
    
    
    **7,672**
    
    
    **33,232**
    
    
    **(25,560**
    **)**
    
    **0.04**
    **%**
    
    **0.20**
    **%**
    
    **-0.16**
    **%****Total
      other income**
    
    
    **10,822**
    
    
    **34,629**
    
    
    **(23,807**
    **)**
    
    **0.06**
    **%**
    
    **0.21**
    **%**
    
    **-0.15**
    **%****Income
      before taxes**
    
    
    **872,465**
    
    
    **591,190**
    
    
    **281,275**
    
    
    **4.30**
    **%**
    
    **3.51**
    **%**
    
    **0.79**
    **%****Taxes
      on income**
    
    
    **45,000**
    
    
    **46,800**
    
    
    **(1,800**
    **)**
    
    **0.22**
    **%**
    
    **0.28**
    **%**
    
    **-0.06**
    **%****Net
      income**
    
    **$**
    **827,465**
    
    **$**
    **544,390**
    
    **$**
    **283,075**
    
    
    **4.08**
    **%**
    
    **3.23**
    **%**
    
    **0.85**
    **%**
  18
 **Results
of operations-three month period ended March 31, 2005 compared to March 31,
2004-continued**





Net sales
for the three months ended March 31, 2005 increased $3,558,010 over the three
months ended March 31, 2004 as shown in the table below.




**Location**
    **Three
      Months**
      **Ended
      3/31/05**
    **Three
      Months Ended 3/31/04**
    **Increase
      (Decrease)**
      **Dollar
      Variance**
    **Increase**
      **(Decrease)**
      **Variance
      %**
    **Sales by Geographic
      ******region******2005**
    **2004****Domestic**
    **$10,031,697**
    **$
      5,603,577**
    **$
      4,428,120**
    **79%**
    **49%**
    **33%****Europe**
    **9,908,999**
    **10,983,449**
    **(1,074,450)**
    **-10%**
    **49%**
    **65%****Asia**
    **421,597**
    **217,257**
    **204,340**
    **94%**
    **2%**
    **2%****Total**
    **$
      20,362,293**
    **$
      16,804,283**
    **$
      3,558,010**
    **21%**
    **100%**
    **100%**


The
primary factors contributing to the sales increase were:




·
    Increased
      volume of WinTV-PVR-150 OEM sales




·
    Stronger
      demand for retail WinTV-PVR-150/350/500
products




·
    Increased
      digital TV product sales




·
    Increased
      WinTV-PVR-USB2 sales due to introduction of lower cost model




·
    Increase
      in the average Euro to USD contract rate of about 1.50% (1.2545 versus
      1.2359) for the three months ended March 31, 2005 compared to the three
      months ended March 31, 2004, which yielded higher converted Euro to USD
      sales




The sales
increases were offset by the following negative trends:




·
    Decrease
      in WinTV PCI analog product sales




·
    Decrease
      in WinTV-USB 1.1 sales




·
    Decrease
      in MediaMVP sales







Net sales
to domestic customers were 49% of net sales for the three months ended March 31,
2005 compared to 33% for the three months ended March 31, 2004. Net sales to
European customers were 49% of net sales compared to 65% for the same period of
last year. Net sales to Asian customers were 2% for the three months ended March
31, 2005 and 2004, respectively.





Gross
profit decreased $111,076 for the three months ended March 31, 2005 compared to
the prior year’s second quarter.




19
 **Results
of operations-three month period ended March 31, 2005 compared to March 31,
2004-continued**





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




**Increase**
      **(decrease)****Due
      to increased sales**
    **$1,307,524****Gross
      profit changes due to product sales mix**
    **(425,887)****Effect
      on gross profit due to lower margin OEM sales**
    **(553,972)****Due
      to increases in labor related and other costs**
    **(438,741)****Total
      increase in gross profit**
    **$(111,076)**


Gross
profit percentage for the three months ended March 31, 2005 was 23.67% compared
to 29.34% for the three months ended March 31, 2004, a decrease of 5.67%.





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




**Increase**
      **(decrease)****Gross
      profit changes due to product sales mix**
    **(2.09)%****Effect
      on gross profit due to lower margin OEM sales**
    **(2.09)%****Labor
      related and other costs**
    **(0.86)%****Net
      decrease in gross profit %**
    **(5.67)%**
 The
decrease in the gross profit percent of 5.67 % for the three months ended March
31, 2005 compared to the three months ended March 31, 2004 was primarily due
to:




·
    Sales
      growth of OEM product sales. Gross profit for OEM products is lower than
      our retail products.




·
    Sales
      mix of retail sales with lower gross profit compared to last year’s second
      quarter.




·
    Labor
      related and other costs contributed to a 0.86% decrease in gross profit
      percent compared to three months ended March 31, 2004. The increase in
      labor related and other costs of 35.26% exceeded the increase in net sales
      of 21.17%.




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




**Three
      months ended March 31,**
    ******Dollar
      Costs**
    **Percentage
      of Sales****2005**
    **2004**
    **Increase**
    **2005**
    **2004**
    **Increase****(Decrease)**
    **(Decrease)****Sales
      and marketing**
    **$
      2,350,422**
    **$
      2,041,614**
    **$
      308,808**
    **11.54%**
    **12.15%**
    **-0.61%****Technical
      support**
    **124,417**
    **107,489**
    **16,928**
    **0.61%**
    **0.64%**
    **-0.03%****General
      and administrative**
    **851,975**
    **1,074,666**
    **(222,691)**
    **4.18%**
    **6.40%**
    **-2.22%****Total**
    **$
      3,326,814**
    **$
      3,223,769**
    **$
      103,045**
    **16.33%**
    **19.19%**
    **-2.86%**


20
 Results of operations-three month period
ended March 31, 2005 compared to March 31,
2004-continued


Selling,
general and administrative expenses increased $103,045 from the prior year’s
second quarter. As a percentage of sales, selling, general and administrative
expenses decreased by 2.86% when compared to the three months ended March 31,
2004.





