**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the quarterly period ended March 31, 2007**

**or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition period from            to           **

**Commission file number 001-33170**

****

**NETLIST,INC.**

(Exact name of registrant asspecified in its charter)

| **Delaware**                                        |   | **95-4812784**       |
|-----------------------------------------------------|--------|----------------------|
| State or other  jurisdiction of                     |   | (I.R.S. employer     |
| incorporation or  organization                      |   | Identification  No.) |
|                                                |   |                 |
| **475 Goddard, Irvine, CA 92618**                   |
| (Address of principal executive offices) (Zip Code) |

 

**(949)435-0025**

(Registrant’s telephonenumber, including area code)

**Securities registered pursuant to Section 12(b) of the Act:**

| **Title of each class**                   |   | **Name of  each exchange on which registered** |
|-------------------------------------------|--------|------------------------------------------------|
| Common Stock,  par value $0.001 per share |   | The NASDAQ  Global Market                      |

 

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 o    No x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check One):

| Large Accelerated Filer      o |   | Accelerated  Filer     o |   | Non-accelerated  filer     x |
|----------------------------------------------------|--------|----------------------------------------------|--------|--------------------------------------------------|

 

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

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

Common Stock, par value$0.001 per share

19,644,487 shares outstanding at April 30, 2007

 

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**NETLIST, INC. AND SUBSIDIARIES**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE THREE MONTHSENDED MARCH 31, 2007**

**TABLE OF CONTENTS**
| PART I.  |   | FINANCIAL  INFORMATION                                                                                                   |
|---------------|--------|--------------------------------------------------------------------------------------------------------------------------|
| Item 1.       |   | Unaudited Condensed Consolidated Balance Sheets at  March 31, 2007 and December 30, 2006                                 |
|          |   | Unaudited Condensed Consolidated Statements of  Operations for the Three Months Ended March 31, 2007   and April 1, 2006 |
|          |   | Unaudited Condensed Consolidated Statements of Cash Flows  for the Three Months Ended March 31, 2007  and April 1, 2006  |
|          |   | Notes to Unaudited Condensed Consolidated Financial  Statements                                                          |
| Item 2.       |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                              |
| Item 3.       |   | Quantitative  and Qualitative Disclosures about Market Risk                                                              |
| Item 4.       |   | Controls and Procedures                                                                                                  |
|          |   |                                                                                                                     |
| PART II. |   | OTHER INFORMATION                                                                                                        |
| Item 1.       |   | Legal Proceedings                                                                                                        |
| Item 1A.      |   | Risk  Factors                                                                                                            |
| Item 2.       |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                                             |
| Item 3.       |   | Defaults upon  Senior Securities                                                                                         |
| Item 4.       |   | Submission of  Matters to a Vote of Security Holders                                                                     |
| Item 5.       |   | Other Information                                                                                                        |
| Item 6.       |   | Exhibits                                                                                                                 |

 

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**PART I.FINANCIAL INFORMATION**

**Item 1. Financial Statements**

**NETLIST, INC. ANDSUBSIDIARIES**

**Unaudited CondensedConsolidated Balance Sheets(in thousands)**
| ** **                                                               | ** ** | **March 31,  2007** | ** ** | **December 30,  2006** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                               |       |                     |       |                        |       |
| Current assets:                                                          |       |                     |       |                        |       |
| Cash and cash  equivalents                                               |       | $                        | 11,694     |                        | $          | 30,975 |   |
| Investments in  marketable securities                                    |       | 16,149                   |       | 5,267                       |       |
| Accounts  receivable, net                                                |       | 18,033                   |       | 23,703                      |       |
| Inventories                                                              |       | 13,380                   |       | 19,473                      |       |
| Deferred taxes                                                           |       | 1,100                    |       | 1,054                       |       |
| Prepaid expenses  and other current assets                               |       | 897                      |       | 988                         |       |
| Total current  assets                                                    |       | 61,253                   |       | 81,460                      |       |
| Property and equipment,  net                                             |       | 3,894                    |       | 3,830                       |       |
| Deferred taxes                                                           |       | 932                      |       | 576                         |       |
| Long-term investments  in marketable securities                          |       | 6,842                    |       | 1,502                       |       |
| Other assets                                                             |       | 636                      |       | 326                         |       |
| Total assets                                                             |       | $                        | 73,557     |                        | $          | 87,694 |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                           |       |                     |       |                        |       |
| Current liabilities:                                                     |       |                     |       |                        |       |
| Accounts payable                                                         |       | $                        | 5,491      |                        | $          | 11,680 |   |
| Revolving line  of credit                                                |       | 12,026                   |       | 19,238                      |       |
| Current portion  of long-term debt                                       |       | 865                      |       | 1,033                       |       |
| Current portion  of deferred gain on sale and leaseback transaction      |       | 118                      |       | 118                         |       |
| Income taxes  payable                                                    |       | 108                      |       | 552                         |       |
| Accrued expenses  and other current liabilities                          |       | 2,459                    |       | 3,255                       |       |
| Total current  liabilities                                               |       | 21,067                   |       | 35,876                      |       |
| Long-term debt,  net of current portion                                  |       | 1,010                    |       | 1,230                       |       |
| Deferred gain on sale  and leaseback transaction, net of current portion |       | 314                      |       | 344                         |       |
| Total  liabilities                                                       |       | 22,391                   |       | 37,450                      |       |
| Commitments and  contingencies                                           |       | —                   |       | —                      |       |
| Stockholders’ equity:                                               |       |                     |       |                        |       |
| Common stock                                                             |       | 20                       |       | 20                          |       |
| Additional paid-in  capital                                              |       | 66,998                   |       | 66,557                      |       |
| Note receivable  from stockholder                                        |       | (1                       | )          | (1                          | )          |
| Accumulated  deficit                                                     |       | (15,855                  | )          | (16,332                     | )          |
| Accumulated  other comprehensive income                                  |       | 4                        |       | —                      |       |
| Total  stockholders’ equity                                         |       | 51,166                   |       | 50,244                      |       |
| Total liabilities and  stockholders’ equity                         |       | $                        | 73,557     |                        | $          | 87,694 |   |

 

See accompanying notes.

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**NETLIST, INC.AND SUBSIDIARIES**

**Unaudited CondensedConsolidated Statements of Operations(in thousands, except per share amounts)**
| ** **                                                 | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                 | ** ** | **March 31,   2007**   | ** ** | **April 1,   2006** | ** ** |
| Net sales                                                  |       | $                                | 37,538     |   | $ | 26,020 |   |
| Cost of sales(1)                                           |       | 32,089                           |       | 23,466 |   |
| Gross profit                                               |       | 5,449                            |       | 2,554 |   |
| Operating  expenses:                                       |       |                             |       |   |   |
| Research and development(1)                                |       | 1,067                            |       | 666 |   |
| Selling, general and administrative(1)                     |       | 3,704                            |       | 1,803 |   |
| Total operating expenses                                   |       | 4,771                            |       | 2,469 |   |
| Operating income                                           |       | 678                              |       | 85 |   |
| Other expense:                                             |       |                             |       |   |   |
| Interest expense, net of interest income                   |       | (48                              | )          | (400 | ) |
| Other income (expense), net                                |       | 1                                |       | (10 | ) |
| Total other expense, net                                   |       | (47                              | )          | (410 | ) |
| Income (loss)  before provision (benefit) for income taxes |       | 631                              |       | (325 | ) |
| Provision  (benefit) for income taxes                      |       | —                           |       | (83 | ) |
| Net income  (loss)                                         |       | $                                | 631        |   | $ | (242 | ) |
| Net income  (loss) per common share:                       |       |                             |       |   |   |
| Basic                                                      |       | $                                | 0.03       |   | $ | (0.02 | ) |
| Diluted                                                    |       | $                                | 0.03       |   | $ | (0.02 | ) |
| Weighted-average  common shares outstanding:               |       |                             |       |   |   |
| Basic                                                      |       | 19,624                           |       | 10,753 |   |
| Diluted                                                    |       | 21,425                           |       | 10,753 |   |

 

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(1)             Amountsinclude stock-based compensation expense as follows:
| Cost of sales                        |   | $   | 64     |   | $      | 7 |   |
|--------------------------------------|--------|-----|--------|--------|--------|---|--------|
| Research and development             |   | 46  |   | 11     |   |
| Selling, general and  administrative |   | 218 |   | 55     |   |

 

See accompanying notes.

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**NETLIST, INC.AND SUBSIDIARIES**

**Unaudited CondensedConsolidated Statements of Cash Flows(in thousands)**
| ** **                                                                                     | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                     | ** ** | **March 31,  2007**         | ** ** | **April 1,  2006** | ** ** |
| Cash flows from  operating activities:                                                         |       |                             |       |   |   |
| Net income (loss)                                                                              |       | $                                | 631        |   | $ | (242 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                                  |       | 254                              |       | 249 |   |
| Amortization of deferred gain on sale and leaseback  transaction                               |       | (30                              | )          | (30 | ) |
| Deferred income taxes                                                                          |       | (402                             | )          | — |   |
| Impairment of long-lived asset                                                                 |       | 114                              |       | — |   |
| Loss on disposal of assets                                                                     |       | —                           |       | 15 |   |
| Stock-based compensation                                                                       |       | 328                              |       | 73 |   |
| Changes in operating assets and liabilities:                                                   |       |                             |       |   |   |
| Accounts receivable                                                                            |       | 5,670                            |       | 137 |   |
| Inventories                                                                                    |       | 6,093                            |       | 315 |   |
| Income taxes receivable                                                                        |       | —                           |       | (83 | ) |
| Prepaid expenses and other current assets                                                      |       | 91                               |       | 166 |   |
| Other assets                                                                                   |       | (310                             | )          | 3 |   |
| Accounts payable                                                                               |       | (6,172                           | )          | 1,987 |   |
| Income taxes payable                                                                           |       | (598                             | )          | — |   |
| Accrued expenses and other current liabilities                                                 |       | (796                             | )          | (12 | ) |
| Net cash provided by operating activities                                                      |       | 4,873                            |       | 2,578 |   |
| Cash flows from  investing activities:                                                         |       |                             |       |   |   |
| Acquisition of property and equipment                                                          |       | (449                             | )          | (67 | ) |
| Proceeds from sale of equipment                                                                |       | —                           |       | 45 |   |
| Purchases of investments in marketable securities                                              |       | (30,618                          | )          | — |   |
| Proceeds from maturities of investments in  marketable securities                              |       | 14,400                           |       | — |   |
| Net cash used in investing activities                                                          |       | (16,667                          | )          | (22 | ) |
| Cash flows from  financing activities:                                                         |       |                             |       |   |   |
| Borrowings on lines of credit                                                                  |       | 40,174                           |       | 22,542 |   |
| Payments on lines of credit                                                                    |       | (47,386                          | )          | (25,933 | ) |
| Payments on debt                                                                               |       | (388                             | )          | (200 | ) |
| Proceeds from exercise of stock options and warrants                                           |       | 113                              |       | 104 |   |
| Net cash used in financing activities                                                          |       | (7,487                           | )          | (3,487 | ) |
| Net decrease in  cash and cash equivalents                                                     |       | (19,281                          | )          | (931 | ) |
| Cash and cash  equivalents, beginning of period                                                |       | 30,975                           |       | 953 |   |
| Cash and cash  equivalents, end of period                                                      |       | $                                | 11,694     |   | $ | 22 |   |

 

See accompanying notes.

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**NETLIST, INC.AND SUBSIDIARIES**

**NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**March 31, 2007**

**NOTE 1—DESCRIPTION OFBUSINESS**

Netlist, Inc. (the “Company”or “Netlist”) was incorporated on June 12, 2000 in Delaware. Netlistdesigns and manufactures high performance memory subsystems for the server,high performance computing and communications markets. The Company’s solutionsare targeted at applications where memory plays a key role in meeting systemperformance requirements.

In December 2006,the Company sold 6,250,000 of its common shares in its initial public offeringat an offering price of $7.00 per share, resulting in proceeds of $39.5million, net of underwriters’ discounts and offering expenses of approximately$4.2 million.

**NOTE 2—SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

*Basis ofPresentation*

The interim unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of Americafor interim financial information and with the instructions to Securities andExchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X.These financial statements do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for complete financial statements. Therefore, these interim unaudited condensed consolidated financialstatements should be read in conjunction with the Company’s auditedconsolidated financial statements and notes thereto for the year ended December30, 2006, included in the Company’s Annual Report on Form 10-K filed with theSEC on February 28, 2007.

The condensedconsolidated financial statements included herein are unaudited; however, theycontain all normal recurring accruals and adjustments that, in the opinion ofthe Company’s management, are necessary to present fairly the consolidatedfinancial position of the Company and its wholly owned subsidiaries as of March31, 2007 and December 30, 2006, and the consolidated results of its operationsand cash flows for the three months ended March 31, 2007 and April 1, 2006. Allintercompany balances and transactions have been eliminated in consolidation.The results of operations for the three months ended March 31, 2007 are notnecessarily indicative of the results to be expected for the full year or anyfuture interim periods.

*Fiscal Year*

Effective January 1,2003, the Company changed its fiscal year from a calendar year to a 52/53-weekfiscal year ending on the Saturday closest to December 31. Each of theCompany’s first three quarters in a fiscal year end on the Saturday closest toMarch 31, June 30 and September 30, respectively.

*Use of Estimates*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of the assets and liabilitiesand disclosure of contingent assets and liabilities at the date of thefinancial statements, and the reported amounts of revenues and expenses duringthe reporting period. Significant estimates made by management include, amongothers, provisions for uncollectible receivables and sales returns, valuationof inventories, recoverability of long-lived assets and realization of deferredtax assets. Actual results could differ from these estimates.

