Table ofContents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **
| **(Mark  One)**                                                                                                                                                               |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                    |
| **x**                                                                                                                                                                         | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                    | ** ** |
| **For the  quarterly period ended July 4, 2009**                                                                                                                         |
| ** **                                                                                                                                                                    | ** ** |
| **or**                                                                                                                                                                        |
| ** **                                                                                                                                                                    | ** ** |
| **o**                                                                                                                                                                         | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                          |   |
| **For the transition period from              to             ** |

 

**Commission file number001-33170**

** **

****

** **

**NETLIST, INC.**

(Exact name of registrant as specified in its charter)

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

 

**51 Discovery, Irvine, CA 92618**

(Address of principal executive offices) (Zip Code)

 

**(949) 435-0025**

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

** **

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

 

IndicatebycheckmarkwhethertheregistranthassubmittedelectronicallyandpostedonitscorporateWebsite,ifany,everyInteractiveDataFilerequiredtobesubmittedandpostedpursuanttoRule405ofRegulationS-T(section232.405ofthischapter)duringthepreceding12months(orforsuchshorterperiodthattheregistrantwasrequiredtosubmitandpostsuchfiles).  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 in Rule 12b-2of 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

 

19,855,411 shares outstanding at July 31, 2009

 

 

 

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**NETLIST, INC. ANDSUBSIDIARIES**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE THREE AND SIXMONTHS ENDED JULY 4, 2009**

 

**TABLE OF CONTENTS**

 
| ** **    | ** **                                                                                                                                   | **Page** |
|---------------|----------------------------------------------------------------------------------------------------------------------------------------------|----------|
| PART I.  | FINANCIAL  INFORMATION                                                                                                                       | 3        |
| Item 1.       | Financial  Statements                                                                                                                        | 3        |
|          | Condensed Consolidated Balance Sheets at July 4,  2009 (unaudited) and January 3, 2009 (audited)                                   | 3        |
|          | Unaudited Condensed Consolidated Statements of  Operations for the Three and Six Months Ended July 4, 2009  and June 28, 2008 | 4        |
|          | Unaudited Condensed Consolidated Statements of Cash  Flows for the Six Months Ended July 4, 2009 and June 28, 2008                 | 5        |
|          | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                              | 6        |
| Item 2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                  | 20       |
| Item 3.       | Quantitative  and Qualitative Disclosures About Market Risk                                                                                  | 32       |
| Item 4.       | Controls and  Procedures                                                                                                                     | 32       |
| Item 4T.      | Controls and  Procedures                                                                                                                     | 33       |
|          |                                                                                                                                         |     |
| PART II. | OTHER INFORMATION                                                                                                                            | 33       |
| Item 1.       | Legal Proceedings                                                                                                                            | 33       |
| Item 1A.      | Risk Factors                                                                                                                                 | 33       |
| Item 2.       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                 | 33       |
| Item 3.       | Defaults  Upon Senior Securities                                                                                                             | 33       |
| Item 4.       | Submission  of Matters to a Vote of Security Holders                                                                                         | 34       |
| Item 5.       | Other Information                                                                                                                            | 34       |
| Item 6.       | Exhibits                                                                                                                                     | 34       |

 

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**PART I. FINANCIALINFORMATION**

 

**Item1. Financial Statements**

 

**NETLIST, INC.AND SUBSIDIARIES**

**CondensedConsolidated Balance Sheets**

**(inthousands, except par value)**

** **
| ** **                                                                                        | ** ** | **(unaudited)**  | ** ** | **(audited)**       | ** ** |
|---------------------------------------------------------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                                                        | ** ** | **July 4,** | ** ** | **January 3,** | ** ** |
| ** **                                                                                        | ** ** | **2009**         | ** ** | **2009**            | ** ** |
|                                                                                              |       |             |       |                |       |
| **ASSETS**                                                                                        |       |             |       |                |       |
| Current  assets:                                                                                  |       |             |       |                |       |
| Cash  and cash equivalents                                                                        |       | $                | 10,106     |                | $          | 15,214 |   |
| Investments  in marketable securities                                                             |       | 9,096            |       | 5,199               |       |
| Accounts  receivable, net                                                                         |       | 1,523            |       | 1,917               |       |
| Inventories                                                                                       |       | 1,954            |       | 1,829               |       |
| Income  taxes receivable                                                                          |       | 651              |       | 1,880               |       |
| Prepaid  expenses and other current assets                                                        |       | 759              |       | 761                 |       |
| Total  current assets                                                                             |       | 24,089           |       | 26,800              |       |
|                                                                                              |       |             |       |                |       |
| Property  and equipment, net                                                                      |       | 5,621            |       | 6,939               |       |
| Long-term  investments in marketable securities                                                   |       | 979              |       | 960                 |       |
| Other  assets                                                                                     |       | 221              |       | 234                 |       |
| Total  assets                                                                                     |       | $                | 30,910     |                | $          | 34,933 |   |
|                                                                                              |       |             |       |                |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                     |       |             |       |                |       |
| Current  liabilities:                                                                             |       |             |       |                |       |
| Accounts  payable                                                                                 |       | $                | 2,455      |                | $          | 1,786 |   |
| Revolving  line of credit                                                                         |       | 2,153            |       | —              |       |
| Current  portion of long-term debt                                                                |       | 328              |       | 474                 |       |
| Current  portion of deferred gain on sale and leaseback transaction                               |       | 118              |       | 118                 |       |
| Accrued  expenses and other current liabilities                                                   |       | 2,713            |       | 2,083               |       |
| Total  current liabilities                                                                        |       | 7,767            |       | 4,461               |       |
| Long-term  debt, net of current portion                                                           |       | 36               |       | 130                 |       |
| Deferred  gain on sale and leaseback transaction, net of current portion                          |       | 49               |       | 108                 |       |
| Total  liabilities                                                                                |       | 7,852            |       | 4,699               |       |
| Commitments  and contingencies                                                                    |       |             |       |                |       |
| Stockholders’  equity:                                                                       |       |             |       |                |       |
| Common  stock, $0.001 par value - 90,000 shares authorized; 19,855 shares issued and  outstanding |       | 20               |       | 20                  |       |
| Additional  paid-in capital                                                                       |       | 69,980           |       | 69,383              |       |
| Accumulated  deficit                                                                              |       | (46,924          | )          | (39,113             | )          |
| Accumulated  other comprehensive loss                                                             |       | (18              | )          | (56                 | )          |
| Total  stockholders’ equity                                                                  |       | 23,058           |       | 30,234              |       |
| Total  liabilities and stockholders’ equity                                                  |       | $                | 30,910     |                | $          | 34,933 |   |

 

Seeaccompanying notes.

 

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**NETLIST, INC. AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Operations**

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

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                              | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                                                              | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                              | ** ** | ** **             | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  sales                                                              |       | $                      | 3,173      |                 | $          | 18,429 |   | $ | 5,335 |   | $ | 31,533 |   |
| Cost  of sales(1)                                                       |       | 2,929                  |       | 15,770               |       | 5,628 |   | 25,743 |   |
| Gross  profit (loss)                                                    |       | 244                    |       | 2,659                |       | (293 | ) | 5,790 |   |
| Operating  expenses:                                                    |       |                   |       |                 |       |   |   |   |   |
| Research  and development(1)                                            |       | 2,030                  |       | 1,716                |       | 3,644 |   | 3,292 |   |
| Selling,  general and administrative(1)                                 |       | 2,120                  |       | 3,310                |       | 4,055 |   | 6,778 |   |
| Total  operating expenses                                               |       | 4,150                  |       | 5,026                |       | 7,699 |   | 10,070 |   |
| Operating  loss                                                         |       | (3,906                 | )          | (2,367               | )          | (7,992 | ) | (4,280 | ) |
| Other  income:                                                          |       |                   |       |                 |       |   |   |   |   |
| Interest  income, net                                                   |       | 18                     |       | 104                  |       | 100 |   | 343 |   |
| Other  income (expense), net                                            |       | (45                    | )          | 23                   |       | 130 |   | (68 | ) |
| Total  other income (expense), net                                      |       | (27                    | )          | 127                  |       | 230 |   | 275 |   |
| Loss  before provision (benefit) for income taxes                       |       | (3,933                 | )          | (2,240               | )          | (7,762 | ) | (4,005 | ) |
| Provision  (benefit) for income taxes                                   |       | 31                     |       | 11                   |       | 49 |   | (1,170 | ) |
| Net  loss                                                               |       | $                      | (3,964     | )                    | $          | (2,251 | ) | $ | (7,811 | ) | $ | (2,835 | ) |
| Net  loss per common share:                                             |       |                   |       |                 |       |   |   |   |   |
| Basic  and diluted                                                      |       | $                      | (0.20      | )                    | $          | (0.11 | ) | $ | (0.39 | ) | $ | (0.14 | ) |
| Weighted-average  common shares outstanding:                            |       |                   |       |                 |       |   |   |   |   |
| Basic  and diluted                                                      |       | 19,855                 |       | 19,855               |       | 19,855 |   | 19,839 |   |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
|                                                                         |
| (1)  Amounts  include stock-based compensation expense as follows: |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| Cost  of sales                                                          |       | $                      | 38         |                 | $          | 48 |   | $ | 67 |   | $ | 62 |   |
| Research  and development                                               |       | 48                     |       | 62                   |       | 106 |   | 85 |   |
| Selling,  general and administrative                                    |       | 204                    |       | 265                  |       | 424 |   | 472 |   |

 

See accompanying notes.

 

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**NETLIST, INC.AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Cash Flows**

**(inthousands)**

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                   | ** ** | **July 4,**     | ** ** | **June 28,** | ** ** |
| ** **                                                                   | ** ** | **2009**             | ** ** | **2008** | ** ** |
| ** **                                                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| Cash  flows from operating activities:                                       | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net  loss                                                                    |       | $                    | (7,811     | ) | $ | (2,835 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                 |       |   |   |
| Depreciation  and amortization                                               |       | 1,150                |       | 1,054 |   |
| Amortization  of deferred gain on sale and leaseback transaction             |       | (59                  | )          | (59 | ) |
| Deferred  income taxes                                                       |       | —               |       | (990 | ) |
| Gain  on disposal of assets                                                  |       | (118                 | )          | — |   |
| Stock-based  compensation                                                    |       | 597                  |       | 619 |   |
| Changes  in operating assets and liabilities:                                |       |                 |       |   |   |
| Accounts  receivable                                                         |       | 394                  |       | 5,593 |   |
| Inventories                                                                  |       | (125                 | )          | (4,998 | ) |
| Income  taxes receivable                                                     |       | 1,229                |       | (195 | ) |
| Prepaid  expenses and other current assets                                   |       | 2                    |       | (583 | ) |
| Other  assets                                                                |       | 13                   |       | 44 |   |
| Accounts  payable                                                            |       | 669                  |       | (1,745 | ) |
| Accrued  expenses and other current liabilities                              |       | 630                  |       | (254 | ) |
| Net  cash used in operating activities                                       |       | (3,429               | )          | (4,349 | ) |
| Cash  flows from investing activities:                                       |       |                 |       |   |   |
| Acquisition  of property and equipment                                       |       | (56                  | )          | (770 | ) |
| Proceeds  from sales of equipment                                            |       | 342                  |       | — |   |
| Purchase  of investments in marketable securities                            |       | (10,203              | )          | (6,672 | ) |
| Proceeds  from maturities and sales of investments in marketable securities  |       | 6,325                |       | 17,500 |   |
| Net  cash (used in) provided by investing activities                         |       | (3,592               | )          | 10,058 |   |
| Cash  flows from financing activities:                                       |       |                 |       |   |   |
| Borrowings  on lines of credit                                               |       | 10,325               |       | 49,490 |   |
| Payments  on lines of credit                                                 |       | (8,172               | )          | (48,700 | ) |
| Payments  on debt                                                            |       | (240                 | )          | (434 | ) |
| Increase  in restricted cash                                                 |       | —               |       | (2,000 | ) |
| Reversal  of unrealized excess tax benefit from exercise of warrants         |       | —               |       | (4 | ) |
| Net  cash provided by (used in) financing activities                         |       | 1,913                |       | (1,648 | ) |
| (Decrease)  increase in cash and cash equivalents                            |       | (5,108               | )          | 4,061 |   |
| Cash  and cash equivalents at beginning of period                            |       | 15,214               |       | 7,182 |   |
| Cash  and cash equivalents at end of period                                  |       | $                    | 10,106     |   | $ | 11,243 |   |

 

Seeaccompanying notes.

 

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**NETLIST, INC.AND SUBSIDIARIES**

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**July 4,2009**

** **

**Note 1—Descriptionof Business**

** **

Netlist, Inc. (the “Company” or “Netlist”) designs andmanufactures high performance memory subsystems for the server, highperformance computing and communications markets. The Company’s memorysubsystems consist of dynamic random access memory integrated circuits, NANDflash memory, or NAND, and other components assembled on a printed circuitboard. Headquartered in Irvine, California, Netlist’s solutions are targeted atapplications where memory plays a key role in meeting system performancerequirements. In 2007, the Company established a manufacturing facility in thePeople’s Republic of China, (the “PRC”), which became operational in July 2007upon the successful qualification of certain key customers.

