** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **

**(MarkOne)**

| **x**      | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------|------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                 |
| ** ** | **For the quarterly period ended  March 29, 2008**                                                    |
| ** ** | ** **                                                                                                 |
| ** ** | **or**                                                                                                     |
| ** ** | ** **                                                                                                 |
| **o**      | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**    |
|       |                                                                                                       |
|       | **For  the transition period from              to** |

 

**Commission file number001-33170**

** **

****

** **

**NETLIST, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**51 Discovery, Irvine, CA 92618**

(Address of principal executive offices) (Zip Code)

 

**(949) 435-0025**

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

** **

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

 

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

 

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

(Do not check if a smaller reporting company) |   | Smaller reporting company     x |
|---------------------------------------------------|--------|---------------------------------------------|--------|------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|

 

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

 

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

 

Common Stock, par value $0.001 per share

19,855,411 shares outstanding at April 30, 2008

 

 

----

 

**NETLIST, INC. ANDSUBSIDIARIES**

**QUARTERLY REPORTON FORM 10-Q**

**FOR THE THREEMONTHS ENDED MARCH 29, 2008**

** **

**TABLE OF CONTENTS**

 
| PART I.  | FINANCIAL  INFORMATION                                                                                                             |   |
|---------------|------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.       | Financial  Statements                                                                                                              |   |
|          | Unaudited  Condensed Consolidated Balance Sheets at March 29, 2008 and  December 29, 2007                                |   |
|          | Unaudited  Condensed Consolidated Statements of Operations for the Three Months Ended  March 29, 2008 and March 31, 2007 |   |
|          | Unaudited  Condensed Consolidated Statements of Cash Flows for the Three Months Ended  March 29, 2008 and March 31, 2007 |   |
|          | Notes  to Unaudited Condensed Consolidated Financial Statements                                                                    |   |
| Item  2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                        |   |
| Item  3.      | Quantitative  and Qualitative Disclosures About Market Risk                                                                        |   |
| Item 4.       | Controls  and Procedures                                                                                                           |   |
| Item 4T.      | Controls  and Procedures                                                                                                           |   |
|          |                                                                                                                               |   |
| PART II. | OTHER  INFORMATION                                                                                                                 |   |
| Item 1.       | Legal  Proceedings                                                                                                                 |   |
| Item 1A.      | Risk Factors                                                                                                                       |   |
| Item  2.      | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                       |   |
| Item  3.      | Defaults  Upon Senior Securities                                                                                                   |   |
| Item  4.      | Submission  of Matters to a Vote of Security Holders                                                                               |   |
| Item 5.       | Other  Information                                                                                                                 |   |
| Item 6.       | Exhibits                                                                                                                           |   |

 

2

----

 

**PART I. FINANCIAL INFORMATION**

** **

**Item 1. Financial Statements**

** **

**NETLIST, INC.AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Balance Sheets**

**(inthousands)**

** **
| ** **                                                               | ** ** | **March 29,** | ** ** | **December 29,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|                                                                     |       |               |       |                  |       |
| **ASSETS**                                                               | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current assets:                                                          |       |               |       |                  |       |
| Cash and cash equivalents                                                |       | $                  | 8,906      |                  | $          | 7,182 |   |
| Investments in marketable securities                                     |       | 15,565             |       | 15,573                |       |
| Accounts receivable, net                                                 |       | 7,901              |       | 12,034                |       |
| Inventories                                                              |       | 3,592              |       | 3,333                 |       |
| Income taxes receivable                                                  |       | 1,911              |       | 708                   |       |
| Deferred taxes                                                           |       | 3,128              |       | 3,464                 |       |
| Prepaid expenses and other current assets                                |       | 663                |       | 392                   |       |
| Total current assets                                                     |       | 41,666             |       | 42,686                |       |
|                                                                     |       |               |       |                  |       |
| Property and equipment,  net                                             |       | 8,002              |       | 8,191                 |       |
| Deferred taxes                                                           |       | 1,473              |       | 1,065                 |       |
| Long-term investments in  marketable securities                          |       | 5,966              |       | 7,814                 |       |
| Other assets                                                             |       | 590                |       | 600                   |       |
| Total assets                                                             |       | $                  | 57,697     |                  | $          | 60,356 |   |
|                                                                     |       |               |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                           | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current liabilities:                                                     |       |               |       |                  |       |
| Accounts payable                                                         |       | $                  | 6,694      |                  | $          | 6,697 |   |
| Revolving line of credit                                                 |       | 3,234              |       | 4,872                 |       |
| Current portion of long-term debt                                        |       | 637                |       | 740                   |       |
| Current portion of deferred gain on sale and leaseback transaction       |       | 118                |       | 118                   |       |
| Accrued expenses and other current liabilities                           |       | 2,477              |       | 2,872                 |       |
| Total current liabilities                                                |       | 13,160             |       | 15,299                |       |
| Long-term debt, net of  current portion                                  |       | 514                |       | 638                   |       |
| Deferred gain on sale and  leaseback transaction, net of current portion |       | 196                |       | 226                   |       |
| Total liabilities                                                        |       | 13,870             |       | 16,163                |       |
| Commitments and  contingencies                                           |       |               |       |                  |       |
| Stockholders’ equity:                                               |       |               |       |                  |       |
| Common stock                                                             |       | 20                 |       | 20                    |       |
| Additional paid-in capital                                               |       | 68,385             |       | 68,109                |       |
| Accumulated deficit                                                      |       | (24,483            | )          | (23,899               | )          |
| Accumulated other comprehensive loss                                     |       | (95                | )          | (37                   | )          |
| Total stockholders’ equity                                          |       | 43,827             |       | 44,193                |       |
| Total liabilities and stockholders’ equity                          |       | $                  | 57,697     |                  | $          | 60,356 |   |

 

See accompanyingnotes.

 

3

----

 

**NETLIST, INC. AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Operations**

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

 
|                                                                    | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|
|                                                                    | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
|                                                                    | ** ** | **2008**               | ** ** | **2007** | ** ** |
|                                                                    | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net sales                                                               | ** ** | $                      | 13,104     |   | $ | 37,538 |   |
| Cost of sales(1)                                                        | ** ** | 9,973                  |       | 32,089 |   |
| Gross profit                                                            | ** ** | 3,131                  |       | 5,449 |   |
| Operating expenses:                                                     | ** ** |                   |       |   |   |
| Research and development(1)                                             | ** ** | 1,576                  |       | 1,067 |   |
| Selling, general and administrative(1)                                  | ** ** | 3,468                  |       | 3,704 |   |
| Total operating expenses                                                | ** ** | 5,044                  |       | 4,771 |   |
| Operating income (loss)                                                 | ** ** | (1,913                 | )          | 678 |   |
| Other income (expense):                                                 | ** ** |                   |       |   |   |
| Interest income (expense), net                                          | ** ** | 239                    |       | (48 | ) |
| Other income (expense), net                                             | ** ** | (91                    | )          | 1 |   |
| Total other income (expense), net                                       | ** ** | 148                    |       | (47 | ) |
| Income (loss) before  provision (benefit) for income taxes              | ** ** | (1,765                 | )          | 631 |   |
| Provision (benefit) for  income taxes                                   | ** ** | (1,181                 | )          | — |   |
| Net income (loss)                                                       | ** ** | $                      | (584       | ) | $ | 631 |   |
|                                                                    | ** ** |                   |       |   |   |
| Net income (loss) per  common share:                                    | ** ** |                   |       |   |   |
| Basic                                                                   | ** ** | $                      | (0.03      | ) | $ | 0.03 |   |
| Diluted                                                                 | ** ** | $                      | (0.03      | ) | $ | 0.03 |   |
| Weighted-average common  shares outstanding:                            | ** ** |                   |       |   |   |
| Basic                                                                   | ** ** | 19,820                 |       | 19,624 |   |
| Diluted                                                                 | ** ** | 19,820                 |       | 21,425 |   |
|                                                                         | ** ** |                   |       |   |   |
| (1)  Amounts include  stock-based compensation expense as follows: | ** ** |                   |       |   |   |
|                                                                    | ** ** |                   |       |   |   |
| Cost of sales                                                           | ** ** | $                      | 14         |   | $ | 64 |   |
| Research and development                                                | ** ** | 23                     |       | 46 |   |
| Selling, general and administrative                                     | ** ** | 207                    |       | 218 |   |

 

See accompanyingnotes.

