Table ofContents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

** **

**(MarkOne)**

 

**x****           QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

** **

**For the quarterly period ended October 2, 2010**

** **

**or**

** **

**o****              TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition period from            to**

 

**Commission file number 001-33170**

 

**NETLIST, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**51 Discovery, Suite 150**

**Irvine, CA 92618**

 (Address of principal executiveoffices) (Zip Code)

 

**(949) 435-0025**

(Registrant’s telephone number, including area code)

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (section232.405 of this chapter) during the preceding 12 months (or for such shorterperiod that the registrant was required to submit and post such files).Yes o  No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or a smaller reporting company. Seedefinition 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) |   |                                   |

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Act).  Yes o   No x

 

Thenumber of shares outstanding of each of the registrant’s classes of commonstock as of the latest practicable date:

 

Common Stock, par value $0.001 per share

25,305,603 shares outstanding at November 1, 2010

 

 

 

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**NETLIST, INC. AND SUBSIDIARIES**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE THREE AND NINE MONTHS ENDED OCTOBER 2, 2010**

** **

**TABLE OFCONTENTS**

 
| ** **    | ** **                                                                                                                                         | ** ** | **Page** |
|---------------|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I.  | FINANCIAL INFORMATION                                                                                                                              |       | 3        |
| Item 1.       | Financial Statements                                                                                                                               |       | 3        |
|          | Condensed Consolidated Balance Sheets at  October 2, 2010 (unaudited) and January 2, 2010 (audited)                                      |       | 3        |
|          | Unaudited Condensed Consolidated Statements of  Operations for the Three and Nine Months Ended October 2, 2010  and October 3, 2009 |       | 4        |
|          | Unaudited Condensed Consolidated Statements of Cash  Flows for the Nine Months Ended October 2, 2010 and October 3, 2009                 |       | 5        |
|          | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                                    |       | 6        |
| Item 2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                        |       | 22       |
| Item 4.       | Controls and Procedures                                                                                                                            |       | 34       |
|          |                                                                                                                                               |       |     |
| PART II. | OTHER INFORMATION                                                                                                                                  |       | 34       |
| Item 1.       | Legal Proceedings                                                                                                                                  |       | 34       |
| Item 1A.      | Risk Factors                                                                                                                                       |       | 34       |
| Item 5.       | Other Information                                                                                                                                  |       | 50       |
| Item 6.       | Exhibits                                                                                                                                           |       | 51       |

 

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**PART I.FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**NETLIST, INC. ANDSUBSIDIARIES**

**Condensed Consolidated BalanceSheets**

**(in thousands, except par value)**

 
| ** **                                                                                                                 | ** ** | **(unaudited)**     | ** ** | **(audited)**       | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                                                                                 | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
| ** **                                                                                                                 | ** ** | **2010**            | ** ** | **2010**            | ** ** |
| ** **                                                                                                                 | ** ** | ** **          | ** ** | ** **          | ** ** |
| **ASSETS**                                                                                                                 | ** ** | ** **          | ** ** | ** **          | ** ** |
| Current assets:                                                                                                            |       |                |       |                |       |
| Cash and cash  equivalents                                                                                                 |       | $                   | 14,722     |                | $          | 9,942 |   |
| Investments in  marketable securities                                                                                      |       | 3,426               |       | 3,949               |       |
| Accounts  receivable, net                                                                                                  |       | 6,951               |       | 4,273               |       |
| Inventories                                                                                                                |       | 3,861               |       | 2,232               |       |
| Prepaid expenses  and other current assets                                                                                 |       | 1,522               |       | 854                 |       |
| Total current  assets                                                                                                      |       | 30,482              |       | 21,250              |       |
|                                                                                                                       |       |                |       |                |       |
| Property and  equipment, net                                                                                               |       | 4,275               |       | 4,779               |       |
| Long-term  investments in marketable securities                                                                            |       | 894                 |       | 941                 |       |
| Other assets                                                                                                               |       | 172                 |       | 221                 |       |
| Total assets                                                                                                               |       | $                   | 35,823     |                | $          | 27,191 |   |
|                                                                                                                       |       |                |       |                |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                             |       |                |       |                |       |
| Current  liabilities:                                                                                                      |       |                |       |                |       |
| Accounts payable                                                                                                           |       | $                   | 6,234      |                | $          | 4,057 |   |
| Accrued payroll  and related liabilities                                                                                   |       | 1,884               |       | 2,332               |       |
| Accrued expenses  and other current liabilities                                                                            |       | 566                 |       | 605                 |       |
| Accrued  engineering charges                                                                                               |       | 573                 |       | 661                 |       |
| Current portion  of long-term debt                                                                                         |       | 640                 |       | 108                 |       |
| Deferred gain on  sale and leaseback transaction                                                                           |       | 20                  |       | 108                 |       |
| Total current  liabilities                                                                                                 |       | 9,917               |       | 7,871               |       |
| Long-term debt,  net of current portion                                                                                    |       | 1,078               |       | 51                  |       |
| Total  liabilities                                                                                                         |       | 10,995              |       | 7,922               |       |
| Commitments and  contingencies                                                                                             |       |                |       |                |       |
| Stockholders’  equity:                                                                                                |       |                |       |                |       |
| Common stock,  $0.001 par value - 90,000 shares authorized; 25,306 (2010) and 20,111 (2009)  shares issued and outstanding |       | 25                  |       | 20                  |       |
| Additional  paid-in capital                                                                                                |       | 88,812              |       | 71,332              |       |
| Accumulated  deficit                                                                                                       |       | (63,904             | )          | (52,026             | )          |
| Accumulated  other comprehensive loss                                                                                      |       | (105                | )          | (57                 | )          |
| Total  stockholders’ equity                                                                                           |       | 24,828              |       | 19,269              |       |
| Total liabilities  and stockholders’ equity                                                                           |       | $                   | 35,823     |                | $          | 27,191 |   |

 

Seeaccompanying notes.

 

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**NETLIST, INC. ANDSUBSIDIARIES**

**Unaudited Condensed ConsolidatedStatements of Operations**

**(in thousands, except per share amounts)**

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **                                        | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                        | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                         |       | $                                | 10,565     |                            | $          | 6,446 |   | $ | 27,759 |   | $ | 11,781 |   |
| Cost of sales(1)                                  |       | 7,545                            |       | 4,879                           |       | 21,103 |   | 10,507 |   |
| Gross profit                                      |       | 3,020                            |       | 1,567                           |       | 6,656 |   | 1,274 |   |
| Operating  expenses:                              |       |                             |       |                            |       |   |   |   |   |
| Research and  development(1)                      |       | 4,958                            |       | 1,975                           |       | 11,156 |   | 5,619 |   |
| Selling, general  and administrative(1)           |       | 2,986                            |       | 2,115                           |       | 8,163 |   | 6,170 |   |
| Total operating  expenses                         |       | 7,944                            |       | 4,090                           |       | 19,319 |   | 11,789 |   |
| Operating loss                                    |       | (4,924                           | )          | (2,523                          | )          | (12,663 | ) | (10,515 | ) |
| Other income  (expense):                          |       |                             |       |                            |       |   |   |   |   |
| Interest income  (expense), net                   |       | (3                               | )          | (25                             | )          | 1 |   | 75 |   |
| Other income,  net                                |       | —                           |       | 4                               |       | 71 |   | 134 |   |
| Total other  income (expense), net                |       | (3                               | )          | (21                             | )          | 72 |   | 209 |   |
| Loss before  provision (benefit) for income taxes |       | (4,927                           | )          | (2,544                          | )          | (12,591 | ) | (10,306 | ) |
| Provision  (benefit) for income taxes             |       | 12                               |       | (458                            | )          | (713 | ) | (409 | ) |
| Net loss                                          |       | $                                | (4,939     | )                               | $          | (2,086 | ) | $ | (11,878 | ) | $ | (9,897 | ) |
| Net loss per  common share:                       |       |                             |       |                            |       |   |   |   |   |
| Basic and  diluted                                |       | $                                | (0.20      | )                               | $          | (0.11 | ) | $ | (0.51 | ) | $ | (0.50 | ) |
|                                              |       |                             |       |                            |       |   |   |   |   |
| Weighted-average  common shares outstanding:      |       |                             |       |                            |       |   |   |   |   |
| Basic and  diluted                                |       | 24,799                           |       | 19,855                          |       | 23,422 |   | 19,855 |   |

 

----

| (1) Amounts  include stock-based compensation expense as follows: |   |   |   |   |   |
|-------------------------------------------------------------------|--------|--------|--------|--------|--------|
|                                                              |   |   |   |   |   |   |   |   |   |
| Cost of sales                                                     |   | $      | 11     |   | $      | 146 |   | $ | 33 |   | $ | 213 |   |
| Research and  development                                         |   | 134    |   | 156    |   | 297 |   | 262 |   |
| Selling, general  and administrative                              |   | 268    |   | 329    |   | 891 |   | 753 |   |
|                                                                   |        |        |        |        |        |  |  |  |  |  |  |  |  |

 

See accompanying notes.

 

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** **

**NETLIST, INC. ANDSUBSIDIARIES**

**Unaudited Condensed ConsolidatedStatements of Cash Flows**

**(in thousands)**

 
| ** **                                                                   | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                   | ** ** | **October 2,**             | ** ** | **October 3,** | ** ** |
| ** **                                                                   | ** ** | **2010**                        | ** ** | **2009** | ** ** |
| ** **                                                                   | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                               | (11,878    | ) | $ | (9,897 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                            |       |   |   |
| Depreciation and  amortization                                               |       | 1,691                           |       | 1,710 |   |
| Amortization of  deferred gain on sale and leaseback transaction             |       | (88                             | )          | (89 | ) |
| Gain on disposal  of assets                                                  |       | —                          |       | (118 | ) |
| Stock-based  compensation                                                    |       | 1,221                           |       | 1,228 |   |
| Changes in  operating assets and liabilities:                                |       |                            |       |   |   |
| Accounts  receivable                                                         |       | (2,678                          | )          | (815 | ) |
| Inventories                                                                  |       | (1,629                          | )          | (57 | ) |
| Income taxes receivable                                                      |       | —                          |       | 1,880 |   |
| Prepaid expenses  and other current assets                                   |       | (668                            | )          | 126 |   |
| Other assets                                                                 |       | 49                              |       | (18 | ) |
| Accounts payable                                                             |       | 1,907                           |       | 183 |   |
| Income taxes  payable                                                        |       | —                          |       | 78 |   |
| Accrued payroll  and related expenses                                        |       | (448                            | )          | 320 |   |
| Accrued expenses  and other current liabilities                              |       | (39                             | )          | 179 |   |
| Accrued  engineering charges                                                 |       | (88                             | )          | 511 |   |
| Net cash used in  operating activities                                       |       | (12,648                         | )          | (4,779 | ) |
| Cash flows from  investing activities:                                       |       |                            |       |   |   |
| Acquisition of  property and equipment                                       |       | (718                            | )          | (89 | ) |
| Proceeds from  sales of equipment                                            |       | —                          |       | 342 |   |
| Purchase of  investments in marketable securities                            |       | (2,395                          | )          | (10,837 | ) |
| Proceeds from  maturities and sales of investments in marketable securities  |       | 2,917                           |       | 12,170 |   |
| Net cash (used  in) provided by investing activities                         |       | (196                            | )          | 1,586 |   |
| Cash flows from  financing activities:                                       |       |                            |       |   |   |
| Borrowings on  line of credit                                                |       | 3,000                           |       | 12,784 |   |
| Payments on line  of credit                                                  |       | (3,000                          | )          | (12,784 | ) |
| Proceeds from  public offering, net                                          |       | 16,210                          |       | — |   |
| Proceeds from  exercise of stock options and warrants                        |       | 54                              |       | — |   |
| Proceeds of bank  term loan                                                  |       | 1,500                           |       | — |   |
| Payments on debt                                                             |       | (140                            | )          | (520 | ) |
| Net cash  provided by (used in) financing activities                         |       | 17,624                          |       | (520 | ) |
| Increase  (decrease) in cash and cash equivalents                            |       | 4,780                           |       | (3,713 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 9,942                           |       | 15,214 |   |
| Cash and cash equivalents  at end of period                                  |       | $                               | 14,722     |   | $ | 11,501 |   |
|                                                                         |       |                            |       |   |   |
| Supplemental  disclosure of non-cash investing activities:                   |       |                            |       |   |   |
| Unrealized  losses from investments in marketable securities                 |       | $                               | 48         |   | $ | 32 |   |
| Purchase of  assets under capital lease                                      |       | $                               | 199        |   | $ | 108 |   |
| Increase in  purchases of property and equipment accrued in accounts payable |       | $                               | 270        |   | $ | — |   |

 

See accompanying notes.

 

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**NETLIST, INC. ANDSUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**October 2, 2010**

 

**Note 1—Description of Business**

 

Netlist, Inc. (the “Company” or “Netlist”) designs, manufacturesand sells high-performance, logic-based memory subsystems for the server,storage and communications equipment markets. The Company’s memory subsystemsconsist of combinations of dynamic random access memory integrated circuits,NAND flash memory, application-specific integrated circuits (“ASICs”) and othercomponents assembled on printed circuit boards. The Company primarily markets and sells its products to leading originalequipment manufacturer (“OEM”) customers. Netlist’s solutions are targeted atapplications where memory plays a key role in meeting system performancerequirements.

 

**Note 2—Summary of Significant Accounting Policies**

 

*Basis ofPresentation*

 

Theinterim unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (the “U.S.”) for interim financial information andwith the instructions to Securities and Exchange Commission (“SEC”)Form 10-Q and Article 8 of SEC Regulation S-X. These financialstatements do not include all of the information and footnotes required byaccounting principles generally accepted in the U.S. for complete financialstatements. Therefore, these unaudited condensed consolidated financialstatements should be read in conjunction with the Company’s audited consolidatedfinancial statements and notes thereto for the year ended January 2, 2010,included in the Company’s Annual Report on Form 10-K filed with the SEC onFebruary 19, 2010.

 

Thecondensed consolidated financial statements included herein as of October 2,2010 are unaudited; however, they contain all normal recurring accruals andadjustments that, in the opinion of the Company’s management, are necessary topresent fairly the condensed consolidated financial position of the Company andits wholly-owned subsidiaries as of October 2, 2010, the condensedconsolidated results of its operations for the three and nine months ended October 2,2010 and October 3, 2009, and the condensed consolidated cash flows forthe nine months ended October 2, 2010 and October 3, 2009.  The results of operations for the three andnine months ended October 2, 2010 are not necessarily indicative of theresults to be expected for the full year or any future interim periods.

 

*Reclassifications*

 

Certainamounts in the 2009 financial statements have been reclassified to conform tothe current year presentation.

 

*Principlesof Consolidation*

 

The condensed consolidated financial statementsinclude the accounts of Netlist, Inc. and its wholly-owned subsidiaries.All intercompany balances and transactions have been eliminated inconsolidation.

 

*FiscalYear*

 

TheCompany operates under a 52/53-week fiscal year ending on the Saturday closestto December 31.  For fiscal 2010,the Company’s fiscal year is scheduled to end on January 1, 2011 and willconsist of 52 weeks. Each of the Company’s first three quarters in a fiscalyear is comprised of 13 weeks.

 

*Use ofEstimates*

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the U.S. requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the condensedconsolidated financial statements, and the reported amounts of net sales andexpenses during the reporting period. By their nature, these estimates andassumptions are subject to an inherent degree of uncertainty.  Significant estimates made by managementinclude, among others, provisions for uncollectible receivables and sales returns,warranty liabilities, valuation of inventories, fair value of financialinstruments, impairment of long-lived assets, stock-based compensation expenseand realization of deferred tax assets. The Company bases its estimates onhistorical experience, knowledge of current conditions and our beliefs of whatcould occur in the future considering available information.  The Company reviews its estimates on anon-going basis. The actual results experienced by the Company may differmaterially and adversely from its estimates. To the extent there are materialdifferences between the estimates and the actual results, future results ofoperations will be affected.

 

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*RevenueRecognition*

 

TheCompany’s revenues primarily consist of product sales of high-performancememory subsystems to OEMs. Revenues also include sales of excess componentinventories to distributors and other users of memory integrated circuits (“ICs”).  Such sales amounted to less than $0.1 millionfor each of the three and nine months ended October 2, 2010, and totaledapproximately $0.6 million and $0.7 million, respectively, for each of thethree and nine months ended October 3, 2009.

 

TheCompany recognizes revenues in accordance with the Financial AccountingStandards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic605.  Accordingly, 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.

 

TheCompany generally uses customer purchase orders and/or contracts as evidence ofan arrangement. Delivery occurs when goods are shipped for customers with FOBShipping Point terms and upon receipt for customers with FOB Destination terms,at which time title and risk of loss transfer to the customer. Shipping documentsare used to verify delivery and customer acceptance. The Company assesseswhether the sales price is fixed or determinable based on the payment termsassociated with the transaction and whether the sales price is subject torefund. Customers are generally allowed limited rights of return for up to30 days, except for sales of excess component inventories, which containno right-of-return privileges. Estimated returns are provided for at the timeof sale based on historical experience or specific identification of an eventnecessitating a reserve. The Company offers a standard product warranty to itscustomers and has no other post-shipment obligations. The Company assessescollectibility based on the creditworthiness of the customer as determined by creditchecks and evaluations, as well as the customer’s payment history.

 

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

 

*Cash andCash Equivalents*

 

Cashand cash equivalents consist of cash and short-term investments with originalmaturities of three months or less, other than short-term investments insecurities that lack an active market.

 

*Investmentsin Marketable Securities*

 

TheCompany accounts for its investments in marketable securities in accordancewith ASC Topic 320.  The Companydetermines the appropriate classification of its investments at the time ofpurchase 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, generally based on market quotes, to the extent they areavailable. Unrealized gains and losses, net of applicable deferred taxes, arerecorded as a component of other comprehensive income (loss). Realized gainsand losses and declines in value judged to be other than temporary aredetermined based on the specific identification method and are reported inother income, net in the unaudited condensed consolidated statements ofoperations.

 

The Company generally invests its excess cash in domestic bank-issuedcertificates of deposit which carry federal deposit insurance, money marketfunds and highly liquid debt instruments of U.S. municipalities, corporationsand the U.S. government and its agencies. All highly liquid investments withstated maturities of three months or less from the date of purchase areclassified as cash equivalents; all investments with stated maturities ofgreater than three months are classified as investments in marketablesecurities.

 

*FairValue of Financial Instruments*

 

TheCompany’s financial instruments consist principally of cash and cashequivalents, investments in marketable securities, accounts receivable,accounts payable, accrued expenses and debt instruments.  Other than for certain investments in auctionrate securities (see Note 4) commercial paper and short-term corporate bonds,the fair value of the Company’s cash equivalents and investments in marketablesecurities is determined based on quoted prices in active markets for identicalassets or Level 1 inputs.  Because oftheir short-term nature, commercial paper and short-term corporate bonds arenot frequently traded.  Although thereare observable quotes for these securities, the markets are not consideredactive.  Accordingly, the fair values ofthese investments are based on Level 2 inputs. The Company recognizes transfers between Levels 1 through 3 of the fairvalue hierarchy at the beginning of the reporting period.  The Company believes that the carrying valuesof all other financial instruments approximate their current fair values due totheir nature and respective durations.

 

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*Allowancefor Doubtful Accounts*

 

The Company evaluates the collectibility of accounts receivable basedon a combination of factors. In cases where the Company is aware ofcircumstances that may impair a specific customer’s ability to meet itsfinancial obligations subsequent to the original sale, the Company will recordan allowance against amounts due, and thereby reduce the net recognizedreceivable to the amount the Company reasonably believes will be collected. Forall other customers, the Company records allowances for doubtful accounts basedprimarily on the length of time the receivables are past due based on the termsof the originating transaction, the current business environment and itshistorical experience.  Uncollectibleaccounts are charged against the allowance for doubtful accounts when all costeffective commercial means of collection have been exhausted.

 

*Concentrationof Credit Risk*

 

Financial instruments that potentially subject the Company tosignificant concentrations of credit risk consist principally of cash and cashequivalents, investments in marketable securities, and accounts receivable.

 

The Company invests its cash equivalents primarilyin money market funds.  Cash equivalentsare maintained with high quality institutions, the composition and maturitiesof which are regularly monitored by management. The Company had $0.4 million ofFederal Deposit Insurance Corporation insured cash and cash equivalents at October 2,2010.  Investments in marketablesecurities are generally in high-credit quality debt instruments with an activeresale market. Such investments are made only in instruments issued or enhancedby high-quality institutions.  TheCompany has not incurred any credit risk losses related to these investments.

 

The Company’s trade accounts receivable are primarily derived fromsales to OEMs in the computer industry. The Company performs creditevaluations of its customers’ financial condition and limits the amount ofcredit extended when deemed necessary, but generally requires no collateral.The Company believes that the concentration of credit risk in its tradereceivables is moderated by its credit evaluation process, relatively shortcollection terms, the high level of credit worthiness of its customers (seeNote 3), and foreign credit insurance. Reserves are maintained for potentialcredit losses, and such losses historically have not been significant and havebeen within management’s expectations.

 

*Inventories*

 

Inventoriesare valued at the lower of actual cost to purchase or manufacture the inventoryor net realizable value of the inventory. Cost is determined on an average costbasis which approximates actual cost on a first-in, first-out basis andincludes raw materials, labor and manufacturing overhead.  At each balance sheet date, the Companyevaluates its ending inventory quantities on hand and on order and records aprovision for excess quantities and obsolescence. Among other factors, theCompany considers historical demand and forecasted demand in relation to theinventory on hand, competitiveness of product offerings, market conditions andproduct life cycles when determining obsolescence and net realizable value ofraw material inventory. Provisions are made to reduce excess or obsoleteinventories to their estimated net realizable values. Once established,write-downs are considered permanent adjustments to the cost basis of theexcess or obsolete inventories.

 

*Propertyand Equipment*

 

Property and equipment are recorded at cost anddepreciated on a straight-line basis over their estimated useful lives, whichgenerally range from three to seven years. Leasehold improvements are recordedat cost and amortized on a straight-line basis over the shorter of theirestimated useful lives or the remaining lease term.

 

*Impairment of Long-Lived Assets*

 

The Company evaluates the recoverability of the carrying value oflong-lived assets held and used in its operations for impairment on at least anannual basis or whenever events or changes in circumstances indicate that theirnet book value may not be recoverable. When such factors and circumstances exist, the Company compares theprojected undiscounted future net cash flows associated with the related assetor group of assets over their estimated useful lives against their respectivecarrying amount.  These projected futurecash flows may vary significantly over time as a result of increasedcompetition, changes in technology, fluctuations in demand, consolidation ofour customers and reductions in 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 value of the asset.  Thefair value of the asset or asset group is based on market value when available,or when unavailable, on discounted expected cash flows.