The
increase in sales and marketing expense of $308,808, was mainly due
to:




·
    Increases
      caused by the strengthening of the Euro to the U.S dollar of $64,342,
      which accounted for about 20.8% of the total increase. The average Euro to
      USD conversion rate was $1.3103 for the three months ended March 31, 2005
      compared to $1.2512 for the three months ended March 31,
    2004




·
    Higher
      advertising expenses of $73,914




·
    Increased
      commission expense of $44,179 due to higher
sales




·
    Increased
      compensation due to additional outside sales persons of
      $44,142




·
    Increased
      European sales office costs of $37,582




·
    Increased
      product promotion costs of $19,673




The
decrease in general and administrative expenses of $222,691 was primarily due
to:




·
    Lower
      executive compensation of $ 31,631, mainly due to vacant Officer’s
      position




·
    Lower
      legal fees of$274,629 as a result of completion of arbitration and
      litigation




·
    Higher
      Directors fees of $45,382




·
    Higher
      consulting fees of $12,500 due to start of 404 Compliance work




·
    Higher
      European tax compliance and accounting items of
$18,972




Research
and development expenses increased $187,047. The increase was mainly due
to




·
    The
      new research and development facility in Taiwan, which began operations
      during March 2004




·
    Higher
      compensation costs of $74,927 due to the hiring of additional
      engineers




·
    Increased
      program development costs of $57,613 due to higher volume of new product
      and product enhancement programs




21
 **Results
of operations-three month period ended March 31, 2005 compared to March 31,
2004-continued**





**Arbitration
Proceeding**





In
November 2002, the estate of Kenneth Aupperle ("Estate") filed a demand for
arbitration against us with the American Arbitration Association. The Estate
claimed certain property rights and interest in us, amounts due and owing to the
Estate based on various corporate agreements with the late Mr. Aupperle and
certain insurance policies. The Estate was seeking to recover a minimum of $2.5
million in damages, fees and expenses.





The
arbitration proceeding was heard before a New York arbitration panel. On April
19, 2004, the arbitration panel awarded the Estate a total of $206,250 in
relation to certain stock options. No fees or expenses were awarded. We accrued
a charge of $206,250 in the second quarter of fiscal year 2004 to cover the
award.





**Litigation
Proceeding**





In March
2002, Polywell International, Inc. ("Polywell"), a supplier of cables to us,
commenced an action seeking $339,520 in damages plus exemplary damages,
attorney's fees, costs and interest with relation to certain unpaid invoices. We
paid these invoices to the sales representative, who subsequently failed to
forward the payments to Polywell. We had dealt with this sales representative
over a number of years, who also represented himself as Polywell's payment and
collection agent.





The case
went to trial and was heard before a jury in the United States District Court in
the Northern District of Texas, Dallas Division. Since we had dealt with the
said sales representative for several years with respect to all purchasing and
payment issues, we believed that paying the invoices to this sales
representative was tantamount to paying Polywell. The jury however ruled in
favor of Polywell and the court granted Polywell a judgment against us, awarding
an amount of $339,520 to Polywell. In addition, we were obligated to pay
Polywell's attorney’s fees and interest. We accrued a charge of $500,000 in the
second quarter of fiscal year 2004 to cover the award.





**Other
income**





Net other
income for the three months ended March 31, 2005 was $10,822 compared to net
other income of $34,629 for the three months ended March 31, 2004 as detailed
below:




**Three
      months ended March 31,****2005**
    
    
    **2004****Interest
      income**
    
    **$**
    **3,150**
    
    **$**
    **1,397****Foreign
      currency transaction gains**
    
    
    **7,672**
    
    
    **33,232****Total
      other income**
    
    **$**
    **10,822**
    
    **$**
    **34,629**




22
 ****


**Results
of operations-three month period ended March 31, 2005 compared to March 31,
2004-continued**





**Re-measurement
of accounts denominated in currencies other than the Euro**


We follow
the rules prescribed in paragraph 16 of SFAS 52 "Foreign Currency Translation",
which states that accounts denominated in a currency other than an entity’s
functional currency, excluding inter-company accounts which are long term in
nature, need to be re-measured into the entity’s functional currency, and any
gain or loss from this re-measurement are included in the determination of net
income and are booked as a component of other income (loss) under the
description “foreign currency”.





**Accumulated
other comprehensive income (loss)**





The Euro
is the functional currency of our European subsidiary, Hauppauge Digital Europe
Sarl. Assets and liabilities of this subsidiary are translated to U.S. Dollars
at the exchange rate in effect at the end of each reporting period, while equity
accounts are translated to U.S. Dollars at the historical rate in effect at the
date of the contribution. Operating results are translated to U.S. Dollars at
the average prevailing exchange rate for the period, with the exception of sales
which are translated to U.S. Dollars at the average monthly forward exchange
contract rate. The use of differing exchange rates results in foreign currency
translation gains or losses. Since the Euro denominated accounts on HDE Sarl’s
books result in a net asset position (total Euro assets are in excess of Euro
liabilities), an increase in the Euro value results in a deferred gain for the
translation of Euro accounts to U.S. Dollars. We had a translation gain of
$1,074,910 recorded on the balance sheet as of September 30, 2004. For the six
months ended March 31, 2005, we recorded on the balance sheet deferred
translation gains $346,800 resulting in a translation gain of $1,421,710
recorded as a component of accumulated other comprehensive income as of March
31, 2005.





We use
forward exchange contracts to reduce our exposure to fluctuations in foreign
currencies. Mark to market gains and losses on these open contracts result from
the difference between the USD value of our open foreign currency forward
contracts at the average contract rate as opposed to the same contracts
translated at the month end forward rate. We qualify for cash flow hedge
accounting as prescribed under SFAS 133, which allows us to record the mark to
market gains and losses in the equity section of our balance sheet under
accumulated other comprehensive income. We had mark to market losses of $99,399
recorded on the balance sheet as of September 30, 2004. For the six months ended
March 31, 2005, we recorded, as component of other comprehensive income, a mark
to market gain of $126,509, resulting in a mark to market gain of $27,110 for contracts
open as of March 31, 2005.