** **

**4**

----

** **

**NETLIST, INC.AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Cash Flows**

**(inthousands)**

** **
|                                                                                      | ** ** | **Three Months Ended** |   |
|-------------------------------------------------------------------------------------------|------------|------------------------|--------|
|                                                                                      | ** ** | **March 29,**     |   | **March 31,** |   |
|                                                                                      | ** ** | **2008**               |   | **2007** |   |
|                                                                                      | ** ** |                   |   |   |   |
| Cash flows from operating  activities:                                                    | ** ** |                   |   |   |   |
| Net income (loss)                                                                         | ** ** | $                      | (584   | ) | $ | 631 |   |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities: | ** ** |                   |   |   |   |
| Depreciation and amortization                                                             | ** ** | 527                    |   | 254 |   |
| Amortization of deferred gain on sale and leaseback transaction                           | ** ** | (30                    | )      | (30 | ) |
| Deferred income taxes                                                                     | ** ** | (72                    | )      | (402 | ) |
| Impairment of long-lived assets                                                           | ** ** | —                 |   | 114 |   |
| Stock-based compensation                                                                  | ** ** | 244                    |   | 328 |   |
| Changes in operating assets and liabilities:                                              | ** ** |                   |   |   |   |
| Accounts receivable                                                                       | ** ** | 4,133                  |   | 5,670 |   |
| Inventories                                                                               | ** ** | (259                   | )      | 6,093 |   |
| Income taxes receivable                                                                   | ** ** | (1,203                 | )      | — |   |
| Prepaid expenses and other current assets                                                 | ** ** | (271                   | )      | 91 |   |
| Other assets                                                                              | ** ** | 10                     |   | (310 | ) |
| Accounts payable                                                                          | ** ** | (3                     | )      | (6,172 | ) |
| Income taxes payable                                                                      | ** ** | —                 |   | (598 | ) |
| Accured expenses and other current liabilities                                            | ** ** | (395                   | )      | (796 | ) |
| Net cash provided by operating activities                                                 | ** ** | 2,097                  |   | 4,873 |   |
| Cash flows from investing  activities:                                                    | ** ** |                   |   |   |   |
| Acquisition of property and equipment                                                     | ** ** | (338                   | )      | (449 | ) |
| Purchase of investments in marketable securities                                          | ** ** | (6,377                 | )      | (30,618 | ) |
| Proceeds from maturities of investments in marketable securities                          | ** ** | 7,150                  |   | 14,400 |   |
| Proceeds from sales of investments in marketable securities                               | ** ** | 1,025                  |   | — |   |
| Net cash provided by (used in) investing activities                                       | ** ** | 1,460                  |   | (16,667 | ) |
| Cash flows from financing  activities:                                                    | ** ** |                   |   |   |   |
| Borrowings on lines of credit                                                             | ** ** | 18,191                 |   | 40,174 |   |
| Payments on lines of credit                                                               | ** ** | (19,829                | )      | (47,386 | ) |
| Payments on debt                                                                          | ** ** | (227                   | )      | (388 | ) |
| Proceeds from exercise of stock options                                                   | ** ** | —                 |   | 113 |   |
| Tax benefit from exercise of warrants                                                     | ** ** | 32                     |   | — |   |
| Net cash used in financing activities                                                     | ** ** | (1,833                 | )      | (7,487 | ) |
| Increase (decrease) in  cash and cash equivalents                                         | ** ** | 1,724                  |   | (19,281 | ) |
| Cash and cash equivalents  at beginning of period                                         | ** ** | 7,182                  |   | 30,975 |   |
| Cash and cash equivalents  at end of period                                               | ** ** | $                      | 8,906  |   | $ | 11,694 |   |

 

See accompanying notes.

 

5

----

 

 

**NETLIST, INC.AND SUBSIDIARIES**

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

**March 29,2008**

** **

**NOTE 1—DESCRIPTIONOF BUSINESS**

** **

Netlist, Inc.(the “Company” or “Netlist”) was incorporated on June 12, 2000 inDelaware. Netlist designs and manufactures high performance memory subsystemsfor the server, high performance computing and communications markets. TheCompany’s solutions are targeted at applications where memory plays a key rolein meeting system performance requirements.

 

**NOTE 2—SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

** **

*Basis ofPresentation*

* *

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

 

The condensedconsolidated financial statements included herein are unaudited; however, theycontain all normal recurring accruals and adjustments that, in the opinion ofthe Company’s management, are necessary to present fairly the consolidatedfinancial position of the Company and its wholly owned subsidiaries as of March 29,2008 and December 29, 2007, the consolidated results of its operations forthe three months ended March 29, 2008 and March 31, 2007, and theconsolidated cash flows for the three months ended March 29, 2008 and March 31,2007. All intercompany balances and transactions have been eliminated inconsolidation. The results of operations for the three months ended March 29,2008 are not necessarily indicative of the results to be expected for the fullyear or any future interim periods.

 

*Fiscal Year*

* *

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

 

*Use of Estimates*

* *

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of the assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expensesduring the reporting period. Significant estimates made by management include,among others, provisions for uncollectible receivables and sales returns,warranty liabilities, valuation of inventories, recoverability of long-livedassets, stock-based compensation expense and realization of deferred taxassets. The Company bases its estimates and assumptions on current facts,historical experience and various other factors that it believes to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities and theaccrual of costs and expenses that are not readily apparent from other sources.The actual results experienced by the Company may differ materially andadversely from the Company’s estimates. To the extent there are materialdifferences between the estimates and the actual results, future results ofoperations will be affected.

 

*RevenueRecognition*

* *

TheCompany’s revenues primarily consist of product sales of high performancememory subsystems to original equipment manufacturers (“OEMs”). Revenues alsoinclude sales of excess inventories to distributors and other users of memoryintegrated circuits (“ICs”) totaling approximately $0.1 million and$1.0 million during the three months ended March 29, 2008 and March 31,2007, respectively.

 

6

----

 

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

 

TheCompany generally uses customer purchase orders and/or contracts as evidence ofan arrangement. Delivery occurs when goods are shipped for customers with FOBShipping Point terms and upon receipt for customers with FOB Destination terms,at which time title and risk of loss transfer to the customer. Shippingdocuments are used to verify delivery and customer acceptance. The Companyassesses whether the sales price is fixed or determinable based on the paymentterms associated with the transaction and whether the sales price is subject torefund. Customers are generally allowed limited rights of return for up to 30 days,except for sales of excess inventories, which contain no right-of-returnprivileges. Estimated returns are provided for at the time of sale based onhistorical experience or specific identification of an event necessitating areserve. The Company offers a standard product warranty to its customers andhas no other post-shipment obligations. The Company assesses collectibilitybased on the creditworthiness of the customer as determined by credit checksand evaluations, as well as the customer’s payment history.

