** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **

**(Mark One)**
| ** ** | **x**      | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                 |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                             |
| ** ** | ** ** | **For the quarterly period ended  September 29, 2007**                                                                                                                 |
| ** ** | ** ** | ** **                                                                                                                                                             |
| ** ** | ** ** | **or**                                                                                                                                                                 |
| ** ** | ** ** | ** **                                                                                                                                                             |
| ** ** | **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                |
|       |       |                                                                                                                                                                   |
|       |       | **For the transition period from               to          ** |

 

**Commissionfile number 001-33170**

** **

****

 

**NETLIST,INC.**

(Exact name of registrant as specified in itscharter)

 

| **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’s telephone number, including area code)**

** **

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

 

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

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

 

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

 

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

 

Common Stock, par value $0.001 per share

19,717,646 shares outstanding at October 31, 2007

 

** **

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** **

**NETLIST, INC. AND SUBSIDIARIES**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 29, 2007**

** **

**TABLE OF CONTENTS**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                                     |   |
|---------------|-------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.       | Financial Statements                                                                                                                      |
|          | Unaudited Condensed Consolidated Balance  Sheets at September 29, 2007 and December 30, 2006                                              |
|          | Unaudited Condensed Consolidated Statements  of Operations for the Three and Nine Months Ended September 29, 2007 and  September 30, 2006 |
|          | Unaudited Condensed Consolidated Statements  of Cash Flows for the Nine Months Ended September 29, 2007 and September 30,  2006           |
|          | Notes to Unaudited Condensed Consolidated  Financial Statements                                                                           |
| Item 2.       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                               |
| Item 3.       | Quantitative and Qualitative Disclosures  About Market Risk                                                                               |
| Item 4.       | Controls and Procedures                                                                                                                   |   |
|          |                                                                                                                                      |   |
| PART II. | OTHER INFORMATION                                                                                                                         |   |
| Item 1.       | Legal Proceedings                                                                                                                         |   |
| Item 1A.      | Risk Factors                                                                                                                              |   |
| Item 2.       | Unregistered Sales of Equity Securities and  Use of Proceeds                                                                              |
| Item 3.       | Defaults Upon Senior Securities                                                                                                           |   |
| Item 4.       | Submission of Matters to a Vote of Security  Holders                                                                                      |   |
| Item 5.       | Other Information                                                                                                                         |   |
| Item 6.       | Exhibits                                                                                                                                  |   |

 

2

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**PART I. FINANCIAL INFORMATION**

** **

**Item 1. FinancialStatements**

** **

**NETLIST, INC. ANDSUBSIDIARIES**

**UnauditedCondensed Consolidated Balance Sheets**

**(in thousands)**

** **
| ** **                                                               | ** ** | **September 29,** | ** ** | **December 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| ** **                                                               | ** ** | ** **             | ** ** | ** **            | ** ** |
| **ASSETS**                                                               | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                          |       |                   |       |                  |       |
| Cash and cash equivalents                                                |       | $                      | 6,450      |                  | $          | 30,975 |   |
| Investments in marketable securities                                     |       | 16,079                 |       | 5,267                 |       |
| Accounts receivable, net                                                 |       | 16,338                 |       | 23,703                |       |
| Inventories                                                              |       | 5,958                  |       | 19,473                |       |
| Deferred taxes                                                           |       | 4,970                  |       | 1,054                 |       |
| Prepaid expenses and other current assets                                |       | 447                    |       | 988                   |       |
| Total current assets                                                     |       | 50,242                 |       | 81,460                |       |
|                                                                     |       |                   |       |                  |       |
| Property and equipment, net                                              |       | 8,071                  |       | 3,830                 |       |
| Deferred taxes                                                           |       | 1,237                  |       | 576                   |       |
| Long-term investments in marketable  securities                          |       | 8,103                  |       | 1,502                 |       |
| Other assets                                                             |       | 690                    |       | 326                   |       |
| Total assets                                                             |       | $                      | 68,343     |                  | $          | 87,694 |   |
|                                                                     |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                            |       |                   |       |                  |       |
| Current liabilities:                                                     |       |                   |       |                  |       |
| Accounts payable                                                         |       | $                      | 9,221      |                  | $          | 11,680 |   |
| Revolving line of credit                                                 |       | 10,280                 |       | 19,238                |       |
| Current portion of long-term debt                                        |       | 829                    |       | 1,033                 |       |
| Current portion of deferred gain on sale  and leaseback transaction      |       | 118                    |       | 118                   |       |
| Income taxes payable                                                     |       | —                 |       | 552                   |       |
| Accrued expenses and other current  liabilities                          |       | 2,739                  |       | 3,255                 |       |
| Total current liabilities                                                |       | 23,187                 |       | 35,876                |       |
| Long-term debt, net of current portion                                   |       | 939                    |       | 1,230                 |       |
| Deferred gain on sale and leaseback  transaction, net of current portion |       | 255                    |       | 344                   |       |
| Total liabilities                                                        |       | 24,381                 |       | 37,450                |       |
| Commitments and contingencies                                            |       |                   |       |                  |       |
| Stockholders’ equity:                                               |       |                   |       |                  |       |
| Common stock                                                             |       | 20                     |       | 20                    |       |
| Additional paid-in capital                                               |       | 67,653                 |       | 66,557                |       |
| Note receivable from stockholder                                         |       | —                 |       | (1                    | )          |
| Accumulated deficit                                                      |       | (23,729                | )          | (16,332               | )          |
| Accumulated other comprehensive income                                   |       | 18                     |       | —                |       |
| Total stockholders’ equity                                          |       | 43,962                 |       | 50,244                |       |
| Total liabilities and stockholders’ equity                          |       | $                      | 68,343     |                  | $          | 87,694 |   |

** **

See accompanying notes.

 

3

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**NETLIST, INC.AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Operations**

**(in thousands, exceptper share amounts)**

** **
| ** **                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | **September 29,**           | ** ** | **September 30,**          | ** ** | **September 29,** | ** ** | **September 30,** | ** ** |
| ** **                                                 | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Net sales                                                  |       | $                                | 27,194     |                            | $          | 43,505 |   | $ | 77,543 |   | $ | 109,439 |   |
| Cost of sales(1)                                           |       | 23,027                           |       | 36,524                          |       | 73,850 |   | 93,971 |   |
| Gross profit                                               |       | 4,167                            |       | 6,981                           |       | 3,693 |   | 15,468 |   |
| Operating expenses:                                        |       |                             |       |                            |       |   |   |   |   |
| Research and development(1)                                |       | 1,256                            |       | 874                             |       | 3,801 |   | 2,388 |   |
| Selling, general and administrative(1)                     |       | 4,040                            |       | 2,583                           |       | 11,589 |   | 6,494 |   |
| Total operating expenses                                   |       | 5,296                            |       | 3,457                           |       | 15,390 |   | 8,882 |   |
| Operating income (loss)                                    |       | (1,129                           | )          | 3,524                           |       | (11,697 | ) | 6,586 |   |
| Other income (expense):                                    |       |                             |       |                            |       |   |   |   |   |
| Interest income (expense), net                             |       | 142                              |       | (565                            | )          | 256 |   | (1,514 | ) |
| Other expense, net                                         |       | (33                              | )          | (87                             | )          | (28 | ) | (82 | ) |
| Total other income (expense), net                          |       | 109                              |       | (652                            | )          | 228 |   | (1,596 | ) |
| Income (loss) before provision (benefit)  for income taxes |       | (1,020                           | )          | 2,872                           |       | (11,469 | ) | 4,990 |   |
| Provision (benefit) for income taxes                       |       | (363                             | )          | 1,084                           |       | (4,227 | ) | 1,896 |   |
| Net income (loss)                                          |       | $                                | (657       | )                               | $          | 1,788 |   | $ | (7,242 | ) | $ | 3,094 |   |
| Net income (loss) per common share:                        |       |                             |       |                            |       |   |   |   |   |
| Basic                                                      |       | $                                | (0.03      | )                               | $          | 0.16 |   | $ | (0.37 | ) | $ | 0.28 |   |
| Diluted                                                    |       | $                                | (0.03      | )                               | $          | 0.12 |   | $ | (0.37 | ) | $ | 0.21 |   |
| Weighted-average common shares outstanding:                |       |                             |       |                            |       |   |   |   |   |
| Basic                                                      |       | 19,689                           |       | 11,235                          |       | 19,655 |   | 11,072 |   |
| Diluted                                                    |       | 19,689                           |       | 15,401                          |       | 19,655 |   | 15,248 |   |

 

----

(1) Amountsinclude stock-based compensation expense as follows:

 
| Cost of sales                       |   | $   | 53     |   | $      | 46  |   | $   | 161    |   | $ | 60 |   |
|-------------------------------------|--------|-----|--------|--------|--------|-----|--------|-----|--------|--------|---|----|--------|
| Research and development            |   | 40  |   | 49     |   | 105 |   | 71  |   |
| Selling, general and administrative |   | 219 |   | 205    |   | 668 |   | 316 |   |

 

See accompanying notes.

** **

**4**

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** **

**NETLIST, INC. ANDSUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Cash Flows**

**(in thousands)**

** **
| ** **                                                                                          | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                          | ** ** | **September 29,**          | ** ** | **September 30,** | ** ** |
| ** **                                                                                          | ** ** | **2007**                        | ** ** | **2006** | ** ** |
|                                                                                                |       |                            |       |   |   |
| Cash flows from operating activities:                                                               |       |                            |       |   |   |
| Net income (loss)                                                                                   |       | $                               | (7,242     | ) | $ | 3,094 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                                       |       | 1,013                           |       | 705 |   |
| Amortization of deferred gain on sale and  leaseback transaction                                    |       | (89                             | )          | (89 | ) |
| Deferred income taxes                                                                               |       | (4,577                          | )          | (54 | ) |
| Impairment of long-lived asset                                                                      |       | 257                             |       | — |   |
| Loss on disposal of assets                                                                          |       | 68                              |       | 15 |   |
| Loss on inventory adjustments                                                                       |       | 5,063                           |       | — |   |
| Facility relocation charge                                                                          |       | 150                             |       | — |   |
| Stock-based compensation                                                                            |       | 934                             |       | 447 |   |
| Amortization of debt discount                                                                       |       | —                          |       | 50 |   |
| Changes in operating assets and  liabilities:                                                       |       |                            |       |   |   |
| Accounts receivable                                                                                 |       | 7,365                           |       | (7,756 | ) |
| Inventories                                                                                         |       | 8,452                           |       | (8,038 | ) |
| Income taxes receivable                                                                             |       | —                          |       | 259 |   |
| Prepaid expenses and other current assets                                                           |       | 541                             |       | (340 | ) |
| Other assets                                                                                        |       | (364                            | )          | (169 | ) |
| Accounts payable                                                                                    |       | (2,442                          | )          | 8,700 |   |
| Income taxes payable                                                                                |       | (706                            | )          | 588 |   |
| Accured expenses and other current  liabilities                                                     |       | (666                            | )          | 1,155 |   |
| Net cash provided by (used in) operating  activities                                                |       | 7,757                           |       | (1,433 | ) |
| Cash flows from investing activities:                                                               |       |                            |       |   |   |
| Acquisition of property and equipment                                                               |       | (5,530                          | )          | (959 | ) |
| Proceeds from sale of equipment                                                                     |       | —                          |       | 45 |   |
| Repayment of note receivable from  stockholder                                                      |       | 1                               |       | — |   |
| Purchase of investments in marketable  securities                                                   |       | (50,944                         | )          | — |   |
| Proceeds from maturities of investments in  marketable securities                                   |       | 33,550                          |       | — |   |
| Net cash used in investing activities                                                               |       | (22,923                         | )          | (914 | ) |
| Cash flows from financing activities:                                                               |       |                            |       |   |   |
| Borrowings on lines of credit                                                                       |       | 86,740                          |       | 106,972 |   |
| Payments on lines of credit                                                                         |       | (95,698                         | )          | (105,264 | ) |
| Borrowings on debt                                                                                  |       | 290                             |       | 2,000 |   |
| Payments on debt                                                                                    |       | (852                            | )          | (676 | ) |
| Repayment of convertible notes                                                                      |       | —                          |       | (950 | ) |
| Proceeds from exercise of stock options and  warrants                                               |       | 161                             |       | 110 |   |
| Tax benefit from exercise of warrants                                                               |       | —                          |       | 203 |   |
| Net cash provided by (used in) financing  activities                                                |       | (9,359                          | )          | 2,395 |   |
| Increase (decrease) in cash and cash  equivalents                                                   |       | (24,525                         | )          | 48 |   |
| Cash and cash equivalents at beginning of  period                                                   |       | 30,975                          |       | 953 |   |
| Cash and cash equivalents at end of period                                                          |       | $                               | 6,450      |   | $ | 1,001 |   |
|                                                                                                |       |                            |       |   |   |
| Supplemental disclosure of non-cash  investing activities:                                          |       |                            |       |   |   |
| Purchase of equipment through capitalized  lease obligations                                        |       | $                               | 67         |   | $ | 113 |   |

** **

See accompanying notes.

