Table ofContents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **

**(MarkOne)**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For thequarterly period ended October 3, 2009**

** **

**or**

** **

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

 

**For the transition period from            to           **

 

**Commission file number 001-33170**

** **

****

** **

**NETLIST, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**51 Discovery, Suite 150**

**Irvine, CA 92618**

(Address of principal executive offices) (Zip Code)

 

**(949) 435-0025**

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

** **

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

 

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

 

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

 

| Large accelerated filer  o          |   | Accelerated filer  o         |
|-----------------------------------------------|--------|----------------------------------------|
|                                          |   |                                   |
| Non-accelerated filer  o            |   | Smaller reporting company  x |
| (Do not check if a smaller reporting company) |   |                                   |

 

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

 

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

 

Common Stock, par value $0.001 per share

 

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

 

 

 

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**NETLIST, INC. ANDSUBSIDIARIES**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE THREE AND NINEMONTHS ENDED OCTOBER 3, 2009**

** **

**TABLE OF CONTENTS**

 
| ** **    | ** **                                                                                                                                                 | **Page** |
|---------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| PART I.  | FINANCIAL INFORMATION                                                                                                                                      | 3        |
| Item 1.       | Financial Statements                                                                                                                                       | 3        |
|          | Condensed Consolidated Balance Sheets at  October 3, 2009 (unaudited) and January 3, 2009 (audited)                                              | 3        |
|          | Unaudited Condensed Consolidated Statements of  Operations for the Three and Nine Months Ended October 3,  2009 and September 27, 2008 | 4        |
|          | Unaudited Condensed Consolidated Statements of Cash  Flows for the Nine Months Ended October 3, 2009 and September 27,  2008                     | 5        |
|          | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                                            | 6        |
| Item 2.       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                                                | 19       |
| Item 3.       | Quantitative and Qualitative  Disclosures About Market Risk                                                                                                | 30       |
| Item 4.       | Controls and  Procedures                                                                                                                                   | 30       |
| Item 4T.      | Controls and Procedures                                                                                                                                    | 30       |
|          |                                                                                                                                                       |     |
| PART II. | OTHER INFORMATION                                                                                                                                          | 30       |
| Item 1.       | Legal Proceedings                                                                                                                                          | 30       |
| Item 1A.      | Risk Factors                                                                                                                                               | 30       |
| Item 2.       | Unregistered Sales of Equity Securities  and Use of Proceeds                                                                                               | 31       |
| Item 3.       | Defaults Upon Senior Securities                                                                                                                            | 31       |
| Item 4.       | Submission of Matters to a Vote of  Security Holders                                                                                                       | 31       |
| Item 5.       | Other Information                                                                                                                                          | 31       |
| Item 6.       | Exhibits                                                                                                                                                   | 31       |

 

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**PART I. FINANCIALINFORMATION**

** **

**Item1. Financial Statements**

** **

**NETLIST, INC.AND SUBSIDIARIES**

**CondensedConsolidated Balance Sheets**

**(inthousands, except par value)**

 
| ** **                                                                                        | ** ** | **(unaudited)**     | ** ** | **(audited)**       | ** ** |
|---------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                                                        | ** ** | **October 3,** | ** ** | **January 3,** | ** ** |
| ** **                                                                                        | ** ** | **2009**            | ** ** | **2009**            | ** ** |
| ** **                                                                                        | ** ** | ** **          | ** ** | ** **          | ** ** |
| **ASSETS**                                                                                        | ** ** | ** **          | ** ** | ** **          | ** ** |
| Current  assets:                                                                                  |       |                |       |                |       |
| Cash  and cash equivalents                                                                        |       | $                   | 11,501     |                | $          | 15,214 |   |
| Investments  in marketable securities                                                             |       | 3,115               |       | 5,199               |       |
| Accounts  receivable, net                                                                         |       | 2,732               |       | 1,917               |       |
| Inventories                                                                                       |       | 1,886               |       | 1,829               |       |
| Income  taxes receivable                                                                          |       | —              |       | 1,880               |       |
| Prepaid  expenses and other current assets                                                        |       | 636                 |       | 761                 |       |
| Total  current assets                                                                             |       | 19,870              |       | 26,800              |       |
|                                                                                              |       |                |       |                |       |
| Property  and equipment, net                                                                      |       | 5,202               |       | 6,939               |       |
| Long-term  investments in marketable securities                                                   |       | 1,742               |       | 960                 |       |
| Other  assets                                                                                     |       | 252                 |       | 234                 |       |
| Total  assets                                                                                     |       | $                   | 27,066     |                | $          | 34,933 |   |
|                                                                                              |       |                |       |                |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                     |       |                |       |                |       |
| Current  liabilities:                                                                             |       |                |       |                |       |
| Accounts  payable                                                                                 |       | $                   | 1,969      |                | $          | 1,786 |   |
| Current  portion of long-term debt                                                                |       | 115                 |       | 474                 |       |
| Current  portion of deferred gain on sale and leaseback transaction                               |       | 118                 |       | 118                 |       |
| Income  taxes payable                                                                             |       | 78                  |       | —              |       |
| Accrued  expenses and other current liabilities                                                   |       | 3,093               |       | 2,083               |       |
| Total  current liabilities                                                                        |       | 5,373               |       | 4,461               |       |
| Long-term  debt, net of current portion                                                           |       | 77                  |       | 130                 |       |
| Deferred  gain on sale and leaseback transaction, net of current portion                          |       | 19                  |       | 108                 |       |
| Total  liabilities                                                                                |       | 5,469               |       | 4,699               |       |
| Commitments  and contingencies                                                                    |       |                |       |                |       |
| Stockholders’  equity:                                                                       |       |                |       |                |       |
| Common  stock, $0.001 par value - 90,000 shares authorized; 19,855 shares issued and  outstanding |       | 20                  |       | 20                  |       |
| Additional  paid-in capital                                                                       |       | 70,611              |       | 69,383              |       |
| Accumulated  deficit                                                                              |       | (49,010             | )          | (39,113             | )          |
| Accumulated  other comprehensive loss                                                             |       | (24                 | )          | (56                 | )          |
| Total  stockholders’ equity                                                                  |       | 21,597              |       | 30,234              |       |
| Total  liabilities and stockholders’ equity                                                  |       | $                   | 27,066     |                | $          | 34,933 |   |

 

Seeaccompanying notes.

 

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**NETLIST, INC. AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Operations**

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

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **October 3,**    | ** ** | **September 27,** | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                                        | ** ** | **2009**               | ** ** | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                        | ** ** | ** **             | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  sales                                        |       | $                      | 6,446      |                   | $          | 28,876 |   | $ | 11,781 |   | $ | 60,409 |   |
| Cost  of sales(1)                                 |       | 4,879                  |       | 26,832                 |       | 10,507 |   | 52,575 |   |
| Gross  profit                                     |       | 1,567                  |       | 2,044                  |       | 1,274 |   | 7,834 |   |
| Operating  expenses:                              |       |                   |       |                   |       |   |   |   |   |
| Research  and development(1)                      |       | 1,975                  |       | 1,651                  |       | 5,619 |   | 4,943 |   |
| Selling,  general and administrative(1)           |       | 2,115                  |       | 3,364                  |       | 6,170 |   | 10,142 |   |
| Total  operating expenses                         |       | 4,090                  |       | 5,015                  |       | 11,789 |   | 15,085 |   |
| Operating  loss                                   |       | (2,523                 | )          | (2,971                 | )          | (10,515 | ) | (7,251 | ) |
| Other  income:                                    |       |                   |       |                   |       |   |   |   |   |
| Interest  (expense) income, net                   |       | (25                    | )          | 38                     |       | 75 |   | 381 |   |
| Other  income (expense), net                      |       | 4                      |       | 13                     |       | 134 |   | (55 | ) |
| Total  other income (expense), net                |       | (21                    | )          | 51                     |       | 209 |   | 326 |   |
| Loss  before provision (benefit) for income taxes |       | (2,544                 | )          | (2,920                 | )          | (10,306 | ) | (6,925 | ) |
| Provision  (benefit) for income taxes             |       | (458                   | )          | 4,502                  |       | (409 | ) | 3,332 |   |
| Net  loss                                         |       | $                      | (2,086     | )                      | $          | (7,422 | ) | $ | (9,897 | ) | $ | (10,257 | ) |
| Net  loss per common share:                       |       |                   |       |                   |       |   |   |   |   |
| Basic  and diluted                                |       | $                      | (0.11      | )                      | $          | (0.37 | ) | $ | (0.50 | ) | $ | (0.52 | ) |
| Weighted-average  common shares outstanding:      |       |                   |       |                   |       |   |   |   |   |
| Basic  and diluted                                |       | 19,855                 |       | 19,855                 |       | 19,855 |   | 19,845 |   |

 

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| (1)   Amounts include stock-based compensation expense as follows: |   |   |   |   |   |
|-------------------------------------------------------------------------|--------|--------|--------|--------|--------|
|                                                                    |   |   |   |   |   |   |   |   |   |
| Cost  of sales                                                          |   | $      | 146    |   | $      | 44 |   | $ | 213 |   | $ | 106 |   |
| Research  and development                                               |   | 156    |   | 55     |   | 262 |   | 140 |   |
| Selling,  general and administrative                                    |   | 329    |   | 263    |   | 753 |   | 735 |   |
|                                                                         |        |        |        |        |        |  |  |  |  |  |  |  |  |

 

See accompanying notes.

 

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**NETLIST, INC.AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Cash Flows**

**(inthousands)**

 
| ** **                                                                   | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                   | ** ** | **October 3,**   | ** ** | **September 27,** | ** ** |
| ** **                                                                   | ** ** | **2009**              | ** ** | **2008** | ** ** |
| ** **                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash  flows from operating activities:                                       | ** ** | ** **            | ** ** | ** ** | ** ** |
| Net  loss                                                                    |       | $                     | (9,897     | ) | $ | (10,257 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                  |       |   |   |
| Depreciation  and amortization                                               |       | 1,710                 |       | 1,779 |   |
| Amortization  of deferred gain on sale and leaseback transaction             |       | (89                   | )          | (89 | ) |
| Deferred  income taxes                                                       |       | —                |       | 3,275 |   |
| (Gain)  loss on disposal of assets                                           |       | (118                  | )          | 17 |   |
| Stock-based  compensation                                                    |       | 1,228                 |       | 981 |   |
| Provision  for bad debts                                                     |       | —                |       | 258 |   |
| Changes  in operating assets and liabilities:                                |       |                  |       |   |   |
| Accounts  receivable                                                         |       | (815                  | )          | (3,973 | ) |
| Inventories                                                                  |       | (57                   | )          | (1,099 | ) |
| Income  taxes receivable                                                     |       | 1,880                 |       | 113 |   |
| Prepaid  expenses and other current assets                                   |       | 126                   |       | (510 | ) |
| Other  assets                                                                |       | (18                   | )          | (229 | ) |
| Accounts  payable                                                            |       | 183                   |       | (1,459 | ) |
| Income  taxes payable                                                        |       | 78                    |       | — |   |
| Accrued  expenses and other current liabilities                              |       | 1,010                 |       | (512 | ) |
| Net  cash used in operating activities                                       |       | (4,779                | )          | (11,705 | ) |
| Cash  flows from investing activities:                                       |       |                  |       |   |   |
| Acquisition  of property and equipment                                       |       | (89                   | )          | (1,077 | ) |
| Proceeds  from sales of equipment                                            |       | 342                   |       | — |   |
| Purchase  of investments in marketable securities                            |       | (10,837               | )          | (6,677 | ) |
| Proceeds  from maturities and sales of investments in marketable securities  |       | 12,170                |       | 19,600 |   |
| Net  cash provided by investing activities                                   |       | 1,586                 |       | 11,846 |   |
| Cash  flows from financing activities:                                       |       |                  |       |   |   |
| Borrowings  on line of credit                                                |       | 12,784                |       | 78,999 |   |
| Payments  on line of credit                                                  |       | (12,784               | )          | (71,630 | ) |
| Payments  on debt                                                            |       | (520                  | )          | (607 | ) |
| Increase  in restricted cash                                                 |       | —                |       | (2,000 | ) |
| Reversal  of unrealized excess tax benefit from exercise of warrants         |       | —                |       | (4 | ) |
| Net  cash provided by (used in) financing activities                         |       | (520                  | )          | 4,758 |   |
| Net  (decrease) increase in cash and cash equivalents                        |       | (3,713                | )          | 4,899 |   |
| Cash  and cash equivalents at beginning of period                            |       | 15,214                |       | 7,182 |   |
| Cash  and cash equivalents at end of period                                  |       | $                     | 11,501     |   | $ | 12,081 |   |
|                                                                         |       |                  |       |   |   |
| Supplemental  disclosure of non-cash investing activities:                   |       |                  |       |   |   |
| Reclassification  of other assets to property and equipment                  |       | $                     | —     |   | $ | 281 |   |
| Purchase  of assets under capital lease                                      |       | $                     | 108        |   | $ | — |   |
| Unrealized  gains (losses) from investments in marketable securities         |       | $                     | 32         |   | $ | (277 | ) |