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*Inventories*

Inventories are valued atthe lower of cost or net realizable value. Cost is determined on a first-in,first-out basis and includes raw materials, labor and manufacturing overhead.At each balance sheet date, the Company evaluates its ending inventories forexcess quantities and obsolescence. This evaluation includes an analysis ofsales levels by product type. 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 thecost basis of the excess or obsolete inventories.

*RevenueRecognition*

The Company’s revenuesprimarily consist of product sales of high performance memory subsystems tooriginal equipment manufacturers (“OEMs”). Revenues also include sales ofexcess inventories to distributors and other users of memory intergratedcircuits (“ICs”) totaling approximately $1.0 million and $5.1 million, duringthe three months ended March 31, 2007 and April 1, 2006, respectively.

The Company recognizesrevenues in accordance with the SEC’s Staff Accounting Bulletin (“SAB”)No. 104, *Revenue Recognition* (“SAB No. 104”). In accordance withthe provisions of SAB No. 104, the Company recognizes revenues when thereis persuasive evidence of an arrangement, product delivery and acceptance haveoccurred, the sales price is fixed or determinable, and collectibility of theresulting receivable is reasonably assured.

For all sales, theCompany uses a binding purchase order as evidence of an arrangement. Deliveryoccurs when goods are shipped for customers with FOB Shipping Point terms andupon receipt for customers with FOB Destination terms, at which time title andrisk of loss transfer to the customer. The Company assesses whether the salesprice is fixed or determinable based on the payment terms associated with thetransaction and whether the sales price is subject to refund. Customers aregenerally allowed limited rights of return for up to 30 days, except for salesof excess inventories, which contain no right-of-return privileges.Estimated returns are provided for at the time of sale based on historicalexperience or specific identification of an event necessitating a reserve.Returns from customers have not been material in any period as the Company’sprincipal customers have adopted build-to-order manufacturingmodels or just-in-time management processes. The Company offers astandard product warranty to its customers and has no other post-shipmentobligations. The Company assesses collectibility based on the creditworthinessof the customer as determined by credit checks and evaluations, as well as thecustomer’s payment history.

Most of the Company’sinternational shipments are made to third-party inventory warehouses, orhubs, and the Company recognizes revenue when the inventory is pulled from thehub for use in production by the customer.

All amounts billed tocustomers related to shipping and handling are classified as revenues, whileall costs incurred by the Company for shipping and handling are classified ascost of sales.

*Warranties*

The Company offerswarranties generally ranging from one to three years to its customers, otherthan on sales of excess inventory, depending on the product and negotiatedterms of purchase agreements. Such warranties require the Company to repair orreplace defective product returned to the Company during such warranty periodat no cost to the customer. An estimate by the Company for warranty relatedcosts is recorded by the Company at the time of sale based on its historicaland estimated product return rates and expected repair or replacement costs.Such costs have historically been consistent between periods and insignificant.The Company’s estimated warranty liability at March 31, 2007 was approximately$0.3 million, and is included as a component of accrued expenses and othercurrent liabilities in the accompanying unaudited condensed consolidatedbalance sheet.

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*Stock-BasedCompensation*

The Company accounts forequity issuances to non-employees in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 123, *Accountingfor Stock-Based Compensation* (“SFAS No. 123”), and Emerging Issues Task Force (“EITF”)No. 96-18, *Accounting for EquityInstruments that are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods and Services*. All transactions inwhich 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 onwhich the third-party performance is complete or the date on which it isprobable that performance will occur.

In accordance with SFASNo. 123(R), *Share-Based Payment*(“SFAS No. 123(R)”),employee and director stock-based compensation expense recognized duringthe period is based on the value of the portion of share-based paymentawards that is ultimately expected to vest during the period. Stock-basedcompensation expense recognized in the accompanying unaudited condensedconsolidated statements of operations includes compensation expense for share-basedpayment awards granted prior to, but not yet vested as of December 31,2005 based on the grant date fair value estimated in accordance with the proforma provisions of SFAS No. 123 and compensation expense for the share-basedpayment awards granted subsequent to December 31, 2005 based on the grantdate fair value estimated in accordance with the provisions of SFASNo. 123(R). Given that stock-based compensation expense recognizedin the unaudited condensed consolidated statements of operations is based onawards ultimately expected to vest, it has been reduced for estimatedforfeitures. SFAS No. 123(R) requires forfeitures to be estimated atthe time of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates.

The fair value of stock-basedawards to employees and directors is calculated using the Black-Scholesoption pricing model. The Black-Scholes model requires subjectiveassumptions regarding future stock price volatility and expected time toexercise, which greatly affect the calculated fair values of the Company’sstock-based awards. The expected term of options granted is derived fromhistorical data on employee exercises and post-vesting employment termination behavior.The risk-free rate selected to value any particular grant is based on the U.S.Treasury rate that corresponds to the expected term of the grant effective asof the date of the grant. The expected volatility is based on the historicalvolatilities of the common stock of comparable publicly traded companies basedon the Company’s belief that it currently has limited historical data regardingthe volatility of its stock price on which to base a meaningful estimate ofexpected volatility. These factors could change in the future, affecting thedetermination of stock-based compensation expense in future periods.

*Net Income (Loss)Per Share*

Basic net income (loss)per share is calculated by dividing net income (loss) by the weighted-averagecommon shares outstanding during the period. Diluted net income (loss) pershare is calculated by dividing the net income (loss) by the weighted-averagecommon shares and dilutive potential common shares outstanding during theperiod. Dilutive potential common shares consist of dilutive shares issuableupon the exercise of outstanding stock options and warrants computed using thetreasury stock method. During fiscal 2006 and prior years, in addition tooutstanding stock options and warrants, dilutive potential common shares alsoconsisted of shares issuable upon the conversion of notes payable andconvertible preferred stock using the “if converted” method.

*New AccountingPronouncements*

In February 2007, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities – Including an Amendment of FASBStatement No. 115* (“SFAS No. 159”). SFAS No. 159 permits entities tochoose to measure many financial instruments and certain other items at fairvalue. The objective is to improve financial reporting by providing entitieswith the opportunity to mitigate volatility in reported earnings caused bymeasuring related assets and liabilities differently without having to applycomplex hedge accounting provisions. SFAS No. 159 also establishes presentationand disclosure requirements designed to facilitate comparison between entitiesthat choose different measurement attributes for similar types of assets andliabilities. The Company will adopt SFAS No. 159 in the first quarter of 2008,is still evaluating the effect, if any, on its consolidated financial positionand consolidated results of operations and has not yet determined its impact.

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**NOTE 3—SUPPLEMENTAL FINANCIAL INFORMATION**

*Inventories*

Inventories consist ofthe following (in thousands):
|                 | ** ** | **March 31,  2007** | ** ** | **December 30,  2006** | ** ** |
|-----------------|------------|--------------------------|------------|-----------------------------|------------|
| Raw materials   |       | $                        | 4,279      |                        | $          | 10,513 |   |
| Work in process |       | 1,984                    |       | 3,343                       |       |
| Finished goods  |       | 7,117                    |       | 5,617                       |       |
|            |       | $                        | 13,380     |                        | $          | 19,473 |   |

 

*ComprehensiveIncome (Loss)*

The components ofcomprehensive income (loss), net of taxes, consist of the following (inthousands): 
|                                              | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **March 31,  2007**         | ** ** | **April 1, 2006** | ** ** |
| Net income  (loss)                           |       | $                                | 631        |   | $ | (242 | ) |
| Other  comprehensive income (loss):          |       |                             |       |   |   |
| Change in net unrealized gain on investments |       | 4                                |       | — |   |
| Comprehensive income  (loss)                 |       | $                                | 635        |   | $ | (242 | ) |

 

*Computationof Net Income (Loss) Per Share*

The following table setsforth the computation of basic and diluted net income (loss) per share,including the reconciliation of the numerator and denominator used in thecalculation of basic and diluted net income (loss) per share (in thousands,except per share data):  
|                                                                   | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                        | ** ** | **March 31,  2007**         | ** ** | **April 1,  2006** | ** ** |
| **Basic  net income (loss) per share:**                           |       |                             |       |   |   |
| Numerator: Net income (loss)                                      |       | $                                | 631        |   | $ | (242 | ) |
| Denominator: Weighted-average common shares  outstanding, basic   |       | 19,624                           |       | 10,753 |   |
| Basic net income (loss) per share                                 |       | $                                | 0.03       |   | $ | (0.02 | ) |
| **Diluted  net income (loss) per share:**                         |       |                             |       |   |   |
| Numerator: Net income (loss)                                      |       | $                                | 631        |   | $ | (242 | ) |
| Weighted-average common shares outstanding,  basic                |       | 19,624                           |       | 10,753 |   |
| Effect of dilutive securities:                                    |       |                             |       |   |   |
| Stock options and warrants                                        |       | 1,801                            |       | — |   |
| Denominator: Weighted-average common shares  outstanding, diluted |       | 21,425                           |       | 10,753 |   |
| Diluted net  income (loss) per share                              |       | $                                | 0.03       |   | $ | (0.02 | ) |

 

All potentially dilutivecommon share equivalents of approximately 3.6 million shares have been excludedfrom the diluted net loss per share calculation for the three months endedApril 1, 2006 as their effect would be anti-dilutive for the period then ended.

*MajorCustomers*

The Company’s product sales have historically beenconcentrated in a small number of customers. The following table sets forthsales to customers comprising 10% or more of the Company’s total revenues:

 
|            | ** ** | **Three Months Ended** | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **March 31,  2007**         | ** ** | **April 1,   2006** | ** ** |
| Customer:  |       |                             |       |   |   |
| A          |       | 38                               | %          | 16 | % |
| B          |       | 11                               | %          | 33 | % |
| C          |       | 31                               | %          | — |   |

 

The Company’s accounts receivable are concentratedwith four customers at March 31, 2007, representing 38%, 21%, 11% and 11% ofaggregate gross receivables. At December 30, 2006, accounts receivable areconcentrated with four customers representing 32%, 19%, 14% and 13% ofaggregate gross receivables. A significant reduction in sales to, or theability to collect receivables from, a significant customer could have amaterial adverse impact on the Company.

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**NOTE 4—CREDIT AGREEMENT**

In April 2007, theCompany executed the Seventh Amendment to the Amended and Restated Credit andSecurity Agreement (the “Seventh Amendment”). The Seventh Amendment, which iseffective as of March 21, 2007, allows the Company to, at its election,increase its line of credit from $25 million, in $2.5 million increments, up toa total of $40 million at the prime rate of interest, which was 8.25% at March31, 2007 and December 30, 2006. In addition, the amendment (i) extends thematurity date of the line of credit to July 31, 2009, (ii) establishes anequipment advance line of $3 million, (iii) increases the sublimit for lettersof credit to $5 million, (iv) sets an inventory sublimit of $7 million, withthe ability to increase to $10 million if certain financial targets are met,(v) provides for the reduction in interest rates on borrowings if certainborrowing amounts and financial performance targets are met, (vi) resets theminimum book net worth, capital expenditures, and minimum debt service coverageratio financial covenants and (vii) eliminates the minimum net income and stoploss financial covenants. As of March 31, 2007, the Company was in compliancewith all financial covenants.

The $40 million creditfacility was preceded by a line of credit facility up to $25 million($3 million of which was in the form of letters of credit), limited to 85%of eligible accounts receivable, plus the least of (i) a percentage ofeligible inventory determined from time to time by the Company’s bank,(ii) 80% of the orderly liquidation value, as defined, of eligibleinventories, and (iii) $7 million. Interest is payable monthly, atthe Company’s option, either at prime rate plus 0.50% or LIBOR plus 3%. Theinterest rate was reduced to the prime rate or LIBOR plus 2.50% inDecember 2006 concurrent with the Company’s raise of capital through aninitial public offering.

Interest on the equipmentadvances is payable monthly, at the Company’s option, either at the prime rate orLIBOR plus 2.50%. Interest only payments were required on the equipmentadvances through January 31, 2007. Commencing February 1, 2007, theCompany was required to repay the equipment advances in 42 equal monthlyinstallments. The outstanding balance on this loan was approximately $1.0million and $1.1 million at March 31, 2007 and December 30, 2006, respectively.(see Note 5).

Interest expense relatedto borrowings on the line of credit was approximately $0.4 million and $0.3million for the three months ended March 31, 2007 and April 1, 2006,respectively. Outstanding borrowings on the line of credit were approximately$12.0 million and $19.2 million at March 31, 2007 and December 30,2006, respectively. Borrowing availability under the line of credit was approximately$2.9 million at March 31, 2007.

**NOTE 5—LONG-TERM DEBT**

Long-term debt consistsof the following (in thousands):
|                                              | ** ** | **March 31,  2007** | ** ** | **December 30,  2006** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Obligations  under capital leases            |       | $                        | 696        |                        | $          | 802 |   |
| Equipment note  payable to bank (see Note 4) |       | 996                      |       | 1,072                       |       |
| Notes payable to  others                     |       | 183                      |       | 389                         |       |
|                                         |       | 1,875                    |       | 2,263                       |       |
| Less current  portion                        |       | (865                     | )          | (1,033                      | )          |
|                                         |       | $                        | 1,010      |                        | $          | 1,230 |   |

 

*Notes Payable to Others*

In November 2002,the Company entered into a $100,000 unsecured loan agreement with anindividual, bearing interest at 7% payable annually, principal due, as amended,in June 2006. In January 2004, $4,000 of the principal amount wasused to exercise certain stock options. The balance of this note was $96,000 atDecember 30, 2006, which, along with accrued interest, was repaid in fullin January 2007.