 

5

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**NETLIST, INC. ANDSUBSIDIARIES**

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

**September 29, 2007**

** **

**NOTE 1—DESCRIPTION OF BUSINESS**

** **

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

 

**NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

** **

*Basis of Presentation*

* *

The interim unaudited condensedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and with the instructions to Securities andExchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X.These financial statements do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for complete financial statements. Therefore, these interim unauditedcondensed consolidated financial statements should be read in conjunction withthe Company’s audited consolidated financial statements and notes thereto forthe year ended December 30, 2006, included in the Company’s Annual Report onForm 10-K filed with the SEC on February 28, 2007.

 

The condensedconsolidated financial statements included herein are unaudited; however, theycontain all normal recurring accruals and adjustments that, in the opinion ofthe Company’s management, are necessary to present fairly the consolidatedfinancial position of the Company and its wholly owned subsidiaries as ofSeptember 29, 2007 and December 30, 2006, the consolidated results of itsoperations for the three and nine months ended September 29, 2007 and September30, 2006, and the consolidated cash flows for the nine months ended September29, 2007 and September 30, 2006. All intercompany balances and transactionshave been eliminated in consolidation. The results of operations for the three andnine months ended September 29, 2007 are not necessarily indicative of theresults to be expected for the full year or any future interim periods.

 

*Fiscal Year*

* *

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

 

*Use of Estimates*

* *

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

 

*Revenue Recognition*

* *

The Company’s revenuesprimarily consist of product sales of high performance memory subsystems tooriginal equipment manufacturers (“OEMs”). Revenues also include sales ofexcess component inventories to distributors and other users of memoryintegrated circuits (“ICs”) totaling approximately $0.4 million and $1.8million, respectively, for the three and nine months ended September 29, 2007and approximately $2.7 million and $10.2 million, respectively, for the threeand nine months ended September 30, 2006.

 

The Company recognizesrevenues in accordance with the SEC’s Staff Accounting Bulletin (“SAB”)No. 104, *Revenue Recognition* (“SAB No. 104”). In accordance withthe provisions of SAB No. 104, the Company recognizes revenues when 

 

6

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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.

 

The Company generallyuses customer purchase orders and/or contracts as evidence of an arrangement.Delivery occurs when goods are shipped for customers with FOB Shipping Pointterms and upon receipt for customers with FOB Destination terms, at which timetitle and risk of loss transfer to the customer. The Company assesses whetherthe sales price is fixed or determinable based on the payment terms associatedwith the transaction and whether the sales price is subject to refund.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. Returns from customers have not been material in any period as theCompany’s principal customers have adopted build-to-order manufacturing modelsor just-in-time management processes. The Company offers a standard productwarranty to its customers and has no other post-shipment obligations. TheCompany assesses collectibility based on the creditworthiness of the customeras determined by credit checks and evaluations, as well as the customer’spayment history.

 

A portion of the Company’sinternational shipments are made to third-party inventory warehouses, or hubs,and the Company recognizes revenue when the inventory is pulled from the hubfor use in production by the customer.

 

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

 

*Inventories*

* *

Inventories are valued atthe lower of cost or net realizable value. Cost is determined on an averagecost basis which approximates actual cost on a first-in, first-out basis andincludes raw materials, labor and manufacturing overhead. At each balance sheetdate, the Company evaluates its ending inventories for excess quantities andobsolescence. This evaluation includes an analysis of sales levels by producttype. Among other factors, the Company considers historical demand andforecasted demand in relation to the inventory on hand, competitiveness ofproduct offerings, market conditions and product life cycles when determiningobsolescence and net realizable value. Provisions are made to reduce excess orobsolete inventories to their estimated net realizable values. Onceestablished, write-downs are considered permanent adjustments to the cost basisof the excess or obsolete inventories.

 

*Warranties*

* *

The Company offerswarranties generally ranging from one to three years to its customers, otherthan on sales of excess inventory, depending on the product and negotiatedterms of purchase agreements. Such warranties require the Company to repair orreplace defective product returned to the Company during such warranty periodat no cost to the customer. An estimate by the Company for warranty-relatedcosts is recorded by the Company at the time of sale based on its historicaland estimated product return rates and expected repair or replacement costs.Such costs have historically been consistent between periods and in-line withmanagement’s expectations. The Company’s warranty liability is included as acomponent of accrued expenses and other current liabilities in the accompanyingunaudited condensed consolidated balance sheets.

 

The following tablesummarizes the activity related to the warranty liability for the nine monthsended September 29, 2007 (in thousands):

 
| Beginning balance, December 30, 2006 |   | $    | 298    |   |
|--------------------------------------|--------|------|--------|--------|
| Charged to costs and expenses        |   | 173  |   |
| Usage                                |   | (114 | )      |
| Ending balance, September 29, 2007   |   | $    | 357    |   |

 

*Stock-Based Compensation*

* *

The Company accounts forequity issuances to non-employees in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 123, *Accountingfor Stock-Based Compensation*(“SFAS No. 123”), and Emerging Issues Task Force (“EITF”) No. 96-18, *Accounting for Equity Instrumentsthat are Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods and Services*. All transactions in which goods orservices are the consideration received for the issuance of equity instrumentsare accounted for based on the fair value of the consideration received or thefair value of the equity instrument issued, whichever is more reliablymeasurable. The measurement date used to determine the fair value of the equityinstrument issued is the earlier of the date on which the third-partyperformance is complete or the date on which it is probable that performancewill occur.

 

7

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In accordance with SFASNo. 123(R), *Share-Based Payment*(“SFAS No. 123(R)”),employee and director stock-based compensation expense recognized during theperiod is based on the value of the portion of share-based payment awards thatis ultimately expected to vest during the period. Stock-based compensationexpense recognized in the accompanying unaudited condensed consolidatedstatements of operations includes compensation expense for share-based paymentawards granted prior to, but not yet vested as of December 31, 2005 basedon the grant date fair value estimated in accordance with the pro formaprovisions of SFAS No. 123 and compensation expense for the share-basedpayment awards granted subsequent to December 31, 2005 based on the grantdate fair value estimated in accordance with the provisions of SFASNo. 123(R). Given that stock-based compensation expense recognized in theunaudited condensed consolidated statements of operations is based on awardsultimately expected to vest, it has been reduced for estimated forfeitures.SFAS No. 123(R) requires forfeitures to be estimated at the time ofgrant and revised, if necessary, in subsequent periods if actual forfeituresdiffer from those estimates.

 

The fair value of stock-basedawards to employees and directors is calculated using the Black-Scholes optionpricing model. The Black-Scholes model requires subjective assumptionsregarding future stock price volatility and expected time to exercise, alongwith assumptions about the risk-free interest rate and expected dividends,which affect the estimated fair values of the Company’s stock-based awards. Theexpected term of options granted is derived from historical data on employeeexercises and post-vesting employment termination behavior. The expectedvolatility is based on the historical volatilities of the common stock ofcomparable 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.

 

*Net Income (Loss) Per Share*

* *

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

 

**NOTE 3—SUPPLEMENTAL FINANCIAL INFORMATION**

** **

*Inventories*

 

Inventories consist ofthe following (in thousands):

 
| ** **      | ** ** | **September 29,** | ** ** | **December 30,** | ** ** |
|-----------------|------------|------------------------|------------|-----------------------|------------|
| ** **      | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Raw materials   |       | $                      | 3,001      |                  | $          | 10,513 |   |
| Work in process |       | 1,889                  |       | 3,343                 |       |
| Finished goods  |       | 1,068                  |       | 5,617                 |       |
|            |       | $                      | 5,958      |                  | $          | 19,473 |   |

 

During the nine monthsended September 29, 2007, the Company incurred a loss of approximately $5.1million due to slow moving and lower-of-cost-or-market-value inventoryadjustments.

 

8

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*Comprehensive Income (Loss)*

* *

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

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **September 29,**           | ** ** | **September 30,**          | ** ** | **September 29,** | ** ** | **September 30,** | ** ** |
| ** **                                    | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net income (loss)                             |       | $                                | (657       | )                               | $          | 1,788 |   | $ | (7,242 | ) | $ | 3,094 |   |
| Other comprehensive income:                   |       |                             |       |                            |       |   |   |   |   |
| Change in net unrealized gain on  investments |       | 25                               |       | —                          |       | 18 |   | — |   |
| Total comprehensive income (loss)             |       | $                                | (632       | )                               | $          | 1,788 |   | $ | (7,224 | ) | $ | 3,094 |   |

 

Accumulated othercomprehensive income reflected on the unaudited condensed consolidated balancesheet at September 29, 2007 represents accumulated net unrealized gains oninvestments in marketable securities.

 

*Computation of Net Income (Loss)Per Share*

 

The following table setsforth the computation of basic and diluted net income (loss) per share,including the reconciliation of the numerator and denominator used in thecalculation of basic and diluted net income (loss) per share (in thousands,except per share data):

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                              | ** ** | **September 29,**           | ** ** | **September 30,**          | ** ** | **September 29,** | ** ** | **September 30,** | ** ** |
| ** **                                                              | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                              | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic net income (loss) per share:**                                  | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator: Net income (loss)                                            |       | $                                | (657       | )                               | $          | 1,788 |   | $ | (7,242 | ) | $ | 3,094 |   |
| Denominator: Weighted-average common shares  outstanding, basic         |       | 19,689                           |       | 11,235                          |       | 19,655 |   | 11,072 |   |
| Basic net income (loss) per share                                       |       | $                                | (0.03      | )                               | $          | 0.16 |   | $ | (0.37 | ) | $ | 0.28 |   |
| **Diluted net income (loss) per share:**                                |       |                             |       |                            |       |   |   |   |   |
| Net income (loss)                                                       |       | $                                | (657       | )                               | $          | 1,788 |   | $ | (7,242 | ) | $ | 3,094 |   |
| Convertible notes interest expense (net of  tax)                        |       | —                           |       | 20                              |       | — |   | 60 |   |
| Numerator: Adjusted net income (loss)  available to common stockholders |       | $                                | (657       | )                               | $          | 1,808 |   | $ | (7,242 | ) | $ | 3,154 |   |
| Weighted-average common shares outstanding,  basic                      |       | 19,689                           |       | 11,235                          |       | 19,655 |   | 11,072 |   |
| Effect of dilutive securities:                                          |       |                             |       |                            |       |   |   |   |   |
| Stock options and warrants                                              |       | —                           |       | 2,089                           |       | — |   | 2,099 |   |
| Convertible preferred stock                                             |       | —                           |       | 1,000                           |       | — |   | 1,000 |   |
| Convertible notes payable                                               |       | —                           |       | 1,077                           |       | — |   | 1,077 |   |
| Denominator: Weighted-average common shares  outstanding, diluted       |       | 19,689                           |       | 15,401                          |       | 19,655 |   | 15,248 |   |
| Diluted net income (loss) per share                                     |       | $                                | (0.03      | )                               | $          | 0.12 |   | $ | (0.37 | ) | $ | 0.21 |   |

 

All potentially dilutivecommon share equivalents of approximately 1.1 million and 1.5 million shareshave been excluded from the diluted net loss per share calculations for thethree and nine months ended September 29, 2007, respectively, as their effectwould be anti-dilutive for the periods then ended.

 

9

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*Major Customers*

 

The Company’s productsales have historically been concentrated in a small number of customers. Thefollowing table sets forth sales to customers comprising 10% or more of theCompany’s total revenues for the periods presented:

 
| ** ** | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** ** | ** ** | **September 29,**           | ** ** | **September 30,**          | ** ** | **September 29,** | ** ** | **September 30,** | ** ** |
| ** ** | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Customer:  |       |                             |       |                            |       |   |   |   |   |
| A          |       | 75                               | %          | 45                              | %          | 53 | % | 37 | % |
| B          |       | —                           | %          | 36                              | %          | — | % | 41 | % |
| C          |       | —                           | %          | —                          | %          | 21 | % | — | % |

 

The Company’s accountsreceivable are concentrated with two customers at September 29, 2007,representing approximately 70% and 10% of aggregate gross receivables. AtDecember 30, 2006, accounts receivable are concentrated with four customersrepresenting approximately 32%, 19%, 14% and 13% of aggregate grossreceivables. A significant reduction in sales to, or the ability to collectreceivables from, a significant customer could have a material adverse impacton the Company.