23
 ****


**Results
of operations-three month period ended March 31, 2005 compared to March 31,
2004-continued**





As stated
above, accumulated other comprehensive income (loss) consists of two components:




·
    Translations
      gains and losses




**·**
    FAS
      133 mark to market gains and losses on our open foreign exchange
      contracts




The table
below details the gains and losses recorded for the components that make up
accumulated other comprehensive income (loss):




**Accumulated
      other comprehensive income**
    
    
    **Balance
      as of Sept.**
      **30,
      2004**
    
    
    **October
      2004****to
      March**
      **2005
      Gains**
    
    
    **Balance
      as of**
      **March
      31, 2005****Translation
      gains**
    
    **$**
    **1,074,910**
    
    **$**
    **346,800**
    
    **$**
    **1,421,710****FAS
      133 mark to market adjustments**
    
    
    **(99,399**
    **)**
    
    **126,509**
    
    
    **27,110****$**********
    ******975,511******
    
    **$**********
    ******473,309******
    
    **$**********
    ******1,448,820******





**Tax
provision**


Our net
tax provision for the three months ended March 31, 2005 and 2004 is as
follows :




**Three months ended March
      31,****2005**
    
    
    **2004****Tax
      attributable to U.S operations**
    
    **$**
    **176,000**
    
    **$**
    **(360,800**
    **)****Tax
      expense European operations**
    
    
    **30,000**
    
    
    **39,300****State
      taxes**
    
    
    **15,000**
    
    
    **7,500****Deferred
      tax asset valuation allowance**
    
    
    **-**
    
    
    **360,800****Net
      operating loss utilization**
    
    
    **(176,000**
    **)**
    
    **-****Net
      tax provision**
    
    ******$**
    ******45,000**
    
    ******$**
    ******46,800**


For the
last five fiscal years, our domestic operation has incurred losses. We analyzed
the future realization of our deferred tax assets as of March 31, 2005, and
although our domestic operation reported a profit for the three months ended
March 31, 2005, due to the seasonal nature of the business it is uncertain at
this time whether our domestic operation will have a profit for the full year.
It light of this, we did not make any adjustments to our valuation allowance for
the quarter ended March 31, 2005.





As a
result of all of the above items mentioned in the Management’s Discussion and
Analysis of Financial Condition and Results of Operations, we recorded net
income of $827,465, for the three months ended March 31, 2005, which resulted in
basic net income per share of $0.09 and diluted net income per share of $0.08 on
weighted average basic and diluted shares of 9,460,702 and 10,101,170,
respectively, compared to a net income of $544,390 for the three months ended
March 31, 2004, which resulted in basic and diluted net income per share of
$0.06 on weighted average basic and diluted shares of 8,901,734 and 9,749,907,
respectively.




24
 **Results
of operations-three month period ended March 31, 2005 compared to March 31,
2004-continued**





Options
to purchase 88,109 and 120,513 shares of common stock at prices ranging $5.25 to
$ 10.06, were outstanding for the three month periods ending March 31, 2005 and
2004, respectively, but were not included in the computation of diluted earnings
per share because they were anti-dilutive.




25


**Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations**
      **Six
      Month Period ended March 31, 2005 Compared to March 31,
      2004**





Results
of operations for the six months ended March 31, 2005 compared to March 31, 2004
are as follows:




**Six**
    
    
    **Six******
    
    
    **Months**
    
    
    **Months******
    
    
    **Ended**
    
    
    **Ended**
    
    
    **Variance**
    
    **Percentage
      of sales****3/31/04**
    
    
    **3/31/04**
    
    
    $
    
    
    **2005**
    
    
    **2004**
    
    
    **Variance****Net
      sales**
    
    **$**
    **43,722,736**
    
    **$**
    **35,034,581**
    
    **$**
    **8,688,155**
    
    
    **100.0**
    **%**
    
    **100.0**
    **%**
    
    **-****Cost
      of sales**
    
    
    **33,591,477**
    
    
    **25,521,988**
    
    
    **8,069,489**
    
    
    **76.83**
    **%**
    
    **72.85**
    **%**
    
    **3.98**
    **%****Gross
      profit**
    
    
    **10,131,259**
    
    
    **9,512,593**
    
    
    **618,666**
    
    
    **23.17**
    **%**
    
    **27.15**
    **%**
    
    **-3.98**
    **%****Gross
      profit %**
    
    
    **23.17**
    **%**
    
    **27.15**
    **%**
    
    **-3.98**
    **%******
    
    
    ******Costs:**
    
    
    
    
    
    
    
    
    
    
    