 

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*Warranties*

 

TheCompany offers warranties generally ranging from one to three years, dependingon the product and negotiated terms of the purchase agreements withcustomers.  Such warranties require theCompany to repair or replace defective product returned to the Company duringthe warranty period at no cost to the customer. Warranties are not offered onsales of excess component inventory.  TheCompany records an estimate for warranty-related costs at the time of salebased on its historical and estimated product return rates and expected repairor replacement costs (see Note 3). Such costs have historically been consistentbetween periods and within management’s expectations and the provisionsestablished.

 

*Stock-BasedCompensation*

 

The Company accounts for equity issuances tonon-employees in accordance with ASC Topic 505. All transactions in which goods or services are the considerationreceived for the issuance of equity instruments are accounted for based on thefair value of the consideration received or the fair value of the equity instrumentissued, whichever is more reliably measurable. The measurement date used todetermine the fair value of the equity instrument issued is the earlier of thedate on which the third-party performance is complete or the date on which itis probable that performance will occur.

 

In accordance with ASC Topic 718, employee anddirector stock-based compensation expense recognized during the period is basedon the value of the portion of stock-based payment awards that is ultimatelyexpected to vest during the period. Given that stock-based compensation expense recognized in the condensedconsolidated statements of operations is based on awards ultimately expected tovest, it has been reduced for estimated forfeitures. ASC Topic 718 requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. TheCompany’s estimated average forfeiture rates are based on historical forfeitureexperience and estimated future forfeitures.

 

The fair value of common stock option awards toemployees and directors is calculated using the Black-Scholes option pricingmodel. The Black-Scholes model requires subjective assumptions regarding futurestock price volatility and expected time to exercise, along with assumptionsabout the risk-free interest rate and expected dividends, which affect theestimated fair values of the Company’s common stock option awards.  The expected term of options granted iscalculated as the average of the weighted vesting period and the contractualexpiration date of the option.  Thiscalculation is based on the safe harbor method permitted by the SEC ininstances where the vesting and exercise terms of options granted meet certainconditions and where limited historical exercise data is available.  The expected volatility is based on thehistorical volatility of the Company’s common stock.  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 expecteddividend assumption is based on the Company’s history and management’sexpectation regarding dividend payouts.  Compensation expense for common stock option awards with graded vestingschedules is recognized on a straight-line basis over the requisite serviceperiod for the last separately vesting portion of the award.

 

The Company recognizes the fair value of restrictedstock awards issued to employees and outside directors as stock-basedcompensation expense on a straight-line basis over the vesting period for thelast separately vesting portion of the awards. Fair value is determined as the difference between the closing price ofour common stock on the grant date and the purchase price of the restrictedstock award, if any, reduced by expected forfeitures.

 

*IncomeTaxes*

 

Under ASC Topic 270, theCompany is required to adjust its effective tax rate each quarter to beconsistent with the estimated annual effective tax rate. The Company is alsorequired to record the tax impact of certain discrete items, unusual orinfrequently occurring, including changes in judgment about valuationallowances and effects of changes in tax laws or rates, in the interim periodin which they occur. In addition, jurisdictions with a projected loss for theyear or a year-to-date loss where no tax benefit can be recognized are excludedfrom the estimated annual effective tax rate. The impact of such an exclusioncould result in a higher or lower effective tax rate during a particularquarter, based upon the mix and timing of actual earnings versus annualprojections.

 

Deferred tax assets and liabilities are recognizedto reflect the estimated future tax effects, calculated at currently effectivetax rates, of future deductible or taxable amounts attributable to events thathave been recognized on a cumulative basis in the condensed consolidatedfinancial statements.  A valuationallowance related to a net deferred tax asset is recorded when it is morelikely than not that some portion of the deferred tax asset will not berealized.

 

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ASC Topic 740 prescribes a recognition threshold andmeasurement requirement for the financial statement recognition of a taxposition that has been taken or is expected to be taken on a tax return andalso provides guidance on de-recognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition. Under ASCTopic 740 the Company may only recognize or continue to recognize tax positionsthat meet a “more likely than not” threshold.

 

*Researchand Development Expenses*

 

Research and development expenditures are expensed in the periodincurred.

 

*Collaborative Arrangement*

 

TheCompany has entered into a collaborative arrangement with a partner in order todevelop products using certain of the Company’s proprietary technology.  Under the arrangement, the developmentpartner was granted a non-exclusive license to specified intellectual propertyfor exclusive use in the development and production of ASIC chipsets for theCompany.  Both the Company and thedevelopment partner provided and continue to provide engineering projectmanagement resources at their own expense. The development partner is entitled to non-recurring engineering feesbased upon the achievement of development milestones, and to a minimum portionof the Company’s purchasing allocations for the component.  Expenses incurred and paid to the developmentpartner are included in research and development expense in the accompanyingcondensed consolidated statements of operations.

 

*Comprehensive Loss*

 

ASC Topic 220 establishes standards for reporting and displayingcomprehensive income and its components in the condensed consolidated financialstatements. Accumulated other comprehensive loss includes unrealized gains orlosses on marketable securities.

 

*Risksand Uncertainties*

 

The Company’s operations in the People’s Republic of China (“PRC”) aresubject to various political, geographical and economic risks and uncertaintiesinherent to conducting business in China. These include, but are not limitedto, (i) potential changes in economic conditions in the region,(ii) managing a local workforce that may subject the Company touncertainties or certain regulatory policies, (iii) changes in otherpolicies of the Chinese governmental and regulatory agencies, and (iv) changesin the laws and policies of the U.S. government regarding the conduct ofbusiness in foreign countries, generally, or in China, in particular.  Additionally, the Chinese government controlsthe procedures by which its local currency, the Chinese Renminbi (“RMB”), isconverted into other currencies and by which dividends may be declared orcapital distributed for the purpose of repatriation of earnings andinvestments.  If restrictions in theconversion of RMB or in the repatriation of earnings and investments throughdividend and capital distribution restrictions are instituted, the Company’soperations and operating results may be negatively impacted.  Restricted net assets of the Company’ssubsidiary in the PRC totaled $2.5 million and $2.7 million at October 2,2010 and January 2, 2010, respectively.

 

*ForeignCurrency Re-measurement*

 

Thefunctional currency of the Company’s foreign subsidiary is the U.S. dollar.Local currency financial statements are re-measured into U.S. dollars at theexchange rate in effect as of the balance sheet date for monetary assets andliabilities and the historical exchange rate for nonmonetary assets andliabilities. Expenses are re-measured using the average exchange rate for theperiod, except items related to nonmonetary assets and liabilities, which are re-measuredusing historical exchange rates. All re-measurement gains and losses areincluded in determining net loss.

 

*Net LossPer Share*

 

Basic net loss per share is calculated by dividing net loss by theweighted-average common shares outstanding during the period, excludingunvested shares issued pursuant to restricted share awards under ourshare-based compensation plans.  Dilutednet loss per share is calculated by dividing the net loss by theweighted-average shares and dilutive potential common shares outstanding duringthe period. Dilutive potential shares consist of dilutive shares issuable uponthe exercise or vesting of outstanding stock options and restricted stockawards, respectively, and the exercise of warrants, computed using the treasurystock method.  In periods of losses,basic and diluted loss per share are the same, as the effect of stock options,unvested restricted share awards and warrants on loss per share isanti-dilutive.

 

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*NewAccounting Pronouncements*

 

InSeptember 2009, the FASB issued Accounting Standards Update (“ASU”)2009-13, *Multiple-Deliverable Revenue Arrangements*(“ASU 2009-13”), which amends the revenue guidance under ASC Topic 605, whichdescribes the accounting for multiple element arrangements.  ASU 2009-13 addresses how to determinewhether an arrangement involving multiple deliverables contains more than oneunit of accounting and how arrangement consideration shall be measured andallocated to the separate units of accounting in the arrangement.  ASU 2009-13 is effective on a prospectivebasis for the Company’s fiscal year 2011, with earlier adoption permitted.  The Company is currently evaluating theadoption of ASU 2009-13 and the impact that ASU 2009-13 will have on itscondensed consolidated financial statements.

 

InSeptember 2009, the FASB issued ASU 2009-14, *CertainRevenue Arrangements That Include Software Elements* (“ASU 2009-14”),which excludes tangible products containing software components andnon-software components that function together to deliver the product’sessential functionality from the scope of ASC Topic 985, which describes theaccounting for software revenue recognition. ASU 2009-14 is effective on a prospective basis for the Company’s fiscalyear 2011, with earlier adoption permitted. The Company is currently evaluating the impact that ASU 2009-14 willhave on its condensed consolidated financial statements.

 

**Note3—Supplemental Financial Information**

 

*Inventories*

 

Inventoriesconsist of the following (in thousands):

 
| ** **      | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|-----------------|------------|---------------------|------------|---------------------|------------|
| ** **      | ** ** | **2010**            | ** ** | **2010**            | ** ** |
|            |       |                |       |                |       |
| Raw materials   |       | $                   | 2,103      |                | $          | 997 |   |
| Work in process |       | 345                 |       | 342                 |       |
| Finished goods  |       | 1,413               |       | 893                 |       |
|            |       | $                   | 3,861      |                | $          | 2,232 |   |

 

*Warranty Liability*

 

Thefollowing table summarizes the activity related to the warranty liability (inthousands):

 
| ** **                     | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **October 2,**             | ** ** | **October 3,** | ** ** |
| ** **                     | ** ** | **2010**                        | ** ** | **2009** | ** ** |
|                           |       |                            |       |   |   |
| Beginning  balance             |       | $                               | 240        |   | $ | 277 |   |
| Charged to costs  and expenses |       | 176                             |       | 122 |   |
| Usage                          |       | (214                            | )          | (155 | ) |
| Ending balance                 |       | $                               | 202        |   | $ | 244 |   |

 

Thewarranty liability is included as a component of accrued expenses and othercurrent liabilities in the accompanying condensed consolidated balance sheets.

 

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*Facility Relocation Costs*

 

Thefollowing table summarizes the activity related to the Company’s accrual forfacility relocation costs during the nine months ended October 2, 2010 andOctober 3, 2009 (in thousands):

 
| ** **                              | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **October 2,**             | ** ** | **October 3,** | ** ** |
| ** **                              | ** ** | **2010**                        | ** ** | **2009** | ** ** |
|                                    |       |                            |       |   |   |
| Beginning  balance                      |       | $                               | 84         |   | $ | 80 |   |
| (Reduction)  increase in expected costs |       | (28                             | )          | 61 |   |
| Net payments                            |       | (10                             | )          | (16 | ) |
| Ending balance                          |       | $                               | 46         |   | $ | 125 |   |

 

In May 2009, the Company entered into an agreement to sublease aportion of its new domestic headquarters facility to another tenant at adiscount from the rent required under its lease commitment.  As a result, the Company recorded anadditional charge of approximately $61,000. In February 2010, the sublessor vacated the space that it hadsubleased.  The Company determined thatthe space could be used in its operations. As a result, the Company reversed $28,000 of its accrual for facilityrelocation costs.  The resulting expenseincrease and reduction are included as a component of selling, general andadministrative expenses in the accompanying condensed consolidated statement ofoperations for the nine months ended October 2, 2010 and October 3,2009.

 

Theliability for facility relocation costs is included as a component of accruedexpenses and other current liabilities in the accompanying condensedconsolidated balance sheets.

 

*ComprehensiveLoss*

 

Thecomponents of comprehensive loss, net of taxes, consist of the following (inthousands):

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                       | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **                                                       | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Net loss                                                         |       | $                                | (4,939     | )                               | $          | (2,086 | ) | $ | (11,878 | ) | $ | (9,897 | ) |
| Other  comprehensive loss:                                       |       |                             |       |                            |       |   |   |   |   |
| Change in net  unrealized gain (loss) on investments, net of tax |       | (1                               | )          | (6                              | )          | (48 | ) | 32 |   |
| Total  comprehensive loss                                        |       | $                                | (4,940     | )                               | $          | (2,092 | ) | $ | (11,926 | ) | $ | (9,865 | ) |

 

Accumulatedother comprehensive loss reflected on the condensed consolidated balance sheetsat October 2, 2010 and January 2, 2010, represents accumulated netunrealized losses on investments in marketable securities.

 

*Computation of Net Loss Per Share*

 

Basicand diluted net loss per share is calculated by dividing net loss by theweighted-average common shares outstanding during the period. The followingtable sets forth the computation of net loss per share (in thousands, exceptper share data):

 
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                  | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **                                                                  | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                  | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator: Net  loss                                                        |       | $                                | (4,939     | )                               | $          | (2,086 | ) | $ | (11,878 | ) | $ | (9,897 | ) |
| Denominator:  Weighted-average common shares outstanding, basic and diluted |       | 24,799                           |       | 19,855                          |       | 23,422 |   | 19,855 |   |
| Net loss per  share, basic and diluted                                      |       | $                                | (0.20      | )                               | $          | (0.11 | ) | $ | (0.51 | ) | $ | (0.50 | ) |

 

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Thefollowing table sets forth potentially dilutive common share equivalents,consisting of shares issuable upon the exercise or vesting of outstanding stockoptions and restricted stock awards, respectively, and the exercise ofwarrants, computed using the treasury stock method.  These potential common shares have beenexcluded from the diluted net loss per share calculations above as their effectwould be anti-dilutive for the periods then ended (in thousands):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **               | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| Common share equivalents |       | 1,779                            |       | 600                             |       | 1,978 |   | 420 |   |

 

Theabove common share equivalents would have been included in the calculation ofdiluted earnings per share had the Company reported net income for the periodsthen ended.

 

*Major Customers*

 

Netsales to some of the Company’s OEM customers include memory modules that arequalified by the Company directly with the OEM customer and sold to electronicmanufacturing services providers (“EMSs”), for incorporation into productsmanufactured exclusively for the OEM customer or in some instances, tofacilitate credit and logistics. These net sales to EMSs have historicallyfluctuated period to period as a portion of the total net sales to the OEMcustomers.  Net sales to Hon HaiPrecision Industry Co. Ltd., an EMS operating under the trade name Foxconn thatpurchases memory modules from the Company for incorporation into productsmanufactured exclusively for Dell, Inc. (“Dell”), representedapproximately 94% and 61% of net sales to Dell for the nine months ended October 2,2010 and October 3, 2009, respectively. Arrow Electronics Inc. (“Arrow”) is an EMS for DRS Electronics, Inc.(“DRS Electronics”).  Substantially allof the Company’s products sold to Arrow are incorporated into componentsmanufactured for DRS Electronics. Similarly, Flextronics International Ltd. (“Flextronics”) distributessubstantially all of the products purchased from the Company to F5 Networks, Inc.(“F5 Networks”).  The following tablesets forth sales to customers comprising 10% or more of the Company’s net salesfor the periods presented:

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **                          | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Customer:**                       | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dell (including Foxconn)            |       | 69                               | %          | 47                              | %          | 53 | % | 48 | % |
| Flextronics (F5 Networks)           |       | 13                               | %          | *                               | %          | 25 | % | * | % |
| Arrow Electronics (DRS Electronics) |       | *                                | %          | 10                              | %          | * | % | 13 | % |
| Hewlett Packard                     |       | *                                | %          | 18                              | %          | * | % | 10 | % |

 

----

*  less than 10% of net sales

 

TheCompany’s accounts receivable are concentrated with two customers at October 2,2010 representing approximately 70% and 18%, and two customers at January 2,2010, representing approximately 68% and 10%, 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.  The Company mitigates riskassociated with foreign receivables by purchasing comprehensive foreign creditinsurance.

 

*Cash Flow Information*

 

Thefollowing table sets forth cash (received) paid for income taxes and interestfor the periods presented (in thousands):

 
| ** **   | ** ** | **Nine Months Ended** | ** ** |
|--------------|------------|---------------------------------|------------|
| ** **   | ** ** | **October 2,**             | ** ** | **October 3,** | ** ** |
| ** **   | ** ** | **2010**                        | ** ** | **2009** | ** ** |
|         |       |                            |       |   |   |
| Income taxes |       | $                               | (725       | ) | $ | (1,175 | ) |
| Interest     |       | $                               | 52         |   | $ | 78 |   |

 

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**Note4—Fair Value Measurements**

 

Thefollowing tables detail the fair value measurements within the fair valuehierarchy of the Company’s investments in marketable securities (in thousands):

 
| ** **                               | ** ** | ** **                  | ** ** | **Fair Value Measurements at October 2, 2010 Using** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | ** **                  | ** ** | **Quoted Prices**                                                                  | ** ** | **Significant** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | ** **                  | ** ** | **in Active**                                                                      | ** ** | **Other** | ** ** | **Significant** | ** ** |
| ** **                               | ** ** | **Fair Value at** | ** ** | **Markets for**                                                                    | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                               | ** ** | **October 2,**         | ** ** | **Identical Assets**                                                               | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                               | ** ** | **2010**                    | ** ** | **(Level 1)**                                                                      | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                               | ** ** | ** **                  | ** ** | ** **                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Available-for-sale debt securities:      | ** ** | ** **                  | ** ** | ** **                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Obligations of the U.S. government       |       | $                           | 1,000      |                                                                                    | $          | 1,000 |   | $ | — |   | $ | — |   |
| Federal agency notes and bonds           |       | 501                         |       | 501                                                                                     |       | — |   | — |   |
| Corporate notes and bonds                |       | 1,925                       |       | —                                                                                  |       | 1,925 |   | — |   |
| Auction and variable floating rate notes |       | 894                         |       | —                                                                                  |       | — |   | 894 |   |
| Total                                    |       | $                           | 4,320      |                                                                                    | $          | 1,501 |   | $ | 1,925 |   | $ | 894 |   |
| ** **                               | ** ** | ** **                  | ** ** |
| ** **                               | ** ** | ** **                  | ** ** | **Fair Value Measurements at January 2, 2010 Using** | ** ** |
| ** **                               | ** ** | ** **                  | ** ** | **Quoted Prices**                                                                  | ** ** | **Significant** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | ** **                  | ** ** | **in Active**                                                                      | ** ** | **Other** | ** ** | **Significant** | ** ** |
| ** **                               | ** ** | **Fair Value at** | ** ** | **Markets for**                                                                    | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                               | ** ** | **January 2,**         | ** ** | **Identical Assets**                                                               | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                               | ** ** | **2010**                    | ** ** | **(Level 1)**                                                                      | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                               | ** ** | ** **                  | ** ** | ** **                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Available-for-sale debt securities:      | ** ** | ** **                  | ** ** | ** **                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Obligations of the U.S. government       |       | $                           | 997        |                                                                                    | $          | 997 |   | $ | — |   | $ | — |   |
| Federal agency notes and bonds           |       | 61                          |       | 61                                                                                      |       | — |   | — |   |
| Commercial paper                         |       | 1,048                       |       | 1,048                                                                                   |       | — |   | — |   |
| Corporate notes and bonds                |       | 1,843                       |       | 1,843                                                                                   |       | — |   | — |   |
| Auction and variable floating rate notes |       | 941                         |       | —                                                                                  |       | — |   | 941 |   |
| Total                                    |       | $                           | 4,890      |                                                                                    | $          | 3,949 |   | $ | — |   | $ | 941 |   |

 

Asof January 3, 2010, the Company reclassified its investments in commercialpaper and corporate notes and bonds, with a fair value of $2.9 million, fromassets measured at fair value using Level 1 inputs to assets measured at fairvalue using Level 2 inputs.  The transferresulted solely from management’s reassessment of the level of activity in thesecondary market for these investments, which historically has been low due tothe short-term nature of the instruments. Management does not believe that the reassessment in any way reflects achange in the actual liquidity or credit quality of these investments.  The reassessment was precipitated by a changein custodial institutions in connection with the Company’s new revolving creditagreement (see Note 6).

 

Fairvalue measurements using Level 3 inputs in the table above relate to theCompany’s investments in auction rate securities. Level 3 inputs areunobservable inputs used to estimate the fair value of assets or liabilitiesand are utilized to the extent that observable inputs are not available.

 

Thefollowing table provides a reconciliation of the beginning and ending balancesfor the Company’s assets measured at fair value using Level 3 inputs (inthousands):

 
| ** **                                                   | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                   | ** ** | **October 2,**             | ** ** | **October 3,** | ** ** |
| ** **                                                   | ** ** | **2010**                        | ** ** | **2009** | ** ** |
|                                                         |       |                            |       |   |   |
| Beginning balance                                            |       | $                               | 941        |   | $ | 960 |   |
| Unrealized (loss) gain included in other  comprehensive loss |       | (47                             | )          | 15 |   |
| Ending balance                                               |       | $                               | 894        |   | $ | 975 |   |

 

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**Note5—Investments in Marketable Securities**

 

Investments in marketable securities consist of the following (inthousands):

 
| ** **                               | ** ** | **October 2, 2010** | ** ** |
|------------------------------------------|------------|-------------------------------|------------|
| ** **                               | ** ** | ** **                    | ** ** | **Net** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Amortized**                 | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                               | ** ** | **Cost**                      | ** ** | **Gain (Loss)** | ** ** | **Value** | ** ** |
|                                     |       |                          |       |   |   |   |   |
| Obligations of the U.S. government       |       | $                             | 1,000      |   | $ | — |   | $ | 1,000 |   |
| Federal agency notes and bonds           |       | 501                           |       | — |   | 501 |   |
| Corporate notes and bonds                |       | 1,923                         |       | 2 |   | 1,925 |   |
| Auction and variable floating rate notes |       | 1,001                         |       | (107 | ) | 894 |   |
|                                     |       | $                             | 4,425      |   | $ | (105 | ) | $ | 4,320 |   |
|                                     |       |                          |       |   |   |   |   |
| ** **                               | ** ** | **January 2, 2010** | ** ** |
| ** **                               | ** ** | ** **                    | ** ** | **Net** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Amortized**                 | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                               | ** ** | **Cost**                      | ** ** | **Gain (Loss)** | ** ** | **Value** | ** ** |
|                                     |       |                          |       |   |   |   |   |
| Obligations of the U.S. government       |       | $                             | 997        |   | $ | — |   | $ | 997 |   |
| Federal agency notes and bonds           |       | 61                            |       | — |   | 61 |   |
| Commercial paper                         |       | 1,048                         |       | — |   | 1,048 |   |
| Corporate notes and bonds                |       | 1,839                         |       | 4 |   | 1,843 |   |
| Auction and variable floating rate notes |       | 1,002                         |       | (61 | ) | 941 |   |
|                                     |       | $                             | 4,947      |   | $ | (57 | ) | $ | 4,890 |   |

 

Realized gains and losses on the sale of investments in marketablesecurities are determined using the specific identification method.  Net realized gains and losses recorded werenot significant in any of the periods reported upon.