 

**NOTE 4—CREDIT AGREEMENT**

** **

In April 2007, theCompany executed the Seventh Amendment to the Amended and Restated Credit andSecurity Agreement (the “Seventh Amendment”). The Seventh Amendment, which waseffective as of March 21, 2007, allows the Company to, at its election,increase its line of credit from $25 million, in $2.5 million increments, up toa total of $40 million at the prime rate of interest, which was 7.75% atSeptember 29, 2007 and 8.25% at December 30, 2006. In addition, the SeventhAmendment (i) extends the maturity date of the line of credit to July 31, 2009,(ii) establishes an equipment advance line of $3 million, (iii) increases thesublimit for letters of credit to $5 million, (iv) sets an inventory sublimitof $7 million, with the ability to increase to $10 million if certain financialtargets are met, (v) provides for the reduction in interest rates on borrowingsif certain borrowing amounts and financial performance targets are met and (vi)revised certain financial covenants.

 

In July 2007, the Companyexecuted the Eighth Amendment to the Amended and Restated Credit and SecurityAgreement (the “Eighth Amendment”), which was effective as of June 29, 2007.Among other things, the Eighth Amendment added certain minimum profitabilityfinancial covenant requirements. As of September 29, 2007, the Company was incompliance with all financial covenants.

 

Borrowings on the line ofcredit are limited to 85% of eligible accounts receivable, plus the least of(i) a percentage of eligible inventory determined from time to time by theCompany’s bank, (ii) 80% of the orderly liquidation value, as defined, ofeligible inventories, and (iii) $7 million. Interest is payablemonthly, at the Company’s option, either at prime rate plus 0.50% or LIBOR plus3%. The interest rate was reduced to the prime rate or LIBOR plus 2.50% inDecember 2006 concurrent with the Company’s raise of capital through aninitial public offering.

 

Interest on the equipmentadvances is payable monthly, at the Company’s option, either at the prime rateor LIBOR plus 2.50%. Interest only payments were required on the equipmentadvances through January 31, 2007. Commencing February 1, 2007, theCompany is required to repay the equipment advances in 42 equal monthlyinstallments. The outstanding balance on this loan was approximately $1.1million and $1.1 million at September 29, 2007 and December 30, 2006,respectively (see Note 5).

 

Any borrowings on theline of credit are collateralized by a general first priority lien against allCompany assets, both tangible and intangible.

 

10

----

 

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

 
| ** **       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **       | ** ** | **September 29,**           | ** ** | **September 30,**          | ** ** | **September 29,** | ** ** | **September 30,** | ** ** |
| ** **       | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Interest expense |       | $                                | 163        |                            | $          | 290 |   | $ | 712 |   | $ | 847 |   |
|                  |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 
| ** **                                       | ** ** | **September 29,** | ** ** | **December 30,** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Outstanding borrowings on the line of  credit    |       | $                      | 10,280     |                  | $          | 19,238 |   |
| Borrowing availability under the line of  credit |       | $                      | 5,460      |                  | $          | 4,872 |   |

 

**NOTE 5—LONG-TERM DEBT**

** **

Long-term debt consistsof the following (in thousands):

 
| ** **                                  | ** ** | **September 29,** | ** ** | **December 30,** | ** ** |
|---------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Obligations under capital leases            |       | $                      | 541        |                  | $          | 802 |   |
| Equipment note payable to bank (see Note 4) |       | 1,137                  |       | 1,072                 |       |
| Notes payable to others                     |       | 90                     |       | 389                   |       |
|                                        |       | 1,768                  |       | 2,263                 |       |
| Less current portion                        |       | (829                   | )          | (1,033                | )          |
|                                        |       | $                      | 939        |                  | $          | 1,230 |   |

 

*Notes Payable to Others*

* *

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

 

In January 2003, theCompany entered into a $300,000 loan agreement with a financing company,collateralized by assets owned by an employee related to the majoritystockholder. This note bears interest at 14% per annum and matures inJanuary 2009. Principal and interest payments of approximately $6,000 aredue and payable monthly. The balance of this note was approximately $90,000 and$133,000 at September 29, 2007 and December 30, 2006, respectively.

 

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

 

*Capital Leases*

* *

The Company has acquiredcertain manufacturing and computer equipment through the use of various capitalleases. As of September 29, 2007, these leases require aggregate monthlypayments of approximately $36,000 and mature at various dates throughMay 2011. The interest rates on these leases vary between 4.3% and 9.4%.

 

11

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Interest expense relatedto long-term debt is presented in the following table (in thousands):

 
| ** **       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **       | ** ** | **September 29,**           | ** ** | **September 30,**          | ** ** | **September 29,** | ** ** | **September 30,** | ** ** |
| ** **       | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Interest expense |       | $                                | 58         |                            | $          | 42 |   | $ | 166 |   | $ | 145 |   |
|                  |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

**NOTE 6—INCOME TAXES**

** **

The following table setsforth the Company’s provision (benefit) for income taxes, along with thecorresponding effective tax rates (in thousands, except percentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **September 29,**           | ** ** | **September 30,**          | ** ** | **September 29,** | ** ** | **September 30,** | ** ** |
| ** **                           | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Provision (benefit) for income taxes |       | $                                | (363       | )                               | $          | 1,084 |   | $ | (4,227 | ) | $ | 1,896 |   |
| Effective tax rate                   |       | (36                              | )%         | 38                              | %          | (37 | )% | 38 | % |
|                                      |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

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

 

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

 

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

 

**NOTE 7—COMMITMENTS AND CONTINGENCIES**

** **

*Federal Securities Class Action*

* *

Beginning in May 2007,the Company and certain of its officers and directors (the “Individuals”) werenamed as defendants in four purported class action shareholder complaints, twoof which were filed in the U.S. District Court for the Southern District of NewYork (Tran v. Netlist, Inc., Case No. 07 CV 3754; Benjamin v. Netlist, Inc.,Case No. 07 CV5518) (the “New York Actions”), and two of which were filed inthe U.S. District Court for the Central District of California (Belodoff v.Netlist, Inc., Case No. SACV07-677 DOC (MLGx); Swofford v. Netlist, Inc., CaseNo. CV07-04006 PSG (FMOx) (the “California Actions”). 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”). The complaintsallege that the Registration Statement and Prospectus issued by the Company inconnection with the IPO contained untrue statements of material fact oromissions of material fact in violation of Sections 11, 12(a)(2) and 15 ofSecurities Act of 1933. The actions seek unspecified monetary damages and otherrelief.

 

On September 5, 2007, theCalifornia Actions were consolidated by the U.S. District Court for the CentralDistrict of California. At that time, the court also designated Belodoff v.Netlist, Inc., Case No. SACV07-677 DOC (MLGx), as the lead case in this matterand appointed Iron Workers Local No. 25 Pension Fund to serve as leadplaintiff.

 

On September 12, 2007,the New York Actions were consolidated by the U.S. District Court for theSouthern District of New York and Iron Workers Local No. 25 Pension Fund wasagain appointed to serve as lead plaintiff. The court also ordered, at therequest of the parties, that the consolidated New York action be transferred tothe U.S. District Court for the Central District of California and consolidatedinto the lead case there.

 

12

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Now that all four actionshave been consolidated into one lead action in the Central District ofCalifornia, and pursuant to a previous court order, the lead plaintiff hassixty days from the order appointing lead plaintiff to file a consolidatedcomplaint. Once the consolidated complaint is filed and served on thedefendants, defendants will have sixty days to respond. The Company believesthese lawsuits lack merit and intends to vigorously defend against them. However,it is impossible at this time to assess whether or not the outcome of theseproceedings will or will not have a material adverse effect on the Company. TheCompany has not recorded any accrual for a contingent liability associated withthis legal proceeding based on its belief that a liability, while possible, isnot probable and any range of potential future charge cannot be reasonablyestimated at this time.

 

*California Derivative Action*

* *

In August 2007, aderivative lawsuit was filed in California Superior Court for County of Orange- Smith v. Hong, Case No. 07CC01359 - against certain of the Company’s currentofficers and directors. This action contains factual allegations similar tothose of the federal lawsuit mentioned above, but the plaintiff in this caseasserts claims, on behalf of Netlist, for violations of California’s insidertrading laws, breaches of fiduciary duty, abuse of control, grossmismanagement, waste of corporate assets, and unjust enrichment. The plaintiffin this action seeks unspecified damages, equitable and/or injunctive reliefand disgorgement of all profits, benefits and other compensation obtained bythe defendants. As this action contains factual allegations similar to thoseaverred in the federal securities class action, the parties have agreed totemporarily stay this action pending a final judicial determination on theDefendants’ anticipated motions to dismiss in the federal action. Accordingly,no response by any Defendant in this action is required at this time. TheCompany believes that this lawsuit lacks merit and intends to vigorously defendagainst it. However, it is impossible at this time to assess whether or not theoutcome of this proceeding will or will not have a material adverse effect onthe Company. The Company has not recorded any accrual for a contingentliability associated with this legal proceeding based on its belief that aliability, while possible, is not probable and any range of potential futurecharge cannot be reasonably.

 

*Other Obligations*

 

During its normal courseof 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 willful misconductof 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.

 

In April 2007, theCompany entered into a four year facility lease agreement for approximately28,700 rentable square feet in Irvine, California. The Company began itsoccupation of the new facility in July 2007, which allows for the consolidationof its headquarters and domestic manufacturing operations into a singlelocation. The total base rent for the term of the lease is approximately $1.7million, with monthly rent payments ranging from approximately $33,000 to$37,000 during the term of the lease.

 

**NOTE 8—RELATED PARTY TRANSACTIONS**

** **

In February 2003,the Company loaned an employee $19,900 to exercise a portion of his then-vestedcommon stock options. This full recourse note bore interest at a rate of 7%payable annually, and was due on February 17, 2008. In December 2006,the employee repaid $23,000 of the note, and thus as of December 30, 2006, theremaining amount outstanding was approximately $1,000, which was recorded as areduction of stockholders’ equity in the consolidated balance sheet. In May2007, the remaining $1,000 was repaid to the Company in full.

 

**NOTE 9—IMPAIRMENT OF LONG-LIVED ASSET**

** **

During fiscal 2006, theCompany acquired certain laser soldering equipment (the “Equipment”) primarilyintended for use in connection with a new product technology to be developedfor a customer. In the first quarter of 2007, management 

 

13

----

 

determined that certain alternative equipment andrelated design processes were a more appropriate complement to the developmentof this technology. As a result, the Company determined the extent to which itexpected to utilize the Equipment in the future had decreased from its originalestimates, and thus the Company concluded that the carrying value of theEquipment of approximately $0.3 million was no longer recoverable and was infact impaired. In accordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*, during thefirst quarter of 2007, the Company estimated the current fair value of theEquipment primarily using market prices for comparable machinery and equipment.As a result of its analysis, the Company recorded an impairment charge ofapproximately $0.1 million to write down the carrying value of the Equipment toits estimated fair value during the three months ended March 31, 2007.Subsequently, during the quarter ended June 30, 2007, management determinedthat, due primarily to the highly customized nature of the Equipment, thelikelihood of alternative uses or disposal through a sale were significantlyremote, and therefore recorded an additional charge of approximately $0.2million to write-off the remaining carrying value of the Equipment as of June30, 2007. These charges are included as a component of research and developmentexpense in the accompanying unaudited condensed consolidated statement ofoperations for the nine months ended September 29, 2007.

 

**NOTE 10— FACILITY RELOCATION COSTS**

** **

As a result therelocation of its new domestic headquarters and manufacturing facility duringthe third quarter of 2007, in September 2007 the Company vacated its previousmanufacturing facility. The Company is currently obligated under anoncancellable operating lease of this facility through November 2010, and hasthus recorded a one-time charge and related liability of approximately$150,000, which is equal to the estimated fair value of the net remaining leasepayments in accordance with SFAS No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities*. This charge is includedas a component of selling, general and administrative expense in theaccompanying unaudited condensed consolidated statements of operations for thethree and nine months ended September 29, 2007. The related liability isincluded as a component of accrued expenses and other current liabilities inthe accompanying unaudited condensed consolidated balance sheet at September29, 2007.

