Table ofContents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

** **

**(MarkOne)**

 
| **x** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|--------------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended July 3, 2010**

 

**or**

 
| **o** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|---------------------------------------------------------------------------------------------------------|

 

**For the transition period from            to         **

 

**Commission file number 001-33170**

 

 

**NETLIST, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**51 Discovery, Suite 150**

**Irvine, CA 92618**

(Address of principal executive offices) (Zip Code)

 

**(949) 435-0025**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that 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 such files).  Yes o  No o

 

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

 

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

 

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

 

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

 

Common Stock, par value $0.001 per share

25,266,327 shares outstanding at July 30, 2010

 

 

 

----

Table ofContents

 

**NETLIST, INC. AND SUBSIDIARIES**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE THREE AND SIX MONTHS ENDED JULY 3, 2010**

 

**TABLE OF CONTENTS**

 
| ** **    | ** **   | ** **                                                                                                                       | ** **   | **Page**     |
|---------------|--------------|----------------------------------------------------------------------------------------------------------------------------------|--------------|--------------|
| PART I.  |         | FINANCIAL INFORMATION                                                                                                            |         | 3            |
| Item 1.       |         | Financial Statements                                                                                                             |         | 3            |
| *** ***  |         | Condensed Consolidated Balance Sheets at July 3,  2010 (unaudited) and January 2, 2010 (audited)                       |         | 3            |
| *** ***  |         | Unaudited Condensed Consolidated Statements of  Operations for the Three and Six Months Ended July 3, 2010 and July 4, 2009 |         | 4            |
| *** ***  |         | Unaudited Condensed Consolidated Statements of Cash  Flows for the Six Months Ended July 3, 2010 and July 4, 2009                |         | 5            |
| *** ***  |         | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                  |         | 6            |
| Item 2.       |         | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                      |         | 22           |
| Item 4T.      |         | Controls and  Procedures                                                                                                         |         | 34           |
| *** ***  | *** *** | *** ***                                                                                                                     | *** *** | *** *** |
| PART II. |         | OTHER INFORMATION                                                                                                                |         | 35           |
| Item 1.       |         | Legal Proceedings                                                                                                                |         | 35           |
| Item 6.       |         | Exhibits                                                                                                                         |         | 35           |

 

2

----

Table ofContents

 

**PART I.FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**NETLIST, INC. ANDSUBSIDIARIES**

**Condensed Consolidated BalanceSheets**

**(in thousands, except par value)**

** **
| ** **                                                                                                                | ** ** | **(unaudited)** | ** ** | **(audited)**  | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|----------------|------------|
| ** **                                                                                                                | ** ** | **July 3,**     | ** ** | **January 2,** | ** ** |
| ** **                                                                                                                | ** ** | **2010**        | ** ** | **2010**       | ** ** |
| **ASSETS**                                                                                                                |       |            | ** ** | ** **     | ** ** |
| Current assets:                                                                                                           |       |            |       |           |       |
| Cash and cash equivalents                                                                                                 |       | $               | 16,993     |           | $          | 9,942 |   |
| Investments in marketable securities                                                                                      |       | 5,211           |       | 3,949          |       |
| Accounts receivable, net                                                                                                  |       | 7,119           |       | 4,273          |       |
| Inventories                                                                                                               |       | 4,259           |       | 2,232          |       |
| Prepaid expenses and other current assets                                                                                 |       | 687             |       | 854            |       |
| Total current assets                                                                                                      |       | 34,269          |       | 21,250         |       |
|                                                                                                                      |       |            |       |           |       |
| Property and equipment, net                                                                                               |       | 4,085           |       | 4,779          |       |
| Long-term investments in marketable securities                                                                            |       | 902             |       | 941            |       |
| Other assets                                                                                                              |       | 242             |       | 221            |       |
| Total assets                                                                                                              |       | $               | 39,498     |           | $          | 27,191 |   |
|                                                                                                                      |       |            |       |           |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                            |       |            |       |           |       |
| Current liabilities:                                                                                                      |       |            |       |           |       |
| Accounts payable                                                                                                          |       | $               | 6,179      |           | $          | 4,057 |   |
| Accrued payroll and related liabilities                                                                                   |       | 1,839           |       | 2,332          |       |
| Accrued expenses and other current liabilities                                                                            |       | 507             |       | 605            |       |
| Accrued engineering charges                                                                                               |       | 1,431           |       | 661            |       |
| Current portion of long-term debt                                                                                         |       | 92              |       | 108            |       |
| Deferred gain on sale and leaseback transaction                                                                           |       | 49              |       | 108            |       |
| Total current liabilities                                                                                                 |       | 10,097          |       | 7,871          |       |
| Long-term debt, net of current portion                                                                                    |       | 10              |       | 51             |       |
| Total liabilities                                                                                                         |       | 10,107          |       | 7,922          |       |
| Commitments and contingencies                                                                                             |       |            |       |           |       |
| Stockholders’ equity:                                                                                                |       |            |       |           |       |
| Common stock, $0.001 par value - 90,000 shares  authorized; 25,266 (2010) and 20,111 (2009) shares issued and outstanding |       | 25              |       | 20             |       |
| Additional paid-in capital                                                                                                |       | 88,435          |       | 71,332         |       |
| Accumulated deficit                                                                                                       |       | (58,965         | )          | (52,026        | )          |
| Accumulated other comprehensive loss                                                                                      |       | (104            | )          | (57            | )          |
| Total stockholders’ equity                                                                                           |       | 29,391          |       | 19,269         |       |
| Total liabilities and stockholders’ equity                                                                           |       | $               | 39,498     |           | $          | 27,191 |   |

 

Seeaccompanying notes.

 

3

----

Table ofContents

 

**NETLIST, INC. ANDSUBSIDIARIES**

**Unaudited Condensed ConsolidatedStatements of Operations**

**(in thousands, except per share amounts)**

 
| ** **                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                       | ** ** | **July 3,**            | ** ** | **July 4,**          | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **                                       | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                             | ** ** | ** **             |       |                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                        |       | $                      | 9,304      |                 | $          | 3,173 |   | $ | 17,194 |   | $ | 5,335 |   |
| Cost of sales(1)                                 |       | 7,486                  |       | 2,929                |       | 13,558 |   | 5,628 |   |
| Gross profit (loss)                              |       | 1,818                  |       | 244                  |       | 3,636 |   | (293 | ) |
| Operating expenses:                              |       |                   |       |                 |       |   |   |   |   |
| Research and development(1)                      |       | 3,190                  |       | 2,030                |       | 6,198 |   | 3,644 |   |
| Selling, general and administrative(1)           |       | 2,607                  |       | 2,120                |       | 5,177 |   | 4,055 |   |
| Total operating expenses                         |       | 5,797                  |       | 4,150                |       | 11,375 |   | 7,699 |   |
| Operating loss                                   |       | (3,979                 | )          | (3,906               | )          | (7,739 | ) | (7,992 | ) |
| Other income (expense):                          |       |                   |       |                 |       |   |   |   |   |
| Interest income, net                             |       | 3                      |       | 18                   |       | 4 |   | 100 |   |
| Other income (expense), net                      |       | 4                      |       | (45                  | )          | 71 |   | 130 |   |
| Total other income (expense), net                |       | 7                      |       | (27                  | )          | 75 |   | 230 |   |
| Loss before provision (benefit) for income taxes |       | (3,972                 | )          | (3,933               | )          | (7,664 | ) | (7,762 | ) |
| Provision (benefit) for income taxes             |       | 2                      |       | 31                   |       | (725 | ) | 49 |   |
| Net loss                                         |       | $                      | (3,974     | )                    | $          | (3,964 | ) | $ | (6,939 | ) | $ | (7,811 | ) |
| Net loss per common share:                       |       |                   |       |                 |       |   |   |   |   |
| Basic and diluted                                |       | $                      | (0.16      | )                    | $          | (0.20 | ) | $ | (0.31 | ) | $ | (0.39 | ) |
|                                             |       |                   |       |                 |       |   |   |   |   |
| Weighted-average common shares outstanding:      |       |                   |       |                 |       |   |   |   |   |
| Basic and diluted                                |       | 24,780                 |       | 19,855               |       | 22,734 |   | 19,855 |   |

 

----

(1)  Amounts include stock-basedcompensation expense as follows:

 
| Cost of sales                       |   | $   | 12     |   | $      | 38  |   | $   | 22     |   | $ | 67 |   |
|-------------------------------------|--------|-----|--------|--------|--------|-----|--------|-----|--------|--------|---|----|--------|
| Research and development            |   | 117 |   | 48     |   | 163 |   | 106 |   |
| Selling, general and administrative |   | 297 |   | 204    |   | 623 |   | 424 |   |

 

See accompanying notes.

 

4

----

Table ofContents

 

**NETLIST, INC. AND SUBSIDIARIES**

**Unaudited Condensed ConsolidatedStatements of Cash Flows**

**(in thousands)**

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                   | ** ** | **July 3,**          | ** ** | **July 4,** | ** ** |
| ** **                                                                   | ** ** | **2010**             | ** ** | **2009** | ** ** |
|                                                                         | ** ** | ** **           | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                        | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                    | (6,939     | ) | $ | (7,811 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                 |       |   |   |
| Depreciation and amortization                                                |       | 1,130                |       | 1,150 |   |
| Amortization of deferred gain on sale and  leaseback transaction             |       | (59                  | )          | (59 | ) |
| Gain on disposal of assets                                                   |       | —               |       | (118 | ) |
| Stock-based compensation                                                     |       | 808                  |       | 597 |   |
| Changes in operating assets and liabilities:                                 |       |                 |       |   |   |
| Accounts receivable                                                          |       | (2,846               | )          | 394 |   |
| Inventories                                                                  |       | (2,027               | )          | (125 | ) |
| Income taxes receivable                                                      |       | —               |       | 1,229 |   |
| Prepaid expenses and other current assets                                    |       | 167                  |       | 2 |   |
| Other assets                                                                 |       | (21                  | )          | 13 |   |
| Accounts payable                                                             |       | 2,078                |       | 669 |   |
| Accrued payroll and related expenses                                         |       | (493                 | )          | 35 |   |
| Accrued expenses and other current liabilities                               |       | (98                  | )          | 84 |   |
| Accrued engineering charges                                                  |       | 770                  |       | 511 |   |
| Net cash used in operating activities                                        |       | (7,530               | )          | (3,429 | ) |
| Cash flows from investing activities:                                        |       |                 |       |   |   |
| Acquisition of property and equipment                                        |       | (392                 | )          | (56 | ) |
| Proceeds from sales of equipment                                             |       | —               |       | 342 |   |
| Purchase of investments in marketable securities                             |       | (2,380               | )          | (10,203 | ) |
| Proceeds from maturities and sales of investments  in marketable securities  |       | 1,110                |       | 6,325 |   |
| Net cash used in investing activities                                        |       | (1,662               | )          | (3,592 | ) |
| Cash flows from financing activities:                                        |       |                 |       |   |   |
| Borrowings on line of credit                                                 |       | 2,000                |       | 10,325 |   |
| Payments on line of credit                                                   |       | (2,000               | )          | (8,172 | ) |
| Proceeds from public offering, net                                           |       | 16,210               |       | — |   |
| Proceeds from exercise of stock options and  warrants                        |       | 90                   |       | — |   |
| Payments on debt                                                             |       | (57                  | )          | (240 | ) |
| Net cash provided by financing activities                                    |       | 16,243               |       | 1,913 |   |
| Increase (decrease) in cash and cash equivalents                             |       | 7,051                |       | (5,108 | ) |
| Cash and cash equivalents at beginning of period                             |       | 9,942                |       | 15,214 |   |
| Cash and cash equivalents at end of period                                   |       | $                    | 16,993     |   | $ | 10,106 |   |
|                                                                         |       |                 |       |   |   |
| Supplemental disclosure of non-cash investing  activities:                   |       |                 |       |   |   |
| Unrealized losses (gains) from investments in  marketable securities         |       | $                    | 47         |   | $ | (38 | ) |
| Increase in purchases of property and equipment  accrued in accounts payable |       | $                    | 44         |   | $ | — |   |

 

See accompanying notes.