 

See accompanyingnotes.

 

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**NETLIST,INC. AND SUBSIDIARIES**

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**October3, 2009**

** **

**Note 1—Descriptionof Business**

** **

Netlist, Inc. (the “Company” or “Netlist”) designs and manufactureshigh performance memory subsystems for the server, high performance computingand communications markets. The Company’s memory subsystems consist of dynamicrandom access memory integrated circuits, NAND flash memory, or NAND, and othercomponents assembled on a printed circuit board. Headquartered in Irvine,California, Netlist’s solutions are targeted at applications where memory playsa key role in meeting system performance requirements. In 2007, the Companyestablished a manufacturing facility in the People’s Republic of China, (the “PRC”),which became operational in July 2007 upon the successful qualification ofcertain key customers.

 

**Note 2—Summary ofSignificant Accounting Policies**

** **

*Basis of Presentation*

* *

The interimunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (the “US”) for interim financial information and with theinstructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article8 of SEC Regulation S-X. These financial statements do not include all of theinformation and footnotes required by accounting principles generally acceptedin the US for complete financial statements. Therefore, these unauditedcondensed consolidated financial statements should be read in conjunction withthe Company’s audited consolidated financial statements and notes thereto forthe year ended January 3, 2009, included in the Company’s Annual Report on Form10-K filed with the SEC on March 30, 2009.

 

The condensed consolidated financial statementsincluded herein as of October 3, 2009 are unaudited; however, they contain allnormal recurring accruals and adjustments that, in the opinion of the Company’smanagement, are necessary to present fairly the consolidated financial positionof the Company and its wholly owned subsidiaries as of October 3, 2009 and January3, 2009, the consolidated results of its operations for the three and nine monthsended October 3, 2009 and September 27, 2008, and the consolidated cash flowsfor the nine months ended October 3, 2009 and September 27, 2008. The resultsof operations for the three and nine months ended October 3, 2009 are notnecessarily indicative of the results to be expected for the full year or anyfuture interim periods.  We haveevaluated subsequent events through November 3, 2009, the filing date of thisquarterly report on Form 10-Q, and determined that no subsequent events haveoccurred that would require recognition in the condensed consolidated financialstatements or disclosure in the notes thereto other than as disclosed in theaccompanying notes.

 

*Principlesof Consolidation*

 

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

 

*Fiscal Year*

* *

The Companyoperates under a 52/53-week fiscal year ending on the Saturday closest to December31. For fiscal 2009, the Company’s fiscal year end is scheduled to be January 2,2010 and will consist of 52 weeks. Each of the Company’s first three quartersin a fiscal year is comprised of 13 weeks.

 

*Use of Estimates*

* *

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

 

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*Revenue Recognition*

* *

TheCompany’s revenues primarily consist of product sales of high performancememory subsystems to original equipment manufacturers (“OEMs”). Revenues alsoinclude sales of excess inventories to distributors and other users of memoryintegrated circuits (“ICs”) totaling approximately $0.6 million and $0.7 million,respectively, for the three and nine months ended October 3, 2009, andapproximately $0.1 million and $0.3 million, respectively, for the three andnine months ended September 27, 2008.

 

TheCompany recognizes revenues in accordance with the Financial AccountingStandards Board (“FASB”) Accounting Standards Codification (“ASC” or the “Codification”)Topic 605.  Accordingly, the Companyrecognizes revenues when there is persuasive evidence of an arrangement,product delivery and acceptance have occurred, the sales price is fixed ordeterminable, and collectability of the resulting receivable is reasonablyassured.

 

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

 

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

 

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

 

*Cash and Cash Equivalents*

* *

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

 

*Investments in MarketableSecurities*

* *

TheCompany accounts for its investments in marketable securities in accordancewith ASC Topic 320.  The Companydetermines the appropriate classification of its investments at the time ofpurchase and reevaluates such designation at each balance sheet date. TheCompany’s investments in marketable securities have been classified andaccounted for as available-for-sale based on management’s investment intentionsrelating to these securities. Available-for-sale securities are stated atmarket value, and are generally based on market quotes, to the extent they areavailable. Unrealized gains and losses, net of applicable deferred taxes, arerecorded as a component of other comprehensive income (loss). Realized gainsand losses and declines in value judged to be other than temporary aredetermined based on the specific identification method and are reported inother income, net in the unaudited condensed consolidated statements ofoperations.

 

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

 

*Fair Value of FinancialInstruments*

* *

TheCompany’s financial instruments consist principally of cash and cashequivalents, investments in marketable securities, accounts receivable,accounts payable, accrued expenses and debt instruments. Effective December 30,2007, the Company adopted the requirements of ASC Topic 820, which defines fairvalue, establishes a framework for measuring fair value in accordance withaccounting principles generally accepted in the US and expands requireddisclosures about fair value measurements. Other than for 

 

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certaininvestments in auction rate securities (see Note 4), the fair value of theCompany’s cash equivalents and investments in marketable securities isdetermined based on quoted prices in active markets for identical assets, orLevel 1 inputs. The Company believes that the carrying values of all otherfinancial instruments approximate their current fair values due to their natureand respective durations.

 

*Allowancefor Doubtful Accounts*

 

The Company evaluates the collectibility of accounts receivable basedon a combination of factors. In cases where the Company is aware ofcircumstances that may impair a specific customer’s ability to meet itsfinancial obligations subsequent to the original sale, the Company will recordan allowance against amounts due, and thereby reduce the net recognizedreceivable to the amount the Company reasonably believes will be collected. Forall other customers, the Company records allowances for doubtful accounts basedprimarily on the length of time the receivables are past due, the currentbusiness environment and its historical experience.

 

*Concentrationof Credit Risk*

 

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

 

The Company invests primarily in money market funds, certificates ofdeposit and high-credit quality debt instruments, including those issued byfederal agencies whose credit is supported by the US government. Cashequivalents are maintained with high quality institutions, the composition andmaturities of which are regularly monitored by management. Investments inmarketable securities are generally in high-credit quality debt instruments withan active resale market. Such investments are made only in instruments issuedor enhanced by high-quality institutions. The Company had $0.3 million of FDICinsured funds at October 3, 2009.  TheCompany has not incurred any credit risk losses related to these investments.

 

The Company’s trade accounts receivable are primarily derived fromsales to OEMs in the computer industry. The Company performs credit evaluationsof its customers’ financial condition and limits the amount of credit extendedwhen deemed necessary, but generally requires no collateral. The Companybelieves that the concentration of credit risk in its trade receivables ismoderated by its credit evaluation process, relatively short collection termsand the high level of credit worthiness of its customers. Reserves aremaintained for potential credit losses, and such losses historically have notbeen significant and have been within management’s expectations.

 

*Inventories*

* *

Inventoriesare valued at the lower of cost or net realizable value. Cost is determined onan average cost basis which approximates actual cost on a first-in, first-outbasis and includes raw materials, labor and manufacturing overhead. At eachbalance sheet date, the Company evaluates its ending inventories for excess quantitiesand obsolescence. Among other factors, the Company considers historical demandand forecasted 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.

 

*Propertyand Equipment*

 

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

 

*Warranties*

* *

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

 

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*Stock-Based Compensation*

 

TheCompany accounts for equity issuances to non-employees in accordance with ASC Topic505.  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.

 

Inaccordance with ASC Topic 718, employee and director stock-based compensationexpense recognized during the period is based on the value of the portion ofstock-based payment awards that is ultimately expected to vest during theperiod. Stock-based compensation expense recognized in the accompanyingunaudited condensed consolidated statements of operations is based on theestimated grant date fair value. Given that stock-based compensation expenserecognized in the unaudited condensed consolidated statements of operations isbased on awards ultimately vested and expected to vest, it has been reduced forestimated forfeitures.  Forfeitures mustbe estimated at the time of grant and revised, if necessary, in subsequentperiods if actual forfeitures differ from those estimates. The estimatedaverage forfeiture rates used by the Company are based on historical forfeitureexperience and estimated future forfeitures.

 

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

 

*Income Taxes*

* *

Under ASC Topic 270, theCompany is required to adjust its effective tax rate each quarter to beconsistent with the estimated annual effective tax rate. The Company is alsorequired to record the tax impact of certain discrete items, unusual orinfrequently occurring, including changes in judgment about valuation allowancesand effects of changes in tax laws or rates, in the interim period in whichthey occur. In addition, jurisdictions with a projected loss for the year or ayear-to-date loss where no tax benefit can be recognized are excluded from theestimated annual effective tax rate. The impact of such an exclusion couldresult in a higher or lower effective tax rate during a particular quarter,based upon the mix and timing of actual earnings versus annual projections.

 

The Companyaccounts for income taxes in accordance with ASC Topic 740.  Deferred tax assets and liabilities arerecognized to reflect the estimated future tax effects, calculated at currentlyeffective tax rates, of future deductible or taxable amounts attributable toevents that have been recognized on a cumulative basis in the consolidatedfinancial statements. A valuation allowance related to a deferred tax asset isrecorded when it is more likely than not that some portion of the deferred taxasset will not be realized.

 

The Companyadopted certain newly issued requirements of ASC Topic 740 on December 31,2006, the first day of its 2007 fiscal year. The new requirements sought to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes.  Additionally, the newguidance prescribes a recognition threshold and measurement requirement for thefinancial statement recognition of a tax position that has been taken or isexpected to be taken on a tax return and also provides guidance on de-recognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. As a result of the new guidance, the Company mayonly recognize or continue to recognize tax positions that meet a “more likelythan not” threshold.

 

*Researchand Development Expenses*

 

Research and development expenditures are expensed in the periodincurred.