 

**NOTE 11—STOCK OPTIONS AND WARRANTS**

** **

*Common Stock Options*

* *

A summary of common stockoption activity as of and for the nine months ended September 29, 2007 ispresented below (shares in thousands):

 
| ** **                                | ** ** | ** **         | ** ** | **Weighted-** | ** ** |
|-------------------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                | ** ** | ** **         | ** ** | **Average**   | ** ** |
| ** **                                | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                | ** ** | **Shares**         | ** ** | **Price**     | ** ** |
| Options outstanding at December 30, 2006  |       | 3,318              |       | $             | 3.34       |   |
| Options granted                           |       | 1,098              |       | 3.18          |       |
| Options exercised                         |       | (126               | )          | 1.28          |       |
| Options cancelled                         |       | (392               | )          | 5.57          |       |
| Options outstanding at September 29, 2007 |       | 3,898              |       | $             | 3.14       |   |

 

In September 2007, theCompany granted options to purchase approximately 380,000 shares of its commonstock to employees, including 100,000 options granted to the Company’s chiefexecutive officer, as a result of the Company’s semi-annual employeeperformance review program. The Company also granted options to purchase 10,000shares of its common stock to each of its five non-employee directors inconnection with Company’s annual non-employee director compensation program.Additionally, the Company granted an option to purchase 200,000 shares of itscommon stock to its new chief financial officer in connection with heremployment by the Company. The securities underlying this option grant areissuable pursuant to an individual option agreement issued by the Company, andare not issued under the Company’s 2006 Equity Incentive Plan.

 

14

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

 
| ** **                                        | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **September 29,**          | ** ** | **September 30,** | ** ** |
| ** **                                        | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| Expected term (in years)                          |       | 5.4                             |       | 6 |   |
| Expected volatility                               |       | 80                              | %          | 40 | % |
| Risk-free interest rate                           |       | 4.46                            | %          | 4.91 | % |
| Expected dividends                                |       | —                          |       | — |   |
| Weighted-average grant date fair value per  share |       | $                               | 2.20       |   | $ | 2.91 |   |
|                                                   |            |                                 |            |  |  |  |  |

 

*AtSeptember 29, 2007, the amount of unearned stock-based compensation currentlyestimated to be expensed from fiscal 2007 through fiscal 2011 related tounvested common stock options is approximately $3.7 million, net of estimatedforfeitures. The weighted-average period over which the unearned stock-basedcompensation is expected to be recognized is approximately 3 years. If thereare any modifications or cancellations of the underlying unvested common stockoptions, the Company may be required to accelerate, increase or cancel anyremaining unearned stock-based compensation expense. Future stock-basedcompensation expense and unearned stock-based compensation will increase to theextent that the Company grants additional common stock options or other equityawards.*

* *

*Warrants*

* *

At September 29, 2007,certain non-employees held outstanding warrants to purchase shares of theCompany’s common stock. A summary of the warrant activity as of and for thenine months ended September 29, 2007 is presented below (shares in thousands):

 
| ** **                                 | ** ** | ** **         | ** ** | **Weighted-** | ** ** |
|--------------------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                 | ** ** | ** **         | ** ** | **Average**   | ** ** |
| ** **                                 | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                 | ** ** | **Shares**         | ** ** | **Price**     | ** ** |
| Warrants outstanding at December 30, 2006  |       | 398                |       | $             | 1.35       |   |
| Warrants granted                           |       | —             |       | —        |       |
| Warrants exercised                         |       | (23                | )          | 1.25          |       |
| Warrants cancelled                         |       | (46                | )          | 3.10          |       |
| Warrants outstanding at September 29, 2007 |       | 329                |       | $             | 1.12       |   |
| Warrants exercisable at September 29, 2007 |       | 329                |       |          |       |

 

In July 2007, a warrantholder exercised 42,000 warrants to purchase shares of the Company’s commonstock, whereby the Company issued approximately 23,000 shares of common stockpursuant to a net issue election and effectively received approximately 19,000shares back from the warrant holder as consideration in lieu of cash for theexercised warrants. The 19,000 shares were forfeited on the exercise date.

 

In August 2007,approximately 27,000 outstanding unvested warrants held by a consulting firmwere deemed cancelled  pursuant to theterms of their governing agreements as a result of the termination of aresource agreement between the Company and the firm in connection with theresignation of the Company’s former chief financial officer. As of September29, 2007, the firm continues to hold approximately 11,000 exercisable warrantswith a per share weighted-average exercise price of $4.10. These outstandingwarrants will be deemed cancelled pursuant to the terms of their governing agreements90 days subsequent to the termination of the resource agreement if they remainunexercised at that time.

 

**NOTE 12—SEGMENT AND GEOGRAPHIC INFORMATION**

** **

The Company operates inone reportable segment: the design and manufacture of high-performance memorysubsystems for the server, high-performance computing and communicationsmarkets. The Company evaluates financial performance on a Company-wide basis.To date, all the Company’s international sales relate to shipments of productsto its U.S. customers’ international manufacturing sites or third-party hubsand have been denominated in U.S. dollars.

 

At September 29, 2007,approximately $2.8 million of the Company’s long-lived assets were locatedoutside the United States in the People’s Republic of China.

 

15

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

** **

**Cautionary Statement**

** **

*Thefollowing discussion and analysis of our financial condition and results of operationsshould be read in conjunction with our Unaudited Condensed ConsolidatedFinancial Statements and the related notes thereto contained in Part I, Item 1of this Report. The information contained in this Quarterly Report onForm 10-Q is not a complete description of our business or the risksassociated with an investment in our common stock. We urge you to carefullyreview and consider the various disclosures made by us in this Report and inour other reports filed with the Securities and Exchange Commission, or SEC,including our Annual Report on Form 10-K for the fiscal year endedDecember 30, 2006 and subsequent reports on Form 10-Q and Form 8-K, whichdiscuss our business in greater detail.*

 

*Thesection entitled “Risk Factors” set forth in Part II, Item 1A, and similardiscussions in our other SEC filings, describe some of the important riskfactors that may affect our business, results of operations and financialcondition. You should carefully consider those risks, in addition to the otherinformation in this Quarterly Report on Form 10-Q and in our other filings withthe SEC, before deciding to purchase, hold or sell our common stock.*

 

*This report contains forward-looking statements that involve risks,uncertainties, estimates and assumptions. These statements are not guaranteesof future performance and are subject to certain risks, uncertainties andassumptions that are difficult to predict. Therefore, our actual results coulddiffer materially and adversely from those expressed in any forward-lookingstatements as a result of various factors, including but not limited to thoseidentified under the heading “Risk Factors” set forth in Part II, Item 1A. Weundertake no obligation to revise or update publicly any forward-lookingstatements for any reason.*

 

**Overview**

** **

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

 

Consistent with theconcentrated nature of the OEM customer base in our target markets, a smallnumber of large customers have historically accounted for a significant portionof our net sales. Net sales to Dell, Hewlett Packard and IBM representedapproximately 53%, 21% and 9%, respectively, for the nine month period endedSeptember 29, 2007, and approximately 36%, 1% and 41%, respectively, for thenine month period ended September 30, 2006. Net sales to some of our OEMcustomers include memory modules that are qualified by us directly with the OEMcustomer and sold to electronic manufacturing services providers, or EMSs, forincorporation into products manufactured exclusively for the OEM customer.These net sales to EMSs have historically fluctuated quarter by quarter as aportion of the total net sales to these OEM customers. Net sales to Hon HaiPrecision Industry Co. Ltd., or Hon Hai, an EMS that purchases memory modulesfrom us for incorporation into products manufactured exclusively for Dell,represented approximately 58% of net sales to Dell for the nine month periodended September 29, 2007 and approximately 27% of net sales to Dell for thenine month period ended September 30, 2006. Net sales to Kingston TechnologyCompany, Inc., or Kingston, and to International Systems Technology Co. Ltd.,or IST, both EMSs that purchase memory modules from us for incorporation intoproducts manufactured exclusively for IBM, represented approximately 42% and21%, respectively, of net sales to IBM for the nine month period endedSeptember 29, 2007 and approximately 57% and 22%, respectively, of net sales toIBM for the nine month period ended September 30, 2006.

 

For the nine months endedSeptember 29, 2007, the market price for mainstream DRAM ICs decreased byapproximately 77%. This decline has adversely affected the selling prices ofmany of our products and contributed to lower revenues, lower gross margin andreduced inventory value during this period. Should the decline in the DRAM ICmarket continue, it would result in lower net sales, lower gross margin andreduced inventory value in subsequent periods.

 

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**Key Business Metrics**

** **

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

 

*Net Sales.**  *Net sales consistprimarily of sales of our high performance memory subsystems, net of aprovision 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. Purchaseorders generally have no cancellation or rescheduling penalty provisions. Weoften ship our products to our customers’ international manufacturing sites.All of our sales to date, however, are denominated in U.S. dollars. We alsosell excess component inventory of DRAM ICs to distributors and other users ofmemory ICs. These sales accounted for approximately $0.4 million and $1.8million, respectively, of our net sales for the three and nine months endedSeptember 29, 2007 and approximately $2.7 million and $10.2 million,respectively, of our net sales for the three and nine months ended September30, 2006. We expect that component inventory sales will continue to decrease asa percentage of net sales in future periods as we diversify our customer baseand therefore are able to use components in a wider range of memory subsystems.

 

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

 

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

 

*Selling, General and Administrative.**  *Selling, general and administrativeexpenses consist primarily of employee salaries and related costs, stock-basedcompensation, independent sales representative commissions, professionalservices, promotional and other selling and marketing expenses, and occupancyand other allocated overhead costs. A significant portion of our sellingefforts is directed at building relationships with OEMs and workingthrough the product approval and qualification process with them. Therefore,the cost of material and overhead related to products manufactured for qualificationis included in selling expenses. As we continue to service existing andpenetrate new OEM customers, we anticipate that our sales and marketingexpenses will increase. We also anticipate that our general and administrativeexpenses will increase as a percentage of net sales as we incur accounting andlegal expenses associated with our ongoing public reporting obligations andcompliance with the requirements of the Sarbanes-Oxley Act of 2002.

 

*Provision (Benefit) for Income Taxes.*   Ourincome tax provision (benefit) is based on the statutory federal tax rate of35% and is typically impacted by state taxes and permanent book-taxdifferences.

 

**Critical Accounting 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 the consolidatedfinancial statements and the reported amounts of net sales and expenses duringthe reporting period. By their nature, these estimates and assumptions aresubject to an inherent 

 

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degree of uncertainty. We base our estimates on ourhistorical experience, knowledge of current conditions and our beliefs of whatcould occur in the future considering available information. We review ourestimates on an on-going basis. Actual results may differ from these estimates,which may result in material adverse effects on our operating results andfinancial position. We believe the following critical accounting policiesinvolve the more significant assumptions and estimates used in the preparationof our consolidated financial statements:

 

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

 

We generally use customerpurchase orders and/or contracts as evidence of an arrangement. Delivery occurswhen goods are shipped for customers with FOB Shipping Point terms and uponreceipt for customers with FOB Destination terms, at which time title and riskof 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 are generallyallowed limited rights of return for up to 30 days, except for sales of excessinventories, which contain no right-of-return privileges. Estimated returns areprovided for at the time of sale based on historical experience or specificidentification of an event necessitating a reserve. Returns from customers havenot been material in any period as our principal customers have adoptedbuild-to-order manufacturing models or just-in-time management processes. Whilethese returns have historically been within our expectations and the provisionsestablished, we cannot guarantee that we will continue to experience similarreturn rates in the future. We offer a standard product warranty to ourcustomers and have no other post-shipment obligations. Any significant increasein product failure rates and the resulting product returns could have amaterial adverse effect on our operating results for the period or periods inwhich such returns materialize.

 

We assess collectibilitybased on the creditworthiness of the customer as determined by credit checksand evaluations, as well as the customer’s payment history. Most of ourinternational shipments are made to third- party inventory warehouses, or hubs,and we recognize revenue when the inventory is pulled from the hub for use inproduction by the customer. We receive a report from the customer on a dailybasis indicating the inventories pulled from a hub for use by the customer, andperform a daily reconciliation of inventories shipped to and pulled by thecustomer to those inventories reflected on the customer’s reports to ensurethat sales are recognized in the appropriate periods.