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In January 2003, theCompany entered into a $300,000 loan agreement with a financing company,collateralized by assets owned by an employee related to the majoritystockholder. This note bears interest at 14% per annum and matures inJanuary 2009. Principal and interest payments of approximately $6,000 aredue and payable monthly. The balance of this note was approximately $119,000and $133,000 at March 31, 2007 and December 30, 2006, respectively.

In August 2005, theCompany entered into an agreement with a financing company in connection withfinancing certain insurance policies. The financing agreement required monthlyprincipal and interest payments of approximately $25,000 through maturity onJune 30, 2006. Interest was payable at 8.55% per annum. The outstandingprincipal balance on this financing was $142,000 at December 31, 2005.During the year ended December 30, 2006, the balance was repaid in full.In August 2006, the Company entered into a new agreement with thefinancing company to finance its insurance policies. The financing agreementrequires monthly principal and interest payments of approximately $32,000through maturity on June 30, 2007. Interest is payable at 9.45% per annum.The outstanding principal balance on this financing was approximately $64,000and $160,000 at March 31, 2007 and December 30, 2006, respectively.

*Capital Leases*

The Company has purchasedmanufacturing and computer equipment through the use of various capital leases.These leases require aggregate monthly payments of approximately $34,000 andmature at various dates through May 2011. The interest rates on theseleases vary between 4.3% and 9.4%.

Interest expense relatedto long-term debt was approximately $57,000, and $46,000 for the three monthsended March 31, 2007 and April 1, 2006, respectively.

**NOTE 6—INCOME TAXES**

The Company recorded atax provision of $0 and $83,000 for the three months ended March 31, 2007 andApril 1, 2006, respectively. The effective tax rates for the Company were 0%and 26% for the three months ended March 31, 2007 and April 1, 2006,respectively.

The Company adopted FASBInterpretation No. 48, *Accounting for Uncertaintyin Income Taxes*(“FIN 48”)*,* on December31, 2006, the first day of fiscal 2007. As a result of the implementation ofFIN 48, the Company recorded an increase in the net liability for unrecognizedtax positions of approximately $0.2 million, which was recorded as anadjustment to the beginning balance of accumulated deficit as of December 31,2006. Including the increase in the net liability, at December 31, 2006 theCompany had approximately $0.5 million of total unrecognized tax benefits.  Included in this balance were $0.5 million oftax positions that, if recognized, would affect the effective tax rate.

The Company’s continuingpractice is to recognize accrued interest and penalties related to unrecognizedtax benefits as a component of tax expense. This policy did not change as aresult of the adoption of FIN 48. The Company had approximately $30,000 accruedfor interest and $0 accrued for penalties at December 31, 2006.

The Company files taxreturns with federal and state jurisdictions. The Company is no longer subjectto IRS or state examinations prior to fiscal 2003, although certaincarryforward attributes that were generated prior to fiscal 2003 may still beadjusted by the IRS if they either have been or will be used in a futureperiod.

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**NOTE 7—COMMITMENTS AND CONTINGENCIES**

*Litigation*

From time to time, the Companymay be involved in litigation relating to claims arising out of its operationsin the normal course of business.

In May 2007, the Companyand certain of its officers and directors were named as defendants in asecurities class action filed in federal court in New York (Tran v. Netlist, etal., No. 07 CV 3754). The complaint is filed on behalf of purchasers of the Company’scommon stock in or traceable to the Company’s initial public offering andasserts claims under Sections 11 and 15 of the Securities Act of 1933. TheCompany has not been served with the complaint.

*Other Obligations*

In March 2007, theCompany entered into a five year lease commitment agreement on a facility inSuzhou in the People’s Republic of China for which the total base rent for theterm of the lease is expected to approximate $800,000.  In March 2007, the Company began itsoccupation of the facility and commenced recording monthly rent expense ofapproximately $13,000.

In April 2007, theCompany entered into a four year facility lease agreement of approximately28,700 rentable square feet in Irvine, California. The Company plans to occupythe new facility in July 2007, which will allow for the consolidation of itsheadquarters and manufacturing operations into a single location. The totalbase rent for the term of the lease will be approximately $1.7 million, withmonthly rent payments ranging from approximately $33,000 to $37,000 during theterm of the lease.

**NOTE 8—RELATED PARTYTRANSACTIONS**

In February 2003,the Company loaned an employee $19,900 to exercise a portion of his then-vestedcommon stock options. This full recourse note bears interest at a rate of 7%payable annually, and is due on February 17, 2008. In December 2006,the employee repaid $23,000 of the note. As of March 31, 2007 and December 30, 2006, the remaining amountoutstanding was approximately $1,000 and has been recorded as a reduction ofstockholders’ equity in the consolidated balance sheets.

**NOTE 9—IMPAIRMENT OFLONG-LIVED ASSET**

During fiscal 2006, theCompany acquired certain laser soldering equipment (the “Equipment”) primarilyintended for use in connection with a new product technology to be developedfor a customer.  In the first quarter of2007, management determined that certain alternative equipment and relateddesign processes were a more appropriate complement to the development of thistechnology. As a result, the Company determined the extent to which it expectsto utilize the Equipment in the future had decreased from its originalestimates. Accordingly, the Company concluded that the carrying value of theEquipment of approximately $0.3 million was no longer recoverable and was infact impaired. In accordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*, the Companyestimated the current fair value of the Equipment primarily using market pricesfor comparable machinery and equipment. As a result of its analysis, theCompany recorded an impairment charge of approximately $0.1 million to writedown the carrying value of the Equipment to its estimated fair value. Thischarge is included as a component of research and development expense for thethree months ended March 31, 2007 in the accompanying unaudited condensedconsolidated statement of operations.

The Company is stillevaluating the extent of possible alternative uses for the Equipment, which mayinclude ultimately disposing of the Equipment through a sale.

**NOTE 10—STOCK OPTIONS AND WARRANTS**

*Common Stock Options*

In November 2000,the Company adopted the 2000 Equity Incentive Plan (the “2000 Plan”) and inOctober 2006, the Company adopted the 2006 Equity Incentive Plan (the “2006Plan”), under which direct stock awards or options to acquire shares of theCompany’s common stock may be granted to employees and nonemployees of theCompany. The 2000 Plan is administered by the Board of Directors or a committeethereof, and the 2006 Plan is administered by the Compensation Committee of theBoard of Directors. The 2000 Plan permitted the issuance of up to 5,750,000shares of the Company’s common stock. Effective as of the Company’s initialpublic offering on December 5, 2006, no further grants may be 

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made under the 2000 Plan.The 2006 Plan permits the issuance of a maximum of 500,000 shares of commonstock, automatically increasing on the first day of each calendar yearbeginning on or after January 1, 2007 by the lesser of (i) 500,000 sharesand (ii) such smaller number of shares as may be determined by our Boardof Directors prior to that date. Options granted under the 2000 Plan and 2006Plan primarily vest over a rate of 25% per year over four years and expire10 years from the date of grant.

In March 2007, theCompany granted options to purchase 3,000 shares of the Company’s common stockto a non-employee consultant, which were immediately vested as of the grantdate and carry an exercise price of $2.55 per share.  The total grant date fair value of theseoptions was approximately $20,000, which was recorded as stock-basedcompensation expense for the three months ended March 31, 2007.

A summary of common stockoption activity as of and for the three months ended March 31, 2007 is presentedbelow (shares in thousands):
|                                             | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price per  Share** | ** ** |
|---------------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Options  outstanding at December 31, 2006   |       | 3,318      |       | $                                                       | 3.34       |   |
| Options granted                             |       | 91         |       | 8.56                                                    |       |
| Options  exercised                          |       | (101       | )          | 1.12                                                    |       |
| Options  cancelled                          |       | (27        | )          | 2.55                                                    |       |
| Options outstanding at  March 31, 2007 |       | 3,281      |       | $                                                       | 3.56       |   |

 

The weighted-averagegrant date fair value per share of stock options granted during the threemonths ended March 31, 2007 and April 1, 2006 was $6.07 and $0.52,respectively. These values were estimated using the following assumptions:
|                           | ** ** | **Three  Months  Ended  March 31,  2007** | ** ** | **Three  Months  Ended  April 1,  2006** | ** ** |
|---------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| Expected term  (in years) |       | 5.4                                            |       | 6                                             |       |
| Expected  volatility      |       | 80                                             | %          | 40                                            | %          |
| Risk-free  interest rate  |       | 4.65                                           | %          | 4.55                                          | %          |
| Expected dividends        |       | —                                         |       | —                                        |       |

 

*At March31, 2007, the amount of unearned stock-based compensation currently estimatedto be expensed from fiscal 2007 through fiscal 2011 related to unvested commonstock options is approximately $3.5 million. The weighted-average period overwhich the unearned stock-based compensation is expected to be recognized isapproximately 3.2 years. If there are any modifications or cancellations of theunderlying unvested common stock options, the Company may be required toaccelerate, increase or cancel any remaining unearned stock-based compensationexpense. Future stock-based compensation expense and unearned stock-basedcompensation will increase to the extent that the Company grants additionalequity awards.*

*Warrants*

From time to time, theCompany issues warrants to non-employees for services rendered or to berendered in the future. Such warrants are issued outside of the 2000 Plan and2006 Plan. As of March 31, 2007 and December 30, 2006, there were warrantsoutstanding to purchase 397,500 shares of common stock. As of March 31, 2007,approximately 368,000 warrants to purchase shares of common stock were fullyvested and exercisable, while the remaining warrants to purchase 29,500 sharesof common stock vest over approximately the next 3.5 years. The weighted-averageexercise price of the warrants outstanding at March 31, 2007 was $1.35 pershare.

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**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.All the Company’s international sales relate to shipments of products to itsU.S. customers’ international manufacturing sites or third-party hubs andare denominated in U.S. dollars.

**NOTE12—SUBSEQUENT EVENT**

In May 2007, the Companyand certain of its officers and directors were named as defendants in asecurities class action filed in federal court in New York (Tran v. Netlist, etal., No. 07 CV 3754). The complaint is filed on behalf of purchasers of the Company’scommon stock in or traceable to the Company’s initial public offering andassets claims under Sections 11 and 15 of the Securities Act of 1933. TheCompany has not been served with the complaint.

**Item2.    Management’s Discussion and Analysisof Financial Condition and Results of Operations**

**Cautionary Statement**

*The following discussion andanalysis of our financial condition and results of operations should be read inconjunction with our Unaudited Condensed Consolidated Financial Statements andthe related notes thereto contained in Part I, Item 1 of this Report. Theinformation contained in this Quarterly Report on Form 10-Q is not a completedescription of our business or the risks associated with an investment in ourcommon stock. We urge you to carefully review and consider the variousdisclosures made by us in this Report and in our other reports filed with theSecurities and Exchange Commission (“SEC”), including our Annual Report onForm 10-K for the fiscal year ended December 30, 2006 and subsequentreports on Form 8-K, which discuss our business in greater detail.*

*The section entitled “RiskFactors” set forth in Part II, Item 1A, and similar discussions in our otherSEC filings, describe some of the important risk factors that may affect ourbusiness, results of operations and financial condition. You should carefullyconsider those risks, in addition to the other information in this QuarterlyReport on Form 10-Q and in our other filings with the SEC, before deciding topurchase, hold or sell our common stock.*

*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 identifiedunder the heading “Risk Factors” set forth in Part II, Item 1A. We undertake noobligation to revise or update publicly any forward-looking statements for anyreason.*

**Overview**

We design, manufactureand sell high performance memory subsystems for the server, high performancecomputing and communications markets. Our memory subsystems consist of dynamicrandom access memory integrated circuits, or DRAM ICs, and other componentsassembled on a printed circuit board, or PCB. We engage with our originalequipment manufacturer, or OEM, customers from the earliest stages of newproduct definition, which provides us unique insight into their full range ofsystem architecture and performance requirements. This close collaboration hasalso allowed us to develop a significant level of systems expertise. Weleverage a portfolio of proprietary technologies and design techniques,including efficient 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.

Due to their importanceto overall system architecture and performance, our products must undergolengthy qualification reviews by our OEM customers, which may last up to sixmonths. In addition, in order to penetrate large OEMs, we have typically beenrequired to demonstrate our ability to meet strict standards for quality, customerservice and turnaround time by first supplying less complex products into alimited range of high volume applications. For example, the initial products wesold to IBM were used in mobile computing applications. The majority of oursales of subsequent products to IBM have been for high-end server applications,our primary market focus. Consistent with the concentrated nature of the 

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OEM customer base in ourtarget markets, a small number of large customers have historically accountedfor a significant portion of our net sales. Dell and IBM represented 38% and11%, respectively, of our net sales in the three months ended March 31, 2007,and 16% and 33%, respectively, of our net sales in the three months ended April1, 2006.  Additionally, Hewlett Packardrepresented 31% of our net sales in the three months ended March 31, 2007. Weexpect that Dell, IBM and Hewlett Packard will continue to represent asignificant percentage of our net sales for at least the next 12 months.

During the three monthsended March 31, 2007, the market price of DRAM ICs decreased over 50%. Thisdecline has adversely affected the selling prices of many of our products andresulted in lower revenues, lower gross margin and reduced inventory valueduring this period. Should the decline in the DRAM IC market continue, it wouldresult in lower net sales, lower gross margin and reduced inventory value insubsequent periods. We expect that the continued softness in the DRAM marketwill have a significant impact on our overall results of operations insubsequent periods.