 

Aportion of the Company’s international shipments are made to third-partyinventory warehouses, or hubs, and the Company recognizes revenue when theinventory is pulled from the hub for use in production by the customer. TheCompany receives a report from the customer on a daily basis indicating theinventories pulled from a hub for use by the customer, and performs a dailyreconciliation of inventories shipped to and pulled by the customer to thoseinventories reflected on the customer’s reports to ensure that sales arerecognized in the appropriate periods.

 

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

 

*Fair Value ofFinancial Instruments*

* *

TheCompany’s financial instruments consist principally of cash and cashequivalents, investments in marketable securities, accounts receivable,accounts payable, accrued expenses and debt instruments. Investments inmarketable securities are comprised of available-for-sale securities that arereported at fair value with the related unrealized gains and losses included inaccumulated other comprehensive income (loss), a component of stockholders’equity, net of tax. Pursuant to Statement of Financial Accounting Standards (“SFAS”)No. 157, *Fair Value Measurements*, the fairvalue of the Company’s cash equivalents and investments in marketablesecurities is determined based on “Level 1” inputs, which consist of quoted pricesin active markets for identical assets. The Company believes that the carryingvalues of all other financial instruments approximate their current values dueto their nature and respective durations.

 

*Inventories*

* *

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

 

*Warranties*

* *

TheCompany offers warranties generally ranging from one to three years to itscustomers, other than on sales of excess inventory, depending on the productand negotiated terms of purchase agreements. Such warranties require theCompany to repair or replace defective product returned to the Company duringsuch warranty period at no cost to the customer. An estimate by the Company forwarranty-related costs is recorded by the Company at the time of sale based onits historical and estimated product return rates and expected repair orreplacement costs. Such costs have historically been consistent between periodsand in-line with management’s expectations. The Company’s warranty liability isincluded as a component of accrued expenses and other current liabilities inthe accompanying unaudited condensed consolidated balance sheets.

 

7

----

 

*Stock-Based Compensation*

* *

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

 

In accordance withSFAS No. 123(R), *Share-Based Payment*(“SFASNo. 123(R)”), employee and director stock-based compensation expenserecognized during the period is based on the value of the portion ofshare-based payment awards that is ultimately expected to vest during theperiod. Stock-based compensation expense recognized in the accompanyingunaudited condensed consolidated statements of operations includes (i) compensationexpense for share-based payment awards granted prior to, but not yet vested asof December 31, 2005 based on the grant date fair value estimated inaccordance with the pro forma provisions of SFAS No. 123 and (ii) compensationexpense for the share-based payment awards granted subsequent to December 31,2005 based on the grant date fair value estimated in accordance with theprovisions of SFAS No. 123(R). Given that stock-based compensation expenserecognized in the unaudited condensed consolidated statements 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. The estimated average forfeiture ratesused by the Company are based on historical forfeiture experience and estimatedfuture forfeitures.

 

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

 

*Income Taxes*

* *

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

 

The Companyadopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48,*Accounting for Uncertainty in Income Taxes—AnInterpretation of FASB Statement No. 109* (“FIN 48”) on December 31,2006, the first day of its fiscal 2007. FIN 48 seeks to reduce thediversity in practice associated with certain aspects of measurement andrecognition in accounting for income taxes. FIN 48 prescribes arecognition threshold and measurement requirement for the financial statementrecognition of a tax position that has been taken or is expected to be taken ona tax return and also provides guidance on de-recognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition. Under FIN 48 the Company may only recognize or continue torecognize tax positions that meet a “more likely than not” threshold.

 

*Risks andUncertainties*

* *

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

 

8

----

 

Due to recentdisruptions of, and the resulting reduced liquidity in certain financialmarkets, two of the Company’s marketable securities investments in AAA ratedauction rate securities with a total purchased cost of $2.0 millionexperienced failed auctions during the fourth quarter of 2007 and first quarterof 2008. Due to the failed auctions, the Company was unable to sell thesecurities at their respective costs, resulting in a decrease in fair valuewhich has been recorded as a component of accumulated other comprehensive loss.These investments have been classified as long-term investments in marketablesecurities in the accompanying unaudited condensed consolidated balance sheetsas of March 29, 2008 and December 29, 2007. As of March 29,2008, the unrealized losses on these two investments totaled approximately $0.2million. The Company has concluded that the unrealized losses on theseinvestments are temporary because (i) the Company believes that thedecline in market value that has occurred is due to general market conditions, (ii) theauction rate securities continue to be of a high credit quality and interest ispaid as due and (iii) the Company has the intent and ability to hold theseinvestments until a recovery in market value occurs. The fair value of thesesecurities could change significantly in the future and the Company may berequired to record other-than-temporary impairment charges or additionalunrealized losses in future periods.

 

*Foreign CurrencyRemeasurement*

* *

The functionalcurrency of the Company’s foreign subsidiary in the PRC is the U.S. dollar. Thelocal currency financial statements of this subsidiary are remeasured into U.S.dollars using the current exchange rate for monetary assets and liabilities andthe historical exchange rate for nonmonetary assets and liabilities. Expensesare remeasured using the average exchange rate for the period, except itemsrelated to nonmonetary assets and liabilities, which are remeasured usinghistorical exchange rates. All remeasurement gains and losses are included indetermining net income (loss).

 

*Net Income (Loss)Per Share*

* *

Basic net income(loss) per share is calculated by dividing net income (loss) by theweighted-average shares outstanding during the period. Diluted net income(loss) per share is calculated by dividing the net income (loss) by the weighted-averageshares and dilutive potential common shares outstanding during the period.Dilutive potential shares consist of dilutive shares issuable upon the exerciseof outstanding stock options and warrants computed using the treasury stockmethod.

 

**NOTE3—SUPPLEMENTAL FINANCIAL INFORMATION**

** **

*Inventories*

 

Inventoriesconsist of the following (in thousands):

 
| ** **      | ** ** | **March 29,** | ** ** | **December 29,** | ** ** |
|-----------------|------------|--------------------|------------|-----------------------|------------|
| ** **      | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|            |       |               |       |                  |       |
| Raw materials   |       | $                  | 1,600      |                  | $          | 1,878 |   |
| Work in process |       | 714                |       | 425                   |       |
| Finished goods  |       | 1,278              |       | 1,030                 |       |
|            |       | $                  | 3,592      |                  | $          | 3,333 |   |

 

*WarrantyLiability*

 

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

 
| ** **                    | ** ** | **Three Months Ended** | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **                    | ** ** | **2008**               | ** ** | **2007** | ** ** |
| ** **                    | ** ** | ** **             | ** ** | ** ** | ** ** |
| Beginning balance             |       | $                      | 353        |   | $ | 298 |   |
| Charged to costs and expenses |       | 26                     |       | 77 |   |
| Usage                         |       | (16                    | )          | (54 | ) |
| Ending balance                |       | $                      | 363        |   | $ | 321 |   |

 

9

----

 

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

 

*FacilityRelocation Costs*

 

The followingtable summarizes the activity related to the Company’s accrual for facilityrelocation costs during the three months ended March 29, 2008 (inthousands):

 
| ** **        | ** ** | **Three Months Ended** | ** ** |
|-------------------|------------|------------------------|------------|
| ** **        | ** ** | **March 29,**     | ** ** |
| ** **        | ** ** | **2008**               | ** ** |
|              |       |                   |       |
| Beginning balance |       | $                      | 103        |   |
| Net payments      |       | (14                    | )          |
| Ending balance    |       | $                      | 89         |   |

* *

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

 

*ComprehensiveIncome (Loss)*

* *

The components ofcomprehensive income (loss), net of taxes, consist of the following (inthousands):

