Table of Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **

**(MarkOne)**
| **x**      | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                        |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                    |
| ** ** | **For  the quarterly period ended June 28, 2008**                                                                                                                        |
| ** ** | ** **                                                                                                                                                                    |
| ** ** | **or**                                                                                                                                                                        |
| ** ** | ** **                                                                                                                                                                    |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                       |
|       |                                                                                                                                                                          |
|       | **For  the transition period from              to            ** |

 

**Commission file number001-33170**

** **

****

** **

**NETLIST, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                    | ** ** | **95-4812784**       |
|---------------------------------|------------|----------------------|
| State  or other jurisdiction of |       | (I.R.S.  Employer    |
| incorporation  or organization  |       | Identification  No.) |

 

**51 Discovery, Irvine, CA 92618**

(Address of principal executive offices) (Zip Code)

 

**(949) 435-0025**

**(Registrant’stelephone number, including area code)**

 

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

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer or a smaller reportingcompany. See definition of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check One):

 
| Large accelerated filer      o |   | Accelerated filer     o |   | Non-accelerated filer      o |   | Smaller reporting company      x |
|----------------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------------|--------|------------------------------------------------------|
|                                               |   |                                        |   | (Do not check if a smaller                       |   |                                                 |
|                                               |   |                                        |   | reporting company)                               |   |                                                 |

 

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

 

The number of shares outstanding of each of the registrant’s classes ofcommon stock as of the latest practicable date:

 

Common Stock, par value $0.001 per share

19,855,411 shares outstanding at July 31, 2008

 

 

 

----

**Table of Contents**

** **

**NETLIST, INC. ANDSUBSIDIARIES**

**QUARTERLY REPORTON FORM 10-Q**

**FOR THE THREE ANDSIX MONTHS ENDED JUNE 28, 2008**

** **

**TABLE OF CONTENTS**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                                         |   |
|---------------|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.       | Financial Statements                                                                                                                          |   |
|          | Unaudited Condensed Consolidated Balance  Sheets at June 28, 2008 and December 29, 2007                                             |   |
|          | Unaudited Condensed Consolidated Statements  of Operations for the Three and Six Months Ended June 28, 2008 and June 30,  2007 |   |
|          | Unaudited Condensed Consolidated Statements  of Cash Flows for the Six Months Ended June 28, 2008 and June 30, 2007                      |   |
|          | Notes to  Unaudited Condensed Consolidated Financial Statements                                                                               |   |
| Item 2.       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                   |   |
| Item 3.       | Quantitative and Qualitative Disclosures  About Market Risk                                                                                   |   |
| Item 4.       | Controls and Procedures                                                                                                                       |   |
| Item 4T.      | Controls and Procedures                                                                                                                       |   |
|          |                                                                                                                                          |   |
| PART II. | OTHER INFORMATION                                                                                                                             |   |
| Item 1.       | Legal Proceedings                                                                                                                             |   |
| Item 1A.      | Risk Factors                                                                                                                                  |   |
| Item 2.       | Unregistered Sales of Equity Securities and  Use of Proceeds                                                                                  |   |
| Item 3.       | Defaults Upon Senior Securities                                                                                                               |   |
| Item 4.       | Submission of Matters to a Vote of Security  Holders                                                                                          |   |
| Item 5.       | Other Information                                                                                                                             |   |
| Item 6.       | Exhibits                                                                                                                                      |   |

 

2

----

Table of Contents

 

**PART I. FINANCIAL INFORMATION**

** **

**Item 1. Financial Statements**

** **

**NETLIST, INC.AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Balance Sheets**

**(inthousands)**

** **
| ** **                                                               | ** ** | **June 28,** | ** ** | **December 29,** | ** ** |
|--------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| ** **                                                               | ** ** | ** **        | ** ** | ** **            | ** ** |
| **ASSETS**                                                               | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                          |       |              |       |                  |       |
| Cash and cash equivalents                                                |       | $                 | 11,243     |                  | $          | 7,182 |   |
| Restricted cash                                                          |       | 2,000             |       | —                |       |
| Investments in marketable securities                                     |       | 11,595            |       | 15,573                |       |
| Accounts receivable, net                                                 |       | 6,441             |       | 12,034                |       |
| Inventories                                                              |       | 8,331             |       | 3,333                 |       |
| Income taxes receivable                                                  |       | 903               |       | 708                   |       |
| Deferred taxes                                                           |       | 3,899             |       | 3,464                 |       |
| Prepaid expenses and other current assets                                |       | 975               |       | 392                   |       |
| Total current assets                                                     |       | 45,387            |       | 42,686                |       |
|                                                                     |       |              |       |                  |       |
| Property and equipment, net                                              |       | 7,907             |       | 8,191                 |       |
| Deferred taxes                                                           |       | 1,620             |       | 1,065                 |       |
| Long-term investments in marketable  securities                          |       | 974               |       | 7,814                 |       |
| Other assets                                                             |       | 556               |       | 600                   |       |
| Total assets                                                             |       | $                 | 56,444     |                  | $          | 60,356 |   |
|                                                                     |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                            |       |              |       |                  |       |
| Current liabilities:                                                     |       |              |       |                  |       |
| Accounts payable                                                         |       | $                 | 4,952      |                  | $          | 6,697 |   |
| Revolving line of credit                                                 |       | 5,662             |       | 4,872                 |       |
| Current portion of long-term debt                                        |       | 547               |       | 740                   |       |
| Current portion of deferred gain on sale  and leaseback transaction      |       | 118               |       | 118                   |       |
| Accrued expenses and other current  liabilities                          |       | 2,618             |       | 2,872                 |       |
| Total current liabilities                                                |       | 13,897            |       | 15,299                |       |
| Long-term debt, net of current portion                                   |       | 397               |       | 638                   |       |
| Deferred gain on sale and leaseback  transaction, net of current portion |       | 167               |       | 226                   |       |
| Total liabilities                                                        |       | 14,461            |       | 16,163                |       |
| Commitments and contingencies                                            |       |              |       |                  |       |
| Stockholders’ equity:                                               |       |              |       |                  |       |
| Common stock                                                             |       | 20                |       | 20                    |       |
| Additional paid-in capital                                               |       | 68,724            |       | 68,109                |       |
| Accumulated deficit                                                      |       | (26,734           | )          | (23,899               | )          |
| Accumulated other comprehensive loss                                     |       | (27               | )          | (37                   | )          |
| Total stockholders’ equity                                          |       | 41,983            |       | 44,193                |       |
| Total liabilities and stockholders’ equity                          |       | $                 | 56,444     |                  | $          | 60,356 |   |

 

See accompanying notes.

 

3

----

Table of Contents

 

**NETLIST, INC. AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Operations**

**(inthousands, except per share amounts)**

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **                                        | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                        | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                         |       | $                                | 18,429     |                           | $          | 12,811 |   | $ | 31,533 |   | $ | 50,349 |   |
| Cost of sales(1)                                  |       | 15,770                           |       | 18,734                         |       | 25,743 |   | 50,823 |   |
| Gross profit (loss)                               |       | 2,659                            |       | (5,923                         | )          | 5,790 |   | (474 | ) |
| Operating expenses:                               |       |                             |       |                           |       |   |   |   |   |
| Research and development(1)                       |       | 1,716                            |       | 1,478                          |       | 3,292 |   | 2,545 |   |
| Selling, general and administrative(1)            |       | 3,310                            |       | 3,845                          |       | 6,778 |   | 7,549 |   |
| Total operating expenses                          |       | 5,026                            |       | 5,323                          |       | 10,070 |   | 10,094 |   |
| Operating loss                                    |       | (2,367                           | )          | (11,246                        | )          | (4,280 | ) | (10,568 | ) |
| Other income:                                     |       |                             |       |                           |       |   |   |   |   |
| Interest income, net                              |       | 104                              |       | 162                            |       | 343 |   | 114 |   |
| Other income (expense), net                       |       | 23                               |       | 4                              |       | (68 | ) | 5 |   |
| Total other income, net                           |       | 127                              |       | 166                            |       | 275 |   | 119 |   |
| Loss before provision (benefit) for income  taxes |       | (2,240                           | )          | (11,080                        | )          | (4,005 | ) | (10,449 | ) |
| Provision (benefit) for income taxes              |       | 11                               |       | (3,864                         | )          | (1,170 | ) | (3,864 | ) |
| Net loss                                          |       | $                                | (2,251     | )                              | $          | (7,216 | ) | $ | (2,835 | ) | $ | (6,585 | ) |
| Net loss per common share:                        |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted                                 |       | $                                | (0.11      | )                              | $          | (0.37 | ) | $ | (0.14 | ) | $ | (0.34 | ) |
| Weighted-average common shares outstanding:       |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted                                 |       | 19,855                           |       | 19,653                         |       | 19,839 |   | 19,638 |   |

 

----

(1)  Amounts include stock-basedcompensation expense as follows:

 
| Cost of sales                       |   | $   | 48     |   | $      | 44  |   | $   | 62     |   | $ | 108 |   |
|-------------------------------------|--------|-----|--------|--------|--------|-----|--------|-----|--------|--------|---|-----|--------|
| Research and development            |   | 62  |   | 19     |   | 85  |   | 65  |   |
| Selling, general and administrative |   | 265 |   | 231    |   | 472 |   | 449 |   |

 

See accompanying notes.

 

4

----

Table of Contents

 

**NETLIST, INC.AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Cash Flows**

**(inthousands)**

** **
| ** **                                                                                 | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                 | ** ** | **June 28,**              | ** ** | **June 30,** | ** ** |
| ** **                                                                                 | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| ** **                                                                                 | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                                      | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net loss                                                                                   |       | $                              | (2,835     | ) | $ | (6,585 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                              |       | 1,054                          |       | 568 |   |
| Amortization of deferred gain on sale and  leaseback transaction                           |       | (59                            | )          | (59 | ) |
| Deferred income taxes                                                                      |       | (990                           | )          | (4,394 | ) |
| Impairment of long-lived asset                                                             |       | —                         |       | 257 |   |
| Loss on inventory adjustments                                                              |       | —                         |       | 6,012 |   |
| Stock-based compensation                                                                   |       | 619                            |       | 622 |   |
| Changes in operating assets and  liabilities:                                              |       |                           |       |   |   |
| Accounts receivable                                                                        |       | 5,593                          |       | 16,414 |   |
| Inventories                                                                                |       | (4,998                         | )          | 7,438 |   |
| Income taxes receivable                                                                    |       | (195                           | )          | — |   |
| Prepaid expenses and other current assets                                                  |       | (583                           | )          | 303 |   |
| Other assets                                                                               |       | 44                             |       | (592 | ) |
| Accounts payable                                                                           |       | (1,745                         | )          | (7,273 | ) |
| Income taxes payable                                                                       |       | —                         |       | (525 | ) |
| Accrued expenses and other current  liabilities                                            |       | (254                           | )          | (596 | ) |
| Net cash provided by (used in) operating  activities                                       |       | (4,349                         | )          | 11,590 |   |
| Cash flows from investing activities:                                                      |       |                           |       |   |   |
| Acquisition of property and equipment                                                      |       | (770                           | )          | (4,248 | ) |
| Repayment of note receivable from  stockholder                                             |       | —                         |       | 1 |   |
| Purchase of investments in marketable  securities                                          |       | (6,672                         | )          | (43,481 | ) |
| Proceeds from maturities and sales of  investments in marketable securities                |       | 17,500                         |       | 24,800 |   |
| Net cash provided by (used in) investing  activities                                       |       | 10,058                         |       | (22,928 | ) |
| Cash flows from financing activities:                                                      |       |                           |       |   |   |
| Borrowings on lines of credit                                                              |       | 49,490                         |       | 61,880 |   |
| Payments on lines of credit                                                                |       | (48,700                        | )          | (76,311 | ) |
| Borrowings on debt                                                                         |       | —                         |       | 290 |   |
| Payments on debt                                                                           |       | (434                           | )          | (658 | ) |
| Increase in restricted cash                                                                |       | (2,000                         | )          | — |   |
| Proceeds from exercise of stock options and  warrants                                      |       | —                         |       | 161 |   |
| Reversal of unrealized excess tax benefit  from exercise of warrants                       |       | (4                             | )          | — |   |
| Net cash used in financing activities                                                      |       | (1,648                         | )          | (14,638 | ) |
| Increase (decrease) in cash and cash  equivalents                                          |       | 4,061                          |       | (25,976 | ) |
| Cash and cash equivalents at beginning of  period                                          |       | 7,182                          |       | 30,975 |   |
| Cash and cash equivalents at end of period                                                 |       | $                              | 11,243     |   | $ | 4,999 |   |

 

See accompanying notes.