 

**Note 2—Summary ofSignificant Accounting Policies**

** **

*Basis of Presentation*

* *

The interimunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (the “US”) for interim financial information and with theinstructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 8of SEC Regulation S-X. These financial statements do not include all of theinformation and footnotes required by accounting principles generally acceptedin the US for complete financial statements. Therefore, these unauditedcondensed consolidated financial statements should be read in conjunction withthe Company’s audited consolidated financial statements and notes thereto forthe year ended January 3, 2009, included in the Company’s Annual Report onForm 10-K filed with the SEC on March 30, 2009.

 

The condensedconsolidated financial statements included herein as of July 4, 2009 areunaudited; however, they contain all normal recurring accruals and adjustmentsthat, in the opinion of the Company’s management, are necessary to presentfairly the consolidated financial position of the Company and its wholly ownedsubsidiaries as of July 4, 2009 and January 3, 2009, the consolidatedresults of its operations for the three and six months ended July 4, 2009and June 28, 2008, and the consolidated cash flows for the six monthsended July 4, 2009 and June 28, 2008. The results of operations forthe three and six months ended July 4, 2009 are not necessarily indicativeof the results to be expected for the full year or any future interim periods.

 

*Principlesof Consolidation*

 

The consolidated financial statements include the accounts of Netlist, Inc.and its wholly owned subsidiaries. All intercompany balances and transactionshave been eliminated in consolidation.

 

*Fiscal Year*

* *

The Companyoperates under a 52/53-week fiscal year ending on the Saturday closest to December 31.For fiscal 2009, the Company’s fiscal year end is scheduled to be January 2,2010 and will consist of 52 weeks. Each of the Company’s first three quartersin a fiscal year is comprised of 13 weeks.

 

*Use of Estimates*

* *

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the US requires management to make estimates andassumptions that affect the reported amounts of the assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period. Significant estimates made by management include, amongothers, valuation of investments in marketable securities, provisions foruncollectible receivables and sales returns, warranty liabilities, valuation ofinventories, recoverability of long-lived assets, stock-based compensationexpense and realization of deferred tax assets. The Company bases its estimatesand assumptions on current facts, historical experience and various otherfactors that it believes to be reasonable under the circumstances, the resultsof which form the basis for making judgments about the carrying values ofassets and liabilities and the accrual of costs and expenses that are notreadily apparent from other sources. The actual results experienced by theCompany may differ materially and adversely from its estimates. To the extentthere are material differences between the estimates and the actual results,future results of operations will be affected.

 

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*Revenue Recognition*

* *

TheCompany’s revenues primarily consist of product sales of high performancememory subsystems to original equipment manufacturers (“OEMs”). Revenues alsoinclude sales of excess inventories to distributors and other users of memoryintegrated circuits (“ICs”) totaling approximately $0.1 million and$0.1 million, respectively for the three and six months ended July 4,2009, and approximately $0.1 million and $0.2 million, respectively, for thethree and six months ended June 28, 2008.

 

TheCompany recognizes revenues in accordance with the SEC’s Staff AccountingBulletin No. 104, *Revenue Recognition*(“SAB 104”). Under the provisions of SAB 104, the Company recognizesrevenues when there is persuasive evidence that an arrangement, productdelivery and acceptance have occurred, the sales price is fixed ordeterminable, and collectibility of the resulting receivable is reasonablyassured.

 

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 inventories, which contain noright-of-return privileges. Estimated returns are provided for at the time ofsale 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 bycredit checks and evaluations, as well as the customer’s payment history.

 

Aportion of the Company’s shipments are made to third-party inventorywarehouses, or hubs, and the Company recognizes revenue when the inventory ispulled from the hub for use in production by the customer. The Company receivesa report from the customer on a daily basis indicating the inventories pulledfrom a hub for use by the customer, and performs a daily reconciliation ofinventories shipped to and pulled by the customer to those inventoriesreflected on the customer’s reports to ensure that sales are recognized in theappropriate periods.

 

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 and Cash Equivalents*

* *

Cashand cash equivalents consist of cash and short-term investments with originalmaturities of three months or less.

 

*Investments in MarketableSecurities*

* *

TheCompany accounts for its investments in marketable securities in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 115, *Accounting for Certain Investments in Debt and Equity Securities*,and Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”)Nos. 115-1 and 124-1, *The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.*TheCompany determines the appropriate classification of its investments at thetime of purchase and reevaluates such designation at each balance sheet date.The Company’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, and are 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 in highly liquid debt instruments of US. municipalities, corporationsand the US 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.

 

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*Fair Value of FinancialInstruments*

* *

TheCompany’s financial instruments consist principally of cash and cashequivalents, investments in marketable securities, accounts receivable,accounts payable, accrued expenses and debt instruments. Effective December 30,2007, the Company adopted SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value in accordance with accounting principlesgenerally accepted in the U.S. and expands required disclosures about fairvalue measurements. Pursuant to SFAS 157, other than for certain investments inauction rate securities (see Note 4), the fair value of the Company’s cashequivalents and investments in marketable securities is determined based onquoted prices in active markets for identical assets or Level 1 inputs. TheCompany believes that the carrying values of all other financial instruments approximatetheir current fair values due to their nature and respective durations.

 

*Allowancefor Doubtful Accounts*

 

The Company evaluates the collectibility of accounts receivable basedon a combination of factors. In cases where the Company is aware of circumstancesthat may impair a specific customer’s ability to meet its financial obligationssubsequent to the original sale, the Company will record an allowance againstamounts due, and thereby reduce the net recognized receivable to the amount theCompany reasonably believes will be collected. For all other customers, theCompany records allowances for doubtful accounts based primarily on the lengthof time the receivables are past due, the current business environment and itshistorical experience.

 

*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 primarily in money market funds, certificates ofdeposit and high-credit quality debt instruments. Cash equivalents aremaintained with high quality institutions, the composition and maturities ofwhich are regularly monitored by management. 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. The US. Treasury through a Temporary GuaranteeProgram of Money Market funds has guaranteed money market investments on handas of September 19, 2008. These funds are guaranteed through September 18,2009. The Company had $7.4 million of US Treasury guaranteed money marketfunds and FDIC insured funds at July 4, 2009.  In addition, the Company had $3.5 million intreasury notes that are direct obligations of the US government. The Companyhas 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 require no collateral. TheCompany believes that the concentration of credit risk in its trade receivablesis moderated by its credit evaluation process, relatively short collectionterms and the high level of credit worthiness of its customers. Reserves aremaintained for potential credit losses, and such losses historically have notbeen significant and have been within management’s expectations.

 

*Inventories*

* *

Inventoriesare valued at the lower of cost or net realizable value. Cost is determined onan average cost basis which approximates actual cost on a first-in, first-outbasis and includes raw materials, labor and manufacturing overhead. At eachbalance sheet date, the Company evaluates its ending inventories for excessquantities and obsolescence. Among other factors, the Company considershistorical demand and forecasted demand in relation to the inventory on hand,competitiveness of product offerings, market conditions and product life cycleswhen determining obsolescence and net realizable value. Provisions are made toreduce excess or obsolete inventories to their estimated net realizable values.Once established, write-downs are considered permanent adjustments to the costbasis of the excess or obsolete inventories.

 

*Propertyand Equipment*

 

Property and equipment are recorded at cost and depreciated on astraight-line basis over their estimated useful lives, which generally rangefrom three to seven years. Leasehold improvements are recorded at cost andamortized on a straight-line basis over the shorter of their estimated useful livesor the remaining lease term.

 

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*Warranties*

* *

TheCompany offers warranties generally ranging from one to three years to itscustomers, other than on sales of excess inventory, depending on the productand negotiated terms of purchase agreements. Such warranties require theCompany to repair or replace defective product returned to the Company duringthe warranty period at no cost to the customer. The Company records an estimatefor warranty-related costs at the time of sale based on, among other factors,its historical and estimated product return rates and expected repair orreplacement costs. Such costs have historically been consistent between periodsand in-line with management’s expectations.

 

*Stock-Based Compensation*

* *

TheCompany accounts for equity issuances to non-employees in accordance withEmerging Issues Task Force Issue No. 96-18, *Accountingfor Equity Instruments that are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods and Services*. All transactionsin which goods or services are the consideration received for the issuance ofequity instruments are accounted for based on the fair value of theconsideration received or the fair value of the equity instrument issued,whichever is more reliably measurable. The measurement date used to determinethe fair value of the equity instrument issued is the earlier of the date on whichthe third-party performance is complete or the date on which it is probablethat performance will occur.

 

Inaccordance with SFAS No. 123(R), *Share-Based Payment*(“SFAS 123R”),employee and director stock-based compensation expense recognized during theperiod is based on the value of the portion of stock-based payment awards thatis ultimately expected to vest during the period. Stock-based compensationexpense recognized in the accompanying unaudited condensed consolidatedstatements of operations is based on the grant date fair value estimated inaccordance with the provisions of SFAS 123R. Given that stock-basedcompensation expense recognized in the unaudited condensed consolidatedstatements of operations is based on awards ultimately expected to vest, it hasbeen reduced for estimated forfeitures. SFAS 123R requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates. The estimated averageforfeiture rates used by the Company are based on historical forfeitureexperience and estimated future forfeitures.

 

The fair value ofcommon stock option awards to employees and directors is calculated using theBlack-Scholes option pricing model. The Black-Scholes model requires subjectiveassumptions regarding future stock price volatility and expected time toexercise, along with assumptions about the risk-free interest rate and expecteddividends, which affect the estimated fair values of these awards. The expectedterm of options granted is derived from historical data on employee exercisesand post-vesting employment termination behavior. The expected volatility isbased on the historical volatilities of our common stock. The risk-free rateselected to value any particular grant is based on the US Treasury rate thatcorresponds to the expected term of the grant effective as of the date of thegrant. The expected dividends assumption is based on the Company’s history andexpectation of dividend payouts. These factors could change in the future,affecting the determination of stock-based compensation expense in futureperiods.

 

*Income Taxes*

* *

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

 

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

 

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The Companyadopted FASB Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes—An Interpretation of FASB Statement No. 109* (“FIN 48”)on December 31, 2006, the first day of its 2007 fiscal year. FIN 48seeks to reduce the diversity in practice associated with certain aspects ofmeasurement and recognition in accounting for income taxes. FIN 48prescribes a recognition threshold and measurement requirement for thefinancial statement recognition of a tax position that has been taken or isexpected to be taken on a tax return and also provides guidance on de-recognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. Under FIN 48 the Company may only recognize orcontinue to recognize tax positions that meet a “more likely than not”threshold.

 

*Researchand Development Expenses*

 

Research and development expenditures are expensed in the periodincurred.

 

*Comprehensive Income (Loss)*

 

SFAS No. 130, *ReportingComprehensive Income*, establishes standards for reporting anddisplaying comprehensive income and its components in the consolidatedfinancial statements. Accumulated other comprehensive income (loss) includesunrealized gains or losses on investments.

 

*Risks and Uncertainties*

* *

The Company’soperations in the PRC are subject to various political, geographical and economicrisks and uncertainties inherent to conducting business in China. Theseinclude, but are not limited to, (i) potential changes in economicconditions in the region, (ii) managing a local workforce that may subjectthe Company to uncertainties or certain regulatory policies and (iii) changesin other policies of the Chinese governmental and regulatory agencies.Additionally, the Chinese government controls the procedures by which its localcurrency, the Chinese Renminbi (“RMB”), is converted into other currencies. Ifchanges or restrictions in the conversion of RMB are instituted, the Company’soperations and operating results may be negatively impacted.

 

*Foreign CurrencyRemeasurement*

* *

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

 

*Net Income(Loss) Per Share*

 

Basic net income (loss) per share is calculated by dividing net income(loss) by the weighted-average number of common shares outstanding during theperiod. Diluted net income (loss) per share is calculated by dividing the netincome (loss) by the weighted-average number of shares and dilutive potentialcommon shares outstanding during the period. Dilutive potential shares consistof dilutive shares issuable upon the exercise of outstanding stock options andwarrants computed using the treasury stock method.

 

*New AccountingPronouncements*

* *

In June 2009, theFASB issued SFAS No. 168, *The FASBAccounting Standards CodificationTM and the Hierarchy of Generally AcceptedAccounting Principles — a Replacement of FASB Statement No. 162*(“SFAS No. 168”)*. *The Codification will become the source ofauthoritative U.S. GAAP.  The statementis effective for financial statements issued for interim and annual periodsending after September 15, 2009. The Company expects to adopt this standard with the filing of itsQuarterly Report on Form 10-Q for the period ended October 3,2009 and does not expect the standard to have a material impact on the Company’sconsolidated financial statements.

 

InApril 2009, the FASB issued FSP FAS 157-4, *DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transactions That Are Not Orderly*(“FSPFAS 157-4”), which provides additional guidance for estimating fair value inaccordance with SFAS 157.  FSP FAS 157-4states that a significant decrease in the volume and level of activity for theasset or liability when compared with normal market activity is an indicationthat transactions or quoted prices may not be determinative of fair valuebecause there may be increased instances of transactions that are not orderlyin such market conditions.  The adoption of FSP FAS 157-4 did nothave a material impact on the Company’s consolidated financial position,results of operations or liquidity.