 

The following table provides the breakdown of investments in marketablesecurities with unrealized losses (in thousands):

 
| ** **                               | ** ** | **October 2, 2010**            | ** ** |
|------------------------------------------|------------|------------------------------------------|------------|
| ** **                               | ** ** | **Continuous Unrealized Loss** | ** ** |
| ** **                               | ** ** | **Less than 12 months**   | ** ** | **12 months or greater** | ** ** |
| ** **                               | ** ** | **Fair**                                 | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                               | ** ** | **Value**                                | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
|                                     |       |                                     |       |   |   |   |   |   |   |
| Auction and variable floating rate notes |       | $                                        | —     |   | $ | — |   | $ | 894 |   | $ | (107 | ) |
|                                     |       |                                     |       |   |   |   |   |   |   |
| ** **                               | ** ** | **January 2, 2010**            | ** ** |
| ** **                               | ** ** | **Continuous Unrealized Loss** | ** ** |
| ** **                               | ** ** | **Less than 12 months**   | ** ** | **12 months or greater** | ** ** |
| ** **                               | ** ** | **Fair**                                 | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                               | ** ** | **Value**                                | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
|                                     |       |                                     |       |   |   |   |   |   |   |
| Corporate notes and bonds                |       | $                                        | 366        |   | $ | (1 | ) | — |   | — |   |
| Auction and variable floating rate notes |       | —                                   |       | — |   | 941 |   | (61 | ) |
|                                     |       | $                                        | 366        |   | $ | (1 | ) | $ | 941 |   | $ | (61 | ) |

 

As of October 2, 2010 and January 2, 2010, the Company heldtwo and four investments, respectively, that were in an unrealized lossposition.

 

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*Auction Rate Securities*

 

Disruptionsin the credit market continue to adversely affect the liquidity and overallmarket for auction rate securities. As of October 2, 2010 and January 2,2010, the Company held two investments in auction rate securities with a totalpurchase cost of $1.0 million. These two investments represent (i) a Baa1rated, fully insured debt obligation of a municipality and (ii) an A3rated debt obligation backed by pools of student loans guaranteed by the U.S.Department of Education. Given the insufficient observable market inputs and relatedinformation available, the Company has classified its investments in auctionrate securities within Level 3 of the fair value hierarchy (see Note 4).

 

TheCompany does not believe that the current illiquidity of its investments inauction rate securities will materially impact its ability to fund its workingcapital needs, capital expenditures or other business requirements. TheCompany, however, remains uncertain as to when liquidity will return to theauction rate markets, whether other secondary markets will become available orwhen the underlying securities may be called by the issuer. Given these andother uncertainties, the Company’s investments in auction rate securities havebeen classified as long-term investments in marketable securities in theaccompanying unaudited condensed consolidated balance sheets. The Company hasconcluded that the estimated gross unrealized losses on these investments,which totaled approximately $107,000 and $42,000 at October 2, 2010 and January 2,2010, are temporary because (i) the Company believes that the absence ofliquidity that has occurred is due to general market conditions, (ii) theauction rate securities continue to be of a relatively high credit quality andinterest is paid as due and (iii) the Company has the intent and abilityto hold these investments until a recovery in the market occurs.

 

*Other Investments in Marketable Securities*

 

Excludingits auction rate securities, the gross unrealized losses on the Company’s otherinvestments in marketable securities totaled approximately $1,000 as of January 2,2010.  There were no securities otherthan auction rate securities in an unrealized loss position at October 2,2010.  The fair value of the Company’sinvestments was determined based on Level 1 and Level 2 inputs, consisting ofquoted prices from actual market transactions for identical investments.

 

The Company maintains an investment portfolio of various holdings,types and maturities. The Company invests in instruments that meet high qualitycredit standards, as specified in its investment policy guidelines. Theseguidelines generally limit the amount of credit exposure to any one issue,issuer or type of instrument. The fair value of the Company’s investments inmarketable securities could change significantly in the future and the Companymay be required to record other-than-temporary impairment charges or unrealizedlosses in future periods.

 

The following table presents the amortized cost and fair value of theCompany’s investments in marketable securities classified as available-for-saleat October 2, 2010 by contractual maturity (in thousands):

 
| ** **              | ** ** | **October 2, 2010** | ** ** |
|-------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **Amortized**                 | ** ** | **Fair** | ** ** |
| ** **              | ** ** | **Cost**                      | ** ** | **Value** | ** ** |
| ** **              | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **Maturity**            | ** ** | ** **                    | ** ** | ** ** | ** ** |
| Less than one year      |       | $                             | 3,424      |   | $ | 3,426 |   |
| Greater than two years* |       | 1,001                         |       | 894 |   |
|                    |       | $                             | 4,425      |   | $ | 4,320 |   |

 

----

*               Comprised of auction rate securities whichgenerally have reset dates of 90 days or less but final contractual maturitydates in excess of 15 years.

 

**Note6—Credit Agreement**

 

OnOctober 31, 2009, the Company entered into a credit agreement with SiliconValley Bank, which was amended on March 24, 2010, June 30, 2010 and September 30,2010.  Currently, the credit agreementprovides that the Company can borrow up to the lesser of (i) 80% ofeligible accounts receivable, or (ii) $10.0 million.  The Company has the option to increase creditavailability to $15.0 million at any time through the maturity date of September 30,2012, subject to the conditions of the credit agreement.

 

Thecredit agreement contains an overall sublimit of $10.0 million to collateralizethe Company’s contingent obligations under letters of credit, foreign exchangecontracts and cash management services.  Amounts outstanding under theoverall sublimit reduce the amount available pursuant to the credit agreement.  At October 2, 2010, letters of credit inthe amount of $2.9 million were outstanding. The letters of credit expire on various dates through October 31,2011.

 

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Interestis payable monthly at either (i) prime plus 1.25%, as long as the Companymaintains $8.5 million in revolving credit availability plus unrestricted cashon deposit with the bank, or (ii) prime plus 2.25%.   Additionally, the credit agreement requirespayments for an unused line, as well as anniversary and early termination fees,as applicable.

 

Inconnection with the September 30, 2010 amendment, Silicon Valley Bankextended a $1.5 million term loan, which bears interest at a rate of prime plus1.75%.  The Company is required to makeequal monthly principal payments which total $0.5 million annually, and aballoon payment of $0.5 at maturity.  Anyremaining unpaid principal is due upon maturity of the credit agreement.  The term loan is classified as long-term debtin the accompanying consolidated balance sheet.

 

The Company’s previous credit facility, which consisted of a revolvingline of credit and a non-revolving equipment line, expired on August 31,2009 and all borrowings were repaid to the bank.  Interest on the credit facility was payablemonthly at the greatest of (i) the sum of the prime rate plus 3%,(ii) the sum of LIBOR plus 6% or (iii) 8%.

 

Thefollowing table presents details of interest expense related to borrowings onrevolving credit lines, along with certain other applicable information (inthousands):

 
| ** **                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **                                                 | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Interest expense                                           |       | $                                | 12         |                            | $          | 34 |   | $ | 36 |   | $ | 46 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| ** **                                                 | ** ** | **October 2,**              | ** ** | **January 2,**             |       |
| ** **                                                 | ** ** | **2010**                         | ** ** | **2010**                        |       |
| Outstanding borrowings on the revolving line of  credit    |       | $                                | —     |                            | $          | — |   |
| Borrowing availability under the revolving line of  credit |       | $                                | 2,382      |                            | $          | — |   |
|                                                            |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

Obligationsunder the credit agreement are secured by a first priority lien on the Company’stangible and intangible assets.  SiliconValley Bank released Netlist Technology Texas, LP as an obligor under thecredit agreement due to the dissolution of this subsidiary in October 2010.

 

Thecredit agreement subjects the Company to certain affirmative and negativecovenants, including financial covenants with respect to the Company’s tangiblenet worth and restrictions on the payment of dividends.  As of October 2,2010, the Company was in compliance with its financial covenants.

 

**Note 7—Long-Term Debt**

 

Long-termdebt consists of the following (in thousands):

 
| ** **                        | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|-----------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                        | ** ** | **2010**            | ** ** | **2010**            | ** ** |
|                              |       |                |       |                |       |
| Obligations  under capital leases |       | $                   | 260        |                | $          | 159 |   |
| Term note  payable to bank        |       | 1,458               |       | —              |       |
|                              |       | 1,718               |       | 159                 |       |
| Less current  portion             |       | (640                | )          | (108                | )          |
|                              |       | $                   | 1,078      |                | $          | 51 |   |

 

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Interestexpense related to long-term debt is presented in the following table (inthousands):

 
| ** **       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **       | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **       | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|             |       |                             |       |                            |       |   |   |   |   |
| Interest expense |       | $                                | 5          |                            | $          | 6 |   | $ | 11 |   | $ | 25 |   |
|                  |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

**Note 8—Income Taxes**

 

Thefollowing table sets forth the Company’s provision (benefit) for income taxes,along with the corresponding effective tax rates (in thousands, exceptpercentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **                           | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                 |       |                             |       |                            |       |   |   |   |   |
| Provision (benefit) for income taxes |       | $                                | 12         |                            | $          | (458 | ) | $ | (713 | ) | $ | (409 | ) |
| Effective tax rate                   |       | (0.2                             | )%         | 18                              | %          | 5.7 | % | 4 | % |
|                                      |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

During the nine months endedOctober 2, 2010, the Company carried back approximately $1.7 million ofgross net operating losses under the Worker, Homeownership, and Business Actand received a federal income tax refund of approximately $0.7 million.  During the three and nine months ended October 3,2009, the Company reduced its unrecognized tax benefits by approximately $0.5million as a result of a lapse in a federal statute of limitations.

 

The Company evaluateswhether a valuation allowance should be established against its deferred taxassets based on the consideration of all available evidence using a “morelikely than not” standard.  Due touncertainty of future utilization, the Company has provided a full valuationallowance as of October 2, 2010 and January 2, 2010.  Accordingly, no benefit has been recognizedfor net deferred tax assets, including net operating losses that cannot berealized currently via carryback to periods of taxable income.

 

The Company had unrecognizedtax benefits at October 2, 2010 and January 2, 2010 of approximately$0.1 million that, if recognized, would affect the Company’s annual effectivetax rate.

 

**Note9—Commitments and Contingencies**

 

*Litigation*

 

*Federal Securities Class Action*

 

Beginning in May 2007, the Company, certain of its officers anddirectors, and the Company’s underwriters were named as defendants in fourpurported class action shareholder complaints, two of which were filed in theU.S. District Court for the Southern District of New York, and two of whichwere filed in the U.S. District Court for the Central District of California.These purported class action lawsuits were filed on behalf of persons andentities who purchased or otherwise acquired the Company’s common stockpursuant or traceable to the Company’s November 30, 2006 initial publicoffering (the “IPO”). The lawsuits were consolidated into a singleaction—Belodoff v. Netlist, Inc., Lead Case No. SACV07-677 DOC(MLGx)—which is currently pending in the Central District of California. LeadPlaintiff filed the Consolidated Complaint in November 2007. Defendantsfiled their motions to dismiss the Consolidated Complaint in January 2008.The motions to dismiss were taken under submission in April 2008 and onMay 30, 2008, the court granted the defendants’ motions. However,plaintiffs were granted the right to amend their complaint and subsequentlyfiled their First Amended Consolidated Class Action Complaint (“AmendedComplaint”) in July 2008. The defendants filed motions to dismiss theAmended Complaint in January 2009, and on April 17, 2009, the courtgranted defendants’ motions to dismiss. However, plaintiffs were again grantedthe right to amend their complaint. Plaintiffs’ filed their Second Amended Consolidated Class ActionComplaint (“Second Amended Complaint”) in May 2009. Generally, the SecondAmended Complaint, like the preceding complaints, alleged that the RegistrationStatement filed by the Company in connection with the IPO contained untruestatements of material fact or omissions of material fact in violation ofSections 11 and 15 of Securities Act of 1933. Defendants filed motions todismiss the Second Amended Complaint in June 2009. The motions to dismisswere taken under submission in August 2009 and on September 1, 2009,the Court granted the defendants’ motions. However, plaintiffs again weregranted the right to amend their complaint.

 

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In December 2008, the parties reached a tentative agreement inprinciple to settle the class action. In February 2010, the partiesexecuted a Stipulation and Agreement of Settlement documenting the essentialterms of the proposed settlement, informed the court of their proposedsettlement, and drafted a joint motion to submit to the court for preliminaryapproval of the proposed settlement. Under the settlement agreement presentedto the court for approval, plaintiffs and the class will dismiss all claims,with prejudice, in exchange for a cash payment of $2.6 million. TheCompany’s directors’ and officers’ liability insurers will pay the settlementamount in accordance with the Company’s insurance policies.

 

On April 19, 2010, the court issued an order preliminarilyapproving the settlement.  A finalsettlement approval was issued on September 30, 2010.

 

*PatentClaims*

 

In May 2008, theCompany initiated discussions with Google, Inc. (“Google”) regarding theCompany’s claim that Google has infringed on a U.S. patent owned by the Company,U.S. Patent No. 7,289,386 (“the ’386 patent”), which relates generally to rankmultiplication in memory modules. On August 29, 2008, Google filed adeclaratory judgment lawsuit against the Company in the United States DistrictCourt for the Northern District of California, seeking a declaration thatGoogle did not infringe the ’386 patent and that the ’386 patent is invalid.Google is not seeking any monetary damages. On November 18, 2008, theCompany filed a counterclaim for infringement of the ’386 patent by Google.Claim construction proceedings were held on November 14, 2009, and theCompany prevailed on every disputed claim construction issue. On June 1, 2010,the Company filed a motion for summary judgment of patent infringement and a motionfor summary judgment to dismiss Google’s affirmative defenses based onNetlist’s activities in the JEDEC standard-setting organization. The hearingsfor these motions have been postponed indefinitely by the Court. On September1, 2010, the United States Patent and Trademark Office (“USPTO”) grantedGoogle’s request for reexamination of the ’386 patent. On September 14, 2010,the Court granted Google’s request to stay the litigation pending theconclusion of the reexamination by the USPTO. On October 20, 2010, SmartModular, Inc. (“SMOD”) filed a request for reexamination of the ’386 patentwith the USPTO. The USPTO is expected to make a determination whether to grantor deny this request in January 2011.

 

OnDecember 4, 2009, the Company filed a patent infringement lawsuit againstGoogle in the United States District Court for the Northern District ofCalifornia, seeking damages and injunctive relief based on Google’sinfringement of U.S. Patent No. 7,619,912 (“the ’912 patent”), which issued inNovember 2009 and is related to the ’386 patent. On February 11, 2010,Google answered the Company’s complaint and asserted counterclaims against theCompany seeking a declaration that the patent is invalid and not infringed, andclaiming that the Company committed fraud, negligent misrepresentation andbreach of contract based on Netlist’s activities in the JEDEC standard-settingorganization. The counterclaim seeks unspecified compensatory damages. Claimconstruction proceedings will be held on March 17, 2011. On October 20 andOctober 21, respectively, SMOD and Google each filed requests for reexaminationof the ’912 patent. The USPTO is expected to make a determination whether togrant or deny these requests in January 2011. The Company intends to vigorouslypursue its infringement claims against Google and to vigorously defend againstGoogle’s claims.

 

OnSeptember 22, 2009, the Company filed a patent infringement lawsuitagainst Inphi Corporation (“Inphi”) in the United States District Court for theCentral District of California. The suit alleges that Inphi is contributorilyinfringing and actively inducing the infringement of a U.S. patent owned by theCompany, U.S. Patent No. 7,532,537 (“the ’537 patent”), which relates generallyto memory modules with load isolation and memory domain translationcapabilities. The Company is seeking damages and injunctive relief based onInphi’s use of its patented technology. On December 22, 2009, the Companyfiled an Amended Complaint asserting claims of patent infringement based on twoadditional patents, the ’912 patent and U.S. Patent No. 7,636,274 (“the ’274patent”), which relate generally to load isolation and memory domaintranslation technologies, as well as rank multiplication. Inphi has deniedinfringement and has asserted that the patents-in-suit are invalid. On April19, 2010, Inphi filed requests for reexamination of the three patents-in-suit,and on April 21, 2010, Inphi filed an interference proceeding on the threepatents-in-suit with the USPTO. Inphi then filed a motion to stay the lawsuit,which was granted on May 18, 2010. On September 1, 2010, the USPTO confirmedthe patentability of all fifty-one claims of the ’912 patent. The Companyintends to vigorously pursue its infringement claims against Inphi and to continueto vigorously defend its patent rights in the USPTO.

 

OnNovember 30, 2009, Inphi filed a patent infringement lawsuit against theCompany in the United States District Court for the Central District ofCalifornia alleging infringement of two Inphi patents generally related tomemory module output buffers. Discovery is currently underway, and the Companyintends to vigorously defend against Inphi’s claims of infringement.

 

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On March 24, 2010,Ring Technologies Enterprises filed a patent infringement lawsuit in the UnitedStates District Court for the Eastern District of Texas against Dell Computerand its suppliers.  The suit alleges thatthe Company and forty-two (42) other defendants infringed on its U.S. PatentNo. 6,879,526.  The Company filed itsanswer to Ring Technologies’ complaint and intends to vigorously defend againstRing Technologies’ claims of infringement.

* *

*Other Contingent Obligations*

 

During its normal course of business, the Company has made certainindemnities, commitments and guarantees under which it may be required to makepayments in relation to certain transactions. These include(i) intellectual property indemnities to the Company’s customers and licenseesin connection with the use, sales and/or license of Company products;(ii) indemnities to vendors and service providers pertaining to claimsbased on the Company’s negligence or willful misconduct; (iii) indemnitiesinvolving the accuracy of representations and warranties in certain contracts;(iv) indemnities to directors and officers of the Company to the maximumextent permitted under the laws of the State of Delaware; and (v) certainreal estate leases, under which the Company may be required to indemnifyproperty owners for environmental and other liabilities, and other claimsarising from the Company’s use of the applicable premises. The duration ofthese indemnities, commitments and guarantees varies and, in certain cases, maybe indefinite. The majority of these indemnities, commitments and guarantees donot provide for any limitation of the maximum potential for future payments theCompany could be obligated to make. Historically, the Company has not beenobligated to make significant payments for these obligations, and noliabilities have been recorded for these indemnities, commitments andguarantees in the accompanying condensed consolidated balance sheets.

 

*Commitment to Purchase Component Inventory*

 

In September, 2010, the Company entered into a $2.5 million commitmentto purchase ASIC devices for use in certain of its high-performance memorymodules that are in the evaluation process with OEM and end-usercustomers.  The Company issued a $1.1million letter of credit to secure payment for future shipments.  See note 6.

 

**Note10—Stockholders’ Equity**

 

*Common Stock*

 

On March 24, 2010,the Company sold 4,594,250 shares of common stock in a registered publicoffering.  The shares were sold to thepublic at a price of $3.85 per share. The Company received net proceeds of $16.2 million, after underwritingdiscounts and commissions, and estimated expenses payable by the Company.

 

*Stock-Based Compensation*

 

TheCompany has stock-based compensation awards outstanding pursuant to the 2000Equity Incentive Plan (the “2000 Plan”) and the 2006 Equity Incentive Plan (the“2006 Plan”).  Effective as of the IPO,no further grants may be made under the 2000 Plan.  In addition to awards made pursuant to the2006 Plan, the Company periodically issues inducement grants outside the 2006Plan to certain new hires.  In the ninemonths ended October 2, 2010, the Company issued 305,000 stock optionspursuant to inducement grants.

 

OnJune 2, 2010, the Company’s shareholders approved an amendment to the 2006Plan to provide that the number of shares of common stock that may be issuedshall be increased annually by a number of shares equal to the lesser of 5.0%of the issued and outstanding shares as of January 1 of each year or1,200,000 shares.  Prior to June 2,2010, the annual increase in shares available under the 2006 Plan was capped at500,000.  The amendment is effective forfiscal 2010.  An additional 505,566shares are available for issuance as a result of the amendment to the 2006Plan.  At October 2, 2010, theCompany had 367,281 shares available for grant pursuant to option, stockappreciation right, performance unit, restricted stock, restricted stock unitor stock grant awards under the 2006 Plan.

 

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Asummary of the Company’s common stock option activity as of and for the ninemonths ended October 2, 2010 is presented below (shares in thousands):

 
| ** **                                  | ** ** | **Options Outstanding** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | ** **                   | ** ** | **Weighted-** | ** ** |
| ** **                                  | ** ** | ** **                   | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | **Number of**           | ** ** | **Exercise** | ** ** |
| ** **                                  | ** ** | **Shares**                   | ** ** | **Price** | ** ** |
| Options outstanding at January 2, 2010 |       | 4,298                        |       | $ | 2.41 |   |
| Options granted                             |       | 588                          |       | 3.35 |   |
| Options exercised                           |       | (80                          | )          | 0.99 |   |
| Options cancelled                           |       | (162                         | )          | 0.87 |   |
| Options outstanding at October 2, 2010 |       | 4,644                        |       | $ | 2.61 |   |

 

A summary of the Company’srestricted stock awards as of and for the nine months ended October 2,2010 is presented below (shares in thousands):

 
| ** **                                  | ** ** | **Restricted Stock Outstanding** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | ** **                                 | ** ** | **Weighted-** | ** ** |
| ** **                                  | ** ** | ** **                                 | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | ** **                                 | ** ** | **Grant-Date** | ** ** |
| ** **                                  | ** ** | **Number of**                         | ** ** | **Fair Value** | ** ** |
| ** **                                  | ** ** | **Shares**                                 | ** ** | **per Share** | ** ** |
| Balance outstanding at January 2, 2010 |       | —                                     |       | $ | — |   |
| Restricted stock granted                    |       | 528                                        |       | 3.46 |   |
| Restricted stock forfeited                  |       | (10                                        | )          | 3.49 |   |
| Restricted stock vested                     |       | (60                                        | )          | 3.49 |   |
| Balance outstanding at October 2, 2010 |       | 458                                        |       | $ | 3.46 |   |

 

Restricted stock awardsvest in eight equal increments at intervals of approximately six months fromthe date of grant.