 

*CollaborativeArrangement*

 

The Company has entered into a collaborative arrangement with a partnerin order to develop products using certain of the Company’s proprietytechnology.  Under the arrangement, thedevelopment partner was granted a non-exclusive license to specifiedintellectual property.  Both the Companyand the development partner provide engineering project management resources attheir own expense.  The developmentpartner is entitled to non-recurring engineering fees based upon theachievement of development milestones, and to a minimum portion of the Company’spurchasing allocations for the component, if prototype and production schedulesare met.  Expenses incurred and paid tothe development partner are included in research and development in theaccompanying condensed consolidated statements of operations.

 

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*Comprehensive Income (Loss)*

 

ASC Topic 220 establishes standards for reporting and displayingcomprehensive income and its components in the condensed consolidated financialstatements. Accumulated other comprehensive income (loss) includes unrealizedgains or losses on investments.

 

*Risks and Uncertainties*

* *

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

 

*Foreign CurrencyRemeasurement*

* *

The functionalcurrency of the Company’s foreign subsidiaries is the US dollar. Local currencyfinancial statements are remeasured into US dollars using the current exchangerate for monetary assets and liabilities and the historical exchange rate fornonmonetary assets and liabilities. Expenses are remeasured using the averageexchange rate for the period, except items related to nonmonetary assets andliabilities, which are remeasured using historical exchange rates. Allremeasurement gains and losses are included in determining net loss.

 

*Net Income(Loss) Per Share*

 

Basic net income (loss) and diluted loss per share is calculated bydividing net income (loss) by the weighted-average number of common sharesoutstanding during the period. Diluted net income per share is calculated bydividing the net income by the weighted-average number of shares and dilutivepotential common shares outstanding during the period. Dilutive potentialshares consist of dilutive shares issuable upon the exercise of outstandingstock options and warrants computed using the treasury stock method.

 

*New AccountingPronouncements*

* *

In June 2009, the FASBissued an update to ASC Topic 105.  TheCodification became the source of authoritative U.S. GAAP for financialstatements issued for interim and annual periods ending after September 15,2009.  The adoption of the Codificationdid not have a material impact on the Company’s consolidated financialposition, results of operations or liquidity.

 

**Note3—Supplemental Financial Information**

** **

*Inventories*

 

Inventoriesconsist of the following (in thousands):

 
| ** **       | ** ** | **October 3,** | ** ** | **January 3,** | ** ** |
|------------------|------------|----------------|------------|----------------|------------|
| ** **       | ** ** | **2009**       | ** ** | **2009**       | ** ** |
| Raw  materials   |       | $              | 891        |           | $          | 976 |   |
| Work  in process |       | 126            |       | 111            |       |
| Finished  goods  |       | 869            |       | 742            |       |
|             |       | $              | 1,886      |           | $          | 1,829 |   |

 

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*WarrantyLiability*

 

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

 
| ** **                     | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** |
| ** **                     | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                           |       |                  |       |   |   |
| Beginning  balance             |       | $                     | 277        |   | $ | 353 |   |
| Charged  to costs and expenses |       | 122                   |       | 86 |   |
| Usage                          |       | (155                  | )          | (140 | ) |
| Ending  balance                |       | $                     | 244        |   | $ | 299 |   |

 

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

 

*FacilityRelocation Costs*

 

The followingtable summarizes the activity related to the Company’s accrual for facilityrelocation costs (in thousands):

 
| ** **                     | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** |
| ** **                     | ** ** | **2009**              | ** ** | **2008** | ** ** |
| Beginning  balance             |       | $                     | 80         |   | $ | 103 |   |
| Charged  to costs and expenses |       | 61                    |       | — |   |
| Net  payments                  |       | (16                   | )          | (54 | ) |
| Ending  balance                |       | $                     | 125        |   | $ | 49 |   |

 

In May2009, the Company entered into an agreement to sublease a portion of itsheadquarters facility to another tenant at a discount from the rent requiredunder its lease commitment.  As a result,the Company recorded an additional facility relocation charge of approximately$61,000, which is included as a component of selling, general andadministrative expenses in the accompanying consolidated statement ofoperations for the nine months ended October 3, 2009.

 

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

 

*Comprehensive Loss*

* *

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

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                              | ** ** | **October 3,**         | ** ** | **September 27,**     | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                                                              | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net  loss                                                               |       | $                      | (2,086     | )                     | $          | (7,422 | ) | $ | (9,897 | ) | $ | (10,257 | ) |
| Other  comprehensive loss:                                              |       |                   |       |                  |       |   |   |   |   |
| Change  in net unrealized loss on investments                           |       | (6                     | )          | (287                  | )          | 32 |   | (264 | ) |
| Reclassification  adjustment for net realized gain included in net loss |       | —                 |       | —                |       | — |   | (13 | ) |
| Total  comprehensive loss                                               |       | $                      | (2,092     | )                     | $          | (7,709 | ) | $ | (9,865 | ) | $ | (10,534 | ) |

 

Accumulated othercomprehensive loss reflected on the condensed consolidated balance sheets at October3, 2009 and January 3, 2009, represents accumulated net unrealized losses oninvestments in marketable securities.

 

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*Computationof Net Loss Per Share*

 

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

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                               | ** ** | **October 3,**         | ** ** | **September 27,**     | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                                               | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Numerator:  Net loss                                     |       | $                      | (2,086     | )                     | $          | (7,422 | ) | $ | (9,897 | ) | $ | (10,257 | ) |
| Denominator:  Weighted-average common shares outstanding |       | 19,855                 |       | 19,855                |       | 19,855 |   | 19,845 |   |
| Net  loss per share, basic and diluted                   |       | $                      | (0.11      | )                     | $          | (0.37 | ) | $ | (0.50 | ) | $ | (0.52 | ) |

 

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

 
| ** **                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **October 3,**         | ** ** | **September 27,**     | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Common  share equivalents |       | 600                    |       | 919                   |       | 420 |   | 902 |   |

 

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

 

*MajorCustomers*

 

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

 
| ** **         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------|------------|------------------------|------------|-----------------------|------------|
| ** **         | ** ** | **October 3,**         | ** ** | **September 27,**     | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **         | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Customer:**      |       |                   | ** ** | ** **            |       |   |   |   |   |
| Dell               |       | 47                     | %          | 47                    | %          | 48 | % | 57 | % |
| Hewlett  Packard   |       | 18                     | %          | 47                    | %          | 10 | % | 34 | % |
| Arrow  Electronics |       | 10                     | %          | *                     | %          | 13 | % | * | % |

 

----

* less than 10% of net sales

 

The Company’saccounts receivable are concentrated with three customers at October 3, 2009,representing approximately 57% , 20% and 10% of aggregate gross receivables. Asignificant reduction in sales to, or the inability to collect receivables froma significant customer could have a material adverse impact on the Company.

 

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**Note4—Fair Value Measurements**

** **

The followingtable details the fair value measurements within the fair value hierarchy ofthe Company’s investments in marketable securities (in thousands):

 
| ** **                            | ** ** | ** **        | ** ** | **Fair Value Measurements at October 3, 2009 Using** | ** ** |
|---------------------------------------|------------|-------------------|------------|------------------------------------------------------|------------|
| ** **                            | ** ** | ** **        | ** ** | **Quoted Prices in**                                 | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                            | ** ** | **Fair Value at** | ** ** | **Active Markets for**                               | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                            | ** ** | **October 3,**    | ** ** | **Identical Assets**                                 | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                            | ** ** | **2009**          | ** ** | **(Level 1)**                                        | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Investments  in marketable securities |       | $                 | 4,857      |                                                 | $          | 3,882 |   | $ | — |   | $ | 975 |   |
|                                       |            |                   |            |                                                      |            |  |  |  |  |  |  |  |  |

 

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

 

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

 
| ** **                                                        | ** ** | **Nine Months   Ended** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                        | ** ** | **October 3,**          | ** ** |
| ** **                                                        | ** ** | **2009**                | ** ** |
| Beginning  balance                                                |       | $                       | 960        |   |
| Transfers  into Level 3                                           |       | —                  |       |
| Unrealized  gain included in accumulated other comprehensive loss |       | 15                      |       |
| Purchases,  sales, issuances and settlements, net                 |       | —                  |       |
| Ending  balance                                                   |       | $                       | 975        |   |

 

**Note5—Investments in Marketable Securities**

 

Investments in marketable securities consist of the following at October3, 2009 (in thousands):

 
| ** **                                | ** ** | **October 3, 2009** | ** **  |
|-------------------------------------------|------------|---------------------|-------------|
| ** **                                | ** ** | ** **          | ** **  | **Net** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Amortized**       | ** **  | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                | ** ** | **Cost**            | ** **  | **Gain (Loss)** | ** ** | **Value** | ** ** |
| Federal  agency notes and bonds           |       | $                   | 3,115       |   | $ | — |   | $ | 3,115 |   |
| Corporate  notes and bonds                |       | 766                 |        | 1 |   | 767 |   |
| Auction  and variable floating rate notes |       | 1,000               |        | (25 | ) | 975 |   |
|                                      |       | $                   |  4,881 |   | $ | (24 | ) | $ | 4,857 |   |

 

Realized gains and losses on the sale of investments in marketablesecurities are determined using the specific identification method.  Net realized gains recorded during the ninemonths ended October 3, 2009 were not significant.

 

Thefollowing table provides the breakdown of investments in marketable securitieswith unrealized losses at October 3, 2009 (in thousands):

 
| ** **                                | ** ** | **October 3, 2009**            | ** **   |
|-------------------------------------------|------------|--------------------------------|--------------|
| ** **                                | ** ** | **Continuous Unrealized Loss** | ** **   |
| ** **                                | ** ** | **Less than 12 months**        | ** **   | **12 months or greater** | ** ** |
| ** **                                | ** ** | **Fair**                       | ** **   | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                                | ** ** | **Value**                      | ** **   | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| Federal  agency notes and bonds           |       | $                              | —       |   | $ | — |   | $ | — |   | $ | — |   |
| Corporate  notes and bonds                |       | —                         |         | — |   | — |   | — |   |
| Auction  and variable floating rate notes |       | —                         |         | — |   | 975 |   | (25 | ) |
|                                      |       | $                              |  — |   | $ | — |   | $ | 975 |   | $ | (25 | ) |

 

As of October 3, 2009, the Company held two investments that were in anunrealized loss position.

 

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*AuctionRate Securities*

 

The disruptions inthe credit market over the past year continue to adversely affect the liquidityand overall market for auction rate securities. As of October 3, 2009, theCompany held two investments in auction rate securities with a total purchasedcost of $1.0 million. These two investments represent (i) a fully insured debtobligation of a municipality and (ii) Baa1 and A3 rated debt obligations backedby pools of student loans guaranteed by the U.S. Department of Education. Giventhe insufficient observable market inputs and related information available, theCompany has classified its investments in auction rate securities within Level3 of the fair value hierarchy. The Company has estimated the fair value ofthese investments using a discounted cash flow model which included assumptionsabout the credit quality and expected duration of the investments, along withdiscount rates affected for the general lack of liquidity. These assumptionsreflect the Company’s estimates about the reasonable assumptions marketparticipants would likely use in valuing the investments, including assumptionsabout risk, developed based on the best information available in thecircumstances.