 

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

 

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

 

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

 

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

 

*Inventories.*   We valueour inventories at the lower of the actual cost to purchase or manufacture theinventory or the net realizable value of the inventory. 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. We regularlyreview inventory quantities on hand and on order and record a provision forexcess and obsolete inventories based primarily on our estimated forecast ofproduct demand and production requirements for the next three to six months. Inaddition, we consider changes in the market 

 

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value of DRAM ICs in determining the realizable value of our rawmaterial inventory. Once established, any write-downs are considered permanentadjustments to the cost basis of our inventories. A significant decrease indemand for our products could result in an increase in the amount of excessinventory quantities on hand. In addition, our estimates of future productdemand may prove to be inaccurate, in which case we may have understated oroverstated the provision required for excess and obsolete inventory. In thefuture, if our inventories are determined to be overvalued, we would berequired to recognize additional expense in our cost of sales at the time ofsuch determination. Likewise, if our inventories are determined to beundervalued, we may have over-reported our costs of sales in previous periodsand would be required to recognize additional gross profit at the time suchinventories are sold. In addition, should the market value of DRAM ICs decreasesignificantly, we may be required to lower our selling prices to reflect thelower cost of our raw materials. If such price decreases reduce the realizablevalue of our inventories to less than our cost, we would be required torecognize additional expense in our cost of sales in the same period. Althoughwe make every reasonable effort to ensure the accuracy of our forecasts offuture product demand, any significant unanticipated changes in demand,technological developments or the market value of DRAM ICs could have amaterial effect on the value of our inventories and our reported operatingresults.

 

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

 

*Stock-Based Compensation.*   Weaccount for equity issuances to non-employees in accordance with Statement ofFinancial Accounting Standards, or SFAS, No. 123, *Accounting for Stock Based Compensation*,and Emerging Issues Task Force, or EITF, Issue No. 96-18, *Accounting for Equity Instruments that are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods andServices*. All transactions in which goods or services are theconsideration received for the issuance of equity instruments are accounted forbased on the fair value of the consideration received or the fair value of theequity instrument issued, whichever is more reliably measurable. Themeasurement date used to determine the fair value of the equity instrumentissued is the earlier of the date on which the third-party performance iscomplete or the date on which it is probable that performance will occur.

 

Prior to January 1,2006, we accounted for stock-based compensation issued to employees anddirectors using the intrinsic value method of accounting prescribed byAccounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees*and related pronouncements. Under thismethod, compensation expense was recognized over the respective vesting periodbased on the excess, on the date of grant, of the fair value of our commonstock over the grant price, net of forfeitures. Deferred stock-basedcompensation was amortized on a straight-line basis over the vesting period ofeach grant.

 

On January 1, 2006,we adopted SFAS No. 123(R), *Share-BasedPayment*, or SFAS No. 123(R),which requires the measurement and recognition of compensation expense for allshare-based payment awards made to our employees and directors based onestimated fair values. We adopted SFAS No. 123(R) using the modifiedprospective transition method, which requires the application of the accountingstandard as of January 1, 2006, the first day of our fiscal year 2006. Ourconsolidated financial statements as of and for the year endedDecember 30, 2006 reflect the impact of adopting SFAS No. 123(R). Inaccordance with the modified prospective transition method, our consolidatedfinancial statements for prior periods have not been restated to reflect, anddo not include, the impact of SFAS No. 123(R).

 

*Wecurrently use the Black-Scholes option pricing model to estimate the fair valueof stock-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 theactual fair values of our stock-based awards as it does not consider certainfactors important to those awards to employees, such as continued employmentand periodic vesting requirements as well as limited transferability. The Black-Scholesmodel requires subjective assumptions regarding future stock price volatilityand expected time to exercise, along with assumptions about the risk-freeinterest rate and expected dividends, all of which affect the estimated fairvalues of the Company’s 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 the Company’s belief that it currently has limitedhistorical data regarding the volatility of its stock price on which to base ameaningful estimate of expected volatility. The risk-free rate selected tovalue any particular grant is based on the U.S. Treasury rate that correspondsto the expected term of the grant effective as of the date of the grant. Theexpected dividends assumption is based on our history and expectation ofdividend payouts. We*

 

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*evaluatethe assumptions used to value stock-based awards on a quarterly basis. Iffactors change and we employ different assumptions, stock-based compensationexpense may differ significantly from what we have recorded in the past.*

* *

*The valueof the portion 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. SFASNo. 123(R) requires forfeitures to be estimated at the time of grantand revised, if necessary, in subsequent periods if actual forfeitures differfrom those estimates. If there are any modifications or cancellations of theunderlying unvested stock-based awards, we may be required to accelerate,increase or cancel any remaining unearned stock-based compensation expense.Future stock-based compensation expense and unearned stock-based compensationwill increase to the extent that we grant additional stock-based awards.*

* *

*Income Taxes.**  *We recognize deferred tax assetsand liabilities based on the differences between the financial statementcarrying values and the tax bases of assets and liabilities. We regularlyreview our deferred tax assets for recoverability and establish a valuationallowance, when determined necessary, based on historical taxable income,projected future taxable income, and the expected timing of the reversals ofexisting temporary differences. If we operate at a loss for an extended periodof time or are unable to generate sufficient future taxable income, or if thereis a material change in the actual effective tax rates or time period withinwhich the underlying temporary differences become taxable or deductible, wecould be required to record a valuation allowance against all or a significantportion of our deferred tax assets which could substantially increase oureffective tax rate for such period. Any significant changes in statutory taxrates or the amount of our valuation allowance could have a material effect onthe value of our deferred tax assets and liabilities, and our reportedfinancial results. Additionally, we adopted Financial Accounting Standards Board,or FASB, Interpretation No. 48, *Accounting for Uncertaintyin Income Taxe*s, or FIN 48, on December 31, 2006, the first day offiscal 2007. FIN 48 is an interpretation of SFAS No. 109, *Accountingfor Income Taxes*, and seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. FIN 48 prescribes a recognition threshold and measurementrequirement for the financial statement recognition of a tax position that hasbeen taken or is expected to be taken on a tax return. FIN 48 provides guidanceon de-recognition, classification, interest and penalties, accounting ininterim periods, disclosure, and transition. Under FIN 48 we may only recognizeor continue to recognize tax positions that meet a “more likely than not”threshold. Refer to Note 6, “Income Taxes,” of Notes to Unaudited CondensedConsolidated Financial Statements for additional information.

 

**Results of Operations**

** **

The following table setsforth certain consolidated statements of operations data as a percentage of netsales for the periods indicated:

 
| ** **                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | **September 29,**           | ** ** | **September 30,**          | ** ** | **September 29,** | ** ** | **September 30,** | ** ** |
| ** **                                                 | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Net sales                                                  |       | 100                              | %          | 100                             | %          | 100 | % | 100 | % |
| Cost of sales                                              |       | 85                               |       | 84                              |       | 95 |   | 86 |   |
| Gross profit                                               |       | 15                               |       | 16                              |       | 5 |   | 14 |   |
| Operating expenses:                                        |       |                             |       |                            |       |   |   |   |   |
| Research and development                                   |       | 5                                |       | 2                               |       | 5 |   | 2 |   |
| Selling, general and administrative                        |       | 15                               |       | 6                               |       | 15 |   | 6 |   |
| Total operating expenses                                   |       | 19                               |       | 8                               |       | 20 |   | 8 |   |
| Operating income (loss)                                    |       | (4                               | )          | 8                               |       | (15 | ) | 6 |   |
| Other income (expense):                                    |       |                             |       |                            |       |   |   |   |   |
| Interest income (expense), net                             |       | 1                                |       | (1                              | )          | — |   | (1 | ) |
| Other expense, net                                         |       | —                           |       | —                          |       | — |   | — |   |
| Total other income (expense), net                          |       | 1                                |       | (1                              | )          | — |   | (1 | ) |
| Income (loss) before provision (benefit)  for income taxes |       | (4                               | )          | 7                               |       | (15 | ) | 5 |   |
| Provision (benefit) for income taxes                       |       | (1                               | )          | 2                               |       | (5 | ) | 2 |   |
| Net income (loss)                                          |       | (2                               | )%         | 5                               | %          | (9 | )% | 3 | % |

 

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*** ***

***Three and NineMonths Ended September 29, 2007 Compared to Three and Nine Months EndedSeptember 30, 2006***

*** ***

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

 

*Thefollowing tables present net sales, cost of sales and gross profit for thethree and nine months ended September 29, 2007 and September 30, 2006 (inthousands, except percentages):*

* *
| ** **    | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **     | ** ** |
|---------------|------------|----------------------------------|------------|------------------------|------------|----------------|------------|
| ** **    | ** ** | **September 29,**           | ** ** | **September 30,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **    | ** ** | **2007**                         | ** ** | **2006**               | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Net sales     |       | $                                | 27,194     |                   | $          | 43,505         |       | $ | (16,311 | ) | (37 | )% |
| Cost of sales |       | 23,027                           |       | 36,524                 |       | (13,497        | )          | (37 | )% |
| Gross profit  |       | $                                | 4,167      |                   | $          | 6,981          |       | $ | (2,814 | ) | (40 | )% |
| Gross margin  |       | 15                               | %          | 16                     | %          | (1             | )%         |   |   |

 
| ** **    | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **   | ** ** |
|---------------|------------|---------------------------------|------------|------------------------|------------|--------------|------------|
| ** **    | ** ** | **September 29,**          | ** ** | **September 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **    | ** ** | **2007**                        | ** ** | **2006**               | ** ** | **Decrease** | ** ** | **Change** | ** ** |
| Net sales     |       | $                               | 77,543     |                   | $          | 109,439      |       | $ | (31,896 | ) | (29 | )% |
| Cost of sales |       | 73,850                          |       | 93,971                 |       | (20,121      | )          | (21 | )% |
| Gross profit  |       | $                               | 3,693      |                   | $          | 15,468       |       | $ | (11,775 | ) | (76 | )% |
| Gross margin  |       | 5                               | %          | 14                     | %          | (9           | )%         |   |   |

 

*Net Sales.**  * Net sales for the three and ninemonths ended September 29, 2007 were adversely impacted by two primary factors.First, the significant decrease in DRAM IC market prices during the period,which was primarily driven by continued oversupply in the DRAM market, forcedus to significantly reduce our selling prices on many of our products.Additionally, we experienced decreases in demand as falling market pricescaused certain customers to delay purchases during the period.

 

The decrease in net sales in the three and nine monthsended September 29, 2007 as compared to the three and nine months endedSeptember 30, 2006 resulted primarily from decreases of approximately $12.6million and $36.8 million, respectively, in sales of our very low profilememory subsystems, decreases of approximately $7.4 million and $14.6 million,respectively, in sales of Double Data Rate, or DDR and DDR2 memory subsystemsand decreases of approximately $7.1 million and $16.3 million, respectively, incertain other memory products. These decreases were slightly offset by anincrease in net sales for the three and nine months ended September 29, 2007 ascompared to the three and nine months ended September 30, 2006 of approximately$8.7 million and $23.0 million, respectively, in sales of laptop personalcomputer memory subsystems and increases of approximately $2.4 million and$14.9 million, respectively, in sales of memory subsystems used to controlRedundant Arrays of Independent Disks, or RAIDs. The overall decreases in netsales are primarily attributable to (i) the market-driven reductions in sellingprices of our products and lower customer demand as described above,particularly on our high volume products with lower average selling prices and(ii) overall lower than expected demand from OEM products in which our productsare incorporated, such as blade servers that use our very low profile memorysubsystems.

 

Should market price declines for DRAM ICs continue,our overall revenues could be adversely impacted as we lower prices on someproducts to meet market conditions.

 

Sales of our componentinventory to distributors and other users of memory ICs representedapproximately 2% and 6% of net sales for the three months ended September 29,2007 and September 30, 2006, respectively, and approximately 2% and 9% of netsales for the nine months ended September 29, 2007 and September 30, 2006,respectively. We expect that component inventory sales will continue torepresent a relatively small percentage of net sales in future periods as wediversify our customer base and therefore are able to use components in a widerrange of memory subsystems.

 

*Gross Profit and Gross Margin.**  * Gross profit for the three monthsended September 29, 2007 as compared to the three months ended September 30,2006 decreased primarily due to the 37% decrease in net sales between the twoperiods. Gross margin for the three months ended September 29, 2007 wasrelatively consistent with that for the three months ended September 30, 2006.The decrease in gross profit and gross margin for the nine months endedSeptember 29, 2007 as 

 

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compared to the nine months ended September 30, 2006 is primarilyattributable to the significant decrease in the market price of DRAM ICs duringthe nine months ended September 29, 2007. This significantly impacted thevaluation of our inventories, whereby we incurred a loss in the nine monthsended September 29, 2007 of approximately $5.1 million as a result of slowmoving and lower-of-cost-or-market-value inventory adjustments. To the extentthat DRAM IC market prices continue to decline, and should our product sales mixshift more toward lower margin products such as laptop memory, our grossprofit, gross margin and overall operating results could be adversely affectedin future periods.