 

5

----

Table ofContents

 

**NETLIST, INC. ANDSUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**July 3, 2010**

 

**Note 1—Description of Business**

 

Netlist, Inc. (the “Company” or “Netlist”) designs, manufacturesand sells high-performance, logic-based memory subsystems for the server,storage and communications equipment markets. The Company’s memory subsystemsconsist of combinations of dynamic random access memory integrated circuits,NAND flash memory, application-specific integrated circuits (“ASICs”) and othercomponents assembled on printed circuit boards. The Company primarily markets and sells its products to leading originalequipment manufacturer (“OEM”) customers. Netlist’s solutions are targeted atapplications where memory plays a key role in meeting system performancerequirements.

 

**Note 2—Summary of Significant Accounting Policies**

 

*Basis ofPresentation*

 

Theinterim unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (the “U.S.”) for interim financial information andwith the instructions to Securities and Exchange Commission (“SEC”)Form 10-Q and Article 8 of SEC Regulation S-X. These financialstatements do not include all of the information and footnotes required byaccounting principles generally accepted in the U.S. for complete financialstatements. Therefore, these unaudited condensed consolidated financialstatements should be read in conjunction with the Company’s auditedconsolidated financial statements and notes thereto for the year endedJanuary 2, 2010, included in the Company’s Annual Report on Form 10-Kfiled with the SEC on February 19, 2010.

 

Thecondensed consolidated financial statements included herein as of July 3,2010 are unaudited; however, they contain all normal recurring accruals andadjustments that, in the opinion of the Company’s management, are necessary topresent fairly the condensed consolidated financial position of the Company andits wholly owned subsidiaries as of July 3, 2010, the condensedconsolidated results of its operations for the three and six months ended July 3,2010 and July 4, 2009, and the condensed consolidated cash flows for thesix months ended July 3, 2010 and July 4, 2009.  The results of operations for the three andsix months ended July 3, 2010 are not necessarily indicative of theresults to be expected for the full year or any future interim periods.

 

*Reclassifications*

 

Certainamounts in the 2009 financial statements have been reclassified to conform withthe current year presentation.

 

*Principlesof Consolidation*

 

The condensed consolidated financial statementsinclude the accounts of Netlist, Inc. and its wholly owned subsidiaries.All intercompany balances and transactions have been eliminated inconsolidation.

 

*FiscalYear*

 

TheCompany operates under a 52/53-week fiscal year ending on the Saturday closestto December 31.  For fiscal 2010, theCompany’s fiscal year is scheduled to end on January 1, 2011 and willconsist of 52 weeks. Each of the Company’s first three quarters in a fiscalyear is comprised of 13 weeks.

 

*Use ofEstimates*

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the U.S. requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the condensedconsolidated financial statements, and the reported amounts of net sales andexpenses during the reporting period. By their nature, these estimates andassumptions are subject to an inherent degree of uncertainty.  Significant estimates made by managementinclude, among others, provisions for uncollectible receivables and salesreturns, warranty liabilities, valuation of inventories, fair value offinancial instruments, impairment of long-lived assets, stock-basedcompensation expense and realization of deferred tax assets. The Company basesits estimates on historical experience, knowledge of current conditions and ourbeliefs of what could occur in the future considering availableinformation.  The Company reviews itsestimates on an on-going basis. The actual results experienced by the Companymay differ materially and adversely from its estimates. To the extent there arematerial differences between the estimates and the actual results, futureresults of operations will be affected.

 

6

----

Table of Contents

 

*RevenueRecognition*

 

TheCompany’s revenues primarily consist of product sales of high-performancememory subsystems to OEMs. Revenues also include sales of excess componentinventories to distributors and other users of memory integrated circuits (“ICs”).  Such sales amounted to less than $0.1 millionfor each of the three and six months ended July 3, 2010, and totaledapproximately $0.1 million for each of the three and six months ended July 4,2009.

 

TheCompany recognizes revenues in accordance with the Financial AccountingStandards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic605.  Accordingly, the Company recognizesrevenues when there is persuasive evidence of an arrangement, product deliveryand acceptance have occurred, the sales price is fixed or determinable, andcollectibility of the resulting receivable is reasonably assured.

 

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 to30 days, except for sales of excess component inventories, which containno right-of-return privileges. Estimated returns are provided for at the timeof sale based on historical experience or specific identification of an eventnecessitating a reserve. The Company offers a standard product warranty to itscustomers and has no other post-shipment obligations. The Company assessescollectibility based on the creditworthiness of the customer as determined bycredit checks and evaluations, as well as the customer’s payment history.

 

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 andCash Equivalents*

 

Cashand cash equivalents consist of cash and short-term investments with originalmaturities of three months or less, other than short-term investments insecurities that lack an active market.

 

*Investmentsin Marketable Securities*

 

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, 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 U.S. municipalities,corporations and the U.S. government and its agencies. All highly liquid investmentswith stated 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.

 

*FairValue of Financial Instruments*

 

TheCompany’s financial instruments consist principally of cash and cashequivalents, investments in marketable securities, accounts receivable,accounts payable, accrued expenses and debt instruments.  Other than for certain investments in auctionrate securities (see Note 4) commercial paper and short-term corporate bonds,the fair value of the Company’s cash equivalents and investments in marketablesecurities is determined based on quoted prices in active markets for identicalassets or Level 1 inputs.  Because oftheir short-term nature, commercial paper and short-term corporate bonds arenot frequently traded.  Although thereare observable quotes for these securities, the markets are not consideredactive.  Accordingly, the fair values ofthese investments are based on Level 2 inputs. The Company recognizes transfers between Levels 1 through 3 of the fairvalue hierarchy at the beginning of the reporting period.  The Company believes that the carrying valuesof all other financial instruments approximate their current fair values due totheir nature and respective durations.

 

7

----

Tableof Contents

 

*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 based on the termsof the originating transaction, the current business environment and itshistorical experience.  Uncollectibleaccounts are charged against the allowance for doubtful accounts when all costeffective commercial means of collection have been exhausted.

 

*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 its cash equivalents primarilyin money market funds.  Cash equivalentsare maintained with high quality institutions, the composition and maturitiesof which are regularly monitored by management. The Company had $0.5 million ofFederal Deposit Insurance Corporation insured cash and cash equivalents at July 3,2010.  Investments in marketablesecurities are generally in high-credit quality debt instruments with an activeresale market. Such investments are made only in instruments issued or enhancedby high-quality institutions.  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 creditevaluations of its customers’ financial condition and limits the amount ofcredit extended when deemed necessary, but generally requires no collateral.The Company believes that the concentration of credit risk in its tradereceivables is moderated by its credit evaluation process, relatively shortcollection terms, the high level of credit worthiness of its customers (seeNote 3), and foreign credit insurance. Reserves are maintained for potentialcredit losses, and such losses historically have not been significant and havebeen within management’s expectations.

 

*Inventories*

 

Inventoriesare valued at the lower of actual cost to purchase or manufacture the inventoryor net realizable value of the inventory. Cost is determined on an average costbasis which approximates actual cost on a first-in, first-out basis andincludes raw materials, labor and manufacturing overhead.  At each balance sheet date, the Companyevaluates its ending inventory quantities on hand and on order and records aprovision for excess quantities and obsolescence. Among other factors, theCompany considers historical demand and forecasted demand in relation to theinventory on hand, competitiveness of product offerings, market conditions andproduct life cycles when determining obsolescence and net realizable value ofraw material inventory. Provisions are made to reduce excess or obsoleteinventories to their estimated net realizable values. Once established,write-downs are considered permanent adjustments to the cost basis of theexcess or obsolete inventories.

 

*Propertyand Equipment*

 

Property and equipment are recorded at cost anddepreciated on a straight-line basis over their estimated useful lives, whichgenerally range from three to seven years. Leasehold improvements are recordedat cost and amortized on a straight-line basis over the shorter of theirestimated useful lives or the remaining lease term.

 

*Impairment of Long-Lived Assets*

 

The Company evaluates the recoverability of the carrying value oflong-lived assets held and used in its operations for impairment on at least anannual basis or whenever events or changes in circumstances indicate that theirnet book value may not be recoverable. When such factors and circumstances exist, the Company compares theprojected undiscounted future net cash flows associated with the related assetor group of assets over their estimated useful lives against their respectivecarrying amount.  These projected futurecash flows may vary significantly over time as a result of increasedcompetition, changes in technology, fluctuations in demand, consolidation ofour customers and reductions in average selling prices.  If the carrying value is determined not to berecoverable from future operating cash flows, the asset is deemed impaired andan impairment loss is recognized to the extent the carrying value exceeds theestimated fair value of the asset.  Thefair value of the asset or asset group is based on market value when available,or when unavailable, on discounted expected cash flows.

 

8

----

Table ofContents

 

*Warranties*

 

TheCompany offers warranties generally ranging from one to three years, dependingon the product and negotiated terms of the purchase agreements withcustomers.  Such warranties require theCompany to repair or replace defective product returned to the Company duringthe warranty period at no cost to the customer. Warranties are not offered onsales of excess component inventory.  TheCompany records an estimate for warranty-related costs at the time of salebased on its historical and estimated product return rates and expected repairor replacement costs (see Note 3). Such costs have historically been consistentbetween periods and within management’s expectations and the provisionsestablished.

 

*Stock-BasedCompensation*

 

The Company accounts 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.

 

In accordance with ASC Topic 718, employee anddirector stock-based compensation expense recognized during the period is basedon the value of the portion of stock-based payment awards that is ultimatelyexpected to vest during the period. Given that stock-based compensation expense recognized in the condensedconsolidated statements of operations is based on awards ultimately expected tovest, it has been reduced for estimated forfeitures. ASC Topic 718 requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. TheCompany’s estimated average forfeiture rates are based on historical forfeitureexperience and estimated future forfeitures.

 

The fair value of common stock option awards toemployees and directors is calculated using the Black-Scholes option pricingmodel. The Black-Scholes model requires subjective assumptions regarding futurestock price volatility and expected time to exercise, along with assumptionsabout the risk-free interest rate and expected dividends, which affect theestimated fair values of the Company’s common stock option awards.  The expected term of options granted iscalculated as the average of the weighted vesting period and the contractualexpiration date of the option.  Thiscalculation is based on the safe harbor method permitted by the SEC ininstances where the vesting and exercise terms of options granted meet certainconditions and where limited historical exercise data is available.  Prior to fiscal 2009, the expected volatilitywas based on the historical volatilities of the common stock of comparablepublicly traded companies based on management’s belief that the Company hadlimited historical data regarding the volatility of its stock price on which tobase a meaningful estimate of expected volatility. Beginning in fiscal 2009,the expected volatility is based on the historical volatility of the Company’scommon stock.  The risk-free rateselected to value any particular grant is based on the U.S. 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 and management’sexpectation regarding dividend payouts. Compensation expense for common stock option awards with graded vestingschedules is recognized on a straight-line basis over the requisite serviceperiod for the last separately vesting portion of the award.