    ****
    
    
    ****
    
    
    ******Sales
      & marketing**
    
    
    **4,782,013**
    
    
    **4,167,323**
    
    
    **614,690**
    
    
    **10.94**
    **%**
    
    **11.89**
    **%**
    
    **-0.95**
    **%****Technical
      support**
    
    
    **244,742**
    
    
    **215,944**
    
    
    **28,798**
    
    
    **0.56**
    **%**
    
    **0.62**
    **%**
    
    **-0.06**
    **%****General
      & administrative**
    
    
    **1,727,115**
    
    
    **1,961,118**
    
    
    **(234,003**
    **)**
    
    **3.95**
    **%**
    
    **5.60**
    **%**
    
    **-1.65**
    **%****Total
      selling, general and administrative costs**
    
    
    **6,753,870**
    
    
    **6,344,385**
    
    
    **409,485**
    
    
    **15.45**
    **%**
    
    **18.11**
    **%**
    
    **-2.66**
    **%****Research
      & development**
    
    
    **1,188,967**
    
    
    **854,664**
    
    
    **334,303**
    
    
    **2.72**
    **%**
    
    **2.44**
    **%**
    
    **0.28**
    **%****Total
      operating costs**
    
    
    **7,942,837**
    
    
    **7,199,049**
    
    
    **743,788**
    
    
    **18.17**
    **%**
    
    **20.55**
    **%**
    
    **-2.38**
    **%****Net
      operating income before litigation and
arbitration**
    
    
    **2,188,422**
    
    
    **2,313,544**
    
    
    **(125,122**
    **)**
    
    **5.00**
    **%**
    
    **6.60**
    **%**
    
    **-1.60**
    **%****Arbitration
      and litigation items:****Arbitration
      proceeding**
    
    
    **-**
    
    
    **206,250**
    
    
    **(206,250**
    **)**
    
    **0.00**
    **%**
    
    **0.59**
    **%**
    
    **-0.59**
    **%****Litigation
      proceeding**
    
    
    **-**
    
    
    **500,000**
    
    
    **(500,000**
    **)**
    
    **0.00**
    **%**
    
    **1.43**
    **%**
    
    **-1.43**
    **%****Net
      operating income**
    
    
    **2,188,422**
    
    
    **1,607,294**
    
    
    **581,128**
    
    
    **5.00**
    **%**
    
    **4.58**
    **%**
    
    **0.42**
    **%****Other
      income (expense)****Interest
      income**
    
    
    **4,661**
    
    
    **3,136**
    
    
    **1,525**
    
    
    **0.01**
    **%**
    
    **0.01**
    **%**
    
    **0.00**
    **%****Foreign
      currency**
    
    
    **(928**
    **)**
    
    **21,899**
    
    
    **(22,827**
    **)**
    
    **0.00**
    **%**
    
    **0.06**
    **%**
    
    **-0.06**
    **%****Total
      other income (expense)**
    
    
    **3,733**
    
    
    **25,035**
    
    
    **(21,302**
    **)**
    
    **0.01**
    **%**
    
    **0.07**
    **%**
    
    **-0.06**
    **%****Income
      before taxes**
    
    
    **2,192,155**
    
    
    **1,632,329**
    
    
    **559,826**
    
    
    **5.01**
    **%**
    
    **4.65**
    **%**
    
    **0.36**
    **%****Taxes
      on income**
    
    
    **101,000**
    
    
    **95,079**
    
    
    **5,921**
    
    
    **0.23**
    **%**
    
    **0.27**
    **%**
    
    **-0.04**
    **%****Net
      income**
    
    **$**
    **2,091,155**
    
    **$**
    **1,537,250**
    
    **$**
    **553,905**
    
    
    **4.78**
    **%**
    
    **4.38**
    **%**
    
    **0.40**
    **%**






26
 **Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





Net sales
for the six months ended March 31, 2005 increased $8,688,155 compared to the six
months ended March 31, 2004 as shown on the table below.


**Location**
    
    **Six
      Months**
      **Ended
      3/31/05**
    
    **Six
      Months**
      **Ended
      3/31/04**
    
    **Increase
      (Decrease) Dollar Variance**
    
    **Increase
      (Decrease) Variance %**
    **Sales
      by**
      **Geographic
      region****2005**
    
    **2004****Domestic**
    
    **$
      18,885,272**
    
    **$
      9,956,307**
    
    **$
      8,928,965**
    
    **90%**
    
    **43%**
    
    **29%****Europe**
    
    **24,058,482**
    
    **24,610,163**
    
    **(551,681)**
    
    **-2%**
    
    **55%**
    
    **70%****Asia**
    
    **778,982**
    
    **468,111**
    
    **310,871**
    
    **66%**
    
    **2%**
    
    **1%****Total**
    
    **$
      43,722,736**
    
    **$
      35,034,581**
    
    **$
      8,688,155**
    
    **25%**
    
    **100%**
    
    **100%**
 The
primary factors contributing to the sales increase
were:




·
    Increased
      volume of WinTV-PVR-150 OEM sales




·
    Stronger
      demand for retail WinTV-PVR-150/350/500
products




·
    Increased
      WinTV-PVR-USB2 sales due to introduction of lower cost model




·
    Increased
      DEC sales to UK and German customers




·
    Increased
      Digital Video Satellite sales




·
    Introduction
      of Portable MediaMVP portable media player in
Europe




·
    Increase
      in the average Euro to USD contract rate of about 5.92% (1.2372 versus
      1.1681) for the six months ended March 31, 2005 compared to the six months
      ended March 31, 2004, which yielded higher converted Euro to USD
      sales




The sales
increases were offset by the following negative trends:




·
    Decrease
      in WinTV PCI analog product sales




·
    Decrease
      in MediaMVP sales compared with the year ago period which included the
      initial product rollout shipments to retailers and
      distributors




·
    Decrease
      in USB 1.1 analog sales







Net sales
to domestic customers were 43% of net sales for the six months ended March 31,
2005 compared to 29% for the six months ended March 31, 2004. Net sales to
European customers were 55% of net sales compared to 70% for the same period of
last year. Net sales to Asian customers were 2% and 1% for the six months ended
March 31, 2005 and 2004.




27
 **Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





Gross
profit increased $618,666 for the six months ended March 31, 2005 compared to
the prior year. The increases and (decreases) in the gross profit are detailed
below:





**Increase****(decrease)****Due
      to increased sales**
    **$
      3,009,014****Gross
      profit changes due to product sales mix**
    **(936,168)****Effect
      on gross profit due to lower margin OEM sales**
    **(780,530)****Due
      to increases in labor related and other costs**
    **(673,650)****Total
      increase in gross profit**
    **$
      618,666**
 Gross
profit percentage for the six months ended March 31, 2005 was 23.17% compared to
27.15% for the six months ended March 31, 2004, a decrease of
3.98%.