 

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InApril 2009, the FASB issued FSP FAS 107-1 and APB 28-1, *Interim Disclosures about Fair Value of Financial Instruments*(“FSP FAS 107-1 and APB 28-1”), which requires disclosures about the fair valueof the Company’s financial instruments for which it is practicable to estimatethat value, whether recognized or not recognized in the balance sheets, in theinterim reporting periods as well as in the annual reporting periods. Inaddition, FSP FAS 107-1 and APB 28-1 requires disclosures of the methods andsignificant assumptions used to estimate the fair value of those financialinstruments.  FSP FAS 107-1 and APB 28-1became effective for the Company in its second quarter of fiscal 2009.  The adoption of FSP FAS 107-1 and APB 28-1 did not have a material impact on theCompany’s consolidated financial position, results of operations or liquidity.

 

InApril 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, *Recognition and Presentation of Other-Than-Temporary Impairments*(“FSP FAS 115-2 and FAS 124-2”), which establishes a new method of recognizingand reporting other-than-temporary impairments of debt securities and requiresadditional disclosures related to debt and equity securities.  FSP FAS 115-2 and FAS 124-2 does not changeexisting recognition and measurement guidance related to other-than-temporaryimpairments of equity securities. FSP FAS 115-2 and FAS 124-2 became effectivefor the Company in its second quarter of fiscal 2009.  The adoption of FSP FAS 115-2 and FAS 124-2 did not have a material impact on theCompany’s consolidated financial position, results of operations or liquidity.

 

In December 2007, the FASB issued SFAS No. 141(R),*Business Combinations* (“SFAS 141(R)”),which replaces SFAS 141. The provisions of SFAS 141(R) aresimilar to those of SFAS 141; however, SFAS 141(R) requirescompanies to record most identifiable assets, liabilities, noncontrollinginterests, and goodwill acquired in a business combination at “full fair value.”SFAS 141(R) also requires companies to record fair value estimates ofcontingent consideration and certain other potential liabilities during theoriginal purchase price allocation and to expense acquisition costs asincurred. SFAS 141(R) applies to all business combinations, includingcombinations by contract alone. Further, under SFAS 141(R), all businesscombinations will be accounted for by applying the acquisition method.SFAS 141(R) is effective for fiscal years beginning on or after December 15,2008. The Company expects SFAS 141(R) will have an impact on itsconsolidated financial statements, but the nature and magnitude of the specificeffects will depend upon the nature, terms and size of the acquisitions thatthe Company consummates.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements* (“SFAS 160”), which will requirenoncontrolling interests (previously referred to as minority interests) to betreated as a separate component of equity, not as a liability or other item outsideof permanent equity. SFAS 160 applies to the accounting for noncontrollinginterests and transactions with non-controlling interest holders inconsolidated financial statements. SFAS 160 will be applied prospectivelyto all noncontrolling interests, including any that arose before the effectivedate except that comparative period information must be recast to classifynoncontrolling interests in equity, attribute net income and othercomprehensive income to noncontrolling interests, and provide other disclosuresrequired by SFAS 160. SFAS 160 is effective for periods beginning onor after December 15, 2008. The adoption of SFAS 160 did not have amaterial impact on the Company’s consolidated financial position, results ofoperations or liquidity.

 

**Note3—Supplemental Financial Information**

** **

*Inventories*

 

Inventoriesconsist of the following (in thousands):

 
| ** **       | ** ** | **July 4,** | ** ** | **January 3,** | ** ** |
|------------------|------------|------------------|------------|---------------------|------------|
| ** **       | ** ** | **2009**         | ** ** | **2009**            | ** ** |
|             |       |             |       |                |       |
| Raw  materials   |       | $                | 1,580      |                | $          | 976 |   |
| Work  in process |       | 161              |       | 111                 |       |
| Finished  goods  |       | 213              |       | 742                 |       |
|             |       | $                | 1,954      |                | $          | 1,829 |   |

 

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*WarrantyLiability*

 

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

 
| ** **                     | ** ** | **Six Months Ended** | ** ** |
|--------------------------------|------------|----------------------|------------|
| ** **                     | ** ** | **July 4,**     | ** ** | **June 28,** | ** ** |
| ** **                     | ** ** | **2009**             | ** ** | **2008** | ** ** |
|                           |       |                 |       |   |   |
| Beginning  balance             |       | $                    | 277        |   | $ | 353 |   |
| Charged  to costs and expenses |       | 92                   |       | 8 |   |
| Usage                          |       | (108                 | )          | (70 | ) |
| Ending  balance                |       | $                    | 261        |   | $ | 291 |   |

 

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

 

*FacilityRelocation Costs*

 

The followingtable summarizes the activity related to the Company’s accrual for facilityrelocation costs during the six months ended July 4, 2009 and June 28,2008 (in thousands):

 
| ** **                     | ** ** | **Six  Months Ended** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **July 4,**      | ** ** | **June 28,** | ** ** |
| ** **                     | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                           |       |                  |       |   |   |
| Beginning  balance             |       | $                     | 80         |   | $ | 103 |   |
| Charged  to costs and expenses |       | 61                    |       | — |   |
| Net  payments                  |       | (17                   | )          | (46 | ) |
| Ending  balance                |       | $                     | 124        |   | $ | 57 |   |

 

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

 

*Comprehensive Loss*

* *

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

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                              | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                                                              | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| Net  loss                                                               |       | $                      | (3,964     | )                    | $          | (2,251 | ) | $ | (7,811 | ) | $ | (2,835 | ) |
| Other  comprehensive loss:                                              |       |                   |       |                 |       |   |   |   |   |
| Change  in net unrealized loss on investments                           |       | 6                      |       | 68                   |       | 38 |   | 23 |   |
| Reclassification  adjustment for net realized gain included in net loss |       | —                 |       | —               |       | — |   | (13 | ) |
| Total  comprehensive loss                                               |       | $                      | (3,958     | )                    | $          | (2,183 | ) | $ | (7,773 | ) | $ | (2,825 | ) |

 

Accumulated othercomprehensive loss reflected on the condensed consolidated balance sheets at July 4,2009 and January 3, 2009, represents accumulated net unrealized losses oninvestments in marketable securities.

 

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*Computationof Net Loss Per Share*

 

Basic and dilutednet loss per share is calculated by dividing net loss by the weighted-averagenumber of common shares outstanding during the period. The following table setsforth the computation of net loss per share (in thousands, except per sharedata):

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                               | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                                               | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                               | ** ** | ** **             | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:  Net loss                                     |       | $                      | (3,964     | )                    | $          | (2,251 | ) | $ | (7,811 | ) | $ | (2,835 | ) |
| Denominator:  Weighted-average common shares outstanding |       | 19,855                 |       | 19,855               |       | 19,855 |   | 19,839 |   |
| Net  loss per share, basic and diluted                   |       | $                      | (0.20      | )                    | $          | (0.11 | ) | $ | (0.39 | ) | $ | (0.14 | ) |

 

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

 
| ** **                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
|                      |       |                   |       |                 |       |   |   |   |   |
| Common  share equivalents |       | 388                    |       | 867                  |       | 277 |   | 868 |   |

 

The above commonshare equivalents would have been included in the calculation of dilutedearnings per share had the Company reported net income for the periods thenended.

 

*MajorCustomers*

 

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

 
| ** **         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------|------------|------------------------|------------|----------------------|------------|
| ** **         | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **         | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Customer:**      |       |                   | ** ** | ** **           |       |   |   |   |   |
| Dell               |       | 60                     | %          | 60                   | %          | 49 | % | 66 | % |
| Hewlett  Packard   |       | *                      | %          | 26                   | %          | * | % | 22 | % |
| Arrow  Electronics |       | 15                     | %          | *                    | %          | 17 | % | * | % |

 

----

* less than 10% of net sales

 

The Company’saccounts receivable are concentrated with two customers at July 4, 2009,representing approximately 62% and 27% of aggregate gross receivables. A significantreduction in sales to, or the inability to collect receivables from, asignificant customer could have a material adverse impact on the Company.

 

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**Note4—Fair Value Measurements**

** **

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

 
| ** **                            | ** ** | ** **        | ** ** | **Fair Value Measurements at July 4, 2009 Using** | ** ** |
|---------------------------------------|------------|-------------------|------------|--------------------------------------------------------|------------|
| ** **                            | ** ** | ** **        | ** ** | **Quoted Prices in**                                   | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                            | ** ** | **Fair Value at** | ** ** | **Active Markets for**                                 | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                            | ** ** | **July 4,**  | ** ** | **Identical Assets**                                   | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                            | ** ** | **2009**          | ** ** | **(Level 1)**                                          | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                            | ** ** | ** **        | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Investments  in marketable securities |       | $                 | 10,075     |                                                   | $          | 9,096 |   | $ | — |   | $ | 979 |   |
|                                       |            |                   |            |                                                        |            |  |  |  |  |  |  |  |  |

 

Fair valuemeasurements using Level 3 inputs in the table above relate to the Company’sinvestments in auction rate securities. Level 3 inputs are unobservable inputsused to estimate the fair value of assets or liabilities and are utilized tothe extent that observable inputs are not available.

 

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

 
| ** **                                                        | ** ** | **Six Months  Ended** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                        | ** ** | **July 4,**      | ** ** |
| ** **                                                        | ** ** | **2009**              | ** ** |
| ** **                                                        | ** ** | ** **            | ** ** |
| Beginning  balance                                                |       | $                     | 960        |   |
| Transfers  into Level 3                                           |       | —                |       |
| Unrealized  gain included in accumulated other comprehensive loss |       | 19                    |       |
| Purchases,  sales, issuances and settlements, net                 |       | —                |       |
| Ending  balance                                                   |       | $                     | 979        |   |

 

**Note 5—Investmentsin Marketable Securities**

 

Investments in marketable securities consist of the following at July 4,2009 (in thousands):

 
| ** **                                | ** ** | **July 4, 2009** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | ** **            | ** ** | **Net** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Amortized**         | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                | ** ** | **Cost**              | ** ** | **Gain (Loss)** | ** ** | **Value** | ** ** |
|                                      |       |                  |       |   |   |   |   |
| Certificates  of deposit                  |       | $                     | 245        |   | $ | — |   | $ | 245 |   |
| US  Government                            |       | 3,557                 |       | 2 |   | 3,559 |   |
| Federal  agency notes and bonds           |       | 5,289                 |       | 3 |   | 5,292 |   |
| Auction  and variable floating rate notes |       | 1,002                 |       | (23 | ) | 979 |   |
|                                      |       | $                     | 10,093     |   | $ | (18 | ) | $ | 10,075 |   |

 

Realized gains and losses on the sale of investments in marketablesecurities are determined using the specific identification method. Netrealized gains recorded during the six months ended July 4, 2009 were notsignificant.

 

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The following table provides the breakdown of investments in marketablesecurities with unrealized losses at July 4, 2009 (in thousands):

 
| ** **                               | ** ** | **July 4, 2009**          | ** ** |
|------------------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **Continuous Unrealized Loss** | ** ** |
| ** **                               | ** ** | **Less than 12 months**        | ** ** | **12 months or greater** | ** ** |
| ** **                               | ** ** | **Fair**                       | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                               | ** ** | **Value**                      | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
|                                     |       |                           |       |   |   |   |   |   |   |
| Certificates of deposit                  |       | $                              | —     |   | $ | — |   | $ | — | ** ** | **$** | **—** | ** ** |
| US Government                            |       | —                         |       | — |   | — |   | — |   |
| Federal agency notes and bonds           |       | —                         |       | — |   | — |   | — |   |
| Auction and variable floating rate notes |       | —                         |       | — |   | 1,002 |   | (23 | ) |
|                                     |       | $                              | —     |   | $ | — |   | $ | 1,002 |   | $ | (23 | ) |

 

As of July 4, 2009, the Company held two investments that were inan unrealized loss position.

 

*AuctionRate Securities*

 

The recentdisruptions in the credit market continue to adversely affect the liquidity andoverall market for auction rate securities. As of July 4, 2009, theCompany held two investments in auction rate securities with a total purchasedcost of $1.0 million. These two investments represent (i) a fully insureddebt obligation of a municipality and (ii)  Baa1 and A3 rated debtobligations backed by pools of student loans guaranteed by the U.S. Departmentof 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. The Company hasestimated the fair value of these investments using a discounted cash flowmodel which included assumptions about the credit quality and expected durationof the investments, along with discount rates affected for the general lack ofliquidity. These assumptions reflect the Company’s estimates about thereasonable assumptions market participants would likely use in valuing theinvestments, including assumptions about risk, developed based on the bestinformation available in the circumstances.

 

The Company doesnot believe that the current illiquidity of its investments in auction ratesecurities will materially impact its ability to fund its working capitalneeds, capital expenditures or other business requirements. The Company,however, remains uncertain as to when liquidity will return to the auction ratemarkets, whether other secondary markets will become available or when theunderlying securities may be called by the issuer. Given these and otheruncertainties, the Company’s investments in auction rate securities have beenclassified as long-term investments in marketable securities in theaccompanying unaudited condensed consolidated balance sheet as of July 4,2009. The Company has concluded that the estimated gross unrealized losses onthese investments, which totaled approximately $23,000 at July 4, 2009,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 high credit quality and interest ispaid as due and (iii) the Company has the intent and ability to hold theseinvestments until a recovery in the market occurs.