 

5

----

Table of Contents

 

**NETLIST, INC.AND SUBSIDIARIES**

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**June 28,2008**

 

**Note 1—Descriptionof Business**

 

Netlist designsand manufactures high performance memory subsystems for the server, highperformance computing and communications markets. The Company’s solutions aretargeted at applications where memory plays a key role in meeting systemperformance requirements.

 

**Note 2—Summary ofSignificant Accounting Policies**

 

*Basis ofPresentation*

 

The interimunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and with the instructions toSecurities and Exchange Commission (“SEC”) Form 10-Q and Article 8 ofSEC Regulation S-X. These financial statements do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements. Therefore,these financial statements should be read in conjunction with the Company’saudited consolidated financial statements and notes thereto for the year ended December 29,2007, included in the Company’s Annual Report on Form 10-K filed with theSEC on February 29, 2008.

 

The condensedconsolidated financial statements included herein are unaudited; however, theycontain all normal recurring accruals and adjustments that, in the opinion ofthe Company’s management, are necessary to present fairly the consolidatedfinancial position of the Company and its wholly owned subsidiaries as of June 28,2008 and December 29, 2007, the consolidated results of its operations forthe three and six months ended June 28, 2008 and June 30, 2007, andthe consolidated cash flows for the six months ended June 28, 2008 and June 30,2007. All intercompany balances and transactions have been eliminated inconsolidation. The results of operations for the three and six months ended June 28,2008 are not necessarily indicative of the results to be expected for the fullyear or any future interim periods.

 

*Fiscal Year*

 

The Companyoperates under a 52/53-week fiscal year ending on the Saturday closest to December 31.For fiscal 2008, the Company’s fiscal year end is scheduled to be January 3,2009 and will consist of 53 weeks. Each of the Company’s first three quartersin a fiscal year is comprised of 13 weeks.

 

*Use of Estimates*

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof the assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements, and the reported amountsof revenues and expenses during the reporting period. Significant estimatesmade by management include, among others, provisions for uncollectiblereceivables and sales returns, warranty liabilities, valuation of inventories,recoverability of long-lived assets, stock-based compensation expense andrealization of deferred tax assets. The Company bases its estimates andassumptions on current facts, historical experience and various other factorsthat it believes to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities and the accrual of costs and expenses that are not readily apparentfrom other sources. The actual results experienced by the Company may differmaterially and adversely from the Company’s estimates. To the extent there arematerial differences between the estimates and the actual results, futureresults of operations will be affected.

 

*RevenueRecognition*

 

The Company’s revenues primarily consist of product sales of highperformance memory subsystems to original equipment manufacturers (“OEMs”).Revenues also include sales of excess inventories to distributors and otherusers of memory integrated circuits (“ICs”) totaling approximately $0.1 millionand $0.2 million, respectively, during the three and six months ended June 28,2008 and approximately $0.4 million and $1.4 million, respectively, for thethree and six months ended June 30, 2007.

 

6

----

Tableof Contents

 

The Company recognizes revenues in accordance with the SEC’s StaffAccounting Bulletin No. 104, *Revenue Recognition*(“SAB 104”). Under the provisions of SAB 104, the Company recognizesrevenues when there is persuasive evidence of an arrangement, product deliveryand acceptance have occurred, the sales price is fixed or determinable, andcollectibility of the resulting receivable is reasonably assured.

 

The Company generally uses customer purchase orders and/or contracts asevidence of an arrangement. Delivery occurs when goods are shipped forcustomers with FOB Shipping Point terms and upon receipt for customers with FOBDestination terms, at which time title and risk of loss transfer to thecustomer. Shipping documents are used to verify delivery and customeracceptance. The Company assesses whether the sales price is fixed or determinablebased on the payment terms associated with the transaction and whether thesales price is subject to refund. Customers are generally allowed limitedrights of return for up to 30 days, except for sales of excessinventories, which contain no right-of-return privileges. Estimated returns areprovided for at the time of sale based on historical experience or specificidentification of an event necessitating a reserve. The Company offers astandard product warranty to its customers and has no other post-shipmentobligations. The Company assesses collectibility based on the creditworthinessof the customer as determined by credit checks and evaluations, as well as thecustomer’s payment history.

 

A portion of the Company’s international shipments are made tothird-party inventory warehouses, or hubs, and the Company recognizes revenuewhen the inventory is pulled from the hub for use in production by thecustomer. The Company receives a report from the customer on a daily basisindicating the inventories pulled from a hub for use by the customer, andperforms a daily reconciliation of inventories shipped to and pulled by thecustomer to those inventories reflected on the customer’s reports to ensurethat sales are recognized in the appropriate periods.

 

All amounts billed to customers related to shipping and handling areclassified as revenues, while all costs incurred by the Company for shippingand handling are classified as cost of sales.

 

*Cash and CashEquivalents*

* *

Cash and cash equivalents consist of cash and short-term investmentswith original maturities of 90 days of less.

* *

*Restricted Cash*

* *

Restricted cash represents amounts pledged as collateral on anoutstanding letter of credit.

* *

*Investments inMarketable Securities*

* *

The Company accounts for its investments in marketable securities inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 115,*Accounting for Certain Investments in Debt andEquity Securities*, and Financial Accounting Standards Board (“FASB”)Staff Position SFAS No. 115-1, *The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.*TheCompany determines the appropriate classification of its investments at thetime of purchase and reevaluates such designation at each balance sheet date. TheCompany’s investments in marketable securities have been classified andaccounted for as available-for-sale based on management’s investment intentionsrelating to these securities. Available-for-sale securities are stated atmarket value based on market quotes. Unrealized gains and losses, net ofdeferred taxes, are recorded as a component of other comprehensive income(loss). The Company follows the guidance provided by Emerging Issues Task Force(“EITF”) Issue No. 03-1, *The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments*,to assess whether its investments with unrealized loss positions are other thantemporarily impaired. Realized gains and losses and declines in value judged tobe other than temporary are determined based on the specific identificationmethod and are reported in other income (expense), net in the unauditedcondensed consolidated statements of operations.

 

The Company generally invests its excess cash in money market funds andin highly liquid debt instruments of United States (“U.S.”) municipalities,corporations, the U.S. government and its agencies and auction rate securities.All highly liquid investments with stated maturities of three months or lessfrom the date of purchase are classified as cash equivalents; all investmentswith stated maturities of greater than three months are classified asinvestments in marketable securities.

* *

*Fair Value ofFinancial Instruments*

* *

The Company’s financial instruments consist principally of cash andcash equivalents, investments in marketable securities, accounts receivable,accounts payable, accrued expenses and debt instruments. Effective December 30,2007, the Company adopted SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value in accordance with accounting principlesgenerally accepted in the United States of America and expands requireddisclosures about fair value measurements. Pursuant to SFAS 157, other than forcertain investments in auction rate securities (see Note 4), the fair value ofthe Company’s cash equivalents and investments in marketable securities isdetermined based on “Level 1” inputs, which consist of quoted prices in activemarkets for identical assets. The Company believes that the carrying values ofall other financial instruments approximate their current fair values due totheir nature and respective durations.

 

7

----

Table of Contents

 

*Inventories*

* *

Inventories are valued at the lower of cost or net realizable value.Cost is determined on an average cost basis which approximates actual cost on afirst-in, first-out basis and includes raw materials, labor and manufacturingoverhead. At each balance sheet date, the Company evaluates its endinginventories for excess quantities and obsolescence. Among other factors, theCompany considers historical demand and forecasted demand in relation to the inventoryon hand, competitiveness of product offerings, market conditions and productlife cycles when determining obsolescence and net realizable value. Provisionsare made to reduce excess or obsolete inventories to their estimated netrealizable values. Once established, write-downs are considered permanentadjustments to the cost basis of the excess or obsolete inventories.

 

*Warranties*

* *

The Company offers warranties generally ranging from one to three yearsto its customers, other than on sales of excess inventory, depending on theproduct and negotiated terms of purchase agreements. Such warranties requirethe Company to repair or replace defective product returned to the Companyduring the warranty period at no cost to the customer. The Company records anestimate for warranty-related costs at the time of sale based on, among otherfactors, its historical and estimated product return rates and expected repairor replacement costs. Such costs have historically been consistent betweenperiods and in-line with management’s expectations. The Company’s warrantyliability is included as a component of accrued expenses and other currentliabilities in the accompanying unaudited condensed consolidated balancesheets.

 

*Stock-BasedCompensation*

* *

The Company accounts for equity issuances to non-employees inaccordance with SFAS No. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”), and EITF Issue No. 96-18, *Accounting for Equity Instruments that are Issued to Other ThanEmployees for Acquiring, or in Conjunction with Selling, Goods and Services*.All transactions in which goods or services are the consideration received forthe issuance of equity instruments are accounted for based on the fair value ofthe consideration received or the fair value of the equity instrument issued,whichever is more reliably measurable. The measurement date used to determinethe fair value of the equity instrument issued is the earlier of the date onwhich the third-party performance is complete or the date on which it isprobable that performance will occur.

 

In accordance withSFAS No. 123(R), *Share-Based Payment*(“SFAS 123R”),employee and director stock-based compensation expense recognized during theperiod is based on the value of the portion of share-based payment awards that isultimately expected to vest during the period. Stock-based compensation expenserecognized in the accompanying unaudited condensed consolidated statements ofoperations includes (i) compensation expense for share-based paymentawards granted prior to, but not yet vested as of December 31, 2005 basedon the grant date fair value estimated in accordance with the pro formaprovisions of SFAS 123 and (ii) compensation expense for theshare-based payment awards granted subsequent to December 31, 2005 basedon the grant date fair value estimated in accordance with the provisions ofSFAS 123R. Given that stock-based compensation expense recognized in theunaudited condensed consolidated statements of operations is based on awardsultimately expected to vest, it has been reduced for estimated forfeitures.SFAS 123R requires forfeitures to be estimated at the time of grantand revised, if necessary, in subsequent periods if actual forfeitures differfrom those estimates. The estimated average forfeiture rates used by theCompany are based on historical forfeiture experience and estimated futureforfeitures.

 

The fair value ofstock-based awards to employees and directors is calculated using theBlack-Scholes option pricing model. The Black-Scholes model requires subjectiveassumptions regarding future stock price volatility and expected time toexercise, along with assumptions about the risk-free interest rate and expecteddividends, which affect the estimated fair values of the Company’s stock-basedawards. The expected term of options granted is derived from historical data onemployee exercises and post-vesting employment termination behavior. Theexpected volatility is based on the historical volatilities of the common stockof comparable publicly traded companies based on the Company’s belief that itcurrently has limited historical data regarding the volatility of its stockprice on which to base a meaningful estimate of expected volatility. Therisk-free rate selected to value any particular grant is based on the U.S.Treasury rate that corresponds to the expected term of the grant effective asof the date of the grant. The expected dividends assumption is based on theCompany’s history and expectation of dividend payouts. These factors couldchange in the future, affecting the determination of stock-based compensationexpense in future periods.

 

*Income Taxes*

* *

The Companyaccounts for income taxes in accordance with SFAS No. 109, *Accounting for Income Taxes* (“SFAS 109”). UnderSFAS 109, deferred tax assets and liabilities are recognized to reflectthe estimated future tax effects, calculated at currently effective tax rates,of future deductible or taxable amounts attributable to events that have beenrecognized on a cumulative basis in the consolidated financial statements. Avaluation allowance related to a deferred tax asset is recorded when it is morelikely than not that some portion of the deferred tax asset will not berealized.

 

8

----

Table of Contents

 

The Companyadopted FASB Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes—An Interpretation of FASB Statement No. 109* (“FIN 48”)on December 31, 2006, the first day of its fiscal 2007. FIN 48 seeksto reduce the diversity in practice associated with certain aspects ofmeasurement and recognition in accounting for income taxes. FIN 48prescribes a recognition threshold and measurement requirement for thefinancial statement recognition of a tax position that has been taken or isexpected to be taken on a tax return and also provides guidance onde-recognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. Under FIN 48 the Company may onlyrecognize or continue to recognize tax positions that meet a “more likely thannot” threshold.

 

*Risks andUncertainties*

* *

The Company’soperations in the People’s Republic of China (“PRC”) are subject to variouspolitical, geographical and economic risks and uncertainties inherent toconducting business in China. These include, but are not limited to, (i) potentialchanges in economic conditions in the region, (ii) managing a localworkforce that may subject the Company to uncertainties or certain regulatorypolicies and (iii) changes in other policies of the Chinese governmentaland regulatory agencies. Additionally, the Chinese government controls theprocedures by which its local currency, the Chinese Renminbi (“RMB”), isconverted into other currencies. If changes or restrictions in the conversionof RMB are instituted, the Company’s operations and operating results may benegatively impacted.