 

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

 

The following tables present research and developmentexpenses for the three and nine months ended September 29, 2007 and September30, 2006 (in thousands, except percentages):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **   | ** ** |
|--------------------------|------------|----------------------------------|------------|------------------------|------------|--------------|------------|
| ** **               | ** ** | **September 29,**           | ** ** | **September 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **               | ** ** | **2007**                         | ** ** | **2006**               | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Research and development |       | $                                | 1,256      |                   | $          | 874          |       | $ | 382 |   | 44 | % |
|                          |            |                                  |            |                        |            |              |            |  |  |  |  |  |

 
| ** **               | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **   | ** ** |
|--------------------------|------------|---------------------------------|------------|------------------------|------------|--------------|------------|
| ** **               | ** ** | **September 29,**          | ** ** | **September 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **               | ** ** | **2007**                        | ** ** | **2006**               | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Research and development |       | $                               | 3,801      |                   | $          | 2,388        |       | $ | 1,413 |   | 59 | % |
|                          |            |                                 |            |                        |            |              |            |  |  |  |  |  |

 

The increase in research and development expense inthe three and nine months ended September 29, 2007 as compared to the three andnine months ended September 30, 2006 resulted primarily from increases of $0.2million and $0.7 million, respectively, in personnel-related expenses andincreases of $0.1 million and $0.2 million, respectively, for certainengineering and design tools, product qualification and other related expenses.Research and development expense for the nine months ended September 29, 2007also increased compared to the corresponding prior year period due to increasesof $0.3 million in equipment-related expenses and $0.1 million in legal andprofessional services. These increases are primarily attributable to (i) anincrease in the number of employees engaged in research and developmentactivities since September 30, 2006, (ii) an increase in research anddevelopment activities related to new and emerging markets and technologies and(iii) impairment write-downs of certain long-lived assets used in the productdevelopment process, as further discussed in Note 9 of Notes to UnauditedCondensed Consolidated Financial Statements.

 

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

 

The following tables present selling, general andadministrative expenses for the three and nine months ended September 29, 2007and September 30, 2006 (in thousands, except percentages):

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **   | ** ** |
|-------------------------------------|------------|----------------------------------|------------|------------------------|------------|--------------|------------|
| ** **                          | ** ** | **September 29,**           | ** ** | **September 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2007**                         | ** ** | **2006**               | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Selling, general and administrative |       | $                                | 4,040      |                   | $          | 2,583        |       | $ | 1,457 |   | 56 | % |
|                                     |            |                                  |            |                        |            |              |            |  |  |  |  |  |

 
| ** **                          | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **   | ** ** |
|-------------------------------------|------------|---------------------------------|------------|------------------------|------------|--------------|------------|
| ** **                          | ** ** | **September 29,**          | ** ** | **September 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2007**                        | ** ** | **2006**               | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Selling, general and administrative |       | $                               | 11,589     |                   | $          | 6,494        |       | $ | 5,095 |   | 78 | % |
|                                     |            |                                 |            |                        |            |              |            |  |  |  |  |  |

 

The increase in selling, general and administrativeexpense in the three and nine months ended September 29, 2007 as compared tothe three and nine months ended September 30, 2006 resulted primarily fromincreases of $0.5 million and $1.8 million, respectively, in personnel-relatedand stock-based compensation expenses, increases of $0.2 million and $1.0million, respectively, in various selling and promotion expenses, increases of$0.3 million and $1.2 million, respectively, in legal and professionalservices, increases of $0.2 million and $0.2 million, respectively, related tocertain facility lease relocation costs, and increases of $0.3 million and $0.6million, respectively, in certain allocated overhead expenses. These increasesare primarily attributable to (i) an increase in the number of employeesengaged in selling, general and 

 

22

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administrative activities since September 30, 2006, (ii) an increase inselling expenses as a result of additional product qualification activities,travel and other costs incurred in connection with our efforts to prepare foroperations at our facility in the People’s Republic of China, (iii) an increasein legal, insurance and professional services primarily related to certainreporting and other obligations as a result of becoming a public company, (iv)costs for current litigation and other legal matters as further discussed inNote 7 of Notes to Unaudited Condensed Consolidated Financial Statements and(v) charges recorded in connection with future lease payments related to ourvacated domestic manufacturing facility as further discussed in Note 10 ofNotes to Unaudited Condensed Consolidated Financial Statements.

 

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

 

The following tables present other income (expense)for the three and nine months ended September 29, 2007 and September 30, 2006(in thousands, except percentages):

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **     | ** ** |
|-----------------------------------|------------|----------------------------------|------------|------------------------|------------|----------------|------------|
| ** **                        | ** ** | **September 29,**           | ** ** | **September 30,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **                        | ** ** | **2007**                         | ** ** | **2006**               | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Interest income (expense), net    |       | $                                | 142        |                   | $          | (565           | )          | $ | 707 |   | (125 | )% |
| Other expense, net                |       | (33                              | )          | (87                    | )          | (54            | )          | (62 | )% |
| Total other income (expense), net |       | $                                | 109        |                   | $          | (652           | )          | $ | 653 |   | (100 | )% |

 
| ** **                        | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **     | ** ** |
|-----------------------------------|------------|---------------------------------|------------|------------------------|------------|----------------|------------|
| ** **                        | ** ** | **September 29,**          | ** ** | **September 30,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **                        | ** ** | **2007**                        | ** ** | **2006**               | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Interest income (expense), net    |       | $                               | 256        |                   | $          | (1,514         | )          | $ | 1,770 |   | (117 | )% |
| Other expense, net                |       | $                               | (28        | )                      | $          | (82            | )          | (54 | ) | (66 | )% |
| Total other income (expense), net |       | $                               | 228        |                   | $          | (1,596         | )          | $ | 1,716 |   | (108 | )% |

 

Net interest income for the three and nine monthsended September 29, 2007 was comprised of interest income of approximately $0.4million and $1.3 million, respectively, partially offset by interest expense ofapproximately $0.3 million and $1.0 million, respectively. The increase in netinterest income in the three and nine months ended September 29, 2007 ascompared to the three and nine months ended September 30, 2006 resultedprimarily from (i) interest income earned on our cash equivalent and marketablesecurities balances, which is attributable to the proceeds from our initialpublic offering, or IPO, in December 2006, and (ii) a decrease in interestexpense due to our lower outstanding line of credit and debt balances in 2007as compared to 2006.

 

Other income, net, primarily includes gains and losseson foreign currency transactions in fiscal 2007 and dispositions of propertyand equipment.

 

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

 

The following tables present the provision (benefit)for income taxes for the three and nine months ended September 29, 2007 andSeptember 30, 2006 (in thousands, except percentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **   | ** ** |
|--------------------------------------|------------|----------------------------------|------------|------------------------|------------|--------------|------------|
| ** **                           | ** ** | **September 29,**           | ** ** | **September 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2007**                         | ** ** | **2006**               | ** ** | **Decrease** | ** ** | **Change** | ** ** |
| Provision (benefit) for income taxes |       | $                                | (363       | )                      | $          | 1,084        |       | $ | (1,447 | ) | (133 | )% |
|                                      |            |                                  |            |                        |            |              |            |  |  |  |  |  |

 
| ** **                           | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **   | ** ** |
|--------------------------------------|------------|---------------------------------|------------|------------------------|------------|--------------|------------|
| ** **                           | ** ** | **September 29,**          | ** ** | **September 30,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2007**                        | ** ** | **2006**               | ** ** | **Decrease** | ** ** | **Change** | ** ** |
| Provision (benefit) for income taxes |       | $                               | (4,227     | )                      | $          | 1,896        |       | $ | (6,123 | ) | (323 | )% |
|                                      |            |                                 |            |                        |            |              |            |  |  |  |  |  |

 

23

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Werecorded a benefit for income taxes for the three and nine months endedSeptember 29, 2007. On an interim basis, we estimate what our effective taxrate will be in each jurisdiction for the full fiscal year and record aquarterly income tax provision (benefit) in accordance with the anticipatedblended annual rate.

 

**Liquidity and Capital Resources**

** **

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

 

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

 

The following table presents working capital, cash andcash equivalents and investments in marketable securities (in thousands):

 
| ** **                          | ** ** | **September 29,** | ** ** | **December 30,** | ** ** |
|-------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Working Capital                     |       | $                      | 27,055     |                  | $          | 45,584 |   |
| Cash and cash equivalents(1)        |       | $                      | 6,450      |                  | $          | 30,975 |   |
| Short-term marketable securities(1) |       | 16,079                 |       | 5,267                 |       |
| Long-term marketable securities     |       | 8,103                  |       | 1,502                 |       |
|                                |       | $                      | 30,632     |                  | $          | 37,744 |   |

 

----

*(1) Included in working capital*

 

*Ourworking capital decreased in the nine months ended September 29, 2007 primarilyas a result of (i) additional net purchases of long-term investments inmarketable securities of approximately $6.6 million, (ii) purchases ofequipment and leasehold improvements of approximately $5.5 million and (iii)decreases in certain current operating assets and liabilities, primarily due tothe overall decline in net sales during the period.*

 

***Cash Provided and Used in the Nine Months EndedSeptember 29, 2007 and September 30, 2006***

 

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

* *
| ** **                                            | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                            | ** ** | **September 29,**          | ** ** | **September 30,** | ** ** |
| ** **                                            | ** ** | **2007**                        | ** ** | **2006** | ** ** |
|                                                  |       |                            |       |   |   |
| **Net cash provided by (used in):**                   |       |                            |       |   |   |
| Operating activities                                  |       | $                               | 7,757      |   | $ | (1,433 | ) |
| Investing activities                                  |       | (22,923                         | )          | (914 | ) |
| Financing activities                                  |       | (9,359                          | )          | 2,395 |   |
| Net increase (decrease) in cash and cash  equivalents |       | $                               | (24,525    | ) | $ | 48 |   |

 

*Operating Activities.*   Netcash provided by operating activities for the nine months ended September 29,2007 was primarily a result of (i) approximately $2.8 million in net non-cashoperating expenses, primarily comprising inventory adjustments, depreciationand amortization, deferred income taxes, stock-based compensation andimpairment of long-lived assets and (ii) approximately $12.2 million in netcash provided by changes in operating assets and liabilities, partially offsetby a net loss of approximately $7.2 million for the nine months ended September29, 2007. Net cash used in operating activities for the nine months endedSeptember 30, 2006 was primarily a result of (i) net income of $3.1 million and(ii) approximately $1.1 million of net non-cash operating expenses, primarilycomprising depreciation and amortization and stock-based compensation offset byapproximately $5.6 million in net cash used by changes in operating assets andliabilities.

 

24

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*Investing Activities.*   Netcash used in investing activities for the nine months ended September 29, 2007was primarily a result of purchases of additional investments in marketablesecurities of approximately $50.9 million, partially offset by proceedsreceived from maturities of certain investments in marketable securities ofapproximately $33.6 million. We also used approximately $5.5 million in cashprimarily to purchase equipment and leasehold improvements related to our newfacilities in the People’s Republic of China and in Irvine, California. Netcash used in investing activities for the nine months ended September 30, 2006resulted from the purchase of approximately $1.0 million of capital equipmentto support growth in our operations in 2006, partially offset by the receipt of$45,000 in proceeds from the sale of certain other capital equipment.

 

*Financing Activities.*   Netcash used in financing activities for the nine months ended September 29, 2007was primarily a result of net repayments on our outstanding revolving line ofcredit of approximately $9.0 million, along with net repayments ofapproximately $0.6 million on our long term debt. Net cash provided byfinancing activities for the nine months ended September 30, 2006 was primarilya result of (i) approximately $1.7 million in net cash provided due toincreased borrowings on our revolving line of credit and (ii) approximately$2.0 million in borrowings on our new term loan facility, partially offset byapproximately $1.6 million in payments on debt and convertible notes payable.

 

***CapitalResources***

*** ***

In April 2007, weexecuted a seventh amendment to our credit agreement with our bank, which waseffective March 21, 2007. This amendment allows us, at our election, toincrease our maximum borrowings on the line of credit from $25 million, in $2.5million increments, up to a total of $40 million. In addition, among otherterms, the amendment (i) extends the maturity date of the line of credit toJuly 31, 2009, (ii) establishes an equipment advance line of $3 million, (iii)increases the sublimit for letters of credit to $5 million, (iv) sets aninventory sublimit of $7 million, subject to increase to $10 million if certaintargets are met and (v) provides for the reduction in interest rates onborrowings if certain borrowing amounts and financial performance targets aremet.

 

Under the revolving lineof credit, we may borrow up to the greater of 85% of eligible accountsreceivable plus the least of (i) a percentage of eligible inventory determinedfrom time to time by the Company’s bank, (ii) 80% of the orderly liquidationvalue, as defined, of eligible inventories, and (iii) $7 million.Interest is payable monthly at the prime rate of 7.75% as of September 29,2007. Outstanding borrowings under the revolving line of credit wereapproximately $10.3 million and $19.2 million as of September 29, 2007 andDecember 30, 2006, respectively. Borrowing availability as of September29, 2007 was approximately $5.5 million.