 

The Company doesnot believe that the current illiquidity of its investments in auction ratesecurities will materially impact its ability to fund its working capitalneeds, capital expenditures or other business requirements. The Company,however, remains uncertain as to when liquidity will return to the auction ratemarkets, whether other secondary markets will become available or when theunderlying securities may be called by the issuer. Given these and otheruncertainties, the Company’s investments in auction rate securities have beenclassified as long-term investments in marketable securities in theaccompanying unaudited condensed consolidated balance sheet as of October 3,2009. The Company has concluded that the estimated gross unrealized losses onthese investments, which totaled approximately $25,000 at October 3, 2009, aretemporary because (i) the Company believes that the absence of liquidity thathas occurred is due to general market conditions, (ii) the auction ratesecurities held by the Company continue to be of a high credit quality andinterest is paid as due and (iii) the Company has the intent and ability tohold these investments until a recovery in the market occurs.

 

*OtherInvestments in Marketable Securities*

 

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

 

The following table presents the amortized cost and fair value of theCompany’s investments in marketable securities classified as available-for-saleat October 3, 2009 by contractual maturity (in thousands):

 
| ** **               | ** ** | **October 3, 2009** | ** **  |
|--------------------------|------------|---------------------|-------------|
| ** **               | ** ** | **Amortized**       | ** **  | **Fair** | ** ** |
| ** **               | ** ** | **Cost**            | ** **  | **Value** | ** ** |
| **Maturity**             | ** ** | ** **          | ** **  | ** ** | ** ** |
| Less  than one year      |       | $                   | 3,115       |   | $ | 3,115 |   |
| One  to two years        |       | 766                 |        | 767 |   |
| Greater  than two years* |       | 1,000               |        | 975 |   |
|                     |       | $                   |  4,881 |   | $ | 4,857 |   |

 

----

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

 

**Note6—Credit Agreement**

** **

The Company’sexisting line of credit agreement and equipment line of credit agreementexpired on August 31, 2009 and all borrowings were repaid to the bank.  Under the Company’s revolving line of creditagreement with its bank, the Company was able to borrow up to the greater of 85%of eligible accounts receivable plus the least of (i) a percentage of eligibleinventory determined from time to time by the Company’s bank, (ii) 80% of theorderly liquidation value, as defined, of eligible inventories, and (iii) $1.0 million.Interest was payable monthly at the greatest of (i) the sum of prime rate plus3%, (ii) LIBOR plus 6% or (iii) 8%.  TheCompany repaid all borrowings on the revolving line of credit in connectionwith the expiration of the revolving line of credit agreement.

 

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In connection withthe prior revolving line of credit agreement, the Company was provided anequipment line of credit allowing it to borrow up to $3.9 million through January3, 2009. The Company was required to repay the equipment advances in monthlyinstallments of $32,440. Interest on the equipment advances was payablemonthly, at the Company’s option, at the greater of (i) prime rate plus 3%, (ii)LIBOR plus 6% or (iii) 8%.  The Companyrepaid all borrowings on the equipment line in connection with the expirationof the credit agreement on August 31, 2009.

 

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

 
| ** **        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------|------------|------------------------|------------|-----------------------|------------|
| ** **        | ** ** | **October 3,**         | ** ** | **September 27,**     | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **        | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Interest  expense |       | $                      | 34         |                  | $          | 94 |   | $ | 46 |   | $ | 180 |   |
|                   |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 
| ** **                                                 | ** ** | **October 3,** | ** ** | **January 3,** | ** ** |
|------------------------------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                                                 | ** ** | **2009**       | ** ** | **2009**       | ** ** |
| Outstanding  borrowings on the revolving line of credit    |       | $              | —     |           | $          | — |   |
| Borrowing  availability under the revolving line of credit |       | $              | —     |           | $          | 1,701 |   |

 

On October 31, 2009, theCompany entered into a revolving credit agreement with another financialinstitution.  Under the credit agreement,the Company may borrow up to the lesser of (i) 80% of eligible accountsreceivable, minus $1.0 million, or (ii) $5.0 million.  The credit agreement contains an overallsublimit of $2.5 million to collateralize the Company’s contingent obligationsunder letters of credit, foreign exchange contracts and cash managementservices.  Amounts outstanding under theoverall sublimit reduce the amount available pursuant to the creditagreement.  This revolving creditagreement subjects the Company to certain affirmative and negative covenants,including financial covenants with respect to the Company’s liquidity andprofitability.  Interest is payablemonthly at either (i) prime plus 1.25%, as long as the Company maintains $8.5million in revolving credit availability plus unrestricted cash on deposit withthe financial institution, or (ii) prime plus 2.25%.  The credit agreement matures on October 30,2010, at which time all advances and interest are due and payable.  Obligations under this revolving creditagreement are secured by a first priority lien on the Company’s tangible andintangible assets.

 

**Note 7—Long-TermDebt**

 

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

 
| ** **                        | ** ** | **October 3,** | ** ** | **January 3,** | ** ** |
|-----------------------------------|------------|----------------|------------|----------------|------------|
| ** **                        | ** ** | **2009**       | ** ** | **2009**       | ** ** |
| Obligations  under capital leases |       | $              | 192        |           | $          | 148 |   |
| Equipment  note payable to bank   |       | —         |       | 450            |       |
| Notes  payable to others          |       | —         |       | 6              |       |
|                              |       | 192            |       | 604            |       |
| Less  current portion             |       | (115           | )          | (474           | )          |
|                              |       | $              | 77         |           | $          | 130 |   |

 

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

 
| ** **        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------|------------|------------------------|------------|-----------------------|------------|
| ** **        | ** ** | **October 3,**         | ** ** | **September 27,**     | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **        | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Interest  expense |       | $                      | 6          |                  | $          | 18 |   | $ | 25 |   | $ | 85 |   |
|                   |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 

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**Note 8—IncomeTaxes**

** **

The following table sets forth the Company’s provision (benefit) forincome taxes, along with the corresponding effective tax rates (in thousands,except percentages):

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **October 3,**         | ** ** | **September 27,**     | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                            | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Provision  (benefit) for income taxes |       | $                      | (458       | )                     | $          | 4,502 |   | $ | (409 | ) | $ | 3,332 |   |
| Effective  tax rate                   |       | (18                    | )%         | 154                   | %          | (4 | )% | 48 | % |
|                                       |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 

The Company is requiredto adjust its effective tax rate each quarter to be consistent with theestimated annual effective tax rate.  TheCompany is also required to record the tax impact of certain discrete items,unusual or infrequently occurring, including changes in judgment aboutvaluation allowances and effects of changes in tax laws or rates, in theinterim period in which they occur.  Inaddition, jurisdictions with a projected loss for the year or a year-to-dateloss where no tax benefit can be recognized are excluded from the estimatedannual effective tax rate.  The impact ofsuch an exclusion could result in a higher or lower effective tax rate during aparticular quarter, based upon the mix and timing of actual earnings versusannual projections.

 

The Company evaluateswhether a valuation allowance should be established against its deferred taxassets based on the consideration of all available evidence using a “morelikely than not” standard.

 

As of October 3, 2009,the Company has provided a full valuation allowance and no benefit has beenrecognized for net operating losses and other deferred tax assets due touncertainty of future utilization.

 

The Company hadunrecognized tax benefits at fiscal year-end January 3, 2009 of approximately$0.6 million.  The Company reduced itsunrecognized tax benefits by approximately $0.5 million during the quarter as aresult of a lapse in a federal statute of limitations.

 

**Note9—Commitments and Contingencies**

 

*FederalSecurities Class Action*

 

Beginning in May 2007,the Company, certain of its officers and directors, and the Company’sunderwriters were named as defendants in four purported class actionshareholder complaints, two of which were filed in the U.S. District Court forthe Southern District of New York, and two of which were filed in the U.S.District Court for the Central District of California. These purported classaction lawsuits were filed on behalf of persons and entities who purchased orotherwise acquired the Company’s common stock pursuant or traceable to theCompany’s November 30, 2006 initial public offering (the “IPO”). The lawsuitswere consolidated into a single action—Belodoff v. Netlist, Inc., Lead Case No.SACV07-677 DOC (MLGx)—which is currently pending in the Central District ofCalifornia. Lead Plaintiff filed the Consolidated Complaint in November 2007.Defendants filed their motions to dismiss the Consolidated Complaint in January2008. The motions to dismiss were taken under submission in April 2008 and on May30, 2008, the Court granted the defendants’ motions. However, plaintiffs weregranted the right to amend their complaint and subsequently filed their FirstAmended Consolidated Class Action Complaint (“Amended Complaint”) in July 2008.  The defendants filed motions to dismiss theAmended Complaint in January 2009, and on April 17, 2009, the Court granteddefendants’ motions to dismiss.  However,plaintiffs were again granted the right to amend their complaint.  Plaintiffs’ filed their Second AmendedConsolidated Class Action Complaint (“Second Amended Complaint”) in May 2009.  Generally, the Second Amended Complaint, likethe preceding complaints, alleged that the Registration Statement issued by theCompany in connection with the IPO contained untrue statements of material factor omissions of material fact in violation of Sections 11 and 15 of SecuritiesAct of 1933. Defendants filed motions to dismiss the Second Amended Complaintin June 2009.  The motions to dismisswere taken under submission in August 2009 and on September 1, 2009, the Courtgranted the defendants’ motions. However, plaintiffs again were granted the right to amend theircomplaint.  In October 2009, following avoluntary mediation of the matter, which took place in December 2008, andsubsequent good-faith settlement negotiations, the parties reached a tentativeagreement in principle to settle the class action.  The parties are currently negotiating theessential terms and conditions of the proposed settlement to submit to theCourt for preliminary approval.  Under thetentative settlement, plaintiffs and the class will dismiss all claims, withprejudice, in exchange for a cash payment of $2.6 million. The Company’sdirectors’ and officers’ liability insurers will pay the settlement amount inaccordance with the Company’s insurance policies.  The parties will ask the court to stay all proceedingsin the action, except as necessary to consummate the proposed settlement.  Despite the tentative agreement to settlethis action, the Company believes that the allegations lack merit and, ifnecessary, intends to vigorously defend all claims asserted.  The Company makes no assurancesat this time that the Court will grant approval of the proposed settlementterms or that the matter ultimately will be settled.

 

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*CaliforniaDerivative Action*

 

In August2007, a derivative lawsuit was filed in California Superior Court for County ofOrange-Smith v. Hong, Case No. 07CC01359-against certain of the Company’sofficers and directors. This action contains factual allegations similar tothose of the federal class action lawsuit described above, but the plaintiff inthis case asserts claims for violations of California’s insider trading laws,breaches of fiduciary duty, abuse of control, gross mismanagement, waste ofcorporate assets, and unjust enrichment. The plaintiff seeks unspecifieddamages, equitable and/or injunctive relief and disgorgement of all profits,benefits and other compensation obtained by the defendants. The defendants inthis action have not responded to the complaint. Pursuant to a stipulation, theparties agreed to temporarily stay the action pending the ultimate decision onthe defendants’ motions to dismiss in the federal securities class action.  In April 2009, following a voluntary mediationof the matter, which took place in December 2008, the parties reached atentative agreement to settle the derivative action. In June 2009, the partiesexecuted a Stipulation and Agreement of Settlement of Derivative Claimsdocumenting the essential terms of the proposed settlement, and on June 26,2009, the parties filed their joint motion for preliminary approval of theproposed settlement with the Court. The Court granted preliminary approval ofthe proposed settlement on July 27, 2009.  The final hearing on the proposed settlementis set for November 5, 2009. The Company makes no assurances at this time thatthe Court will grant final approval of the proposed settlement terms or thatthe matter ultimately will be settled.  Despite the pending settlement reached in thisderivative action, the Company believes that the allegations lack merit.  In addition, the Company receivedcorrespondence from counsel for a purported shareholder requesting that theCompany take actions to investigate and remedy alleged wrongdoing byunidentified former and current officers and/or directors based on allegationssimilar to those in the Smith v. Hong derivative case. The Company, through itsBoard of Directors, has evaluated and rejected this request.  The proposed settlement also is intended toresolve any remaining issues arising from this shareholder request.  Despite the pending settlement reached, theCompany believes that the allegations raised in the shareholder request alsolack merit.