**Key Business Metrics**

The following describescertain line items in our statements of operations that are important tomanagement’s assessment of our financial performance:

*Net Sales.**  *Net sales consist primarily ofsales of our high performance memory subsystems, net of a provision forestimated returns under our right of return policies, which range up to30 days. We generally do not have long-term sales agreements with ourcustomers. Although OEM customers typically provide us with non-bindingforecasts of future product demand over specific periods of time, theygenerally place purchase orders with us approximately two weeks in advance ofscheduled delivery. Selling prices are typically negotiated monthly, based oncompetitive market conditions and the current price of DRAM ICs. Purchaseorders generally have no cancellation or rescheduling penalty provisions. Weoften ship our products to our customers’ international manufacturing sites.All of our sales to date, however, are denominated in U.S. dollars. We alsosell excess component inventory of DRAM ICs to distributors and other users ofmemory ICs. These sales accounted for approximately 3% and 19% of our net salesin the three months ended March 31, 2007 and April 1, 2006, respectively. Weexpect that component inventory sales will continue to decrease as a percentageof net sales in future periods as we diversify our customer base and thereforeare able to use components in a wider range of memory subsystems.

*Cost of Sales.**  *Our cost of sales includes the costof materials, manufacturing costs, depreciation and amortization of equipment,inventory valuation provisions, stock-based compensation and occupancy costsand other allocated fixed costs. The DRAM ICs incorporated into our productsconstitute a significant portion of our cost of sales, and thus our cost ofsales will fluctuate based on the current price of DRAM ICs. We attempt to passthrough such DRAM IC cost fluctuations to our customers by frequentlyrenegotiating pricing prior to the placement of their purchase orders. To theextent we are successful, a large majority of our product cost is variable, andthus our cost of sales and gross margin percentages may not be significantlyimpacted by changes in sales volume. However, the sales prices of our memory subsystemscan also fluctuate due to competitive situations unrelated to the pricing ofDRAM ICs, which will affect gross margins. The gross margin on our sales ofexcess component DRAM IC inventory is much lower than the gross margin on oursales of our memory subsystems. As a result, a decrease in DRAM IC inventorysales as a percentage of our overall sales would result in an improved overallgross margin. We assess the valuation of our inventories on a monthly basis andrecord a provision to cost of sales as necessary to reduce inventories to thelower of cost or market value.

*Research and Development.**  *Research and development expenseconsists primarily of employee and independent contractor compensation andrelated costs, stock-based compensation, computer-aided design softwarelicenses, reference design development costs, patent-related fees, depreciationor rental of evaluation equipment, and occupancy and other allocated overheadcosts. Also included in research and development expense are the costs ofmaterial and overhead related to the production of engineering samples of newproducts under development or products used solely in the research anddevelopment process. Our customers typically do not separately compensate usfor design and engineering work involved in developing application-specificproducts for them. All research and development costs are expensed as incurred.As we continue to develop additional proprietary technologies, we anticipatethat research and development expenditures will increase.

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*Selling, General andAdministrative.**  *Selling,general and administrative expenses consist primarily of employee salaries andrelated costs, stock-based compensation, independent sales representativecommissions, professional services, promotional and other selling and marketingexpenses, and occupancy and other allocated overhead costs. A significantportion of our selling efforts is directed at building relationships withOEMs 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 penetrate new OEM customers, we anticipate that oursales and marketing expenses will increase. We also anticipate that our generaland administrative expenses will increase as a percentage of net sales as weincur accounting and legal expenses associated with our ongoing publicreporting obligations and compliance with the requirements of theSarbanes-Oxley Act of 2002.

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

**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 our more significantassumptions and estimates used in the preparation of our consolidated financialstatements:

*Revenue Recognition.*   Werecognize revenues in accordance with the Securities and Exchange Commission’sStaff Accounting Bulletin No. 104, *Revenue Recognition*,or SAB No. 104. Under the provisions of SAB No. 104, we recognize revenueswhen there is persuasive evidence of an arrangement, product delivery andacceptance have occurred, the sales price is fixed or determinable, andcollectibility of the resulting receivable is reasonably assured.

For all sales, we use abinding purchase order as evidence of an arrangement. Delivery occurs whengoods are shipped for customers with FOB Shipping Point terms and upon receiptfor customers with FOB Destination terms, at which time title and risk of losstransfer to the customer. Shipping documents are used to verify delivery andcustomer acceptance. We assess whether the sales price is fixed or determinablebased on the payment terms associated with the transaction and whether thesales price is subject to refund. Customers are generally allowed limitedrights of return for up to 30 days, except for sales of excess inventories,which contain no right-of-return privileges. Estimated returns are provided forat the time of sale based on historical experience or specific identificationof an event necessitating a reserve. Returns from customers have not beenmaterial in any period as our principal customers have adopted build-to-ordermanufacturing models or just-in-time management processes. We offer a standardproduct warranty to our customers and have no other post-shipment obligations.We assess collectibility based on the creditworthiness of the customer asdetermined by credit checks and evaluations, as well as the customer’s paymenthistory. Most of our international shipments are made to third- party inventorywarehouses, or hubs, and we recognize revenue when the inventory is pulled fromthe hub for use in production by the customer. We receive a report from thecustomer on a daily basis indicating the inventories pulled from a hub for useby the customer, and perform a daily reconciliation of inventories shipped toand pulled by the customer to those inventories reflected on the customer’sreports to ensure that sales are recognized in the appropriate periods.

Customers are generallyallowed limited rights of return for up to 30 days. Estimated returns areprovided for at the time of sale based on historical experience or specificidentification of an event necessitating a reserve. While these returns havehistorically been within our expectations and the provisions established, wecannot guarantee that we will continue to experience similar return rates inthe future. Any significant increase in product failure rates and the resultingproduct returns could have a material adverse effect on our operating results forthe period or periods in which such returns materialize.

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All amounts billed tocustomers related to shipping and handling are classified as net sales, whileall costs incurred by us for shipping and handling are classified as cost ofsales.

*Warranty Reserve.*   Weoffer warranties on our memory subsystems generally ranging from one to threeyears, depending on the product and negotiated terms of purchase agreementswith our customers. Such warranties require us to repair or replace defectiveproduct returned to us during such warranty period at no cost to the customer.Our estimates for warranty related costs are recorded at the time of sale basedon historical and estimated future product return rates and expected repair orreplacement costs. While such costs have historically been insignificant,unexpected changes in failure rates could have a material adverse impact on us.

*Accounts Receivable.*   Weperform credit evaluations of our customers’ financial condition and limit theamount of credit extended to our customers as deemed necessary, but generallyrequire no collateral. We continuously monitor collections and payments fromour customers and maintain a provision for estimated credit losses based uponour historical experience and any specific customer collection issues that wehave identified. Generally, these credit losses have been within ourexpectations and the provisions established. However, we cannot guarantee thatwe will continue to experience credit loss rates similar to those we haveexperienced in the past.

Our accounts receivableare highly concentrated among a small number of customers, and a significantchange in the liquidity or financial position of one of these customers couldhave a material adverse effect on the collectibility of our accountsreceivable, our liquidity and our future operating results.

*Inventories.*   Wevalue our inventories at the lower of the actual cost to purchase ormanufacture the inventory or the net realizable value of the inventory. Cost isdetermined on a first-in, first-out basis and includes raw materials, labor andmanufacturing overhead. We regularly review inventory quantities on hand and onorder and record a provision for excess and obsolete inventories basedprimarily on our estimated forecast of product demand and productionrequirements for the next three to six months. In addition, we consider changesin the market value of DRAM ICs in determining the realizable value of our rawmaterial inventory. Once established, any write-downs are considered permanentadjustments to the cost basis of our inventories. A significant decrease indemand for our products could result in an increase in the amount of excessinventory quantities on hand. In addition, our estimates of future productdemand may prove to be inaccurate, in which case we may have understated oroverstated the provision required for excess and obsolete inventory. In thefuture, if our inventories are determined to be overvalued, we would berequired to recognize additional expense in our cost of sales at the time ofsuch determination. Likewise, if our inventories are determined to beundervalued, we may have over-reported our costs of sales in previous periodsand would be required to recognize additional gross profit at the time suchinventories are sold. In addition, should the market value of DRAM ICs decreasesignificantly, we may be required to lower our selling prices to reflect thelower cost of our raw materials. If such price decreases reduce the realizablevalue of our inventories to less than our cost, we would be required torecognize additional expense in our cost of sales in the same period. Althoughwe make every reasonable effort to ensure the accuracy of our forecasts offuture product demand, any significant unanticipated changes in demand, technologicaldevelopments or the market value of DRAM ICs could have a material effect onthe value of our inventories and our reported operating results.

*Long-Lived Assets.**  *We review the recoverability of thecarrying value of long-lived assets on an annual basis or whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. Recoverability of these assets is determined based upon theforecasted undiscounted future net cash flows from the operations to which theassets relate, utilizing our best estimates, appropriate assumptions andprojections at the time. These projected future cash flows may varysignificantly over time as a result of increased competition, changes intechnology, fluctuations in demand, consolidation of our customers 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.*   Weaccount for equity issuances to non-employees in accordance with Statement ofFinancial Accounting Standards, or SFAS, No. 123, *Accounting for Stock Based Compensation*,and Emerging Issues Task Force, or EITF Issue No. 96-18, *Accounting for Equity Instruments that are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods andServices*. All transactions in which goods or services are theconsideration received for the issuance of equity instruments are accounted forbased on the fair value of the consideration received or the fair value of theequity 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.

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Prior to January 1,2006, we accounted for stock-based compensation issued to employees using theintrinsic value method of accounting prescribed by Accounting Principles BoardOpinion No. 25, *Accounting for StockIssued to Employees*and related pronouncements. Under this method,compensation expense was recognized over the respective vesting period based onthe excess, on the date of grant, of the fair value of our common stock overthe grant price, net of forfeitures. Deferred stock-based compensation wasamortized on a straight-line basis over the vesting period of each grant.

On January 1, 2006,we adopted SFAS No. 123(R), *Share-BasedPayment*, or SFAS No. 123(R),which requires the measurement and recognition of compensation expense for allshare-based payment awards made to our employees and directors related to ourAmended and Restated 2000 Equity Incentive Plan based on estimated fair values.We adopted SFAS No. 123(R) using the modified prospective transitionmethod, which requires the application of the accounting standard as ofJanuary 1, 2006, the first day of our fiscal year 2006. Our consolidatedfinancial statements as of and for the year ended December 30, 2006reflect the impact of adopting SFAS No. 123(R). In accordance with themodified prospective transition method, our consolidated financial statementsfor prior periods have not been restated to reflect, and do not include, theimpact of SFAS No. 123(R). The value of the portion of the award that isultimately expected to vest is recognized as expense over the requisite serviceperiods in our consolidated statement of operations. As stock-basedcompensation expense recognized in the consolidated statement of operations isbased on awards ultimately expected to vest, it has been reduced for estimatedforfeitures. SFAS No. 123(R) requires forfeitures to be estimated atthe time of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates.

*Income Taxes.**  *We recognize deferred tax assetsand liabilities based on the differences between the financial statementcarrying values and the tax bases of assets and liabilities. We regularlyreview our deferred tax assets for recoverability and establish a valuationallowance based on historical taxable income, projected future taxable income,and the expected timing of the reversals of existing temporary differences. Ifwe operate at a loss for an extended period of time or are unable to generatesufficient future taxable income, or if there is a material change in theactual effective tax rates or time period within which the underlying temporarydifferences become taxable or deductible, we could be required to record avaluation allowance against all or a significant portion of our deferred taxassets which could substantially increase our effective tax rate for suchperiod. Any significant changes in statutory tax rates or the amount of ourvaluation allowance could have a material effect on the value of our deferredtax assets and liabilities, and our reported financial results. Additionally,the Company adopted Financial Accounting Standards Board, or FASB,Interpretation No. 48, *Accounting for Uncertaintyin Income Taxe*s, or FIN 48, on December 31, 2006, the first day offiscal 2007. FIN 48 is an interpretation of SFAS No. 109, *Accountingfor Income Taxes*, and 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.  FIN 48 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. Refer to Note. 6, “Income Taxes,” for additional information.

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**Results of Operations**

The following table setsforth certain consolidated statements of operations data as a percentage of netsales for the periods indicated: 
|                                                            | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                 | ** ** | **March 31,  2007**         | ** ** | **April 1,  2006** | ** ** |
| ** **                                                 |       |                             |       |   |   |
| Net sales                                                  |       | 100.0                            | %          | 100.0 | % |
| Cost of sales                                              |       | 85.5                             |       | 90.2 |   |
| Gross profit                                               |       | 14.5                             |       | 9.8 |   |
| Operating  expenses:                                       |       |                             |       |   |   |
| Research and development                                   |       | 2.8                              |       | 2.6 |   |
| Selling, general and administrative                        |       | 9.9                              |       | 6.9 |   |
| Total operating expenses                                   |       | 12.7                             |       | 9.5 |   |
| Operating income                                           |       | 1.8                              |       | 0.3 |   |
| Interest  expense, net                                     |       | (0.1                             | )          | (1.6 | ) |
| Other income  (expense), net                               |       | —                           |       | — |   |
| Income (loss)  before provision (benefit) for income taxes |       | 1.7                              |       | (1.2 | ) |
| Provision  (benefit) for income taxes                      |       | —                           |       | (0.3 | ) |
| Net income (loss)                                          |       | 1.7                              | %          | (0.9 | )% |

 

***Three Months Ended March 31, 2007 Compared to ThreeMonths Ended April 1, 2006***

*Net Sales.**  *Net sales for the three monthsended March 31, 2007 were $37.5 million, a net increase of$11.5 million, or 44%, over the three months ended April 1, 2006. Sales oflaptop personal computer, or PC, memory subsystems increased approximately$11.0 million over the three months ended April 1, 2006 primarily as a resultof certain opportunities that arose in the market to sell such additional unitsduring the current period. This was offset by a decrease in sales of our verylow profile memory subsystems of approximately $8.3 million. In addition, DDR2server memory subsystem sales increased by approximately $2.8 million while DDRsubsystem sales decreased by approximately $0.3 million as customers continuetransitioning to DDR2 architectures. Finally, sales of memory subsystems usedto control redundant arrays of independent disks (RAIDs), which commenced latein the second quarter of fiscal 2006, contributed to approximately $11.3 of ourrevenues for the three months ended March 31, 2007.