 

*Foreign CurrencyRemeasurement*

* *

The functionalcurrency of the Company’s foreign subsidiaries is the U.S. dollar. Localcurrency financial statements are remeasured into U.S. dollars using thecurrent exchange rate for monetary assets and liabilities and the historicalexchange rate for nonmonetary assets and liabilities. Expenses are remeasuredusing the average exchange rate for the period, except items related tononmonetary assets and liabilities, which are remeasured using historicalexchange rates. All remeasurement gains and losses are included in determiningnet income (loss).

 

**Note3—Supplemental Financial Information**

** **

*Inventories*

 

Inventoriesconsist of the following (in thousands):

 
| ** **      | ** ** | **June 28,** | ** ** | **December 29,** | ** ** |
|-----------------|------------|-------------------|------------|-----------------------|------------|
| ** **      | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Raw materials   |       | $                 | 3,579      |                  | $          | 1,878 |   |
| Work in process |       | 1,314             |       | 425                   |       |
| Finished goods  |       | 3,438             |       | 1,030                 |       |
|            |       | $                 | 8,331      |                  | $          | 3,333 |   |

 

*WarrantyLiability*

 

The followingtable summarizes the activity related to the warranty liability (in thousands):

 
| ** **                    | ** ** | **Six Months Ended** | ** ** |
|-------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **June 28,**              | ** ** | **June 30,** | ** ** |
| ** **                    | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| ** **                    | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Beginning balance             |       | $                              | 353        |   | $ | 298 |   |
| Charged to costs and expenses |       | 8                              |       | 140 |   |
| Usage                         |       | (70                            | )          | (93 | ) |
| Ending balance                |       | $                              | 291        |   | $ | 345 |   |

 

The warrantyliability is included as a component of accrued expenses and other currentliabilities in the accompanying unaudited condensed consolidated balancesheets.

 

9

----

Table of Contents

 

*FacilityRelocation Costs*

 

The followingtable summarizes the activity related to the Company’s accrual for facilityrelocation costs during the six months ended June 28, 2008 (in thousands):

 
| ** **                    | ** ** | **Six Months  Ended** | ** ** |
|-------------------------------|------------|----------------------------|------------|
| ** **                    | ** ** | **June 28,**          | ** ** |
| ** **                    | ** ** | **2008**                   | ** ** |
| Beginning balance             |       | $                          | 103        |   |
| Charged to costs and expenses |       | —                     |       |
| Net payments                  |       | (46                        | )          |
| Ending balance                |       | $                          | 57         |   |

 

The liability forfacility relocation costs is included as a component of accrued expenses andother current liabilities in the accompanying unaudited condensed consolidatedbalance sheets.

 

*Comprehensive Loss*

* *

The components ofcomprehensive loss, net of taxes, consist of the following (in thousands):

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                              | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **                                                              | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                    |       |                             |       |                           |       |   |   |   |   |
| Net loss                                                                |       | $                                | (2,251     | )                              | $          | (7,216 | ) | $ | (2,835 | ) | $ | (6,585 | ) |
| Other comprehensive loss:                                               |       |                             |       |                           |       |   |   |   |   |
| Change in net unrealized loss on  investments                           |       | 68                               |       | (11                            | )          | 23 |   | (7 | ) |
| Reclassification adjustment for net  realized gain included in net loss |       | —                           |       | —                         |       | (13 | ) | — |   |
| Total comprehensive loss                                                |       | $                                | (2,183     | )                              | $          | (7,227 | ) | $ | (2,825 | ) | $ | (6,592 | ) |

 

Accumulated othercomprehensive loss reflected on the unaudited condensed consolidated balancesheets at June 28, 2008 and December 29, 2007 represents accumulatednet unrealized losses on investments in marketable securities.

 

*Computationof Net Loss Per Share*

 

Basic and dilutednet loss per share is calculated by dividing net loss by the weighted-averagecommon shares outstanding during the period. The following table sets forth thecomputation of net loss per share (in thousands, except per share data):

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                               | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **                                               | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                               | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator: Net loss                                      |       | $                                | (2,251     | )                              | $          | (7,216 | ) | $ | (2,835 | ) | $ | (6,585 | ) |
| Denominator: Weighted-average common shares  outstanding |       | 19,855                           |       | 19,653                         |       | 19,839 |   | 19,638 |   |
| Net loss per share, basic and diluted                    |       | $                                | (0.11      | )                              | $          | (0.37 | ) | $ | (0.14 | ) | $ | (0.34 | ) |

 

The followingtable sets forth all potentially dilutive common share equivalents, consistingof shares issuable upon the exercise of outstanding stock options and warrantscomputed using the treasury stock method, which have been excluded from thediluted net loss per share calculations above as their effect would beanti-dilutive for the periods then ended (in thousands):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **               | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                     |       |                             |       |                           |       |   |   |   |   |
| Common share equivalents |       | 867                              |       | 1,414                          |       | 868 |   | 1,660 |   |

 

10

----

Table of Contents

 

*MajorCustomers*

 

The Company’sproduct sales have historically been concentrated in a small number ofcustomers. The following table sets forth sales to customers comprising 10% ormore of the Company’s total revenues for the periods presented:

 
| ** **      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **      | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **      | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Customer:**   |       |                             |       |                           |       |   |   |   |   |
| Dell            |       | 60                               | %          | 48                             | %          | 66 | % | 41 | % |
| Hewlett Packard |       | 26                               | %          | 19                             | %          | 22 | % | 28 | % |
| IBM             |       | —                           | %          | 12                             | %          | — | % | 11 | % |

 

The Company’saccounts receivable are concentrated with two customers at June 28, 2008representing approximately 65% and 18% of aggregate gross receivables. Asignificant reduction in sales to, or the inability to collect receivablesfrom, a significant customer could have a material adverse impact on theCompany.

 

**Note4—Fair Value Measurements**

 

In accordance withSFAS 157, the following table details the fair value measurements within thefair value hierarchy of the Company’s investments in marketable securities (inthousands):

 
| ** **                           | ** ** | ** **                  | ** ** | **Fair Value Measurements at June 28, 2008 Using** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | ** **                  | ** ** | **Quoted Prices in**                                                        | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                           | ** ** | **Fair Value at** | ** ** | **Active Markets for**                                                      | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                           | ** ** | **June 28,**           | ** ** | **Identical Assets**                                                             | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                           | ** ** | **2008**                    | ** ** | **(Level 1)**                                                                    | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                           | ** ** | ** **                  | ** ** | ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Investments in marketable securities |       | $                           | 12,569     |                                                                                  | $          | 11,595 |   | $ | — |   | $ | 974 |   |
|                                      |            |                             |            |                                                                                       |            |  |  |  |  |  |  |  |  |

 

Fair valuemeasurements using Level 3 inputs in the table above relate to the Company’sinvestments in auction rate securities.

 

The followingtable provides a reconciliation of the beginning and ending balances for theCompany’s assets measured at fair value using Level 3 inputs (in thousands):

 
| ** **                                                        | ** ** | **Six Months  Ended** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                        | ** ** | **June 28,**          | ** ** |
| ** **                                                        | ** ** | **2008**                   | ** ** |
| ** **                                                        | ** ** | ** **                 | ** ** |
| Beginning balance                                                 |       | $                          | —     |   |
| Transfers into Level 3                                            |       | 1,002                      |       |
| Unrealized loss included in accumulated  other comprehensive loss |       | (28                        | )          |
| Purchases, sales, issuances and  settlements, net                 |       | —                     |       |
| Ending balance                                                    |       | $                          | 974        |   |

 

During the quarterended June 28, 2008, the Company was able to liquidate at par value two ofits marketable securities investments in AAA rated auction rate securities witha total purchased cost of $2.0 million. Accordingly, the Company reversedthe cumulative unrealized loss on these investments of approximately $0.2million that was previously recorded as of March 29, 2008.

 

The recentdisruptions in the credit market continue to adversely affect the market forauction rate securities, such that these securities generally remain illiquid.As of June 28, 2008, the Company held two investments in auction ratesecurities with a total purchased cost of $1.0 million. These two investmentsrepresent (i) a fully insured debt obligation of a municipality and (ii) aAAA rated debt obligation backed by pools of student loans guaranteed by theU.S. Department of Education. Given the insufficient observable marketinformation available, the Company has valued these investments usingassumptions including discounted cash flows, credit quality and expectedduration. The Company is not currently able to predict how long theseinvestments will remain illiquid, and as such, they have been classified aslong-term investments in marketable securities in the accompanying unaudited

 

11

----

Tableof Contents

 

condensed consolidatedbalance sheet. The Company does not believe that the illiquidity of theseinvestments will materially impact its ability to fund its working capitalneeds, capital expenditures or other business requirements. The Company hasconcluded that the unrealized losses on these investments, which totaledapproximately $28,000 at June 28, 2008, are temporary because (i) theCompany believes that the decline in market value and absence of liquidity thathas occurred is due to general market conditions, (ii) the auction ratesecurities continue to be of a high credit quality and interest is paid as dueand (iii) the Company has the intent and ability to hold these investmentsuntil a recovery in market value occurs.

 

The fair value ofthe Company’s investments in marketable securities could change significantlyin the future and the Company may be required to record other-than-temporaryimpairment charges or additional unrealized losses in future periods.

 

**Note5—Credit Agreement**

 

In May 2008,the Company executed the Ninth Amendment to its Amended and Restated Credit andSecurity Agreement (the “Ninth Amendment”). Among other things, the NinthAmendment revised certain minimum profitability financial covenant requirementsand also eliminated the Company’s previous minimum monthly book net worthfinancial covenant requirement. Additionally, the Company’s nonrevolvingequipment financing line of credit was revised to allow the Company to borrowup to an additional maximum of $0.9 million to finance up to 80% of the cost ofequipment purchases through the end of fiscal 2008. Principal on any of theseadditional borrowings is scheduled to be repaid in 42 equal monthlyinstallments commencing January 1, 2009. Interest on the Company’sexisting and future equipment line of credit advances is payable monthly at theprime rate. The Ninth Amendment is effective as of the beginning of the Company’ssecond quarter of 2008.

 

The following table presents details ofinterest expense related to borrowings on the line of credit, along with certainother applicable information (in thousands):

 
| ** **                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                       | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **                                       | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Interest expense                                 |       | $                                | 26         |                           | $          | 159 |   | $ | 86 |   | $ | 549 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| ** **                                       | ** ** | ** **                       | ** ** | ** **                     | ** ** | **June 28,** | ** ** | **December 29,** | ** ** |
| ** **                                       | ** ** | ** **                       | ** ** | ** **                     | ** ** | **2008** | ** ** | **2007** | ** ** |
| Outstanding borrowings on the line of  credit    |       |                             |       |                           |       | $ | 5,662 |   | $ | 4,872 |   |
| Borrowing availability under the line of  credit |       |                             |       |                           |       | $ | 337 |   | $ | 6,366 |   |
|                                                  |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

Any borrowingsunder the Company’s revolving and equipment lines of credit are collateralizedby a general first priority lien against all of the Company’s assets, bothtangible and intangible.

 

**Note 6—Letters ofCredit**

 

In June 2008,the Company entered into an agreement with its bank to issue a commercialletter of credit (“LC”) up to $2 million to support purchases of inventory froma supplier. As part of this agreement, the Company is required to pledge cashas collateral for the full amount of the LC, and thus, as of June 28,2008, $2 million is classified as restricted cash in the accompanying unauditedcondensed consolidated balance sheet.

 

Subsequently, in July 2008,the Company entered into a second similar agreement with its bank to issueanother commercial LC up to $2 million to support inventory purchases fromanother supplier. This agreement also requires the Company to pledge cash ascollateral for the full amount of the LC.