 

*PatentClaims*

 

In May 2008, theCompany initiated discussions with Google, Inc. regarding the Company’s claimsthat Google has infringed on a US patent assigned to the Company relatinggenerally to “rank multiplication” in memory modules. On August 29, 2008,Google filed a declaratory judgment lawsuit against the Company in UnitedStates District Court for the Northern District of California, seeking adeclaration that Google did not infringe on the Company’s patent, and that theCompany’s patent is invalid. Google is not seeking any monetary damages. On November18, 2008, the Company filed a counterclaim for infringement of the patent byGoogle. The Company expects to vigorously pursue its claim against Google andto vigorously defend against Google’s claim of invalidity.

 

On March 17, 2009,the Company filed a complaint for patent infringement against MetaRAM, Inc. forits infringement of one of the Company’s patents. On March 26, 2009, MetaRAMfiled a complaint against the Company for patent infringement. The parties arecurrently discussing an amicable settlement of these claims.  If these discussions are unsuccessful, theCompany expects to vigorously pursue its claim against MetaRAM and tovigorously defend against MetaRAM’s separate claim.

 

On September 22,2009, the Company filed a patent infringement lawsuit against Inphi Corporationin the U.S. District Court for the Central District of California.  The suit alleges that Inphi is contributorilyinfringing and actively inducing the infringement of a US patent assigned tothe Company which is directed to memory modules with load isolation and memorydomain translation capabilities.  TheCompany is seeking damages and injunctive relief based on Inphi’s use of itspatented technology.  Inphi has not yetanswered the Company’s complaint.

 

*TradeSecret Claim*

 

On November18, 2008, the Company filed a claim for trade secret misappropriation againstTexas Instruments (TI) in Santa Clara County Superior Court, based in TI’sdisclosure of confidential Company materials to the JEDEC standard-settingbody.  On February 20, 2009, TI filed itsanswer.  The parties are currentlyengaged in settlement discussions.  Ifthose discussions are unsuccessful, the Company expects to vigorously pursueits claims against TI.

 

*Other Contingent Obligations*

 

During its normal course ofbusiness, the Company has made certain indemnities, commitments and guaranteesunder which it may be required to make payments in relation to certaintransactions. These include (i) intellectual property indemnities to theCompany’s customers and licensees in connection with the use, sales and/orlicense of Company products; (ii) indemnities to vendors and service providerspertaining to claims based on the Company’s negligence or willful misconduct; (iii)indemnities involving the accuracy of representations and warranties in certaincontracts; (iv) indemnities to directors and officers of the Company to the 

 

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maximum extent permitted under the laws of the Stateof Delaware; and (v) certain real estate leases, under which the Company may berequired to indemnify property owners for environmental and other liabilities,and other claims arising from the Company’s use of the applicable premises. Theduration of these indemnities, commitments and guarantees varies and, incertain cases, may be indefinite. The majority of these indemnities,commitments and guarantees do not provide for any limitation of the maximumpotential for future payments the Company could be obligated to make.Historically, the Company has not been obligated to make significant paymentsfor these obligations, and no liabilities have been recorded for theseindemnities, commitments and guarantees in the accompanying condensed consolidatedbalance sheets.

 

**Note10—Stock Options and Warrants**

** **

*Common Stock Options*

* *

A summary of the Company’s common stock option activity as of and forthe nine months ended October 3, 2009 is presented below (shares in thousands):

 
| ** **                              | ** ** | ** **    | ** ** | **Weighted-** | ** ** |
|-----------------------------------------|------------|---------------|------------|---------------|------------|
| ** **                              | ** ** | ** **    | ** ** | **Average**   | ** ** |
| ** **                              | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                              | ** ** | **Shares**    | ** ** | **Price**     | ** ** |
| Options  outstanding at January 3, 2009 |       | 4,281         |       | $             | 2.64       |   |
| Options  granted                        |       | 700           |       | 0.34          |       |
| Options  exercised                      |       | —        |       | —        |       |
| Options  cancelled                      |       | (501          | )          | 1.99          |       |
| Options  outstanding at October 3, 2009 |       | 4,480         |       | $             | 2.35       |   |

 

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

* *
| ** **                                        | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** |
| ** **                                        | ** ** | **2009**              | ** ** | **2008** | ** ** |
| Expected  term (in years)                         |       | 5.4                   |       | 5.4 |   |
| Expected  volatility                              |       | 111                   | %          | 80 | % |
| Risk-free  interest rate                          |       | 2.94                  | %          | 3.12 | % |
| Expected  dividends                               |       | —                |       | — |   |
| Weighted-average  grant date fair value per share |       | $                     | 0.28       |   | $ | 1.13 |   |
|                                                   |            |                       |            |  |  |  |  |

* *

*At October3, 2009, the amount of unearned stock-based compensation currently estimated tobe expensed from fiscal 2009 through fiscal 2012 related to unvested commonstock options is approximately $1.3 million, net of estimated forfeitures. Theweighted-average period over which the unearned stock-based compensation isexpected to be recognized is approximately 1.9 years. If there are anymodifications or cancellations of the underlying unvested common stock options,the Company may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense. Future stock-based compensationexpense and unearned stock-based compensation will increase to the extent thatthe Company grants additional common stock options or other stock-based awards.*

 

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* *

*Warrants*

* *

A summary ofactivity with respect to outstanding warrants to purchase shares of the Company’scommon stock as of and for the nine months ended October 3, 2009 is presentedbelow (shares in thousands):

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

 

**Note11—Segment and Geographic Information**

** **

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

 

At October 3,2009, approximately $3.3 million of the Company’s net long-lived assets werelocated in the PRC.

 

**Item 2.   Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

** **

**CautionaryStatement**

** **

*Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with our Unaudited CondensedConsolidated Financial Statements and the related notes thereto contained in PartI, Item 1 of this Report. The information contained in this Quarterly Report onForm 10-Q is not a complete description of our business or the risks associatedwith an investment in our common stock. We urge you to carefully review andconsider the various disclosures made by us in this Report and in our otherreports filed with the Securities and Exchange Commission, or SEC, includingour Annual Report on Form 10-K for the fiscal year ended January 3, 2009 andsubsequent reports on Form 10-Q and Form 8-K, which discuss our business ingreater detail.*

 

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

 

*ThisReport contains forward-looking statements that involve risks, uncertainties,estimates and assumptions. These statements are not guarantees of futureperformance and are subject to certain risks, uncertainties and assumptionsthat are difficult to predict. Therefore, our actual results could differmaterially and adversely from those expressed in any forward-looking statementsas a result of various factors, including but not limited to those identified underthe heading “Risk Factors” set forth in Part II, Item 1A of this Report and inour Annual Report on Form 10-K for the fiscal year ended January 3, 2009.  Except as required by law, we undertake noobligation to revise or update publicly any forward-looking statements for anyreason.*

 

**Overview**

** **

We design, manufacture andsell high performance memory subsystems for the server, high performancecomputing and communications markets. Our memory subsystems consist of dynamicrandom access memory integrated circuits, (“DRAM ICs”) , NAND flash memory (“NAND”)and other components assembled on a printed circuit board (“PCB”). We alsodesign custom semiconductor logic devices which are integrated into our memorysubsystems in order to increase their performance. We engage with our originalequipment manufacturer (“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 has alsoallowed us to develop a significant level of systems expertise. We leverage aportfolio of proprietary technologies and design techniques, includingefficient planar design, alternative packaging techniques and customsemiconductor logic, to deliver memory subsystems with high memory density,small form factor, high signal integrity, attractive thermal characteristicsand low cost per bit.

 

Consistent withthe concentrated nature of the OEM customer base in our target markets, a smallnumber of large customers have historically accounted for a significant portionof our net sales. Dell, Hewlett Packard and Arrow Electronics representedapproximately 48%, 10% and 13%, respectively, of our net sales for the ninemonths ended October 3, 2009. Dell and Hewlett Packard representedapproximately 57% and 34%, respectively, of our net sales for the nine monthsended September 27, 2008. Net sales to some of our OEM customers include memorymodules that are qualified by us directly with the OEM customer and sold toelectronic manufacturing services providers (“EMSs”) for incorporation intoproducts manufactured exclusively for the OEM 

 

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customer.  These net sales to EMSs have historicallyfluctuated period by period as a portion of the total net sales to these OEMcustomers. Net sales to Hon Hai Precision Industry Co. Ltd., an EMS thatpurchases memory modules from us for incorporation into products manufacturedexclusively for Dell, represented approximately 61% of net sales to Dell forthe nine months ended October 3, 2009, and approximately 12% of net sales toDell for the nine months ended September 27, 2008.

 

**Key BusinessMetrics**

** **

The followingdescribes certain line items in our consolidated statements of operations thatare important to management’s assessment of our financial performance:

 

*Net Sales.*  Net sales consist primarily of sales of ourhigh performance memory subsystems, net of a provision for estimated returnsunder our right of return policies, which generally range up to 30 days. Wegenerally do not have long-term sales agreements with our customers. AlthoughOEM customers typically provide us with non-binding forecasts of future productdemand over specific periods of time, they generally place orders with usapproximately two weeks in advance of scheduled delivery. Selling prices aretypically negotiated monthly, based on competitive market conditions and thethen current price of DRAM ICs and NAND. Purchase orders generally have nocancellation or rescheduling penalty provisions. We often ship our products toour customers’ international manufacturing sites. All of our sales to date,however, are denominated in US dollars. We also sell excess component inventoryof DRAM ICs and NAND to distributors and other users of memory ICs. As comparedto previous years, component inventory sales have significantly decreased as apercentage of net sales as a result of our efforts to diversify both ourcustomer and product line bases. This diversification effort has also allowedus to use components in a wider range of memory subsystems. We expect thatcomponent inventory sales will continue to represent a minimal portion of ournet sales in future periods.

 

*Cost ofSales.*  Our cost of sales includes thecost of materials, manufacturing costs, depreciation and amortization ofequipment, inventory valuation provisions, stock-based compensation andoccupancy costs and other allocated fixed costs. The DRAM ICs and NANDincorporated into our products constitute a significant portion of our cost ofsales, and thus our cost of sales will fluctuate based on the current price ofDRAM ICs and NAND. We attempt to pass through such DRAM IC and NAND costfluctuations to our customers by frequently renegotiating pricing prior to theplacement of their purchase orders. To the extent we are successful, a largemajority of our product cost is variable, and thus our cost of sales and grossmargin percentages may not be significantly impacted by changes in salesvolume. However, the sales prices of our memory subsystems can also fluctuatedue to competitive situations unrelated to the pricing of DRAM ICs and NAND,which affects gross margins. The gross margin on our sales of excess componentDRAM IC and NAND inventory is much lower than the gross margin on our sales ofour memory subsystems. As a result, a decrease in DRAM IC and NAND inventorysales as a percentage of our overall sales could result in an improved overallgross margin. We assess the valuation of our inventories on a monthly basis andrecord a provision to cost of sales as necessary to reduce inventories to thelower of cost or net realizable value.