 

Thefollowing table presents details of the assumptions used to calculate theweighted-average grant date fair value of common stock options granted by theCompany:

 
| ** **                                       | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **October 2,**             | ** ** | **October 3,** | ** ** |
| ** **                                       | ** ** | **2010**                        | ** ** | **2009** | ** ** |
| Expected term (in years)                         |       | 5.5                             |       | 5.4 |   |
| Expected volatility                              |       | 146                             | %          | 111 | % |
| Risk-free interest rate                          |       | 2.14                            | %          | 2.94 | % |
| Expected dividends                               |       | —                          |       | — |   |
| Weighted-average grant date fair value per share |       | $                               | 3.07       |   | $ | 0.28 |   |
|                                                  |            |                                 |            |  |  |  |  |

 

The weighted-average fairvalue per share of the restricted stock granted in the nine months ended October 2,2010 was $3.46, calculated based on the fair market value of the Company’scommon stock on the respective grant dates.

 

At October 2, 2010,the amount of unearned stock-based compensation currently estimated to beexpensed from fiscal 2010 through fiscal 2014 related to unvested common stockoptions and restricted stock awards is approximately $3.6 million, net ofestimated forfeitures. The weighted-average period over which the unearnedstock-based compensation is expected to be recognized is approximately 3.1years. If there are any modifications or cancellations of the underlying unvestedawards, the Company may be required to accelerate, increase or cancel anyremaining unearned stock-based compensation expense.

 

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*Warrants*

 

Asummary of activity with respect to outstanding warrants to purchase shares ofthe Company’s common stock for the nine months ended October 2, 2010 ispresented below (shares in thousands):

 
| ** **                                                    | ** ** | ** **         | ** ** | **Weighted-** | ** ** |
|---------------------------------------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                                    | ** ** | ** **         | ** ** | **Average**   | ** ** |
| ** **                                                    | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                                    | ** ** | **Shares**         | ** ** | **Price**     | ** ** |
| Warrants outstanding at January 2, 2010                  |       | 18                 |       | $             | 1.25       |   |
| Warrants exercised                                            |       | (18                | )          | 1.25          |       |
| Warrants outstanding and exercisable at  October 2, 2010 |       | —             |       | $             | —     |   |

 

**Note11—Segment and Geographic Information**

 

TheCompany operates 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.

 

AtOctober 2, 2010 and January 2, 2010, approximately $2.6 million and$3.0 million, respectively, of the Company’s net long-lived assets were locatedin the PRC.

 

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

 

**Cautionary Statement**

 

*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 containedin this 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 January 2, 2010 and subsequent reports on Form 8-K,which discuss our business in greater detail.*

 

*This Report contains forward-looking statements regarding future eventsand our future performance.  Theseforward-looking statements involve risks and uncertainties that could causeactual results to differ materially from those expected or projected.  These risks and uncertainties include, butare not limited to, continuing development, qualification and volume productionof NetVaultTMNV and HyperCloudTM; the rapidly-changing nature of technology; risksassociated with intellectual property, including the costs and unpredictabilityof litigation over infringement of our property and the possibility of our patents being reexamined by the United StatesPatent and Trademark Office; volatility in the pricing of DRAM ICs and NAND;changes in and uncertainty of customer acceptance of, and demand for, ourexisting products and products under development, including uncertainty ofand/or delays in product orders and product qualifications; delays in our andour customers’ product releases and development; introductions of new productsby competitors; changes in end-user demand for technology solutions; ourability to attract and retain skilled personnel; our reliance on suppliers ofcritical components and vendors in the supply chain; fluctuations in the marketprice of critical components; evolving industry standards; and the politicaland regulatory environment in the People’s Republic of China.  Other risks and uncertainties are describedunder the heading “Risk Factors” in Part II, Item IA of thisQuarterly Report on Form 10-Q, and similar discussions in our other SECfilings.  Except as required by law, weundertake no obligation to revise or update publicly any forward-lookingstatements for any reason.*

 

**Overview**

 

We design, manufacture and sell high-performance, logic-based memorysubsystems for the server, storage and communications equipment markets. Ourmemory subsystems consist of combinations of dynamic random access memoryintegrated circuits (“DRAM ICs” or “DRAM”), NAND flash memory (“NAND”),application-specific integrated circuits (“ASICs”) and other componentsassembled on printed circuit boards (“PCBs”). We primarily market and sell our products to leading original equipmentmanufacturer (“OEM”) customers.  Oursolutions are targeted at applications where memory plays a key role in meetingsystem performance requirements.

 

In November 2009, we introduced HyperCloudTMDDR3 memory technology.  HyperCloudTMutilizes an ASIC chipset that incorporates Netlist patented rank multiplicationtechnology that increases memory capacity and load reduction functionality thatincreases memory bandwidth.  We expectthat this achievement will make possible improved levels of performance formemory intensive datacenter applications and workloads, including financialservices applications, search engines, social networks/communications, mediainternet portals, virtualization, and high performance scientific anddefense-related computing.  HyperCloudTMmemory is being evaluated by several of our OEM customers for use in theirserver products.  HyperCloudTM isinteroperable with Joint Electronics Devices Engineering Council (“JEDEC”)standard DDR3 memory modules.  OurHyperCloudTM products are designed to allow for installation in servers withoutthe need for a bios change.  As such,their anticipated sales launch is not dependent on the design plans or productcycle of our OEM customers.  As of October 2,2010, we have not shipped any production quantities of HyperCloudTM.

 

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In February 2010, we announced general availability of NetVaultTM NV, a non-volatile cachememory subsystem targeting Redundant Array of Independent Disks, (“RAID”)storage applications.  NetVaultTM NV provides server and storage OEMs a solutionfor enhanced datacenter fault recovery. Unlike our traditional battery-poweredfault tolerant cache product which relied solely on batteries to power thecache, NetVaultTM NV utilizes a combination of DRAM for highthroughput performance and flash for extended data retention.  The introduction of NetVaultTM NV, as well as the launch ofthe Dell, Inc. (“Dell”) PERC 7 line of servers in December 2009, hasresulted in RAID controller subsystem revenues of $13.7 million, or 49% oftotal revenues for the nine months ended October 2, 2010, including $4.4million of NetVault NV.  This comparesfavorably with $3.3 million of RAID controller subsystems, or 28% of totalrevenues for the nine months ended October 3, 2009.  Although revenues through October 2,2010 have been primarily for shipments to Dell, we intend to qualify NetVault TMNV with several OEMs and topursue end-user opportunities.  Based onsell through activity through October 2010, we do not anticipatesignificant sales of NetVaultTMNV products for Dell in the fourth quarter of 2010.  Dell has initiated marketing activities thatwe expect will increase the sell through of NetVaultTMNV such that we can resumevolume production and delivery of the product in the first quarter of fiscal2011.

 

The remainder of our revenues arises primarily from OEM sales of custommemory modules, the majority of which are utilized in data center andindustrial applications.  When developingcustom modules for an equipment product launch, we engage with our OEMcustomers from the earliest stages of new product definition, providing us uniqueinsight into their full range of system architecture and performancerequirements. This close collaboration has also allowed us to develop asignificant level of systems expertise. We leverage a portfolio of proprietarytechnologies and design techniques, including efficient planar design,alternative packaging techniques and custom semiconductor logic, to delivermemory subsystems with high speed, capacity and signal integrity, small formfactor, attractive thermal characteristics and low cost per bit.  Revenues from custom modules have improved asa result of OEM product placements on new platforms and improved economicconditions compared with 2009.  Thecontinuation of this trend, which cannot be assured, is dependent on ourability to qualify our memory modules on new platforms as current platformsreach the end of their life cycles, and on the state of the global economy.

 

Consistentwith the concentrated nature of the OEM customer base in our target markets, asmall number of large customers have historically accounted for a significantportion of our net sales.  Dell andFlextronics International Ltd. (“Flextronics”) represented approximately 53%and 25%, respectively, of our net sales for the nine months ended October 2,2010.  Dell, Arrow Electronics, Inc.(“Arrow”) and Hewlett Packard, Inc. represented approximately 48%, 13% and 10%, respectively, of our netsales for the nine months ended October 3, 2009.  Net sales to some of our OEM customersinclude memory modules that are qualified by us directly with the OEM customerand sold to electronic manufacturing services providers (“EMSs”), forincorporation into products manufactured exclusively for the OEM customer or insome instances, to facilitate credit and logistics. These net sales to EMSshave historically fluctuated period to period as a portion of the total netsales to the OEM customers.  Net sales toHon Hai Precision Industry Co. Ltd., an EMS operating under the trade nameFoxconn that purchases memory modules from us for incorporation into productsmanufactured exclusively for Dell, represented approximately 94% and 61% of netsales to Dell for the nine months ended October 2, 2010 and October 3,2009, respectively.  Arrow is an EMS forDRS Electronics, Inc. (“DRS Electronics”). Substantially all of our products sold to Arrow are incorporated intocomponents manufactured for DRS Electronics. Similarly, Flextronics distributes substantially all of the productspurchased from us to F5 Networks, Inc.

 

**Key Business Metrics**

 

Thefollowing describes certain line items in our condensed consolidated statementsof operations that are important to management’s assessment of our financialperformance:

 

*Net Sales.*  Net sales consist primarily of sales of ourhigh performance memory subsystems, net of a provision for estimated returns underour right of return policies, which generally range up to 30 days. Wegenerally do not have long-term sales agreements with our customers. AlthoughOEM customers typically provide us with non-binding forecasts of future productdemand over specific periods of time, they generally place orders with usapproximately two weeks in advance of scheduled delivery. Selling prices aretypically negotiated monthly, based on competitive market conditions and thecurrent price of DRAM ICs and NAND. Purchase orders generally have nocancellation or rescheduling penalty provisions. We often ship our products toour customers’ international manufacturing sites. All of our sales to date,however, are denominated in United States (“U.S.”) dollars. We also sell excesscomponent inventory of DRAM ICs and NAND to distributors and other users ofmemory ICs.  As compared to previousyears, component inventory sales remain a relatively small percentage of netsales as a result of our efforts to diversify both our customer and productline bases. This diversification effort has also allowed us to use componentsin a wider range of memory subsystems. We expect that component inventory saleswill continue to represent a minimal portion of our net sales in futureperiods.

 

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*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 flash memory cost fluctuationsto our customers by renegotiating pricing prior to the placement of theirpurchase orders.  However, the salesprices of our memory subsystems can also fluctuate due to competitivesituations unrelated to the pricing of DRAM ICs and NAND, which affects grossmargins. The gross margin on our sales of excess component DRAM IC and NANDinventory is much lower than the gross margin on our sales of our memorysubsystems.  We assess the valuation ofour inventories on a monthly basis and record a provision to cost of sales asnecessary to reduce inventories to the lower of cost or net realizable value.

 

*Research and Development.*  Research and development expense consistsprimarily of employee and independent contractor compensation and relatedcosts, non-recurring engineering fees, patent filing and protection legal fees,computer-aided design software licenses, reference design development costs,depreciation or rental of evaluation equipment, stock-based compensation, andoccupancy and other allocated overhead costs. Also included in research anddevelopment expense are the costs of material and overhead related to the productionof engineering samples of new products under development or products usedsolely in the research and development process, reduced by estimated salvagevalue.  Our customers typically do notseparately compensate us for design and engineering work involved in developingapplication-specific products for incorporation into their products.  All research and development costs areexpensed as incurred. We anticipate that research and development expenditureswill increase in future periods as we seek to expand new product opportunities,increase our activities related to new and emerging markets and continue todevelop additional proprietary technologies.

 

*Selling, General and Administrative.*  Selling, general and administrative expensesconsist primarily of employee salaries and related costs, stock-basedcompensation, independent sales representative commissions, professionalservices, promotional and other selling and marketing expenses, sample expenseand occupancy and other allocated overhead costs. A significant portion of ourselling effort is directed at building relationships with OEMs and othercustomers and working through the product approval and qualification processwith them. Therefore, the cost of material and overhead related to products manufacturedfor qualification is included in selling expenses. As we continue to serviceexisting and establish new customers, we anticipate that our sales andmarketing expenses will increase.

 

*Provision (Benefit) for Income Taxes.*  We are required to adjust our effective taxrate each quarter to be consistent with the estimated annual effective taxrate.  We are also required to record thetax impact 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 projectedloss for the year or a year-to-date loss where no tax benefit can be recognizedare excluded from the estimated annual effective tax rate.  The impact of such an exclusion could resultin a higher or lower effective tax rate during a particular quarter, based uponthe mix and timing of actual earnings versus annual projections.

 

We evaluate whether avaluation allowance should be established against our deferred tax assets basedon the consideration of all available evidence using a “more likely than not”standard.  As of October 2, 2010 andJanuary 2, 2010, we have provided a full valuation allowance and no benefithas been recognized for net operating losses and other deferred tax assets dueto uncertainty of future utilization.

 

**Critical Accounting Policies**

 

The preparation of our condensed consolidated financial statements inconformity with accounting principles generally accepted in the U.S. requiresus to make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosures of contingent assets and liabilities at thedate of the condensed consolidated financial statements and the reportedamounts of net sales and expenses during the reporting period. By their nature,these estimates and assumptions are subject to an inherent degree ofuncertainty. We base our estimates on our historical experience, knowledge ofcurrent conditions and our beliefs of what could occur in the futureconsidering available information. We review our estimates on an on-goingbasis. Actual results may differ from these estimates, which may result inmaterial adverse effects on our operating results and financial position. Webelieve the following critical accounting policies involve our more significantassumptions and estimates used in the preparation of our condensed consolidatedfinancial statements:

 

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*Revenue Recognition.*  We recognize revenues in accordance with theFinancial Accounting Standards Board (“FASB”) Accounting Standards Codification(“ASC”) Topic 605. Accordingly, we recognize revenues when there is persuasiveevidence that an arrangement, product delivery and acceptance have occurred,the sales price is fixed or determinable, and collectibility of the resultingreceivable is reasonably assured.

 

We generally use customer purchase orders and/or contracts as evidenceof an arrangement. Delivery occurs when goods are shipped for customers withFOB Shipping Point terms and upon receipt for customers with FOB Destinationterms, at which time title and risk of loss transfer to the customer. Shippingdocuments are used to verify delivery and customer acceptance. We assesswhether the sales price is fixed or determinable based on the payment termsassociated with the transaction and whether the sales price is subject torefund.  Customers are generally allowedlimited rights of return for up to 30 days, except for sales of excesscomponent 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 sales returns have historically been within our expectationsand the provisions established, we cannot guarantee that we will continue toexperience similar sales return rates in the future. Any significant increasein product return rates could have a material adverse effect on our operatingresults for the period or periods in which such returns materialize.  We assess collectibility based on thecreditworthiness of the customer as determined by credit checks andevaluations, as well as the customer’s payment history.

 

All amounts billed to customers related to shipping and handling areclassified as net sales, while all costs incurred by us for shipping andhandling are classified as cost of sales.

 

*Fair Value of Financial Instruments.*  Our financial instruments consist principallyof cash and cash equivalents, investments in marketable securities, accountsreceivable, accounts payable, accrued expenses and debt instruments.  Other than for certain investments in auctionrate securities, commercial paper and short-term corporate bonds, the fairvalue of our cash equivalents and investments in marketable securities isdetermined based on quoted prices in active markets for identical assets orLevel 1 inputs.  Because of theirshort-term nature, commercial paper and short-term corporate bonds are notfrequently traded.  Although there areobservable quotes for these securities, the markets are not consideredactive.  Accordingly, the fair values ofthese investments are based on Level 2 inputs. The fair value of our auction rate securities is determined based onLevel 3 inputs. We recognize transfers between Levels 1 through 3 of the fairvalue hierarchy at the beginning of the reporting period.  We believe that the carrying values of allother financial instruments approximate their current fair values due to theirnature and respective durations.

 

*Allowance for Doubtful Accounts.*  We perform credit evaluations of ourcustomers’ financial condition and limit the amount of credit extended to ourcustomers as deemed necessary, but generally require no collateral.  We evaluate the collectibility of accountsreceivable based on a combination of factors. In cases where we are aware ofcircumstances that may impair a specific customer’s ability to meet itsfinancial obligations subsequent to the original sale, we will record anallowance against amounts due, and thereby reduce the net recognized receivableto the amount that we reasonably believe will be collected. For all othercustomers, we record allowances for doubtful accounts based primarily on thelength of time the receivables are past due based on the terms of theoriginating transaction, the current business environment and our historicalexperience.  Uncollectible accounts arecharged against the allowance for doubtful accounts when all cost effectivecommercial means of collection have been exhausted.  Generally, our credit losses have been withinour expectations and the provisions established. However, we cannot guaranteethat we will continue to experience credit loss rates similar to those we haveexperienced in the past.

 

Our accounts receivable are highly concentrated among a small number ofcustomers, and a significant change in the liquidity or financial position ofone of these customers could have a material adverse effect on thecollectability of our accounts receivable, our liquidity and our futureoperating results.

 

*Inventories.*  We value our inventories at the lower of theactual cost to purchase or manufacture the inventory or the net realizablevalue 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.  At each balance sheet date, weevaluate ending inventory quantities on hand and record a provision for excessquantities and obsolescence.  Among otherfactors, we consider historical demand and forecasted demand in relation to theinventory on hand, competitiveness of product offerings, market conditions andproduct life cycles when determining obsolescence and net realizable value. Inaddition, we consider changes in the market value of DRAM ICs and NAND indetermining the net realizable value of our raw material inventory. Onceestablished, any write downs are considered permanent adjustments to the costbasis of our excess or obsolete inventories.

 

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A significant decrease in demand for our products could result in anincrease in the amount of excess inventory quantities on hand. In addition, ourestimates of future product demand may prove to be inaccurate, in which case wemay have understated or overstated the provision required for excess andobsolete inventory.  In the future, ifour inventories are determined to be overvalued, we would be required torecognize additional expense in our cost of sales at the time of suchdetermination. Likewise, if our inventories are determined to be undervalued,we may have over-reported our costs of sales in previous periods and would berequired to recognize additional gross profit at the time such inventories aresold. In addition, should the market value of DRAM ICs or NAND decreasesignificantly, we may be required to lower our selling prices to reflect thelower current cost of our raw materials. If such price decreases reduce the net realizable value of ourinventories to less than our cost, we would be required to recognize additionalexpense in our cost of sales in the same period. Although we make everyreasonable effort to ensure the accuracy of our forecasts of future productdemand, any significant unanticipated changes in demand, technologicaldevelopments or the market value of DRAM ICs or NAND could have a materialeffect on the value of our inventories and our reported operating results.

 

*Impairment of Long-Lived Assets.*  We evaluate the recoverability of thecarrying value of long-lived assets held and used in our operations forimpairment on at least an annual basis or whenever events or changes incircumstances indicate that their net book value may not be recoverable.  When such factors and circumstances exist, wecompare the projected undiscounted future net cash flows associated with therelated asset or group of assets over their estimated useful lives againsttheir respective carrying amount.  Theseprojected future cash flows may vary significantly over time as a result ofincreased competition, changes in technology, fluctuations in demand,consolidation of our customers and reductions in 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 value of the asset.  Thefair value of the asset or asset group is based on market value when available,or when unavailable, on discounted expected cash flows.

 

*Warranty Reserve.*  We offer product warranties generally rangingfrom one to three years, depending on the product and negotiated terms ofpurchase agreements with our customers. Such warranties require us to repair orreplace defective product returned to us during the warranty period at no costto the customer.  Warranties are notoffered on sales of excess component inventory. 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 consistentbetween periods and within our expectations and the provisions established,unexpected changes in failure rates could have a material adverse impact on us,requiring additional warranty reserves, and adversely affecting our grossprofit and gross margins.

 

*Stock-Based Compensation.*  We account for equity issuances tonon-employees in accordance with ASC Topic 505. All transactions in which goods or services are the considerationreceived for the issuance of equity instruments are accounted for based on thefair value of the consideration received or the fair value of the equityinstrument issued, whichever is more reliably measurable. The measurement dateused to determine the fair value of the equity instrument issued is the earlierof the date on which the third-party performance is complete or the date onwhich it is probable that performance will occur.

 

In accordance with ASC Topic 718, employee and director stock-basedcompensation expense recognized during the period is based on the value of theportion of stock-based payment awards that is ultimately expected to vestduring the period.  Given thatstock-based compensation expense recognized in the condensed consolidatedstatements of operations is based on awards ultimately expected to vest, it hasbeen reduced for estimated forfeitures. ASC Topic 718 requires forfeitures tobe estimated at the time of grant and revised, if necessary, in subsequentperiods if actual forfeitures differ from those estimates. Our estimatedaverage forfeiture rates are based on historical forfeiture experience andestimated future forfeitures.

 

The fair value of common stock option awards to employees and directorsis calculated using the Black-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, all of which affect the estimated fair values of our common stockoption awards. The expected term of options granted is calculated as theaverage of the weighted vesting period and the contractual expiration date ofthe option.  This calculation is based onthe safe harbor method permitted by the SEC in instances where the vesting andexercise terms of options granted meet certain conditions and where limitedhistorical exercise data is available. The expected volatility is based on the historical volatility of ourcommon stock.  The risk-free rateselected to value any particular grant is based on the U.S. Treasury rate thatcorresponds to the expected term of the grant effective as of the date of thegrant. The expected dividends assumption is based on our history and ourexpectations regarding dividend payouts. We evaluate the assumptions used tovalue our common stock option awards on a quarterly basis. If factors changeand we employ different assumptions, stock- based compensation expense maydiffer significantly from what we have recorded in prior periods.  Compensation expense for common stock optionawards with graded vesting schedules is recognized on a straight-line basisover the requisite service period for the last separately vesting portion ofthe award.

 

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We recognize the fair value of restricted stock awards issued toemployees and outside directors as stock-based compensation expense on astraight-line basis over the vesting period for the last separately vestingportion of the awards.  Fair value isdetermined as the difference between the closing price of our common stock onthe grant date and the purchase price of the restricted stock award, if any,reduced by expected forfeitures.

 

If there are any modifications or cancellations of the underlyingvested or unvested stock-based awards, we may be required to accelerate,increase or cancel any remaining unearned stock-based compensation expense, orrecord additional expense for vested stock-based awards.  Future stock-based compensation expense andunearned stock- based compensation may increase to the extent that we grantadditional common stock options or other stock-based awards.

 

*IncomeTaxes.*  Under ASC Topic 270, we arerequired to adjust our effective tax rate each quarter to be consistent withthe estimated annual effective tax rate. We are 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.