 

12

----

Table of Contents

 

**Note 7—Long-TermDebt**

 

Long-term debtconsists of the following (in thousands):

 
| ** **                       | ** ** | **June 28,** | ** ** | **December 29,** | ** ** |
|----------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2008**          | ** ** | **2007**              | ** ** |
|                             |       |              |       |                  |       |
| Obligations under capital leases |       | $                 | 225        |                  | $          | 432 |   |
| Equipment note payable to bank   |       | 678               |       | 872                   |       |
| Notes payable to others          |       | 41                |       | 74                    |       |
|                             |       | 944               |       | 1,378                 |       |
| Less current portion             |       | (547              | )          | (740                  | )          |
|                             |       | $                 | 397        |                  | $          | 638 |   |

 

Interest expenserelated to long-term debt is presented in the following table (in thousands):

 
| ** **       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **       | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **       | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Interest expense |       | $                                | 30         |                           | $          | 51 |   | $ | 67 |   | $ | 108 |   |
|                  |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

**Note 8—IncomeTaxes**

** **

The followingtable sets forth the Company’s provision (benefit) for income taxes, along withthe corresponding effective tax rates (in thousands, except percentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **                           | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Provision (benefit) for income taxes |       | $                                | 11         |                           | $          | (3,864 | ) | $ | (1,170 | ) | $ | (3,864 | ) |
| Effective tax rate                   |       | —                           | %          | (35                            | )%         | (29 | )% | (37 | )% |
|                                      |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

Under Accounting Principles Board Opinion No. 28, *Interim Financial Reporting*, the Company is required toadjust its effective tax rate each quarter to be consistent with the estimatedannual effective tax rate. The Company is also required to record the taximpact of certain discrete items, unusual or infrequently occurring, includingchanges in judgment about valuation allowances and effects of changes in taxlaws or rates, in the interim period in which they occur. In addition,jurisdictions with a projected loss for the year or a year-to-date loss whereno tax benefit can be recognized are excluded from the estimated annualeffective tax rate. The impact of such an exclusion could result in a higher orlower effective tax rate during a particular quarter, based upon the mix andtiming of actual earnings versus annual projections.

 

The differencebetween the Company’s effective tax rate for the three months ended June 28,2008 and the 35% federal statutory rate is primarily attributable to a changein annual projected pre-tax income and the tax benefit recorded in the priorquarter.

 

**Note9—Commitments and Contingencies**

** **

*FederalSecurities Class Action*

 

Beginning in May 2007,the Company, certain of its officers and directors, and the Company’sunderwriters were named as defendants in four purported class actionshareholder complaints, two of which were filed in the U.S. District Court forthe Southern District of New York, and two of which were filed in the U.S.District Court for the Central District of California. These purported classaction lawsuits were filed on behalf of persons and entities who purchased orotherwise acquired the Company’s common stock pursuant or traceable to theCompany’s November 30, 2006 Initial Public Offering (the “IPO”). Thelawsuits were consolidated into a single action—Belodoff v. Netlist, Inc.,Lead Case No. SACV07-677 DOC (MLGx)—which is currently pending in theCentral District of California. Lead Plaintiff filed the Consolidated Complainton November 5, 2007. Defendants filed their motions to dismiss theConsolidated Complaint on January 9, 2008. The motions to dismiss weretaken under submission on April 28, 2008 and on May 30, 2008, theCourt granted the defendants’ motions. However, plaintiffs were granted theright to amend their complaint and subsequently filed their First AmendedConsolidated Class Action Complaint on July 15, 2008. Generally, theAmended Complaint alleges that the Registration Statement issued by the Companyin connection with the IPO contained untrue statements of material fact oromissions of material fact in violation of Sections 11 and 15 ofSecurities Act of 1933. The deadline for defendants to answer, move to dismissor otherwise respond to the Amended Complaint is September 2, 2008. TheCompany believes that the allegations

 

13

----

Table of Contents

 

lack merit and intends tovigorously defend all claims asserted. However, at this time, the Company isunable to form a professional judgment that an unfavorable outcome iseither probable or remote, and it is not possible to assess whether or not theoutcome of these proceedings will or will not have a material adverse effect onthe Company. If an unfavorable outcome should eventually occur, the Company isnot at this time able to estimate the amount or range of possible loss.

 

*CaliforniaDerivative Action*

 

In August 2007,a derivative lawsuit was filed in California Superior Court for County ofOrange—Smith v. Hong, Case No. 07CC01359—against certain of the Company’sofficers and directors. This action contains factual allegations similar to thoseof the federal class action lawsuit described above, but the plaintiff in thiscase also asserts claims for violations of California’s insider trading laws,breaches of fiduciary duty, abuse of control, gross mismanagement, waste ofcorporate assets, and unjust enrichment. The plaintiff seeks unspecifieddamages, equitable and/or injunctive relief and disgorgement of all profits,benefits and other compensation obtained by the defendants. The defendants inthis action have not responded to the complaint. Pursuant to a stipulation, theparties agreed to temporarily stay the action pending the ultimate decision onthe defendants’ motions to dismiss in the federal securities class action. Theparties also agreed that twenty days after the court in the federal securitiesclass action issues a final ruling as to the motions to dismiss brought in thataction, the parties will meet and confer regarding the time for defendants torespond to the complaint in this derivative action. The Company believes thatthe allegations lack merit and intends to vigorously defend all claimsasserted. At this time, however, the Company is unable to form aprofessional judgment that an unfavorable outcome is either probable or remote.Moreover, if an unfavorable outcome should eventually occur, the Company is notat this time able to estimate the amount or range of possible loss. Inaddition, the Company has received correspondence from counsel for a purportedshareholder requesting that the Company take actions to investigate and remedyalleged wrongdoing by unidentified former and current officers and/or directorsbased on allegations similar to those in the Smith v. Hong derivative case. TheCompany is evaluating its response to this request.

 

*OtherObligations*

 

During its normalcourse of business, the Company has made certain indemnities, commitments andguarantees under which it may be required to make payments in relation tocertain transactions. These include (i) intellectual property indemnitiesto the Company’s customers and licensees in connection with the use, salesand/or license of Company products; (ii) indemnities to vendors andservice providers pertaining to claims based on the negligence or willfulmisconduct of the Company; (iii) indemnities involving the accuracy ofrepresentations and warranties in certain contracts; (iv) indemnities todirectors and officers of the Company to the maximum extent permitted under thelaws of the State of Delaware; and (v) certain real estate leases, underwhich the Company may be required to indemnify property owners forenvironmental and other liabilities, and other claims arising from the Company’suse of the applicable premises. The duration of these indemnities, commitmentsand guarantees varies and, in certain cases, may be indefinite. The majority ofthese indemnities, commitments and guarantees do not provide for any limitationof the maximum potential for future payments the Company could be obligated tomake. Historically, the Company has not been obligated to make significantpayments for these obligations, and no liabilities have been recorded for theseindemnities, commitments and guarantees in the accompanying unaudited condensedconsolidated balance sheets.

 

**Note10—Stock Options and Warrants**

 

*Common Stock Options*

* *

A summary of theCompany’s common stock option activity as of and for the six months ended June 28,2008 is presented below (shares in thousands):

 
| ** **                                     | ** ** | ** **         | ** ** | **Weighted-** | ** ** |
|------------------------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                     | ** ** | ** **         | ** ** | **Average**   | ** ** |
| ** **                                     | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                     | ** ** | **Shares**         | ** ** | **Price**     | ** ** |
| Options outstanding at December 29,  2007 |       | 3,746              |       | $             | 3.06       |   |
| Options granted                                |       | 665                |       | 1.64          |       |
| Options exercised                              |       | —             |       | —        |       |
| Options cancelled                              |       | (313               | )          | 2.60          |       |
| Options outstanding at June 28, 2008      |       | 4,098              |       | $             | 2.87       |   |

 

14

----

Table of Contents

 

The following table presents details of the assumptions used tocalculate the weighted-average grant date fair value of common stock optionsgranted by the Company:

 
| ** **                                        | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 28,**              | ** ** | **June 30,** | ** ** |
| ** **                                        | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| Expected term (in years)                          |       | 5.4                            |       | 5.4 |   |
| Expected volatility                               |       | 80                             | %          | 80 | % |
| Risk-free interest rate                           |       | 3.10                           | %          | 4.74 | % |
| Expected dividends                                |       | —                         |       | — |   |
| Weighted-average grant date fair value per  share |       | $                              | 1.11       |   | $ | 3.63 |   |
|                                                   |            |                                |            |  |  |  |  |

 

*At June 28,2008, the amount of unearned stock-based compensation currently estimated to beexpensed from fiscal 2008 through fiscal 2012 related to unvested common stockoptions is approximately $3.1 million, net of estimated forfeitures. Theweighted-average period over which the unearned stock-based compensation isexpected to be recognized is approximately 2.5 years. If there are anymodifications or cancellations of the underlying unvested common stock options,the Company may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense. Future stock-based compensationexpense and unearned stock-based compensation will increase to the extent thatthe Company grants additional common stock options or other equity awards.*

* *

*Warrants*

* *

A summary ofactivity with respect to outstanding warrants to purchase shares of the Company’scommon stock as of and for the six months ended June 28, 2008 is presentedbelow (shares in thousands):

 
| ** **                                                  | ** ** | ** **         | ** ** | **Weighted-** | ** ** |
|-------------------------------------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                                  | ** ** | ** **         | ** ** | **Average**   | ** ** |
| ** **                                                  | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                                  | ** ** | **Shares**         | ** ** | **Price**     | ** ** |
| Warrants outstanding at December 29,  2007             |       | 318                |       | $             | 1.01       |   |
| Warrants granted                                            |       | —             |       | —        |       |
| Warrants exercised                                          |       | (97                | )          | 1.00          |       |
| Warrants cancelled                                          |       | (203               | )          | 1.00          |       |
| Warrants outstanding and exercisable at  June 28, 2008 |       | 18                 |       | $             | 1.25       |   |

 

In February 2008,certain warrant holders exercised 300,000 warrants to purchase shares of theCompany’s common stock, whereby the Company issued approximately 97,000 sharesof common stock pursuant to a net issue election and effectively receivedapproximately 203,000 shares back from the warrant holders as consideration inlieu of cash for the exercised warrants. The 203,000 shares were forfeited onthe exercise date.

 

**Note11—Segment and Geographic Information**

** **

The Companyoperates in one reportable segment: the design and manufacture ofhigh-performance memory subsystems for the server, high-performance computingand communications markets. The Company evaluates financial performance on aCompany-wide basis.

 

At June 28,2008, approximately $4.0 million of the Company’s net long-lived assets werelocated outside the United States, primarily in the PRC.

 

**Item 2.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

** **

**CautionaryStatement**

** **

*The following discussion and analysis of our financial condition andresults of operations should be read in conjunction with our UnauditedCondensed Consolidated Financial Statements and the related notes theretocontained in Part I, Item 1 of this Report. The information contained inthis Quarterly Report on Form 10-Q is not a complete description of ourbusiness or the risks associated with an investment in our common stock. Weurge you to carefully review and consider the various disclosures made by us inthis Report and in our other reports filed with the Securities and ExchangeCommission, or SEC, including our Annual Report on Form 10-K for thefiscal year ended December 29, 2007 and subsequent reports on Form 10-Qand Form 8-K, which discuss our business in greater detail.*

 

15

----

Table of Contents

 

*This Report, along with similar discussions in our other SEC filings,describes some of the important risks that may affect our business, results ofoperations and financial condition. You should carefully consider those risks,in addition to the other information in this Report and in our other filingswith the SEC, before deciding to purchase, hold or sell our common stock.*

 

*This Report contains forward-looking statements that involve risks,uncertainties, estimates and assumptions. These statements are not guaranteesof future performance and are subject to certain risks, uncertainties andassumptions that are difficult to predict. Therefore, our actual results coulddiffer materially and adversely from those expressed in any forward-lookingstatements as a result of various factors. We undertake no obligation to reviseor update publicly any forward-looking statements for any reason.*

 

**Overview**

** **

We design,manufacture and sell high performance memory subsystems for the server, highperformance computing and communications markets. Our memory subsystems consistof dynamic random access memory integrated circuits, or DRAM ICs, NAND andother components assembled on a printed circuit board, or PCB. We engage withour original equipment manufacturer, or OEM, customers from the earliest stagesof new product definition, which provides us unique insight into their fullrange of system architecture and performance requirements. This closecollaboration has also allowed us to develop a significant level of systemsexpertise. We leverage a portfolio of proprietary technologies and designtechniques, including efficient planar design, alternative packaging techniquesand custom semiconductor logic, to deliver memory subsystems with high memorydensity, small form factor, high signal integrity, attractive thermalcharacteristics and low cost per bit.