 

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

 

*Selling, General and Administrative.*  Selling, general and administrative expensesconsist primarily of employee salaries and related costs, stock-basedcompensation, independent sales representative commissions, professionalservices, promotional and other selling and marketing expenses, and occupancyand other allocated overhead costs. A significant portion of our sellingefforts is directed at building relationships with OEMs and other customers andworking through the product approval and qualification process with them.Therefore, the cost of material and overhead related to products manufacturedfor qualification is included in selling expenses. As we continue to serviceexisting and establish new customers, we anticipate that our sales andmarketing expenses will increase. Beginning in fiscal 2010, we will be subjectto attestation services requirements with respect to our internal control overfinancial reporting, the result of which will increase our legal and accountingexpenses in future periods.

 

*Provision (Benefit) forIncome Taxes.*  Under the Financial Accounting StandardsBoard (“FASB”) Accounting Standards Codification (“ASC”) Topic 270, we arerequired to adjust our effective tax rate each quarter to be consistent withthe estimated annual effective tax rate. We are also required to record the tax impact of certain discrete items,unusual or infrequently occurring, including changes in judgment aboutvaluation allowances and effects of changes in tax laws or rates, in theinterim period in which they occur.  Inaddition, jurisdictions with a projected loss for the year or a year-to-dateloss where no tax benefit can be recognized are excluded from the estimatedannual effective tax rate.  The impact ofsuch an exclusion could result in a higher or lower effective tax rate during aparticular quarter, based upon the mix and timing of actual earnings versusannual projections.

 

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In accordance with ASCTopic 740, we evaluate whether a valuation allowance should be establishedagainst its deferred tax assets based on the consideration of all availableevidence using a “more likely than not” standard.

 

As of October 3, 2009, wehave provided a full valuation allowance and no benefit has been recognized fornet operating losses and other deferred tax assets due to uncertainty of futureutilization.

 

**CriticalAccounting Policies**

** **

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the U.S. requires us to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosures of contingentassets and liabilities at the date of the consolidated financial statements andthe reported amounts of net sales and expenses during the reporting period. Bytheir nature, these estimates and assumptions are subject to an inherent degreeof uncertainty. We base our estimates on our historical experience, knowledgeof current conditions and our beliefs of what could occur in the futureconsidering available information. We review our estimates on an on-goingbasis. Actual results may differ from these estimates, which may result inmaterial adverse effects on our operating results and financial position. Webelieve the following critical accounting policies involve the more significantassumptions and estimates used in the preparation of our consolidated financialstatements:

 

*Revenue Recognition.* We recognize revenues in accordance withASC Topic 605.  Accordingly, we recognizerevenues when there is persuasive evidence that an arrangement, productdelivery and acceptance have occurred, the sales price is fixed or determinable,and collectability of the resulting receivable is reasonably assured.

 

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

 

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

 

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

 

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

 

*Warranty Reserve.* We offer warranties on our memory subsystemsgenerally ranging from one to three years, depending on the product andnegotiated terms of purchase agreements with our customers. Such warrantiesrequire us to repair or replace defective product returned to us during thewarranty period at no cost to the customer. Our estimates for warranty-relatedcosts are recorded at the time of sale based on historical and estimated futureproduct return rates and expected repair or replacement costs. While such costshave historically been within our expectations and the provisions established,unexpected changes in failure rates could have a material adverse impact on us,requiring additional warranty reserves, and adversely affecting our grossprofit and gross margins.

 

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*Accounts Receivable.* We perform credit evaluations of ourcustomers’ financial condition and limit the amount of credit extended to ourcustomers as deemed necessary, but generally require no collateral. Wecontinuously monitor collections and payments from our customers and maintain aprovision for estimated credit losses based upon our historical experience andany specific customer collection issues that we have identified. Generally,these credit losses have been within our expectations and the provisionsestablished. However, we cannot guarantee that we will continue to experiencecredit loss rates similar to those we have experienced in the past.

 

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

 

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

 

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

 

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

 

We use theBlack-Scholes option pricing model to estimate the fair value of our commonstock option awards. While this model meets the requirements of ASC Topic 718,the estimated fair values generated by it may not be indicative of the actualfair values of these awards as it does not consider certain factors importantto those awards to employees, such as continued employment and periodic vestingrequirements as well as limited transferability. The Black-Scholes modelrequires subjective assumptions regarding future stock price volatility andexpected time to exercise, along with assumptions about the risk-free interestrate and expected dividends, all of which affect the estimated fair values ofour common stock option awards. The expected term of options granted is derivedfrom historical data on employee exercises and post-vesting employmenttermination behavior. The expected volatility is based on the historicalvolatilities of our common stock. The risk-free rate selected to value anyparticular grant is based on the U.S. Treasury rate that corresponds to theexpected term of the grant effective as of the date of the grant. The expecteddividends assumption is based on our history and expectation of dividendpayouts. We evaluate the assumptions used to value our common stock optionawards on a quarterly basis. If factors change and we employ differentassumptions, stock-based compensation expense may differ significantly fromwhat we have recorded in prior periods.

 

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The value of theportion of stock-based awards that are ultimately expected to vest isrecognized as expense over the requisite service periods in our consolidatedfinancial statements. Given that stock-based compensation expense recognized inour consolidated financial statements is based on awards ultimately expected tovest, it has been reduced for estimated forfeitures. ASC Topic 718 requires forfeituresto be estimated at the time of grant and revised, if necessary, in subsequentperiods if actual forfeitures differ from those estimates. If there are anymodifications or cancellations of the underlying unvested stock-based awards,we may be required to accelerate, increase or cancel any remaining unearnedstock-based compensation expense. Future stock-based compensation expense andunearned stock-based compensation will increase to the extent that we grantadditional common stock options or other stock-based awards.

 

*IncomeTaxes.***Under the ASC Topic 270, we are required to adjust our effectivetax rate each quarter to be consistent with the estimated annual effective taxrate. We are also required to record the tax impact of certain discrete items,unusual or infrequently occurring, including changes in judgment aboutvaluation allowances and effects of changes in tax laws or rates, in theinterim period in which they occur. In addition, jurisdictions with a projectedloss for the year, or a year-to-date loss where no tax benefit can berecognized, are excluded from our estimated annual effective tax rate. Theimpact of excluding these items could result in a higher or lower effective taxrate during a particular quarter, based upon the mix and timing of actualearnings versus annual projections.

 

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

 

We adopted theguidance in ASC Topic 740 on December 31, 2006, the first day of fiscal 2007.This guidance sought to reduce the diversity in practice associated withcertain aspects of measurement and recognition in accounting for incometaxes.  ASC Topic 740 prescribes arecognition threshold and measurement requirement for the financial statementrecognition of a tax position that has been taken or is expected to be taken ona tax return and also provides guidance on de-recognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition. Under ASC Topic 740 we may only recognize or continue to recognizetax positions that meet a “more likely than not” threshold.

 

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

 

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**Results ofOperations**

** **

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

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **October 3,**         | ** ** | **September 27,**     | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                                        | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Net  sales                                        |       | 100                    | %          | 100                   | %          | 100 | % | 100 | % |
| Cost  of sales                                    |       | 76                     |       | 93                    |       | 89 |   | 87 |   |
| Gross  profit                                     |       | 24                     |       | 7                     |       | 11 |   | 13 |   |
| Operating  expenses:                              |       |                   |       |                  |       |   |   |   |   |
| Research  and development                         |       | 31                     |       | 6                     |       | 48 |   | 8 |   |
| Selling,  general and administrative              |       | 33                     |       | 12                    |       | 52 |   | 17 |   |
| Total  operating expenses                         |       | 63                     |       | 17                    |       | 100 |   | 25 |   |
| Operating  loss                                   |       | (39                    | )          | (10                   | )          | (88 | ) | (12 | ) |
| Other  income:                                    |       |                   |       |                  |       |   |   |   |   |
| Interest  (expense) income, net                   |       | —                 |       | —                |       | 1 |   | 1 |   |
| Other  income (expense), net                      |       | —                 |       | —                |       | 1 |   | — |   |
| Total  other income (expense), net                |       | —                 |       | —                |       | 2 |   | 1 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Loss  before provision (benefit) for income taxes |       | (39                    | )          | (10                   | )          | (87 | ) | (11 | ) |
| Provision  (benefit) for income taxes             |       | (7                     | )          | 16                    |       | (3 | ) | 6 |   |
| Net  loss                                         |       | (32                    | )%         | (26                   | )%         | (84 | )% | (17 | )% |

 

***Three and Nine Months Ended October 3, 2009 Comparedto Three and Nine Months Ended September 27, 2008***

*** ***

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

 

*The following table presents netsales, cost of sales and gross profit for the three and nine months ended October3, 2009 and September 27, 2008 (in thousands, except percentages):*

 
| ** **     | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|----------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **     | ** ** | **October 3,**         | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **     | ** ** | **2009**               | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
|           |       |                   |       |              |       |       |       |   |   |
| Net  sales     |       | $                      | 6,446      |              | $          | 28,876     |       | $ | (22,430 | ) | (78 | )% |
| Cost  of sales |       | 4,879                  |       | 26,832            |       | (21,953    | )          | (82 | )% |
| Gross  profit  |       | $                      | 1,567      |              | $          | 2,044      |       | $ | (477 | ) | (23 | )% |
| Gross  margin  |       | 24                     | %          | 7                 | %          | 17         | %          |   |   |

 
| ** **     | ** ** | **Nine Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|----------------|------------|-----------------------|------------|-------------------|------------|------------|------------|
| ** **     | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **     | ** ** | **2009**              | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
|           |       |                  |       |              |       |       |       |   |   |
| Net  sales     |       | $                     | 11,781     |              | $          | 60,409     |       | $ | (48,628 | ) | (80 | )% |
| Cost  of sales |       | 10,507                |       | 52,575            |       | (42,068    | )          | (80 | )% |
| Gross  profit  |       | $                     | 1,274      |              | $          | 7,834      |       | $ | (6,560 | ) | (84 | )% |
| Gross  margin  |       | 11                    | %          | 13                | %          | (2         | )%         |   |   |

 

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

 

The decrease in net salesfor the three months ended October 3, 2009, as compared to the three monthsended September 27, 2008, resulted primarily from decreases of approximately (i)$16.4 million in sales of laptop personal computer memory subsystems, and (ii) $6.6million in sales of our high density server modules.

 

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The decrease in net salesfor the nine months ended October 3, 2009, as compared to the nine months endedSeptember 27, 2008, resulted primarily from decreases of approximately (i) $25.1million in net sales of certain high density memory modules for the servermarket and related applications, (ii) $1.6 million in net sales of memorysubsystems used to control RAIDs and (iii) $22.5 million in net sales of laptoppersonal computer memory subsystems.