 

Deferred tax assets and liabilities are recognized to reflect theestimated future tax effects, calculated at currently effective tax rates, offuture deductible or taxable amounts attributable to events that have beenrecognized on a cumulative basis in the condensed consolidated financialstatements.  A valuation allowancerelated to a net deferred tax asset is recorded when it is more likely than notthat some portion of the deferred tax asset will not be realized.

 

ASC Topic 740 prescribes a recognition threshold and measurement requirementfor the financial statement recognition of a tax position that has been takenor is expected to be taken on a tax return and also provides guidance onde-recognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. Under ASC Topic 740 we may only recognizeor continue to recognize tax positions that meet a “more likely than not”threshold.

 

The application of tax laws and regulations is subject to legal andfactual interpretation, judgment and uncertainty. Tax laws and regulationsthemselves are subject to change as a result of changes in fiscal policy,changes in legislation, the evolution of regulations and court rulings.Therefore, the actual liability for U.S. or foreign taxes may be materiallydifferent from our estimates, which could result in the need to recordadditional tax liabilities or potentially reverse previously recorded taxliabilities.

 

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**Results of Operations**

 

Thefollowing table sets forth certain condensed consolidated statements ofoperations data as a percentage of net sales for the periods indicated:

 
| ** **                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **October 2,**              | ** ** | **October 3,**             | ** ** | **October 2,** | ** ** | **October 3,** | ** ** |
| ** **                                       | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                             |       |                             |       |                            |       |   |   |   |   |
| Net sales                                        |       | 100                              | %          | 100                             | %          | 100 | % | 100 | % |
| Cost of sales                                    |       | 71                               |       | 76                              |       | 76 |   | 89 |   |
| Gross profit                                     |       | 29                               |       | 24                              |       | 24 |   | 11 |   |
| Operating expenses:                              |       |                             |       |                            |       |   |   |   |   |
| Research and development                         |       | 47                               |       | 31                              |       | 40 |   | 48 |   |
| Selling, general and administrative              |       | 28                               |       | 33                              |       | 29 |   | 52 |   |
| Total operating expenses                         |       | 75                               |       | 63                              |       | 70 |   | 100 |   |
| Operating loss                                   |       | (46                              | )          | (39                             | )          | (46 | ) | (89 | ) |
| Other income (expense):                          |       |                             |       |                            |       |   |   |   |   |
| Interest income (expense), net                   |       | —                           |       | —                          |       | — |   | 1 |   |
| Other income, net                                |       | —                           |       | —                          |       | — |   | 1 |   |
| Total other income (expense), net                |       | —                           |       | —                          |       | — |   | 2 |   |
| Loss before provision (benefit) for income taxes |       | (46                              | )          | (39                             | )          | (46 | ) | (87 | ) |
| Provision (benefit) for income taxes             |       | —                           |       | (7                              | )          | (3 | ) | (3 | ) |
| Net loss                                         |       | (46                              | )%         | (32                             | )%         | (43 | )% | (84 | )% |

 

***Three and Nine Months Ended October 2,2010 Compared to Three and Nine Months Ended October 3, 2009***

 

***Net Sales, Cost of Sales and Gross Profit***

 

Thefollowing table presents net sales, cost of sales and gross profit for thethree and nine months ended October 2, 2010 and October 3, 2009 (inthousands, except percentages):

 
| ** **    | ** ** | **Three Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|---------------|------------|----------------------------------|------------|---------------------|------------|------------|------------|
| ** **    | ** ** | **October 2,**              | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **    | ** ** | **2010**                         | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|          |       |                             |       |                |       |       |       |   |   |
| Net sales     |       | $                                | 10,565     |                | $          | 6,446      |       | $ | 4,119 |   | 64 | % |
| Cost of sales |       | 7,545                            |       | 4,879               |       | 2,666      |       | 55 | % |
| Gross profit  |       | $                                | 3,020      |                | $          | 1,567      |       | $ | 1,453 |   | 93 | % |
| Gross margin  |       | 29                               | %          | 24                  | %          | 4          | %          |   |   |
|          |       |                             |       |                |       |       |       |   |   |
| ** **    | ** ** | **Nine Months Ended**  | ** ** | ** **          | ** ** | ** ** | ** ** |
| ** **    | ** ** | **October 2,**              | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **    | ** ** | **2010**                         | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|          |       |                             |       |                |       |       |       |   |   |
| Net sales     |       | $                                | 27,759     |                | $          | 11,781     |       | $ | 15,978 |   | 136 | % |
| Cost of sales |       | 21,103                           |       | 10,507              |       | 10,596     |       | 101 | % |
| Gross profit  |       | $                                | 6,656      |                | $          | 1,274      |       | $ | 5,382 |   | 422 | % |
| Gross margin  |       | 24                               | %          | 11                  | %          | 13         | %          |   |   |

 

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*Net Sales.*** Overall, net sales of our RAID, data centeroptimization and industrial applications increased as a result of the selectionof our memory modules for inclusion in new product platforms.  Net sales in all product categories havebenefited from resurgence in technology investment, as general economicconditions have improved since early 2009. Should economic conditions erode positive sales trends may not continue.

 

Theincrease in net sales for the three months ended October 2, 2010 ascompared with the three months ended October 3, 2009 resulted primarilyfrom increases of approximately (i) $4.9 million in sales of NetVaultTMnon-volatile cache systems used in RAID controller subsystems, including $1.7million from the launch of NetVaultTM NV, the flash-based cache system thatbecame generally available in 2010, and (ii) $0.8 million in sales ofmemory modules utilized in data center targeted server applications, offset bydecreases of (i) $0.7 million in sales of memory modules used in laptopapplications, and (ii) $0.6 million from the re-sale of DRAM components.

 

Theincrease in net sales for the nine months ended October 2, 2010 ascompared with the nine months ended October 3, 2009 resulted fromincreases of approximately (i) $10.3 million in sales of NetVaultTMproducts, including $4.4 million from NetVaultTM NV, (ii) $5.0 million insales of memory modules utilized in data center targeted server applications,and (iii) $1.0 million in sales of memory modules designed for industrialapplications.

 

*Gross Profit and Gross Margin.*** The overall improvements in gross profit aredue to increased sales and manufacturing volume, as well as a shift in salestoward higher margin products.  Grossprofit for the three months ended October 2, 2010 as compared to the threemonths ended October 3, 2009 increased due to the 64% increase in netsales between the two periods, resulting in profits earned on each unit sold,as well as an improved ability to absorb fixed manufacturing costs.  These volume based improvements werepartially offset by increased DRAM prices, which affected margins in someproduct categories.  Gross profits forthe nine months ended October 2, 2010 as compared to the nine months endedOctober 3, 2009 were impacted by the same trends, including a 136%increase in net sales between the two periods.

 

***Research and Development****.*

 

Thefollowing table presents research and development expenses for the three andnine months ended October 2, 2010 and October 3, 2009 (in thousands,except percentages):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|--------------------------|------------|------------------------|------------|---------------------|------------|------------|------------|
| ** **               | ** ** | **October 2,**    | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **               | ** ** | **2010**               | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|                     |       |                   |       |                |       |       |       |   |   |
| Research and development |       | $                      | 4,958      |                | $          | 1,975      |       | $ | 2,983 |   | 151 | % |
|                          |            |                        |            |                     |            |            |            |  |  |  |  |  |

 
| ** **               | ** ** | **Nine Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|--------------------------|------------|-----------------------|------------|---------------------|------------|------------|------------|
| ** **               | ** ** | **October 2,**   | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **               | ** ** | **2010**              | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|                     |       |                  |       |                |       |       |       |   |   |
| Research and development |       | $                     | 11,156     |                | $          | 5,619      |       | $ | 5,537 |   | 99 | % |
|                          |            |                       |            |                     |            |            |            |  |  |  |  |  |

 

Theincrease in research and development expense in the three months ended October 2,2010 as compared to the three months ended October 3, 2009 resultedprimarily from increases of (i) $2.1 million in engineering expenses as aresult of an increase in non-recurring engineering charges and both internalengineering headcount and outside contractors engaged in new productdevelopment activities, (ii) $0.8 million in material expenses related toproduct builds and testing, primarily related to our HyperCloudTM products and (iii) $0.1million in legal and professional fees as we continue to increase patent filingand protection activities related to new and emerging markets.

 

Theincrease in research and development expense in the nine months ended October 2,2010 as compared to the nine months ended October 3, 2009 resultedprimarily from increases of (i) $3.1 million in non-recurring engineeringcharges, headcount, and outside consultants, (ii) $1.1 million in patentfiling and protection legal fees, and (iii) $1.3 million in productqualification builds and testing.

 

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

 

Thefollowing table presents selling, general and administrative expenses for thethree and nine months ended October 2, 2010 and October 3, 2009 (inthousands, except percentages):

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------------------|------------|---------------------|------------|------------|------------|
| ** **                          | ** ** | **October 2,**    | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2010**               | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|                                |       |                   |       |                |       |       |       |   |   |
| Selling, general and administrative |       | $                      | 2,986      |                | $          | 2,115      |       | $ | 871 |   | 41 | % |
|                                     |            |                        |            |                     |            |            |            |  |  |  |  |  |

 
| ** **                          | ** ** | **Nine Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-------------------------------------|------------|-----------------------|------------|---------------------|------------|------------|------------|
| ** **                          | ** ** | **October 2,**   | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2010**              | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|                                |       |                  |       |                |       |       |       |   |   |
| Selling, general and administrative |       | $                     | 8,163      |                | $          | 6,170      |       | $ | 1,993 |   | 32 | % |
|                                     |            |                       |            |                     |            |            |            |  |  |  |  |  |

 

Theincrease in selling, general and administrative expense in the three monthsended October 2, 2010 as compared to the three months ended October 3,2009 resulted primarily from increases of approximately (i) $0.4 millionin personnel-related expenses primarily attributable to hiring personnel tosupport the development of markets for HyperCloudTM and NetVaultTM NV, (ii) $0.3million in product samples and travel costs as a result of activities relatedto the OEM qualification process for HyperCloudTM and NetVaultTM NV, and (iii) $0.2million in commission expenses due to an increase in sales revenue.

 

Theincrease in selling, general and administrative expense in the nine monthsended October 2, 2010 as compared to the nine months ended October 3,2009 resulted primarily from increases of approximately (i) $0.9 millionin personnel-related expenses, (ii) $0.6 million in product samples andtravel costs as a result of activities related to the OEM qualification processfor HyperCloudTM and NetVaultTM NV, and (iii) $0.5 million in commissionexpenses.

 

***Other Income (Expense).***

 

Thefollowing table presents other income for the three and nine months ended October 2,2010 and October 3, 2009 (in thousands, except percentages):

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------------------|------------|---------------------|------------|------------|------------|
| ** **                        | ** ** | **October 2,**    | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                        | ** ** | **2010**               | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|                              |       |                   |       |                |       |       |       |   |   |
| Interest income (expense), net    |       | $                      | (3         | )                   | $          | (25        | )          | $ | 22 |   | (88 | )% |
| Other income, net                 |       | —                 |       | 4                   |       | (4         | )          | 100 | % |
| Total other income (expense), net |       | $                      | (3         | )                   | $          | (21        | )          | $ | 18 |   | 86 | % |

 
| ** **                        | ** ** | **Nine Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------------|------------|-----------------------|------------|---------------------|------------|------------|------------|
| ** **                        | ** ** | **October 2,**   | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                        | ** ** | **2010**              | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|                              |       |                  |       |                |       |       |       |   |   |
| Interest income (expense), net    |       | $                     | 1          |                | $          | 75         |       | $ | (74 | ) | (99 | )% |
| Other income, net                 |       | 71                    |       | 134                 |       | (63        | )          | (47 | )% |
| Total other income (expense), net |       | $                     | 72         |                | $          | 209        |       | $ | (137 | ) | (66 | )% |

 

Netinterest income (expense) for the three and nine months ended October 2,2010 was comprised of nominal interest income, offset by nominal interestexpense.  Net interest income for thethree and nine months ended October 3, 2009 was comprised of interestincome of approximately $0.02 million and $0.1 million, respectively, partiallyoffset by interest expense of approximately $0.05 million and $0.03 million,respectively.  The decrease in interestincome in the three and nine months ended October 2, 2010 as compared tothe three and nine months ended October 3, 2009 was due to a combinationof our lower average cash and investment balances and the decrease in the yieldearned on those balances due to lower interest rates.  The decrease in interest expense in the threemonths and nine months ended October 2, 2010 as compared to the three andnine months ended October 3, 2009 resulted primarily from our loweraverage outstanding balances on our line of credit and debt balances during thecurrent year.

 

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Otherincome, net, for the nine months ended October 2, 2010 was primarilycomprised of cash proceeds from the early termination of a sublease of ourheadquarters facility.  Other income,net, for the nine months ended October 3, 2009 was primarily comprised ofgains from the sale of equipment held for sale during the first quarter.

 

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

 

Thefollowing table presents the provision (benefit) for income taxes for the threeand nine months ended October 2, 2010 and October 3, 2009 (inthousands, except percentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------|------------|------------|------------|
| ** **                           | ** ** | **October 2,**              | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2010**                         | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|                                 |       |                             |       |                |       |       |       |   |   |
| Provision (benefit) for income taxes |       | $                                | 12         |                | $          | (458       | )          | $ | 470 |   | (103 | )% |
|                                      |            |                                  |            |                     |            |            |            |  |  |  |  |  |

 
| ** **                           | ** ** | **Nine Months Ended** | ** ** | ** **          | ** ** | ** ** | ** ** |
|--------------------------------------|------------|-----------------------|------------|---------------------|------------|------------|------------|
| ** **                           | ** ** | **October 2,**   | ** ** | **October 3,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2010**              | ** ** | **2009**            | ** ** | **Change** | ** ** | **Change** | ** ** |
|                                 |       |                  |       |                |       |       |       |   |   |
| Provision (benefit) for income taxes |       | $                     | (713       | )                   | $          | (409       | )          | $ | 304 |   | (74 | )% |
|                                      |            |                       |            |                     |            |            |            |  |  |  |  |  |

 

During the nine months endedOctober 2, 2010, we carried back approximately $1.7 million of gross netoperating losses under the Worker, Homeownership, and Business Act and recordeda tax benefit and income tax receivable of approximately $0.7 million, whichwas received in April 2010.  Ourincome tax benefit of $0.5 million and $0.4 million for the three and ninemonths ended October 3, 2009, respectively, was the result of a change inour liability for unrecognized tax benefits due to a lapse in a federal statuteof limitations.  We recorded a provisionfor income taxes for the quarter ended October 2, 2010 as a result ofstate taxes.

 

**Liquidity and Capital Resources**

 

Sinceour inception, 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 and from the sale and leaseback ofour domestic manufacturing facility.

 

***Working Capital and Cash and Marketable Securities***

 

Thefollowing table presents working capital, cash and cash equivalents andinvestments in marketable securities (in thousands):

 
| ** **                          | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|-------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                          | ** ** | **2010**            | ** ** | **2010**            | ** ** |
| Working Capital                     |       | $                   | 20,565     |                | $          | 13,379 |   |
|                                |       |                |       |                |       |
| Cash and cash equivalents(1)        |       | $                   | 14,722     |                | $          | 9,942 |   |
| Short-term marketable securities(1) |       | 3,426               |       | 3,949               |       |
| Long-term marketable securities     |       | 894                 |       | 941                 |       |
|                                |       | $                   | 19,042     |                | $          | 14,832 |   |

 

----

(1) Includedin working capital

 

Ourworking capital increased in the nine months ended October 2, 2010primarily as a result of our increase in cash, cash equivalents and short-termmarketable securities resulting from our public offering of our shares ofcommon stock.  Additionally, weexperienced increases in certain operating assets, offset by increases incertain operating liabilities resulting from our increase in sales of ourlegacy products and production ramp up for HyperCloudTM and NetVaultTM NV.

 

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***Cash Provided and Used in the Nine Months Ended October 2,2010 and October 3, 2009***

 

Thefollowing table summarizes our cash flows for the periods indicated (inthousands):

 
| ** **                                            | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **October 2,**   | ** ** | **October 3,** | ** ** |
| ** **                                            | ** ** | **2010**              | ** ** | **2009** | ** ** |
|                                                  |       |                  |       |   |   |
| **Net cash provided by (used in):**                   |       |                  |       |   |   |
| Operating activities                                  |       | $                     | (12,648    | ) | $ | (4,779 | ) |
| Investing activities                                  |       | (196                  | )          | 1,586 |   |
| Financing activities                                  |       | 17,624                |       | (520 | ) |
| Net increase (decrease) in cash and cash  equivalents |       | $                     | 4,780      |   | $ | (3,713 | ) |

 

*Operating Activities.* Net cash used in operatingactivities for the nine months ended October 2, 2010 was primarily aresult of (i) net loss of approximately $11.9 million and (ii) cashused by changes in operating assets and liabilities of approximately $3.6million, partially offset by approximately $2.8 million in net non-cash operatingexpenses, primarily consisting of depreciation and amortization and stock-basedcompensation expense.  Net cash used inoperating activities for the nine months ended October 3, 2009 wasprimarily a result of a net loss of approximately $9.9 million, partiallyoffset by (i) approximately $2.7 million in net non-cash operatingexpenses, primarily comprising depreciation and amortization and stock-basedcompensation, and (ii) approximately $2.4 million in net cash provided bychanges in operating assets and liabilities.

 

Accountsreceivable increased approximately $2.7 million during the nine months ended October 2,2010 primarily as a result of the increase in our net sales during the period.During the same period, we were successful in collecting cash from sales to ourcustomers substantially in accordance with our standard payment terms withthose customers.  Inventories increasedapproximately $1.6 million during the nine months ended October 2, 2010 aswe prepared for qualification and production of our HyperCloudTM products andinitiated production of our NetVaultTM NV products.  During the nine months ended October 2,2010, we were able to partially fund the growth in our accounts receivable andinventory through an increase in accounts payable of $1.9 million, primarilyfrom component vendors.

 

*Investing Activities.* Net cash used in investingactivities for the nine months ended October 2, 2010 was primarily theresult of the acquisition of $0.7 million in property and equipment, offset bynet sales of marketable securities of $0.5 million.  Net cash provided by investing activities forthe nine months ended October 3, 2009 was primarily a result of net salesof marketable securities of $1.3 million and proceeds from the sale ofequipment of $0.3 million.

 

*Financing Activities.* Net cash provided byfinancing activities for the nine months ended October 2, 2010 was aresult of the net proceeds of $16.2 million from the sale of 4,594,250 sharesof our common stock in a registered public offering, which closed on March 24,2010, and the proceeds of a $1.5 million term loan obtained from Silicon ValleyBank.  Net cash used in financingactivities for the nine months ended October 3, 2009 was the result ofrepayment of approximately $0.5 million on our long-term debt.

 

***Capital Resources***

 

OnOctober 31, 2009, we entered into a credit agreement with Silicon ValleyBank, which was amended on March 24, 2010, June 30, 2010 and September 30,2010.  Currently, the credit agreementprovides that we can borrow up to the lesser of (i) 80% of eligibleaccounts receivable, or (ii) $10.0 million.  We have the option to increase creditavailability to $15.0 million at any time through the maturity date of September 30,2012, subject to the conditions of the credit agreement.

 

Thecredit agreement contains an overall sublimit of $10.0 million to collateralizeour contingent obligations under letters of credit, foreign exchange contractsand cash management services.  Amounts outstanding under the overallsublimit reduce the amount available pursuant to the credit agreement.  At October 2, 2010, letters of credit inthe amount of $2.9 million were outstanding. The letters of credit expire on various dates through October 31,2011.

 

InSeptember, 2010, we entered into a $2.5 million commitment to purchase ASICdevices for use in certain of our high-performance memory modules that are inthe evaluation process with OEM and end-user customers.  We issued a $1.1 million letter of credit tosecure payment for future shipments.

 

Interestis payable monthly at either (i) prime plus 1.25%, as long as we maintain$8.5 million in revolving credit availability plus unrestricted cash on depositwith the bank, or (ii) prime plus 2.25%.  Additionally, the creditagreement requires payments for an unused line, as well as anniversary andearly termination fees, as applicable.

 

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Thefollowing table presents details of outstanding borrowings and availabilityunder our line of credit (in thousands):

 
| ** **                                                 | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | **2010**            | ** ** | **2010**            | ** ** |
| Outstanding borrowings on the revolving line of  credit    |       | $                   | —     |                | $          | — |   |
| Borrowing availability under the revolving line of  credit |       | $                   | 2,382      |                | $          | — |   |

 

Inaddition, in connection with the September 30, 2010 amendment, SiliconValley Bank extended a $1.5 million term loan under the credit agreement, whichbears interest at a rate of 1.75%.  Weare required to make equal monthly principal payments which total $0.5 millionannually, and a balloon payment of $0.5 million at maturity.  As of October 2, 2010, $1.5 million wasoutstanding under the term loan.

 

Allobligations under the credit agreement are secured by a first priority lien onthe Company’s tangible and intangible assets. Silicon Valley Bank released Netlist Technology Texas, LP as an obligorunder the credit agreement due to the dissolution of this subsidiary in October 2010.

 

Theonly restriction on the use of funds under the revolving line of credit is thatwe must be in compliance with the covenants of the credit agreement.  The credit agreement includes affirmative andnegative covenants, including financial covenants with respect to our liquidityand profitability.  As of October 2,2010, we were in compliance with all financial covenants and expect to maintaincompliance for the foreseeable future. However, we have in the past been in violation of one or more covenantsof other credit agreements, and we could violate one or more covenants in thefuture. If we were to be in violation of covenants under our credit agreement,our lender could choose to accelerate payment on all outstanding loan balances.If that were to occur, we may be unable to quickly obtain equivalent orsuitable replacement financing. If we were not able to secure alternativesources of funding, such acceleration would have a material adverse impact onour financial condition.

 

Wehave in the past utilized equipment leasing arrangements to finance certaincapital expenditures.  Equipment leasescontinue to be a financing alternative that we expect to pursue in the future.

 

Webelieve our existing cash 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.

 

***New Accounting Pronouncements***

 

InSeptember 2009, the FASB issued Accounting Standards Update (“ASU”)2009-13, *Multiple-Deliverable Revenue Arrangements*(“ASU 2009-13”), which amends the revenue guidance under ASC Topic 605, whichdescribes the accounting for multiple element arrangements.  ASU 2009-13 addresses how to determinewhether an arrangement involving multiple deliverables contains more than oneunit of accounting and how arrangement consideration shall be measured andallocated to the separate units of accounting in the arrangement.  ASU 2009-13 is effective on a prospectivebasis for the Company’s fiscal year 2011, with earlier adoption permitted.  We are currently evaluating the adoption ofASU 2009-13 and the impact that ASU 2009-13 will have on our condensedconsolidated financial statements.