 

The Company recognizes the fair value of restrictedstock awards issued to employees and outside directors as stock-basedcompensation expense on a straight-line basis over the vesting period for thelast separately vesting portion of the awards. Fair value is determined as the difference between the closing price ofour common stock on the grant date and the purchase price of the restrictedstock award, if any, reduced by expected forfeitures.

 

*IncomeTaxes*

 

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 valuationallowances and effects of changes in tax laws or rates, in the interim periodin which they occur. In addition, jurisdictions with a projected loss for theyear or a year-to-date loss where no tax benefit can be recognized are excludedfrom the estimated annual effective tax rate. The impact of such an exclusioncould result in a higher or lower effective tax rate during a particularquarter, based upon the mix and timing of actual earnings versus annualprojections.

 

Deferred tax assets and liabilities are recognizedto reflect the estimated future tax effects, calculated at currently effectivetax rates, of future deductible or taxable amounts attributable to events thathave been recognized on a cumulative basis in the condensed consolidatedfinancial statements.  A valuationallowance related to a net deferred tax asset is recorded when it is morelikely than not that some portion of the deferred tax asset will not berealized.

 

9

----

Table ofContents

 

ASC Topic 740 prescribes a recognition threshold andmeasurement requirement for the financial statement recognition of a taxposition that has been taken or is expected to be taken on a tax return andalso provides guidance on de-recognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition. Under ASCTopic 740 the Company may only recognize or continue to recognize tax positionsthat meet a “more likely than not” threshold.

 

*Researchand Development Expenses*

 

Research and development expenditures are expensed in the periodincurred.

 

*Collaborative Arrangement*

 

TheCompany has entered into a collaborative arrangement with a partner in order todevelop products using certain of the Company’s proprietary technology.  Under the arrangement, the developmentpartner was granted a non-exclusive license to specified intellectual propertyfor exclusive use in the development and production of ASIC chipsets for theCompany.  Both the Company and thedevelopment partner provided and continue to provide engineering projectmanagement resources at their own expense. The development partner is entitled to non-recurring engineering fees basedupon the achievement of development milestones, and to a minimum portion of theCompany’s purchasing allocations for the component.  Expenses incurred and paid to the developmentpartner are included in research and development expense in the accompanyingcondensed consolidated statements of operations.

 

*Comprehensive Loss*

 

ASC Topic 220 establishes standards for reporting and displayingcomprehensive income and its components in the condensed consolidated financialstatements. Accumulated other comprehensive loss includes unrealized gains orlosses on investments.

 

*Risksand Uncertainties*

 

The Company’s operations in the PRC are subject tovarious political, geographical and economic risks and uncertainties inherentto conducting business in China. These include, but are not limited to,(i) potential changes in economic conditions in the region,(ii) managing a local workforce that may subject the Company touncertainties or certain regulatory policies, (iii) changes in otherpolicies of the Chinese governmental and regulatory agencies, and (iv) changesin the laws and policies of the U.S. government regarding the conduct ofbusiness in foreign countries, generally, or in China, in particular.  Additionally, the Chinese government controlsthe procedures by which its local currency, the Chinese Renminbi (“RMB”), isconverted into other currencies and by which dividends may be declared orcapital distributed for the purpose of repatriation of earnings andinvestments.  If restrictions in theconversion of RMB or in the repatriation of earnings and investments throughdividend and capital distribution restrictions are instituted, the Company’soperations and operating results may be negatively impacted.  Restricted net assets of our subsidiary inthe PRC totaled $2.7 million at both July 3, 2010 and January 2,2010.

 

*ForeignCurrency Re-measurement*

 

Thefunctional currency of the Company’s foreign subsidiary is the U.S. dollar.Local currency financial statements are re-measured into U.S. dollars at theexchange rate in effect as of the balance sheet date for monetary assets andliabilities and the historical exchange rate for nonmonetary assets andliabilities. Expenses are re-measured using the average exchange rate for theperiod, except items related to nonmonetary assets and liabilities, which arere-measured using historical exchange rates. All re-measurement gains andlosses are included in determining net loss.

 

*Net LossPer Share*

 

Basic net loss per share is calculated by dividing net loss by the weighted-averagecommon shares outstanding during the period, excluding unvested shares issuedpursuant to restricted share awards under our share-based compensationplans.  Diluted net loss per share iscalculated by dividing the net loss by the weighted-average shares and dilutivepotential common shares outstanding during the period. Dilutive potentialshares consist of dilutive shares issuable upon the exercise or vesting ofoutstanding stock options and restricted stock awards, respectively, and theexercise of warrants, computed using the treasury stock method.  In periods of losses, basic and diluted lossper share are the same, as the effect of stock options, unvested restrictedshare awards and warrants on loss per share is anti-dilutive.

 

10

----

Table of Contents

 

*NewAccounting Pronouncements*

 

InSeptember 2009, the FASB issued Accounting Standards Update (“ASU”)2009-13, *Multiple-Deliverable Revenue Arrangements*(“ASU 2009-13”), which amends the revenue guidance under ASC Topic 605, whichdescribes the accounting for multiple element arrangements.  ASU 2009-13 addresses how to determinewhether an arrangement involving multiple deliverables contains more than oneunit of accounting and how arrangement consideration shall be measured andallocated to the separate units of accounting in the arrangement.  ASU 2009-13 is effective on a prospective basisfor the Company’s fiscal year 2011, with earlier adoption permitted.  The Company is currently evaluating theadoption of ASU 2009-13 and the impact that ASU 2009-13 will have on itscondensed consolidated financial statements.

 

InSeptember 2009, the FASB issued ASU 2009-14, *CertainRevenue Arrangements That Include Software Elements* (“ASU 2009-14”),which excludes tangible products containing software components andnon-software components that function together to deliver the product’sessential functionality from the scope of ASC Topic 985, which describes theaccounting for software revenue recognition. ASU 2009-14 is effective on a prospective basis for the Company’s fiscalyear 2011, with earlier adoption permitted. The Company is currently evaluating the impact that ASU 2009-14 will haveon its condensed consolidated financial statements.

 

**Note3—Supplemental Financial Information**

 

*Inventories*

 

Inventoriesconsist of the following (in thousands):

 
| ** **      | ** ** | **July 3,** | ** ** | **January 2,** | ** ** |
|-----------------|------------|------------------|------------|---------------------|------------|
| ** **      | ** ** | **2010**         | ** ** | **2010**            | ** ** |
|            |       |             |       |                |       |
| Raw materials   |       | $                | 2,334      |                | $          | 997 |   |
| Work in process |       | 656              |       | 342                 |       |
| Finished goods  |       | 1,269            |       | 893                 |       |
|            |       | $                | 4,259      |                | $          | 2,232 |   |

 

*Warranty Liability*

 

Thefollowing table summarizes the activity related to the warranty liability (inthousands):

 
| ** **                    | ** ** | **Six Months Ended** | ** ** |
|-------------------------------|------------|----------------------|------------|
| ** **                    | ** ** | **July 3,**     | ** ** | **July 4,** | ** ** |
| ** **                    | ** ** | **2010**             | ** ** | **2009** | ** ** |
|                          |       |                 |       |   |   |
| Beginning balance             |       | $                    | 240        |   | $ | 277 |   |
| Charged to costs and expenses |       | 81                   |       | 92 |   |
| Usage                         |       | (111                 | )          | (108 | ) |
| Ending balance                |       | $                    | 210        |   | $ | 261 |   |

 

Thewarranty liability is included as a component of accrued expenses and othercurrent liabilities in the accompanying condensed consolidated balance sheets.

 

11

----

Table of Contents

 

*Facility Relocation Costs*

 

Thefollowing table summarizes the activity related to the Company’s accrual forfacility relocation costs during the six months ended July 3, 2010 and July 4,2009 (in thousands):

 
| ** **                             | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------|------------|----------------------|------------|
| ** **                             | ** ** | **July 3,**     | ** ** | **July 4,** | ** ** |
| ** **                             | ** ** | **2010**             | ** ** | **2009** | ** ** |
|                                   |       |                 |       |   |   |
| Beginning balance                      |       | $                    | 84         |   | $ | 80 |   |
| (Reduction) increase in expected costs |       | (28                  | )          | 61 |   |
| Net payments                           |       | (6                   | )          | (17 | ) |
| Ending balance                         |       | $                    | 50         |   | $ | 124 |   |

 

In May 2009, the Company entered into an agreement to sublease aportion of its new domestic headquarters facility to another tenant at adiscount from the rent required under its lease commitment.  As a result, the Company recorded anadditional charge of approximately $61,000. In February 2010, the sublessor vacated the space that it hadsubleased.  The Company determined thatthe space could be used in its operations. As a result, the Company reversed $28,000 of its accrual for facilityrelocation costs.  The resulting expenseincrease and reduction are included as a component of selling, general andadministrative expenses in the accompanying condensed consolidated statement ofoperations for the six months ended July 3, 2010 and July 4, 2009.

 

Theliability for facility relocation costs is included as a component of accruedexpenses and other current liabilities in the accompanying condensedconsolidated balance sheets.

 

*ComprehensiveLoss*

 

Thecomponents of comprehensive loss, net of taxes, consist of the following (inthousands):

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                       | ** ** | **July 3,**       | ** ** | **July 4,**     | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **                                                       | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                             |       |                   |       |                 |       |   |   |   |   |
| Net loss                                                         |       | $                      | (3,974     | )                    | $          | (3,964 | ) | $ | (6,939 | ) | $ | (7,811 | ) |
| Other comprehensive loss:                                        |       |                   |       |                 |       |   |   |   |   |
| Change in net unrealized gain (loss) on  investments, net of tax |       | (12                    | )          | 6                    |       | (47 | ) | 38 |   |
| Total comprehensive loss                                         |       | $                      | (3,986     | )                    | $          | (3,958 | ) | $ | (6,986 | ) | $ | (7,773 | ) |

 

Accumulatedother comprehensive loss reflected on the condensed consolidated balance sheetsat July 3, 2010 and January 2, 2010, represents accumulated netunrealized losses on investments in marketable securities.

 

*Computation of Net Loss Per Share*

 

Basicand diluted net loss per share is calculated by dividing net loss by theweighted-average common shares outstanding during the period. The followingtable sets forth the computation of net loss per share (in thousands, exceptper share data):

 
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                  | ** ** | **July 3,**       | ** ** | **July 4,**     | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **                                                                  | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                  | ** ** | ** **             | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator: Net loss                                                         |       | $                      | (3,974     | )                    | $          | (3,964 | ) | $ | (6,939 | ) | $ | (7,811 | ) |
| Denominator: Weighted-average common shares  outstanding, basic and diluted |       | 24,780                 |       | 19,855               |       | 22,734 |   | 19,855 |   |
| Net loss per share, basic and diluted                                       |       | $                      | (0.16      | )                    | $          | (0.20 | ) | $ | (0.31 | ) | $ | (0.39 | ) |

 

12

----

Tableof Contents

 

Thefollowing table sets forth potentially dilutive common share equivalents,consisting of shares issuable upon the exercise or vesting of outstanding stockoptions and restricted stock awards, respectively, and the exercise ofwarrants, computed using the treasury stock method.  These potential common shares have beenexcluded from the diluted net loss per share calculations above as their effectwould be anti-dilutive for the periods then ended (in thousands):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|------------------------|------------|----------------------|------------|
| ** **               | ** ** | **July 3,**       | ** ** | **July 4,**     | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **               | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Common share equivalents |       | 1,798                  |       | 388                  |       | 2,070 |   | 277 |   |

 

Theabove common share equivalents would have been included in the calculation ofdiluted earnings per share had the Company reported net income for the periodsthen ended.