Although sales of laptopPC memory increased significantly during the three months ended March 31, 2007compared to the comparable quarter of 2006, such sales were adversely impactedby the significant decrease in DRAM IC market prices during the quarter.  Such market price decreases cause us todecrease pricing on many of our products, including laptop PC memorysubsystems.  Should such market pricedeclines continue, our overall revenues could be adversely impacted as we lowerprices on some products to meet market conditions.

Sales of our componentinventory to distributors and other users of memory ICs represented 3% and 19%of net sales for the three months ended March 31, 2007 and April 1, 2006,respectively. We expect that component inventory sales will continue torepresent a relatively small percentage of net sales in future periods as wediversify our customer base and therefore are able to use components in a widerrange of memory subsystems.

*Gross Profit and GrossMargin.**  *Grossprofit for the three months ended March 31, 2007 was $5.5 million, anincrease of $2.9 million, or 113%, over the three months ended April 1, 2006.Gross margin increased to 14.5% from 9.8% for the same period. The increase inboth gross profit and gross margin is primarily attributable to increased salesof DDR2 server memory subsystems and memory subsystems to control RAIDs, whichgenerate higher margins due to their innovative design.  These increases were 

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partially offset by thecomparatively low gross margins realized on sales of laptop memory to one OEMcustomer during the three months ended March 31, 2007.   The gross margin on sales of laptop PCmemory was adversely impacted by the significant decrease in the market priceof DRAM ICs during the first quarter of fiscal 2007.  To the extent that such market price declinescontinue and should our product sales mix shift more toward lower marginproducts such as laptop memory, our gross profit, gross margin and overalloperating results could be adversely affected.

*Research and Development.**  *Research and development expensesfor the three months ended March 31, 2007 were $1.1 million, an increase of$0.4 million compared to the three months ended April 1, 2006. Theincrease was primarily attributable to (i) an increase of $0.1 million relatedto additional personnel engaged in research and development activities sinceApril 1, 2006, (ii) $0.1 million related to the impairment write-down ofcertain long-lived assets used in the product development process and (iii) anincrease of $0.1 million related to equipment, testing and certain otherprofessional services incurred.

*Selling, General andAdministrative.**  *Selling,general and administrative expenses for the three months ended March 31,2007 were $3.7 million, an increase of $1.9 million compared to the threemonths ended April 1, 2006. The increase was primarily attributable to (i)an increase of $0.6 million related to additional personnel engaged in selling,general and administrative activities since April 1, 2006, (ii) an increase of$0.7 million in legal and professional services, primarily related to reportingand other obligations as a result of becoming a publicly traded company, alongwith costs incurred to set up our operation in China, (iii) an increase of $0.4million related to certain selling and promotional expenses and (iv) anincrease of $0.2 million in stock-based compensation.

*Other Expense, Net.**  *Other expense, net, for the threemonths ended March 31, 2007 was $47,000, a decrease of $0.4 million compared tothe three months ended April 1, 2006. The decrease was due primarily tointerest income of approximately $0.4 million earned during the current periodon our investments in marketable securities, which significantly offset ourinterest expense of approximately $0.5 million for the three months ended March31, 2007.

*Provision (Benefit) forIncome Taxes.**  *We did not record a provision for incometaxes for the three months ended March 31, 2007 which is compared to anincome tax benefit of $83,000 recorded for the three months ended April 1,2006. As of March 31, 2007, we have estimated our annual effective tax rate tobe zero for fiscal 2007, which is based on our projected annualized income andthe effect of research and development credits.

**New AccountingPronouncements**

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities –Including an Amendment of FASB Statement No. 115*, or SFAS No.159.SFAS No. 159 permits entities to choose to measure many financial instrumentsand certain other items at fair value. The objective is to improve financialreporting by providing entities with the opportunity to mitigate volatility inreported earnings caused by measuring related assets and liabilitiesdifferently without having to apply complex hedge accounting provisions. SFASNo. 159 also establishes presentation and disclosure requirements designed tofacilitate comparison between entities that choose different measurementattributes for similar types of assets and liabilities. We will adopt SFAS No.159 in the first quarter of 2008 and are still evaluating the effect, if any,on our consolidated financial position and consolidated results of operationsand have not yet determined its impact.

**Liquidity and Capital Resources**

Since our inception, wehave financed our operations primarily through issuances of equity and debtsecurities and cash generated from operations. We have also funded ouroperations with a revolving line of credit under our bank credit facility, fromcapitalized lease obligations, financing of receivables and from the sale andleaseback of our manufacturing facility.

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*Working Capital and Cashand Marketable Securities.**  *Thefollowing table presents working capital, cash and cash equivalents andinvestments in marketable securities (in thousands):
|                                      | ** ** | **March 31,** | ** ** | **December 30,** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| Working Capital                      |       | $                  | 40,186     |                  | $          | 45,584 |   |
| Cash and cash  equivalents(1)        |       | $                  | 11,694     |                  | $          | 30,975 |   |
| Short-term  marketable securities(1) |       | 16,149             |       | 5,267                 |       |
| Long-term  marketable securities     |       | 6,842              |       | 1,502                 |       |
|                                 |       | $                  | 34,685     |                  | $          | 37,744 |   |

 

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*(1) Included in working capital*

*Our working capital decreased in the three months endedMarch 31, 2007 primarily as a result of additional purchases of long-terminvestments in marketable securities and property and equipment during theperiod.*

***CashProvided and Used in the Three Months Ended March 31, 2007 and April 1, 2006***

*Operating Activities.*   Netcash provided by operating activities for the three months ended March 31,2007 was $4.9 million primarily as a result of $0.6 million in net incomefor the three months ended March 31, 2007 and (i) $0.3 million in net non-cashoperating expenses, primarily comprising depreciation and amortization, deferredincome taxes, stock-based compensation and impairment of long-lived assets and(ii) $4.0 million in net cash provided by changes in operating assets andliabilities. Net cash provided by operating activities for the three monthsended April 1, 2006 was $2.6 million. This was primarily the result of the netloss for the three months ended April 1, 2006 offset by (i) $0.3 million in netnon-cash operating expenses, primarily comprising depreciation and amortizationand stock-based compensation expense, and (ii) $2.5 million in net cashprovided by changes in operating assets and liabilities.

*Investing Activities.*   Netcash used in investing activities for the three months ended March 31, 2007 was$16.7 million primarily as a result of purchases of additional investments inmarketable securities during the period of approximately $30.6 million,partially offset by proceeds received from maturities of certain investments inmarketable securities of approximately $14.4 million. Net cash used ininvesting activities for the three months ended April 1, 2006 was $22,000resulting from the purchase of $67,000 of capital equipment to supportoperations, partially offset by the receipt of $45,000 in proceeds from thesale of certain other capital equipment.

*Financing Activities.*   Netcash used in financing activities for the three months ended March 31,2007 was $7.5 million primarily as a result of net repayments on ouroutstanding revolving line of credit of approximately $7.2 million. Net cashused in financing activities for the three months ended April 1, 2006 was $3.5million resulting primarily from net repayments on our outstanding revolvingline of credit of approximately $3.4 million.

***Capital Resources***

In April 2007, weexecuted a seventh amendment (the “Seventh Amendment”) to our credit agreementwith our bank, which is effective March 21, 2007.  The Seventh Amendment allows us, at ourelection, to increase our maximum borrowings on the line of credit from $25million, in $2.5 million increments, up to a total of $40 million. In addition,among other terms, the Seventh Amendment (i) extends the maturity date of theline of credit to July 31, 2009, (ii) establishes an equipment advance line of$3 million, (iii) increases the sublimit for letters of credit to $5 million,(iv) sets an inventory sublimit of $7 million, subject to increase to $10million if certain targets are met and (v) provides for the reduction ininterest rates on borrowings if certain borrowing amounts and financial performancetargets are met.

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Under the revolving lineof credit, we may borrow up to the greater of 85% of eligible accountsreceivable plus the least of (i) a percentage of eligible inventory determinedfrom time to time by the Company’s bank, (ii) 80% of the orderly liquidationvalue, as defined, of eligible inventories, and (iii) $7 million.Interest is payable monthly at the prime rate of 8.25% as of March 31, 2007.Outstanding borrowings under the revolving line of credit were $12.0 millionand $19.2 million as of March 31, 2007 and December 30, 2006,respectively. Borrowing availability as of March 31, 2007 was $2.9 million.

Under the equipmentfinancing line of credit, we may borrow up to 80% of the cost of equipmentpurchases up to the maximum of $3 million. Interest on equipment line of creditadvances was payable at the prime rate plus 0.5% prior to the Company’s initialpublic offering in December 2006 and was reduced to the prime ratethereafter. Principal is due monthly through the maturity date of the creditagreement in July 2009, when all unpaid principal and interest is due.Outstanding borrowings under the new equipment line of credit were $996,000 and$1.1 million at March 31, 2007 and December 30, 2006, respectively.

Under the terms of thecredit agreement, as stipulated within the Seventh Amendment, we are requiredto comply with certain financial and other covenants. The financial covenantsrequire us to (i) achieve minimum book net worth on a monthly basis, (ii) limitannual capital expenditures under a defined annual cap and (iii) achieve aminimum quarterly debt service coverage ratio. While we are currently incompliance with all financial covenants and expect to maintain compliance forthe foreseeable future, we have in the past been in violation of one or morecovenants. We cannot assure you that we will not violate one or more covenantsin the future. If we were to be in violation of covenants under our creditagreement, our lender could choose to accelerate payment on all outstandingloan balances. There can be no assurance that we would be able to quicklyobtain equivalent or suitable replacement financing in this event. If we werenot able to secure alternative sources of funding, such acceleration would havea material adverse impact on our financial condition.

We have in the pastutilized equipment leasing arrangements to finance capital expenditures.Equipment leases will continue to be a financing alternative that we may pursuein the future.

We believe our existingcash balances, borrowing availability under our bank credit facility, and thecash expected to be generated from operations, will be sufficient to meet ouranticipated cash needs for at least the next 12 months. Our future capitalrequirements will depend on many factors, including our levels of net sales,the timing and extent of expenditures to support research and developmentactivities, the expansion of manufacturing capacity both domestically andinternationally and the continued market acceptance of our products. We couldbe required, or may choose, to seek additional funding through public orprivate equity or debt financings. In addition, in connection with any futureacquisitions, we may require additional funding which may be provided in theform of additional debt or equity financing or a combination thereof. Theseadditional funds may not be available on terms acceptable to us, or at all.

**Item 3.**                          Quantitativeand Qualitative Disclosures About Market Risk

***Interest Rate Risk***

Our exposure to marketrisk for changes in interest rates relates primarily to our bank creditfacility because borrowings under the facility are variable rate borrowings,generally at prime. Assuming that all lines under the facility are fully drawnand holding other variables constant, each 1.0% increase in interest rates onour variable rate borrowings will result in an increase in annual interestexpense and a decrease in our cash flows and income before taxes ofapproximately $0.4 million per year. We do not use derivative instruments tohedge the interest rate risk related to our credit facility.

We have invested most ofthe proceeds of our initial public offering in securities which may be subjectto market risk for changes in interest rates. To mitigate this risk, wemaintain a portfolio of cash equivalents and investments in a variety ofmarketable securities, which include commercial paper, money market funds,government and non-government debt securities. We currently do not use derivative financial instruments.

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Our cash equivalents andinvestments in marketable securities are classified as available-for-sale inaccordance with SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*, and are therefore stated at fair value.Differences between fair value and amortized cost are recorded as unrealizedgains and losses and are reported, net of taxes, as a component of accumulatedother comprehensive income (loss). The fair value of our investments inmarketable securities fluctuates based on changes in market conditions andinterest rates; however, given the general short-term maturities of ourinvestments, we do not believe these instruments are subject to significantmarket or interest rate risk.

Thecarrying value, maturity and estimated fair value of our cash equivalents andinvestments in marketable securities as of March 31, 2007 were as follows:
| ** **                      | ** ** | ** **                                                    | ** ** | **Maturity**       | ** ** | ** **          | ** ** |
|---------------------------------|------------|---------------------------------------------------------------|------------|--------------------|------------|---------------------|------------|
| ** **                      | ** ** | ** **                                                    | ** ** | **Within**         | ** ** | **Greater**         | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Carrying**                                                  | ** ** | **One Year**  | ** ** | **Than One**   | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Value**                                                     | ** ** | **after**          | ** ** | **Year After** | ** ** | **Fair Value** | ** ** |
| ** **                      | ** ** | **March 31,**                                            | ** ** | **March 31,** | ** ** | **March 31,**  | ** ** | **March 31,** | ** ** |
| ** **                      | ** ** | **2007**                                                      | ** ** | **2007**           | ** ** | **2007**            | ** ** | **2007** | ** ** |
| ** **                      | ** ** | **(In thousands, except interest rates)** | ** ** |
|                            |       |                                                          |       |               |       |                |       |   |   |
| **Investments**                 | ** ** | ** **                                                    | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** |
| Cash equivalents                |       | $                                                             | 11,163     |               | $          | 11,163              |       | $ | — |   | $ | 11,163 |   |
| Weighted average interest rate  |       | 5.29                                                          | %          | 5.29               | %          | —              | %          |   |   |
|                            |       |                                                          |       |               |       |                |       |   |   |
| Marketable  securities          |       | $                                                             | 22,991     |               | $          | 16,149              |       | $ | 6,842 |   | $ | 22,991 |   |
| Weighted average  interest rate |       | 5.32                                                          | %          | 5.27               | %          | 5.40                | %          |   |   |

 

***Off-Balance SheetArrangements***

We do not have anyrelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. Inaddition, we do not have any undisclosed borrowings or debt, and we have notentered into any synthetic leases. We are, therefore, not materially exposed toany financing, liquidity, market or credit risk that could arise if we hadengaged in such relationships.