 

*OtherInvestments in Marketable Securities*

 

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 additionalunrealized losses in future periods.

 

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The following table presents the amortized cost and fair value of theCompany’s investments in marketable securities classified as available-for-saleat July 4, 2009 by contractual maturity (in thousands):

 
| ** **               | ** ** | **Amortized** | ** ** | **Fair**   | ** ** |
|--------------------------|------------|---------------|------------|------------|------------|
| ** **               | ** ** | **Cost**      | ** ** | **Value**  | ** ** |
| **Maturity**             | ** ** | ** **    | ** ** | ** ** | ** ** |
| Less  than one year      |       | $             | 9,091      |       | $          | 9,096 |   |
| One  to two years        |       | —        |       | —     |       |
| Greater  than two years* |       | 1,002         |       | 979        |       |
|                     |       | $             | 10,093     |       | $          | 10,075 |   |

 

----

| * | Comprised of auction  rate securities which generally have reset dates of 90 days or less but final  contractual maturity dates in excess of 15 years. |
|---|--------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**Note6—Credit Agreement**

 

Under the Company’srevolving line of credit agreement with its bank, the Company may borrow up tothe greater of 85% of eligible accounts receivable plus the least of (i) apercentage of eligible inventory determined from time to time by the Company’sbank, (ii) 80% of the orderly liquidation value, as defined, of eligibleinventories, and (iii) $1 million. Interest is payable monthly at thegreater of (i) the sum of prime rate plus 3%, (ii) LIBOR plus 6% or (iii) 8%.This line of credit expired on July 31, 2009; however, subsequent toquarter end, this line of credit agreement was extended until August 31,2009. Maximum borrowings on the line are $5,000,000.

 

In connection withits credit agreement, the Company was provided an equipment line of creditallowing it to borrow up to $3.9 million through January 3, 2009. TheCompany is required to repay the equipment advances in monthly installments of$32,440. Interest on the equipment advances is payable monthly, at the Company’soption, at the greater of (i)  prime rate plus 3%, (ii) LIBOR plus 6%or (iii) 8%.

 

The following table presents details of interestexpense related to borrowings on the line of credit, along with certain otherapplicable information (in thousands):

 
| ** **        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------|------------|------------------------|------------|----------------------|------------|
| ** **        | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **        | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
| Interest  expense |       | $                      | 9          |                 | $          | 26 |   | $ | 12 |   | $ | 86 |   |
|                   |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 
| ** **                                       | ** ** | **July 4,** | ** ** | **January 3,** | ** ** |
|--------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                       | ** ** | **2009**         | ** ** | **2009**            | ** ** |
| Outstanding  borrowings on the line of credit    |       | $                | 2,153      |                | $          | — |   |
| Borrowing  availability under the line of credit |       | $                | —     |                | $          | 1,701 |   |

 

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

 

As of July 4,2009, the Company was in compliance with its financial covenants under itscredit agreement.

 

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**Note 7—Long-TermDebt**

** **

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

 
| ** **                        | ** ** | **July 4,** | ** ** | **January 3,** | ** ** |
|-----------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                        | ** ** | **2009**         | ** ** | **2009**            | ** ** |
|                              |       |             |       |                |       |
| Obligations  under capital leases |       | $                | 109        |                | $          | 148 |   |
| Equipment  note payable to bank   |       | 255              |       | 450                 |       |
| Notes  payable to others          |       | —           |       | 6                   |       |
|                              |       | 364              |       | 604                 |       |
| Less  current portion             |       | (328             | )          | (474                | )          |
|                              |       | $                | 36         |                | $          | 130 |   |

 

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

 
| ** **        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------|------------|------------------------|------------|----------------------|------------|
| ** **        | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **        | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
|              |       |                   |       |                 |       |   |   |   |   |
| Interest  expense |       | $                      | 8          |                 | $          | 30 |   | $ | 19 |   | $ | 67 |   |
|                   |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

**Note 8—IncomeTaxes**

** **

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

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                            | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                  |       |                   |       |                 |       |   |   |   |   |
| Provision  (benefit) for income taxes |       | $                      | 31         |                 | $          | 11 |   | $ | 49 |   | $ | (1,170 | ) |
| Effective  tax rate                   |       | 1                      | %          | —               | %          | 1 | % | (29 | )% |
|                                       |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

Under APB 28, *Interim Financial Reporting*, the Company is required toadjust its effective tax rate each quarter to be consistent with the estimatedannual effective tax rate.  The Companyis also required 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, jurisdictionswith a projected loss for the year or a year-to-date loss where no tax benefitcan be recognized are excluded from the estimated annual effective taxrate.  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.

 

In accordance with SFAS No. 109,*Accounting for Income Taxes*, the Companyevaluates whether a valuation allowance should be established against itsdeferred tax assets based on the consideration of all available evidence usinga “more likely than not” standard.

 

As of July 4, 2009,the Company has provided a full valuation allowance and no benefit has beenrecognized for net operating losses and other deferred tax assets due touncertainty of future utilization.

 

The Company hadunrecognized tax benefits under FIN 48 at fiscal year end January 3, 2009of approximately $0.6 million.  TheCompany anticipates a reduction of approximately $0.5 million of unrecognizedtax benefits as a result of a lapse in applicable federal and state statutes oflimitations during the current fiscal year.

 

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**Note 9—Commitments and Contingencies**

** **

*FederalSecurities 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 on November 5, 2007. Defendantsfiled their motions to dismiss the Consolidated Complaint on January 9,2008. The motions to dismiss were taken under submission on April 28, 2008and on May 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 (the “AmendedComplaint”) on July 15, 2008. Generally, the Amended Complaint allegedthat the Registration Statement issued by the Company in connection with theIPO contained untrue statements of material fact or omissions of material factin violation of Sections 11 and 15 of Securities Act of 1933. Thedefendants filed motions to dismiss the Amended Complaint on January 9,2009, and on April 17, 2009, the Court granted defendants’ motions todismiss.  However, plaintiffs were againgranted the right to amend their complaint. Plaintiffs’ filed a second amended complaint on or about May 21,2009.  Defendants filed motions todismiss the second amended complaint on June 22, 2009, and oral argumentson the motions to dismiss are scheduled for August 31, 2009. The Companybelieves that the allegations lack merit and intends to vigorously defend allclaims asserted. However, at this time, the Company is unable to form aprofessional judgment that an unfavorable outcome is either probable or remote,and it is not possible to assess whether or not the outcome of theseproceedings will or will not have a material adverse effect on the Company. Ifan unfavorable outcome should eventually occur, the Company is not at this timeable to estimate the amount or range of possible loss.

 

*CaliforniaDerivative Action*

 

In August 2007, a derivative lawsuit was filed inCalifornia Superior Court for County of Orange-Smith v. Hong, Case No. 07CC01359-againstcertain of the Company’s officers and directors. This action contains factualallegations similar to those of the federal class action lawsuit describedabove, but the plaintiff in this case asserts claims for violations ofCalifornia’s insider trading laws, breaches of fiduciary duty, abuse ofcontrol, gross mismanagement, waste of corporate assets, and unjust enrichment.The plaintiff seeks unspecified damages, equitable and/or injunctive relief anddisgorgement of all profits, benefits and other compensation obtained by thedefendants. The defendants in this action have not responded to the complaint.Pursuant to a stipulation, the parties agreed to temporarily stay the actionpending the ultimate decision on the defendants’ motions to dismiss in thefederal securities class action.  In April 2009,following a voluntary mediation of the matter which took place in December 2008,the parties reached a tentative agreement to settle the derivative action. In June 2009,the parties executed a Stipulation and Agreement of Settlement of DerivativeClaims documenting the essential terms of the proposed settlement, and on June 26,2009, the parties filed their joint motion for preliminary approval of theproposed settlement with the Court. The Court granted preliminary approval ofthe proposed settlement on July 27, 2009. The final hearing on the proposed settlement is set for November 5,2009. The Company makes no assurances at this time that the Court will grantfinal approval of the proposed settlement terms or that the matter ultimatelywill be settled.  Despite the pendingsettlement reached in this derivative action, the Company believes that theallegations lack merit.  In addition, theCompany received correspondence from counsel for a purported shareholderrequesting that the Company take actions to investigate and remedy allegedwrongdoing by unidentified former and current officers and/or directors basedon allegations similar to those in the Smith v. Hong derivative case. TheCompany, through its Board of Directors, has evaluated and rejected thisrequest.  The proposed settlement also isintended to resolve any remaining issues arising from this shareholder request.  Despite the pending settlement reached, theCompany believes that the allegations raised in the shareholder request alsolack merit.

 

*PatentClaims*

 

In May 2008, the Company initiated discussions with Google, Inc.regarding the Company’s claims that Google has infringed on a US Patentassigned to the Company relating generally to “rank multiplication” in memorymodules. On August 29, 2008, Google filed a declaratory judgment lawsuitagainst the Company in United States District Court for the Northern Districtof California, seeking a declaration that Google did not infringe on theCompany’s patent, and that the Company’s patent is invalid. Google is notseeking any monetary damages. On November 18, 2008, the Company filed acounterclaim for infringement of the patent by Google. The Company expects tovigorously pursue its claim against Google and to vigorously defend againstGoogle’s claim of invalidity.

 

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On March 17, 2009, the Company filed a complaint for patentinfringement against MetaRAM, Inc. for its infringement of one of theCompany’s patents. On March 26, 2009, MetaRAM filed a complaint againstthe Company for patent infringement. The parties are currently discussing anamicable settlement of these claims.  Ifthese discussions are unsuccessful, the Company expects to vigorously pursueits claim against MetaRAM and to vigorously defend against MetaRAM’s separateclaim.

 

*TradeSecret Claim*

 

OnNovember 18, 2008, the Company filed a claim for trade secretmisappropriation against Texas Instruments (TI) in Santa Clara County SuperiorCourt, based in TI’s disclosure of confidential Company materials to the JEDECstandard-setting body.  On February 20,2009, TI filed its answer.  The partiesare currently engaged in settlement discussions.  If those discussions are unsuccessful, theCompany expects to vigorously pursue its claims against TI.

 

*OtherContingent 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) intellectualproperty indemnities to the Company’s customers and licensees in connectionwith the use, sales and/or license of Company products; (ii) indemnitiesto vendors and service providers pertaining to claims based on the Company’snegligence or willful misconduct; (iii) indemnities involving the accuracyof representations and warranties in certain contracts; (iv) indemnitiesto directors and officers of the Company to the maximum extent permitted underthe laws of the State of Delaware; and (v) certain real estate leases,under which the Company may be required to indemnify property owners forenvironmental and other liabilities, and other claims arising from the Company’suse of the applicable premises. The duration of these indemnities, commitmentsand guarantees varies and, in certain cases, may be indefinite. The majority ofthese indemnities, commitments and guarantees do not provide for any limitationof the maximum potential for future payments the Company could be obligated tomake. Historically, the Company has not been obligated to make significantpayments for these obligations, and no liabilities have been recorded for theseindemnities, commitments and guarantees in the accompanying consolidatedbalance sheets.

 

**Note 10—Stock Options and Warrants**

** **

*CommonStock Options*

* *

A summary of the Company’scommon stock option activity as of and for the six months ended July 4,2009 is presented below (shares in thousands):

 
| ** **                                   | ** ** | ** **    | ** ** | **Weighted-** | ** ** |
|----------------------------------------------|------------|---------------|------------|---------------|------------|
| ** **                                   | ** ** | ** **    | ** ** | **Average**   | ** ** |
| ** **                                   | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                   | ** ** | **Shares**    | ** ** | **Price**     | ** ** |
| Options  outstanding at January 3, 2009 |       | 4,281         |       | $             | 2.64       |   |
| Options  granted                             |       | 630           |       | 0.33          |       |
| Options  exercised                           |       | —        |       | —        |       |
| Options  cancelled                           |       | (382          | )          | 1.98          |       |
| Options  outstanding at July 4, 2009    |       | 4,529         |       | $             | 2.37       |   |

 

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

* *
| ** **                                        | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **July 4,**     | ** ** | **June 28,** | ** ** |
| ** **                                        | ** ** | **2009**             | ** ** | **2008** | ** ** |
| Expected  term (in years)                         |       | 5.4                  |       | 5.4 |   |
| Expected  volatility                              |       | 111                  | %          | 80 | % |
| Risk-free  interest rate                          |       | 2.96                 | %          | 3.10 | % |
| Expected  dividends                               |       | —               |       | — |   |
| Weighted-average  grant date fair value per share |       | $                    | 0.27       |   | $ | 1.11 |   |
|                                                   |            |                      |            |  |  |  |  |

* *

*At July 4,2009, the amount of unearned stock-based compensation currently estimated to beexpensed from fiscal 2009 through fiscal 2012 related to unvested common stockoptions is approximately $1.9 million, net of estimated forfeitures. Theweighted-average period over which the unearned stock-based compensation isexpected to be recognized is approximately 1.7 years. If there are anymodifications or cancellations of the underlying unvested common stock options,the Company may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense. Future stock-based compensationexpense and unearned stock-based compensation will increase to the extent thatthe Company grants additional common stock options or other stock-based awards.*

* *

*Warrants*

* *

A summary of activitywith respect to outstanding warrants to purchase shares of the Company’s commonstock as of and for the six months ended July 4, 2009 is presented below(shares in thousands):

 
| ** **                                                 | ** ** | ** **    | ** ** | **Weighted-** | ** ** |
|------------------------------------------------------------|------------|---------------|------------|---------------|------------|
| ** **                                                 | ** ** | ** **    | ** ** | **Average**   | ** ** |
| ** **                                                 | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                                 | ** ** | **Shares**    | ** ** | **Price**     | ** ** |
| Warrants  outstanding at January 3, 2009              |       | 18            |       | $             | 1.25       |   |
| Warrants  granted                                          |       | —        |       | —        |       |
| Warrants  exercised                                        |       | —        |       | —        |       |
| Warrants  cancelled                                        |       | —        |       | —        |       |
| Warrants  outstanding and exercisable at July 4, 2009 |       | 18            |       | $             | 1.25       |   |

 

**Note 11—Segment and Geographic Information**

** **

The Company operates inone reportable segment: the design and manufacture of high-performance memorysubsystems for the server, high-performance computing and communicationsmarkets. The Company evaluates financial performance on a Company-wide basis.