 

*Major Customers*

 

Netsales to some of the Company’s OEM customers include memory modules that arequalified by the Company directly with the OEM customer and sold to electronicmanufacturing services providers (“EMSs”), for incorporation into productsmanufactured exclusively for the OEM customer or in some instances, tofacilitate credit and logistics. These net sales to EMSs have historicallyfluctuated period to period as a portion of the total net sales to the OEMcustomers.  Net sales to Hon HaiPrecision Industry Co. Ltd., an EMS operating under the trade name Foxconn thatpurchases memory modules from the Company for incorporation into productsmanufactured exclusively for Dell, Inc. (“Dell”), representedapproximately 92% and 58% of net sales to Dell for the six months ended July 3,2010 and July 4, 2009, respectively. Arrow Electronics Inc. (“Arrow”) is an EMS for DRS Electronics, Inc.(“DRS Electronics”).  Substantially allof the Company’s products sold to Arrow are incorporated into componentsmanufactured for DRS Electronics. Similarly, Flextronics International Ltd. (“Flextronics”) distributessubstantially all of the products purchased from the Company to F5 Networks, Inc.(“F5 Networks”).  The following tablesets forth sales to customers comprising 10% or more of the Company’s net salesfor the periods presented:

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                          | ** ** | **July 3,**       | ** ** | **July 4,**     | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **                          | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Customer:**                       | ** ** | ** **             | ** ** | ** **           |       |   |   | ** ** |   |
| Dell (including Foxconn)            |       | 49                     | %          | 60                   | %          | 44 | % | 49 | % |
| Flextronics (F5 Networks)           |       | 32                     | %          | *                    | %          | 32 | % | * | % |
| Arrow Electronics (DRS Electronics) |       | *                      | %          | 15                   | %          | * | % | 17 | % |

 

----

*  less than 10% of net sales

 

TheCompany’s accounts receivable are concentrated with two customers at July 3,2010 representing approximately 48% and 40%, and two customers at January 2,2010, representing approximately 68% and 10%, of aggregate gross receivables. Asignificant reduction in sales to, or the inability to collect receivablesfrom, a significant customer could have a material adverse impact on theCompany.  The Company mitigates riskassociated with foreign receivables by purchasing comprehensive foreign creditinsurance.

 

*Cash Flow Information*

 

Thefollowing table sets forth cash received (paid) for income taxes and interestfor the periods presented (in thousands):

 
| ** **   | ** ** | **Six Months Ended** | ** ** |
|--------------|------------|----------------------|------------|
| ** **   | ** ** | **July 3,**     | ** ** | **July 4,** | ** ** |
| ** **   | ** ** | **2010**             | ** ** | **2009** | ** ** |
|         |       |                 |       |   |   |
| Income taxes |       | $                    | 725        |   | $ | (12 | ) |
| Interest     |       | $                    | (36        | ) | $ | (29 | ) |

 

13

----

Table ofContents

 

**Note4—Fair Value Measurements**

 

Thefollowing tables detail the fair value measurements within the fair valuehierarchy of the Company’s investments in marketable securities (in thousands):

 
| ** **                               | ** ** | ** **                            | ** ** | **Fair Value Measurements at July 3, 2010 Using**                 | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Fair Value at  July 3,  2010** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets  (Level 1)** | ** ** | **Significant  Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
| ** **                               | ** ** | ** **                            | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Available for sale debt securities:      | ** ** | ** **                            | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Obligations of the U.S. government       |       | $                                     | 1,000      |                                                                   | $          | 1,000 |   | $ | — |   | $ | — |   |
| Federal agency notes and bonds           |       | 500                                   |       | 500                                                                    |       | — |   | — |   |
| Commercial paper                         |       | 1,049                                 |       | —                                                                 |       | 1,049 |   | — |   |
| Corporate notes and bonds                |       | 2,662                                 |       | —                                                                 |       | 2,662 |   | — |   |
| Auction and variable floating rate notes |       | 902                                   |       | —                                                                 |       | — |   | 902 |   |
| Total                                    |       | $                                     | 6,113      |                                                                   | $          | 1,500 |   | $ | 3,711 |   | $ | 902 |   |

 
| ** **                               | ** ** | ** **                               | ** ** | **Fair Value Measurements at January 2, 2010  Using**             | ** ** |
|------------------------------------------|------------|------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Fair Value at  January 2,  2010** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets  (Level 1)** | ** ** | **Significant  Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
| ** **                               | ** ** | ** **                               | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Available for sale debt securities:      | ** ** | ** **                               | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Obligations of the U.S. government       |       | $                                        | 997        |                                                                   | $          | 997 |   | $ | — |   | $ | — |   |
| Federal agency notes and bonds           |       | 61                                       |       | 61                                                                     |       | — |   | — |   |
| Commercial paper                         |       | 1,048                                    |       | 1,048                                                                  |       | — |   | — |   |
| Corporate notes and bonds                |       | 1,843                                    |       | 1,843                                                                  |       | — |   | — |   |
| Auction and variable floating rate notes |       | 941                                      |       | —                                                                 |       | — |   | 941 |   |
| Total                                    |       | $                                        | 4,890      |                                                                   | $          | 3,949 |   | $ | — |   | $ | 941 |   |

 

Asof January 3, 2010, the Company reclassified its investments in commercialpaper and corporate notes and bonds, with a fair value of $2,891,000, fromassets measured at fair value using Level 1 inputs to assets measured at fairvalue using Level 2 inputs.  The transferresulted solely from management’s reassessment of the level of activity in thesecondary market for these investments, which historically has been low due tothe short-term nature of the instruments. Management does not believe that the reassessment in any way reflects achange in the actual liquidity or credit quality of these investments.  The reassessment was precipitated by a changein custodial institutions in connection with the Company’s new revolving creditagreement (see Note 6).

 

Fairvalue measurements using Level 3 inputs in the table above relate to theCompany’s investments in auction rate securities. Level 3 inputs areunobservable inputs used to estimate the fair value of assets or liabilitiesand are utilized to the extent that observable inputs are not available.

 

Thefollowing table provides a reconciliation of the beginning and ending balancesfor the Company’s assets measured at fair value using Level 3 inputs (inthousands):

 
| ** **                                                        | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                        | ** ** | **July 3,**     | ** ** | **July 4,** | ** ** |
| ** **                                                        | ** ** | **2010**             | ** ** | **2009** | ** ** |
|                                                              |       |                 |       |   |   |
| Beginning balance                                                 |       | $                    | 941        |   | $ | 960 |   |
| Unrealized loss included in accumulated other  comprehensive loss |       | (39                  | )          | 19 |   |
| Ending balance                                                    |       | $                    | 902        |   | $ | 979 |   |

 

14

----

Table ofContents

 

**Note5—Investments in Marketable Securities**

 

Investments in marketable securities consist of the following (inthousands):

 
| ** **                               | ** ** | **July 3, 2010** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | ** **            | ** ** | **Net** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Amortized**         | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                               | ** ** | **Cost**              | ** ** | **Gain (Loss)** | ** ** | **Value** | ** ** |
| Obligations of the U.S. government       |       | $                     | 999        |   | $ | 1 |   | $ | 1,000 |   |
| Federal agency notes and bonds           |       | 500                   |       | — |   | 500 |   |
| Commercial paper                         |       | 1,049                 |       | — |   | 1,049 |   |
| Corporate notes and bonds                |       | 2,665                 |       | (3 | ) | 2,662 |   |
| Auction and variable floating rate notes |       | 1,003                 |       | (101 | ) | 902 |   |
|                                     |       | $                     | 6,216      |   | $ | (103 | ) | $ | 6,113 |   |

 
| ** **                               | ** ** | **January 2, 2010** | ** ** |
|------------------------------------------|------------|-------------------------------|------------|
| ** **                               | ** ** | ** **                    | ** ** | **Net** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Amortized**                 | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                               | ** ** | **Cost**                      | ** ** | **Gain (Loss)** | ** ** | **Value** | ** ** |
|                                     |       |                          |       |   |   |   |   |
| Obligations of the U.S. government       |       | $                             | 997        |   | $ | — |   | $ | 997 |   |
| Federal agency notes and bonds           |       | 61                            |       | — |   | 61 |   |
| Commercial paper                         |       | 1,048                         |       | — |   | 1,048 |   |
| Corporate notes and bonds                |       | 1,839                         |       | 4 |   | 1,843 |   |
| Auction and variable floating rate notes |       | 1,002                         |       | (61 | ) | 941 |   |
|                                     |       | $                             | 4,947      |   | $ | (57 | ) | $ | 4,890 |   |

 

Realized gains and losses on the sale of investments in marketablesecurities are determined using the specific identification method.  Net realized gains and losses recorded werenot significant in any of the periods reported upon.

 

15

----

Table of Contents

 

The following table provides the breakdown of investments in marketablesecurities with unrealized losses (in thousands):

 
| ** **                               | ** ** | **July 3, 2010**          | ** ** |
|------------------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **Continuous Unrealized Loss** | ** ** |
| ** **                               | ** ** | **Less than 12 months**        | ** ** | **12 months or greater** | ** ** |
| ** **                               | ** ** | **Fair**                       | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                               | ** ** | **Value**                      | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
|                                     |       |                           |       |   |   |   |   |   |   |
| Corporate notes and bonds                |       | 1,922                          |       | (3 | ) | — |   | — |   |
| Auction and variable floating rate notes |       | —                         |       | — |   | 902 |   | (101 | ) |
|                                     |       | $                              | 1,922      |   | $ | (3 | ) | $ | 902 |   | $ | (101 | ) |
|                                          |            |                                |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                               | ** ** | **January 2, 2010**       | ** ** |
|------------------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **Continuous Unrealized Loss** | ** ** |
| ** **                               | ** ** | **Less than 12 months**        | ** ** | **12 months or greater** | ** ** |
| ** **                               | ** ** | **Fair**                       | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                               | ** ** | **Value**                      | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
|                                     |       |                           |       |   |   |   |   |   |   |
| Corporate notes and bonds                |       | $                              | 366        |   | $ | (1 | ) | — |   | — |   |
| Auction and variable floating rate notes |       | —                         |       | — |   | 941 |   | (61 | ) |
|                                     |       | $                              | 366        |   | $ | (1 | ) | $ | 941 |   | $ | (61 | ) |
|                                          |            |                                |            |  |  |  |  |  |  |  |  |  |  |

 

As of July 3, 2010 and January 2, 2010, the Company heldseven and four investments, respectively, that were in an unrealized lossposition.

 

*Auction Rate Securities*

 

Disruptionsin the credit market continue to adversely affect the liquidity and overallmarket for auction rate securities. As of July 3, 2010 and January 2,2010, the Company held two investments in auction rate securities with a totalpurchase cost of $1.0 million. These two investments represent (i) a Baa1rated, fully insured debt obligation of a municipality and (ii) an A3rated debt obligation backed by pools of student loans guaranteed by the U.S.Department of Education. Given the insufficient observable market inputs and relatedinformation available, the Company has classified its investments in auctionrate securities within Level 3 of the fair value hierarchy (see Note 4).