 

Consistent withthe concentrated nature of the OEM customer base in our target markets, a smallnumber of large customers have historically accounted for a significant portionof our net sales. Dell and Hewlett Packard represented approximately 66% and22%, respectively, of our net sales for the six months ended June 28,2008. Dell, Hewlett Packard and IBM represented approximately 41%, 28% and 11%,respectively, of our net sales for the six months ended June 30, 2007. Netsales to some of our OEM customers include memory modules that are qualified byus directly with the OEM customer and sold to electronic manufacturing servicesproviders, or EMSs, for incorporation into products manufactured exclusivelyfor the OEM customer. These net sales to EMSs have historically fluctuatedperiod by period as a portion of the total net sales to these OEM customers.Net sales to Hon Hai Precision Industry Co. Ltd., an EMS thatpurchases memory modules from us for incorporation into products manufacturedexclusively for Dell, represented approximately 18% of net sales to Dell forthe six months ended June 28, 2008 and approximately 67% of net sales toDell for the six months ended June 30, 2007. Net sales to KingstonTechnology Company, Inc., and to International SystemsTechnology Co. Ltd., both EMSs that purchase memory modules from usfor incorporation into products manufactured exclusively for IBM, representedapproximately 34% and 25%, respectively, of net sales to IBM for the six monthsended June 30, 2007.

 

**Key BusinessMetrics**

 

The followingdescribes certain line items in our statements of operations that are importantto management’s assessment of our financial performance:

*Net Sales.***Netsales consist primarily of sales of our high performance memory subsystems, netof a provision for estimated returns under our right of return policies, whichgenerally range up to 30 days. We generally do not have long-term salesagreements with our customers. Although OEM customers typically provide us withnon-binding forecasts of future product demand over specific periods of time,they generally place orders with us approximately two weeks in advance ofscheduled delivery. Selling prices are typically negotiated monthly, based oncompetitive market conditions and the current price of DRAM ICs and NAND.Purchase orders generally have no cancellation or rescheduling penaltyprovisions. We often ship our products to our customers’ internationalmanufacturing sites. All of our sales to date, however, are denominated in U.S.dollars. We also sell excess component inventory of DRAM ICs and NAND todistributors and other users of memory ICs. As compared to previous years,component inventory sales have significantly decreased as a percentage of netsales as a result of our efforts to diversify our customer base which hasresulted in our ability to use components in a wider range of memorysubsystems. We expect that component inventory sales will continue to representa minimal portion of our net sales in future periods.

 

*Cost of Sales.***Our cost of sales includes the cost ofmaterials, manufacturing costs, depreciation and amortization of equipment,inventory valuation provisions, stock-based compensation and occupancy costsand other allocated fixed costs. The DRAM ICs and NAND incorporated into ourproducts constitute a significant portion of our cost of sales, and thus ourcost of sales will fluctuate based on the current price of DRAM ICs and NAND.We attempt to pass through such DRAM IC and NAND cost fluctuations to ourcustomers by frequently renegotiating pricing prior to the placement of theirpurchase orders. To the extent we are successful, a large majority of ourproduct cost is variable, and thus our cost of sales and gross marginpercentages may not be significantly impacted by changes in sales volume.However, the sales prices of our memory subsystems can also fluctuate due tocompetitive situations unrelated to the pricing of DRAM ICs and NAND, whichwill affect gross margins. The gross margin on our sales of excess

 

16

----

Table of Contents

 

component DRAM IC andNAND inventory is much lower than the gross margin on our sales of our memorysubsystems. As a result, a decrease in DRAM IC and NAND inventory sales as a percentageof our overall sales would result in an improved overall gross margin. Weassess the valuation of our inventories on a monthly basis and record aprovision to cost of sales as necessary to reduce inventories to the lower ofcost or net realizable value.

 

*Research and Development.***Research and development expense consistsprimarily of employee and independent contractor compensation and relatedcosts, stock-based compensation, computer-aided design software licenses,reference design development costs, patent-related fees, depreciation or rentalof evaluation equipment, and occupancy and other allocated overhead costs. Alsoincluded in research and development expense are the costs of material andoverhead related to the production of engineering samples of new products underdevelopment or products used solely in the research and development process.Our customers typically do not separately compensate us for design andengineering work involved in developing application-specific products for them.All research and development costs are expensed as incurred. We anticipate thatresearch and development expenditures will increase in future periods as weseek to expand new product opportunities, increase our activities related tonew and emerging markets and continue to develop additional proprietarytechnologies.

 

*Selling, General andAdministrative.***Selling,general and administrative expenses consist primarily of employee salaries andrelated costs, stock-based compensation, independent sales representativecommissions, professional services, promotional and other selling and marketingexpenses, and occupancy and other allocated overhead costs. A significantportion of our selling efforts is directed at building relationships with OEMsand other customers and working through the product approval andqualification process with them. Therefore, the cost of material and overheadrelated to products manufactured for qualification is included in sellingexpenses. As we continue to service existing and penetrate new customers, weanticipate that our sales and marketing expenses will increase. We alsoanticipate that our general and administrative expenses related to accountingand legal expenses associated with our ongoing public reporting obligationswill generally remain consistent during the remainder of fiscal 2008; however,beginning in fiscal 2009, we anticipate being subject to attestation servicesrequirements with respect to our internal control over financial reporting, theresult of which will increase such expenses in future periods.

 

*Provision (Benefit) forIncome Taxes.* Our income tax provision (benefit) isbased on the statutory federal tax rate of 35% and is typically impacted bystate taxes and permanent book-tax differences.

 

**CriticalAccounting Policies**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires us to make estimates andassumptions that affect the reported amounts of assets and liabilities and disclosuresof contingent assets and liabilities at the date of the consolidated financialstatements and the reported amounts of net sales and expenses during thereporting period. By their nature, these estimates and assumptions are subjectto an inherent degree of uncertainty. We base our estimates on our historicalexperience, knowledge of current conditions and our beliefs of what could occurin the future considering available information. We review our estimates on anon-going basis. Actual results may differ from these estimates, which mayresult in material adverse effects on our operating results and financialposition. We believe the following critical accounting policies involve themore significant assumptions and estimates used in the preparation of ourconsolidated financial statements:

 

*Revenue Recognition.*We recognize revenues in accordance with the SEC’s Staff Accounting Bulletin No. 104,*Revenue Recognition*, or SAB 104.Under the provisions of SAB 104, we recognize revenues when there is persuasiveevidence of an arrangement, product delivery and acceptance have occurred, thesales price is fixed or determinable, and collectibility of the resultingreceivable is reasonably assured.

We generally usecustomer purchase orders and/or contracts as evidence of an arrangement.Delivery occurs when goods are shipped for customers with FOB Shipping Pointterms and upon receipt for customers with FOB Destination terms, at which timetitle and risk of loss transfer to the customer. Shipping documents are used toverify delivery and customer acceptance. We assess whether the sales price isfixed or determinable based on the payment terms associated with thetransaction and whether the sales price is subject to refund.

 

Customers aregenerally allowed limited rights of return for up to 30 days, except for salesof excess inventories, which contain no right-of-return privileges. Estimatedreturns are provided for at the time of sale based on historical experience orspecific identification of an event necessitating a reserve. We offer astandard product warranty to our customers and have no other post-shipmentobligations. While these returns have historically been within our expectationsand the provisions established, we cannot guarantee that we will continue toexperience similar return rates in the future. Any significant increase inproduct failure rates and the resulting product returns could have a materialadverse effect on our operating results for the period or periods in which suchreturns materialize.

 

17

----

Table of Contents

 

We assesscollectibility based on the creditworthiness of the customer as determined bycredit checks and evaluations, as well as the customer’s payment history. Aportion of our international shipments are made to third party inventorywarehouses, or hubs, and we recognize revenue when the inventory is pulled fromthe hub for use in production by the customer. We receive a report from thecustomer on a daily basis indicating the inventories pulled from a hub for useby the customer, and perform a daily reconciliation of inventories shipped toand pulled by the customer to those inventories reflected on the customer’sreports to ensure that sales are recognized in the appropriate periods. We havehistorically had good visibility into the inventories on-hand at hub locationsand also what our customers intend to pull within each reporting period.However, if a customer does not pull our inventory from its hub in accordancewith the schedule it originally provided to us, our predicted future revenuescould vary from our forecasts and our results of operations could be materiallyand adversely affected. Additionally, since we own inventories that arephysically located in hubs, our ability to effectively manage inventory levelsmay be impaired, causing our inventory turns to decrease, which would increaseexpenses associated with excess and obsolete inventories and negatively impactour cash flow.

 

All amounts billedto customers related to shipping and handling are classified as net sales,while all costs incurred by us for shipping and handling are classified as costof sales.

 

*Warranty Reserve.*We offer warranties on our memory subsystems generally ranging from one tothree years, depending on the product and negotiated terms of purchaseagreements with our customers. Such warranties require us to repair or replacedefective product returned to us during the warranty period at no cost to thecustomer. Our estimates for warranty-related costs are recorded at the time ofsale based on historical and estimated future product return rates and expectedrepair or replacement costs. While such costs have historically been within ourexpectations and the provisions established, unexpected changes in failurerates could have a material adverse impact on us, requiring additional warrantyreserves, and adversely affecting our gross profit and gross margins.

 

*Accounts Receivable.*We perform credit evaluations of our customers’ financial condition and limitthe amount of credit extended to our customers as deemed necessary, butgenerally require no collateral. We continuously monitor collections andpayments from our customers and maintain a provision for estimated creditlosses based upon our historical experience and any specific customercollection issues that we have identified. Generally, these credit losses havebeen within our expectations and the provisions established. However, we cannotguarantee that we will continue to experience credit loss rates similar tothose we have experienced in the past.

 

Our accountsreceivable are highly concentrated among a small number of customers, and asignificant change in the liquidity or financial position of one of thesecustomers could have a material adverse effect on the collectibility of ouraccounts receivable, our liquidity and our future operating results.

 

*Inventories.*We value our inventories at the lower of the actual cost to purchase ormanufacture the inventory or the net realizable value of the inventory. Cost isdetermined on an average cost basis which approximates actual cost on afirst-in, first-out basis and includes raw materials, labor and manufacturingoverhead. We regularly review inventory quantities on hand and on order andrecord a provision for excess and obsolete inventories based primarily on ourestimated forecast of product demand and production requirements for the nextthree to six months. In addition, we consider changes in the market value ofDRAM ICs and NAND in determining the net realizable value of our raw materialinventory. Once established, any write downs are considered permanentadjustments to the cost basis of our inventories. A significant decrease indemand for our products could result in an increase in the amount of excessinventory quantities on hand. In addition, our estimates of future productdemand may prove to be inaccurate, in which case we may have understated oroverstated the provision required for excess and obsolete inventory. In thefuture, if our inventories are determined to be overvalued, we would berequired to recognize additional expense in our cost of sales at the time ofsuch determination. Likewise, if our inventories are determined to beundervalued, we may have over-reported our costs of sales in previous periodsand would be required to recognize additional gross profit at the time suchinventories are sold. In addition, should the market value of DRAM ICs and NANDdecrease significantly, we may be required to lower our selling prices toreflect the lower cost of our raw materials. If such price decreases reduce thenet realizable value of our inventories to less than our cost, we would berequired to recognize additional expense in our cost of sales in the sameperiod. Although we make every reasonable effort to ensure the accuracy of ourforecasts of future product demand, any significant unanticipated changes indemand, technological developments or the market value of DRAM ICs and NANDcould have a material effect on the value of our inventories and our reportedoperating results.

 

*Long-Lived Assets.***We review the recoverability of thecarrying value of long-lived assets on an annual basis or whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. Recoverability of these assets is determined based upon theforecasted undiscounted future net cash flows from the operations to which theassets relate, utilizing our best estimates, appropriate assumptions andprojections at the time. These projected future cash flows may varysignificantly over time as a result of increased competition, changes intechnology, fluctuations in demand, consolidation of our customers and reductionsin average selling prices. If the carrying value is determined not to berecoverable from future operating cash flows, the asset is deemed impaired andan impairment loss is recognized to the extent the carrying value exceeds theestimated fair market value of the asset.

 

18

----

Table of Contents

 

*Stock-Based Compensation.*We account for equity issuances to non-employees in accordance with Statementof Financial Accounting Standards, or SFAS, No. 123, *Accounting for Stock Based Compensation*,and Emerging Issues Task Force Issue No. 96-18, *Accounting for Equity Instruments that are Issued to Other ThanEmployees for Acquiring, or in Conjunction with Selling, Goods and Services*.All transactions in which goods or services are the consideration received forthe issuance of equity instruments are accounted for based on the fair value ofthe consideration received or the fair value of the equity instrument issued,whichever is more reliably measurable. The measurement date used to determinethe fair value of the equity instrument issued is the earlier of the date onwhich the third-party performance is complete or the date on which it is probablethat performance will occur.