 

Under the equipmentfinancing line of credit, we may borrow up to 80% of the cost of equipmentpurchases up to a maximum of $3 million. Interest on equipment line of creditadvances was payable at the prime rate plus 0.5% prior to the Company’s initialpublic offering in December 2006 and was reduced to the prime ratethereafter. Principal is due monthly through the maturity date of the creditagreement in July 2009, when all unpaid principal and interest is due.Outstanding borrowings under the new equipment line of credit wereapproximately $1.1 million and $1.1 million at September 29, 2007 andDecember 30, 2006, respectively.

 

Any borrowings on theline of credit are collateralized by a general first priority lien against allof our assets, both tangible and intangible.

 

In July 2007, we executedan eighth amendment to our credit agreement, which was effective June 29, 2007,and which revised the various financial and other covenants of which we arerequired to comply. The amendment requires us to (i) achieve minimum book networth on a monthly basis, (ii) limit annual capital expenditures under adefined annual cap, (iii) achieve certain minimum monthly profitabilitythresholds and (iv) maintain a minimum liquidity threshold as of the end ofeach month. While we are currently in compliance with all financial covenantsand expect to maintain compliance for the foreseeable future, we have in thepast been in violation of one or more covenants. We cannot assure you that wewill not violate one or more covenants in the future. If we were to be inviolation of covenants under our credit agreement, our lender could choose toaccelerate payment on all outstanding loan balances. There can be no assurancethat we would be able to quickly obtain equivalent or suitable replacementfinancing in this event. If we were not able to secure alternative sources offunding, such acceleration would have a material adverse impact on ourfinancial condition.

 

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

 

We believe our existingcash balances, borrowing availability under our bank credit facility, and thecash expected to be generated from operations, will be sufficient to meet ouranticipated cash needs for at least the next 12 months. Our future 

 

25

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capital requirements will depend on many factors,including our levels of net sales, the timing and extent of expenditures tosupport research and development activities, the expansion of manufacturingcapacity both domestically and internationally and the continued marketacceptance of our products. We could be required, or may choose, to seekadditional funding through public or private equity or debt financings. Inaddition, in connection with any future acquisitions, we may require additionalfunding which may be provided in the form of additional debt or equityfinancing or a combination thereof. These additional funds may not be availableon terms acceptable to us, or at all.

 

***Off-BalanceSheet Arrangements***

*** ***

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

*** ***

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

** **

***Interest Rate Risk***

*** ***

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

 

We have invested most ofthe proceeds of our IPO in securities which may be subject to market risk forchanges in interest rates. To mitigate this risk, we maintain a portfolio ofcash equivalents and investments in a variety of marketable securities, whichinclude commercial paper, money market funds, government and non-governmentdebt securities. We currently do not use derivative financial instruments.

 

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

 

The carrying value,maturity and estimated fair value of our cash equivalents and investments inmarketable securities as of September 29, 2007 were as follows (in thousands,except interest rates):

 
| ** **                     | ** ** | ** **             | ** ** | **Maturity**                         | ** ** | ** **                                  | ** ** |
|--------------------------------|------------|------------------------|------------|--------------------------------------|------------|---------------------------------------------|------------|
| ** **                     | ** ** | **Carrying  Value**    | ** ** | **Within One  Year after** | ** ** | **Greater Than  One Year  After** | ** ** | **Fair Value** | ** ** |
| ** **                     | ** ** | **September 29,** | ** ** | **September 29,**               | ** ** | **September 29,**                      | ** ** | **September 29,** | ** ** |
| ** **                     | ** ** | **2007**               | ** ** | **2007**                             | ** ** | **2007**                                    | ** ** | **2007** | ** ** |
|                           |       |                   |       |                                 |       |                                        |       |   |   |
| **Investments**                |       |                   |       |                                 |       |                                        |       |   |   |
| Cash equivalents               |       | $                      | 4,799      |                                 | $          | 4,799                                       |       | $ | — |   | $ | 4,799 |   |
| Weighted average interest rate |       | 5.30                   | %          | 5.30                                 | %          | —                                      |       |   |   |
|                           |       |                   |       |                                 |       |                                        |       |   |   |
| Marketable securities          |       | $                      | 25,181     |                                 | $          | 16,079                                      |       | $ | 8,103 |   | $ | 25,181 |   |
| Weighted average interest rate |       | 5.62                   | %          | 5.69                                 | %          | 5.47                                        | %          |   |   |

 

26

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**Item 4.**                          Controls and Procedures

** **

*(a) Evaluation of Disclosure Controls and Procedures.*   Wecarried out an evaluation, under the supervision and with the participation ofour management, including our principal executive officer and principalfinancial officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)of the Securities Exchange Act of 1934, (“Exchange Act”)) as of the end of ourfiscal quarter ended September 29, 2007. Based upon that evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures are effective in ensuring that informationrequired to be disclosed by us in reports that we file or submit under theExchange Act (i) is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms and (ii) is accumulated andcommunicated to our management, including our principal executive officer andprincipal financial officer to allow timely decisions regarding requireddisclosure.

 

*(b)Change in internal controls over financial reporting.*   During the fiscal quarter that endedSeptember 29, 2007, there have not been any changes in our internal controlover financial reporting (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 Internal Control***

 

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

 

**PART II. OTHER INFORMATION**

** **

**Item 1.**                          Legal Proceedings

** **

The information set forthin the sections entitled Federal Securities Class Action and CaliforniaDerivative Action under Note 7 of Notes to Unaudited Condensed ConsolidatedFinancial Statements, included in Part I, Item I of this Report, isincorporated herein by reference.

 

**Item 1A.**                 Risk Factors

** **

***ThisReport includes forward-looking statements. These forward-looking statementsgenerally are identified by words such as “believe”, “expect”, “anticipate”, “estimate”,“intend”, “strategy”, “may”, “will likely” and similar words or phrases. Aforward-looking statement is neither a prediction nor a guarantee of futureevents or circumstances, and those future events or circumstances may notoccur. Investors should not place undue reliance on the forward-lookingstatements, which speak only as of the date of this Report. We are under noobligation to update or alter any forward-looking statements, whether as aresult of new information, future events or otherwise. These forward-lookingstatements are all based on currently available market, operating, financialand competitive information and are subject to various risks and uncertainties,including but not limited to the rapidly-changing nature of technology;evolving industry standards; introductions of new products by competitors;changes in end-user demand for technology solutions; our ability to attract andretain skilled personnel; our reliance on suppliers of critical components;fluctuations in the market price of critical components; and the political andregulatory environment in the People’s Republic of China (“PRC”). Our actualfuture results and trends may differ materially depending on a variety offactors including, but not limited to, the risks and***

 

27

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***uncertaintiesdiscussed below. The risks below are not the only ones we face. Additionalrisks and risks that management currently considers immaterial may also have anadverse effect on us.***

*** ***

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

** **

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

 

•       the loss of, or a significant reduction in salesto, a key customer;

 

•       the cyclical nature of the industry in which weoperate;

 

•       a reduction in the demand for our highperformance memory subsystems or the systems into which they are incorporated;

 

•       changes in the prices of our products or in thecost of the materials that we use to build our products, including fluctuationsin the market price of DRAM ICs;

 

•       our inability to develop new or enhancedproducts that achieve customer or market acceptance in a timely manner;

 

•       the timing of introductions of competingproducts or technologies;

 

•       our ability to adequately finance future growth;

 

•       our ability to procure an adequate supply of keycomponents, particularly DRAM ICs;

 

•       our failure to maintain the qualification of ourproducts with our current customers or to qualify future products with ourcurrent or prospective customers;

 

•       our failure to produce products that meet thequality requirements of our customers;

 

•       our establishment and ongoing operation of a newmanufacturing facility in the PRC;

 

•       the loss of any of our key personnel;

 

•       delays in fulfilling orders for our products ora failure to fulfill orders;

 

•       disputes regarding intellectual property rights;

 

•       litigation involving our products;

 

•       our customers’ failure to pay us on a timelybasis; and;

 

•       changes in accounting principles or policies.

 

Due to the variousfactors mentioned above, and others, the results of any prior quarterly orannual periods should not be relied upon as an indication of our futureoperating performance.

 

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

** **

Sales to Dell, IBM andHewlett Packard represented approximately 53%, 9% and 21%, respectively, of ournet sales in the nine months ended September 29, 2007. Sales to Dell and IBMrepresented 36% and 41%, respectively, of our net sales in the nine monthsended September 30, 2006. We currently expect that sales to Dell and HewlettPackard will continue to represent a significant percentage of our net salesfor at least the next 12 months. We do not have long-term agreements withthese customers, or with any other customer. Any one of these three customerscould decide at any time to discontinue, decrease or delay their purchase ofour products. In addition, the prices that these customers pay for our productscould 

 

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change at any time. The loss of Dell, IBM or HewlettPackard as a customer, or a significant reduction in sales to any of them,would significantly reduce our net sales and adversely affect our operatingresults.

 

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

 

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

 

**A limited number of relatively large potentialcustomers dominate the markets for our products.**

** **

Our target markets arecharacterized by a limited number of large companies. Consolidation in one ormore of our target markets may further increase this industry concentration. Asa result, we anticipate that sales of our products will continue to beconcentrated among a limited number of large customers in the foreseeablefuture. We believe that our financial results will depend in significant parton our success in establishing and maintaining relationships with, andeffecting substantial sales to, these potential customers. Even if we establishthese relationships, our financial results will be largely dependent on thesecustomers’ sales and business results.

 

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

** **

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

 

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

** **

In the nine months endedSeptember 29, 2007 and September 30, 2006, we derived approximately 69% and83%, respectively, of our net sales from sales of our high performance memorysubsystems for use in the server market. We expect these memory subsystems tocontinue to account for a significant portion of our net sales in the nearterm. Continued market acceptance of these products for use in servers iscritical to our success. If the demand for servers deteriorates or if thedemand for our products to be incorporated in servers declines, our operatingresults would be adversely affected, and we would be forced to diversify ourproduct portfolio and our target markets. We may not be able to achieve thisdiversification, and our inability to do so may adversely affect our business.

 

**We have historically incurred losses and may continueto incur losses.**

** **

We incurred net losseseach year from the inception of our business through fiscal 2005, as well asfor the nine months ended September 29, 2007. Our cumulative net losses were$23.7 million and $16.3 million as of September 29, 2007 andDecember 30, 2006, respectively. We may not be able to achieve or maintainprofitability on a quarterly or annual basis in the future.

 

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

** **

The prices of ourproducts are adjusted periodically based in part on the market price of DRAMICs, which have historically constituted approximately 70% - 90% of the totalcost of our memory subsystems. Once our prices with a customer are negotiated,we are generally unable to revise pricing with that customer until our nextregularly scheduled price adjustment. Consequently, we are exposed to the risksassociated with the volatility of the price of DRAM ICs during that period. Ifthe market price for DRAM ICs increases, we generally cannot pass this priceincrease on to our customers for products purchased under an existing purchaseorder. As a result, our cost of sales could increase and our gross marginscould 

 

29

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decrease. Alternatively, if there is a decline in theprice of DRAM ICs, we may need to reduce our selling prices for subsequentpurchase orders, which may result in a decline in our expected net sales.

 

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

 

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

** **

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

 

The recent declines incustomer demand and revenues has caused us to reduce our purchases of DRAM ICs.Should we not maintain sufficient purchase levels with some suppliers, our abilityto obtain future supplies of raw materials may be impaired due to the practiceof some suppliers to allocate their products to customers with the highestregular demand.

 

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

 

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

 

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

** **

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

 

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

 

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

** **

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

 

•       identify and adjust to the changing requirementsof our current and potential customers;

 

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•       identify and adapt to emerging technologicaltrends and evolving industry standards in our markets;

 

•       design and introduce cost-effective, innovativeand performance-enhancing features that differentiate our products from thoseof our competitors;

 

•       develop relationships with potential suppliersof components required for these new or enhanced products;

 

•       qualify these products for use in our customers’products; and

 

•       develop and maintain effective marketingstrategies.

 

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

 

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

** **

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

 

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

** **

We participate in ahighly competitive market, and we expect competition to intensify. Many ofthese competitors have longer operating histories, significantly greaterresources and name recognition, a larger base of customers and longer-standingrelationships with customers and suppliers than we have. As a result, some ofthese competitors are able to devote greater resources to the development,promotion and sale of products and are better positioned than we are toinfluence customer acceptance of their products over our products. Thesecompetitors also may be able to respond better to new or emerging technologiesor standards and may be able to deliver products with comparable or superiorperformance at a lower price. For these reasons, we may not be able to competesuccessfully against these competitors.