**Item 4.**                          Controlsand Procedures

*(a) Evaluation ofDisclosure Controls and Procedures.*   We carriedout an evaluation, under the supervision and with the participation of ourmanagement, including our principal executive officer and principle financialofficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of theSecurities Exchange Act of 1934, (“Exchange Act”)) as of the end of our fiscalquarter ended March 31, 2007. Based upon that evaluation, our principalexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures are effective in ensuring that information required tobe disclosed by us in reports that we file or submit under the Exchange Act (i)is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms and (ii) is accumulated and communicatedto our management, including our principal executive officer and principalfinancial officer to allow timely decisions regarding required disclosure.

*(b) Change in internalcontrols over financial reporting.*   During thefiscal quarter that ended March 31, 2007, there have not been any changes inour internal control over financial reporting (as defined in Rules 13a-15(f)and 15d-15(f) under the Exchange Act) that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

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**PART II.OTHER INFORMATION**

**Item 1.**                          LegalProceedings

The information set forthunder Note 7 of Notes to Unaudited Condensed Consolidated Financial Statements,included in Part I, Item I of this Report, is incorporated herein by reference.

**Item 1A.**                 Risk Factors

***This Report includesforward-looking statements. These forward-looking statements generally areidentified by words such as “believe”, “expect”, “anticipate”, “estimate”, “intend”,“strategy”, “may”, “will likely” and similar words or phrases. Aforward-looking statement is neither a prediction nor a guarantee of futureevents or circumstances, and those future events or circumstances may notoccur. Investors should not place undue reliance on the forward-lookingstatements, which speak only as of the date of this Report. We are under noobligation to update or alter any forward-looking statements, whether as aresult of new information, future events or otherwise. These forward-lookingstatements are all based on currently available operating, financial andcompetitive information and are subject to various risks and uncertainties,including but not limited to the rapidly-changing nature of technology;evolving industry standards; introductions of new products by competitors;changes in end-user demand for technology solutions; our ability to attract andretain skilled personnel; our reliance on suppliers of critical components; andthe political and regulatory environment in the People’s Republic of China (“PRC”).Our actual future results and trends may differ materially depending on avariety of factors including, but not limited to, the risks and uncertaintiesdiscussed below. The risks below are not the only ones we face. Additionalrisks and risks that management currently considers immaterial may also have anadverse effect on us.***

**We have a limited operating history, and we expect anumber of factors to cause our operating results to fluctuate on a quarterlyand annual basis, which may make it difficult to predict our futureperformance.**

Our limited operatinghistory makes it difficult to predict our future performance. Our operatingresults have varied significantly in the past and will continue to fluctuatefrom quarter-to-quarter or year-to-year in the future due to a variety offactors, many of which are beyond our control. Factors relating to our businessthat may contribute to these quarterly and annual fluctuations include thefollowing factors, as well as other factors described elsewhere in this report:

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

·       the cyclical nature of theindustry in which we operate;

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

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

·       our inability to developnew or enhanced products that achieve customer or market acceptance in a timelymanner;

·       the timing of introductionsof competing products or technologies;

·       our ability to adequately financefuture growth;

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

·       our failure to maintain thequalification of our products with our current customers or to qualify futureproducts with our current or prospective customers;

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

·       our establishment andongoing operation of a new manufacturing facility in the PRC;

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·       the loss of any of our keypersonnel;

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

·       disputes regardingintellectual property rights;

·       litigation involving ourproducts;

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

·       changes in accountingprinciples or policies.

Due to the variousfactors mentioned above, and others, the results of any prior quarterly or annualperiods should not be relied upon as an indication of our future operatingperformance.

**Sales to a limited number of customers represent asignificant portion of our net sales and the loss of, or a significantreduction in sales to, any one of these customers could materially harm ourbusiness.**

Sales to Dell, IBM andHewlett Packard represented 38%, 11% and 31%, respectively, of our net sales inthe three months ended March 31, 2007. Sales to Dell and IBM represented 16%and 33%, respectively, of our net sales in the three months ended April 1,2006. We expect that sales to Dell, IBM and Hewlett Packard will continue torepresent a significant percentage of our net sales for at least the next12 months. We do not have long-term agreements with these customers, orwith any other customer. Any one of these three customers could decide at anytime to discontinue, decrease or delay their purchase of our products. Inaddition, the prices that these two customers pay for our products could changeat any time. The loss of Dell, IBM or Hewlett Packard as a customer, or asignificant reduction in sales to any of them, would significantly reduce ournet sales and adversely affect our operating results.

Our ability to maintainor increase our net sales to our key customers depends on a variety of factors,many of which are beyond our control. These factors include our customers’continued sales of servers and other computing systems that incorporate ourmemory subsystems and our customers’ continued incorporation of our productsinto their systems.

Because of these andother factors, we cannot assure you that net sales to these customers willcontinue or that the amount of such net sales will reach or exceed historicallevels in any future period. Because these customers account for a substantialportion of our net sales, the failure of any one of these customers to pay on atimely basis would negatively impact our cash flow.

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

Our target markets arecharacterized by a limited number of large companies. Consolidation in one ormore of our target markets may further increase this industry concentration. Asa result, we anticipate that sales of our products will continue to be concentratedamong a limited number of large customers in the foreseeable future. We believethat our financial results will depend in significant part on our success inestablishing and maintaining relationships with, and effecting substantialsales to, these potential customers. Even if we establish these relationships,our financial results will be largely dependent on these customers’ sales andbusiness results.

**The markets in which we compete are cyclical innature, and any future downturn could adversely affect our business.**

The markets in which wecompete and in which our customers operate have been cyclical and arecharacterized by wide fluctuations in product supply and demand. These marketshave experienced significant downturns, often connected with, or inanticipation of, maturing product cycles, reductions in technology spending anddeclines in general economic conditions. These downturns have beencharacterized by diminished product demand, production overcapacity, highinventory levels and the erosion of average selling prices. As a result, oursales will likely decline during these periods. In addition, if we are unableto control our expenses adequately in response to reduced net sales, ourresults of operations would be negatively impacted.

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**We are subject to risks relating to productconcentration and lack of market diversification.**

In the three months endedMarch 31, 2007 and April 1, 2006, we derived 60% and 75%, respectively, of ournet sales from sales of our high performance memory subsystems for use in theserver market. We expect these memory subsystems to continue to account formost of our net sales in the near term. Continued market acceptance of theseproducts for use in servers is critical to our success. If the demand forservers deteriorates or if the demand for our products to be incorporated inservers declines, our operating results would be adversely affected, and wewould be forced to diversify our product portfolio and our target markets. Wemay not be able to achieve this diversification, and our inability to do so mayadversely affect our business.

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

We incurred net losseseach year from the inception of our business through fiscal 2005. Ourcumulative net losses were $15.9 million and $16.3 million as ofMarch 31, 2007 and December 30, 2006, respectively. We may not be able tomaintain profitability on a quarterly or annual basis in the future.

**The price of DRAM ICs is volatile, and excessinventory of DRAM ICs, other components, and finished products could adverselyaffect our gross margin.**

The prices of ourproducts are adjusted periodically based in part on the market price of DRAMICs, which have historically constituted approximately 75% - 90% of the totalcost of our memory subsystems. Once our prices with a customer are negotiated,we are generally unable to revise pricing with that customer until our nextregularly scheduled price adjustment. Consequently, we are exposed to the risksassociated with the volatility of the price of DRAM ICs during that period. Ifthe market price for DRAM ICs increases, we generally cannot pass this priceincrease on to our customers for products purchased under an existing purchaseorder. As a result, our cost of sales could increase and our gross marginscould decrease. Alternatively, if there is a decline in the price of DRAM ICs,we may need to reduce our selling prices for subsequent purchase orders, whichmay result in a decline in our expected net sales.

Customer demand for ourproducts, and thus DRAM ICs, can be difficult to estimate because we do nothave long-term commitments from our customers, and our customers may cancel ordefer purchase orders for any reason. If we overestimate customer demand, wemay have excess inventory of DRAM ICs. If there is a subsequent decline in theprice of DRAM ICs, the value of our inventory will fall. As a result, we mayneed to write-down the value of our DRAM IC inventory, which may result in asignificant decrease in our gross margin and financial condition. If weunderestimate customer demand, we may not have sufficient inventory of DRAM ICsto manufacture our products. This will lead to delays in the delivery of ourproducts, which could cause order cancellations, the loss of customers and adecrease in our net sales.

**We use a small number of DRAM IC suppliers and aresubject to risks of disruption in the supply of DRAM ICs.**

Our ability to fulfillcustomer orders is dependent on a sufficient supply of DRAM ICs, which are anessential component of our memory subsystems. There is a relatively smallnumber of suppliers of DRAM ICs, and we purchase from only a subset ofthese suppliers. We have no long-term DRAM supply contracts. Our dependence ona small number of suppliers and the lack of any guaranteed sources of DRAMsupply expose us to several risks, including the inability to obtain anadequate supply of DRAM ICs, price increases, delivery delays and poorquality.

From time to time,shortages in DRAM ICs have required some suppliers to limit the supply of theirDRAM ICs. As a result, we may be unable to obtain the DRAM ICs necessary tofill customers’ orders for our products in a timely manner. If we are unable toobtain a sufficient supply of DRAM ICs to meet our customers’ requirements,these customers may reduce future orders for our products or not purchase ourproducts at all, which would cause our net sales to decline and harm ouroperating results. In addition, our reputation could be harmed, we may not beable to replace any lost business with new customers, and we may lose marketshare to our competitors.

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Our customers qualify theDRAM ICs of our suppliers for use in their systems. If one of our suppliersshould experience quality control problems, it may be disqualified by one ormore of our customers. This would disrupt our supplies of DRAM ICs and reducethe number of suppliers available to us, and may require that we qualify a newsupplier.

**If the supply of other component materials used tomanufacture our products is interrupted, or if our inventory becomes obsolete,our results of operations and financial condition could be adversely affected.**

We use consumables andother components, including PCBs, to manufacture our memory subsystems. Wesometimes procure PCBs and other components from single or limited sources totake advantage of volume pricing discounts. Material shortages ortransportation problems could interrupt the manufacture of our products fromtime to time in the future. These delays in manufacturing could adverselyaffect our results of operations.

Frequent technologychanges and the introduction of next-generation products also may result in theobsolescence of other items of inventory, such as our custom-built PCBs, whichcould reduce our gross margin and adversely affect our operating performanceand financial condition. We may not be able to sell some products developed forone customer to another customer because our products are often designed toaddress specific customer requirements, and if we are able to sell theseproducts our margin on such products may be reduced.

**We may lose our competitive position if we are unableto timely and cost-effectively develop new or enhanced products that meet ourcustomers’ requirements and achieve market acceptance.**

Our industry ischaracterized by intense competition, rapid technological change, evolvingindustry standards and rapid product obsolescence. Evolving industry standardsand technological change or new, competitive technologies could render ourexisting products obsolete. Accordingly, our ability to compete in the futurewill depend in a large part on our ability to identify and develop new orenhanced products on a timely and cost-effective basis, and to respond tochanging customer requirements. In order to develop and introduce new orenhanced products, we need to:

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

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

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

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

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

·       develop and maintaineffective marketing strategies.

Our product developmentefforts are costly and inherently risky. It is difficult to foresee changes ordevelopments in technology or anticipate the adoption of new standards.Moreover, once these things are identified, if at all, we will need to hire theappropriate technical personnel, develop the product and identify and eliminatedesign flaws. As a result, we may not be able to successfully develop new orenhanced products, or we may experience delays in the development andintroduction of new or enhanced products. Delays in product development andintroduction could result in the loss of, or delays in generating, net salesand the loss of market share, as well as damage to our reputation. Even if wedevelop new or enhanced products, they may not meet our customers’ requirementsor gain market acceptance. Accordingly, we cannot assure you that our futureproduct development efforts will result in the development of new or enhancedproducts or that such products will achieve market acceptance.

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**Our customers require that our products undergo alengthy and expensive qualification process without any assurance of net sales.**

Our prospective customersgenerally make a significant commitment of resources to test and evaluate ourmemory subsystems prior to purchasing our products and integrating them intotheir systems. This extensive qualification process involves rigorousreliability testing and evaluation of our products, which may continue for sixmonths or longer and is often subject to delays. In addition to qualificationof specific products, some of our customers may also require us to undergo atechnology qualification if our product designs incorporate innovativetechnologies that the customer has not previously encountered. Such technologyqualifications often take substantially longer than product qualifications andcan take over a year to complete. Qualification by a prospective customer doesnot ensure any sales to that prospective customer. Even after successfulqualification and sales of our products to a customer, changes in our products,our manufacturing facilities, our production processes or our componentsuppliers may require a new qualification process, which may result inadditional delays. In addition, because the qualification process is bothproduct-specific and platform-specific, our existing customers sometimesrequire us to requalify our products, or to qualify our new products, for usein new platforms or applications. For example, as our OEM customers transitionfrom prior generation DDR DRAM architectures to current generation DDR2 DRAMarchitectures, we must design and qualify new products for use by thosecustomers. In the past, this process of design and qualification has taken upto six months to complete, during which time our net sales to those customersdeclined significantly. After our products are qualified, it can take severalmonths before the customer begins production and we begin to generate netsales. We must devote substantial resources, including design, engineering,sales, marketing and management efforts, to qualify our products withprospective customers in anticipation of sales. If we delay or do not succeedin qualifying a product with a prospective customer, we will not be able tosell that product to that prospect, which would harm our operating results andbusiness.