 

TheCompany does not believe that the current illiquidity of its investments inauction rate securities will materially impact its ability to fund its workingcapital needs, capital expenditures or other business requirements. TheCompany, however, remains uncertain as to when liquidity will return to theauction rate markets, whether other secondary markets will become available orwhen the underlying securities may be called by the issuer. Given these andother uncertainties, the Company’s investments in auction rate securities havebeen classified as long-term investments in marketable securities in theaccompanying unaudited condensed consolidated balance sheet as of July 3,2010. The Company has concluded that the estimated gross unrealized losses onthese investments, which totaled approximately $101,000 at July 3, 2010,are temporary because (i) the Company believes that the absence ofliquidity that has occurred is due to general market conditions, (ii) theauction rate securities continue to be of a relatively 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.

 

*Other Investments in Marketable Securities*

 

Excludingits auction rate securities, the gross unrealized losses on the Company’s otherinvestments in marketable securities totaled approximately $3,000 and $1,000 asof July 3, 2010 and January 2, 2010, respectively, and are generallydue to the ongoing uncertainties in the credit and financial markets, as wellas changes in interest rates. The fair value of these investments wasdetermined based on Level 1 and Level 2 inputs, consisting of quoted pricesfrom actual market transactions for identical investments. The Company hasdetermined that the unrealized losses on these investments as of July 3,2010 are temporary in nature. Factors considered in determining whetherimpairments are other than temporary include (i) the length of time andextent to which fair value has been less than the amortized cost basis,(ii) the financial condition and near-term prospects of the investee and(iii) the Company’s intent and ability to hold an investment for a periodof time sufficient to allow for any anticipated recovery in market value.

 

16

----

Table of Contents

 

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 July 3, 2010 by contractual maturity (in thousands):

 
| ** **              | ** ** | **July 3, 2010** | ** ** |
|-------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **Amortized**         | ** ** | **Fair** | ** ** |
| ** **              | ** ** | **Cost**              | ** ** | **Value** | ** ** |
| **Maturity**            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Less than one year      |       | $                     | 5,213      |   | $ | 5,211 |   |
| One to two years        |       | —                |       | — |   |
| Greater than two years* |       | 1,003                 |       | 902 |   |
|                    |       | $                     | 6,216      |   | $ | 6,113 |   |

 

----

*                 Comprised of auction rate securities whichgenerally have reset dates of 90 days or less but final contractual maturitydates in excess of 15 years.

 

**Note6—Credit Agreement**

 

OnOctober 31, 2009, the Company entered into a revolving credit agreementwith Silicon Valley Bank.  Under the original terms of the creditagreement, the Company could borrow up to the lesser of (i) 80% ofeligible accounts receivable, minus $1.0 million, or (ii) $5.0million.  The revolving credit agreement was amended on March 24,2010 to allow for increased accounts receivable eligibility and to remove the$1.0 million reduction from the calculated accounts receivable borrowing baseand further amended on June 30, 2010 to modify certain financial covenants.  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 the overall sublimit reduce theamount available pursuant to the credit agreement.  At July 3, 2010, letters of credit inthe amount of $1.8 million were outstanding. The letters of credit expire on September 30, 2010.

 

Interestis payable monthly at either (i) prime plus 1.25%, as long as the Companymaintains $8.5 million in revolving credit availability plus unrestricted cashon deposit with the financial institution, or (ii) prime plus 2.25%. The minimum monthly interest due is $3,750 minus the aggregate amount of anyinterest earned by the bank. The credit agreement matures on October 30,2010, at which time all advances and interest are due and payable.

 

The Company’s previous credit facility, which consisted of a revolvingline of credit and a non-revolving equipment line, expired on August 31,2009 and all borrowings were repaid to the bank.  Interest on the credit facility was payablemonthly at the greatest of (i) the sum of the prime rate plus 3%,(ii) the sum of LIBOR plus 6% or (iii) 8%.

 

Thefollowing table presents details of interest expense related to borrowings on revolvingcredit lines, along with certain other applicable information (in thousands):

 
| ** **       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------|------------|------------------------|------------|----------------------|------------|
| ** **       | ** ** | **July 3,**       | ** ** | **July 4,**     | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **       | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Interest expense |       | $                      | 13         |                 | $          | 9 |   | $ | 24 |   | $ | 12 |   |
|                  |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 
| ** **                                                 | ** ** | **July 3,** | ** ** | **January 2,** | ** ** |
|------------------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | **2010**         | ** ** | **2010**            | ** ** |
| Outstanding borrowings on the revolving line of  credit    |       | $                | —     |                | $          | — |   |
| Borrowing availability under the revolving line of  credit |       | $                | 3,200      |                | $          | — |   |

 

17

----

Table of Contents

 

Obligationsunder this revolving credit agreement are secured by a first priority lien onthe Company’s tangible and intangible assets. In connection with the revolving credit agreement, the Company enteredinto an Intercompany Subordination Agreement, which provided that one of theCompany’s subsidiaries, Netlist Technology Texas, LP, is an additional obligoron the revolving credit agreement.

 

Therevolving credit agreement subjects the Company to certain affirmative andnegative covenants, including financial covenants with respect to the Company’sliquidity and profitability and restrictions on the payment of dividends. As of July 3, 2010, the Company was in compliance with its financialcovenants.

 

**Note 7—Long-Term Debt**

 

Long-termdebt consists of the following (in thousands):

 
| ** **                       | ** ** | **July 3,** | ** ** | **January 2,** | ** ** |
|----------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                       | ** ** | **2010**         | ** ** | **2010**            | ** ** |
| Obligations under capital leases |       | $                | 102        |                | $          | 159 |   |
| Less current portion             |       | (92              | )          | (108                | )          |
|                             |       | $                | 10         |                | $          | 51 |   |

 

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

 
| ** **       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------|------------|------------------------|------------|----------------------|------------|
| ** **       | ** ** | **July 3,**       | ** ** | **July 4,**     | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **       | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Interest expense |       | $                      | 2          |                 | $          | 8 |   | $ | 5 |   | $ | 19 |   |
|                  |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

**Note 8—Income Taxes**

 

Thefollowing table sets forth the Company’s provision (benefit) for income taxes,along with the corresponding effective tax rates (in thousands, exceptpercentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                           | ** ** | **July 3,**       | ** ** | **July 4,**     | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **                           | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Provision (benefit) for income taxes |       | $                      | 2          |                 | $          | 31 |   | $ | (725 | ) | $ | 49 |   |
| Effective tax rate                   |       | (0.1                   | )%         | (0.8                 | )%         | 9.5 | % | (0.6 | )% |
|                                      |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

The Company is required toadjust its effective tax rate each quarter to be consistent with the estimatedannual effective tax rate.  The Company isalso required to record the tax impact of certain discrete items, unusual orinfrequently occurring, including changes in judgment about valuationallowances and effects of changes in tax laws or rates, in the interim periodin which they occur.  In addition,jurisdictions with a projected loss for the year or a year-to-date loss whereno tax benefit can be recognized are excluded from the estimated annualeffective tax rate.  The impact of suchan 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.

 

During the six months ended July 3,2010, the Company carried back approximately $1.7 million of gross netoperating losses under the Worker, Homeownership, and Business Act and receiveda federal income tax refund of approximately $0.7 million.

 

18

----

Table of Contents

 

TheCompany evaluates whether a valuation allowance should be established againstits deferred tax assets based on the consideration of all available evidenceusing a “more likely than not” standard. Due to uncertainty of future utilization, the Company has provided afull valuation allowance as of July 3, 2010 and January 2, 2010.  Accordingly, no benefit has been recognizedfor net deferred tax assets, including net operating losses that cannot berealized currently via carryback to periods of taxable income.

 

The Company had unrecognizedtax benefits at July 3, 2010 and January 2, 2010 of approximately$0.1 million that, if recognized, would affect the Company’s annual effectivetax rate.

 

**Note9—Commitments and Contingencies**

 

*Litigation*

 

*Federal Securities Class Action*

 

Beginning in May 2007, the Company, certain of its officers anddirectors, and the Company’s underwriters were named as defendants in fourpurported class action shareholder complaints, two of which were filed in theU.S. District Court for the Southern District of New York, and two of whichwere filed in the U.S. District Court for the Central District of California.These purported class action lawsuits were filed on behalf of persons andentities who purchased or otherwise acquired the Company’s common stockpursuant or traceable to the Company’s November 30, 2006 initial publicoffering (the “IPO”). The lawsuits were consolidated into a singleaction—Belodoff v. Netlist, Inc., Lead Case No. SACV07-677 DOC(MLGx)—which is currently pending in the Central District of California. LeadPlaintiff filed the Consolidated Complaint in November 2007. Defendantsfiled their motions to dismiss the Consolidated Complaint in January 2008.The motions to dismiss were taken under submission in April 2008 and onMay 30, 2008, the court granted the defendants’ motions. However,plaintiffs were granted the right to amend their complaint and subsequentlyfiled their First Amended Consolidated Class Action Complaint (“AmendedComplaint”) in July 2008. The defendants filed motions to dismiss theAmended Complaint in January 2009, and on April 17, 2009, the courtgranted defendants’ motions to dismiss. However, plaintiffs were again grantedthe right to amend their complaint. Plaintiffs’ filed their Second Amended Consolidated Class ActionComplaint (“Second Amended Complaint”) in May 2009. Generally, the SecondAmended Complaint, like the preceding complaints, alleged that the RegistrationStatement filed by the Company in connection with the IPO contained untrue statementsof material fact or omissions of material fact in violation of Sections 11and 15 of Securities Act of 1933. Defendants filed motions to dismiss theSecond Amended Complaint in June 2009. The motions to dismiss were takenunder submission in August 2009 and on September 1, 2009, the Courtgranted the defendants’ motions. However, plaintiffs again were granted theright to amend their complaint.

 

In December 2008, the parties reached a tentative agreement inprinciple to settle the class action. In February 2010, the partiesexecuted a Stipulation and Agreement of Settlement documenting the essentialterms of the proposed settlement, informed the court of their proposedsettlement, and drafted a joint motion to submit to the court for preliminaryapproval of the proposed settlement. Under the settlement agreement presentedto the court for approval, plaintiffs and the class will dismiss all claims,with prejudice, in exchange for a cash payment of $2.6 million. TheCompany’s directors’ and officers’ liability insurers will pay the settlementamount in accordance with the Company’s insurance policies.

 

On April 19, 2010, the court issued an order preliminarilyapproving the settlement.  A finalsettlement approval hearing is scheduled to be held on September 30, 2010.Despite the proposed agreement to settle this action, the Company believes thatthe allegations lack merit and, if necessary, intends to vigorously defend allclaims asserted. The Company makes no assurances at this time that the courtwill grant approval of the proposed settlement terms or that the matterultimately will be settled.

 

*Patent Claims*

 

In May 2008, the Company initiated discussions withGoogle, Inc. regarding the Company’s claims that Google has infringed on aUS patent assigned to the Company relating generally to “rank multiplication”in memory modules. On August 29, 2008, Google filed a declaratory judgmentlawsuit against the Company in United States District Court for the NorthernDistrict of California, seeking a declaration that Google did not infringe onthe Company’s patent, and that the Company’s patent is invalid. Google is notseeking any monetary damages. On November 18, 2008, the Company filed acounterclaim for infringement of the patent by Google. Claim constructionproceedings were held on November 14, 2009, and the Company prevailed onevery disputed claim construction issue. On June 1, 2010, the Companyfiled a motion for summary judgment of patent infringement and a motion forsummary judgment dismissing Google’s affirmative defenses based on Netlist’sactivities with the JEDEC standard-setting body. Trial is currently set for November 1,2010.