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






**Increase**
      **(decrease)****Gross
      profit changes due to retail product sales mix**
    **(2.15)%****Effect
      on gross profit due to lower margin OEM sales**
    **(1.78)%****Labor
      related and other costs**
    **(0.05)%****Net
      decrease in gross profit %**
    **(3.98)%**
   The
decrease in the gross profit percent of 3.98 % for the six months ended March
31, 2005 compared to the six months ended March 31, 2004 was primarily due
to:




·
    Sales
      growth of OEM product sales. Gross profit for OEM products is lower than
      our retail products, but do not require the sales, promotion and customer
      support required of our retail sales.




·
    Sales
      mix of retail sales with lower gross profit compared to last year’s second
      quarter.




·
    Labor
      related and other costs contributed to a 0.05% decrease in gross profit
      percent compared to six months ended March 31, 2004. The increase in labor
      related and other costs of 25.70% exceeded the increase in net sales of
      24.80%.




28
 ****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





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




******Six
      months ended December 31,****Dollar Costs**
    ******Percentage
      of Sales****2005**
    
    ******2004**
    
    **Increase**
      ******Decrease****)**
    
    **2005**
    
    **2004**
    
    **Increase**
      **(****Decrease)****Sales
      and marketing**
    
    **$
      4,782,013**
    
    **$4,167,323**
    
    **$614,690**
    
    **10.94%**
    
    **11.89%**
    
    **-0.95%****Technical
      support**
    
    **244,742**
    
    **215,944**
    
    **28,798**
    
    **0.56%**
    
    **0.62%**
    
    **-0.06%****General
      and administrative**
    
    ******1,727,115**
    
    **1,961,118**
    
    **(****234,003****)**
    
    **3.95****%**
    
    **5.60****%**
    
    **-****1.65****%****Total**
    
    **$****6,753,870**
    
    **$****6,344,385**
    
    **$****409,485**
    
    **15.45****%**
    
    **18.11****%**
    
    **-****2.66****%**
   Selling,
general and administrative expenses increased $409,485 from the prior year. As a
percentage of sales, selling, general and administrative expenses decreased by
2.66% when compared to the six months ended March 31, 2004.





The
increase in sales and marketing expense of $614,690, was mainly due
to:




·
    Increases
      caused by the strengthening of the Euro to the U.S dollar of $194,396,
      which accounted for about 43.2% of the total increase. The average Euro to
      USD conversion rate was $1.3035 for the six months ended March 31, 2005
      compared to $1.2211 for the six months ended March 31,
  2004




·
    Higher
      advertising expenses of $179,465 due to higher sales based co-operative
      advertising




·
    Increased
      commission expense of $115,261 due to higher
sales




·
    Increased
      compensation due to additional outside sales person and outside sales reps
      of $115,131




The
decrease in general and administrative expenses of $234,003 was primarily due
to:




·
    Lower
      executive compensation of $ 64,892, mainly due to vacant Officer’s
      position




·
    Lower
      legal fees of $332,652 as a result of completion of arbitration and
      litigation




·
    Higher
      Directors fees of $73,705




·
    Higher
      consulting fees of $36,000 due to start of 404 Compliance work and
      Transfer Price study




·
    Higher
      European tax compliance and accounting items of
$35,976




Research
and development expenses increased $334,303. The increase was mainly due
to




29


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**


·
    Higher
      compensation $87,660 attributable to the research and development facility
      in Taiwan, which began operations during March 2004




·
    Higher
      compensation costs of $130,063 due to additional
  engineers




·
    Increased
      program development costs of $78,569 due to higher volume of new product
      and product enhancement programs




**Other
income (expense)**


Net other
income for the six months ended March 31, 2005 was $3,733 compared to net other
income of $25,035 for the six months ended March 31, 2004 as detailed
below:





**Six
      months ended March 31**,**2005**
    
    
    **2004****Interest
      income**
    
    **$**
    **4,661**
    
    **$**
    **3,136****Foreign
      currency transaction gains (losses)**
    
    
    **(928**
    **)**
    
    **21,899****Total
      other income**
    
    **$**
    **3,733**
    
    **$**
    **25,035**





**Arbitration
Proceeding**





In
November 2002, the estate of Kenneth Aupperle ("Estate") filed a demand for
arbitration against us with the American Arbitration Association. The Estate
claimed certain property rights and interest in us, amounts due and owing to the
Estate based on various corporate agreements with the late Mr. Aupperle and
certain insurance policies. The Estate was seeking to recover a minimum of $2.5
million in damages, fees and expenses.





The
arbitration proceeding was heard before a New York arbitration panel. On April
19, 2004, the arbitration panel awarded the Estate a total of $206,250 in
relation to certain stock options. No fees or expenses were awarded. We accrued
a charge of $206,250 in the second quarter of fiscal year 2004 to cover the
award.





**Litigation
Proceeding**





In March
2002, Polywell International, Inc. ("Polywell"), a supplier of cables to us,
commenced an action seeking $339,520 in damages plus exemplary damages,
attorney's fees, costs and interest with relation to certain unpaid invoices. We
paid these invoices to the sales representative, who subsequently failed to
forward the payments to Polywell. We had dealt with this sales representative
over a number of years, who also represented himself as Polywell's payment and
collection agent.




30


****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





The case
went to trial and was heard before a jury in the United States District Court in
the Northern District of Texas, Dallas Division. Since we had dealt with the
said sales representative for several years with respect to all purchasing and
payment issues, we believed that paying the invoices to this sales
representative was tantamount to paying Polywell. The jury, however, ruled in
favor of Polywell and the court granted Polywell a judgment against us, awarding
an amount of $339,520 to Polywell. In addition, we were obligated to pay
Polywell's attorney’s fees and interest.





We
accrued a charge of $500,000 in the second quarter of fiscal year 2004 to cover
the award.





**Re-measurement
of accounts denominated in currencies other than the Euro**


We follow
the rules prescribed in paragraph 16 of SFAS 52 "Foreign Currency Translation",
which states that accounts denominated in a currency other than an entity’s
functional currency, excluding inter-company accounts which are long term in
nature, need to be re-measured into the entity’s functional currency, and any
gain or loss from this re-measurement are included in the determination of net
income and are booked as a component of other income (loss) under the
description “foreign currency”.