 

On January 1,2006, we adopted SFAS No. 123(R), *Share-Based Payment*,or SFAS 123R, which requires the measurement and recognition ofcompensation expense for all share-based payment awards made to our employeesand directors based on estimated fair values. We adoptedSFAS 123R using the modified prospective transition method, whichrequires the application of the accounting standard as of January 1, 2006,the first day of our fiscal year 2006. In accordance with the modifiedprospective transition method, our consolidated financial statements for priorperiods have not been restated to reflect, and do not include, the impact ofadopting SFAS 123R.

 

We currently usethe Black-Scholes option pricing model to estimate the fair value ofstock-based awards. While this model meets the requirements of SFAS 123R,the estimated fair values generated by it may not be indicative of the actualfair values of our stock-based awards as it does not consider certain factorsimportant to those awards to employees, such as continued employment andperiodic vesting requirements as well as limited transferability. TheBlack-Scholes model requires subjective assumptions regarding future stockprice volatility and expected time to exercise, along with assumptions aboutthe risk-free interest rate and expected dividends, all of which affect theestimated fair values of our stock-based awards. The expected term of optionsgranted is derived from historical data on employee exercises and post-vestingemployment termination behavior. The expected volatility is based on thehistorical volatilities of the common stock of comparable publicly tradedcompanies based on our belief that we currently have limited historical dataregarding the volatility of our stock price on which to base a meaningfulestimate of expected volatility. The risk-free rate selected to value anyparticular grant is based on the U.S. Treasury rate that corresponds to theexpected term of the grant effective as of the date of the grant. The expecteddividends assumption is based on our history and expectation of dividendpayouts. We evaluate the assumptions used to value stock-based awards on aquarterly basis. If factors change and we employ different assumptions,stock-based compensation expense may differ significantly from what we haverecorded in prior periods.

 

The value of theportion of stock-based awards that are ultimately expected to vest isrecognized as expense over the requisite service periods in our financialstatements. Given that stock-based compensation expense recognized in ourfinancial statements is based on awards ultimately expected to vest, it hasbeen reduced for estimated forfeitures. SFAS 123R requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. If thereare any modifications or cancellations of the underlying unvested stock-basedawards, we may be required to accelerate, increase or cancel any remaining unearnedstock-based compensation expense. Future stock-based compensation expense andunearned stock-based compensation will increase to the extent that we grantadditional stock-based awards.

 

*Income Taxes.***We recognize deferred tax assets andliabilities based on the differences between the financial statement carryingvalues and the tax bases of assets and liabilities. We regularly review ourdeferred tax assets for recoverability and establish a valuation allowance,when determined necessary, based on historical taxable income, projected futuretaxable income, and the expected timing of the reversals of existing temporarydifferences. If we operate at a loss for an extended period of time or areunable to generate sufficient future taxable income, or if there is a materialchange in the actual effective tax rates or time period within which theunderlying temporary differences become taxable or deductible, we could berequired to record a valuation allowance against all or a significant portionof our deferred tax assets which could substantially increase our effective taxrate for such period. Any significant changes in statutory tax rates or theamount of our valuation allowance could have a material effect on the value ofour deferred tax assets and liabilities, and our reported financial results.Additionally, we adopted Financial Accounting Standards Board, or FASB,Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes—An Interpretation of FASB Statement No. 109*, orFIN 48, on December 31, 2006, the first day of fiscal 2007. FIN 48 seeksto reduce the diversity in practice associated with certain aspects ofmeasurement and recognition in accounting for income taxes. FIN 48 prescribes arecognition threshold and measurement requirement for the financial statementrecognition of a tax position that has been taken or is expected to be taken ona tax return and also provides guidance on de-recognition, classification,interest and penalties, accounting in interim periods, disclosure, and transition.Under FIN 48 we may only recognize or continue to recognize tax positions thatmeet a “more likely than not” threshold.

 

The application oftax laws and regulations is subject to legal and factual interpretation,judgment and uncertainty. Tax laws and regulations themselves are subject tochange as a result of changes in fiscal policy, changes in legislation, theevolution of regulations and court rulings. Therefore, the actual liability forU.S. or foreign taxes may be materially different from our estimates, whichcould result in the need to record additional tax liabilities or potentiallyreverse previously recorded tax liabilities.

 

19

----

Table of Contents

 

**Results ofOperations**

 

The followingtable sets forth certain consolidated statements of operations data as apercentage of net sales for the periods indicated:

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 28,**                | ** ** | **June 30,**              | ** ** | **June 28,** | ** ** | **June 30,** | ** ** |
| ** **                                        | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Net sales                                         |       | 100                              | %          | 100                            | %          | 100 | % | 100 | % |
| Cost of sales                                     |       | 86                               |       | 146                            |       | 82 |   | 101 |   |
| Gross profit (loss)                               |       | 14                               |       | (46                            | )          | 18 |   | (1 | ) |
| Operating expenses:                               |       |                             |       |                           |       |   |   |   |   |
| Research and development                          |       | 9                                |       | 12                             |       | 10 |   | 5 |   |
| Selling, general and administrative               |       | 18                               |       | 30                             |       | 21 |   | 15 |   |
| Total operating expenses                          |       | 27                               |       | 42                             |       | 32 |   | 20 |   |
| Operating loss                                    |       | (13                              | )          | (88                            | )          | (14 | ) | (21 | ) |
| Other income:                                     |       |                             |       |                           |       |   |   |   |   |
| Interest income, net                              |       | 1                                |       | 1                              |       | 1 |   | — |   |
| Other income (expense), net                       |       | —                           |       | —                         |       | — |   | — |   |
| Total other income, net                           |       | 1                                |       | 1                              |       | 1 |   | — |   |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Loss before provision (benefit) for income  taxes |       | (12                              | )          | (86                            | )          | (13 | ) | (21 | ) |
| Provision (benefit) for income taxes              |       | —                           |       | (30                            | )          | (4 | ) | (8 | ) |
| Net loss                                          |       | (12                              | )%         | (55                            | )%         | (9 | )% | (13 | )% |

 

***Three and Six MonthsEnded June 28, 2008 Compared to Three and Six Months Ended June 30,2007***

 

***NetSales, Cost of Sales and Gross Profit.***

 

*The following tables present net sales, cost of sales andgross profit for the three and six months ended June 28, 2008 and June 30,2007 (in thousands, except percentages):*

 
| ** **          | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **     | ** ** |
|---------------------|------------|----------------------------------|------------|-------------------|------------|----------------|------------|
| ** **          | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **          | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Net sales           |       | $                                | 18,429     |              | $          | 12,811         |       | $ | 5,618 |   | 44 | % |
| Cost of sales       |       | 15,770                           |       | 18,734            |       | (2,964         | )          | (16 | )% |
| Gross profit (loss) |       | $                                | 2,659      |              | $          | (5,923         | )          | $ | 8,582 |   | 145 | % |
| Gross margin        |       | 14                               | %          | (46               | )%         | 61             | %          |   |   |
|                |       |                             |       |              |       |           |       |   |   |
| ** **          | ** ** | **Six Months Ended**   | ** ** | ** **        | ** ** | ** **     | ** ** |
| ** **          | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **          | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Net sales           |       | $                                | 31,533     |              | $          | 50,349         |       | $ | (18,816 | ) | (37 | )% |
| Cost of sales       |       | 25,743                           |       | 50,823            |       | (25,080        | )          | (49 | )% |
| Gross profit (loss) |       | $                                | 5,790      |              | $          | (474           | )          | $ | 6,264 |   | 1,322 | % |
| Gross margin        |       | 18                               | %          | (1                | )%         | 19             | %          |   |   |

 

*Net Sales.*** The overall decrease in our net sales duringthe six months ended June 28, 2008 as compared to the six months ended June 30,2007 was primarily driven by the slower than expected growth in sales ofcertain of our flash and highdensity server modules, as well as a decline in net sales of memory subsystemsused to control redundant arrays of independent disks, or RAIDs, as a result ofcertain key programs and designs nearing an end-of-life in 2008. The decreasein our net sales during this period was partially offset, however, by stronggrowth in our line of low-power fully buffered dual in-line memory modules, orFBDIMMs, which experienced a significant ramp in sales volumes to certain keyOEM customers beginning in 2008.

 

20

----

Tableof Contents

 

The increase in net salesfor the three months ended June 28, 2008 as compared to the three monthsended June 30, 2007 resulted primarily from increases of approximately (i) $10.7million in net sales of our low-power FBDIMMs and (ii) $1.7 million in netsales of laptop personal computer memory subsystems. The above increases werepartially offset by decreases of approximately (i) $2.7 million in netsales of memory subsystems used to control RAIDs and (ii) $4.3 million innet sales of certain high density memory modules for the server market andrelated applications.

 

The decrease in net salesfor the six months ended June 28, 2008 as compared to the six months endedJune 30, 2007 resulted primarily from decreases of approximately (i) $15.9million in net sales of certain high density memory modules for the servermarket and related applications, (ii) $10.6 million in net sales of memorysubsystems used to control RAIDs and (iii) $7.5 million in net sales oflaptop personal computer memory subsystems. The above decreases were partiallyoffset by an increase of approximately $16.3 million in net sales of ourlow-power FBDIMMs.

 

Sales of our componentinventory to distributors and other users of memory ICs representedapproximately 1% and 3% of net sales for the three months ended June 28,2008 and June 30, 2007, respectively, and approximately 1% and 3% of netsales for the six months ended June 28, 2008 and June 30, 2007,respectively. As compared to previous years, component inventory sales havesignificantly decreased as a percentage of net sales as a result of our effortsto diversify our customer base, which has resulted in our ability to usecomponents in a wider range of memory subsystems.

 

*Gross Profit and GrossMargin.*** The increase in gross profit and gross marginfor the three and six months ended June 28, 2008 as compared to the threeand six months ended June 30, 2007 is substantially due to our grosslosses in the 2007 periods presented, which primarily resulted from significantdecreases in the market price of DRAM ICs during the first half of 2007. Theseprice declines negatively impacted the valuation of our inventories, whereby weincurred losses in the three and six months ended June 30, 2007 ofapproximately $1.6 million and $6.0 million, respectively, which directlyaffected our gross margins for these periods. As compared to 2007, during thethree and six months ended June 28, 2008, we generally experienced astabilization of DRAM IC market prices, which contributed to a more normalizedgross margin for these periods. However, as compared to the first quarter of2008, during the three months ended June 28, 2008, we experienced a slightincrease in the market price for DRAM ICs that we purchased during the periodto fulfill certain customer orders. As a result of pre-established sales andpricing agreements, we were generally not able to pass these higher costs on toour customers, and thus our gross profit and gross margins were negativelyaffected for the 2008 periods presented. Nevertheless, in 2008 we have begun torealize certain benefits and cost savings of having transitioned a majority ofour production manufacturing volume to our facility in the People’s Republic ofChina.

 

Should the market pricesof DRAM ICs and/or NAND decline in future periods, or should our product salesmix shift more toward lower margin products, our gross profit, gross margin andoverall operating results could be adversely affected.

 

***Researchand Development***.

 

The following tablespresent research and development expenses for the three and six months ended June 28,2008 and June 30, 2007 (in thousands, except percentages):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **   | ** ** |
|--------------------------|------------|----------------------------------|------------|-------------------|------------|--------------|------------|
| ** **               | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **               | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Research and development |       | $                                | 1,716      |              | $          | 1,478        |       | $ | 238 |   | 16 | % |
|                     |       |                             |       |              |       |         |       |   |   |
| ** **               | ** ** | **Six Months Ended**   | ** ** | ** **        | ** ** | ** **   | ** ** |
| ** **               | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **               | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Research and development |       | $                                | 3,292      |              | $          | 2,545        |       | $ | 747 |   | 29 | % |

 

The increase in researchand development expense in the three months ended June 28, 2008 ascompared to the three months ended June 30, 2007 resulted primarily fromincreases of approximately (i) $0.2 million in personnel-related expensesand (ii) $0.1 million in certain legal and professional services. Theabove increases were partially offset primarily by decreases of approximately$0.1 million in equipment-related expenses.

 

The increase in researchand development expense in the six months ended June 28, 2008 as comparedto the six months ended June 30, 2007 resulted primarily from increases ofapproximately (i) $0.7 million in personnel-related expenses, (ii) $0.1million for certain engineering and design tools and related expenses and (iii) $0.1million in legal and professional services. The above increases were partiallyoffset primarily by decreases of approximately (i) $0.1 million inexpenses related to product qualification testing, stock compensation andvarious allocated overhead expenses and (ii) $0.1 million inequipment-related expenses.