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **                                                              | ** ** | **2008**               | ** ** | **2007** | ** ** |
|                                                                    |       |                   |       |   |   |
| Net income (loss)                                                       |       | $                      | (584       | ) | $ | 631 |   |
| Other comprehensive income  (loss):                                     |       |                   |       |   |   |
| Change in net unrealized gain (loss) on investments, net of tax         |       | (45                    | )          | 4 |   |
| Reclassification adjustment for net realized gain included in net  loss |       | (13                    | )          | — |   |
| Total comprehensive income  (loss)                                      |       | $                      | (642       | ) | $ | 635 |   |

 

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

 

*Computationof Net Income (Loss) Per Share*

 

The followingtable sets forth the computation of basic and diluted net income (loss) pershare, including the reconciliation of the numerator and denominator used inthe calculation of basic and diluted net income (loss) per share (in thousands,except per share data):

 

10

----

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                       | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **                                                       | ** ** | **2008**               | ** ** | **2007** | ** ** |
| ** **                                                       | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Basic net income (loss) per  share:**                          | ** ** | ** **             | ** ** | ** ** | ** ** |
| Numerator: Net income (loss)                                     |       | $                      | (584       | ) | $ | 631 |   |
| Denominator: Weighted-average common shares outstanding, basic   |       | 19,820                 |       | 19,624 |   |
| Basic net income (loss) per share                                |       | $                      | (0.03      | ) | $ | 0.03 |   |
| **Diluted net income (loss) per share:**                         |       |                   |       |   |   |
| Numerator: Net income (loss)                                     |       | $                      | (584       | ) | $ | 631 |   |
| Weighted-average common shares outstanding, basic                |       | 19,820                 |       | 19,624 |   |
| Effect of dilutive securities:                                   |       |                   |       |   |   |
| Stock options and warrants                                       |       | —                 |       | 1,801 |   |
| Denominator: Weighted-average common shares outstanding, diluted |       | 19,820                 |       | 21,425 |   |
| Diluted net income (loss) per share                              |       | $                      | (0.03      | ) | $ | 0.03 |   |

 

All potentiallydilutive common share equivalents of approximately 840,000 shares have beenexcluded from the diluted net loss per share calculation for the three monthsended March 29, 2008 as their effect would be anti-dilutive for the periodthen ended.

 

*MajorCustomers*

 

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

 
| ** **      | ** ** | **Three Months Ended** | ** ** |
|-----------------|------------|------------------------|------------|
| ** **      | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **      | ** ** | **2008**               | ** ** | **2007** | ** ** |
| **Customer:**   | ** ** | ** **             | ** ** | ** ** | ** ** |
| Dell            |       | 74                     | %          | 38 | % |
| Hewlett Packard |       | 17                     | %          | 31 | % |
| IBM             |       | —                 |       | 11 | % |

 

The Company’saccounts receivable are concentrated with two customers at March 29, 2008representing approximately 74% and 21% of aggregate gross receivables. Asignificant reduction in sales to, or the inability to collect receivablesfrom, a significant customer could have a material adverse impact on theCompany.

 

**NOTE4—CREDIT AGREEMENT**

** **

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

 

11

----

 

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

 
| ** **                                                 | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **                                                 | ** ** | **2008**               | ** ** | **2007** | ** ** |
|                                                       |       |                   |       |   |   |   |   |
| Interest expense                                           |       | $                      | 60         |   | $ | 390 |   |
|                                                       |       |                   |       |   |   |
| ** **                                                 | ** ** | **March 29,**     | ** ** | **December 29,** | ** ** |
| ** **                                                 | ** ** | **2008**               | ** ** | **2007** | ** ** |
|                                                       |       |                   |       |   |   |   |   |
| Outstanding borrowings on  the revolving line of credit    |       | $                      | 3,234      |   | $ | 4,872 |   |
| Borrowing availability  under the revolving line of credit |       | $                      | 4,047      |   | $ | 6,366 |   |

 

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

 

**NOTE 5—LONG-TERMDEBT**

** **

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

 
| ** **                        | ** ** | **March 29,** | ** ** | **December 29,** | ** ** |
|-----------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|                              |       |               |       |                  |       |
| Equipment note payable to  bank   |       | $                  | 775        |                  | $          | 872 |   |
| Notes payable to others           |       | 58                 |       | 74                    |       |
| Obligations under capital  leases |       | 318                |       | 432                   |       |
|                              |       | 1,151              |       | 1,378                 |       |
| Less current portion              |       | (637               | )          | (740                  | )          |
|                              |       | $                  | 514        |                  | $          | 638 |   |

 

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

 
| ** **       | ** ** | **Three Months Ended** | ** ** |
|------------------|------------|------------------------|------------|
| ** **       | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **       | ** ** | **2008**               | ** ** | **2007** | ** ** |
|             |       |                   |       |   |   |
| Interest expense |       | $                      | 37         |   | $ | 57 |   |
|                  |            |                        |            |  |  |  |  |

 

**NOTE 6—INCOMETAXES**

** **

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

 
| ** **                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **                            | ** ** | **2008**               | ** ** | **2007** | ** ** |
|                                  |       |                   |       |   |   |
| Provision (benefit) for  income taxes |       | $                      | (1,181     | ) | $ | — |   |
| Effective tax rate                    |       | (67                    | )%         | — | % |
|                                       |            |                        |            |  |  |  |  |

 

The differencebetween the Company’s effective tax rate for the three months ended March 29,2008 and the 35% federal statutory rate is primarily attributable to certainpermanent differences being a larger percentage of the Company’s estimatedannualized pre-tax income. The permanent difference dollar amounts areconsistent with the prior year. The difference in the Company’s effective taxrate for the three months ended March 31, 2007 and the federal statutoryrate is primarily based on the effect of research and development credits andthe Company’s annualized projected pre-tax income at that time.

 

12

----

 

**NOTE7—COMMITMENTS AND CONTINGENCIES**

** **

*FederalSecurities Class Action*

 

Beginning in May 2007,the Company, certain of its officers and directors, and the Company’sunderwriters were named as defendants in four purported class actionshareholder complaints, two of which were filed in the U.S. District Court forthe Southern District of New York, and two of which were filed in the U.S.District Court for the Central District of California. These purported classaction lawsuits were filed on behalf of persons and entities who purchased orotherwise acquired the Company’s common stock pursuant or traceable to theCompany’s November 30, 2006 Initial Public Offering (the “IPO”). Thelawsuits have been consolidated into a single action—Belodoff v. Netlist, Inc.,Lead Case No. SACV07-677 DOC (MLGx)—which is pending in the CentralDistrict of California. Lead Plaintiff filed the Consolidated Complaint on November 5,2007. Generally, the complaint alleges that the Registration Statement issuedby the Company in connection with the IPO contained untrue statements ofmaterial fact or omissions of material fact in violation of Sections 11and 15 of Securities Act of 1933. Defendants filed their motions to dismiss thecomplaint on January 9, 2008. The hearing on Defendants’ motions todismiss was held on April 28, 2008, at which time the court took thematter under submission. The Company believes that the allegations lack meritand intends to vigorously defend all claims asserted. However, at this time,the Company is unable to form a professional judgment that an unfavorableoutcome is either probable or remote, and it is not possible to assess whetheror not the outcome of these proceedings will or will not have a materialadverse effect on the Company. If an unfavorable outcome should eventuallyoccur, the Company is not at this time able to estimate the amount or range ofpossible loss.