 

At July 4, 2009,approximately $3.5 million of the Company’s net long-lived assets were locatedoutside the U.S., primarily in the PRC.

 

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

** **

**Cautionary Statement**

** **

*Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with our Unaudited CondensedConsolidated Financial Statements and the related notes thereto contained in Part I,Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Qis not a complete description of our business or the risks associated with aninvestment in our common stock. We urge you to carefully review and considerthe various disclosures made by us in this Report and in our other reportsfiled with the Securities and Exchange Commission, or SEC, including our AnnualReport on Form 10-K for the fiscal year ended January 3, 2009 andsubsequent reports on Form 10-Q and Form 8-K, which discuss ourbusiness in greater detail.*

 

*Thesection entitled “Risk Factors” set forth in Part II, Item 1A of thisReport, and similar discussions in our other SEC filings, describe some of theimportant risk factors that may affect our business, results of operations andfinancial condition. You should carefully consider those risks, in addition tothe other information in this Report and in our other filings with the SEC,before deciding to purchase, hold or sell our common stock.*

 

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*ThisReport contains forward-looking statements that involve risks, uncertainties,estimates and assumptions. These statements are not guarantees of futureperformance and are subject to certain risks, uncertainties and assumptionsthat are difficult to predict. Therefore, our actual results could differmaterially and adversely from those expressed in any forward-looking statementsas a result of various factors, including but not limited to those identified underthe heading “Risk Factors” set forth in Part II, Item 1A of thisReport.  We undertake no obligation torevise or update publicly any forward-looking statements for any reason.*

 

**Overview**

** **

We design, manufacture and sell high performancememory subsystems for the server, high performance computing and communicationsmarkets. Our memory subsystems consist of dynamic random access memoryintegrated circuits, (DRAM ICs”) , NAND flash memory, (“NAND”), and othercomponents assembled on a printed circuit board, (“PCB”). We also design customsemiconductor logic devices which are integrated into our memory subsystems inorder to increase their performance. We engage with our original equipmentmanufacturer, (“OEM”), customers from the earliest stages of new productdefinition, which provides us unique insight into their full range of systemarchitecture and performance requirements. This close collaboration has alsoallowed us to develop a significant level of systems expertise. We leverage aportfolio of proprietary technologies and design techniques, includingefficient planar design, alternative packaging techniques and customsemiconductor logic, to deliver memory subsystems with high memory density,small form factor, high signal integrity, attractive thermal characteristicsand low cost per bit.

 

Consistent with theconcentrated nature of the OEM customer base in our target markets, a smallnumber of large customers have historically accounted for a significant portionof our net sales. Dell and Arrow Electronics represented approximately 49% and17%, respectively, of our net sales for the six months ended July 4, 2009.Dell and Hewlett Packard represented approximately 66% and 22%, respectively,of our net sales for the six months ended June 28, 2008. Net sales to someof our OEM customers include memory modules that are qualified by us directlywith the OEM customer and sold to electronic manufacturing services providers,(“EMSs”), for incorporation into products manufactured exclusively for the OEMcustomer. These net sales to EMSs have historically fluctuated period by periodas a portion of the total net sales to these OEM customers. Net sales to HonHai Precision Industry Co. Ltd., an EMS that purchases memory modules from usfor incorporation into products manufactured exclusively for Dell, representedapproximately 58% of net sales to Dell for the six months ended July 4,2009 and approximately 18% of net sales to Dell for the six months ended June 28,2008.

 

**Key Business Metrics**

** **

The following describes certainline items in our consolidated statements of operations that are important tomanagement’s assessment of our financial performance:

 

*Net Sales.*  Net sales consist primarily of sales of ourhigh performance memory subsystems, net of a provision for estimated returnsunder our right of return policies, which generally range up to 30 days.We generally do not have long-term sales agreements with our customers.Although OEM customers typically provide us with non-binding forecasts offuture product demand over specific periods of time, they generally placeorders with us approximately two weeks in advance of scheduled delivery.Selling prices are typically negotiated monthly, based on competitive marketconditions and the current price of DRAM ICs and NAND. Purchase ordersgenerally have no cancellation or rescheduling penalty provisions. We oftenship our products to our customers’ international manufacturing sites. All ofour sales to date, however, are denominated in US dollars. We also sell excesscomponent inventory of DRAM ICs and NAND to distributors and other users ofmemory ICs. As compared to previous years, component inventory sales havesignificantly decreased as a percentage of net sales as a result of our effortsto diversify both our customer and product line bases. This diversificationeffort has also allowed us to use components in a wider range of memorysubsystems. We expect that component inventory sales will continue to representa minimal portion of our net sales in future periods.

 

*Cost of Sales.*  Our cost of sales includes the cost ofmaterials, manufacturing costs, depreciation and amortization of equipment,inventory valuation provisions, stock-based compensation and occupancy costsand other allocated fixed costs. The DRAM ICs and NAND incorporated into ourproducts constitute a significant portion of our cost of sales, and thus ourcost of sales will fluctuate based on the current price of DRAM ICs and NAND.We attempt to pass through such DRAM IC and NAND cost fluctuations to our customersby frequently renegotiating pricing prior to the placement of their purchaseorders. To the extent we are successful, a large majority of our product costis variable, and thus our cost of sales and gross margin percentages may not besignificantly impacted by changes in sales volume. However, the sales prices ofour memory subsystems can also fluctuate due to competitive situationsunrelated to the pricing of DRAM ICs and NAND, which affects gross margins. Thegross margin on our sales of excess component DRAM IC and NAND inventory ismuch lower than the gross margin on our sales of our memory subsystems. As aresult, a decrease in DRAM IC and NAND inventory sales as a percentage of ouroverall sales could result in an improved overall gross margin. We assess thevaluation of our inventories on a monthly basis and record a provision to costof sales as necessary to reduce inventories to the lower of cost or netrealizable value.

 

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

 

*Selling, General 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, and occupancyand other allocated overhead costs. A significant portion of our sellingefforts 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 productsmanufactured for qualification is included in selling expenses. As we continueto service existing and establish new customers, we anticipate that our salesand marketing expenses will increase. Since the beginning of fiscal 2009, wehave been subject to attestation services requirements with respect to ourinternal control over financial reporting, the result of which will increaseour legal and accounting expenses in future periods.

 

*Provision (Benefit) forIncome Taxes.*  Under Accounting Principles Board Opinion No. 28,*Interim Financial Reporting*, we arerequired to adjust our effective tax rate each quarter to be consistent withthe estimated annual effective tax rate. We are also  required to recordthe tax impact of certain discrete items, unusual or infrequently occurring,including changes in judgment about valuation allowances and effects of changesin tax laws 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.

 

In accordance withStatements of Financial Accounting Standards No. 109, *Accountingfor Income Taxes*, we evaluate whether a valuation allowance shouldbe established against its deferred tax assets based on the consideration ofall available evidence using a “more likely than not” standard.

 

As of July 4, 2009,we have provided a full valuation allowance and no benefit has been recognizedfor net operating losses and other deferred tax assets due to uncertainty offuture utilization.

 

**Critical AccountingPolicies**

** **

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the U.S. requires us to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosures of contingentassets and liabilities at the date of the consolidated financial statements andthe reported amounts of net sales and expenses during the reporting period. Bytheir nature, these estimates and assumptions are subject to an inherent degreeof uncertainty. We base our estimates on our historical experience, knowledgeof current 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 the more significantassumptions and estimates used in the preparation of our consolidated financialstatements:

 

*Revenue Recognition.* We recognize revenues in accordance withthe SEC’s Staff Accounting Bulletin No. 104, *RevenueRecognition*, or SAB 104. Under the provisions of SAB 104,we recognize revenues when there is persuasive evidence that an arrangement,product delivery and acceptance have occurred, the sales price is fixed ordeterminable, and collectibility of the resulting receivable is reasonablyassured.

 

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

 

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

 

We assesscollectibility based on the creditworthiness of the customer as determined bycredit checks and evaluations, as well as the customer’s payment history. Aportion of our shipments are made to third party inventory warehouses, or hubs,and we recognize revenue when the inventory is pulled from the hub for use inproduction by the customer. We receive a report from the customer on a dailybasis indicating the inventories pulled from a hub for use by the customer, andperform a daily reconciliation of inventories shipped to and pulled by thecustomer to those inventories reflected on the customer’s reports to ensurethat sales are recognized in the appropriate periods. We have historically hadgood visibility into the inventories on-hand at hub locations and also what ourcustomers intend to pull within each reporting period. However, if a customerdoes not pull our inventory from its hub in accordance with the schedule itoriginally provided to us, our predicted future revenues could vary from ourforecasts and our results of operations could be materially and adverselyaffected. Additionally, since we own inventories that are physically located inhubs, our ability to effectively manage inventory levels may be impaired,causing our inventory turns to decrease, which would increase expensesassociated with excess and obsolete inventories and negatively impact our cashflow.

 

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

 

*Warranty Reserve.* We offer warranties on our memorysubsystems generally ranging from one to three years, depending on the productand negotiated terms of purchase agreements with our customers. Such warrantiesrequire us to repair or replace defective product returned to us during thewarranty period at no cost to the customer. Our estimates for warranty-relatedcosts are recorded at the time of sale based on historical and estimated futureproduct return rates and expected repair or replacement costs. While such costshave historically been 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.

 

*Accounts Receivable.* 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. Wecontinuously monitor collections and payments from our customers and maintain aprovision for estimated credit losses based upon our historical experience andany specific customer collection issues that we have identified. Generally,these credit losses have been within our expectations and the provisionsestablished. However, we cannot guarantee that we will continue to experiencecredit loss rates similar to those we have experienced in the past.

 

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

 

*Inventories.* We value our inventories at the lower ofthe actual cost to purchase or manufacture the inventory or the net realizablevalue of the inventory. Cost is determined on an average cost basis whichapproximates actual cost on a first-in, first-out basis and includes rawmaterials, labor and manufacturing overhead. We regularly review inventoryquantities on hand and on order and record a provision for excess and obsoleteinventories based primarily on our estimated forecast of product demand andproduction requirements for the next three to six months. In addition, weconsider changes in the market value of DRAM ICs and NAND in determining thenet realizable value of our raw material inventory. Once established, any writedowns are considered permanent adjustments to the cost basis of ourinventories. A significant decrease in demand for our products could result inan increase in the amount of excess inventory quantities on hand. In addition,our estimates of future product demand may prove to be inaccurate, in whichcase we may have understated or overstated the provision required for excessand obsolete inventory. In the future, if our inventories are determined to beovervalued, we would be required to recognize additional expense in our cost ofsales at the time of such determination. Likewise, if our inventories aredetermined to be undervalued, we may have over-reported our costs of sales inprevious periods and would be required to recognize additional gross profit atthe time such inventories are sold. In addition, should the market value ofDRAM ICs and NAND decrease significantly, we may be required to lower ourselling prices to reflect the lower cost of our raw materials. If such pricedecreases reduce the net realizable value of our inventories to less than ourcost, we would be required to recognize additional expense in our cost of salesin the same period. Although we make every reasonable effort to ensure theaccuracy of our forecasts of future product demand, any significantunanticipated changes in demand, technological developments or the market valueof DRAM ICs and NAND could have a material effect on the value of ourinventories and our reported operating results.

 

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*Long-Lived Assets.***We review the recoverability of thecarrying value of long-lived assets on an annual basis or whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. Recoverability of these assets is determined based upon theforecasted undiscounted future net cash flows from the operations to which theassets relate, utilizing our best estimates, appropriate assumptions andprojections at the time. These projected future cash flows may varysignificantly over time as a result of increased competition, changes intechnology, fluctuations in demand, consolidation of our customers andreductions in average selling prices. If the carrying value is determined notto be recoverable from future operating cash flows, the asset is deemedimpaired and an impairment loss is recognized to the extent the carrying valueexceeds the estimated fair market value of the asset.