**Accumulated
other comprehensive income (loss)**





The Euro
is the functional currency of our European subsidiary, Hauppauge Digital Europe
Sarl. Assets and liabilities of this subsidiary are translated to U.S. Dollars
at the exchange rate in effect at the end of each reporting period, while equity
accounts are translated to U.S. Dollars at the historical rate in effect at the
date of the contribution. Operating results are translated to U.S. Dollars at
the average prevailing exchange rate for the period, with the exception of sales
which are translated to U.S. Dollars at the average monthly forward exchange
contract rate. The use of differing exchange rates results in foreign currency
translation gains or losses. Since the Euro denominated accounts on HDE Sarl’s
books result in a net asset position (total Euro assets are in excess of Euro
liabilities), an increase in the Euro value results in a deferred gain for the
translation of Euro accounts to U.S. Dollars. We had a translation gain of
$1,074,910 recorded on the balance sheet as of September 30, 2004. For the six
months ended March 31 2005, we recorded on the balance sheet deferred
translation gains $346,800 resulting in a translation gain of $1,421,710
recorded as a component of accumulated other comprehensive income as of March
31, 2005.





We use
forward exchange contracts to reduce our exposure to fluctuations in foreign
currencies. Mark to market gains and losses on these open contracts result from
the difference between the USD value of our open foreign currency forward
contracts at the average contract rate as opposed to the same contracts
translated at the month end forward rate. We qualify for cash flow hedge
accounting as prescribed under SFAS 133, which allows us to record the mark to
market gains and losses in the equity section of our balance sheet under
accumulated other comprehensive income. We had mark to market




31


****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





losses of
$99,399 recorded on the balance sheet as of September 30, 2004. For the six
months ended March 31, 2005, we recorded, as component of other comprehensive
income, a mark to market gain of $126,509, resulting in a mark to market gain of
$27,110 for contracts
open as of March 31, 2005.





As stated
above, accumulated other comprehensive income (loss) consists of two components:




·
    Translations
      gains and losses




**·**
    FAS
      133 mark to market gains and losses on our open foreign exchange
      contracts




The table
below details the gains and losses recorded for the components that make up
accumulated other comprehensive income (loss):




**Accumulated
      other comprehensive income**
    **Balance
      as**
      **of
      Sept. 30, 2004**
    
    **October
      2004 to March**
      **2005
      Gains**
    
    **Balance
      as of**
      **March
      31, 2005****Translation
      gains**
    **$1,074,910**
    
    **$346,800**
    
    **$1,421,710****FAS
      133 mark to market adjustments**
    **(99,399)**
    
    **126,509**
    
    **27,110****$****975,511******
    
    **$****473,309******
    
    **$****1,448,820******


**Tax
provision**


Our net
tax provision for the six months ended March 31, 2005 and 2004 is as
follows :





**Six
      months ended March 31,****2005**
    
    
    **2004****Tax
      attributable to U.S operations**
    
    **$**
    **303,000**
    
    **$**
    **(434,100**
    **)****Tax
      expense European operations**
    
    
    **71,000**
    
    
    **80,079****State
      taxes**
    
    
    **30,000**
    
    
    **15,000****Deferred
      tax asset valuation allowance**
    
    
    **-**
    
    
    **434,100****Net
      operating loss utilization**
    
    
    **(303,000**
    **)**
    
    **-****Net
      tax provision**
    
    **$******
    ******101,000**
    
    **$******
    ******95,079**





For the
last five fiscal years, our domestic operation has incurred losses. We analyzed
the future realization of our deferred tax assets as of March 31, 2005, and
although our domestic operation reported a profit for the six months ended March
31, 2005, due to the seasonal nature of the business it is uncertain at this
time whether our domestic operation will have a profit for the full year. It
light of this, we did not make any adjustments to our valuation allowance for
the six months ended March 31, 2005.




32


****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





As a
result of all of the above items mentioned in the Management’s Discussion and
Analysis of Financial Condition and Results of Operations, we recorded net
income of $2,091,155, for the six months ended March 31, 2005, which resulted in
basic net income per share of $0.22 and diluted net income per share of $0.21 on
weighted average basic and diluted shares of 9,368,428 and 9,999,405,
respectively, compared to a net income of $1,537,250 for the six months ended
March 31, 2004, which resulted in basic net income per share of $0.17 and
diluted net income per share of $0.16 on weighted average basic and diluted
shares of 8,891,135 and 9,576,099, respectively.





Options
to purchase 91,878 and 228,905 shares of common stock at prices ranging $5.25 to
$ 10.06 and $3.88 to $10.06, respectively, were outstanding for the six month
periods ending March 31, 2005 and 2004, respectively, but were not included in
the computation of diluted earnings per share because they were anti-dilutive.





**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 65%, 68% and 73 % of sales for the years
ended September 30, 2004, 2003 and 2002, 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 March 31, 2005 and
September 30, 2004 is set forth below:






**March
      31, 2005**
    **September
      30, 2004****Cash**
    **$8,976,708**
    **$8,661,589****Working
      Capital**
    **16,794,689**
    **13,760,121****Stockholders’
      Equity**
    **17,398,441**
    **14,327,425**





We had
cash and cash equivalents as of March 31, 2005 of $8,796,708, an increase of
$315,119 from September 30, 2004.