 

*CaliforniaDerivative Action*

 

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

 

*OtherObligations*

 

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

 

13

----

 

**NOTE8—STOCK OPTIONS AND WARRANTS**

** **

*Common Stock Options*

* *

A summary ofcommon stock option activity as of and for the three months ended March 29,2008 is presented below (shares in thousands):

 
| ** **                                     | ** ** | ** **    | ** ** | **Weighted-** | ** ** |
|------------------------------------------------|------------|---------------|------------|---------------|------------|
| ** **                                     | ** ** | ** **    | ** ** | **Average**   | ** ** |
| ** **                                     | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                     | ** ** | **Shares**    | ** ** | **Price**     | ** ** |
| Options outstanding at  December 29, 2007 |       | 3,746         |       | $             | 3.06       |   |
| Options granted                                |       | 395           |       | 1.88          |       |
| Options exercised                              |       | —        |       | —        |       |
| Options cancelled                              |       | (288          | )          | 2.38          |       |
| Options outstanding at  March 29, 2008    |       | 3,853         |       | $             | 2.99       |   |

 

Thefollowing table presents details of the assumptions used to calculate the weighted-averagegrant date fair value of common stock options granted by the Company:

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **                                        | ** ** | **2008**               | ** ** | **2007** | ** ** |
| Expected term (in years)                          |       | 5.4                    |       | 5.4 |   |
| Expected volatility                               |       | 80                     | %          | 80 | % |
| Risk-free interest rate                           |       | 3.02                   | %          | 4.65 | % |
| Expected dividends                                |       | —                 |       | — |   |
| Weighted-average grant  date fair value per share |       | $                      | 1.27       |   | $ | 6.07 |   |
|                                                   |            |                        |            |  |  |  |  |

 

*At March 29,2008, the amount of unearned stock-based compensation currently estimated to beexpensed from fiscal 2008 through fiscal 2012 related to unvested common stockoptions is approximately $3.2 million, net of estimated forfeitures. Theweighted-average period over which the unearned stock-based compensation isexpected to be recognized is approximately 2.7 years. If there are anymodifications or cancellations of the underlying unvested common stock options,the Company may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense. Future stock-based compensationexpense and unearned stock-based compensation will increase to the extent thatthe Company grants additional common stock options or other equity awards.*

* *

*Warrants*

* *

A summary ofactivity with respect to outstanding warrants to purchase shares of theCompany’s common stock as of and for the three months ended March 29, 2008is presented below (shares in thousands):

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

 

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

 

14

----

 

**NOTE9—SEGMENT AND GEOGRAPHIC INFORMATION**

** **

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

 

At March 29,2008, approximately $3.4 million of the Company’s net long-lived assets werelocated outside the United States in the PRC.

 

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

** **

**CautionaryStatement**

** **

*Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with our Unaudited Condensed ConsolidatedFinancial Statements and the related notes thereto contained in Part I,Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Qis not a complete description of our business or the risks associated with aninvestment in our common stock. We urge you to carefully review and considerthe various disclosures made by us in this Report and in our other reportsfiled with the Securities and Exchange Commission, or SEC, including our AnnualReport on Form 10-K for the fiscal year ended December 29, 2007 andsubsequent reports on Form 8-K, which discuss our business in greaterdetail.*

 

*ThisReport, along with similar discussions in our other SEC filings, describe someof the important risks that may affect our business, results of operations andfinancial condition. You should carefully consider those risks, in addition tothe other information in this Report and in our other filings with the SEC,before deciding to purchase, hold or sell our common stock.*

 

*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. We undertake no obligation to revise or updatepublicly any forward-looking statements for any reason.*

 

**Overview**

** **

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

 

Consistent withthe concentrated nature of the OEM customer base in our target markets, a smallnumber of large customers have historically accounted for a significant portionof our net sales. Dell and Hewlett Packard represented approximately 74% and17%, respectively, of our net sales for the three months ended March 29,2008. Dell, Hewlett Packard and IBM represented approximately 38%, 31% and 11%,respectively, of our net sales for the three months ended March 31, 2007.Net sales to some of our OEM customers include memory modules that arequalified by us directly with the OEM customer and sold to electronicmanufacturing services providers, or EMSs, for incorporation into productsmanufactured exclusively for the OEM customer. These net sales to EMSs havehistorically fluctuated period by period as a portion of the total net sales tothese OEM customers. Net sales to Hon Hai PrecisionIndustry Co. Ltd., an EMS that purchases memory modules from us forincorporation into products manufactured exclusively for Dell, representedapproximately 35% of net sales to Dell for the three months ended March 29,2008 and approximately 76% of net sales to Dell for the three months ended March 31,2007. Net sales to Kingston Technology Company, Inc., and to InternationalSystems Technology Co. Ltd., both EMSs that purchase memory modulesfrom us for incorporation into products manufactured exclusively for IBM,represented approximately 31% and 19%, respectively, of net sales to IBM forthe three months ended March 31, 2007.

 

15

----

 

**Key BusinessMetrics**

** **

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

 

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

 

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

 

*Research and Development.***Research and development expense consistsprimarily of employee and independent contractor compensation and relatedcosts, stock-based compensation, computer-aided design software licenses,reference design development costs, patent-related fees, depreciation or rentalof evaluation equipment, and occupancy and other allocated overhead costs. Alsoincluded in research and development expense are the costs of material andoverhead related to the production of engineering samples of new products underdevelopment or products used solely in the research and development process.Our customers typically do not separately compensate us for design andengineering work involved in developing application-specific products for them.All research and development costs are expensed as incurred. As we continue todevelop additional proprietary technologies, we anticipate that research anddevelopment expenditures will increase.

 

*Selling, General andAdministrative.***Selling,general and administrative expenses consist primarily of employee salaries andrelated costs, stock-based compensation, independent sales representativecommissions, professional services, promotional and other selling and marketingexpenses, and occupancy and other allocated overhead costs. A significantportion of our selling efforts is directed at building relationships with OEMsand other customers and working through the product approval andqualification process with them. Therefore, the cost of material and overheadrelated to products manufactured for qualification is included in sellingexpenses. As we continue to service existing and penetrate new customers, weanticipate that our sales and marketing expenses will increase. We alsoanticipate that our general and administrative expenses related to accountingand legal expenses associated with our ongoing public reporting obligationswill generally remain consistent until such time that we are required to obtainattestation services from our independent registered public accounting firmwith respect to our internal control over financial reporting, the result ofwhich will increase such expenses in future periods.

 

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

 

**CriticalAccounting Policies**

** **

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires us to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosures of contingent assets and liabilities at the date of theconsolidated financial statements and the reported amounts of net sales andexpenses during the reporting period. By their nature, these estimates andassumptions are subject to an inherent degree of uncertainty. We base ourestimates on our historical experience, knowledge of current conditions and ourbeliefs of

 

16

----

 

what could occur in thefuture considering available information. We review our estimates on anon-going basis. Actual results may differ from these estimates, which mayresult in material adverse effects on our operating results and financialposition. We believe the following critical accounting policies involve themore significant assumptions and estimates used in the preparation of ourconsolidated financial statements:

 

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

 

We generally usecustomer purchase orders and/or contracts 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. Shipping documents are used to verifydelivery and customer acceptance. We assess whether the sales price is fixed ordeterminable based on the payment terms associated with the transaction andwhether the sales price is subject to refund.

 

Customers aregenerally allowed limited rights of return for up to 30 days, except for salesof excess inventories, which contain no right-of-return privileges. Estimatedreturns are provided for at the time of sale based on historical experience orspecific identification of an event necessitating a reserve. We offer a standardproduct warranty to our customers and have no other post-shipment obligations.While these returns have historically been within our expectations and theprovisions established, we cannot guarantee that we will continue to experiencesimilar return rates in the future. Any significant increase in product failurerates and the resulting product returns could have a material adverse effect onour operating results for the period or periods in which such returnsmaterialize.