 

19

----

Table of Contents

 

On December 4, 2009, the Company filed a patent infringement suitagainst Google in the United States District Court for the Northern District ofCalifornia, seeking damages and injunctive relief based on Google’sinfringement of a recently issued patent related to the Company’spatent-in-suit in the August 29, 2008 declaratory judgment action filed byGoogle. On February 3, 2010 the court ordered a settlement conference inboth cases by May 4, 2010. On February 11, 2010, Google answered theCompany’s complaint and has asserted counterclaims against the Company seekinga declaration that the patent is invalid and not infringed, and claiming thatthe Company committed fraud, negligent misrepresentation and contractualbreaches in connection with the setting of standards covered by the patent. Thecounterclaim seeks unspecified compensatory damages.  Claim construction proceedings are currentlyscheduled for September 9, 2010. The Company intends to vigorously pursue its infringement claims againstGoogle and to vigorously defend against Google’s claims.

 

On September 22, 2009, the Company filed a patent infringementlawsuit against Inphi Corporation in the United States District Court for theCentral 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. The Company is seeking damages and injunctiverelief based on Inphi’s use of its patented technology. On December 22,2009, Netlist filed an Amended Complaint asserting claims of patentinfringement based on two additional patents concerning load isolation andmemory domain translation technologies. Inphi has denied infringement and hasasserted that the patents-in-suit are invalid. On April 20, 2010, Inphifiled a request for reexamination of all three patents in suit with the UnitedStates Patent and Trademark Office and concurrently, filed a motion to stay thecase until the Patent Office completes reexamination. The stay was granted on May 18,2010; however, the Company intends to continue to vigorously pursue itsinfringement claims and to vigorously defend against Inphi’s claims of invalidityin the Patent Office as well as the Court.

 

On November 30, 2009, Inphi Corporation filed a patentinfringement lawsuit against the Company in the United States District Courtfor the Central District of California alleging infringement of two patentsrelated to memory module output buffers. Discovery is currently underway, andthe Company intends to vigorously defend against Inphi’s claims ofinfringement.

 

On March 24, 2010, Ring Technologies Enterprises filed a patentinfringement lawsuit in the United States District Court for the EasternDistrict of Texas against Dell Computer and its suppliers.  The suit alleges that the Company andforty-two (42) other defendants infringed on its patent no. 6,879,526.  The Company is preparing an answer to RingTechnologies’ complaint and intends to vigorously defend against RingTechnologies’ claims of infringement.

 

*Trade Secret Claim*

 

On November 18, 2008, the Company filed a claim for trade secretmisappropriation against Texas Instruments (“TI”) in Santa Clara CountySuperior Court, based on TI’s disclosure of confidential Company materials tothe JEDEC standard-setting body. Pursuant to a confidential settlement agreement between the parties, thecase was dismissed with prejudice on May 10, 2010.

 

*Other Contingent Obligations*

 

During its normal course of business, the Company has made certainindemnities, commitments and guarantees under which it may be required to makepayments in relation to certain transactions. These include(i) intellectual property indemnities to the Company’s customers andlicensees in connection with the use, sales and/or license of Company products;(ii) indemnities to vendors and service providers pertaining to claimsbased on the Company’s negligence or willful misconduct; (iii) indemnitiesinvolving the accuracy of representations and warranties in certain contracts;(iv) indemnities to directors and officers of the Company to the maximumextent permitted under the laws of the State of Delaware; and (v) certainreal estate leases, under which the Company may be required to indemnifyproperty owners for environmental and other liabilities, and other claimsarising from the Company’s use of the applicable premises. The duration ofthese indemnities, commitments and guarantees varies and, in certain cases, maybe indefinite. The majority of these indemnities, commitments and guarantees donot provide for any limitation of the maximum potential for future payments theCompany could be obligated to make. Historically, the Company has not beenobligated to make significant payments for these obligations, and noliabilities have been recorded for these indemnities, commitments andguarantees in the accompanying condensed consolidated balance sheets.

 

20

----

Table of Contents

 

**Note10—Stockholders’ Equity**

 

*Common Stock*

 

On March 24, 2010,the Company sold 4,594,250 shares of common stock in a registered publicoffering.  The shares were sold to thepublic at a price of $3.85 per share. The Company received net proceeds of $16.2 million, after underwritingdiscounts and commissions, and estimated expenses payable by the Company.

 

*Stock-Based Compensation*

 

TheCompany has stock-based compensation awards outstanding pursuant to the 2000Equity Incentive Plan (the “2000 Plan”) and the 2006 Equity Incentive Plan (the“2006 Plan”).  Effective as of the IPO,no further grants may be made under the 2000 Plan.  In addition to awards made pursuant to the2006 Plan, the Company periodically issues inducement grants outside the 2006Plan to certain new hires.  In the sixmonths ended July 3, 2010, the Company issued 305,000 stock optionspursuant to inducement grants.

 

OnJune 2, 2010, the Company’s shareholders approved an amendment to the 2006Plan to provide that the number of shares of common stock that may be issuedshall be increased annually by a number of shares equal to the lesser of 5.0%of the issued and outstanding shares as of January 1 of each year or1,200,000 shares.  Prior to June 2,2010, the annual increase in shares available under the 2006 Plan was capped at500,000.  The amendment is effective forfiscal 2010.  An additional 505,566shares are available for issuance as a result of the amendment to the 2006Plan.  At July 3, 2010, the Companyhad 607,281 shares available for grant pursuant to option, stock appreciationright, performance unit, restricted stock, restricted stock unit or stock grantawards under the 2006 Plan.

 

Asummary of the Company’s common stock option activity as of and for the sixmonths ended July 3, 2010 is presented below (shares in thousands):

 
| ** **                                  | ** ** | **Options Outstanding** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|
| ** **                                  | ** ** | ** **              | ** ** | **Weighted-** | ** ** |
| ** **                                  | ** ** | ** **              | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | **Number of**           | ** ** | **Exercise** | ** ** |
| ** **                                  | ** ** | **Shares**              | ** ** | **Price** | ** ** |
| Options outstanding at January 2, 2010 |       | 4,298                   |       | $ | 2.41 |   |
| Options granted                             |       | 360                     |       | 3.58 |   |
| Options exercised                           |       | (56                     | )          | 1.19 |   |
| Options cancelled                           |       | (142                    | )          | 0.93 |   |
| Options outstanding at July 3, 2010    |       | 4,460                   |       | $ | 2.57 |   |

 

A summary of the Company’srestricted stock awards as of and for the six months ended July 3, 2010 ispresented below (shares in thousands):

 
| ** **                                  | ** ** | **Restricted Stock Outstanding** |       |
|---------------------------------------------|------------|----------------------------------|------------|
| ** **                                  | ** ** | ** **                       | ** ** | **Weighted-** |   |
| ** **                                  | ** ** | ** **                       | ** ** | **Average** |   |
| ** **                                  | ** ** | ** **                       | ** ** | **Grant-Date** |   |
| ** **                                  | ** ** | **Number of**                    | ** ** | **Fair Value** |   |
| ** **                                  | ** ** | **Shares**                       | ** ** | **per Share** | ** ** |
| Balance outstanding at January 2, 2010 |       | —                           |       | $ | — |   |
| Restricted stock granted                    |       | 486                              |       | 3.48 |   |
| Balance outstanding at July 3, 2010    |       | 486                              |       | $ | 3.48 |   |

 

Restricted stock awardsvest in eight equal increments at intervals of approximately six months fromthe date of grant.

 

21

----

Table of Contents

 

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

 
| ** **                                       | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------|------------|
| ** **                                       | ** ** | **July 3,**     | ** ** | **July 4,** | ** ** |
| ** **                                       | ** ** | **2010**             | ** ** | **2009** | ** ** |
| Expected term (in years)                         |       | 5.5                  |       | 5.4 |   |
| Expected volatility                              |       | 146                  | %          | 111 | % |
| Risk-free interest rate                          |       | 2.43                 | %          | 2.96 | % |
| Expected dividends                               |       | —               |       | — |   |
| Weighted-average grant date fair value per share |       | $                    | 3.30       |   | $ | 0.27 |   |
|                                                  |            |                      |            |  |  |  |  |

 

The weighted-average fairvalue per share of the restricted stock granted in the six months ended July 3,2010 was $3.48, calculated based on the fair market value of the Company’scommon stock on the respective grant dates.

 

At July 3, 2010, theamount of unearned stock-based compensation currently estimated to be expensedfrom fiscal 2010 through fiscal 2014 related to unvested common stock optionsand restricted stock awards is approximately $3.2 million, net of estimatedforfeitures. The weighted-average period over which the unearned stock-basedcompensation is expected to be recognized is approximately 3.1 years. If thereare any modifications or cancellations of the underlying unvested awards, theCompany may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense.

 

*Warrants*

 

Asummary of activity with respect to outstanding warrants to purchase shares ofthe Company’s common stock for the six months ended July 3, 2010 ispresented below (shares in thousands):

 
| ** **                                                 | ** ** | ** **    | ** ** | **Weighted-** | ** ** |
|------------------------------------------------------------|------------|---------------|------------|---------------|------------|
| ** **                                                 | ** ** | ** **    | ** ** | **Average**   | ** ** |
| ** **                                                 | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                                 | ** ** | **Shares**    | ** ** | **Price**     | ** ** |
| Warrants outstanding at January 2, 2010               |       | 18            |       | $             | 1.25       |   |
| Warrants exercised                                         |       | (18           | )          | 1.25          |       |
| Warrants outstanding and exercisable at  July 3, 2010 |       | —        |       | $             | —     |   |

 

**Note11—Segment and Geographic Information**

 

TheCompany operates 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.

 

AtJuly 3, 2010 and January 2, 2010, approximately $2.6 million and $3.0million, respectively, of the Company’s net long-lived assets were located inthe PRC.

 

**Note12—Subsequent Events**

 

InJuly 2010, the Company purchased approximately $0.4 million of equipmentunder two 36-month capital lease agreements. The interest rates on the leases are approximately 6%.  Annual repayment commitments under the leasesare approximately $0.1 million.

 

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

 

**Cautionary Statement**

 

*The following discussion and analysis of our financial condition andresults of operations should be read in conjunction with our UnauditedCondensed Consolidated Financial Statements and the related notes theretocontained in Part I, Item 1 of this Report. The information containedin this Quarterly Report on Form 10-Q is not a complete description of ourbusiness or the risks associated with an investment in our common stock. Weurge you to carefully review and consider the various disclosures made by us inthis Report and in our other reports filed with the Securities and ExchangeCommission, or SEC, including our Annual Report on Form 10-K for thefiscal year ended January 2, 2010 and subsequent reports on Form 8-K,which discuss our business in greater detail.*

 

22

----

 

Table ofContents

 

*The section entitled “Risk Factors” set forth in Part I, Item 1A of ourAnnual Report on Form 10-K for the fiscal year ended January 2, 2010 filed withthe SEC on February 19, 2010, and similar discussions in our other SEC filings,describe some of the important risk factors that may affect our business,results of operations and financial condition. You should carefully considerthose risks, in addition to the other information in this Report and in ourother filings with the SEC, before deciding to purchase, hold or sell ourcommon stock.*

 

*This Report contains forward-looking statements that involve risks,uncertainties, estimates and assumptions. These statements are not guaranteesof future performance and are subject to certain risks, uncertainties andassumptions that are difficult to predict. These forward-looking statements involve risks and uncertainties thatcould cause actual results to differ materially from those expected orprojected.  These risks and uncertaintiesinclude, but are not limited to, continuing development, qualification andvolume production of NetVaultTMNV and HyperCloudTM; the rapidly-changing natureof technology; risks associated with intellectual property, including the costsand unpredictability of litigation over infringement of our intellectualproperty; volatility in the pricing of DRAM ICs and NAND; changes in anduncertainty of customer acceptance of, and demand for, our existing productsand products under development, including uncertainty of and/or delays inproduct orders and product qualifications; delays in our and our customers’product releases and development; introductions of new products by competitors;changes in end-user demand for technology solutions; our ability to attract andretain skilled personnel; our reliance on suppliers of critical components;fluctuations in the market price of critical components; evolving industrystandards; and the political and regulatory environment in the People’sRepublic of China.  Other risks anduncertainties are described under the heading “Risk Factors” in our AnnualReport on Form 10-K for the year ended January 2, 2010.  Except as required by law, we undertake noobligation to revise or update publicly any forward-looking statements for anyreason.*

 

**Overview**

 

We design, manufacture and sell high-performance, logic-based memorysubsystems for the server, storage and communications equipment markets. Ourmemory subsystems consist of combinations of dynamic random access memoryintegrated circuits (“DRAM ICs” or “DRAM”), NAND flash memory (“NAND”),application-specific integrated circuits (“ASICs”) and other componentsassembled on printed circuit boards (“PCBs”). We primarily market and sell our products to leading original equipmentmanufacturer (“OEM”) customers.  Oursolutions are targeted at applications where memory plays a key role in meetingsystem performance requirements.