 

Sales of our component inventory to distributors andother users of memory ICs represented approximately 9% and 1% of net sales forthe three months ended October 3, 2009 and September 27, 2008, respectively,and approximately 6% and 1% of net sales for the nine months ended October 3,2009 and September 27, 2008, respectively. As compared to the previous year,component inventory sales increased as we purchased inventory for a sale whichwe later decided not to fulfill.

 

*Gross Profit and GrossMargin.*** Gross profit for the three and nine monthsended October 3, 2009 as compared to the three and nine months ended September 27,2008 decreased primarily due to the 78% and 80% decreases in net sales betweenthe comparative three and nine month periods in fiscal 2009 and 2008,respectively. The increase in gross margin of 17 percentage points for thethree months ended October 3, 2009, as compared to the three months ended September27, 2008, is mainly due to the reduction in sales of commoditized products inthe current quarter.  These gross marginimprovements are offset by an inability to absorb manufacturing costs caused bythe significant drop in units manufactured and sold during the most recentquarter.  These decreases were partiallyoffset by a shift in product mix toward higher margin contributingproducts.  The decrease in gross marginfor the nine months ended October 3, 2009, as compared to the nine months endedSeptember 27, 2008, of 2 percentage points is mostly due to unused capacity inour manufacturing facility, significantly offset by an increase in productmargin of 11% due to the improved conditions in the DRAM market, and a changein product mix and customer base during the period.

 

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

 

The following table presents research and development expenses for thethree and nine months ended October 3, 2009 and September 27, 2008 (inthousands, except percentages):

 
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|---------------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                | ** ** | **October 3,**         | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                | ** ** | **2009**               | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
| Research  and development |       | $                      | 1,975      |              | $          | 1,651      |       | $ | 324 |   | 20 | % |
|                           |            |                        |            |                   |            |            |            |  |  |  |  |  |

 
| ** **                | ** ** | **Nine Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|---------------------------|------------|-----------------------|------------|-------------------|------------|------------|------------|
| ** **                | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                | ** ** | **2009**              | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
| Research  and development |       | $                     | 5,619      |              | $          | 4,943      |       | $ | 676 |   | 14 | % |
|                           |            |                       |            |                   |            |            |            |  |  |  |  |  |

 

The increase in researchand development expense in the three months ended October 3, 2009, as comparedto the three months ended September 27, 2008, resulted primarily from increasesof (i) $0.3 million in personnel-related expenses as a result of an increase inthe number of outside contractors engaged in research and developmentactivities during the third quarter of 2009 and (ii) $0.4 million in legal andprofessional fees as we continue to increase activities related to new andemerging markets in 2009. The above increases were offset by a decrease ofapproximately $0.4 million in expenses related to product qualification buildsand testing.

 

The increase in researchand development expense in the nine months ended October 3, 2009, as comparedto the nine months ended September 27, 2008, resulted primarily from increasesof approximately (i) $1.3 million in personnel-related expenses as a result ofan increase in the number of outside contractors engaged in research anddevelopment activities and (ii) $0.6 million in legal and professional fees aswe continue to increase activities related to new and emerging markets. Theabove increases were offset by a decrease of approximately $1.2 million inexpenses related to new product builds and testing.

 

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

 

The following tablepresents selling, general and administrative expenses for the three and ninemonths ended October 3, 2009 and September 27, 2008 (in thousands, exceptpercentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                           | ** ** | **October 3,**         | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2009**               | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
| Selling,  general and administrative |       | $                      | 2,115      |              | $          | 3,364      |       | $ | (1,249 | ) | (37 | )% |
|                                      |            |                        |            |                   |            |            |            |  |  |  |  |  |

 
| ** **                           | ** ** | **Nine Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|--------------------------------------|------------|-----------------------|------------|-------------------|------------|------------|------------|
| ** **                           | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2009**              | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
| Selling,  general and administrative |       | $                     | 6,170      |              | $          | 10,142     |       | $ | (3,972 | ) | (39 | )% |
|                                      |            |                       |            |                   |            |            |            |  |  |  |  |  |

 

The decrease in selling,general and administrative expense for the three months ended October 3, 2009,as compared to the three months ended September 27, 2008, resulted primarilyfrom decreases of (i) $0.6 million in personnel-related expenses primarilyattributable to a decrease in the number of employees and outside contractorsengaged in selling, general and administrative functions of approximately 51%during the 2009 quarter as compared to the 2008 quarter , (ii) $0.3 million inbad debt expense, (iii) $0.2 million in product qualification expense andrelated travel costs as a result of a decrease in the number of sales personnelduring the most recent quarter, and (iv) $0.1 million in commission expensesdue to a decline in sales revenue during the most recent quarter.

 

The decrease in selling,general and administrative expense in the nine months ended October 3, 2009, ascompared to the nine months ended September 27, 2008, resulted primarily fromdecreases of approximately (i) $2.4 million in personnel-related expenses, (ii)$0.7 million in product qualification expense and related travel costs, (iii) $0.4million in commission expenses, (iv) $0.3 million in bad debt expense, and (v) $0.2million in legal and professional fees.

 

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

 

The following table presents other income (expense) for the three andnine months ended October 3, 2009 and September 27, 2008 (in thousands, exceptpercentages):

 
| ** **                         | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                         | ** ** | **October 3,**         | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                         | ** ** | **2009**               | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
| Interest  (expense) income, net    |       | $                      | (25        | )                 | $          | 38         |       | $ | (63 | ) | (166 | )% |
| Other  income (expense), net       |       | 4                      |       | 13                |       | (9         | )          | (69 | )% |
| Total  other income (expense), net |       | $                      | (21        | )                 | $          | 51         |       | $ | (72 | ) | (141 | )% |

 
| ** **                         | ** ** | **Nine Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------------|------------|-----------------------|------------|-------------------|------------|------------|------------|
| ** **                         | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                         | ** ** | **2009**              | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
| Interest  (expense) income, net    |       | $                     | 75         |              | $          | 381        |       | $ | (306 | ) | (80 | )% |
| Other  income (expense), net       |       | 134                   |       | (55               | )          | 189        |       | (344 | )% |
| Total  other income (expense), net |       | $                     | 209        |              | $          | 326        |       | $ | (117 | ) | (36 | )% |

 

Net interest income(expense) for the three and nine months ended October 3, 2009 was comprised ofinterest income of approximately $0.02 million and $0.1 million, respectively,offset by interest expense of approximately $0.05 million and $0.03 million,respectively.  Net interest income forthe three and nine months ended September 27, 2008 was comprised of interestincome of approximately $0.2 million and $0.7 million, respectively, offset byinterest expense of approximately $0.1 million and $0.3 million,respectively.  The decrease in interestincome in the three and nine months ended October 3, 2009, as compared to thethree and nine months ended September 27, 2008, was due to a combination of ourlower overall cash and investment balances and the decrease in the yield earnedon those balances due to lower interest rates. The decrease in interest expense during 2009, as compared to 2008,resulted primarily from our lower average outstanding balances on our line ofcredit and debt balances during the current year.

 

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Otherincome (expense), net, for the nine months ended October 3, 2009 is primarilycomprised of gains from the sale of equipment held for sale during the firstquarter.  Other expense, net, for the nine months ended September27, 2008 is primarily comprised of losses on certain foreign currencyremeasurement transactions, partially offset by realized gains on the sale ofcertain investments in marketable securities.

 

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

 

The following tablepresents the provision (benefit) for income taxes for the three and nine monthsended October 3, 2009 and September 27, 2008 (in thousands, exceptpercentages):

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                            | ** ** | **October 3,**         | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                            | ** ** | **2009**               | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
| Provision  (benefit) for income taxes |       | $                      | (458       | )                 | $          | 4,502      |       | $ | (4,960 | ) | (110 | )% |
| Effective  tax rate                   |       | (18                    | )%         | 154               | %          |       |       |   |   |
|                                       |            |                        |            |                   |            |            |            |  |  |  |  |  |

 
| ** **                            | ** ** | **Nine Months Ended** | ** ** | ** **        | ** ** | ** ** | ** ** |
|---------------------------------------|------------|-----------------------|------------|-------------------|------------|------------|------------|
| ** **                            | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                            | ** ** | **2009**              | ** ** | **2008**          | ** ** | **Change** | ** ** | **Change** | ** ** |
| Provision  (benefit) for income taxes |       | $                     | (409       | )                 | $          | 3,332      |       | $ | (3,741 | ) | (112 | )% |
| Effective  tax rate                   |       | (4                    | )%         | 48                | %          |       |       |   |   |
|                                       |            |                       |            |                   |            |            |            |  |  |  |  |  |

 

On an interimbasis, we estimate what our effective tax rate will be in each jurisdiction forthe full fiscal year and record a quarterly income tax provision (benefit) inaccordance with the anticipated blended annual rate. We discontinued recordingincome tax benefits in the consolidated financial statements until it isdetermined that it is more likely than not that we will generate sufficienttaxable income to realize our deferred tax assets.  We recorded a benefit for income taxes forthe three months ended October 3, 2009 due to a change in our liability forunrecognized tax benefits as a result of a lapse in a federal statute oflimitations.  This benefit was nettedwith a provision recorded for state minimum taxes.  During the three months ended September 27,2008 we recorded a benefit forincome taxes which was reserved against during the third quarter of fiscal 2008when we recorded a net charge to income tax expense of approximately $4.5million related to establishing a partial valuation allowance against ourdeferred income tax assets.  Ourdetermination to record a valuation allowance was based on our recent historyof cumulative losses as well as uncertainty of the utilization of deferred taxassets in the near future.

 

**Liquidity andCapital Resources**

** **

Since ourinception, we have financed our operations primarily through issuances ofequity and debt securities and cash generated from operations. We have alsofunded our operations with a revolving line of credit, from capitalized leaseobligations, financing of receivables and from the sale and leaseback of ourdomestic manufacturing facility.

 

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

 

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

 
| ** **                                          | ** ** | **October 3,** | ** **   | **January 3,** | ** ** |
|-----------------------------------------------------|------------|----------------|--------------|----------------|------------|
| ** **                                          | ** ** | **2009**       | ** **   | **2009**       | ** ** |
| Working  Capital                                    |       | $              | 14,497       |           | $          | 22,339 |   |
|                                                |       |           |         |           |       |
| Cash  and cash equivalents(1)                       |       | $              | 11,501       |           | $          | 15,214 |   |
| Short-term  investments in marketable securities(1) |       | 3,115          |         | 5,199          |       |
| Long-term  investments in marketable securities     |       | 1,742          |         | 960            |       |
|                                                |       | $              |  16,358 |           | $          | 21,373 |   |

 

----

*(1) Included in working capital*

 

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*Our working capital decreased during the nine months ended October3, 2009 primarily as a result of a decrease in cash and short-term investmentsin marketable securities of $5.8 million to support operations, a decrease inincome tax receivable of $1.9 million, and an increase in current liabilitiesof $1.3 million, offset by an increase in accounts receivable of $0.8 million.*

 

***CashProvided and Used in the Nine Months Ended October 3, 2009 and September 27,2008***

 

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

* *
| ** **                                            | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **October 3,**        | ** ** | **September 27,** | ** ** |
| ** **                                            | ** ** | **2009**              | ** ** | **2008** | ** ** |
| **Net cash provided by (used in):**                   |       |                  |       |   |   |
| Operating  activities                                 |       | $                     | (4,779     | ) | $ | (11,705 | ) |
| Investing  activities                                 |       | 1,586                 |       | 11,846 |   |
| Financing  activities                                 |       | (520                  | )          | 4,758 |   |
| Net  increase (decrease) in cash and cash equivalents |       | $                     | (3,713     | ) | $ | 4,899 |   |

 

*Operating Activities.* Net cash used in operating activitiesfor the nine months ended October 3, 2009 was primarily a result of a net lossof approximately $9.9 million for the nine months ended October 3, 2009partially offset by (i) approximately $2.4 million in net cash provided bychanges in operating assets and liabilities, and (ii) approximately $2.7million in net non-cash operating expenses, primarily comprised of depreciationand amortization and stock-based compensation, offset by a gain on disposals ofassets.