 

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

 

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

 

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

 

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

 

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

 

17

----

 

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

 

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

 

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

 

On January 1,2006, we adopted SFAS No. 123(R), *Share-Based Payment*,or SFAS No. 123(R), which requires the measurement and recognition ofcompensation expense for all share-based payment awards made to our employeesand directors based on estimated fair values. We adopted SFAS No. 123(R) usingthe modified prospective transition method, which requires the application ofthe accounting standard as of January 1, 2006, the first day of our fiscalyear 2006. In accordance with the modified prospective transition method, ourconsolidated financial statements for prior periods have not been restated toreflect, and do not include, the impact of SFAS No. 123(R).

 

We currently usethe Black-Scholes option pricing model to estimate the fair value ofstock-based awards. While this model meets the requirements of SFAS No. 123(R),the estimated fair values generated by it may not be indicative of the actualfair values of our stock-based awards as it does not consider certain factorsimportant to those awards to employees, such as continued employment andperiodic vesting requirements as well as limited transferability. TheBlack-Scholes model requires subjective assumptions regarding future stockprice volatility and expected time to exercise, along with assumptions aboutthe risk-free interest rate and expected dividends, all of which affect theestimated fair values of our stock-based awards. The expected term of optionsgranted is derived from historical data on employee exercises and post-vestingemployment termination behavior. The expected volatility is based on thehistorical volatilities of the common stock of comparable publicly tradedcompanies based on our belief that we currently have limited historical dataregarding the volatility of our stock price on which to base a meaningfulestimate of expected volatility. The risk-free rate selected to value anyparticular grant is based on the U.S. Treasury rate that corresponds to theexpected term of the grant effective as of the date of the grant. The expecteddividends assumption is based on our history and expectation of dividendpayouts. We evaluate the assumptions used to value stock-based awards on aquarterly basis. If factors change and we employ different assumptions,stock-based compensation expense may differ significantly from what we haverecorded in the past.

 

18

----

 

The value of theportion of stock-based awards that are ultimately expected to vest isrecognized as expense over the requisite service periods in our financialstatements in fiscal 2006 and thereafter. As stock-based compensation expenserecognized in our financial statements is based on awards ultimately expectedto vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. If thereare any modifications or cancellations of the underlying unvested stock-basedawards, we may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense. Future stock-based compensationexpense and unearned stock-based compensation will increase to the extent thatwe grant additional stock-based awards.

 

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

 

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

 

19

----

 

**Results ofOperations**

** **

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

 
| ** **                                                 | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
| ** **                                                 | ** ** | **2008**               | ** ** | **2007** | ** ** |
|                                                       |       |                   |       |   |   |
| Net sales                                                  |       | 100                    | %          | 100 | % |
| Cost of sales                                              |       | 76                     |       | 85 |   |
| Gross profit                                               |       | 24                     |       | 15 |   |
| Operating expenses:                                        |       |                   |       |   |   |
| Research and development                                   |       | 12                     |       | 3 |   |
| Selling, general and administrative                        |       | 26                     |       | 10 |   |
| Total operating expenses                                   |       | 38                     |       | 13 |   |
| Operating income (loss)                                    |       | (15                    | )          | 2 |   |
| Other income (expense):                                    |       |                   |       |   |   |
| Interest income (expense), net                             |       | 2                      |       | — |   |
| Other income (expense), net                                |       | —                 |       | — |   |
| Total other income (expense), net                          |       | 2                      |       | — |   |
| Income (loss) before  provision (benefit) for income taxes |       | (13                    | )          | 2 |   |
| Provision (benefit) for  income taxes                      |       | (9                     | )          | — |   |
| Net income (loss)                                          |       | (4                     | )%         | 2 | % |

 

***Three Months Ended March 29,2008 Compared to Three Months Ended March 31, 2007***

*** ***

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

 

*The following table presents net sales, cost of sales andgross profit for the three months ended March 29, 2008 and March 31,2007 (in thousands, except percentages):*

* *
| ** **    | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **     | ** ** |
|---------------|------------|------------------------|------------|--------------------|------------|----------------|------------|
| ** **    | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **    | ** ** | **2008**               | ** ** | **2007**           | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
|          |       |                   |       |               |       |           |       |   |   |
| Net sales     |       | $                      | 13,104     |               | $          | 37,538         |       | $ | (24,434 | ) | (65 | )% |
| Cost of sales |       | 9,973                  |       | 32,089             |       | (22,116        | )          | (69 | )% |
| Gross profit  |       | $                      | 3,131      |               | $          | 5,449          |       | $ | (2,318 | ) | (43 | )% |
| Gross margin  |       | 24                     | %          | 15                 | %          | 9              | %          |   |   |

 

*Net Sales.*** The overall decrease in our net sales wasprimarily driven by the slower than expected growth in sales of certain of ourflash and high density server modules.

 

The decrease in net salesin the three months ended March 29, 2008 as compared to the three monthsended March 31, 2007 resulted primarily from decreases of approximately (i) $9.6million in sales of laptop personal computer memory subsystems, (ii) $7.9million in sales of memory subsystems used to control Redundant Arrays ofIndependent Disks, or RAIDs, (iii) $3.5 million in sales of our very lowprofile memory subsystems, and (iv) $2.0 million in sales of our DoubleData Rate, or DDR, and DDR2 memory subsystems.

 

Sales of our componentinventory to distributors and other users of memory ICs representedapproximately 0.4% and 3% of net sales for the three months ended March 29,2008 and March 31, 2007, respectively. Component inventory sales havedecreased as a percentage of net sales as a result of our efforts to diversifyour customer base which has resulted in our ability to use components in awider range of memory subsystems.

 

*Gross Profit and GrossMargin.*** Gross profit for the three months ended March 29,2008 as compared to the three months ended March 31, 2007 decreasedprimarily due to the 65% decrease in net sales between the two periods. Theincrease in gross margin for the three months ended March 29, 2008 ascompared to the three months ended March 31, 2007 is partially due togeneral stabilization of DRAM IC market prices during the first quarter of2008, whereas during the first quarter of 2007, we incurred a loss ofapproximately $1.6 million for slow-moving and lower-of-cost-or-market value

 

20

----

 

inventory adjustments dueprimarily to the significant decreases in the market price of DRAM ICs duringthat period. The increase is also a result of certain shifts in product mixthat provide for higher margins. Additionally, in 2008 we have begun to realizecertain benefits and cost savings of having transitioned a significant portionof our production manufacturing volume over the last two quarters to ourfacility in the People’s Republic of China.

 

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

 

***Researchand Development***.

 

The following tablepresents research and development expenses for the three months ended March 29,2008 and March 31, 2007 (in thousands, except percentages):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **   | ** ** |
|--------------------------|------------|------------------------|------------|--------------------|------------|--------------|------------|
| ** **               | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **               | ** ** | **2008**               | ** ** | **2007**           | ** ** | **Increase** | ** ** | **Change** | ** ** |
|                     |       |                   |       |               |       |         |       |   |   |
| Research and development |       | $                      | 1,576      |               | $          | 1,067        |       | $ | 509 |   | 48 | % |
|                          |            |                        |            |                    |            |              |            |  |  |  |  |  |

 

The increase in researchand development expense in the three months ended March 29, 2008 ascompared to the three months ended March 31, 2007 resulted primarily fromincreases of (i) $0.4 million in personnel-related expenses as a result ofan increase in the number of employees engaged in research and developmentactivities since March 31, 2007, (ii) $0.1 million for certainengineering and design tools and related expenses and (iii) $0.1 millionin legal and professional services as we continue to increase activitiesrelated to new and emerging markets in 2008. The above increases were partiallyoffset by a decrease of approximately $0.1 million in expenses related toproduct qualification testing, stock compensation and various allocatedoverhead expenses.