 

In November 2009, we introduced HyperCloudTM DDR3 memorytechnology.  HyperCloudTM utilizes an ASICchipset that incorporates Netlist patented rank multiplication technology thatincreases memory capacity and load reduction functionality that increasesmemory bandwidth.  We expect that thisachievement will make possible improved levels of performance for memoryintensive datacenter applications and workloads, including search engines,social networks/communications, media internet portals, virtualization, andhigh performance scientific and defense-related computing.  HyperCloudTM memory is being evaluated byseveral of our OEM customers for use in their server products.  HyperCloudTM is interoperable with JointElectronics Devices Engineering Council (“JEDEC”) standard DDR3 memorymodules.  Our HyperCloudTM products aredesigned to allow for installation in servers without the need for a bioschange.  As such, their anticipated saleslaunch is not dependent on the design plans or product cycle of our OEMcustomers.  As of July 3, 2010, we havenot shipped any production quantities of HyperCloudTM.

 

In February 2010, we announced general availability of NetVaultTM NV, a non-volatile cachememory subsystem targeting Redundant Array of Independent Disks, (“RAID”)storage applications.  NetVaultTM NV provides server and storage OEMs a solutionfor enhanced datacenter fault recovery. Unlike our traditional battery-poweredfault tolerant cache product which relied solely on batteries to power thecache, NetVaultTM NV utilizes a combination of DRAM for highthroughput performance and flash for extended data retention.  The introduction of NetVaultTM NV, as well as the launch ofthe Dell, Inc. (“Dell”) PERC 7 line of servers in December 2009, has resultedin RAID controller subsystem revenues of $7.0 million, or 41% of total revenuesfor the six months ended July 3, 2010, compared with $1.5 million, or 29% oftotal revenues for the six months ended July 4, 2009.  Although revenues through July 3, 2010 havebeen exclusively for shipments to Dell, we intend to qualify NetVault TMNV with several OEMs and topursue end-user opportunities.  Althoughwe can make no assurances, we anticipate that NetVaultTM products will continue to contributesignificantly to our revenues as the product ramps through the second half of2010.

 

The remainder of our revenues arise primarily from OEM sales of custommemory modules, the majority of which are utilized in data center andindustrial applications.  When developingcustom modules for an equipment product launch, we engage with our OEM customersfrom the earliest stages of new product definition, providing us unique insightinto their full range of system architecture and performance requirements. Thisclose collaboration has also allowed us to develop a significant level ofsystems expertise. We leverage a portfolio of proprietary technologies anddesign techniques, including efficient planar design, alternative packagingtechniques and custom semiconductor logic, to deliver memory 

 

23

----

Table of Contents

 

subsystemswith high speed, capacity and signal integrity, small form factor, attractivethermal characteristics and low cost per bit. Revenues from custom modules have improved as a result of OEM productplacements on new platforms and improved economic conditions compared with2009.  The continuation of this trend,which cannot be assured, is dependent on our ability to qualify our memorymodules on new platforms as current platforms reach the end of their lifecycles, and on the state of the global economy.

 

Consistentwith the concentrated nature of the OEM customer base in our target markets, asmall number of large customers have historically accounted for a significantportion of our net sales.  Dell andFlextronics International Ltd. (“Flextronics”) represented approximately 44%and 32%, respectively, of our net sales for the six months ended July 3,2010.  Dell and Arrow Electronics, Inc. (“Arrow”)represented approximately 49% and 17%, respectively, of our net sales for thesix months ended July 4, 2009.  Net salesto some of our OEM customers include memory modules that are qualified by usdirectly with the OEM customer and sold to electronic manufacturing servicesproviders (“EMSs”), for incorporation into products manufactured exclusivelyfor the OEM customer or in some instances, to facilitate credit and logistics.These net sales to EMSs have historically fluctuated period to period as aportion of the total net sales to the OEM customers.  Net sales to Hon Hai Precision Industry Co.Ltd., an EMS operating under the trade name Foxconn that purchases memorymodules from us for incorporation into products manufactured exclusively forDell, represented approximately 92% and 58% of net sales to Dell for the sixmonths ended July 3, 2010 and July 4, 2009, respectively.  Arrow is an EMS for DRS Electronics, Inc. (“DRSElectronics”).  Substantially all of ourproducts sold to Arrow are incorporated into components manufactured for DRSElectronics.  Similarly, Flextronicsdistributes substantially all of the products purchased from us to F5 Networks,Inc.

 

**Key Business Metrics**

 

Thefollowing describes certain line items in our condensed consolidated statementsof operations that are important to management’s assessment of our financialperformance:

 

*Net Sales.*  Net sales consist primarily of sales of ourhigh performance memory subsystems, net of a provision for estimated returnsunder our right of return policies, which generally range up to 30 days.We generally do not have long-term sales agreements with our customers.Although OEM customers typically provide us with non-binding forecasts offuture product demand over specific periods of time, they generally place orderswith us approximately two weeks in advance of scheduled delivery. Sellingprices are typically negotiated monthly, based on competitive market conditionsand the 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 United States (“U.S.”) dollars. We also sell excesscomponent inventory of DRAM ICs and NAND to distributors and other users ofmemory ICs.  As compared to previousyears, component inventory sales remain a relatively small percentage of netsales as a result of our efforts to diversify both our customer and productline bases. This diversification effort has also allowed us to use componentsin a wider range of memory subsystems. We expect that component inventory saleswill continue to represent a minimal portion of our net sales in futureperiods.

 

*Cost of Sales.*  Our cost of sales includes the cost ofmaterials, manufacturing costs, depreciation and amortization of equipment,inventory valuation provisions, stock-based compensation and occupancy costsand other allocated fixed costs. The DRAM ICs and NAND incorporated into ourproducts constitute a significant portion of our cost of sales, and thus ourcost of sales will fluctuate based on the current price of DRAM ICs and NAND.We attempt to pass through such DRAM IC and NAND flash memory cost fluctuationsto our customers by renegotiating pricing prior to the placement of theirpurchase orders.  However, the salesprices of our memory subsystems can also fluctuate due to competitivesituations unrelated to the pricing of DRAM ICs and NAND, which affects grossmargins. The gross margin on our sales of excess component DRAM IC and NANDinventory is much lower than the gross margin on our sales of our memorysubsystems.  We assess the valuation ofour inventories on a monthly basis and record a provision to cost of sales asnecessary to reduce inventories to the lower of cost or net realizable value.

 

*Research and Development.*  Research and development expense consistsprimarily of employee and independent contractor compensation and relatedcosts, non-recurring engineering fees, patent filing and protection legal fees,computer-aided design software licenses, reference design development costs,depreciation or rental of evaluation equipment, stock-based compensation, andoccupancy and other allocated overhead costs. Also included in research and developmentexpense are the costs of material and overhead related to the production ofengineering samples of new products under development or products used solelyin the research and development process, reduced by estimated salvage value.  Our customers typically do not separatelycompensate us for design and engineering work involved in developingapplication-specific products for incorporation into their products.  All research and development costs areexpensed as incurred. We anticipate that research and development expenditureswill increase in future periods as we seek to expand new product opportunities,increase our activities related to new and emerging markets and continue todevelop additional proprietary technologies.

 

24

----

Tableof Contents

* *

*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, sample expenseand occupancy and other allocated overhead costs. A significant portion of ourselling effort is directed at building relationships with OEMs and othercustomers and working through the product approval and qualification processwith them. Therefore, the cost of material and overhead related to productsmanufactured for qualification is included in selling expenses. As we continueto service existing and establish new customers, we anticipate that our salesand marketing expenses will increase.

 

*Provision (Benefit) for Income Taxes.*  We are required to adjust our effective taxrate each quarter to be consistent with the estimated annual effective taxrate.  We are also required to record thetax impact of certain discrete items, unusual or infrequently occurring,including changes in judgment about valuation allowances and effects of changesin tax laws or rates, in the interim period in which they occur.  In addition, jurisdictions with a projectedloss for the year or a year-to-date loss where no tax benefit can be recognizedare excluded from the estimated annual effective tax rate.  The impact of such an exclusion could resultin a higher or lower effective tax rate during a particular quarter, based uponthe mix and timing of actual earnings versus annual projections.

 

We evaluate whether avaluation allowance should be established against our deferred tax assets basedon the consideration of all available evidence using a “more likely than not”standard.  As of July 3, 2010 andJanuary 2, 2010, we have provided a full valuation allowance and no benefit hasbeen recognized for net operating losses and other deferred tax assets due touncertainty of future utilization.

 

**Critical Accounting Policies**

 

The preparation of our condensed consolidated financial statements inconformity with accounting principles generally accepted in the U.S. requires usto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosures of contingent assets and liabilities at thedate of the condensed consolidated financial statements and the reportedamounts of net sales and expenses during the reporting period. By their nature,these estimates and assumptions are subject to an inherent degree ofuncertainty. We base our estimates on our historical experience, knowledge ofcurrent conditions and our beliefs of what could occur in the futureconsidering available information. We review our estimates on an on-goingbasis. Actual results may differ from these estimates, which may result inmaterial adverse effects on our operating results and financial position. Webelieve the following critical accounting policies involve our more significantassumptions and estimates used in the preparation of our condensed consolidatedfinancial statements:

 

*Revenue Recognition.*  We recognize revenues in accordance with theFinancial Accounting Standards Board (“FASB”) Accounting Standards Codification(“ASC”) Topic 605. Accordingly, we recognize revenues when there is persuasiveevidence that an arrangement, product delivery and acceptance have occurred,the sales price is fixed or determinable, and collectibility of the resultingreceivable is reasonably assured.

 

We generally use customer purchase orders and/or contracts as evidenceof an arrangement. Delivery occurs when goods are shipped for customers withFOB Shipping Point terms and upon receipt for customers with FOB Destinationterms, at which time title and risk of loss transfer to the customer. Shippingdocuments are used to verify delivery and customer acceptance. We assesswhether the sales price is fixed or determinable based on the payment termsassociated with the transaction and whether the sales price is subject torefund.  Customers are generally allowedlimited rights of return for up to 30 days, except for sales of excesscomponent 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 sales returns have historically been within ourexpectations and the provisions established, we cannot guarantee that we willcontinue to experience similar sales return rates in the future. Anysignificant increase in product return rates could have a material adverseeffect on our operating results for the period or periods in which such returnsmaterialize.  We assess collectibilitybased on the creditworthiness of the customer as determined by credit checksand evaluations, as well as the customer’s payment history.