The
increase in cash was due to:





33


****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continue**





**Sources
of cash:**




**Net
      income adjusted for non cash items**
    
    **$**
    **2,200,239****Increase
      in accounts payable other current liabilities**
    
    
    **748,262****Proceeds
      from employee stock purchases**
    
    
    **656,309****Decrease
      in inventories**
    
    
    **117,778****Less
      cash used for:****Increase
      in accounts receivable**
    
    
    **(2,765,721**
    **)****Increase
      in prepaid expenses and other current assets**
    
    
    **(346,477**
    **)****Capital
      equipment purchases**
    
    
    **(145,514**
    **)****Purchase
      of treasury stock**
    
    
    **(149,757**
    **)****Net
      cash increase**
    
    **$**
    **315
      119**





Net cash
of $45,919 used in operating activities was primarily due to a increases in
accounts receivable and prepaid expenses and other current assets of $2,765,721
and $346,477, respectively. The increase in receivables is the result of higher
fiscal 2005 second quarter sales compared to the sales of fourth quarter of
fiscal 2004. These uses of cash was offset by net income adjusted for non cash
items of $2,200,239, a decrease in inventory of $117,778 and an increase in
accounts payable and other current liabilities of $748,262.





Cash of
$145,514 and $149,757 was used to purchase fixed assets and repurchase treasury
stock. Proceeds from the stock purchased by employees through the exercise of
options and the employee stock purchase plan provided additional cash of
$656,309.





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 March 31, 2005, we held 602,067 treasury shares
purchased for $1,734,070 at an average purchase price of approximately $2.88 per
share.





We
believe that our cash and cash equivalents as of March 31, 2005 and our
internally generated cash flow will provide us with sufficient liquidity to meet
our currently foreseeable short-term and long-term capital needs.





**Future
Contractual Obligations**


The
following table shows our contractual obligations related to lease obligations
as of March 31, 2005:




**Payments
      due by period****Total**
    
    **Less
      than 1 year**
    
    **1-3
      years**
    
    **3
      to 5 years****Operating
      lease obligations**
    
    **$
      1,490,741**
    
    **$
      535,797**
    
    **$
      729,944**
    
    **$
      225,000**
   34
 **Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





**Critical
Accounting Policies and Estimates**





We
believe the following critical accounting policies affect the significant
judgments and estimates used in the preparation of our financial
statements:




·
    Revenue
      Recognition




·
    Management’s
      estimates




·
    Hedging
      program for European subsidiary inventory purchases denominated in U.S.
      dollars




·
    Translation
      of assets and liabilities denominated in non functional currencies on our
      European financial statements






**Revenue
Recognition**





Our
revenues are primarily derived from the sale of computer boards which enable you
to view television programs on your personal computer. Sales of computer boards
are commonly classified as computer hardware. Our sales are primarily to
retailers, distributors and original equipment manufacturers. Sales to our
customers are documented by a purchase order which describes the conditions of
sale. Sales are recorded when products are shipped to our customers, the product
price is fixed and determinable, collection of the resulting receivable is
probable and product returns are reasonably estimable.


Revenue
from freight charged to customers is recognized when products are shipped.
Provisions for customer returns and other adjustments are provided for in the
period the related sales are recorded based upon historical data.





**Management’s
Estimates**





The
discussion and analysis of our financial condition and results of operations are
based upon our consolidated financial statements which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires management to make
estimates and judgments that affect the reported amounts of assets, liabilities
and related disclosure of contingent assets and liabilities at the date of the
consolidated financial statements and the reported amounts for revenues and
expenses during the reporting period. On an ongoing basis, management evaluates
estimates, including those related to sales provisions, as described above,
income taxes, bad debts, inventory reserves and contingencies. We base our
estimates on historical data, when available, experience, and on various other
assumptions that are believed to be reasonable under the circumstances, the
combined results of which form the basis for making judgments approximating the
carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates.




35





**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





**Hedging
program for sales denominated in a foreign currency**





For each
of the past three fiscal years, over 60 % of our sales were generated by our
European subsidiary and were:




·
    Invoiced
      in local currency-primarily the Euro




·
    Collected
      in local currency-primarily the Euro


On the
supply side, since we predominantly deal with North American and Asian suppliers
and contract manufacturers, approximately 75% of our inventory required to
support our 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. Consequently,
our financial results are subject to market risks resulting from the
fluctuations in the Euro to U.S. Dollar exchange rates.





We
attempt to reduce these 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 U.S. Dollar
denominated inventory purchases required to support our European
sales.





We do not
try to hedge against all possible foreign currency exposures because of the
inherent difficulty in estimating the volatility of the Euro. The contracts we
procure are specifically entered into to as a hedge against forecasted or
existing or foreign currency exposure. We do not enter into contracts for
speculative purposes. Although we maintain these programs to reduce the short
term impact of changes in currency exchange rates, long term strengthening or
weakening of the U.S. dollar against the Euro impacts our sales, our gross
profit, operating income and retained earnings. Factors that could impact the
effectiveness of our hedging program are:






·
    volatility
      of the currency markets




·
    availability
      of hedging instruments




·
    accuracy
      of our inventory forecasts




Additionally,
there is the risk that foreign exchange fluctuations will make our products less
competitive in foreign markets, which would substantially reduce our
sales.




36


****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





**Translation
of assets and liabilities denominated in non functional currencies on our
European financial statements** ****





The
functional currency of our European subsidiary is the Euro. In preparing our
consolidated financial statements, we are required to translate assets and
liabilities denominated in a non functional currency, mainly U.S. Dollars, to
Euros on the books of our European subsidiary. This process results in exchange
gains and losses depending on the changes in the Euro to U.S. Dollar exchange
rate. Under the relevant accounting guidance, with the exception of gains and
losses that are attributable to inter-company accounts which are long term in
nature, we are obligated to include these gains and losses on our statement of
operations, which we report in other income or expense under the
description “foreign currency”.


The
extent of these gains and losses can fluctuate greatly from month to month
depending on the change in the exchange rate, causing results to vary widely.
Due to the past volatility of the Euro, it is difficult to forecast the long
term trend of these gains and losses.





**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.





**Euro**


On
January 1, 1999, the Euro was adopted in Europe as the common legal currency
among 11 of the 15 member countries of the European Community. On that date, the
participating countries established fixed Euro conversion rates (i.e. the
conversion exchange rate between their existing currencies and the Euro). The
Euro now trades on currency exchanges and is available for non-cash
transactions. A new European Central Bank was established to direct monetary
policy for the participating countries.