 

21

----

Tableof Contents

 

The increases inpersonnel-related expenses are primarily attributable to an increase in thenumber of employees engaged in research and development activities since June 30,2007, as well as compensation increases. The increases in legal andprofessional services are primarily a result of our increased activities in2008 related to new product opportunities and new and emerging markets. Thedecreases in equipment-related expenses are due to impairment write-downs thatwe recorded in 2007 related to certain long-lived assets used in the productdevelopment process.

 

***Selling,General and Administrative***.

 

The following tablespresent selling, general and administrative expenses for the three and sixmonths ended June 28, 2008 and June 30, 2007 (in thousands, exceptpercentages):

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** |         |       |
|-------------------------------------|------------|----------------------------------|------------|-------------------|------------|--------------|------------|
| ** **                          | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **Decrease** | ** ** | **Change** | ** ** |
| Selling, general and administrative |       | $                                | 3,310      |              | $          | 3,845        |       | $ | (535 | ) | (14 | )% |
|                                |       |                             |       |              |       |         |       |   |   |
| ** **                          | ** ** | **Six Months Ended**   | ** ** | ** **        | ** ** |         |       |
| ** **                          | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **Decrease** | ** ** | **Change** | ** ** |
| Selling, general and administrative |       | $                                | 6,778      |              | $          | 7,549        |       | $ | (771 | ) | (10 | )% |

 

The decrease in selling,general and administrative expense in the three months ended June 28, 2008as compared to the three months ended June 30, 2007 resulted primarilyfrom decreases of approximately (i) $0.6 million in personnel-relatedexpenses and (ii) $0.1 million in legal and professional fees. The abovedecreases are partially offset primarily by an increase ofapproximately $0.2 million in various allocated overhead expenses.

 

The decrease in selling,general and administrative expense in the six months ended June 28, 2008as compared to the six months ended June 30, 2007 resulted primarily fromdecreases of approximately (i) $0.5 million in personnel-related expenses,(ii) $0.3 million in legal and professional fees, (iii) $0.2 millionin commission and travel-related expenses and (iv) $0.1 million in productqualification, evaluation and advertising. The above decreases are partiallyoffset primarily by an increase of approximately $0.3 million in variousallocated overhead expenses, which include, but are not limited to, expensesfor rent, insurance and depreciation.

 

The decreases inpersonnel-related expenses are primarily attributable to a decrease in thenumber of employees engaged in selling, general and administrative activitiesof approximately 29% since June 30, 2007. The decreases in legal andprofessional fees are primarily a result of the significant costs we incurredin 2007 to begin operating as a public company, including costs related to ourinitial documentation and assessment of internal control over financialreporting, as well as lower legal fees in 2008 related to current litigationmatters since the majority of such expenses became reimbursable from ourinsurance carrier in the current year.

 

22

----

Table of Contents

 

***OtherIncome (Expense)***.

 

The following tablespresent other income (expense) for the three and six months ended June 28,2008 and June 30, 2007 (in thousands, except percentages):

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **     | ** ** |
|-----------------------------|------------|----------------------------------|------------|-------------------|------------|----------------|------------|
| ** **                  | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **                  | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Interest income, net        |       | $                                | 104        |              | $          | 162            |       | $ | (58 | ) | (36 | )% |
| Other income (expense), net |       | 23                               |       | 4                 |       | 19             |       | 475 | % |
| Total other income, net     |       | $                                | 127        |              | $          | 166            |       | $ | (39 | ) | (23 | )% |
|                        |       |                             |       |              |       |           |       |   |   |
| ** **                  | ** ** | **Six Months Ended**   | ** ** | ** **        | ** ** | ** **     | ** ** |
| ** **                  | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **                  | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Interest income, net        |       | $                                | 343        |              | $          | 114            |       | $ | 229 |   | 201 | % |
| Other income (expense), net |       | $                                | (68        | )                 | $          | 5              |       | (73 | ) | (1,460 | )% |
| Total other income, net     |       | $                                | 275        |              | $          | 119            |       | $ | 156 |   | 131 | % |

 

Net interest income forthe three and six months ended June 28, 2008 was comprised of interestincome of approximately $0.2 million and $0.5 million, respectively, partiallyoffset by interest expense of approximately $0.1 million and $0.2 million,respectively. Net interest income for the three and six months ended June 30,2007 was comprised of interest income of approximately $0.4 million and $0.9million, respectively, partially offset by interest expense of approximately$0.3 million and $0.7 million, respectively. The decrease in interest incomeduring 2008 as compared to 2007 was primarily due to our lower overall cash andinvestment balances on-hand during the current year. The decrease in interestexpense during 2008 as compared to 2007 resulted primarily from our loweroutstanding line of credit and debt balances during the current year.

 

Other expense, net, forthe six months ended June 28, 2008 is primarily comprised of losses oncertain foreign currency remeasurement transactions, partially offset byrealized gains on the sale of certain investments in marketable securities.

 

***Provision(Benefit) for Income Taxes***.

 

The following tables presentthe provision (benefit) for income taxes for the three and six months ended June 28,2008 and June 30, 2007 (in thousands, except percentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **   | ** ** |
|--------------------------------------|------------|----------------------------------|------------|-------------------|------------|--------------|------------|
| ** **                           | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Provision (benefit) for income taxes |       | $                                | 11         |              | $          | (3,864       | )          | $ | 3,875 |   | (100 | )% |
| Effective tax rate                   |       | —                           | %          | (35               | )%         |         |       |   |   |
|                                 |       |                             |       |              |       |         |       |   |   |
| ** **                           | ** ** | **Six Months Ended**   | ** ** | ** **        | ** ** | ** **   | ** ** |
| ** **                           | ** ** | **June 28,**                | ** ** | **June 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2008**                         | ** ** | **2007**          | ** ** | **Decrease** | ** ** | **Change** | ** ** |
| Benefit for income taxes             |       | $                                | (1,170     | )                 | $          | (3,864       | )          | $ | 2,694 |   | (70 | )% |
| Effective tax rate                   |       | (29                              | )%         | (37               | )%         |         |       |   |   |

 

Under Accounting Principles Board Opinion No. 28, *Interim Financial Reporting*, we are required to adjust oureffective tax rate each quarter to be consistent with the estimated annualeffective tax rate. We are also required to record the tax impact of certaindiscrete items, unusual or infrequently occurring, including changes injudgment about valuation allowances and effects of changes in tax laws orrates, in the interim period in which they occur. In addition, jurisdictionswith a projected loss for the year or a year-to-date loss where no tax benefitcan be recognized are excluded from the estimated annual effective tax rate.The impact of such an exclusion could result in a higher or lower effective taxrate during a particular quarter, based upon the mix and timing of actualearnings versus annual projections.

 

We recorded a provision for income taxes for the three monthsended June 28, 2008. Our estimated effective tax benefit rate ofapproximately 0% for the three months June 28, 2008 was affected by achange in annual projected pre-tax income and the tax benefit from thatrecorded in the prior quarter.

 

23

----

Table of Contents

 

**Liquidity andCapital Resources**

** **

Since ourinception, we have financed our operations primarily through issuances ofequity and debt securities and cash generated from operations. We have alsofunded our operations with a revolving line of credit under our bank creditfacility, from capitalized lease obligations, financing of receivables and fromthe sale and leaseback of our domestic manufacturing facility.

 

***WorkingCapital and Cash and Marketable Securities***

 

The following tablepresents working capital, cash and cash equivalents and investments inmarketable securities (in thousands):

 
| ** **                          | ** ** | **June 28,** | ** ** | **December 29,** | ** ** |
|-------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Working Capital                     |       | $                 | 31,490     |                  | $          | 27,387 |   |
|                                |       |              |       |                  |       |
| Cash and cash equivalents(1)        |       | $                 | 11,243     |                  | $          | 7,182 |   |
| Restricted cash(1)                  |       | 2,000             |       | —                |       |
| Short-term marketable securities(1) |       | 11,595            |       | 15,573                |       |
| Long-term marketable securities     |       | 974               |       | 7,814                 |       |
|                                |       | $                 | 25,812     |                  | $          | 30,569 |   |

 

----

*(1) Included in workingcapital*

 

*Our working capital increased in the six months ended June 28,2008 primarily as a result of (i) a combined increase in our cash and cashequivalents, restricted cash and short-term investments in marketablesecurities balances of approximately $2.1 million due primarily to maturitiesand sales of certain long-term investments in marketable securities, (ii) acombined increase in our income taxes receivable and current deferred taxes ofapproximately $0.6 million and (iii) a combined decrease in our currentliabilities of approximately $1.4 million.*

 

***CashProvided and Used in the Six Months Ended June 28, 2008 and June 30,2007***

 

*The following table summarizes our cash flows for theperiods indicated (in thousands):*

* *
| ** **                                            | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                            | ** ** | **June 28,**              | ** ** | **June 30,** | ** ** |
| ** **                                            | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| **Net cash provided by (used in):**                   |       |                           |       |   |   |
| Operating activities                                  |       | $                              | (4,349     | ) | $ | 11,590 |   |
| Investing activities                                  |       | 10,058                         |       | (22,928 | ) |
| Financing activities                                  |       | (1,648                         | )          | (14,638 | ) |
| Net increase (decrease) in cash and cash  equivalents |       | $                              | 4,061      |   | $ | (25,976 | ) |

 

*Operating Activities.*Net cash used in operating activities for the six months ended June 28,2008 was primarily a result of (i) our net loss for the period ofapproximately $2.8 million, and (ii) approximately $2.1 million in netcash used by changes in operating assets and liabilities, partially offset byapproximately $0.6 million in net non-cash operating expenses, primarilycomprising depreciation and amortization, deferred income taxes and stock-basedcompensation.

 

Accounts receivabledecreased approximately $5.6 million during the six months ended June 28,2008 primarily due to the overall decline in our net sales during 2008. Duringthe same period, we were successful in collecting cash from sales to ourcustomers substantially in accordance with our standard payment terms with thosecustomers.

 

Inventories increasedapproximately $5.0 million during the six months ended June 28, 2008primarily due to purchases of materials during the second quarter of 2008 tomeet forecasted sales obligations. In the future, our inventory levels willcontinue to be determined based on, among other factors, (i) the level ofcustomer orders received and overall demand, (ii) the stage at which ourproducts are in their respective life cycles and (iii) competitivesituations in the marketplace. We make efforts to balance such considerationsagainst the risk of obsolescence or potentially excess inventory levels.

 

24

----

Table of Contents

 

Net cash provided byoperating activities for the six months ended June 30, 2007 was primarilya result of (i) approximately $3.0 million in net non-cash operatingexpenses, primarily comprising inventory adjustments, depreciation andamortization, deferred income taxes, stock-based compensation and impairment oflong-lived assets and (ii) approximately $15.2 million in net cashprovided by changes in operating assets and liabilities, partially offset by anet loss of approximately $6.6 million for the six months ended June 30,2007. The changes in operating assets and liabilities which had a significantimpact on cash provided by operating activities included (i) a decrease inaccounts receivable of approximately $16.4 million, (ii) a decrease ininventories of approximately $7.4 million and (iii) a decrease in accountspayable of approximately $7.3 million. All such decreases in operating assetsand liabilities were primarily due to the overall decline in the level of netsales and related operating activities during the first half of fiscal 2007 ascompared to the second half of fiscal 2006.

 

*Investing Activities.*Net cash provided by investing activities for the six months ended June 28,2008 was primarily a result of proceeds we received from maturities and salesof certain investments in marketable securities of approximately $17.5 million,partially offset by purchases of additional investments in marketablesecurities of approximately $6.7 million. We also used approximately $0.8million in cash to purchase additional manufacturing equipment and otherproperty and equipment.

 

Net cash used ininvesting activities for the six months ended June 30, 2007 was primarilya result of purchases of additional investments in marketable securities ofapproximately $43.5 million, partially offset by proceeds we received frommaturities of certain investments in marketable securities of approximately$24.8 million. During the same period, we also used approximately $4.3 millionin cash primarily to purchase equipment and leasehold improvements for ourfacilities in the People’s Republic of China and in Irvine, California.

 

*Financing Activities.*Net cash used in financing activities for the six months ended June 28,2008 was primarily a result of an increase in restricted cash balances inconnection with our pledge of $2.0 million in cash as collateral for a letterof credit and repayments of approximately $0.4 million on our long term debt.This is partially offset by approximately $0.8 million in net proceeds we receivedduring the period from borrowings on our outstanding revolving line of credit.

 

Net cash used infinancing activities for the six months ended June 30, 2007 was primarilya result of approximately $14.4 million in net repayments on our outstandingrevolving line of credit, along with net repayments of approximately $0.4million on our long term debt.