 

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

 

The following tablepresents selling, general and administrative expenses for the three monthsended March 29, 2008 and March 31, 2007 (in thousands, exceptpercentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **   | ** ** |
|--------------------------------------|------------|------------------------|------------|--------------------|------------|--------------|------------|
|                                 | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** | ** **   | ** ** | **%** | ** ** |
|                                 | ** ** | **2008**               | ** ** | **2007**           | ** ** | **Decrease** | ** ** | **Change** | ** ** |
|                                 |       |                   |       |               |       |         |       |   |   |
| Selling, general and  administrative |       | $                      | 3,468      |               | $          | 3,704        |       | $ | (236 | ) | (6 | )% |
|                                      |            |                        |            |                    |            |              |            |  |  |  |  |  |

 

The decrease in selling,general and administrative expense in the three months ended March 29,2008 as compared to the three months ended March 31, 2007 resultedprimarily from decreases of (i) $0.2 million in commission andtravel-related expenses as well as $0.2 million in product qualification,evaluation and advertising during the first quarter of 2008 as compared to thefirst quarter of 2007 and (ii) $0.1 million in legal and professional feesas a result of the significant costs we incurred in 2007 to begin operating asa public company, including costs related to our initial documentation andassessment of internal control over financial reporting. The above decreasesare partially offset by increases of (i) $0.1 million in personnel-relatedexpenses due primarily to compensation increases and increases in the costs ofour employee insurance plan coverage premiums and (ii) $0.2 million invarious allocated overhead expenses which include, but are not limited to,expenses for insurance, depreciation and rent. The number of employees engagedin selling, general and administrative activities as of March 29, 2008decreased approximately 19% from March 31, 2007.

 

21

----

 

***OtherIncome (Expense)***.

 

The following tablepresents other income (expense) for the three months ended March 29, 2008and March 31, 2007 (in thousands, except percentages):

 
| ** **                         | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **     | ** ** |
|------------------------------------|------------|------------------------|------------|--------------------|------------|----------------|------------|
| ** **                         | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **                         | ** ** | **2008**               | ** ** | **2007**           | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
|                               |       |                   |       |               |       |           |       |   |   |
| Interest income (expense),  net    |       | $                      | 239        |               | $          | (48            | )          | $ | 287 |   | 598 | % |
| Other income (expense),  net       |       | (91                    | )          | 1                  |       | (92            | )          | (9,200 | )% |
| Total other income  (expense), net |       | $                      | 148        |               | $          | (47            | )          | $ | 195 |   | 415 | % |

 

Net interest income forthe three months ended March 29, 2008 was comprised of interest income ofapproximately $0.3 million, partially offset by interest expense of approximately$0.1 million. Net interest expense for the three months ended March 31,2007 was comprised of interest expense of approximately $0.5 million, partiallyoffset by interest income of approximately $0.4 million. The decrease ininterest expense in the three months ended March 29, 2008 as compared tothe three months ended March 31, 2007 resulted primarily from our loweroutstanding line of credit and debt balances in the first quarter of 2008 ascompared to the first quarter of 2007.

 

Other expense, net, forthe three months ended March 29, 2008 is primarily comprised of losses oncertain foreign currency remeasurement transactions, partially offset byrealized gains on the sale of certain investments in marketable securities.

 

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

 

The following tablepresents the provision (benefit) for income taxes for the three months ended March 29,2008 and March 31, 2007 (in thousands, except percentages):

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **   | ** ** |
|---------------------------------------|------------|------------------------|------------|--------------------|------------|--------------|------------|
| ** **                            | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                            | ** ** | **2008**               | ** ** | **2007**           | ** ** | **Decrease** | ** ** | **Change** | ** ** |
|                                  |       |                   |       |               |       |         |       |   |   |
| Provision (benefit) for  income taxes |       | $                      | (1,181     | )                  | $          | —       |       | $ | (1,181 | ) | 100 | % |
|                                       |            |                        |            |                    |            |              |            |  |  |  |  |  |

 

On an interimbasis, we estimate what our effective tax rate will be in each jurisdiction forthe full fiscal year and record a quarterly income tax provision (benefit) inaccordance with the anticipated blended annual rate. We recorded a benefit for income taxes for the three monthsended March 29, 2008. Our estimated effective tax benefit rate ofapproximately 67% for the three months ended March 29, 2008 is partiallydriven by certain permanent differences being a larger percentage of ourestimated annualized pre-tax income. The permanent difference dollar amountsare consistent with the prior year. During the three months ended March 31,2007, we had estimated an annual effective tax rate of zero for fiscal 2007,which was primarily based on the effect of research and development credits andour projected annualized pre-tax income at that time.

 

**Liquidity andCapital Resources**

** **

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

 

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

 

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

 

 
| ** **                           | ** ** | **March 29,** | ** ** | **December 29,** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|                                 |       |               |       |                  |       |
| Working Capital                      |       | $                  | 28,506     |                  | $          | 27,387 |   |
|                                 |       |               |       |                  |       |
| Cash and cash  equivalents(1)        |       | $                  | 8,906      |                  | $          | 7,182 |   |
| Short-term marketable  securities(1) |       | 15,565             |       | 15,573                |       |
| Long-term marketable  securities     |       | 5,966              |       | 7,814                 |       |
|                                 |       | $                  | 30,437     |                  | $          | 30,569 |   |

----

*(1) Included in workingcapital*

 

22

----

 

*Our working capital increased slightly in the three monthsended March 29, 2008 primarily as a result of an increase in our cash andcash equivalents balance of approximately $1.7 million due primarily tomaturities and sales of certain investments in marketable securities. Thisincrease in working capital was partially offset by purchases of equipment ofapproximately $0.3 million and payments on long term debt of approximately $0.2million.*

 

***CashProvided and Used in the Three Months Ended March 29, 2008 and March 31,2007***

 

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

* *

* *
| ** **                                            | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|
|                                                  | ** ** | **March 29,**     | ** ** | **March 31,** | ** ** |
|                                                  | ** ** | **2008**               | ** ** | **2007** | ** ** |
| ** **                                            | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Net cash provided by (used in):**                   |       |                   |       |   |   |   |   |
| Operating activities                                  |       | $                      | 2,097      |   | $ | 4,873 |   |
| Investing activities                                  |       | 1,460                  |       | (16,667 | ) |
| Financing activities                                  |       | (1,833                 | )          | (7,487 | ) |
| Net increase (decrease) in  cash and cash equivalents |       | $                      | 1,724      |   | $ | (19,281 | ) |

 

*Operating Activities.*Net cash provided by operating activities for the three months ended March 29,2008 was primarily a result of (i) approximately $0.7 million in netnon-cash operating expenses, primarily comprising depreciation and amortizationand stock-based compensation and (ii) approximately $2.0 million in netcash provided by changes in operating assets and liabilities, partially offsetby a net loss of approximately $0.6 million for the three months ended March 29,2008. Net cash provided by operating activities for the three months ended March 31,2007 was primarily a result of approximately $0.6 million in net income for thequarter and (i) approximately $0.3 million in net non-cash operatingexpenses, primarily comprising depreciation and amortization, deferred incometaxes, stock-based compensation and impairment of long-lived assets and (ii) approximately$4.0 million in net cash provided by changes in operating assets andliabilities.

 

Accounts receivable decreasedapproximately $4.1 million during the three months ended March 29, 2008primarily as a result of the decline in our net sales during the period. Duringthe same period, we were successful in collecting cash from sales to ourcustomers substantially in accordance with our standard payment terms withthose customers.