 

InSeptember 2009, the FASB issued ASU 2009-14, *CertainRevenue Arrangements That Include Software Elements* (“ASU 2009-14”),which excludes tangible products containing software components andnon-software components that function together to deliver the product’sessential functionality from the scope of ASC Topic 985, which describes theaccounting for software revenue recognition. ASU 2009-14 is effective on a prospective basis for our fiscal year2011, with earlier adoption permitted. We are currently evaluating the impact that ASU 2009-14 will have on itscondensed consolidated financial statements.

 

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***Off-Balance Sheet Arrangements***

 

Wedo not have any relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. In addition, we do not have any undisclosed borrowings ordebt, and we have not entered into any synthetic leases. We are, therefore, notmaterially exposed to any financing, liquidity, market or credit risk thatcould arise if we had engaged in such relationships.

 

**Item 4.****                        ****Controlsand Procedures**

 

*(a) Evaluation of Disclosure Controls and Procedures.* We carried outan evaluation, under the supervision and with the participation of ourmanagement, including our principal executive officer and principal financialofficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934, (“Exchange Act”)) as ofthe end of our fiscal quarter ended October 2, 2010.  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) is accumulated and communicated to our management, including ourprincipal executive officer and principal financial officer as appropriate toallow timely decisions regarding required disclosure.

 

*(b) Change in internal controls over financial reporting.* During thefiscal quarter that ended October 2, 2010, there were no changes in ourinternal controls over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

 

***Inherent Limitations on Internal Control***

 

Acontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Further, the benefits of controls must be considered relative to theircosts. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, have been detected. These inherent limitationsinclude the realities that judgments in decision making can be faulty, and thatbreakdowns can occur because of simple errors. Additionally, controls can becircumvented by the individual acts of some persons, by collusion of two ormore people, or by management override of the control. The design of any systemof controls is also based in part upon certain assumptions about the likelihoodof future events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions. Because ofthe inherent limitations in a cost-effective control system, misstatements dueto error or fraud may occur and not be detected.

 

**PART II. OTHER INFORMATION**

 

**Item 1.****                         ****LegalProceedings**

 

Theinformation set forth in the sections entitled Federal SecuritiesClass Action, Patent Claims and Trade Secret Claim under Note 9 of Notesto Unaudited Condensed Consolidated Financial Statements, included inPart I, Item I of this Report, is incorporated herein by reference.

 

**Item 1A.****                ****RiskFactors**

 

*You should consider each of the following factors aswell as the other information in this Report in evaluating our business and ourprospects.  The risks described below arenot the only ones we face. Additional risks we are not presently aware of orthat we currently believe are immaterial may also impair our businessoperations. The trading price of our common stock could decline due to any ofthese risks, and you could lose all or part of your investment. In assessingthese risks, you should also refer to the other information contained orincorporated by reference in this Report, including our consolidated financialstatements and related notes.*

 

***Risks related to our business***

 

**We expect a number offactors to cause our operating results to fluctuate on a quarterly and annualbasis, which may make it difficult to predict our future performance.**

 

Our operating results have varied significantly in the past and willcontinue to fluctuate from quarter-to-quarter or year-to-year in the future dueto a variety of factors, many of which are beyond our control. Factors relatingto our business that may contribute to these quarterly and annual fluctuationsinclude the following factors, as well as other factors described elsewhere inthis Report:

 

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·                  our inability to develop newor enhanced products that achieve customer or market acceptance in a timelymanner, including our HyperCloudTM memory module and our flash-based memoryproducts;

 

·                  our failure to maintain thequalification of our products with our current customers or to qualify futureproducts with our current or prospective customers in a timely manner or atall;

 

·                  the timing of actual oranticipated introductions of competing products or technologies by us or ourcompetitors, customers or suppliers;

 

·                  the loss of, or asignificant reduction in sales to, a key customer;

 

·                  the cyclical nature of theindustry in which we operate;

 

·                  a reduction in the demandfor our high performance memory subsystems or the systems into which they areincorporated;

 

·                  our customers’ failure topay us on a timely basis;

 

·                  costs, inefficiencies andsupply risks associated with outsourcing portions of the design and themanufacture of integrated circuits;

 

·                  our ability to absorbmanufacturing overhead if our revenues decline or vary from our projections;

 

·                  delays in fulfilling ordersfor our products or a failure to fulfill orders;

 

·                  our ability to procure anadequate supply of key components, particularly DRAM ICs and NAND;

 

·                  dependence on largesuppliers who are also competitors and whose manufacturing priorities may notsupport our production schedules;

 

·                  changes in the prices of ourproducts or in the cost of the materials that we use to build our products,including fluctuations in the market price of DRAM ICs and NAND;

 

·                  our ability to effectivelyoperate our manufacturing facility in the PRC;

 

·                  manufacturing inefficienciesassociated with the start-up of new manufacturing operations, new products andinitiation of volume production;

 

·                  our failure to produceproducts that meet the quality requirements of our customers;

 

·                  disputes regardingintellectual property rights and the possibility of our patents beingreexamined by the United States Patent and Trademark Office;

 

·                  the costs and managementattention diversion associated with litigation;

 

·                  the loss of any of our keypersonnel;

 

·                  changes in regulatorypolicies or accounting principles;

 

·                  our ability to adequatelymanage or finance internal growth or growth through acquisitions; and

 

·                  the effect of ourinvestments and financing arrangements on our liquidity.

 

Due to the various factors mentioned above, and others, the results ofany prior quarterly or annual periods should not be relied upon as anindication of our future operating performance. In one or more future periods,our results of operations may fall below the expectations of securitiesanalysts and investors. In that event, the market price of our common stockwould likely decline. In addition, the market price of our common stock may fluctuateor decline regardless of our operating performance.

 

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**We have historicallyincurred losses and may continue to incur losses.**

 

Since the inception of our business in 2000, we have only experiencedone fiscal year (2006) with profitable results. In order to regainprofitability, or to achieve and sustain positive cash flows from operations inthe future, we must further reduce operating expenses and/or increase ourrevenues. Although we have in the past engaged, and are continuing to engage,in a series of cost reduction actions, these expense reductions alone may notmake us profitable or allow us to sustain profitability if it is achieved. Ourability to achieve profitability will depend on increased revenue growth from,among other things, increased demand for our memory subsystems and relatedproduct offerings, as well as our ability to expand into new and emergingmarkets. We may not be successful in achieving the necessary revenue growth orthe expected expense reductions. Moreover, we may be unable to sustain past orexpected future expense reductions in subsequent periods. We may not achieveprofitability or sustain such profitability, if achieved, on a quarterly orannual basis in the future.

 

Any failure to achieve profitability could result in increased capitalrequirements and pressure on our liquidity position. Many companies areexperiencing difficulty in achieving access to capital in these challengingtimes. We believe 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. Our capital requirements could result in our havingto, or otherwise choosing to, seek additional funding through public or privateequity offerings or debt financings, which funding may not be available onterms acceptable to us, or at all, either of which could result in ourinability to meet certain of our financial obligations and other relatedcommitments.

 

**We are subject to risksrelating to product concentration and lack of market diversification.**

 

We have historically derived a substantial portion of our net salesfrom sales of our high performance memory subsystems for use in the servermarket. We expect these memory subsystems to continue to account for asignificant portion of our net sales in the near term. Continued marketacceptance of these products for use in servers is critical to our success.

 

In an attempt to set our products apart from those of our competitors,we have invested a significant portion of our research and development budgetinto the design of ASIC devices, such as the HyperCloud**TM** memory subsystem, introduced in November 2009.This new design and the products they are incorporated into are subject toincreased risks as compared to our existing products. For example:

 

·                  we may be unable to achievecustomer or market acceptance of the HyperCloud**TM** memory subsystem or other new products, or achieve suchacceptance in a timely manner;

 

·                  the HyperCloud**TM** memory subsystem or other new productsmay contain currently undiscovered flaws, the correction of which would resultin increased costs and time to market;

 

·                  we are dependent on alimited number of suppliers for both the DRAM ICs and the ASIC devices that areessential to the functionality of the HyperCloud**TM** memory subsystem, and could experience supply chaindisruption as a result of business issues that are specific to our suppliers orthe industry as a whole; and

 

·                  we will be required todemonstrate the quality and reliability of the HyperCloud**TM** memory subsystem or other new products toour customers, and will be required to qualify these new products with ourcustomers, both of which will require a significant investment of time andresources prior to the receipt of any revenue from such customers.

 

Any failure or delay in placing or qualifying new products with ourcustomers would likely result in reductions in our net sales and wouldadversely impact our results of operations.

 

Additionally, if the demand for servers deteriorates or if the demandfor our products to be incorporated in servers declines, our operating resultswould be adversely affected, and we would be forced to diversify our productportfolio and our target markets. We may not be able to achieve thisdiversification, and our inability to do so may adversely affect our business.

 

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**We may lose our competitiveposition if we are unable to timely and cost-effectively develop new orenhanced products that meet our customers’ requirements and achieve marketacceptance.**

 

Our industry is characterized by intense competition, rapidtechnological change, evolving industry standards and rapid productobsolescence. Evolving industry standards and technological change or new,competitive technologies could render our existing products obsolete.Accordingly, our ability to compete in the future will depend in large part onour ability to identify and develop new or enhanced products on a timely andcost-effective basis, and to respond to changing customer requirements. Inorder to develop and introduce new or enhanced products, we need to:

 

·                  identify and adjust to thechanging requirements of our current and potential customers;

 

·                  identify and adapt toemerging technological trends and evolving industry standards in our markets;

 

·                  design and introducecost-effective, innovative and performance-enhancing features thatdifferentiate our products from those of our competitors;

 

·                  develop relationships withpotential suppliers of components required for these new or enhanced products;

 

·                  qualify these products foruse in our customers’ products; and

 

·                  develop and maintaineffective marketing strategies.

 

Our product development efforts are costly and inherently risky. It isdifficult to foresee changes or developments in technology or anticipate theadoption of new standards. Moreover, once these things are identified, if atall, we will need to hire the appropriate technical personnel or retain thirdparty designers, develop the product, identify and eliminate design flaws, andmanufacture the product in production quantities either in-house or throughthird-party manufacturers. As a result, we may not be able to successfullydevelop new or enhanced products or we may experience delays in the developmentand introduction of new or enhanced products. Delays in product development andintroduction could result in the loss of, or delays in generating, net salesand the loss of market share, as well as damage to our reputation. Even if wedevelop new or enhanced products, they may not meet our customers’ requirementsor gain market acceptance. Accordingly, we cannot assure you that our futureproduct development efforts will result in the development of new or enhancedproducts or that such products will achieve market acceptance.

 

**Our customers require thatour products undergo a lengthy and expensive qualification process without anyassurance of net sales.**

 

Our prospective customers generally make a significant commitment ofresources to test and evaluate our memory subsystems prior to purchasing ourproducts and integrating them into their systems. This extensive qualificationprocess involves rigorous reliability testing and evaluation of our products,which may continue for six months or longer and is often subject to delays. Inaddition to qualification of specific products, some of our customers may alsorequire us to undergo a technology qualification if our product designsincorporate innovative technologies that the customer has not previouslyencountered. Such technology qualifications often take substantially longerthan product qualifications and can take over a year to complete. Qualificationby a prospective customer does not ensure any sales to that prospectivecustomer. Even after successful qualification and sales of our products to acustomer, changes in our products, our manufacturing facilities, our productionprocesses or our component suppliers may require a new qualification process,which may result in additional delays.

 

In addition, because the qualification process is both product-specificand platform-specific, our existing customers sometimes require us to requalifyour products, or to qualify our new products, for use in new platforms orapplications. For example, as our OEM customers transition from priorgeneration DDR2 DRAM architectures to current generation DDR3 DRAM architectures,we must design and qualify new products for use by those customers. In thepast, this process of design and qualification has taken up to six months tocomplete, during which time our net sales to those customers declinedsignificantly. After our products are qualified, it can take several monthsbefore the customer begins production and we begin to generate net sales.

 

We must devote substantial resources, including design, engineering,sales, marketing and management efforts, to qualify our products withprospective customers in anticipation of sales. Significant delays in thequalification process could result in an inability to keep up with rapidtechnology change or new, competitive technologies.  If we delay or do not succeed in qualifying aproduct with an existing or prospective customer, we will not be able to sellthat product to that customer, which would harm our operating results andbusiness.

 

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**Sales to a limited numberof customers represent a significant portion of our net sales and the loss of,or a significant reduction in sales to, any one of these customers couldmaterially harm our business.**

 

Sales to certain of our OEM customers such as Dell, Flextronics,Hewlett Packard and Arrow have historically represented a substantial majorityof our net sales. Dell and Flextronics represented approximately 53% and 25%,respectively, of our net sales for the nine months ended October 2,2010.  Dell, Arrow, and Hewlett Packardrepresented approximately 48%, 13% and 10%, respectively, of our net sales forthe nine months ended October 3, 2009. We currently expect that sales to major OEM customers will continue torepresent a significant percentage of our net sales for the foreseeable future.We do not have long-term agreements with our OEM customers, or with any othercustomer. Any one of these customers could decide at any time to discontinue, decreaseor delay their purchase of our products. In addition, the prices that thesecustomers pay for our products could change at any time. The loss of any of ourOEM customers, or a significant reduction in sales to any of them, couldsignificantly reduce our net sales and adversely affect our operating results.

 

Our ability to maintain or increase our net sales to our key customersdepends on a variety of factors, many of which are beyond our control. Thesefactors include our customers’ continued sales of servers and other computingsystems that incorporate our memory subsystems and our customers’ continuedincorporation of our products into their systems.  Because of these and other factors, net salesto these customers may not continue and the amount of such net sales may notreach or exceed historical levels in any future period. Because these customersaccount for a substantial portion of our net sales, the failure of any one ofthese customers to pay on a timely basis would negatively impact our cash flow.In addition, while we may not be contractually obligated to accept returnedproducts, we may determine that it is in our best interest to accept returns inorder to maintain good relations with our customers.

 

**A limited number ofrelatively large potential customers dominate the markets for our products.**

 

Our target markets are characterized by a limited number of largecompanies. Consolidation in one or more of our target markets may furtherincrease this industry concentration. As a result, we anticipate that sales ofour products will continue to be concentrated among a limited number of largecustomers in the foreseeable future. We believe that our financial results willdepend in significant part on our success in establishing and maintaining relationshipswith, and effecting substantial sales to, these potential customers. Even if weestablish these relationships, our financial results will be largely dependenton these customers’ sales and business results.

 

**If a standardized memorysolution which addresses the demands of our customers is developed, our netsales and market share may decline.**

 

Many of our memory subsystems are specifically designed for our OEMcustomers’ high performance systems. In a drive to reduce costs and assuresupply of their memory module demand, our OEM customers may endeavor to designJEDEC standard DRAM modules into their new products. Although we alsomanufacture JEDEC modules, this trend could reduce the demand for our higherpriced customized memory solutions which in turn would have a negative impacton our financial results. In addition, customers deploying custom memorysolutions today may in the future choose to adopt a JEDEC standard, and theadoption of a JEDEC standard module instead of a previously custom module mightallow new competitors to participate in a share of our customers’ memory modulebusiness that previously belonged to us.

 

If our OEM customers were to adopt JEDEC standard modules, our futurebusiness may be limited to identifying the next generation of high performancememory demands of OEM customers and developing solutions that addresses suchdemands. Until fully implemented, this next generation of products mayconstitute a much smaller market, which may reduce our net sales and marketshare.

 

**We may not be able tomaintain our competitive position because of the intense competition in ourtargeted markets.**

 

We participate in a highly competitive market, and we expectcompetition to intensify. Many of our competitors have longer operating histories,significantly greater resources and name recognition, a larger base ofcustomers and longer-standing relationships with customers and suppliers thanwe have. As a result, some of these competitors are able to devote greaterresources to the development, promotion and sale of products and are betterpositioned than we are to influence customer acceptance of their products overour products. These competitors also may be able to respond better to new oremerging technologies or standards and may be able to deliver products withcomparable or superior performance at a lower price. For these reasons, we maynot be able to compete successfully against these competitors.

 

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In addition to the competitors described above, some of our OEMcustomers have their own internal design groups that may develop solutions thatcompete with ours. These design groups have some advantages over us, includingdirect access to their respective companies’ technical information andtechnology roadmaps. Our OEM customers also have substantially greaterresources, financial and otherwise, than we do, and may have lower coststructures than ours. As a result, they may be able to design and manufacturecompetitive products more efficiently or inexpensively. If any of these OEMcustomers are successful in competing against us, our sales could decline, ourmargins could be negatively impacted and we could lose market share, any or allof which could harm our business and results of operations. Further, some ofour significant suppliers are also competitors, many of whom have the abilityto manufacture competitive products at lower costs as a result of their higherlevels of integration.

 

We expect our competitors to continue to improve the performance oftheir current products, reduce their prices and introduce new or enhancedtechnologies that may offer greater performance and improved pricing. If we areunable to match or exceed the improvements made by our competitors, our marketposition would deteriorate and our net sales would decline. In addition, ourcompetitors may develop future generations and enhancements of competitiveproducts that may render our technologies obsolete or uncompetitive.

 

We also expect to face competition from new and emerging companies thatmay enter our existing or future markets. These potential competitors may havesimilar or alternative products which may be less costly or provide additionalfeatures.

 

**Our operating results maybe adversely impacted by worldwide economic and political uncertainties andspecific conditions in the markets we address, including the cyclical nature ofand volatility in the memory market and semiconductor industry.**

 

Adverse changes in domestic and global economic and politicalconditions have made it extremely difficult for our customers, our vendors andus to accurately forecast and plan future business activities, and they couldcause U.S. and foreign businesses to slow spending on our products andservices, which would further delay and lengthen sales cycles.  In addition, sales of our products aredependent upon demand in the computing, networking, communications, printer,storage and industrial markets. These markets have been cyclical and arecharacterized by wide fluctuations in product supply and demand. These marketshave experienced significant downturns, often connected with, or inanticipation of, maturing product cycles, reductions in technology spending anddeclines in general economic conditions. These downturns have beencharacterized by diminished product demand, production overcapacity, highinventory levels and the erosion of average selling prices.

 

We may experience substantial period-to-period fluctuations in futureoperating results due to factors affecting the computing, networking,communications, printers, storage and industrial markets. A decline orsignificant shortfall in demand in any one of these markets could have amaterial adverse effect on the demand for our products. As a result, our saleswill likely decline during these periods. In addition, because many of ourcosts and operating expenses are relatively fixed, if we are unable to controlour expenses adequately in response to reduced sales, our gross margins,operating income and cash flow would be negatively impacted.

 

During challenging economic times our customers may face issues gainingtimely access to sufficient credit, which could result in an impairment oftheir ability to make timely payments to us. If that were to occur, we may berequired to increase our allowance for doubtful accounts and our days salesoutstanding would be negatively impacted. Furthermore, our vendors may facesimilar issues gaining access to credit, which may limit their ability tosupply components or provide trade credit to us. We cannot predict the timing,strength or duration of any economic slowdown or subsequent economic recovery,worldwide, or in the memory market and related semiconductor industry. If theeconomy or markets in which we operate fail to improve or continue to worsen,our business, financial condition and results of operations will likely bematerially and adversely affected. Additionally, the combination of our lengthysales cycle coupled with challenging macroeconomic conditions could compoundthe negative impact on the results of our operations.

 

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**Our lack of a significantbacklog of unfilled orders, and the difficulty inherent in forecasting customerdemand, makes it difficult to forecast our short-term production requirementsto meet that demand, and any failure to optimally calibrate our productioncapacity and inventory levels to meet customer demand could adversely affectour revenues, gross margins and earnings.**

 

We make significant decisions regarding the levels of business that wewill seek and accept, production schedules, component procurement commitments,personnel needs and other resource requirements, based on our estimates ofcustomer requirements. We do not have long-term purchase agreements with ourcustomers. Instead, our customers often place purchase orders no more than twoweeks in advance of their desired delivery date, and these purchase ordersgenerally have no cancellation or rescheduling penalty provisions. Theshort-term nature of commitments by many of our customers, the fact that ourcustomers may cancel or defer purchase orders for any reason, and thepossibility of unexpected changes in demand for our customers’ products eachreduce our ability to accurately estimate future customer requirements for ourproducts. This fact, combined with the quick turn-around times that apply toeach order, makes it difficult to forecast our production needs and allocateproduction capacity efficiently. We attempt to forecast the demand for the DRAMICs, NAND, and other components needed to manufacture our products. Lead timesfor components vary significantly and depend on various factors, such as thespecific supplier and the demand and supply for a component at a given time.

 

Our production expense and component purchase levels are based in parton our forecasts of our customers’ future product requirements and to a largeextent are fixed in the short term. As a result, we likely will be unable toadjust spending on a timely basis to compensate for any unexpected shortfall inthose orders. If we overestimate customer demand, we may have excess rawmaterial inventory of DRAM ICs and NAND. If there is a subsequent decline inthe prices of DRAM ICs or NAND, the value of our inventory will fall. As aresult, we may need to write-down the value of our DRAM IC or NAND inventory,which may result in a significant decrease in our gross margin and financialcondition. Also, to the extent that we manufacture products in anticipation offuture demand that does not materialize, or in the event a customer cancels orreduces outstanding orders, we could experience an unanticipated increase inour finished goods inventory. In the past, we have had to write-down inventorydue to obsolescence, excess quantities and declines in market value below ourcosts. Any significant shortfall of customer orders in relation to ourexpectations could hurt our operating results, cash flows and financialcondition.

 

Also, any rapid increases in production required by our customers couldstrain our resources and reduce our margins. If we underestimate customerdemand, we may not have sufficient inventory of DRAM ICs and NAND on hand tomanufacture enough product to meet that demand. We also may not have sufficientmanufacturing capacity at any given time to meet our customers’ demands forrapid increases in production. These shortages of inventory and capacity willlead to delays in the delivery of our products, and we could forego salesopportunities, lose market share and damage our customer relationships.