**We may not be able to maintain our competitiveposition because of the intense competition in our targeted markets.**

We participate in ahighly competitive market, and we expect competition to intensify. Many ofthese competitors have longer operating histories, significantly greaterresources and name recognition, a larger base of customers and longer-standingrelationships with customers and suppliers than we have. As a result, some ofthese competitors are able to devote greater resources to the development,promotion and sale of products and are better positioned than we are to influencecustomer acceptance of their products over our products. These competitors alsomay be able to respond better to new or emerging technologies or standards andmay be able to deliver products with comparable or superior performance at alower price. For these reasons, we may not be able to compete successfullyagainst these competitors.

In addition to thecompetitors described above, some of our OEM customers have their own internaldesign groups that may develop solutions that compete with ours. These designgroups have some advantages over us, including direct access to theirrespective companies’ technical information and technology roadmaps. Our OEMcustomers also have substantially greater resources, financial or otherwise,than we do, and may have lower cost structures than ours. As a result, they maybe able to design and manufacture competitive products more efficiently orinexpensively. If any of these OEM customers are successful in competingagainst us, our sales could decline, our margins could be negatively impactedand we could lose market share, any or all of which could harm our business andresults of operations.

We expect our competitorsto continue to improve the performance of their current products, reduce theirprices and introduce new or enhanced technologies that may offer greaterperformance and improved pricing. If we are unable to match or exceed theimprovements made by our competitors, our market position would deteriorate andour net sales would decline. In addition, our competitors may develop futuregenerations and enhancements of competitive products that may render ourtechnologies obsolete or uncompetitive.

We also expect to facecompetition from new and emerging companies that may enter our existing orfuture markets. These potential competitors may have similar or alternativeproducts which may be less costly or provide additional features.

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**The establishment and ongoing operation of our plannedmanufacturing facility in the People’s Republic of China, or the PRC, could exposeus to new and significant risks.**

We are in the process ofestablishing a new manufacturing facility in the PRC. To prepare this facilityfor operation, we will need to purchase new equipment, replicate our currentmanufacturing processes and hire additional technical personnel. Thedifficulties normally associated with this complicated process will becompounded by language and cultural differences, as well as the geographicdistance from our current facility. Our management has limited experience in creatingor overseeing foreign operations, and this new facility may divert substantialamounts of their time. Further, this new facility will be subject to factoryaudits by our customers. We may not be able to begin operations at this newfacility on a timely basis, or at all. Even if this facility becomesoperational and is qualified by our customers, we cannot assure you that wewill be able to maintain control over product quality, delivery schedules,manufacturing yields and costs as we increase our output. We will also have tomanage a local workforce that may subject us to uncertainties or regulatorypolicies. Any difficulties in operating this new facility could cause productdelivery delays and reduce our operating results.

We currently anticipate thatour new manufacturing facility in the PRC will become operational in the secondhalf of 2007. Once this facility is established and becomes operational, someof our net sales will be denominated in Chinese Renminbi, or Yuan. The Chinesegovernment controls the procedures by which Yuan is converted into othercurrencies, and conversion of Yuan generally requires government consent. As aresult, Yuan may not be freely convertible into other currencies at all times.If the Chinese government institutes changes in currency conversion procedures,or imposes restrictions on currency conversion, those actions may negativelyimpact our operations and could reduce our operating results. In addition,fluctuations in the exchange rate between Yuan and U.S. dollars may adverselyaffect our expenses and results of operations as well as the value of ourassets and liabilities. These fluctuations may also adversely affect thecomparability of our period-to-period results. If we decide to declaredividends and repatriate funds from our Chinese operations, we will be requiredto comply with the procedures and regulations of applicable Chinese law. Anychanges to these procedures and regulations, or our failure to comply withthose procedures and regulations, could prevent us from making dividends andrepatriating funds from our Chinese operations, which could adversely affectour financial condition. If we are able make dividends and repatriate fundsfrom our Chinese operations, these dividends would be subject to U.S. corporateincome tax.

The PRC currentlyprovides for favorable tax rates for certain foreign-owned enterprisesoperating in specified locations in the PRC. We are establishing our China facility in such a tax-favored location.  Should the PRC government enact a revisedincome tax structure, it is possible that we would not realize the tax benefitsthat we currently anticipate and this could adversely impact our operatingresults.

**We depend on a few key employees, and if we lose theservices of any of those employees or are unable to hire additional personnel,our business could be harmed.**

Our success to date hasbeen highly dependent on the experience, relationships and technical knowledgeof Chun K. Hong, our President, Chief Executive Officer and Chairman of theBoard, Jayesh Bhakta, our Chief Technology Officer, and Christopher Lopes,our Vice President of Sales. We believe that our future success will bedependent on our ability to retain the services of these key employees, developtheir successors, reduce our reliance on them, and properly manage thetransition of their roles should departures occur.

The loss of these keyemployees could delay the development and introduction of, and negativelyimpact our ability to sell our products and otherwise harm our business. We donot have employment agreements with any of these key employees other thanMr. Hong. We do not carry “Key Man” life insurance on any of our keyemployees.

Our future success alsodepends on our ability to attract, retain and motivate highly skilledengineering, manufacturing, other technical and sales personnel. Competitionfor experienced personnel is intense. We may not be successful in attractingnew engineers or other technical personnel, or in retaining or motivating ourexisting personnel. If we are unable to hire and retain engineers with theskills necessary to keep pace with the evolving technologies in our markets,our ability to continue to provide our current products and to develop new orenhanced products will be negatively impacted, which would harm our business.In addition, the shortage of experienced engineers, and other factors, may leadto increased recruiting, relocation and compensation costs for such engineers,which may exceed our expectations and resources. These increased costs may makehiring new engineers difficult, or may reduce our margins.

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As of March 31,2007, approximately 21% of our workforce consisted of contract personnel. Weinvest considerable time and expense in training these contract employees. Wemay experience high turnover rates in our contract employee workforce, whichmay require us to expend additional resources in the future. If we convert anyof these contract employees into permanent employees, we may have to pay finder’sfees to the contract agency.

**Our lack of a significant backlog of unfilled orders,and the difficulty inherent in forecasting customer demand, makes it difficultto forecast our short-term production requirements to meet that demand.**

We do not have long-termpurchase agreements with our customers. Instead, our customers generally placepurchase orders no more than two weeks in advance of their desired deliverydate, and these purchase orders generally have no cancellation or reschedulingpenalty provisions. This fact, combined with the quick turn-around times thatapply to each order, makes it difficult to forecast our production needs andallocate production capacity efficiently. Our production expense levels arebased in part on our forecasts of our customers’ future product requirementsand to a large extent are fixed in the short term. As a result, we likely willbe unable to adjust spending on a timely basis to compensate for any unexpectedshortfall in those orders. Any significant shortfall of customer orders inrelation to our expectations could hurt our operating results, cash flows andfinancial condition. Also, any rapid increases in production required by ourcustomers could strain our resources and reduce our margins. If such a rapidincrease were to occur at any given time, we may not have sufficient short-termmanufacturing capacity to meet our customers’ immediate demands.

We attempt to forecastthe demand for the DRAM ICs and other components needed to manufacture ourproducts. Lead times for components vary significantly and depend on variousfactors, such as the specific supplier and the demand and supply for acomponent at a given time. If we underestimate customer demand or if we havenot provided for sufficient manufacturing capacity, we would not be able to manufacturea sufficient quantity of our products and could forego sales opportunities,lose market share and damage our customer relationships.

**If we are unable to manufacture our productsefficiently, our operating results could suffer.**

We must continuously reviewand improve our manufacturing processes in an effort to maintain satisfactorymanufacturing yields and product performance, lower our costs and otherwiseremain competitive. For example, we began implementing lead-free solderingtechnologies in our manufacturing processes in the second quarter of 2005, and “Reductionof Hazardous Substances” manufacturing processes in the fourth quarter of 2005,both of which have been fully implemented. Implementing process improvements inthe future could negatively impact our manufacturing yields, which would inturn adversely affect our results of operations.

As we manufacture morecomplex products, the risk of encountering delays or difficulties increases.The start-up costs associated with implementing new manufacturing technologies,methods and processes, including the purchase of new equipment, and anyresulting manufacturing delays and inefficiencies, could negatively impact ourresults of operations.

If we need to addmanufacturing capacity, an expansion of our existing manufacturing facility orestablishment of a new facility could be subject to factory audits by ourcustomers. For example, our new manufacturing facility in the PRC will need tobe audited and approved by our key customers. Any delays or unexpected costsresulting from this audit process could adversely affect our net sales andresults of operations. In addition, we cannot be certain that we will be ableto increase our manufacturing capacity on a timely basis or meet the standardsof any applicable factory audits.

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

We rely on a combinationof patent protection, trade secret laws and restrictions on disclosure toprotect our intellectual property rights. We have submitted a number of patentapplications regarding our proprietary processes and technology. It is notcertain when or if any of the claims in the remaining applications will beallowed. To date we have had only four patents issued. We intend to continuefiling patent applications with respect to most of the new processes andtechnologies that we develop. However, patent protection may not be availablefor some of these processes or technologies.

It is possible that ourefforts to protect our intellectual property rights may not:

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

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

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

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

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

·       otherwise adequatelyprotect our intellectual property rights.

Others may attempt toreverse engineer, copy or otherwise obtain and use our proprietary technologieswithout our consent. Monitoring the unauthorized use of our technologies isdifficult. We cannot be certain that the steps we have taken will prevent theunauthorized use of our technologies. This is particularly true in foreigncountries, such as the PRC, where we are in the process of establishing a newmanufacturing facility and where the laws may not protect our proprietaryrights to the same extent as applicable U.S. laws.

If some or all of theclaims in our patent applications are not allowed, or if any of ourintellectual property protections are limited in scope by a court orcircumvented by others, we could face increased competition with regard to ourproducts. Increased competition could significantly harm our business and ouroperating results.

**We may be involved in costly legal proceedings todefend against claims that we infringe the intellectual property rights ofothers or to enforce or protect our intellectual property rights.**

Lawsuits claiming that weare infringing others’ intellectual property rights may be brought against us,and we may have to defend against claims of infringement or invalidity. Wecurrently plan to explore new technologies such as flash memory and to developnew products for our existing markets, such as communications, and for newmarkets, such as networking. By making use of these new technologies andentering these new markets there is an increased likelihood that others mightallege that our products infringe on their intellectual property rights.Litigation is inherently uncertain, and an adverse outcome could subject us tosignificant liability for damages or invalidate our proprietary rights. Anadverse outcome also could force us to take specific actions, including causingus to:

·       cease selling products thatare claimed to be infringing a third party’s intellectual property;

·       pay royalties on past orfuture sales;

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

·       redesign those productsthat are claimed to be infringing a third party’s intellectual property.

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There is a limited poolof experienced technical personnel that we can draw upon to meet our hiringneeds. As a result, a number of our existing employees have worked for ourexisting or potential competitors at some point during their careers, and weanticipate that a number of our future employees will have similar workhistories. In the past, some of these competitors have claimed that ouremployees misappropriated their trade secrets or violated non-competition ornon-solicitation agreements. Some of our competitors may threaten or bringlegal action involving similar claims against us or our existing employees ormake such claims in the future to prevent us from hiring qualified candidates.Lawsuits of this type may be brought, even if there is no merit to the claim, simplyas a strategy to drain our financial resources and divert management’sattention away from our business.

We also may find itnecessary to litigate against others, including our competitors, customers andformer employees, to enforce our intellectual property and contractual andcommercial rights including, in particular, our trade secrets, as well as tochallenge the validity and scope of the proprietary rights of others. We couldbecome subject to counterclaims or countersuits against us as a result of thislitigation. Moreover, any legal disputes with customers could cause them tocease buying or using our products or delay their purchase of our products andcould substantially damage our relationship with them.

Any litigation,regardless of its outcome, would be time consuming and costly to resolve,divert our management’s time and attention and negatively impact our results ofoperations.

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

Although some of thecomponents used in our final products contain the intellectual property ofthird parties, we believe that our suppliers bear the sole responsibility toobtain any rights and licenses to such third party intellectual property. Whilewe have no knowledge that any third party licensor disputes our belief, wecannot assure you that disputes will not arise in the future. The operation ofour business and our ability to compete successfully depends significantly onour continued operation without claims of infringement or demands resultingfrom such claims, including demands for payments of money in the form of, forexample, ongoing licensing fees.

We are also developingproducts to enter new markets, such as the industrial flash market. Similar toour current products, we may use components in these new products that containthe intellectual property of third parties. While we will exercise necessaryprecautions to avoid infringing on the intellectual property rights of thirdparties, we cannot assure you that disputes will not arise.

If it is determined thatwe are required to obtain inbound licenses and we fail to obtain licenses, orif such licenses are not available on economically feasible terms, ourbusiness, operating results and financial condition could be significantlyharmed.

**If our products do not meet the quality standards ofour customers, we may be forced to stop shipments of products until the qualityissues are resolved.  If our products aredefective or are used in defective systems, we may be subject to productrecalls or product liability claims.**

Our customers require ourproducts to meet strict quality standards. Should our products not meet such standards, our customers maydiscontinue purchases from us until we are able to resolve the quality issuesthat are causing us to not meet the standards, Such “quality holds” could havea significant adverse impact on our revenues and operating results.