 

*Stock-Based Compensation.* We account for equity issuances tonon-employees in accordance with Emerging Issues Task Force Issue No. 96-18,*Accounting for Equity Instruments that areIssued to Other Than Employees for Acquiring, or in Conjunction with Selling,Goods and Services*. All transactions in which goods or services arethe consideration received for the issuance of equity instruments are accountedfor based on the fair value of the consideration received or the fair value ofthe equity instrument issued, whichever is more reliably measurable. Themeasurement date used to determine the fair value of the equity instrumentissued is the earlier of the date on which the third-party performance iscomplete or the date on which it is probable that performance will occur.

 

On January 1,2006, we adopted Statements of Financial Accounting Standards, or SFAS, No. 123R,*Share-Based Payment*, (“SFAS 123R”),which requires the measurement and recognition of compensation expense for allstock-based payment awards made to our employees and directors based onestimated fair values.

 

We currently usethe Black-Scholes option pricing model to estimate the fair value of our commonstock option awards. While this model meets the requirements of SFAS 123R,the estimated fair values generated by it may not be indicative of the actualfair values of these awards as it does not consider certain factors importantto those awards to employees, such as continued employment and periodic vestingrequirements as well as limited transferability. The Black-Scholes modelrequires subjective assumptions regarding future stock price volatility andexpected time to exercise, along with assumptions about the risk-free interestrate and expected dividends, all of which affect the estimated fair values ofour common stock option awards. The expected term of options granted is derivedfrom historical data on employee exercises and post-vesting employmenttermination behavior. The expected volatility is based on the historicalvolatilities of the common stock of comparable publicly traded companies basedon our belief that we currently have limited historical data regarding thevolatility of our stock price on which to base a meaningful estimate ofexpected volatility. The risk-free rate selected to value any particular grantis based on the US Treasury rate that corresponds to the expected term of thegrant effective as of the date of the grant. The expected dividends assumptionis based on our history and expectation of dividend payouts. We evaluate theassumptions used to value our common stock option awards on a quarterly basis.If factors change and we employ different assumptions, stock-based compensationexpense may differ significantly from what we have recorded in prior periods.

 

The value of theportion of stock-based awards that are ultimately expected to vest isrecognized as expense over the requisite service periods in our consolidatedfinancial statements. Given that stock-based compensation expense recognized inour consolidated financial statements is based on awards ultimately expected tovest, it has been reduced for estimated forfeitures.SFAS 123R requires forfeitures to be estimated at the time of grantand revised, if necessary, in subsequent periods if actual forfeitures differfrom those estimates. If there are any modifications or cancellations of theunderlying unvested stock-based awards, we may be required to accelerate,increase or cancel any remaining unearned stock-based compensation expense.Future stock-based compensation expense and unearned stock-based compensationwill increase to the extent that we grant additional common stock options orother stock-based awards.

 

*IncomeTaxes.***Under Accounting Principles Board Opinion No. 28,*Interim Financial Reporting*, 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 our estimated annualeffective tax rate. The impact of excluding these items could result in ahigher or lower effective tax rate during a particular quarter, based upon themix and timing of actual earnings versus annual projections.

 

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We recognizedeferred tax assets and liabilities based on the differences between thefinancial statement carrying values and the tax bases of assets andliabilities. We regularly review our deferred tax assets for recoverability andestablish a valuation allowance, when determined necessary, based on historicaltaxable income, projected future taxable income, and the expected timing of thereversals of existing temporary differences. If we operate at a loss for anextended period of time or are unable to generate sufficient future taxableincome, or if there is a material change in the actual effective tax rates ortime period within which the underlying temporary differences become taxable ordeductible, we could be required to record a valuation allowance against all ora significant portion of our deferred tax assets which could substantiallyincrease our effective tax rate for such period. Any significant changes instatutory tax rates or the amount of our valuation allowance could have amaterial effect on the value of our deferred tax assets and liabilities, andour reported financial results. In the future, if we realize a deferred taxasset that currently carries a valuation allowance, we may record a reductionto income tax expense in the period of such realization.

 

We adoptedFinancial Accounting Standards Board, or FASB, Interpretation No. 48, *Accounting for Uncertainty in Income Taxes—An Interpretation of FASBStatement No. 109*, or FIN 48, on December 31, 2006, thefirst day of fiscal 2007. FIN 48 seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. FIN 48 prescribes a recognition threshold and measurementrequirement for the financial statement recognition of a tax position that hasbeen taken or is expected to be taken on a tax return and also providesguidance on de-recognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition. Under FIN 48 we may onlyrecognize or continue to recognize tax positions that meet a “more likely thannot” threshold.

 

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

 

**Results ofOperations**

** **

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

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **July 4,**       | ** ** | **June 28,**    | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                                        | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                              |       |                   |       |                 |       |   |   |   |   |
| Net  sales                                        |       | 100                    | %          | 100                  | %          | 100 | % | 100 | % |
| Cost  of sales                                    |       | 92                     |       | 86                   |       | 105 |   | 82 |   |
| Gross  profit (loss)                              |       | 8                      |       | 14                   |       | (5 | ) | 18 |   |
| Operating  expenses:                              |       |                   |       |                 |       |   |   |   |   |
| Research  and development                         |       | 64                     |       | 9                    |       | 68 |   | 10 |   |
| Selling,  general and administrative              |       | 67                     |       | 18                   |       | 76 |   | 21 |   |
| Total  operating expenses                         |       | 131                    |       | 27                   |       | 144 |   | 32 |   |
| Operating  loss                                   |       | (123                   | )          | (13                  | )          | (149 | ) | (14 | ) |
| Other  income:                                    |       |                   |       |                 |       |   |   |   |   |
| Interest  income, net                             |       | 1                      |       | 1                    |       | 2 |   | 1 |   |
| Other  income (expense), net                      |       | (2                     | )          | —               |       | 2 |   | — |   |
| Total  other income (expense), net                |       | (1                     | )          | 1                    |       | 4 |   | 1 |   |
|                                              |       |                   |       |                 |       |   |   |   |   |
| Loss  before provision (benefit) for income taxes |       | (124                   | )          | (12                  | )          | (145 | ) | (13 | ) |
| Provision  (benefit) for income taxes             |       | 1                      |       | —               |       | 1 |   | (4 | ) |
| Net  loss                                         |       | (125                   | )%         | (12                  | )%         | (146 | )% | (9 | )% |

 

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***Three and Six MonthsEnded July 4, 2009 Compared to Three and Six Months Ended June 28,2008***

*** ***

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

 

*The following table presents net sales, cost of sales andgross profit for the three and six months ended July 4, 2009 and June 28,2008 (in thousands, except percentages):*

 
| ** **     | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **     | ** ** |
|----------------|------------|------------------------|------------|-------------------|------------|----------------|------------|
| ** **     | ** ** | **July 4,**       | ** ** | **June 28,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **     | ** ** | **2009**               | ** ** | **2008**          | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
|           |       |                   |       |              |       |           |       |   |   |
| Net  sales     |       | $                      | 3,173      |              | $          | 18,429         |       | $ | (15,256 | ) | (83 | )% |
| Cost  of sales |       | 2,929                  |       | 15,770            |       | (12,841        | )          | (81 | )% |
| Gross  profit  |       | $                      | 244        |              | $          | 2,659          |       | $ | (2,415 | ) | (91 | )% |
| Gross  margin  |       | 8                      | %          | 14                | %          | (7             | )%         |   |   |

 
|                 | ** ** | **Six  Months Ended** | ** ** | ** **        | ** ** | ** **     | ** ** |
|----------------------|------------|-----------------------|------------|-------------------|------------|----------------|------------|
|                 | ** ** | **July 4,**      | ** ** | **June 28,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
|                 | ** ** | **2009**              | ** ** | **2008**          | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
|                 |       |                  |       |              |       |           |       |   |   |
| Net  sales           |       | $                     | 5,335      |              | $          | 31,533         |       | $ | (26,198 | ) | (83 | )% |
| Cost  of sales       |       | 5,628                 |       | 25,743            |       | (20,115        | )          | (78 | )% |
| Gross  profit (loss) |       | $                     | (293       | )                 | $          | 5,790          |       | $ | (6,083 | ) | (105 | )% |
| Gross  margin        |       | (5                    | )%         | 18                | %          | (24            | )%         |   |   |

 

*Net Sales.*** The overall decrease in our net sales wasprimarily driven by a sharp reduction in demand from our current customer base,mainly due to the commodization of current product offerings in the past year.  We continue to transition to a new businessstrategy focused on the development of high-margin subsystems based on customlogic devices.

 

The decrease in net salesfor the three months ended July 4, 2009 as compared to the three monthsended June 28, 2008 resulted primarily from decreases of approximately (i) $4.2million in sales of laptop personal computer memory subsystems, and (ii) $11.2million in sales of our high density server modules.

 

The decrease in net salesfor the six months ended July 4, 2009 as compared to the six months ended June 28,2008 resulted primarily from decreases of approximately (i) $17.3 millionin net sales of certain high density memory modules for the server market andrelated applications, (ii) $3.2 million in net sales of memory subsystemsused to control RAIDs and (iii) $6.1 million in net sales of laptoppersonal computer memory subsystems.

 

Sales of our componentinventory to distributors and other users of memory ICs representedapproximately 2% and 1% of net sales for the three months ended July 4,2009 and June 28, 2008, respectively, and approximately 2% and 1% of netsales for the six months ended July 4, 2009 and June 28, 2008,respectively. As compared to previous years, component inventory sales havesignificantly decreased as a percentage of net sales as a result of our effortsto diversify our customer base, which has resulted in our ability to usecomponents in a wider range of memory subsystems.

 

*Gross (Loss) Profit andGross Margin.*** Gross (loss)profit for the three and six months ended July 4, 2009 as compared to thethree and six months ended June 28, 2008 decreased primarily due to the83% decrease in net sales between the two periods. The decrease in gross marginfor the three months ended July 4, 2009 as compared to the three monthsended June 28, 2008 is mainly due to the inability to absorb manufacturingcosts caused by the significant drop in units manufactured and sold during themost recent quarter.  These decreaseswere partially offset by a shift in product mix toward higher margincontributing products.  The decrease ingross margin for the six months ended July 4, 2009 as compared to the sixmonths ended June 28, 2008 of 24% is mostly due to unused capacity in ourmanufacturing facility, partially offset by an increase in product margin of11% due to the change in product mix and customer base during the period.

 

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***Researchand Development****.*

 

The following tablepresents research and development expenses for the three and six months ended July 4,2009 and June 28, 2008 (in thousands, except percentages):

 
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **   | ** ** |
|---------------------------|------------|------------------------|------------|-------------------|------------|--------------|------------|
| ** **                | ** ** | **July 4,**       | ** ** | **June 28,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                | ** ** | **2009**               | ** ** | **2008**          | ** ** | **Increase** | ** ** | **Change** | ** ** |
|                      |       |                   |       |              |       |         |       |   |   |
| Research  and development |       | $                      | 2,030      |              | $          | 1,716        |       | $ | 314 |   | 18 | % |
|                           |            |                        |            |                   |            |              |            |  |  |  |  |  |

 
|                      | ** ** | **Six  Months Ended** |       |              |       |         |       |
|---------------------------|------------|-----------------------|------------|-------------------|------------|--------------|------------|
|                      | ** ** | **July 4,**      | ** ** | **June 28,** |       |         |       | % |   |
|                      | ** ** | **2009**              | ** ** | **2008**          | ** ** | **Increase** | ** ** | **Change** | ** ** |
|                      |       |                  |       |              |       |         |       |   |   |
| Research  and development |       | $                     | 3,644      |              | $          | 3,292        |       | $ | 352 |   | 11 | % |
|                           |            |                       |            |                   |            |              |            |  |  |  |  |  |

 

The increase in researchand development expense in the three months ended July 4, 2009 as comparedto the three months ended June 28, 2008 resulted primarily from increasesof (i) $0.6 million in personnel-related expenses as a result of anincrease in the number of outside contractors engaged in research anddevelopment activities during the second quarter of 2009 and (ii) $0.1million in legal and professional fees as we continue to increase activitiesrelated to new and emerging markets in 2009. The above increases were offset bya decrease of approximately $0.5 million in expenses related to productqualification builds and testing.

 

The increase in researchand development expense in the six months ended July 4, 2009 as comparedto the six months ended June 28, 2008 resulted primarily from increases ofapproximately (i) $0.9 million in personnel-related expenses as a resultof an increase in the number of outside contractors engaged in research anddevelopment activities and (ii) $0.3 million in legal and professionalfees as we continue to increase activities related to new and emerging markets.The above increases were offset by a decrease of approximately $0.9 million inexpenses related to product qualification builds and testing.