 

***Capital Resources***

 

Under ourrevolving line of credit, we may borrow up to the greater of 85% of eligibleaccounts receivable plus the least of (i) a percentage of eligibleinventory determined from time to time by our bank, (ii) 80% of theorderly liquidation value, as defined, of eligible inventories, and (iii) $1 million.

 

In May 2008,we executed a ninth amendment to our credit agreement, which is effective as ofthe beginning of our second fiscal quarter of 2008. Among other things, theamendment revised certain financial and other covenants of which we arerequired to comply. The amendment requires us to (i) limit capitalexpenditures under a defined annual cap, (ii) achieve certain minimummonthly profitability thresholds and (iii) maintain a minimum liquiditythreshold as of the end of each month. Additionally, the amendment revised theinterest rate on our borrowings on the revolving line of credit to fluctuatebetween the prime rate and prime plus 0.5% based our combined monthly accountbalance with the bank. Furthermore, under the amendment, our nonrevolvingequipment financing line of credit was revised to allow us to borrow up to anadditional maximum of $0.9 million to finance up to 80% of the cost ofequipment purchases through the end of fiscal 2008. Principal on any of theseadditional borrowings is scheduled to be repaid in 42 equal monthlyinstallments commencing January 1, 2009. Interest on our existing andfuture equipment line of credit advances is payable monthly at the prime rate.

 

The followingtable presents details of outstanding borrowings and availability under ourlines of credit (in thousands):

 
| ** **                                              | ** ** | **June 28,** | ** ** | **December 29,** | ** ** |
|---------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Outstanding borrowings on the line of  credit           |       | $                 | 5,662      |                  | $          | 4,872 |   |
| Outstanding borrowings on the equipment  line of credit |       | $                 | 678        |                  | $          | 872 |   |
| Borrowing availability under the line of  credit        |       | $                 | 337        |                  | $          | 6,366 |   |
| Prime rate                                              |       | 5.0               | %          | 7.25                  | %          |

 

Any borrowings underour revolving and equipment lines of credit are collateralized by a generalfirst priority lien against all of our assets, both tangible and intangible.

 

25

----

Table of Contents

 

While we arecurrently in compliance with all of our financial covenants and expect tomaintain compliance for the foreseeable future, we have in the past been inviolation of one or more covenants. We cannot assure you that we will notviolate one or more covenants in the future. If we were to be in violation ofcovenants under our credit agreement, our lender could choose to acceleratepayment on all outstanding loan balances. There can be no assurance that wewould be able to quickly obtain equivalent or suitable replacement financing inthis event. If we were not able to secure alternative sources of funding, suchacceleration would have a material adverse impact on our financial condition.

 

We have in the pastutilized equipment leasing arrangements to finance certain capitalexpenditures. Equipment leases will continue to be a financing alternative thatwe may pursue in the future.

 

*Lettersof Credit*

 

In June 2008,we entered into an agreement with our bank to issue a commercial letter ofcredit, or LC, up to $2 million to support purchases of inventory from asupplier. As part of this agreement, we are required to pledge cash ascollateral for the full amount of the LC, and thus, as of June 28, 2008,$2 million is classified as restricted cash in the accompanying unauditedcondensed consolidated balance sheet.

 

Subsequently, in July 2008,we entered into a second similar agreement with our bank to issue anothercommercial LC up to $2 million to support inventory purchases from a supplier.This agreement also requires us to pledge cash as collateral for the fullamount of the LC.

 

*Investmentsin Marketable Securities*

 

During the quarterended June 28, 2008, we were able to liquidate at par value two of ourmarketable securities investments in AAA rated auction rate securities with atotal purchased cost of $2.0 million and accordingly, we reversed thecumulative unrealized loss on these investments of approximately $0.2 millionthat was previously recorded as of March 29, 2008.

 

The recentdisruptions in the credit market continue to adversely affect the market forauction rate securities, such that these securities generally remain illiquid.As of June 28, 2008, we held two investments in auction rate securitieswith a total purchased cost of $1.0 million. These two investments represent (i) afully insured debt obligation of a municipality and (ii) a AAA rated debtobligation backed by pools of student loans guaranteed by the U.S. Departmentof Education. Given the insufficient observable market information available,we have valued these investments using assumptions including discounted cashflows, credit quality and expected duration. We are not currently able topredict how long these investments will remain illiquid, and as such, they havebeen classified as long-term investments in marketable securities in theaccompanying unaudited condensed consolidated balance sheets. We do not believethat the illiquidity of these investments will materially impact our ability tofund our working capital needs, capital expenditures or other businessrequirements. We have concluded that the unrealized losses on theseinvestments, which totaled approximately $28,000 at June 28, 2008, aretemporary because (i) we believe that the decline in market value andabsence of liquidity that has occurred is due to general market conditions, (ii) theauction rate securities continue to be of a high credit quality and interest ispaid as due and (iii) we have the intent and ability to hold theseinvestments until a recovery in market value occurs.

 

The fair value ofour investments in marketable securities could change significantly in thefuture and we may be required to record other-than-temporary impairment chargesor additional unrealized losses in future periods.

 

We believe ourexisting cash and investment balances, borrowing availability under our bankcredit facility, and the cash expected to be generated from operations, will besufficient to meet our anticipated cash needs for at least the next12 months. Our future capital requirements will depend on many factors,including our levels of net sales, the timing and extent of expenditures tosupport research and development activities, the expansion of manufacturingcapacity both domestically and internationally and the continued marketacceptance of our products. We could be required, or may choose, to seekadditional funding through public or private equity or debt financings. Inaddition, in connection with any future acquisitions, we may require additionalfunding which may be provided in the form of additional debt or equityfinancing or a combination thereof. These additional funds may not be availableon terms acceptable to us, or at all.

 

***Off-Balance SheetArrangements***

 

***We do not have any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. In addition, we do not have anyundisclosed borrowings or debt, and we have not entered into any syntheticleases. We are, therefore, not materially exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in such relationships.***

 

26

----

Table of Contents

 

**Item 3.**                          Quantitative and QualitativeDisclosures About Market Risk

 

***As a SmallerReporting Company, we are not required to make any disclosure pursuant to thisItem 3.***

 

**Item 4.**                          Controls and Procedures

 

***Not Applicable.***

 

**Item 4T.**                 Controls and Procedures

 

*(a) Evaluation ofDisclosure Controls and Procedures.* We carried out anevaluation, under the supervision and with the participation of our management,including our principal executive officer and principal financial officer, ofthe effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) of theSecurities Exchange Act of 1934, (“Exchange Act”)) as of the end of our fiscalquarter ended June 28, 2008. Based upon that evaluation, our principalexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures are effective to provide reasonable assurance thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act (i) is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms and (ii) isaccumulated and communicated to our management, including our principalexecutive officer and principal financial officer as appropriate to allowtimely decisions regarding required disclosure.

 

*(b) Change in internal controls over financial reporting.* During the fiscal quarter that ended June 28,2008, there have not been any changes in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

***InherentLimitations on Internal Control***

 

A control system, no matter how well conceived and operated,can provide only reasonable, not absolute, assurance that the objectives of thecontrol system are met. Further, the benefits of controls must be consideredrelative to their costs. Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, have been detected. Theseinherent limitations include the realities that judgments in decision makingcan be faulty, and that breakdowns can occur because of simple errors.Additionally, controls can be circumvented by the individual acts of somepersons, by collusion of two or more people, or by management override of thecontrol. The design of any system of controls is also based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

**PART II. OTHER INFORMATION**

** **

**Item 1.**                          Legal Proceedings

 

The informationset forth in the sections entitled Federal Securities Class Action andCalifornia Derivative Action under Note 7 of Notes to Unaudited CondensedConsolidated Financial Statements, included in Part I, Item I of thisReport, is incorporated herein by reference.

 

**Item 1A.**                 Risk Factors

 

***As a Smaller Reporting Company, we are not required to makeany disclosure pursuant to this Item 1A. Please refer to the Risk Factors setforth in Part I, Item 1A of our Annual Report on Form 10-K for thefiscal year ended December 29, 2007 filed with the Securities and ExchangeCommission on February 29, 2008.***

 

**Item 2.**                          Unregistered Sales of EquitySecurities and Use of Proceeds

** **

None.

 

**Item 3.**                          Defaults Upon SeniorSecurities

** **

None.

 

27

----

Table of Contents

 

**Item 4.**                          Submission of Matters to aVote of Security Holders

 

(a) Our 2008 annual meeting of stockholders washeld on May 28, 2008.

 

(b) At our 2008 annual meeting of stockholders,the stockholders elected each of the following nominees as directors, to serveon our Board of Directors until our 2009 annual meeting of stockholders oruntil their respective successors are elected and qualified (or their earlierresignation or removal). The vote for each director was as follows:

 
| ** **        | ** ** | **Votes  For** | ** ** | **Votes  Withheld** | ** ** | **Abstentions** | ** ** |
|-------------------|------------|----------------|------------|---------------------|------------|-----------------|------------|
| Chun Ki Hong      |       | 11,409,006     |       | 697,781             |       | 7,748,624       |       |
| Nam Ki Hong       |       | 11,730,681     |       | 376,106             |       | 7,748,624       |       |
| Thomas F. Lagatta |       | 11,255,174     |       | 851,613             |       | 7,748,624       |       |
| Alan H. Portnoy   |       | 11,732,221     |       | 374,566             |       | 7,748,624       |       |
| David M. Rickey   |       | 11,255,174     |       | 851,613             |       | 7,748,624       |       |
| Preston Romm      |       | 11,255,174     |       | 851,613             |       | 7,748,624       |       |

 

**Item 5.**                          Other Information

** **

None.

 

**Item 6.**                         Exhibits

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                     |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description of Document**                                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                           |
| 3.1(1)      |       | Restated Certificate of Incorporation of  Netlist, Inc.                                                                                                                                                                                   |
|        |       |                                                                                                                                                                                                                                           |
| 3.2(1)      |       | Amended and Restated Bylaws of Netlist, Inc.                                                                                                                                                                                              |
|        |       |                                                                                                                                                                                                                                           |
| 31.1(2)     |       | Certification of Chief Executive Officer  pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as Amended.                                                                                       |
|        |       |                                                                                                                                                                                                                                           |
| 31.2(2)     |       | Certification of Chief Financial Officer  pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as Amended.                                                                                       |
|        |       |                                                                                                                                                                                                                                           |
| 32(3)       |       | Certification of Chief Executive Officer  and Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 and furnished herewith  pursuant to SEC Release No. 33-8238. |

 

----

(1)         Incorporatedby reference to the corresponding exhibit number of the registration statementon Form S-1 of the registrant (No. 333-136735) filed with theSecurities and Exchange Commission on October 23, 2006.

 

(2)         Filedherewith.

 

(3)         Theinformation in Exhibit 32 shall not be deemed “filed” for purposes of Section 18of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”), orotherwise subject to the liabilities of that section, nor shall they be deemedincorporated by reference in any filing under the Securities Act of 1933, asamended, or the Exchange Act (including this Report), unless Netlist, Inc.specifically incorporates the foregoing information into those documents byreference.

 

28

----

Table of Contents

 

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| Date: August 7, 2008 |       | NETLIST, INC.                               |
|---------------------------|------------|---------------------------------------------|
|                      |       | a Delaware corporation                      |
|                      |       | (Registrant)                                |
|                      |       |                                        |
|                      | By:        | /s/ Chun K.  Hong                           |
| ** **                | ** ** | **Chun K.  Hong**                           |
| ** **                | ** ** | **President,  Chief Executive Officer and** |
| ** **                | ** ** | **Chairman  of the Board**                  |
| ** **                | ** ** | **(Principal  Executive Officer)**          |
| ** **                | ** ** | ** **                                  |
| ** **                | ** ** | ** **                                  |
|                      | By:        | /s/ Gail  Itow                              |
| ** **                | ** ** | **Gail  Itow**                              |
| ** **                | ** ** | **Vice  President and Chief Financial**     |
| ** **                | ** ** | **Officer**                                 |
| ** **                | ** ** | **(Principal  Financial Officer)**          |

 

29

----

Table of Contents

 

**EXHIBITINDEX**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                     |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description of Document**                                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                           |
| 31.1        |       | Certification of Chief Executive Officer  pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as Amended.                                                                                       |
|        |       |                                                                                                                                                                                                                                           |
| 31.2        |       | Certification of Chief Financial Officer  pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act, as Amended.                                                                                       |
|        |       |                                                                                                                                                                                                                                           |
| 32          |       | Certification of Chief Executive Officer  and Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 and furnished herewith  pursuant to SEC Release No. 33-8238. |

 

30

----