 

In addition to thecompetitors described above, some of our OEM customers have their own internaldesign groups that may develop solutions that compete with ours. These designgroups have some advantages over us, including direct access to theirrespective companies’ technical information and technology roadmaps. Our OEMcustomers also have substantially greater resources, financial or otherwise,than we do, and may have lower cost structures than ours. As a result, they maybe 

 

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able to design and manufacture competitive productsmore efficiently or inexpensively. If any of these OEM customers are successfulin competing against us, our sales could decline, our margins could benegatively impacted and we could lose market share, any or all of which couldharm our business and results of operations.

 

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

 

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

 

**The establishment and ongoing operation of ourmanufacturing facility in the People’s Republic of China, or the PRC, couldexpose us to new and significant risks.**

** **

Thus far in fiscal 2007,we have invested significant time and effort in establishing a newmanufacturing facility in the PRC and preparing it for full-scale operations.Our new manufacturing facility became operational in July 2007 and wassuccessfully qualified by certain key customers. The difficulties normallyassociated with this complicated process are compounded by language andcultural differences, as well as the geographic distance from our currentfacility. Our management has limited experience in creating or overseeingforeign operations, and this new facility may divert substantial amounts oftheir time. Further, this new facility will be subject to factory audits by ourcustomers. Even if this facility is fully operational and is qualified by ourcustomers, we cannot assure you that we will be able to maintain control overproduct quality, delivery schedules, manufacturing yields and costs as weincrease our output. We also have to manage a local workforce that may subjectus to uncertainties or regulatory policies. Should our facility achieve fulloperations, we will still be subject to risks related to managing the increasedproduction capacity provided by the facility. Should anticipated demand notmaterialize, the costs related to having excess capacity would have an adverseimpact on our gross margins and operating results.

 

As we continue toincrease our operations in the PRC, some of our net sales may be denominated inChinese Renminbi, or Yuan in future periods. The Chinese government controlsthe procedures by which Yuan is converted into other currencies, and conversionof Yuan generally requires government consent. As a result, Yuan may not befreely convertible into other currencies at all times. If the Chinesegovernment institutes changes in currency conversion procedures, or imposesrestrictions on currency conversion, those actions may negatively impact ouroperations and could reduce our operating results. In addition, fluctuations inthe exchange rate between Yuan and U.S. dollars may adversely affect ourexpenses and results of operations as well as the value of our assets andliabilities. These fluctuations may also adversely affect the comparability ofour period-to-period results. If we decide to declare dividends and repatriatefunds from our Chinese operations, we will be required to comply with theprocedures and regulations of applicable Chinese law. Any changes to theseprocedures and regulations, or our failure to comply with those procedures andregulations, could prevent us from making dividends and repatriating funds fromour Chinese operations, which could adversely affect our financial condition.If we are able to make dividends and repatriate funds from our Chineseoperations, these dividends would be subject to U.S. corporate income tax.

 

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

 

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

** **

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

 

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

 

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

 

As of September 29, 2007,approximately 16% of our workforce consisted of contract personnel. We investconsiderable time and expense in training these contract employees. We mayexperience high turnover rates in our contract employee workforce, which mayrequire us to expend additional resources in the future. If we convert any ofthese contract employees into permanent employees, we may have to pay finder’sfees to the contract agency.

 

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

** **

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

 

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

 

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

** **

We must continuouslyreview and improve our manufacturing processes in an effort to maintainsatisfactory manufacturing yields and product performance, lower our costs andotherwise remain competitive. For example, we began implementing lead-freesoldering technologies in our manufacturing processes in the second quarter of2005, and “Reduction of Hazardous Substances” manufacturing processes in thefourth quarter of 2005, both of which have been fully implemented. Implementingprocess improvements in the future could negatively impact our manufacturingyields, which would in turn adversely affect our results of operations.

 

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

 

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

 

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**If we failto protect our proprietary rights, our customers or our competitors might gainaccess to our proprietary designs, processes and technologies, which couldadversely affect our operating results.**

 

We rely on a combinationof patent protection, trade secret laws and restrictions on disclosure toprotect our intellectual property rights. We have submitted a number of patentapplications regarding our proprietary processes and technology. It is not certainwhen or if any of the claims in the remaining applications will be allowed. Todate we have had only four patents issued. We intend to continue filing patentapplications with respect to most of the new processes and technologies that wedevelop. However, patent protection may not be available for some of theseprocesses or technologies.

 

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

 

•       prevent challenges to, or the invalidation orcircumvention of, our existing intellectual property rights;

 

•       prevent our competitors from independentlydeveloping similar products, duplicating our products or designing around anypatents that may be issued to us;

 

•       prevent disputes with third parties regardingownership of our intellectual property rights;

 

•       prevent disclosure of our trade secrets andknow-how to third parties or into the public domain;

 

•       result in valid patents, including internationalpatents, from any of our pending or future applications; or

 

•       otherwise adequately protect our intellectualproperty rights.

 

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

 

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

 

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

** **

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

 

•       cease selling products that are claimed to beinfringing a third party’s intellectual property;

 

•       pay royalties on past or future sales;

 

•       seek a license from the third party intellectualproperty owner to use their technology in our products, which license may notbe available on reasonable terms, or at all; or

 

•       redesign those products that are claimed to beinfringing a third party’s intellectual property.

 

There is a limited poolof experienced technical personnel that we can draw upon to meet our hiringneeds. As a result, a number of our existing employees have worked for ourexisting or potential competitors at some point during their careers, and weanticipate that a number of our future employees will have similar workhistories. In the past, some of these competitors have claimed that ouremployees misappropriated their trade secrets or violated non-competition ornon-solicitation agreements. Some of our competitors may threaten or bringlegal action involving similar claims against us or our existing employees ormake such claims in the future to prevent us from hiring qualified candidates.Lawsuits of this type 

 

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may be brought, even if there is no merit to theclaim, simply as a strategy to drain our financial resources and divertmanagement’s attention away from our business.

 

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

 

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

 

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

** **

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

 

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

 

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

 

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

** **

Our customers require ourproducts to meet strict quality standards. Should our products not meet suchstandards, our customers may discontinue purchases from us until we are able toresolve the quality issues that are causing us to not meet the standards, Such “qualityholds” could have a significant adverse impact on our revenues and operatingresults.

 

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

 

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

** **

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

 

•       difficulties in integrating the operations,technologies or products of the acquired companies;

 

•       the diversion of management’s time and attentionfrom the normal daily operations of the business;

 

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•       insufficient increases in net sales to offset increasedexpenses associated with acquisitions or acquired companies;

 

•       difficulties in retaining business relationshipswith suppliers and customers of the acquired companies;

 

•       the overestimation of potential synergies or adelay in realizing those synergies;

 

•       entering markets in which we have no or limitedexperience and in which competitors have stronger market positions; and

 

•       the potential loss of key employees of theacquired companies.

 

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

 

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

** **

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

 

**Our internal controls over financial reporting may notbe effective, which could have a significant and adverse effect on ourbusiness.**

** **

We plan to evaluate ourinternal controls over financial reporting to allow management to report onthose internal controls as required by Section 404 of the Sarbanes-OxleyAct of 2002 and the rules and regulations of the Securities and ExchangeCommission, which we collectively refer to as Section 404. This willinvolve system and process evaluations and testing to comply with themanagement assessment requirements of Section 404, which will initiallyhave to be made in our annual report on Form 10-K for our 2007 fiscalyear. Effective internal controls are necessary for us to produce reliablefinancial reports and are important in our effort to prevent financial fraud.In the course of our Section 404 evaluations, we may identify conditionsthat may result in significant deficiencies or material weaknesses and we mayconclude that enhancements, modifications or changes to our internal controlsare necessary or desirable. Implementing any such matters would divert theattention of our management, could involve significant costs, and maynegatively impact our results of operations.

 

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

 

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

** **

Many of our memorysubsystems are specifically designed for our OEM customers’ high performancesystems. Our business would be harmed if these high performance systems were tobecome standardized so that DRAM IC manufacturers or other companies coulddevelop and manufacture a commodity memory module addressing the demands ofsome or all of these high performance applications. If DRAM IC manufacturers orother companies are able to develop a standardized 

 

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solution, our future business may be limited toidentifying the next generation of high performance memory demands of OEMcustomers and developing a solution that addresses such demands. Until fullyimplemented, this next generation of products may constitute a much smallermarket, which may reduce our net sales and market share.

 

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

** **

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

 

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

** **

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

 

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

** **

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

 

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

** **

As of September 29, 2007,our executive officers, directors and 5% stockholders beneficially own, intotal, approximately 50% of our outstanding common stock. As a result, thesestockholders, acting together, have the ability to exert substantial influenceover all matters requiring approval by our stockholders, including the electionand removal of directors and any proposed merger, consolidation or sale of allor substantially all of our assets and other corporate transactions. Thisconcentration of control could be disadvantageous to other stockholders withinterests different from those of our executive officers, directors andprincipal stockholders. For example, our executive officers, directors andprincipal stockholders could delay or prevent an acquisition or merger even ifthe transaction would benefit other stockholders. In addition, this significantconcentration of share ownership may adversely affect the trading price for ourcommon stock because investors may perceive disadvantages in owning stock incompanies with stockholders that have the ability to exercise significantcontrol.

 

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

** **

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

 

•       our board of directors is authorized, withoutprior stockholder approval, to designate and issue preferred stock, commonlyreferred to as “blank check” preferred stock, with rights senior to those ofour common stock;

 

•       stockholder action by written consent is prohibited;

 

•       nominations for election to our board ofdirectors and the submission of matters to be acted upon by stockholders at ameeting are subject to advance notice requirements; and

 

•       our board of directors is expressly authorizedto make, alter or repeal our bylaws.

 

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

 

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

** **

During the period fromJuly 1, 2007 through September 29, 2007, we issued 22,909 shares of our commonstock pursuant to an exercise of a warrant dated January 1, 2003, to purchase42,000 shares of common stock. This exercise was made pursuant to a net issueelection and the balance of the shares was forfeited.

 

We did not repurchase anyof our outstanding equity securities during the quarter ended September 29,2007.

 

**Item 3.**                          Defaults Upon SeniorSecurities

** **

None.

 

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

** **

None.

 

**Item 5.**                          Other Information

** **

None.

 

**Item 6.**                          Exhibits

 
| **Exhibit** | ** ** | ** **                                                   |
|-------------|------------|--------------------------------------------------------------|
| **Number**  | ** ** | **Description  of Document**                                 |
|        |       |                                                         |
| 3.1(1)      |       | Restated  Certificate of Incorporation of Netlist, Inc. |
|        |       |                                                         |
| 3.2(1)      |       | Amended and  Restated Bylaws of Netlist, Inc.           |
|        |       |                                                         |
| 10.1(2)     |       | Offer Letter  to Nita Moritz dated August 16, 2007           |

 

38

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| 10.2(3) |   | Stock Option  Agreement dated September 17, 2007 for options to purchase 200,000 shares of  the Registrant’s common stock awarded to Nita J. Moritz                                                                             |
|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                                                                 |
| 31.1(4) |   | 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(4) |   | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of  the Securities Exchange Act, as Amended.                                                                                                 |
|    |   |                                                                                                                                                                                                                                 |
| 32(5)   |   | Certification  of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  and furnished herewith pursuant to SEC Release No. 33-8238. |

 

----

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

 

(2)         Incorporatedby reference to the corresponding exhibit number of the current report onForm 8-K of the registrant filed with the Securities and ExchangeCommission on September 18, 2007.

 

(3)         Incorporatedby reference to exhibit number 4.3 of the registration statement on Form S-8of the registrant (No. 333-146192) filed with the Securities and ExchangeCommission on September 20, 2007.

 

(4)         Filedherewith.

 

(5)         Theinformation in Exhibit 32 shall not be deemed “filed” for purposes of Section18 of 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.

 

39

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**SIGNATURES**

 

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

 
| Date:  November 6, 2007 |       |       |       | 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/ Nita J. Moritz                         |
| ** **              | ** ** | ** ** | ** ** | **Nita J. Moritz**                         |
| ** **              | ** ** | ** ** | ** ** | **Vice President and Chief Financial**     |
| ** **              | ** ** | ** ** | ** ** | **Officer**                                |
| ** **              | ** ** | ** ** | ** ** | **(Principal Financial Officer)**          |

 

40

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**EXHIBIT INDEX**

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

 

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