 

**Declines in our averagesales prices, driven by volatile prices for DRAM ICs and NAND, among otherfactors, may result in declines in our revenues and gross profit.**

 

Our industry is competitive and historically has been characterized bydeclines in average sales price, based in part on the market price of DRAM ICsand NAND, which have historically constituted a substantial portion of thetotal cost of our memory subsystems. Our average sales prices may decline dueto several factors, including overcapacity in the worldwide supply of DRAM andNAND memory components as a result of worldwide economic conditions, increasedmanufacturing efficiencies, implementation of new manufacturing processes andexpansion of manufacturing capacity by component suppliers.

 

Once our prices with a customer are negotiated, we are generally unableto revise pricing with that customer until our next regularly scheduled priceadjustment. Consequently, we are exposed to the risks associated with thevolatility of the price of DRAM ICs and NAND during that period. If the marketprices for DRAM ICs and NAND increase, we generally cannot pass the priceincreases on to our customers for products purchased under an existing purchaseorder. As a result, our cost of sales could increase and our gross marginscould decrease. Alternatively, if there are declines in the price of DRAM ICsand NAND, we may need to reduce our selling prices for subsequent purchaseorders, which may result in a decline in our expected net sales.

 

In addition, since a large percentage of our sales are to a smallnumber of customers that are primarily distributors and large OEMs, thesecustomers have exerted, and we expect they will continue to exert, pressure onus to make price concessions. If not offset by increases in volume of sales orthe sales of newly-developed products with higher margins, decreases in averagesales prices would likely have a material adverse effect on our business andoperating results.

 

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**We use a small number ofcustom ASIC, DRAM IC and NAND suppliers and are subject to risks of disruptionin the supply of custom ASIC, DRAM ICs and NAND.**

 

Our ability to fulfill customer orders or produce qualification samplesis dependent on a sufficient supply of DRAM ICs and NAND, which are essentialcomponents of our memory subsystems. We are also dependent on a sufficientsupply of custom ASIC devices to produce our HyperCloudTM memory modules.  There are a relatively small number ofsuppliers of DRAM ICs and NAND, and we purchase from only a subset of thesesuppliers. We have no long-term DRAM or NAND supply contracts. Additionally, wecould face obstacles in moving production of our ASIC components away from ourcurrent design and production partners. Our dependence on a small number of suppliers and the lack of any guaranteedsources of ASIC components, DRAM and NAND supply expose us to several risks,including the inability to obtain an adequate supply of these importantcomponents, price increases, delivery delays and poor quality.

 

The recent declines in customer demand and revenues have caused us toreduce our purchases of DRAM ICs and NAND. Should we not maintain sufficientpurchase levels with some suppliers, our ability to obtain future supplies ofraw materials may be impaired due to the practice of some suppliers to allocatetheir products to customers with the highest regular demand.

 

From time to time, shortages in DRAM ICs and NAND have required somesuppliers to limit the supply of their DRAM ICs and NAND. As a result, we maybe unable to obtain the DRAM ICs or NAND necessary to fill customers’ ordersfor our products in a timely manner. If we are unable to obtain a sufficientsupply of DRAM ICs or NAND to meet our customers’ requirements, these customersmay reduce future orders for our products or not purchase our products at all,which would cause our net sales to decline and harm our operating results. Inaddition, our reputation could be harmed, we may not be able to replace anylost business with new customers, and we may lose market share to our competitors.

 

Our customers qualify the ASIC components, DRAM ICs and NAND of oursuppliers for use in their systems. If one of our suppliers should experiencequality control problems, it may be disqualified by one or more of ourcustomers. This would disrupt our supplies of ASIC components, DRAM ICs andNAND and reduce the number of suppliers available to us, and may require thatwe qualify a new supplier.  If oursuppliers are unable to produce qualification samples on a timely basis or atall, we could experience delays in the qualification process, which could havea significant impact on our ability to sell that product.

 

**If the supply of othercomponent materials used to manufacture our products is interrupted, or if ourinventory becomes obsolete, our results of operations and financial conditioncould be adversely affected.**

 

We use consumables and other components, including PCBs, to manufactureour memory subsystems. We sometimes procure PCBs and other components fromsingle or limited sources to take advantage of volume pricing discounts.Material shortages or transportation problems could interrupt the manufactureof our products from time to time in the future. These delays in manufacturingcould adversely affect our results of operations.

 

Frequent technology changes and the introduction of next-generationproducts also may result in the obsolescence of other items of inventory, suchas our custom-built PCBs, which could reduce our gross margin and adverselyaffect our operating performance and financial condition. We may not be able tosell some products developed for one customer to another customer because ourproducts are often designed to address specific customer requirements, and evenif we are able to sell these products to another customer, our margin on suchproducts may be reduced.

 

**A prolonged disruption ofour manufacturing facility could have a material adverse effect on ourbusiness, financial condition and results of operations.**

 

We maintain a manufacturing facility in the PRC for producing most ofour products, which allows us to utilize our materials and processes, protectour intellectual property and develop the technology for manufacturing. Aprolonged disruption or material malfunction of, interruption in or the loss ofoperations at our manufacturing facility, or the failure to maintain sufficientlabor force at such facility, would limit our capacity to meet customer demandsand delay new product development until a replacement facility and equipment,if necessary, were found. The replacement of the manufacturing facility couldtake an extended amount of time before manufacturing operations could restart.The potential delays and costs resulting from these steps could have a materialadverse effect on our business, financial condition and results of operations.

 

**If we are unable tomanufacture our products efficiently, our operating results could suffer.**

 

We must continuously review and improve our manufacturing processes inan effort to maintain satisfactory manufacturing yields and productperformance, to lower our costs and to otherwise remain competitive. As wemanufacture more complex products, the risk of encountering delays ordifficulties increases. The start-up costs associated with implementing newmanufacturing technologies, methods and processes, including the purchase ofnew equipment, and any resulting manufacturing delays and inefficiencies, couldnegatively impact our results of operations.

 

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If we need to add manufacturing capacity, an expansion of our existingmanufacturing facility or establishment of a new facility could be subject tofactory audits by our customers. Any delays or unexpected costs resulting fromthis audit process could adversely affect our net sales and results ofoperations. In addition, we cannot be certain that we will be able to increaseour manufacturing capacity on a timely basis or meet the standards of anyapplicable factory audits.

 

**We depend on third-partiesto design and manufacture custom components for some of our products.**

 

Significant customized components, such as ASICs, that are used in someof our products are designed and manufactured by third parties. The ability andwillingness of such third parties to perform in accordance with theiragreements with us is largely outside of our control. If one or more of ourdesign or manufacturing partners fails to perform its obligations in a timelymanner or at satisfactory quality levels, our ability to bring products tomarket or deliver products to our customers, as well as our reputation, couldsuffer. In the event of any such failures, we may have no readily availablealternative source of supply for such products, since, in our experience, thelead time needed to establish a relationship with a new design and/ormanufacturing partner is at least 12 months, and the estimated time forour OEM customers to re-qualify our product with components from a new vendorranges from four to nine months. We cannot assure you that we can redesign, orcause to have redesigned, our customized components to be manufactured by a newmanufacturer in a timely manner, nor can we assure you that we will notinfringe on the intellectual property of our current design or manufacturepartner when we redesign the custom components, or cause such components to beredesigned by a new manufacturer. A manufacturing disruption experienced by ourmanufacturing partners, the failure of our manufacturing partners to dedicateadequate resources to the production of our products, the financial instabilityof our manufacturing or design partners, or any other failure of our design ormanufacturing partners to perform according to their agreements with us, wouldhave a material adverse effect on our business, financial condition and resultsof operations.

 

We have many other risks due to our dependence on third-partymanufacturers, including: reduced control over delivery schedules, quality, manufacturingyields and cost; the potential lack of adequate capacity during periods ofexcess demand; limited warranties on products supplied to us; and potentialmisappropriation of our intellectual property. We are dependent on ourmanufacturing partners to manufacture products with acceptable quality andmanufacturing yields, to deliver those products to us on a timely basis and toallocate a portion of their manufacturing capacity sufficient to meet ourneeds. Although our products are designed using the process design rules ofthe particular manufacturers, we cannot assure you that our manufacturingpartners will be able to achieve or maintain acceptable yields or deliversufficient quantities of components on a timely basis or at an acceptable cost.Additionally, we cannot assure you that our manufacturing partners willcontinue to devote adequate resources to produce our products or continue toadvance the process design technologies on which the qualification andmanufacturing of our products are based.

 

**If our products do not meetthe quality standards of our customers, we may be forced to stop shipments ofproducts until the quality issues are resolved.**

 

Our customers require our products to meet strict quality standards.Should our products not meet such standards, our customers may discontinuepurchases from us until we are able to resolve the quality issues that arecausing us to not meet the standards. Such “quality holds” could have asignificant adverse impact on our revenues and operating results.

 

**If our products aredefective or are used in defective systems, we may be subject to warranty,product recalls or product liability claims.**

 

If our products are defectively manufactured, contain defectivecomponents or are used in defective or malfunctioning systems, we could besubject to warranty and product liability claims and product recalls, safetyalerts or advisory notices. While we have product liability insurance coverage,it may not be adequate to satisfy claims made against us. We also may be unableto obtain insurance in the future at satisfactory rates or in adequate amounts.Warranty and product liability claims or product recalls, regardless of theirultimate outcome, could have an adverse effect on our business, financialcondition and reputation, and on our ability to attract and retain customers.In addition, we may determine that it is in our best interest to accept productreturns in circumstances where we are not contractually obligated to do so inorder to maintain good relations with our customers. Accepting product returnsmay negatively impact our operating results.

 

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**If we fail to protect ourproprietary rights, our customers or our competitors might gain access to ourproprietary designs, processes and technologies, which could adversely affectour operating results.**

 

We rely on a combination of patent protection, trade secret laws and restrictionson disclosure to protect our intellectual property rights. We have submitted anumber of patent applications regarding our proprietary processes andtechnology. It is not certain when or if any of the claims in the remainingapplications will be allowed. To date we have had only fifteen patents issued.We intend to continue filing patent applications with respect to most of thenew processes and technologies that we develop. However, patent protection maynot be available for some of these processes or technologies.

 

It is possible that our efforts to protect our intellectual propertyrights may not:

 

·                  prevent challenges to, orthe invalidation or circumvention of, our existing intellectual propertyrights;

 

·                  prevent our competitors fromindependently developing similar products, duplicating our products ordesigning around any patents that may be issued to us;

 

·                  prevent disputes with thirdparties regarding ownership of our intellectual property rights;

 

·                  prevent disclosure of ourtrade secrets and know-how to third parties or into the public domain;

 

·                  result in valid patents,including international patents, from any of our pending or futureapplications; or

 

·                  otherwise adequately protectour intellectual property rights.

 

Others may attempt to reverse engineer, copy or otherwise obtain anduse our proprietary technologies without our consent. Monitoring theunauthorized use of our technologies is difficult. We cannot be certain thatthe steps we have taken will prevent the unauthorized use of our technologies.This is particularly true in foreign countries, such as the PRC, where we haveestablished a manufacturing facility and where the laws may not protect ourproprietary rights to the same extent as applicable U.S. laws.

 

If some or all of the claims in our patent applications are notallowed, or if any of our intellectual property protections are limited inscope by a court or circumvented by others, we could face increased competitionwith regard to our products. Increased competition could significantly harm ourbusiness and our operating results.

 

**We are involved in andexpect to continue to be involved in costly legal and administrativeproceedings to defend against claims that we infringe the intellectual propertyrights of others or to enforce or protect our intellectual property rights.**

 

As is common to the semiconductor industry, we have experiencedsubstantial litigation regarding patent and other intellectual property rights.Lawsuits claiming that we are infringing others’ intellectual property rightshave been and may in the future be brought against us, and we are currentlydefending  against claims of invalidityin the United States Patent and Trademark Office (“USPTO”).  See Note 9 of Notes to Unaudited CondensedConsolidated Financial Statements, included in Part I, Item I of thisReport, for a description of our legal contingencies.

 

The process of obtaining and protecting patents is inherentlyuncertain.  In addition to the patentissuance process established by law and the procedures of the USPTO, we mustcomply with JEDEC administrative procedures in protecting our intellectualproperty within its industry standard setting process.  These procedures evolve over time, aresubject to variability in their application, and may be inconsistent with eachother.  Failure to comply with JEDEC’sadministrative procedures could jeopardize our ability to claim that ourpatents have been infringed.

 

By making use of new technologies and entering new markets there is anincreased likelihood that others might allege that our products infringe ontheir intellectual property rights. Litigation is inherently uncertain, and anadverse outcome in existing or any future litigation could subject us tosignificant liability for damages or invalidate our proprietary rights. Anadverse outcome also could force us to take specific actions, including causingus to:

 

·                  cease manufacturing and/orselling products, or using certain processes, that are claimed to be infringinga third party’s intellectual property;

 

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·                  pay damages (which in someinstances may be three times actual damages), including royalties on past orfuture sales;

 

·                  seek a license from thethird party intellectual property owner to use their technology in ourproducts, which license may not be available on reasonable terms, or at all; or

 

·                  redesign those products thatare claimed to be infringing a third party’s intellectual property.

 

If any adverse ruling in any such matter occurs, any resultinglimitations in our ability to market our products, or delays and costsassociated with redesigning our products or payments of license fees to third parties,or any failure by us to develop or license a substitute technology oncommercially reasonable terms could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

There is a limited pool of experienced technical personnel that we candraw upon to meet our hiring needs. As a result, a number of our existingemployees have worked for our existing or potential competitors at some pointduring their careers, and we anticipate that a number of our future employees willhave similar work histories. In the past, some of these competitors haveclaimed that our employees misappropriated their trade secrets or violatednon-competition or non-solicitation agreements. Some of our competitors maythreaten or bring legal action involving similar claims against us or ourexisting employees or make such claims in the future to prevent us from hiringqualified candidates. Lawsuits of this type may be brought, even if there is nomerit to the claim, simply as a strategy to drain our financial resources anddivert management’s attention away from our business.

 

We also may find it necessary to litigate against others, including ourcompetitors, customers and former employees, to enforce our intellectualproperty and contractual and commercial rights including, in particular, ourtrade secrets, as well as to challenge the validity and scope of theproprietary rights of others. We could become subject to counterclaims orcountersuits against us as a result of this litigation. Moreover, any legaldisputes with customers could cause them to cease buying or using our productsor delay their purchase of our products and could substantially damage ourrelationship with them.

 

Any litigation, regardless of its outcome, would be time consuming andcostly to resolve, divert our management’s time and attention and negativelyimpact our results of operations. We cannot assure you that current or futureinfringement claims by third parties or claims for indemnification by customersor end users of our products resulting from infringement claims will not beasserted in the future or that such assertions, if proven to be true, will notmaterially adversely affect our business, financial condition or results ofoperations.

 

**If we are required toobtain licenses to use third party intellectual property and we fail to do so,our business could be harmed.**

 

Although some of the components used in our final products contain theintellectual property of third parties, we believe that our suppliers bear thesole responsibility to obtain any rights and licenses to such third partyintellectual property. While we have no knowledge that any third party licensordisputes our belief, we cannot assure you that disputes will not arise in thefuture. The operation of our business and our ability to compete successfullydepends significantly on our continued operation without claims of infringementor demands resulting from such claims, including demands for payments of moneyin the form of, for example, ongoing licensing fees.

 

We are also developing products to enter new markets. Similar to ourcurrent products, we may use components in these new products that contain theintellectual property of third parties. While we plan to exercise precautionsto avoid infringing on the intellectual property rights of third parties, wecannot assure you that disputes will not arise.

 

If it is determined that we are required to obtain inbound licenses andwe fail to obtain licenses, or if such licenses are not available on economicallyfeasible terms, our business, operating results and financial condition couldbe significantly harmed.

 

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**The flash memory market isconstantly evolving and competitive, and we may not have rights to manufactureand sell certain types of products utilizing emerging flash formats, or we maybe required to pay a royalty to sell products utilizing these formats.**

 

The flash-based storage market is constantly undergoing rapidtechnological change and evolving industry standards. Many consumer devices,such as digital cameras, PDAs and smartphones, are transitioning to emergingflash memory formats, such as the Memory Stick, and xD Picture Card formats,which we do not currently manufacture and do not have rights to manufacture.Although we do not currently serve the consumer flash market, it is possiblethat certain OEMs may choose to adopt these higher-volume, lower-costformats. This could result in a decline in demand, on a relative basis, forother products that we manufacture such as CompactFlash, SD and embedded USBdrives. If we decide to manufacture flash memory products utilizing emergingformats such as those mentioned, we will be required to secure licenses to giveus the right to manufacture such products that may not be available atreasonable rates or at all. If we are not able to supply flash card formats atcompetitive prices or if we were to have product shortages, our net sales couldbe adversely impacted and our customers would likely cancel orders or seekother suppliers to replace us.

 

**Our indemnificationobligations for the infringement by our products of the intellectual propertyrights of others could require us to pay substantial damages.**

 

As is common in the industry, we currently have in effect a number ofagreements in which we have agreed to defend, indemnify and hold harmless ourcustomers and suppliers from damages and costs which may arise from theinfringement by our products of third-party patents, trademarks or otherproprietary rights. The scope of such indemnity varies, but may, in someinstances, include indemnification for damages and expenses, includingattorneys’ fees. Our insurance does not cover intellectual propertyinfringement. The term of these indemnification agreements is generallyperpetual any time after execution of the agreement. The maximum potentialamount of future payments we could be required to make under these indemnificationagreements is unlimited. We may periodically have to respond to claims andlitigate these types of indemnification obligations. Although our suppliers maybear responsibility for the intellectual property inherent in the componentsthey sell to us, they may lack the financial ability to stand behind suchindemnities. Additionally, it may be costly to enforce any indemnificationsthat they have granted to us. Accordingly, any indemnification claims bycustomers could require us to incur significant legal fees and couldpotentially result in the payment of substantial damages, both of which couldresult in a material adverse effect on our business and results of operations.

 

**We depend on a few keyemployees, and if we lose the services of any of those employees or are unableto hire additional personnel, our business could be harmed.**

 

To date, we have been highly dependent on the experience, relationshipsand technical knowledge of certain key employees. We believe that our futuresuccess will be dependent on our ability to retain the services of these keyemployees, develop their successors, reduce our reliance on them, and properlymanage the transition of their roles should departures occur.

 

The loss of these key employees could delay the development andintroduction of, and negatively impact our ability to sell, our products andotherwise harm our business. We do not have employment agreements with any ofthese key employees other than Chun K. Hong, our President, Chief ExecutiveOfficer and Chairman of the Board. In 2010, we obtained “Key Man” lifeinsurance on Chun K. Hong; however, we do not carry “Key Man” life insurance onany of our other key employees.

 

Our future success also depends on our ability to attract, retain andmotivate highly skilled engineering, manufacturing, and other technical andsales personnel. Competition for experienced personnel is intense. We may notbe successful in attracting new engineers or other technical personnel, or inretaining or motivating our existing personnel. If we are unable to hire andretain engineers with the skills necessary to keep pace with the evolvingtechnologies in our markets, our ability to continue to provide our currentproducts and to develop new or enhanced products will be negatively impacted,which would harm our business. In addition, the shortage of experiencedengineers, and other factors, may lead to increased recruiting, relocation andcompensation costs for such engineers, which may exceed our expectations andresources. These increased costs may make hiring new engineers difficult, ormay reduce our margins.

 

Historically, a significant portion of our workforce has consisted ofcontract personnel. We invest considerable time and expense in training thesecontract employees. We may experience high turnover rates in our contractemployee workforce, which may require us to expend additional resources in thefuture. If we convert any of these contract employees into permanent employees,we may have to pay finder’s fees to the contract agency.

 

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**We rely on third-partymanufacturers’ representatives and the failure of these manufacturers’representatives to perform as expected could reduce our future sales.**

 

We sell some of our products to customers through manufacturers’representatives. We are unable to predict the extent to which our manufacturers’representatives will be successful in marketing and selling our products.Moreover, many of our manufacturers’ representatives also market and sellcompeting products. Our representatives may terminate their relationships withus at any time. Our future performance will also depend, in part, on ourability to attract additional manufacturers’ representatives that will be ableto market and support our products effectively, especially in markets in whichwe have not previously distributed our products. If we cannot retain ourcurrent manufacturers’ representatives or recruit additional or replacementmanufacturers’ representatives, our sales and operating results will be harmed.

 

**The establishment andongoing operation of our manufacturing facility in the PRC could expose us tonew and significant risks.**

 

During fiscal 2007, we invested significant time and effort inestablishing a manufacturing facility in the PRC and preparing it forfull-scale operations. This manufacturing facility became operational in July 2007and was successfully qualified by certain key customers at that time. As ofFebruary 1, 2009, substantially all of our world-wide manufacturingproduction was being performed in the PRC. Language and cultural differences,as well as the geographic distance from our headquarters in Irvine, further compoundthe difficulties of running a manufacturing operation in the PRC. Ourmanagement has limited experience in creating or overseeing foreign operations,and this new facility may divert substantial amounts of their time. We cannotassure you that we will be able to maintain control over product quality,delivery schedules, manufacturing yields and costs as we increase our output.We also have to manage a local workforce that may subject us to uncertaintiesor regulatory policies and we remain subject to risks related to managing theincreased production capacity provided by the facility. Should anticipateddemand not materialize, the costs related to having excess capacity would havean adverse impact on our gross margins and operating results.

 

Changes in the labor laws of the PRC could increase the cost ofemploying the local workforce. The increased industrialization of the PRC couldalso increase the price of local labor. Either of these factors couldnegatively impact the cost savings we currently enjoy from having ourmanufacturing facility in the PRC.

 

In the future, some of our net sales may be denominated in ChineseRenminbi (“RMB”). The Chinese government controls the procedures by which RMBis converted into other currencies, and conversion of RMB generally requiresgovernment consent. As a result, RMB may not be freely convertible into othercurrencies at all times. If the Chinese government institutes changes incurrency conversion procedures, or imposes restrictions on currency conversion,those actions may negatively impact our operations and could reduce ouroperating results. In addition, fluctuations in the exchange rate between RMBand U.S. dollars may adversely affect our expenses and results of operations aswell as the value of our assets and liabilities. These fluctuations may alsoadversely affect the comparability of our period-to-period results. If wedecide to declare dividends and repatriate funds from our Chinese operations,we will be required to comply with the procedures and regulations of applicableChinese law. Any changes to these procedures and regulations, or our failure tocomply with those procedures and regulations, could prevent us from makingdividends and repatriating funds from our Chinese operations, which couldadversely affect our financial condition. If we are able to make dividends andrepatriate funds from our Chinese operations, these dividends would be subjectto U.S. corporate income tax.