Prior to
the adoption of the Euro, we billed our European customers in German Marks or
British Pounds, depending upon which currency the customer preferred to be
billed in. Effective January 1, 1999, we began invoicing our customers who are
located in the eleven member countries in Euros. We continue to bill customers
located in the United Kingdom in British Pounds. The benefits to billing
customers in Euros were twofold:




·
    Our
      foreign currency hedging program was streamlined to the Euro and the
      British Pound




·
    The
      pricing from country to country was harmonized, eliminating price
      differences between countries due to the fluctuating local
      currencies




37


****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**





We
handled the conversion to the Euro without any material disruptions to our
operations.





**Recent
Accounting Pronouncements**





On
December 15, 2004 , the Financial Accounting Standards Board (“FASB”) issued a
revised SFAS No. 123R “Share Based Payment” This statement requires us to
measure all employee stock based compensation, such as the options granted under
our stock options plans, using a fair value method and to recognize such expense
in our consolidated financial statements. The adoption of SFAS No. 123R will
reduce our net income, but will not affect our cash flows. The statement is
effective as of the beginning of our fiscal yea r ending September 30,
2006.





We are
evaluating the effect this statement will have on its operations.




**Item
      3.**
    **Quantitative
      and Qualitative Disclosures about Market
  Risks**


For each
of the past three fiscal years, over 60 % of our sales were generated by our
European subsidiary and were:




·
    Invoiced
      in local currency-primarily the Euro




·
    Collected
      in local currency-primarily the Euro




On the
supply side, since we predominantly deal with North American and Asian suppliers
and contract manufacturers, approximately 75% of our inventory required to
support our 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. Consequently,
our financial results are subject to market risks resulting from the
fluctuations in the Euro to U.S. Dollar exchange rates.





We
attempt to reduce these 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 U.S. Dollar
denominated inventory purchases required to support our European sales.




38


****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**




**Item
      3.**
    **Quantitative
      and Qualitative Disclosures about Market Risks -
      continued**
 
 We do not
try to hedge against all possible foreign currency exposures because of the
inherent difficulty in estimating the volatility of the Euro. The contracts we
procure are specifically entered into to as a hedge against forecasted or
existing or foreign currency exposure. We do not enter into contracts for
speculative purposes. Although we maintain these programs to reduce the short
term impact of changes in currency exchange rates, long term strengthening or
weakening of the U.S. dollar against the Euro impacts our sales, our gross
profit, operating income and retained earnings. Factors that could impact the
effectiveness of our hedging program are:




·
    volatility
      of the currency markets




·
    availability
      of hedging instruments




·
    accuracy
      of our inventory forecasts




Additionally,
there is the risk that foreign exchange fluctuations will make our products less
competitive in foreign markets, which would substantially reduce our
sales.





As of
March 31, 2005, we had foreign currency contracts outstanding of approximately
$7,052,000 against the delivery of the Euro. The contracts expire through August
2005. Our accounting policies for these instruments designate such instruments
as cash flow hedging transactions. We do not enter into such contracts for
speculative purposes. We record all derivative gains and losses on the balance
sheet as a component of stockholders’ equity under the caption “Accumulated
other comprehensive income (loss)”. We recorded a deferred gain of $406,300 and
$126,509 for the three and six months ended March 31, 2005. As of March 31,
2005, a deferred gain of $27,110 reflecting the cumulative mark to market loss
of our derivatives, was recorded on our balance sheet as a component of
accumulated other comprehensive income in our equity section.





We use
the average monthly forward contract exchange rate to translate our Euro
denominated sales into our U.S. dollar reporting currency. For the three month
and six month periods ended March 31, 2005, the use of the monthly average spot
rate instead of the average monthly forward contract exchange rate to value
Euro denominated sales would have resulted in an increase in sales of
$337,699 and $978,484, respectively. This sales increase is related to our
contracts that closed during these periods and the changes in the fair
value of our derivative contracts.  For the three month and six month
periods ended March 31, 2004, the use of the monthly average spot rate instead
of the average monthly forward contract exchange rate to value
Euro  denominated
sales would have resulted in a sales increase of $103,835 and $909,368,
respectively.





39


****


**Results
of operations-six month period ended March 31, 2005 compared to March 31,
2004-continued**




**Item
      4.**
    **Controls
      and Procedures**





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 March 31, 2005
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 six months and fiscal quarter ended
March 31, 2005 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.





**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," "anticipate," "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, 2004), 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.


****


**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.




40


**Item
      2.**
    **Unregistered
      Sales of Equity Securities and Use of Proceed**s**-
      continued**





The table
below summarized repurchases of our common stock under our stock repurchase
program:




MaximumTotal
      Number
    NumberTotal
    Average
    of
      Shares
    of
      SharesNumber
    Price
    Purchased
      as
    that
      May Yetof
      Shares
    Paid
      per
    Part
      of Publicly
    Be
      PurchasedPeriod
    Purchased
    Share
    Announced
      Plan
    Under
      the PlanPurchases
      as of September 30, 2004
    567,067
    $2.79
    567,067
    282,933October
      1 to October 31, 2004
    5,000
    3.49
    5,000
    277,933February
      1 to February 28, 2005
    20,000
    4.57
    20,000
    257,933March
      1 to March 31, 2005
    10,000
    4.08
    10,000
    247,933Purchases
      as of March 31, 2005
    602,067
    $2.88
    602,067
    247,933




**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
      200231.2
    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
      200232
    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
  41





**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: May 13, 2005
    By:
    /s/ Kenneth
  PlotkinKENNETH PLOTKINTitle:  Chief Executive
      Officer and Director






****Date: May 13, 2005
    By:
    /s/ Gerald
    TucciaroneGERALD TUCCIARONETitle: Treasurer
      and ChiefFinancial
      Officer




42