 

*Investing Activities.*Net cash provided by investing activities for the three months ended March 29,2008 was primarily a result of proceeds received from maturities and sales ofcertain investments in marketable securities of approximately $8.2 million,partially offset by purchases of additional investments in marketablesecurities of approximately $6.4 million. We also used approximately $0.3million in cash to purchase additional manufacturing equipment. Net cash usedin investing activities for the three months ended March 31, 2007 wasprimarily a result of purchases of additional investments in marketablesecurities during the period of approximately $30.6 million, partially offset byproceeds received from maturities of certain investments in marketablesecurities of approximately $14.4 million.

 

Due to recentdisruptions of, and the resulting reduced liquidity in certain financialmarkets, two of our marketable securities investments in AAA rated auction ratesecurities with a total purchased cost of $2.0 million experienced failedauctions during the fourth quarter of 2007 and first quarter of 2008. Due tothe failed auctions, we were unable to sell the securities at their respectivecosts, resulting in a decrease in fair value which has been recorded as acomponent of accumulated other comprehensive loss. These investments have beenclassified as long-term investments in marketable securities in ourconsolidated balance sheets as of March 29, 2008 and December 29,2007. As of March 29, 2008, the unrealized losses on these two investmentstotaled approximately $0.2 million. We have concluded that the unrealizedlosses on these investments are temporary because (i) we believe that thedecline in market value that has occurred is due to general market conditions, (ii) theauction rate securities continue to be of a high credit quality and interest ispaid as due and (iii) we have the intent and ability to hold theseinvestments until a recovery in market value occurs. The fair value of thesesecurities could change significantly in the future and we may be required torecord other-than-temporary impairment charges or additional unrealized lossesin future periods.

 

*Financing Activities.*Net cash used in financing activities for the three months ended March 29,2008 was primarily a result of net repayments on our outstanding revolving lineof credit of approximately $1.6 million, along with repayments of approximately$0.2 million on our long term debt. Net cash used in financing activities forthe three months ended March 31, 2007 was primarily a result of netrepayments on our outstanding revolving line of credit of approximately $7.2million.

 

23

----

 

***Capital Resources***

*** ***

Under ourrevolving line of credit, we may borrow up to the greater of 85% of eligibleaccounts receivable plus the least of (i) a percentage of eligibleinventory determined from time to time by the Company’s bank, (ii) 80% ofthe orderly liquidation value, as defined, of eligible inventories, and (iii) $7 million.Interest is payable monthly at the prime rate, which was 5.25% at March 29,2008.

 

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

 

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

 
| ** **                                                 | ** ** | **March 29,** | ** ** | **December 29,** | ** ** |
|------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **2008**           | ** ** | **2007**              | ** ** |
|                                                       |       |               |       |                  |       |
| Outstanding borrowings on  the revolving line of credit    |       | $                  | 3,234      |                  | $          | 4,872 |   |
| Outstanding borrowings on  the equipment line of credit    |       | $                  | 775        |                  | $          | 872 |   |
| Borrowing availability  under the revolving line of credit |       | $                  | 4,047      |                  | $          | 6,366 |   |

 

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

 

While we arecurrently in compliance with all financial covenants and expect to maintaincompliance for the foreseeable future, we have in the past been in violation ofone or more covenants. We cannot assure you that we will not violate one ormore covenants in the future. If we were to be in violation of covenants underour credit agreement, our lender could choose to accelerate payment on alloutstanding loan balances. There can be no assurance that we would be able toquickly obtain equivalent or suitable replacement financing in this event. Ifwe were not able to secure alternative sources of funding, such accelerationwould have a material adverse impact on our financial condition.

 

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

 

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

 

***Off-Balance SheetArrangements***

*** ***

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

*** ***

***24***

----

*** ***

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

** **

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

*** ***

**Item 4.         Controland Procedures**

** **

***Not Applicable.***

*** ***

**Item4T.      Controls and Procedures**

** **

*(a) Evaluation ofDisclosure Controls and Procedures.* We carried out anevaluation, under the supervision and with the participation of our management,including our principal executive officer and principal financial officer, ofthe effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) of theSecurities Exchange Act of 1934, (“Exchange Act”)) as of the end of our fiscalquarter ended March 29, 2008. Based upon that evaluation, our principalexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures are effective to provide reasonable assurance thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act (i) is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms and (ii) isaccumulated and communicated to our management, including our principalexecutive officer and principal financial officer as appropriate to allowtimely decisions regarding required disclosure.

 

*(b) Change ininternal controls over financial reporting.* During the fiscal quarter that ended March 29,2008, there have not been any changes in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

***Inherent Limitations on InternalControl***

 

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

 

**PART II. OTHER INFORMATION**

** **

**Item 1.         LegalProceedings**

** **

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

 

**Item 1A.      RiskFactors**

** **

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

*** ***

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

** **

On February 1,2008, we issued 97,297 shares of our common stock pursuant to an exercise ofcertain warrants dated February 12, 2003, to purchase 300,000 shares ofcommon stock. This exercise was made pursuant to a net issue election and thebalance of the shares was forfeited. The sale of these securities was made inreliance on the exemption from registration provided by Section 4(2) ofthe Securities Act of 1933, as amended.

 

25

----

 

We did notrepurchase any of our outstanding equity securities during the quarter ended March 29,2008.

 

**Item 3.         DefaultsUpon Senior Securities**

** **

None.

 

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

** **

None.

 

**Item 5.         OtherInformation**

** **

None.

 

**Item6.        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)     |       | Ninth  Amendment to Amended and Restated Credit and Security Agreement, dated  May 2, 2008, 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(2)     |       | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as Amended.                                                                                                             |
|        |       |                                                                                                                                                                                                                                                                 |
| 31.2(2)     |       | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as Amended.                                                                                                             |
|        |       |                                                                                                                                                                                                                                                                 |
| 32(3)       |       | Certification  of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002 and furnished herewith pursuant to SEC Release No. 33-8238.                       |

----

(1)   Incorporated by reference to thecorresponding exhibit number of the registration statement on Form S-1 ofthe registrant (No. 333-136735) filed with the Securities and ExchangeCommission on October 23, 2006.

 

(2)   Filed herewith.

 

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

 

26

----

 

**SIGNATURES**

 

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

 
| Date:  May 8, 2008 |       | NETLIST,  INC.                             |
|-------------------------|------------|--------------------------------------------|
|                    |       | a  Delaware corporation                    |
|                    |       | (Registrant)                               |
|                    |       |                                       |
|                    | By:        | /s/ Chun K. Hong                           |
| ** **              | ** ** | **Chun K. Hong**                           |
| ** **              | ** ** | **President, Chief Executive Officer and** |
| ** **              | ** ** | **Chairman of the Board**                  |
| ** **              | ** ** | **(Principal Executive Officer)**          |
| ** **              | ** ** | ** **                                 |
| ** **              | ** ** | ** **                                 |
|                    | By:        | /s/ Gail Itow                              |
| ** **              | ** ** | **Gail Itow**                              |
| ** **              | ** ** | **Vice President and Chief Financial**     |
| ** **              | ** ** | **Officer**                                |
| ** **              | ** ** | **(Principal Financial Officer)**          |

 

27

----

 

**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                                           |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description  of Document**                                                                                                                                                                                                                                         |
|        |       |                                                                                                                                                                                                                                                                 |
| 10.1        |       | Ninth  Amendment to Amended and Restated Credit and Security Agreement, dated  May 2, 2008, 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 Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as Amended.                                                                                                             |
|        |       |                                                                                                                                                                                                                                                                 |
| 31.2        |       | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as Amended.                                                                                                             |
|        |       |                                                                                                                                                                                                                                                                 |
| 32          |       | Certification  of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002 and furnished herewith pursuant to SEC Release No. 33-8238.                       |

 

28

----