 

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

 

The following tablepresents selling, general and administrative expenses for the three and sixmonths ended July 4, 2009 and June 28, 2008 (in thousands, exceptpercentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **   | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------------|------------|--------------|------------|
| ** **                           | ** ** | **July 4,**       | ** ** | **June 28,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2009**               | ** ** | **2008**          | ** ** | **Decrease** | ** ** | **Change** | ** ** |
|                                 |       |                   |       |              |       |         |       |   |   |
| Selling,  general and administrative |       | $                      | 2,120      |              | $          | 3,310        |       | $ | (1,190 | ) | (36 | )% |
|                                      |            |                        |            |                   |            |              |            |  |  |  |  |  |

 
|                                 | ** ** | **Six  Months Ended** |       |              |       |         |       |
|--------------------------------------|------------|-----------------------|------------|-------------------|------------|--------------|------------|
|                                 | ** ** | **July 4,**      | ** ** | **June 28,** |       |         |       | % |   |
|                                 | ** ** | **2009**              | ** ** | **2008**          | ** ** | **Decrease** | ** ** | **Change** | ** ** |
|                                 |       |                  |       |              |       |         |       |   |   |
| Selling,  general and administrative |       | $                     | 4,055      |              | $          | 6,778        |       | $ | (2,723 | ) | (40 | )% |
|                                      |            |                       |            |                   |            |              |            |  |  |  |  |  |

 

The decrease in selling,general and administrative expense for the three months ended July 4, 2009as compared to the three months ended June 28, 2008 resulted primarilyfrom decreases of (i) $0.8 million in personnel-related expenses primarilyattributable to a decrease in the number of employees and outside contractorsengaged in selling, general and administrative functions of approximately 51%during the 2009 quarter as compared to the 2008 quarter , (ii) $0.1million in commission expenses due to a decline in sales revenue during themost recent quarter, (iii) $0.2 million in product qualification expenseand related travel costs as a result of a decrease in the number of salespersonnel during the most recent quarter.

 

The decrease in selling,general and administrative expense in the six months ended July 4, 2009 ascompared to the six months ended June 28, 2008 resulted primarily from decreasesof approximately (i) $1.7 million in personnel-related expenses, (ii) $0.3million in legal and professional fees, (iii) $0.2 million in commissionand travel-related expenses and (iv) $0.5 million in productqualification, evaluation and advertising.

 

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

 

The following table presents other income (expense) for the three andsix months ended July 4, 2009 and June 28, 2008 (in thousands, exceptpercentages):

 
| ** **                         | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **     | ** ** |
|------------------------------------|------------|------------------------|------------|-------------------|------------|----------------|------------|
| ** **                         | ** ** | **July 4,**       | ** ** | **June 28,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **                         | ** ** | **2009**               | ** ** | **2008**          | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
|                               |       |                   |       |              |       |           |       |   |   |
| Interest  income, net              |       | $                      | 18         |              | $          | 104            |       | $ | (86 | ) | (83 | )% |
| Other  income (expense), net       |       | (45                    | )          | 23                |       | (68            | )          | (296 | )% |
| Total  other income (expense), net |       | $                      | (27        | )                 | $          | 127            |       | $ | (154 | ) | (121 | )% |

 
|                               | ** ** | **Six  Months Ended** |       |              |       |           |       |
|------------------------------------|------------|-----------------------|------------|-------------------|------------|----------------|------------|
|                               | ** ** | **July 4,**      | ** ** | **June 28,** | ** ** | **Increase**   |       | % |   |
|                               | ** ** | **2009**              | ** ** | **2008**          | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
|                               |       |                  |       |              |       |           |       |   |   |
| Interest  income, net              |       | $                     | 100        |              | $          | 343            |       | $ | (243 | ) | (71 | )% |
| Other  income (expense), net       |       | $                     | 130        |              | $          | (68            | )          | 198 |   | (291 | )% |
| Total  other income (expense), net |       | $                     | 230        |              | $          | 275            |       | $ | (45 | ) | (16 | )% |

 

Net interest income forthe three and six months ended July 4, 2009 was comprised of interestincome of approximately $0.01 million and $0.04 million, respectively, offsetby interest expense of approximately $0.01 million and $0.02 million,respectively.  Net interest income forthe three and six months ended June 28, 2008 was comprised of interestincome of approximately $0.2 million and $0.5 million, respectively, partiallyoffset by interest expense of approximately $0.1 million and $0.2 million,respectively.  The decrease in interestincome in the three and six months ended July 4, 2009 as compared to thethree and six months ended June 28, 2008 was due to a combination of ourlower overall cash and investment balances and the decrease in the yield earnedon those balances due to lower interest rates. The decrease in interest expense during 2009 as compared to 2008resulted primarily from our lower average outstanding balances on our line ofcredit and debt balances during the current year.

 

Otherincome (expense), net, for the six months ended July 4, 2009 is primarilycomprised of gains from the sale of equipment held for sale during the firstquarter.  Other expense, net, for the three and six months endedJune 28, 2008 is primarily comprised of losses on certain foreign currencyremeasurement transactions, partially offset by realized gains on the sale ofcertain investments in marketable securities.

 

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

 

The following tablepresents the provision (benefit) for income taxes for the three and six monthsended July 4, 2009 and June 28, 2008 (in thousands, exceptpercentages):

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **   | ** ** |
|-----------------------------|------------|------------------------|------------|-------------------|------------|--------------|------------|
| ** **                  | ** ** | **July 4,**       | ** ** | **June 28,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                  | ** ** | **2009**               | ** ** | **2008**          | ** ** | **Increase** | ** ** | **Change** | ** ** |
|                        |       |                   |       |              |       |         |       |   |   |
| Provision  for income taxes |       | $                      | 31         |              | $          | 11           |       | $ | 20 |   | 182 | % |
| Effective  tax rate         |       | 1                      | %          | —            | %          |         |       |   |   |
|                             |            |                        |            |                   |            |              |            |  |  |  |  |  |

 
|                                  | ** ** | **Six  Months Ended** |       |              |       |         |       |
|---------------------------------------|------------|-----------------------|------------|-------------------|------------|--------------|------------|
|                                  | ** ** | **July 4,**      | ** ** | **June 28,** |       |         |       | % |   |
|                                  | ** ** | **2009**              | ** ** | **2008**          | ** ** | **Decrease** | ** ** | **Change** | ** ** |
|                                  |       |                  |       |              |       |         |       |   |   |
| Provision  (benefit) for income taxes |       | $                     | 49         |              | $          | (1,170       | )          | $ | 1,219 |   | (104 | )% |
| Effective  tax rate                   |       | 1                     | %          | (29               | )%         |         |       |   |   |
|                                       |            |                       |            |                   |            |              |            |  |  |  |  |  |

 

On an interimbasis, we estimate what our effective tax rate will be in each jurisdiction forthe full fiscal year and record a quarterly income tax provision (benefit) inaccordance with the anticipated blended annual rate. We discontinued recordingincome tax benefits in the consolidated financial statements until it isdetermined that it is more likely than not that we will generate sufficienttaxable income to realize our deferred tax assets.  We recorded a provision for income taxes forthe three 

 

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months ended July 4,2009 due to state minimum taxes.  Duringthe three months ended June 28, 2008 we recorded a benefit for income taxes which was reservedagainst during the third quarter of fiscal 2008 when we recorded a net chargeto income tax expense of approximately $4.5 million related to establishing apartial valuation allowance against our deferred income tax assets.  Our determination to record a valuationallowance was based on our recent history of cumulative losses as well asuncertainty of the utilization of deferred tax assets in the near future.

 

**Liquidity andCapital Resources**

** **

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

 

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

 

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

 
| ** **                           | ** ** | **July 4,** | ** **   | **January 3,** | ** ** |
|--------------------------------------|------------|------------------|--------------|---------------------|------------|
| ** **                           | ** ** | **2009**         | ** **   | **2009**            | ** ** |
| Working  Capital                     |       | $                | 16,322       |                | $          | 22,339 |   |
|                                 |       |             |         |                |       |
| Cash  and cash equivalents(1)        |       | $                | 10,106       |                | $          | 15,214 |   |
| Short-term  marketable securities(1) |       | 9,096            |         | 5,199               |       |
| Long-term  marketable securities     |       | 979              |         | 960                 |       |
|                                 |       | $                |  20,181 |                | $          | 21,373 |   |

 

----

*(1) Included in workingcapital*

 

*Our working capital decreased during the six months ended July 4,2009 primarily as a result of (i) a decrease in cash and marketablesecurities of $1.2 million to support operations, a decrease in accountsreceivable of $0.4 million, a decrease in income tax receivable of $1.2 millionand increases in inventory of $0.1 million and current liabilities of $3.3million.*

 

***CashProvided and Used in the Six Months Ended July 4, 2009 and June 28,2008***

 

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

* *
| ** **                                            | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------|------------|
| ** **                                            | ** ** | **July 4,**     | ** ** | **June 28,** | ** ** |
| ** **                                            | ** ** | **2009**             | ** ** | **2008** | ** ** |
|                                                  |       |                 |       |   |   |
| **Net cash provided by (used in):**                   |       |                 |       |   |   |
| Operating  activities                                 |       | $                    | (3,429     | ) | $ | (4,349 | ) |
| Investing  activities                                 |       | (3,592               | )          | 10,058 |   |
| Financing  activities                                 |       | 1,913                |       | (1,648 | ) |
| Net  increase (decrease) in cash and cash equivalents |       | $                    | (5,108     | ) | $ | 4,061 |   |

 

*Operating Activities.* Net cash used in operating activitiesfor the six months ended July 4, 2009 was primarily a result of a net lossof approximately $7.8 million for the six months ended July 4, 2009partially offset by (i) approximately $2.8 million in net cash provided bychanges in operating assets and liabilities, and (ii) approximately $1.6million in net non-cash operating expenses, primarily comprised of depreciationand amortization, stock-based compensation and gain on disposal of assets.

 

Accounts receivabledecreased approximately $0.4 million during the six months ended July 4,2009 primarily as a result of the decline 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.

 

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Inventories increasedapproximately $0.1 million during the six months ended July 4, 2009primarily as a result of preparing for a customer order due to ship in thethird quarter.  In the future, ourinventory levels will continue to be determined based on, among other factors, (i) thelevel of customer orders received and overall demand, (ii) the stage atwhich our products are in their respective life cycles and (iii) competitivesituations in the marketplace.  We makeefforts to balance such considerations against the risk of obsolescence orpotential excess inventory levels.

 

Net cash used inoperating activities for the six months ended June 28, 2008 was primarilya result of (i) our net loss for the period of approximately $2.8 million,and (ii) approximately $2.1 million in net cash used by changes inoperating assets and liabilities, partially offset by approximately $0.6million in net non-cash operating expenses, primarily comprised of depreciationand amortization, deferred income taxes and stock-based compensation.

 

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

 

Inventories increasedapproximately $5.0 million during the six months ended June 28, 2008primarily due to purchases of materials during the second quarter of 2008 tomeet forecasted sales obligations.

 

*Investing Activities.* Net cash used in investing activitiesfor the six months ended July 4, 2009 was primarily a result of purchasesof additional investments in marketable securities of approximately $10.2million, partially offset by (i) proceeds received from maturities andsales of certain investments in marketable securities of approximately $6.3million and (ii) proceeds from the sale of equipment of approximately $0.3million.

 

Net cash provided byinvesting activities for the six months ended June 28, 2008 was primarilya result of proceeds we received from maturities and sales of certaininvestments in marketable securities of approximately $17.5 million, partiallyoffset by purchases of additional investments in marketable securities ofapproximately $6.7 million. We also used approximately $0.8 million in cash topurchase additional manufacturing equipment and other property and equipment.

 

Due to recentdisruptions of, and the resulting reduced liquidity in certain financialmarkets, two of our marketable securities investments in Baa1 and A3 ratedauction rate securities with a total purchased cost of $1.0 million beganto experience failed auctions during the fourth quarter of 2007, whichcontinued into the second quarter of 2009. Due to the failed auctions, we havebeen unable to sell the securities at their respective costs, resulting in adecrease in fair value which has been recorded as a component of accumulatedother comprehensive loss. These investments have been classified as long-terminvestments in marketable securities in our consolidated balance sheets as of July 4,2009 and January 3, 2009. As of July 4, 2009 and June 28, 2008,the unrealized losses on these two investments totaled approximately $.02million and $0.2 million, respectively. We have concluded that the unrealizedlosses on these investments are temporary because (i) we believe that thedecline in market value that has occurred is due to general market conditions, (ii) theauction rate securities continue to be of a high credit quality and interest ispaid as due and (iii) we have the intent and ability to hold theseinvestments until a recovery in market value occurs. The fair value of thesesecurities could change significantly in the future and we may be required torecord other-than-temporary impairment charges or additional unrealized lossesin future periods.

 

*Financing Activities.* Net cash provided by financing activities for the six months ended July 4,2009 was primarily a result of (i) net borrowing on our outstandingrevolving line of credit of approximately $2.2 million; partially offset byrepayment of approximately $0.2 million on our long term debt.

 

Net cash used infinancing activities for the six months ended June 28, 2008 was primarilya result of an increase in restricted cash balances in connection with ourpledge of $2.0 million in cash as collateral for a letter of credit andrepayments of approximately $0.4 million on our long term debt. This ispartially offset by approximately $0.8 million in net proceeds we receivedduring the period from borrowings on our outstanding revolving line of credit.