 

Accounts receivableincreased approximately $0.8 million during the nine months ended October 3,2009 primarily as a result of the timing of net sales within the quarter ended October3, 2009 compared with the timing of net sales within the quarter ended January 3,2009.  During the nine months ended October3, 2009, we were successful in collecting cash from sales to our customerssubstantially in accordance with our standard payment terms with thosecustomers.

 

Inventories increasedapproximately $0.1 million during the nine months ended October 3, 2009primarily as a result of preparing for a customer order due to ship in thefourth quarter.  In the future, ourinventory levels will continue to be determined based on, among other factors, (i)the level of customer orders received and overall demand, (ii) the stage atwhich our products are in their respective life cycles and (iii) competitivesituations in the marketplace.  We makeefforts to balance such considerations against the risk of obsolescence orpotential excess inventory levels.

 

Net cash used inoperating activities for the nine months ended September 27, 2008 was primarilya result of (i) our net loss for the period of approximately $10.3 million and (ii)approximately $7.7 million in net cash used by changes in operating assets andliabilities, partially offset by approximately $6.2 million in net non-cashoperating expenses, primarily comprising deferred income taxes, depreciationand amortization and stock-based compensation.

 

Accounts receivableincreased approximately $3.7 million during the nine months ended September 27,2008 primarily due to timing differences for certain of our customer paymentreceipts near the end of the third quarter of 2008.

 

*Investing Activities.* Net cash provided by investingactivities for the nine months ended October 3, 2009 was primarily a result of (i)proceeds received from maturities and sales of certain investments inmarketable securities of approximately $12.2 million and (ii) proceeds from thesale of equipment of approximately $0.3 million, both offset by purchases ofadditional investments in marketable securities of approximately $10.8 million.

 

Net cash provided byinvesting activities for the nine months ended September 27, 2008 was primarilya result of proceeds we received from maturities and sales of certaininvestments in marketable securities of approximately $19.6 million, partiallyoffset by purchases of additional investments in marketable securities ofapproximately $6.7 million. We also used approximately $1.1 million in cash topurchase additional manufacturing equipment and other property and equipment.

 

Due to recentdisruptions of, and the resulting reduced liquidity in certain financialmarkets, two of our marketable securities investments in Baa1 and A3 ratedauction rate securities with a total purchased cost of $1.0 million began toexperience failed auctions during the fourth quarter of 2007, which continuedinto the third quarter of 2009. Due to the failed auctions, we have been unableto sell the securities at their respective costs, resulting in a decrease infair value which has been recorded as a component of accumulated othercomprehensive loss. These investments have been classified as long-terminvestments in marketable securities in our consolidated balance sheets as of October3, 2009 and January 3, 2009. As of October 3, 2009 and September 27, 2008, theunrealized losses on these two investments totaled approximately $0.03 millionand $0.04 million, respectively. We have concluded that the unrealized losseson these investments are temporary because (i) we believe that the decline inmarket value that has occurred is due to general market conditions, (ii) theauction rate securities continue to be of a high credit quality and interest ispaid as due and 

 

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(iii) we have the intentand ability to hold these investments until a recovery in market value occurs.The fair value of these securities could change significantly in the future andwe may be required to record other-than-temporary impairment charges oradditional unrealized losses in future periods.

 

*Financing Activities.* Net cash used in financing activities for the nine months ended October 3,2009 was a result of repayment of approximately $0.5 million on our long termdebt.

 

Net cash provided byfinancing activities for the nine months ended September 27, 2008 was primarilya result of approximately $7.4 million in net proceeds we received from netborrowings on our outstanding line of credit. This is partially offset by (i) anincrease in restricted cash balances in connection with our pledge of $2.0million in cash as collateral for a letter of credit and (ii) repayments ofapproximately $0.6 million on our long term debt.

 

***Capital Resources***

*** ***

Our revolving lineof credit agreement and equipment line of credit agreement expired on August 31,2009 and all borrowings were repaid to the bank.  Under our revolving line of credit agreement,we were able to borrow up to the greater of 85% of eligible accounts receivableplus the least of (i) a percentage of eligible inventory determined from timeto time by our bank, (ii) 80% of the orderly liquidation value, as defined, ofeligible inventories, and (iii) $1.0 million. Interest was payable monthly atthe greater of (i) the sum of prime rate plus 3%, (ii) LIBOR plus 6% or (iii) 8%.

 

In connection withour prior revolving line of credit agreement, we were provided an equipmentline of credit allowing us to borrow up to $3.9 million through January 3,2009. We were required to repay the equipment advances in monthly installmentsof $32,440. Interest on the equipment advances was payable monthly, at ouroption, at the greater of (i) prime rate plus 3%, (ii) LIBOR plus 6% or (iii) 8%.We repaid all borrowings on the equipment line in connection with theexpiration of the credit agreement on August 31, 2009.

 

On October 31, 2009 weentered into a new revolving credit agreement with another financialinstitution.  Under this revolving creditagreement, we may borrow up to the lesser of (i) 80% of eligible accountsreceivable, minus $1.0 million, or (ii) $5.0 million.  This revolving credit agreement contains anoverall sublimit of $2.5 million to collateralize our contingent obligationsunder letters of credit, foreign exchange contracts and cash managementservices.  Amounts outstanding under theoverall sublimit reduce the amount available pursuant to this revolving creditagreement.  This revolving creditagreement subjects us to certain affirmative and negative covenants, includingfinancial covenants with respect to our liquidity and profitability.  Interest is payable monthly at either (i) primeplus 1.25%, as long as we maintain $8.5 million in revolving creditavailability plus unrestricted cash on deposit with the financial institution,or (ii) prime plus 2.25%.  This revolvingcredit agreement matures on October 30, 2010, at which time all advances andinterest are due and payable. Obligations under this revolving credit agreement are secured by a firstpriority lien on our tangible and intangible assets.  As October 31, 2009, we had $0.9 millionavailable to borrow under this revolving credit agreement.

 

While we expect tomaintain compliance with our revolving credit agreement for the foreseeablefuture, we have in the past been in violation of one or more covenantscontained in previously existing credit agreements. We cannot assure you thatwe will not violate one or more covenants in the future. If we were to be inviolation of covenants under our new revolving credit agreement, our lendercould choose to accelerate payment on all outstanding loan balances. There canbe no assurance that we would be able to quickly obtain equivalent or suitablereplacement financing in this event. If we were not able to secure alternativesources of funding, such acceleration would have a material adverse impact onour financial condition.

 

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

 

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

 

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*NewAccounting Pronouncements*

 

In June 2009, the FASBissued an update to ASC Topic 105.  TheCodification became the source of authoritative U.S. GAAP for financialstatements issued for interim and annual periods ending after September 15,2009.  The adoption of the Codificationdid not have a material impact on our consolidated financial position, resultsof operations or liquidity.

 

***Off-Balance SheetArrangements***

*** ***

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

*** ***

**Item 3.**                          Quantitative andQualitative Disclosures About Market Risk

** **

***Notapplicable.  As a Smaller ReportingCompany, we are not required to make any disclosure pursuant to this Item 3.***

*** ***

**Item 4.**                          Controls and Procedures

** **

***Not applicable.***

*** ***

**Item 4T.**                 Controls and Procedures

** **

*(a) Evaluation ofDisclosure Controls and Procedures.* We carried out an evaluation, under the supervisionand with the participation of our management, including our principal executiveofficer and principal financial officer, of the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules 13a-15(e)and 15d-15(e) of the Securities Exchange Act of 1934, (“Exchange Act”)) as ofthe end of our fiscal quarter ended October 3, 2009. Based upon thatevaluation, our principal executive officer and principal financial officerconcluded that our disclosure controls and procedures are effective to providereasonable assurance that information required to be disclosed by us in reportsthat we file or submit under the Exchange Act (i) is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms and (ii) is accumulated and communicated to our management, including ourprincipal executive officer and principal financial officer as appropriate toallow timely decisions regarding required disclosure.

 

*(b) Change ininternal controls over financial reporting.* During the fiscal quarter that ended October3, 2009, there were no changes in our internal controls over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)that have materially affected, or are reasonably likely to materially affect,our internal controls over financial reporting.

 

***Inherent Limitations on InternalControl***

 

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

 

**PART II. OTHER INFORMATION**

 

**Item 1.**                          Legal Proceedings

** **

The informationset forth in the sections entitled Federal Securities Class Action, CaliforniaDerivative Action, Patent Claims and Trade Secret Claim under Note 9 of Notesto Unaudited Condensed Consolidated Financial Statements, included in Part I,Item I of this Report, is incorporated herein by reference.

 

**Item 1A.**                 Risk Factors

** **

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

 

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

 

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

 
| **Item  2.** | ** ** | **Unregistered Sales of Equity  Securities and Use of Proceeds** |
|--------------|------------|------------------------------------------------------------------|

 

None.

 
| **Item 3.** | ** ** | **Defaults Upon Senior Securities** |
|-------------|------------|-------------------------------------|

** **

None.

 
| **Item 4.** | ** ** | **Submission of Matters to a Vote 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.                                                                                                                                                                                              |
|        |       |                                                                                                                                                                                                                                           |
| 31.1(2)     |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) and Rule 15d-14(a) of the Securities  Exchange Act, as Amended.                                                                                       |
|        |       |                                                                                                                                                                                                                                           |
| 31.2(2)     |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) and Rule 15d-14(a) of the Securities  Exchange Act, as Amended.                                                                                       |
|        |       |                                                                                                                                                                                                                                           |
| 32(3)       |       | Certification of Chief Executive Officer and Chief Financial Officer  pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 and furnished herewith pursuant to SEC Release  No. 33-8238. |

 

----

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

 

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**SIGNATURES**

 

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

 
| Date: November 3, 2009 |       | NETLIST, INC.                               |
|-----------------------------|------------|---------------------------------------------|
|                        |       | a Delaware corporation                      |
|                        |       | (Registrant)                                |
|                        |       |                                        |
|                        | By:        | /s/ Chun K. Hong                            |
| ** **                  | ** ** | **Chun K. Hong**                            |
| ** **                  | ** ** | **President, Chief Executive  Officer and** |
| ** **                  | ** ** | **Chairman of the Board**                   |
| ** **                  | ** ** | **(Principal Executive Officer)**           |
|                        |       |                                        |
|                        |       |                                        |
|                        | By:        | /s/ Gail Itow                               |
| ** **                  | ** ** | **Gail Itow**                               |
| ** **                  | ** ** | **Vice President and Chief  Financial**     |
| ** **                  | ** ** | **Officer**                                 |
| ** **                  | ** ** | **(Principal Financial Officer)**           |

 

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**EXHIBIT INDEX**

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

 

----

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

 

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