 

The PRC currently provides for favorable tax rates for certainforeign-owned enterprises operating in specified locations in the PRC. We haveestablished our PRC facility in such a tax-favored location. Should the PRCgovernment enact a revised tax structure, it is possible that we would notrealize the tax benefits that we currently anticipate and this could adverselyimpact our operating results.

 

**Economic, political andother risks associated with international sales and operations could adverselyaffect our net sales.**

 

Part of our growth strategy involves making sales to foreigncorporations and delivering our products to facilities located in foreigncountries. To facilitate this process and to meet the long-term projecteddemand for our products, we have set up a manufacturing facility in the PRC.Selling and manufacturing in foreign countries subjects us to additional risksnot present with our domestic operations. We have begun operating in businessand regulatory environments in which we have little or no previous experience.We will need to overcome language and cultural barriers to effectively conductour operations in these environments. In addition, the economies of the PRC andother countries have been highly volatile in the past, resulting in significantfluctuations in local currencies and other instabilities. These instabilitiesaffect a number of our customers and suppliers in addition to our foreignoperations and continue to exist or may occur again in the future.

 

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Internationalturmoil and the threat of future terrorist attacks, both domestically andinternationally, have contributed to an uncertain political and economic climate,both in the U.S. and globally, and have negatively impacted the worldwideeconomy. The occurrence of one or more of these instabilities could adverselyaffect our foreign operations and some of our customers or suppliers, each ofwhich could adversely affect our net sales. In addition, our failure to meetapplicable regulatory requirements or overcome cultural barriers could resultin production delays and increased turn-around times, which would adverselyaffect our business.

 

Our international sales are subject to other risks, includingregulatory risks, tariffs and other trade barriers, timing and availability ofexport licenses, political and economic instability, difficulties in accountsreceivable collections, difficulties in managing distributors, lack of asignificant local sales presence, difficulties in obtaining governmentalapprovals, compliance with a wide variety of complex foreign laws and treatiesand potentially adverse tax consequences. In addition, the United States orforeign countries may implement quotas, duties, taxes or other charges orrestrictions upon the importation or exportation of our products, leading to areduction in sales and profitability in that country.

 

**Our operations could bedisrupted by power outages, natural disasters or other factors.**

 

Our current manufacturing facilities are located in Suzhou, PRC. Due tothis geographic concentration, a disruption of our manufacturing operations,resulting from equipment failure, power failures, quality control issues, humanerror, government intervention or natural disasters, including earthquakes,fires or floods, could interrupt or interfere with our manufacturing operationsand consequently harm our business, financial condition and results ofoperations. Such disruptions would cause significant delays in shipments of ourproducts and adversely affect our operating results.

 

**Our failure to comply withenvironmental laws and regulations could subject us to significant fines andliabilities or cause us to incur significant costs.**

 

We are subject to various and frequently changing U.S. federal, stateand local and foreign governmental laws and regulations relating to theprotection of the environment, including those governing the discharge ofpollutants into the air and water, the management and disposal of hazardoussubstances and wastes, the cleanup of contaminated sites and the maintenance ofa safe workplace. In particular, some of our manufacturing processes mayrequire us to handle and dispose of hazardous materials from time to time. Forexample, in the past our manufacturing operations have used lead-based solderin the assembly of our products. Today, we use lead-free soldering technologiesin our manufacturing processes, as this is required for products entering the EuropeanUnion. We could incur substantial costs, including clean-up costs, civil orcriminal fines or sanctions and third-party claims for property damage orpersonal injury, as a result of violations of, or noncompliance with,environmental laws and regulations. These laws and regulations also couldrequire us to incur significant costs to remain in compliance.

 

**Our internal controls overfinancial reporting may not be effective, which could have a significant andadverse effect on our business.**

 

Section 404 of the Sarbanes-Oxley Act of 2002 and the rules andregulations of the SEC, which we collectively refer to as Section 404,require us to evaluate our internal controls over financial reporting to allowmanagement to report on those internal controls as of the end of each year.Effective internal controls are necessary for us to produce reliable financialreports and are important in our effort to prevent financial fraud. In thecourse of our Section 404 evaluations, we may identify conditions that mayresult in significant deficiencies or material weaknesses and we may concludethat enhancements, modifications or changes to our internal controls arenecessary or desirable. Implementing any such matters would divert theattention of our management, could involve significant costs, and maynegatively impact our results of operations.

 

We note that there are inherent limitations on the effectiveness ofinternal controls, as they cannot prevent collusion, management override orfailure of human judgment. If we fail to maintain an effective system ofinternal controls or if management or our independent registered publicaccounting firm were to discover material weaknesses in our internal controls,we may be unable to produce reliable financial reports or prevent fraud, and itcould harm our financial condition and results of operations, result in a lossof investor confidence and negatively impact our stock price.

 

**If we do not effectivelymanage future growth, our resources, systems and controls may be strained andour results of operations may suffer.**

 

We have in the past expanded our operations, both domestically andinternationally. Any future growth may strain our resources, managementinformation and telecommunication systems, and operational and financial controls.To manage future growth effectively, including the expansion of volume in ourmanufacturing facility in the PRC, we must be able to improve and expand oursystems and controls. We may not be able to do this in a timely orcost-effective manner, and our current systems and controls may not be adequateto support our future operations. In addition, our officers have relativelylimited experience in managing a rapidly growing business or a public company.As a result, they may not be able to provide the guidance necessary to managefuture growth or maintain future market position. Any failure to manage ourgrowth or improve or expand our existing systems and controls, or unexpecteddifficulties in doing so, could harm our business.

 

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**If we acquire otherbusinesses or technologies in the future, these acquisitions could disrupt ourbusiness and harm our operating results and financial condition.**

 

We will evaluate opportunities to acquire businesses or technologiesthat might complement our current product offerings or enhance our technicalcapabilities. We have no experience in acquiring other businesses or technologies.Acquisitions entail a number of risks that could adversely affect our businessand operating results, including, but not limited to:

 

·                  difficulties in integratingthe operations, technologies or products of the acquired companies;

 

·                  the diversion of management’stime and attention from the normal daily operations of the business;

 

·                  insufficient increases innet sales to offset increased expenses associated with acquisitions or acquiredcompanies;

 

·                  difficulties in retainingbusiness relationships with suppliers and customers of the acquired companies;

 

·                  the overestimation ofpotential synergies or a delay in realizing those synergies;

 

·                  entering markets in which wehave no or limited experience and in which competitors have stronger marketpositions; and

 

·                  the potential loss of keyemployees of the acquired companies.

 

Future acquisitions also could cause us to incur debt or be subject tocontingent liabilities. In addition, acquisitions could cause us to issueequity securities that could dilute the ownership percentages of our existingstockholders. Furthermore, acquisitions may result in material charges oradverse tax consequences, substantial depreciation, deferred compensationcharges, in-process research and development charges, the amortization ofamounts related to deferred stock-based compensation expense and identifiablepurchased intangible assets or impairment of goodwill, any or all of whichcould negatively affect our results of operations.

 

**Incurring indebtednesscould adversely affect our cash flow and prevent us from fulfilling ourfinancial obligations.**

 

On September 30, 2010, we renewed our revolving credit agreementand concurrently obtained term loan financing. Incurring debt could havematerial consequences, such as:

 

·                  requiring us to dedicate aportion of our cash flow from operations and other capital resources to debtservice, thereby reducing our ability to fund working capital, capitalexpenditures, and other cash requirements;

 

·                  increasing our vulnerabilityto adverse economic and industry conditions;

 

·                  limiting our flexibility inplanning for, or reacting to, changes and opportunities in, our business andindustry, which may place us at a competitive disadvantage; and

 

·                  limiting our ability toincur additional debt on acceptable terms, if at all.

 

Additionally, if we are unable to maintain liquidity levels, as definedin the credit agreement, or if we were to default under our credit agreementand were unable to obtain a waiver for such a default, interest on theobligations would accrue at an increased rate. In the case of a default, thelenders could accelerate our obligations under the credit agreement; however,acceleration will be automatic in the case of bankruptcy and insolvency eventsof default.

 

Additionally, to the extent we have made intercompany loans to oursubsidiaries and have pledged such loans to the lenders under the creditagreement, our subsidiaries would be required to pay the amount of theintercompany loans to the lenders in the event we are in default under thecredit agreement. Any actions taken by the lenders against us in the event weare in default under the credit agreement could harm our financial condition.Finally, the credit facility contains certain restrictive covenants, includingprovisions restricting our ability to incur additional indebtedness, guaranteecertain obligations, create or assume liens and pay dividends.

 

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**Our investments in auctionrate securities are subject to risks which may cause losses and affect theliquidity of these investments.**

 

We hold certain investments in auction rate securities that havefailed, or may in the future fail, their respective auctions. An auctionfailure means that the parties wishing to sell their securities could not doso. As a result of failed auctions, our ability to liquidate and fully recoverthe carrying value of our investments in the near term may be limited or notexist. If the issuers of these investments are unable to close future auctionsand their credit ratings deteriorate, we may in the future be required torecord an impairment charge on these investments. We also may be required towait until market stability is restored for these investments or until thefinal maturity of the underlying notes (up to 30 years) to realize ourinvestments’ cost value.

 

***Risks related to our common stock***

 

**Our principal stockholdershave significant voting power and may take actions that may not be in the bestinterest of our other stockholders.**

 

As of October 18, 2010, our executive officers, directors and 5%stockholders beneficially own, in total, approximately 25% of our outstandingcommon stock. As a result, these stockholders, acting together, have theability to exert substantial influence over all matters requiring approval byour stockholders, including the election and removal of directors and anyproposed merger, consolidation or sale of all or substantially all of ourassets and other corporate transactions. This concentration of control could bedisadvantageous to other stockholders with interests different from those ofour executive officers, directors and principal stockholders. For example, ourexecutive officers, directors and principal stockholders could delay or preventan acquisition or merger even if the transaction would benefit otherstockholders. In addition, this significant concentration of share ownershipmay adversely affect the trading price for our common stock because investorsmay perceive disadvantages in owning stock in companies with stockholders thathave the ability to exercise significant control.

 

**Anti-takeover provisionsunder our charter documents and Delaware law could delay or prevent a change ofcontrol and could also limit the market price of our stock.**

 

Our certificate of incorporation and bylaws contain provisions thatcould delay or prevent a change of control of our company or changes in ourboard of directors that our stockholders might consider favorable. In addition,these provisions could limit the price that investors would be willing to payin the future for shares of our common stock. The following are examples ofprovisions which are included in our certificate of incorporation and bylaws,each as amended:

 

·                  our board of directors isauthorized, without prior stockholder approval, to designate and issuepreferred stock, commonly referred to as “blank check” preferred stock, withrights senior to those of our common stock;

 

·                  stockholder action bywritten consent is prohibited;

 

·                  nominations for election toour board of directors and the submission of matters to be acted upon bystockholders at a meeting are subject to advance notice requirements; and

 

·                  our board of directors isexpressly authorized to make, alter or repeal our bylaws.

 

Inaddition, we are governed by the provisions of Section 203 of the DelawareGeneral Corporate Law, which may prohibit certain business combinations withstockholders owning 15% or more of our outstanding voting stock. These andother provisions in our certificate of incorporation and bylaws, and ofDelaware law, could make it more difficult for stockholders or potentialacquirers to obtain control of our board of directors or initiate actions thatare opposed by the then-current board of directors, including delaying orimpeding a merger, tender offer, or proxy contest or other change of controltransaction involving our company. Any delay or prevention of a change of controltransaction or changes in our board of directors could prevent the consummationof a transaction in which our stockholders could receive a substantial premiumover the then-current market price for their shares.

 

**The price of and volume intrading of our common stock has and may continue to fluctuate significantly.**

 

Our common stock has been publicly traded since November 2006. Theprice of our common stock and the trading volume of our shares are volatile andhave in the past fluctuated significantly. There can be no assurance as to theprices at which our common stock will trade in the future or that an activetrading market in our common stock will be sustained in the future. The marketprice at which our common stock trades may be influenced by many factors,including but not limited to, the following:

 

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·                  our operating and financialperformance and prospects, including our ability to achieve and sustainprofitability in the future;

 

·                  investor perception of usand the industry in which we operate;

 

·                  the availability and levelof research coverage of and market making in our common stock;

 

·                  changes in earningsestimates or buy/sell recommendations by analysts;

 

·                  general financial and othermarket conditions; and

 

·                  changing and recentlyvolatile domestic and international economic conditions.

 

In addition, shares of our common stock and the public stock markets ingeneral, have experienced, and may continue to experience, extreme price andtrading volume volatility. These fluctuations may adversely affect the marketprice of our common stock and a shareholders ability to sell their shares intothe market at the desired time or at the desired price.

 

In 2007, following a drop in the price of our stock, securitieslitigation was initiated against the company. Given the historic volatility ofour industry, we may become engaged in this type of litigation in the future.Securities litigation is expensive and time-consuming.

 

**Item 5.****                      ****OtherInformation**

 

**BankFinancing Agreement**

 

OnSeptember 30, 2010, we entered into an amendment to our existing creditagreement with Silicon Valley Bank.  Theamendment extends the maturity date of our revolving credit facility to September 30,2012 and increases our borrowing capacity to the lesser of (i) 80% ofeligible accounts receivable, or (ii) $10.0 million.  We have the option to increase creditavailability under the revolving credit facility to $15.0 million at any timethrough the extended maturity date, subject to the conditions of the creditagreement.  At October 2, 2010,there were no borrowings outstanding under the revolving credit facility.

 

Intereston the revolving credit facility is payable monthly at either (i) primeplus 1.25%, as long as we maintain $8.5 million in revolving creditavailability plus unrestricted cash on deposit with Silicon Valley Bank, or (ii) primeplus 2.25%.   Additionally, thecredit agreement requires payments for an unused line, as well as anniversaryand early termination fees, as applicable.

 

Inconnection with the amendment, Silicon Valley Bank also extended a $1.5 millionterm loan under the credit agreement, which bears interest at a rate of primeplus 1.75%.  We are required to makeequal monthly principal payments which total $0.5 million annually, and aballoon payment of $0.5 at maturity.  Anyremaining unpaid principal is due upon maturity of the credit agreement.   As of October 2, 2010, $1.5 million wasoutstanding under the term loan.

 

Allobligations under the credit agreement are secured by a first priority lien onour tangible and intangible assets. The credit agreement subjects us to certainaffirmative and negative covenants, including financial covenants with respectto our tangible net worth and restrictions on the payment of dividends. As of October 2, 2010, we were in compliance with its financial covenants.

 

**ASICDesign and Production Agreement**

 

OnAugust 11, 2010, we entered into an agreement with Open Silicon, Inc.for the design and production of an ASIC device to be incorporated into aproduct that is under development.  Theagreement requires that we pay non-recurring engineering fees over the courseof the design phase and specifies terms regarding the purchase of productiondevices.  We have requested confidentialtreatment regarding portions of this agreement pursuant to Rule 24b-2 ofthe Securities and Exchange Act of 1934.

 

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**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.                                                                                                                                                                                                    |
|        |       |                                                                                                                                                                                                                                                  |
| 10.1(2)     |       | Amendment  to Loan Documents entered into as of September 30, 2010, by and between  Silicon Valley Bank and Netlist, Inc.                                                                                                                   |
|        |       |                                                                                                                                                                                                                                                  |
| 10.2(2)*    |       | ASIC  Design and Production Agreement between Open Silicon, Inc. and  Netlist, Inc.                                                                                                                                                         |
|        |       |                                                                                                                                                                                                                                                  |
| 10.3(2)*    |       | Design  and Production Agreement relating to Register ASIC (the “Production Register  Agreement”), dated July 31, 2008, by and between Netlist, Inc. and  Toshiba America Electronic Components, Inc. (“Toshiba”). |
|        |       |                                                                                                                                                                                                                                                  |
| 10.4(2)*    |       | Amendment  #1 to the Production Register Agreement, dated May 22, 2009, by and  between Netlist, Inc. and Toshiba.                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                  |
| 10.5(2)*    |       | Amendment  #1 to the Production Register Agreement, dated January 28, 2010, by and  between Netlist, Inc. and Toshiba.                                                                                                                      |
|        |       |                                                                                                                                                                                                                                                  |
| 10.6(2)*    |       | Amendment  #2 to the Production Register Agreement, dated March 10, 2010, by and  between Netlist, Inc. and Toshiba.                                                                                                                        |
|        |       |                                                                                                                                                                                                                                                  |
| 10.7(2)*    |       | Design  and Production Agreement relating to ID ASIC (the “Production ID Agreement”),  dated July 31, 2008, by and between Netlist, Inc. and Toshiba.                                                                             |
|        |       |                                                                                                                                                                                                                                                  |
| 10.8(2)*    |       | Amendment  #1 to the Production ID Agreement, dated January 28, 2010, by and  between Netlist, Inc. and Toshiba.                                                                                                                            |
|        |       |                                                                                                                                                                                                                                                  |
| 10.9(2)*    |       | Amendment  #2 to the Production ID Agreement, dated March 10, 2010, by and between  Netlist, Inc. and Toshiba.                                                                                                                              |
|        |       |                                                                                                                                                                                                                                                  |
| 10.10(2)*   |       | Development  and Supply Agreement, dated as of September 10, 2008, by and between  Netlist, Inc. and Diablo Technologies, Inc. (“Diablo”).                                                                                   |
|        |       |                                                                                                                                                                                                                                                  |
| 10.11(2)*   |       | Settlement  Agreement and Amendment to Development and Supply Agreement, dated  January 12, 2010, between Netlist, Inc. and Diablo.                                                                                                         |
|        |       |                                                                                                                                                                                                                                                  |
| 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.        |

 

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(1)         Incorporated by reference to the correspondingexhibit number of the registration statement on Form S-1 of the registrant(No. 333-136735) filed with the Securities and Exchange Commission onOctober 23, 2006.

 

(2)         Filed herewith.

 

(3)         The information in Exhibit 32 shall not bedeemed “filed” for purposes of Section 18 of the Securities Exchange Actof 1934, as amended, (the “Exchange Act”), or otherwise subject to theliabilities of that section, nor shall they be deemed incorporated by referencein any filing under the Securities Act of 1933, as amended, or the Exchange Act(including this Report), unless the registrant specifically incorporates theforegoing information into those documents by reference.

 

* Confidential treatment hasbeen requested with respect to portions of this exhibit pursuant toRule 24b-2 of the Securities Exchange Act of 1934 and these confidentialportions have been redacted from the filing made herewith.  A complete copy of this exhibit, includingthe redacted terms, has been separately filed with the Securities and ExchangeCommission.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| Date:  November 16, 2010 |       | 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 M. Sasaki                         |
| ** **                    | ** ** | **Gail M. Sasaki**                         |
| ** **                    | ** ** | **Vice President and Chief Financial**     |
| ** **                    | ** ** | **Officer**                                |
| ** **                    | ** ** | **(Principal Financial Officer)**          |

 

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**EXHIBIT INDEX**

 
| **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.                                                                                                                                                                                                    |
|        |       |                                                                                                                                                                                                                                                  |
| 10.1(2)     |       | Amendment  to Loan Documents entered into as of September 30, 2010, by and between  Silicon Valley Bank and Netlist, Inc.                                                                                                                   |
|        |       |                                                                                                                                                                                                                                                  |
| 10.2(2)*    |       | ASIC  Design and Production Agreement between Open Silicon, Inc. and  Netlist, Inc.                                                                                                                                                         |
|        |       |                                                                                                                                                                                                                                                  |
| 10.3(2)*    |       | Design  and Production Agreement relating to Register ASIC (the “Production Register  Agreement”), dated July 31, 2008, by and between Netlist, Inc. and  Toshiba America Electronic Components, Inc. (“Toshiba”). |
|        |       |                                                                                                                                                                                                                                                  |
| 10.4(2)*    |       | Amendment  #1 to the Production Register Agreement, dated May 22, 2009, by and  between Netlist, Inc. and Toshiba.                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                  |
| 10.5(2)*    |       | Amendment  #1 to the Production Register Agreement, dated January 28, 2010, by and  between Netlist, Inc. and Toshiba.                                                                                                                      |
|        |       |                                                                                                                                                                                                                                                  |
| 10.6(2)*    |       | Amendment  #2 to the Production Register Agreement, dated March 10, 2010, by and  between Netlist, Inc. and Toshiba.                                                                                                                        |
|        |       |                                                                                                                                                                                                                                                  |
| 10.7(2)*    |       | Design  and Production Agreement relating to ID ASIC (the “Production ID Agreement”),  dated July 31, 2008, by and between Netlist, Inc. and Toshiba.                                                                             |
|        |       |                                                                                                                                                                                                                                                  |
| 10.8(2)*    |       | Amendment  #1 to the Production ID Agreement, dated January 28, 2010, by and  between Netlist, Inc. and Toshiba.                                                                                                                            |
|        |       |                                                                                                                                                                                                                                                  |
| 10.9(2)*    |       | Amendment  #2 to the Production ID Agreement, dated March 10, 2010, by and between  Netlist, Inc. and Toshiba.                                                                                                                              |
|        |       |                                                                                                                                                                                                                                                  |
| 10.10(2)*   |       | Development  and Supply Agreement, dated as of September 10, 2008, by and between  Netlist, Inc. and Diablo Technologies, Inc. (“Diablo”).                                                                                   |
|        |       |                                                                                                                                                                                                                                                  |
| 10.11(2)*   |       | Settlement  Agreement and Amendment to Development and Supply Agreement, dated  January 12, 2010, between Netlist, Inc. and Diablo.                                                                                                         |
|        |       |                                                                                                                                                                                                                                                  |
| 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.        |

 

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(1)         Incorporated by reference to the correspondingexhibit number of the registration statement on Form S-1 of the registrant(No. 333-136735) filed with the Securities and Exchange Commission onOctober 23, 2006.

 

(2)         Filed herewith.

 

(3)         The information in Exhibit 32 shall not bedeemed “filed” for purposes of Section 18 of the Securities Exchange Actof 1934, as amended, (the “Exchange Act”), or otherwise subject to the liabilitiesof that section, nor shall they be deemed incorporated by reference in anyfiling under the Securities Act of 1933, as amended, or the Exchange Act(including this Report), unless Netlist, Inc. specifically incorporatesthe foregoing information into those documents by reference.

 

* Confidential treatment hasbeen requested with respect to portions of this exhibit pursuant toRule 24b-2 of the Securities Exchange Act of 1934 and these confidentialportions have been redacted from the filing made herewith.  A complete copy of this exhibit, includingthe redacted terms, has been separately filed with the Securities and ExchangeCommission.

 

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