If our products aredefectively manufactured, contain defective components or are used in defectiveor malfunctioning systems, we could be subject to product liability claims andproduct recalls, safety alerts or advisory notices. While we have productliability insurance coverage, it may not be adequate to satisfy claims madeagainst us. We also may be unable to obtain insurance in the future atsatisfactory rates or in adequate amounts. Product liability claims or productrecalls, regardless of their ultimate outcome, could have an adverse effect onour business, financial condition and reputation, and on our ability to attractand retain customers. In addition, we may determine that it is in our bestinterest to accept product returns in circumstances where we are notcontractually obligated to do so in order to maintain good relations with ourcustomers. Accepting product returns may negatively impact our operatingresults.

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**If we acquire other businesses or technologies in thefuture, these acquisitions could disrupt our business and harm our operatingresults and financial condition.**

We will evaluateopportunities to acquire businesses or technologies that might complement ourcurrent product offerings or enhance our technical capabilities. We have noexperience in acquiring other businesses or technologies. Acquisitions entail anumber of risks that could adversely affect our business and operating results,including:

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

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

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

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

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

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

·       the potential loss of key employeesof the acquired companies.

Future acquisitions alsocould cause us to incur debt or be subject to contingent liabilities. Inaddition, acquisitions could cause us to issue equity securities that coulddilute the ownership percentages of our existing stockholders. Furthermore,acquisitions may result in material charges or adverse tax consequences,substantial depreciation, deferred compensation charges, in-process researchand development charges, the amortization of amounts related to deferred stock-basedcompensation expense and identifiable purchased intangible assets or impairmentof goodwill, any or all of which could negatively affect our results ofoperations.

**If we do not effectively manage our growth, ourresources, systems and controls may be strained and our results of operationsmay suffer.**

We have expanded, andplan to continue to expand, our operations, both domestically andinternationally. Any future growth may strain our resources, managementinformation and telecommunication systems, and operational and financialcontrols. To manage our growth effectively, including the development of ournew manufacturing facility in the PRC, we must continue to improve and expandour systems and controls. We may not be able to do this in a timely orcost-effective manner, and our current systems and controls may not be adequateto support our future operations. In addition, our officers have relativelylimited experience in managing a rapidly growing business or a public company.As a result, they may not be able to provide the guidance necessary to continueour growth or maintain our market position. Any failure to manage our growth orimprove or expand our existing systems and controls, or unexpected difficultiesin doing so, could harm our business.

**Our internal controls over financial reporting may notbe effective, and our independent auditors may not be able to certify as totheir effectiveness, which could have a significant and adverse effect on ourbusiness.**

We plan to evaluate ourinternal controls over financial reporting to allow management to report on,and our registered public accounting firm to attest to, those internal controlsas will be required by Section 404 of the Sarbanes-Oxley Act of 2002 andthe rules and regulations of the Securities and Exchange Commission, whichwe collectively refer to as Section 404. This will involve system andprocess evaluations and testing to comply with the management assessment andindependent registered public accounting firm attestation requirements ofSection 404, which will initially have to be made in our annual report onForm 10-K for our 2007 fiscal year. Effective internal controls arenecessary for us to produce reliable financial reports and are important in oureffort to prevent financial fraud. In the course of our Section 404evaluations, we may identify conditions that may result in significantdeficiencies or material weaknesses and we may conclude that enhancements,modifications or changes to our internal controls are necessary or desirable.Implementing any such matters would divert the attention of our management,could involve significant costs, and may negatively impact our results ofoperations.

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We note that there areinherent limitations on the effectiveness of internal controls, as they cannotprevent collusion, management override or failure of human judgment. If we failto maintain an effective system of internal controls or if management or ourindependent registered public accounting firm were to discover materialweaknesses in our internal controls, we may be unable to produce reliablefinancial reports or prevent fraud, and it could harm our financial conditionand results of operations, result in a loss of investor confidence andnegatively impact our share price.

**If a standardized memory solution which addresses thedemands of our customers is developed, our net sales and market share maydecline.**

Many of our memorysubsystems are specifically designed for our OEM customers’ high performancesystems. Our business would be harmed if these high performance systems were tobecome standardized so that DRAM IC manufacturers or other companies coulddevelop and manufacture a commodity memory module addressing the demands ofsome or all of these high performance applications. If DRAM IC manufacturers orother companies are able to develop a standardized solution, our futurebusiness may be limited to identifying the next generation of high performancememory demands of OEM customers and developing a solution that addresses suchdemands. Until fully implemented, this next generation of products mayconstitute a much smaller market, which may reduce our net sales and marketshare.

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**Our failure to comply with environmental laws andregulations could subject us to significant fines and liabilities or cause usto incur significant costs.**

We are subject to variousand frequently changing U.S. federal, state and local and foreign governmentallaws and regulations relating to the protection of the environment, includingthose governing the discharge of pollutants into the air and water, themanagement and disposal of hazardous substances and wastes, the cleanup ofcontaminated sites and the maintenance of a safe workplace. In particular, someof our manufacturing processes may require us to handle and dispose ofhazardous materials from time to time. For example, in the past ourmanufacturing operations have used lead-based solder in the assembly of ourproducts. Today, we use lead-free soldering technologies in our manufacturingprocesses, as this is required for products entering the European Union. Wecould incur substantial costs, including clean-up costs, civil or criminalfines or sanctions and third-party claims for property damage or personalinjury, as a result of violations of, or noncompliance with, environmental lawsand regulations. These laws and regulations also could require us to incursignificant costs to remain in compliance.

**Economic, political and other risks associated withinternational sales and operations could adversely affect our net sales.**

Part of our growthstrategy involves making sales to foreign corporations and delivering ourproducts to facilities located in foreign countries. To facilitate this processand to meet the long-term projected demand for our products, we are planning toset up a new manufacturing facility in the PRC. Selling and manufacturing inforeign countries subjects us to additional risks not present with our domesticoperations. We will begin operating in business and regulatory environments in whichwe have little or no previous experience. We will need to overcome language andcultural barriers to effectively conduct our operations in these newenvironments. In addition, the economies of the PRC and other countries havebeen highly volatile in the past, resulting in significant fluctuations inlocal currencies and other instabilities. These instabilities affect a numberof our customers and suppliers in addition to our foreign operations andcontinue to exist or may occur again in the future. International turmoil andthe threat of future terrorist attacks, both domestically and internationally,have contributed to an uncertain political and economic climate, both in theU.S. and globally, and have negatively impacted the worldwide economy. The occurrenceof one or more of these instabilities could adversely affect our foreignoperations and some of our customers or suppliers, each of which couldadversely affect our net sales. In addition, our failure to meet applicableregulatory requirements or overcome cultural barriers could result inproduction delays and increased turn-around times, which would adversely affectour business.

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

Our current manufacturingfacility is located in Irvine, California. Due to this geographicconcentration, a disruption of our manufacturing operations, resulting fromequipment failure, power failures, quality control issues, human error,government intervention or natural disasters, including earthquakes, fires orfloods, could interrupt or interfere with our manufacturing operations andconsequently harm our business, financial condition and results of operations.Such disruptions would cause significant delays in shipments of our productsand adversely affect our operating results.

**Our principal stockholders have significant votingpower and may take actions that may not be in the best interest of our otherstockholders.**

As of March 31, 2007, ourexecutive officers, directors and 5% stockholders beneficially own, in total,approximately 50% of our outstanding common stock. As a result, thesestockholders, acting together, have the ability to exert substantial influenceover all matters requiring approval by our stockholders, including the electionand removal of directors and any proposed merger, consolidation or sale of allor substantially all of our assets

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and other corporatetransactions. This concentration of control could be disadvantageous to otherstockholders with interests different from those of our executive officers,directors and principal stockholders. For example, our executive officers,directors and principal stockholders could delay or prevent an acquisition ormerger even if the transaction would benefit other stockholders. In addition,this significant concentration of share ownership may adversely affect thetrading price for our common stock because investors may perceive disadvantagesin owning stock in companies with stockholders that have the ability to exercisesignificant control.

**Anti-takeover provisions under our charter documentsand Delaware law could delay or prevent a change of control and could alsolimit the market price of our stock.**

Our certificate ofincorporation and bylaws contain provisions that could delay or prevent achange of control of our company or changes in our board of directors that ourstockholders might consider favorable. In addition, these provisions couldlimit the price that investors would be willing to pay in the future for sharesof our common stock. The following are examples of provisions which areincluded in our certificate of incorporation and bylaws, each as amended:

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

·       stockholder action bywritten consent is prohibited;

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

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

In addition, we aregoverned by the provisions of Section 203 of the Delaware GeneralCorporate Law, which may prohibit certain business combinations withstockholders owning 15% or more of our outstanding voting stock. These andother provisions in our certificate of incorporation and bylaws, and ofDelaware law could make it more difficult for stockholders or potentialacquirors to obtain control of our board of directors or initiate actions thatare opposed by the then-current board of directors, including delaying orimpeding a merger, tender offer, or proxy contest or other change of controltransaction involving our company. Any delay or prevention of a change ofcontrol transaction or changes in our board of directors could prevent theconsummation of a transaction in which our stockholders could receive asubstantial premium over the then-current market price for their shares.

**Item 2.**                          UnregisteredSales of Equity Securities and Use of Proceeds

On December 5, 2006 wecompleted our initial public offering of our common stock pursuant to ourRegistration Statement on Form S-1 (File No. 333-136735) that was declaredeffective by the SEC on November 29, 2006. There has been no material changewith respect to our use of the net proceeds from our initial public offering tothe information discussed in our Annual Report on Form 10-K for the year endedDecember 30, 2006.

**Item 3.**                          DefaultsUpon Senior Securities

None.

**Item 4.**                          Submissionof Matters to a Vote of Securities Holders

None.

**Item 5.**                          OtherInformation

None.

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**Item 6.**                          Exhibits
| Exhibit    | ** ** | ** **                                                                                                                                                                                                                                                                     |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number** | ** ** | **Description of Document**                                                                                                                                                                                                                                                    |
|       |       |                                                                                                                                                                                                                                                                           |
| 3.1(1)     |       | Restated Certificate of Incorporation of  Netlist, Inc.                                                                                                                                                                                                                   |
|       |       |                                                                                                                                                                                                                                                                           |
| 3.2(1)     |       | Amended and Restated Bylaws of Netlist, Inc.                                                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                                           |
| 10.1(2)    |       | Lease (Multi-Tenant; Net), dated April 2, 2007, by  and between The Irvine Company LLC, a Delaware limited liability company, and  Netlist, Inc., a Delaware corporation.                                                                                                      |
|       |       |                                                                                                                                                                                                                                                                           |
| 10.2(2)    |       | Seventh Amendment to Amended and Restated Credit and  Security Agreement, dated effective as of March 21, 2007, by and among  Netlist, Inc., a Delaware corporation, Netlist Technology Texas, L.P., a  Texas limited partnership, and Wells Fargo Bank, National Association. |
|       |       |                                                                                                                                                                                                                                                                           |
| 31.1       |       | Certification of Principal Executive Officer, as  required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|       |       |                                                                                                                                                                                                                                                                           |
| 31.2       |       | Certification of Principal Financial Officer, as  required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|       |       |                                                                                                                                                                                                                                                                           |
| 32(3)      |       | Certification of Chief Executive Officer and Chief  Financial Officer, as required 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 thecorresponding exhibit number of the registration statement on Form S-1of the registrant (No. 333-136735) filed with the Securities andExchange Commission on October 23, 2006.

 

(2)          Incorporated byreference to the corresponding exhibit number of the current report onForm 8-K of the registrant filed with the Securities and ExchangeCommission on April 6, 2007.

(3)   The information in Exhibit32 shall not be deemed “filed” for purposes of Section 18 of the SecuritiesExchange Act of 1934, as amended, (the “Exchange Act”), or otherwise subject tothe liabilities of that section, nor shall they be deemed incorporated byreference in any filing under the Securities Act of 1933, as amended, or theExchange Act (including this Report), unless Netlist, Inc. specificallyincorporates the foregoing information into those documents by reference.

37

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
| Date: May 15, 2007 |       | NETLIST, INC.                                                     |
|--------------------|------------|-------------------------------------------------------------------|
|               |       | a Delware corporation                                             |
|               |       | (Registrant)                                                      |
|               |       |                                                              |
|               | By:        | /s/ Chun K. Hong                                                  |
|               | ** ** | **Chun K.  Hong**                                                 |
|               | ** ** | **President,  Chief Executive Officer and Chairman of the Board** |
|               | ** ** | **(Principal  Executive Officer)**                                |
|               | ** ** | ** **                                                        |
|               | ** ** | ** **                                                        |
|               | By:        | /s/ Lee Kim                                                       |
|               | ** ** | **Lee Kim**                                                       |
|               | ** ** | **Vice  President and Chief Financial Officer**                   |
|               | ** ** | **(Principal  Financial Officer)**                                |

 

38

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**EXHIBITINDEX**
| Exhibit    | ** ** | ** **                                                                                                                                                                                                |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number** | ** ** | **Description of Document**                                                                                                                                                                               |
|       |       |                                                                                                                                                                                                      |
| 31.1       |       | Certification of Principal Executive Officer, as  required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                     |
|       |       |                                                                                                                                                                                                      |
| 31.2       |       | Certification of Principal Financial Officer, as  required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                     |
|       |       |                                                                                                                                                                                                      |
| 32.1       |       | Certification of Chief Executive Officer and Chief  Financial Officer, as required pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002 and furnished herewith pursuant to SEC Release No. 33-8238. |

 

39

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