 

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***Capital Resources***

*** ***

Under our revolving line of credit, we may borrow upto the greater of 85% of eligible accounts receivable plus the least of (i) apercentage of eligible inventory determined from time to time by our bank, (ii) 80%of the orderly liquidation value, as defined, of eligible inventories, and (iii) $1 million.Interest is payable monthly at the greater of (i) prime rate plus 3%, (ii) LIBORplus 6% or (iii) 8%.  This revolvingline of credit agreement  is subject toour credit agreement, which was extended through August 31, 2009.  Our credit agreement provides us with maximumborrowings of $5,000,000.

 

In connection with its credit agreement, the Companywas provided an equipment line of credit allowing it to borrow up to $3.9million through January 3, 2009. The Company is required to repay theequipment advances in monthly installments of $32,440. Interest on theequipment advances is payable monthly, at the Company’s option, at the greaterof (i)  prime rate plus 3%, (ii) LIBOR plus 6% or (iii) 8%.

 

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

 
| ** **                                                 | ** ** | **July 4,** | ** ** | **January 3,** | ** ** |
|------------------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | **2009**         | ** ** | **2009**            | ** ** |
| Outstanding  borrowings on the revolving line of credit    |       | $                | 2,153      |                | $          | — |   |
| Outstanding  borrowings on the equipment line of credit    |       | $                | 255        |                | $          | 450 |   |
| Borrowing  availability under the revolving line of credit |       | $                | —     |                | $          | 1,701 |   |

 

Any borrowingsunder our revolving and equipment lines of credit are collateralized by ageneral first priority lien against all of our assets, both tangible andintangible.

 

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

 

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

 

We believe ourexisting cash balances, borrowing availability under our credit agreement, andthe cash expected to be generated from operations, will be sufficient to meetour anticipated cash needs for at least the next 12 months. Our futurecapital requirements will depend on many factors, including our levels of netsales, the timing and extent of expenditures to support research anddevelopment activities, the expansion of manufacturing capacity bothdomestically and internationally and the continued market acceptance of ourproducts. We could be required, or may choose, to seek additional fundingthrough public or private equity or debt financings. In addition, in connectionwith any future acquisitions, we may require additional funding which may beprovided in the form of additional debt or equity financing or a combinationthereof. These additional funds may not be available on terms acceptable to us,or at all.

 

*New AccountingPronouncements*

 

In June 2009, theFASB issued SFAS No. 168, *The FASBAccounting Standards CodificationTM and the Hierarchy of Generally AcceptedAccounting Principles — a Replacement of FASB Statement No. 162*(“SFAS No. 168”)*. *The Codification will become the source ofauthoritative U.S. GAAP.  The statementis effective for financial statements issued for interim and annual periodsending after September 15, 2009.  Weexpect to adopt this standard with the filing of our Quarterly Report on Form 10-Qfor the period ended October 3, 2009 and do not expect the standardto have a material impact on our  consolidated financial statements.

 

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InApril 2009, the FASB issued FSP FAS 157-4, *DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transactions That Are Not Orderly*(“FSPFAS 157-4”), which provides additional guidance for estimating fair value inaccordance with SFAS 157.  FSP FAS 157-4states that a significant decrease in the volume and level of activity for theasset or liability when compared with normal market activity is an indicationthat transactions or quoted prices may not be determinative of fair valuebecause there may be increased instances of transactions that are not orderlyin such market conditions.  Accordingly,further analysis of transactions or quoted prices is needed, and a significantadjustment to the transactions or quoted prices may be necessary to estimatefair value.  FSP FAS 157-4 becameeffective for us beginning in our second quarter of fiscal 2009. The adoption of FSP FAS 157-4 did nothave a material impact on our consolidated financial position, results ofoperations or liquidity.

 

InApril 2009, the FASB issued FSP FAS 107-1 and APB 28-1, *Interim Disclosures about Fair Value of Financial Instruments*(“FSP FAS 107-1 and APB 28-1”), which requires disclosures about the fair valueof the Company’s financial instruments for which it is practicable to estimatethat value, whether recognized or not recognized in the balance sheets, in theinterim reporting periods as well as in the annual reporting periods. Inaddition, FSP FAS 107-1 and APB 28-1 requires disclosures of the methods andsignificant assumptions used to estimate the fair value of those financialinstruments.  FSP FAS 107-1 and APB 28-1became effective for us in our second quarter of fiscal 2009.  The adoption of FSP FAS 107-1 and APB 28-1 did not have a material impact on ourconsolidated financial position, results of operations or liquidity.

 

InApril 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, *Recognition and Presentation of Other-Than-Temporary Impairments*(“FSP FAS 115-2 and FAS 124-2”), which establishes a new method of recognizingand reporting other-than-temporary impairments of debt securities and requiresadditional disclosures related to debt and equity securities.  FSP FAS 115-2 and FAS 124-2 does not changeexisting recognition and measurement guidance related to other-than-temporaryimpairments of equity securities. FSP FAS 115-2 and FAS 124-2 became effectivefor us beginning in our second quarter of fiscal 2009.  The adoption of FSP FAS 115-2 and FAS 124-2 did not have a material impact ourconsolidated financial position, results of operations or liquidity.

 

In December 2007, the FASB issued SFAS No. 141(R),*Business Combinations* (“SFAS 141(R)”),which replaces SFAS 141. The provisions of SFAS 141(R) aresimilar to those of SFAS 141; however, SFAS 141(R) requirescompanies to record most identifiable assets, liabilities, noncontrollinginterests, and goodwill acquired in a business combination at “full fair value.”SFAS 141(R) also requires companies to record fair value estimates ofcontingent consideration and certain other potential liabilities during theoriginal purchase price allocation and to expense acquisition costs asincurred. SFAS 141(R) applies to all business combinations, includingcombinations by contract alone. Further, under SFAS 141(R), all businesscombinations will be accounted for by applying the acquisition method.SFAS 141(R) is effective for fiscal years beginning on or after December 15,2008. We expect SFAS 141(R) will have an impact on its consolidatedfinancial statements, but the nature and magnitude of the specific effects willdepend upon the nature, terms and size of the acquisitions that we consummate.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements* (“SFAS 160”), which will requirenoncontrolling interests (previously referred to as minority interests) to betreated as a separate component of equity, not as a liability or other itemoutside of permanent equity.  SFAS 160applies to the accounting for noncontrolling interests and transactions withnon-controlling interest holders in consolidated financial statements.SFAS 160 will be applied prospectively to all noncontrolling interests,including any that arose before the effective date except that comparativeperiod information must be recast to classify noncontrolling interests inequity, attribute net income and other comprehensive income to noncontrollinginterests, and provide other disclosures required by SFAS 160.SFAS 160 is effective for periods beginning on or after December 15,2008. The adoption of SFAS 160 did not have a material impact on ourconsolidated financial position, results of operations or liquidity.

 

***Off-Balance SheetArrangements***

*** ***

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

*** ***

**Item 3.**                          Quantitative and Qualitative Disclosures About MarketRisk

** **

***Not applicable/As a Smaller Reporting Company, we are not required to make any disclosurepursuant to this Item 3.***

*** ***

**Item 4.**                          Controls and Procedures

** **

***Not applicable.***

*** ***

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*** ***

**Item 4T.**                 Controls and Procedures

** **

*(a) Evaluation ofDisclosure Controls and Procedures.* We carried out an evaluation, under the supervisionand with the participation of our management, including our principal executiveofficer and principal financial officer, of the effectiveness of the design andoperation of our disclosure controls 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 July 4, 2009. Based upon thatevaluation, our principal executive officer and principal financial officerconcluded that our disclosure controls and procedures are effective to providereasonable assurance that information required to be disclosed by us in reportsthat we file or submit under the Exchange Act (i) is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms and (ii) is accumulated and communicated to our management,including our principal executive officer and principal financial officer asappropriate to allow timely decisions regarding required disclosure.

 

*(b) Change ininternal controls over financial reporting.* During the fiscal quarter that ended July 4,2009, there were no changes in our internal controls over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) under the ExchangeAct) that have materially affected, or are reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

***Inherent Limitations on InternalControl***

 

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.**                          Legal Proceedings

** **

The informationset forth in the sections entitled Federal Securities Class Action,California Derivative Action and Patent Claims under Note 9 of Notes toUnaudited Condensed Consolidated Financial Statements, included in Part I,Item I of this Report, is incorporated herein by reference.

 

**Item 1A.**                 Risk Factors

** **

***As a Smaller Reporting Company, we are not required to makeany disclosure pursuant to this Item 1A; however, we have included the riskfactor directly below given the macroeconomic environment in which we arecurrently operating. Please also refer to the Risk Factors set forth in Part I,Item 1A of our Annual Report on Form 10-K for the fiscal year ended January 3,2009 filed with the Securities and Exchange Commission on March 30, 2009.***

*** ***

**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.**

 

Recentlygeneral worldwide economic conditions have experienced a downturn due to thecredit conditions impacted by the subprime-mortgage turmoil and other factors,slower economic activity, concerns about inflation and deflation, increasedenergy costs, decreased consumer confidence, reduced corporate profits andcapital spending, adverse business conditions and liquidity concerns in thememory market, recent international conflicts and the impact of naturaldisasters and public health emergencies. These conditions make it extremelydifficult for our customers, our vendors and us to accurately forecast and planfuture business activities, and they could cause US and foreign businessesto further slow spending on our products and services, which would furtherdelay and lengthen sales cycles. Furthermore, during continuing challengingeconomic times our customers may face issues gaining timely access tosufficient credit, which could result in an impairment of their ability to maketimely payments to us. If that were to occur, we may be required to increaseour allowance for doubtful accounts and our days sales outstanding would benegatively impacted. We cannot predict the timing, strength or duration of thecurrent economic slowdown or subsequent economic recovery, worldwide, or in thememory market and related semiconductor industry. If the economy or markets inwhich we operate continue to worsen, our business, financial condition and resultsof operations will likely be materially and adversely affected. Additionally,the combination of our lengthy sales cycle coupled with challengingmacroeconomic conditions could compound the negative impact on the results ofour operations.

 

**Item 2.**                          Unregistered Sales of Equity Securities and Use ofProceeds

** **

None.

 

**Item 3.**                          Defaults Upon Senior Securities

** **

None.

 

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**Item 4.**                          Submission of Matters to a Vote of Security Holders

** **

(a) Our 2009 annual meeting of stockholders washeld on May 27, 2009.

 

(b) At our 2009 annual meeting of stockholders,the stockholders elected each of the following nominees as directors, to serveon our Board of Directors until our 2010 annual meeting of stockholders oruntil their respective successors are elected and qualified (or their earlierresignation or removal). The vote for each director was as follows:

 
| ** **         | ** ** | **Votes   For** | ** ** | **Votes  Withheld** | ** ** |
|--------------------|------------|-----------------|------------|---------------------|------------|
| ** **         | ** ** | ** **      | ** ** | ** **          | ** ** |
| Chun  Ki Hong      |       | 10,066,003      |       | 2,352,020           |       |
| Nam  Ki Hong       |       | 10,061,947      |       | 2,356,076           |       |
| Thomas  F. Lagatta |       | 10,222,066      |       | 2,195,957           |       |
| Alan  H. Portnoy   |       | 10,248,416      |       | 2,169,607           |       |

 

**Item 5.**                          Other Information

** **

None.

 

**Item 6.**                         Exhibits

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

 

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| (1)    | Incorporated  by reference to the corresponding exhibit number of the registration  statement on Form S-1 of the registrant (No. 333-136735) filed with  the Securities and Exchange Commission on October 23, 2006.                                                                                                                                                                                                                                                                                                       |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (2)    | Filed  herewith.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (3)    | The  information in Exhibit 32 shall not be deemed “filed” for purposes of  Section 18 of the Securities Exchange Act of 1934, as amended, (the  “Exchange Act”), or otherwise subject to the liabilities of that section, nor  shall they be deemed incorporated by reference in any filing under the  Securities Act of 1933, as amended, or the Exchange Act (including this Report),  unless Netlist, Inc. specifically incorporates the foregoing information  into those documents by reference. |

 

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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: August 14, 2009 |       | NETLIST, INC.                               |
|----------------------------|------------|---------------------------------------------|
|                       |       | a Delaware corporation                      |
|                       |       | (Registrant)                                |
|                       |       |                                        |
|                       | By:        | /s/ Chun K. Hong                            |
| ** **                 | ** ** | **Chun K. Hong**                            |
| ** **                 | ** ** | **President, Chief Executive  Officer and** |
| ** **                 | ** ** | **Chairman of the Board**                   |
| ** **                 | ** ** | **(Principal Executive Officer)**           |
|                       |       |                                        |
|                       |       |                                        |
|                       | By:        | /s/ Gail Itow                               |
| ** **                 | ** ** | **Gail Itow**                               |
| ** **                 | ** ** | **Vice President and Chief  Financial**     |
| ** **                 | ** ** | **Officer**                                 |
| ** **                 | ** ** | **(Principal Financial Officer)**           |

 

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**EXHIBIT INDEX**

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

 

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