 

All amounts billed to customers related to shipping and handling areclassified as net sales, while all costs incurred by us for shipping andhandling are classified as cost of sales.

 

25

----

Table of Contents

 

*Fair Value of Financial Instruments.*  Our financial instruments consist principallyof cash and cash equivalents, investments in marketable securities, accountsreceivable, accounts payable, accrued expenses and debt instruments.  Other than for certain investments in auctionrate securities, commercial paper and short-term corporate bonds, the fairvalue of our cash equivalents and investments in marketable securities isdetermined based on quoted prices in active markets for identical assets orLevel 1 inputs.  Because of theirshort-term nature, commercial paper and short-term corporate bonds are notfrequently traded.  Although there areobservable quotes for these securities, the markets are not consideredactive.  Accordingly, the fair values ofthese investments are based on Level 2 inputs. We recognize transfers between Levels 1 through 3 of the fair valuehierarchy at the beginning of the reporting period.  We believe that the carrying values of allother financial instruments approximate their current fair values due to theirnature and respective durations.

 

*Allowance for Doubtful Accounts.*  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.  We evaluate the collectibility of accountsreceivable based on a combination of factors. In cases where we are aware ofcircumstances that may impair a specific customer’s ability to meet itsfinancial obligations subsequent to the original sale, we will record anallowance against amounts due, and thereby reduce the net recognized receivableto the amount that we reasonably believe will be collected. For all othercustomers, we record allowances for doubtful accounts based primarily on thelength of time the receivables are past due based on the terms of theoriginating transaction, the current business environment and our historicalexperience.  Uncollectible accounts arecharged against the allowance for doubtful accounts when all cost effectivecommercial means of collection have been exhausted.  Generally, our credit losses have been withinour expectations and the provisions established. However, we cannot guaranteethat we will continue to experience credit loss rates similar to those we haveexperienced in the past.

 

Our accounts receivable are highly concentrated among a small number ofcustomers, and a significant change in the liquidity or financial position ofone of these customers could have a material adverse effect on thecollectability of our accounts receivable, our liquidity and our futureoperating results.

 

*Inventories.*  We value our inventories at the lower of the actualcost to purchase or manufacture the inventory or the net realizable value ofthe inventory.  Cost is determined on anaverage cost basis which approximates actual cost on a first-in, first-outbasis and includes raw materials, labor and manufacturing overhead.  At each balance sheet date, we evaluateending inventory quantities on hand and record a provision for excessquantities and obsolescence.  Among otherfactors, we consider historical demand and forecasted demand in relation to theinventory on hand, competitiveness of product offerings, market conditions andproduct life cycles when determining obsolescence and net realizable value. Inaddition, we consider changes in the market value of DRAM ICs and NAND indetermining the net realizable value of our raw material inventory. Onceestablished, any write downs are considered permanent adjustments to the costbasis of our excess or obsolete inventories.

 

A significant decrease in demand for our products could result in anincrease in the amount of excess inventory quantities on hand. In addition, ourestimates of future product demand may prove to be inaccurate, in which case wemay have understated or overstated the provision required for excess andobsolete inventory.  In the future, ifour inventories are determined to be overvalued, we would be required torecognize additional expense in our cost of sales at the time of suchdetermination. Likewise, if our inventories are determined to be undervalued,we may have over-reported our costs of sales in previous periods and would berequired to recognize additional gross profit at the time such inventories aresold. In addition, should the market value of DRAM ICs or NAND decreasesignificantly, we may be required to lower our selling prices to reflect thelower current cost of our raw materials. If such price decreases reduce the net realizable value of ourinventories to less than our cost, we would be required to recognize additionalexpense in our cost of sales in the same period. Although we make everyreasonable effort to ensure the accuracy of our forecasts of future productdemand, any significant unanticipated changes in demand, technologicaldevelopments or the market value of DRAM ICs or NAND could have a materialeffect on the value of our inventories and our reported operating results.

 

*Impairment of Long-Lived Assets.*  We evaluate the recoverability of thecarrying value of long-lived assets held and used in our operations forimpairment on at least an annual basis or whenever events or changes incircumstances indicate that their net book value may not be recoverable.  When such factors and circumstances exist, wecompare the projected undiscounted future net cash flows associated with therelated asset or group of assets over their estimated useful lives againsttheir respective carrying amount.  Theseprojected future cash flows may vary significantly over time as a result ofincreased competition, changes in technology, fluctuations in demand, consolidationof our customers and reductions in average selling prices.  If the carrying value is determined not to berecoverable from future operating cash flows, the asset is deemed impaired andan impairment loss is recognized to the extent the carrying value exceeds theestimated fair value of the asset.  Thefair value of the asset or asset group is based on market value when available,or when unavailable, on discounted expected cash flows.

 

26

----

Table of Contents

 

*Warranty Reserve.*  We offer product warranties generally rangingfrom one to three years, depending on the product and negotiated terms ofpurchase agreements with our customers. Such warranties require us to repair orreplace defective product returned to us during the warranty period at no costto the customer.  Warranties are notoffered on sales of excess component inventory. Our estimates for warranty-related costs are recorded at the time ofsale based on historical and estimated future product return rates and expectedrepair or replacement costs. While such costs have historically been consistentbetween periods and 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.

 

*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.

 

In accordance with ASC Topic 718, employee and director stock-basedcompensation expense recognized during the period is based on the value of theportion of stock-based payment awards that is ultimately expected to vestduring the period.  Given thatstock-based compensation expense recognized in the condensed consolidatedstatements of operations is based on awards ultimately expected to vest, it hasbeen reduced for estimated forfeitures. ASC Topic 718 requires forfeitures tobe estimated at the time of grant and revised, if necessary, in subsequentperiods if actual forfeitures differ from those estimates. Our estimatedaverage forfeiture rates are based on historical forfeiture experience andestimated future forfeitures.

 

The fair value of common stock option awards to employees and directorsis calculated using the Black-Scholes option pricing model.  The Black-Scholes model requires subjectiveassumptions regarding future stock price volatility and expected time to exercise,along with assumptions about the risk-free interest rate and expecteddividends, all of which affect the estimated fair values of our common stockoption awards. The expected term of options granted is calculated as theaverage of the weighted vesting period and the contractual expiration date ofthe option.  This calculation is based onthe safe harbor method permitted by the SEC in instances where the vesting andexercise terms of options granted meet certain conditions and where limitedhistorical exercise data is available. Prior to fiscal 2009, the expected volatility was based on thehistorical volatilities of the common stock of comparable publicly tradedcompanies based on our belief that we had limited historical data regarding thevolatility of our stock price on which to base a meaningful estimate ofexpected volatility. Beginning in fiscal 2009, the expected volatility is basedon the historical volatility 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 our expectations regardingdividend payouts. We evaluate the assumptions used to value our common stockoption awards 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. Compensation expense for common stock option awards with graded vestingschedules is recognized on a straight-line basis over the requisite serviceperiod for the last separately vesting portion of the award.

 

We recognize the fair value of restricted stock awards issued toemployees and outside directors as stock-based compensation expense on astraight-line basis over the vesting period for the last separately vestingportion of the awards.  Fair value isdetermined as the difference between the closing price of our common stock onthe grant date and the purchase price of the restricted stock award, if any,reduced by expected forfeitures.

 

If there are any modifications or cancellations of the underlyingvested or unvested stock-based awards, we may be required to accelerate,increase or cancel any remaining unearned stock-based compensation expense, orrecord additional expense for vested stock-based awards.  Future stock-based compensation expense andunearned stock- based compensation may increase to the extent that we grantadditional common stock options or other stock-based awards.

 

*IncomeTaxes.*  Under 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 taximpact of certain discrete items, unusual or infrequently occurring, includingchanges in judgment about valuation allowances and effects of changes in taxlaws or rates, in the interim period in which they occur. In addition,jurisdictions with a projected loss for the year or a year-to-date loss whereno tax benefit can be recognized are excluded from the estimated annualeffective tax rate. The impact of such an exclusion could result in a higher orlower effective tax rate during a particular quarter, based upon the mix andtiming of actual earnings versus annual projections.

 

27

----

Table of Contents

 

Deferred tax assets and liabilities are recognized to reflect theestimated future tax effects, calculated at currently effective tax rates, offuture deductible or taxable amounts attributable to events that have beenrecognized on a cumulative basis in the condensed consolidated financialstatements.  A valuation allowance relatedto a net deferred tax asset is recorded when it is more likely than not thatsome portion of the deferred tax asset will not be realized.

 

ASC Topic 740 prescribes a recognition threshold and measurementrequirement for the financial statement recognition of a tax position that hasbeen taken or is expected to be taken on a tax return and also providesguidance on de-recognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition. Under ASC Topic 740 we may onlyrecognize or continue to recognize tax positions that meet a “more likely thannot” threshold.

 

The application of tax laws and regulations is subject to legal andfactual interpretation, judgment and uncertainty. Tax laws and regulationsthemselves are subject to change as a result of changes in fiscal policy,changes in legislation, the evolution of regulations and court rulings.Therefore, the actual liability for U.S. or foreign taxes may be materiallydifferent from our estimates, which could result in the need to recordadditional tax liabilities or potentially reverse previously recorded taxliabilities.

 

**Results of Operations**

 

Thefollowing table sets forth certain condensed consolidated statements ofoperations data as a percentage of net sales for the periods indicated:

 
| ** **                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                       | ** ** | **July 3,**            | ** ** | **July 4,**          | ** ** | **July 3,** | ** ** | **July 4,** | ** ** |
| ** **                                       | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                             | ** ** | ** **             |       |                 | ** ** |   |   |   |   |
| Net sales                                        |       | 100                    | %          | 100                  | %          | 100 | % | 100 | % |
| Cost of sales                                    |       | 80                     |       | 92                   |       | 79 |   | 105 |   |
| Gross profit (loss)                              |       | 20                     |       | 8                    |       | 21 |   | (5 | ) |
| Operating expenses:                              |       |                   |       |                 |       |   |   |   |   |
| Research and development                         |       | 34                     |       | 64                   |       | 36 |   | 68 |   |
|                                             |       |                   |       |                 |       |   |   |   |   |
| Selling, general and administrative              |       | 28                     |       | 67                   |       | 30 |   | 76 |   |
| Total operating expenses                         |       | 62                     |       | 131                  |       | 66 |   | 144 |   |
| Operating loss                                   |       | (43                    | )          | (123                 | )          | (45 | ) | (149 | ) |
| Other income (expense):                          |       |                   |       |                 |       |   |   |   |   |
| Interest income, net                             |       | —                 |       | 1                    |       | — |   | 2 |   |
| Other income (expense), net                      |       | —                 |       | (2                   | )          | 1 |   | 2 |   |
| Total other income (expense), net                |       | —                 |       | (1                   | )          | 1 |   | 4 |   |
| Loss before provision (benefit) for income taxes |       | (43                    | )          | (124                 | )          | (44 | ) | (145 | ) |
|                                             |       |                   |       |                 |       |   |   |   |   |
| Provision (benefit) for income taxes             |       | —                 |       | 1                    |       | (4 | ) | 1 |   |
| Net loss                                         |       | (43                    | )%         | (125                 | )%         | (40 | )% | (146 | )% |

 

28

----

Table of Contents

 

***Three and Six Months EndedJuly 3, 2010 Compared to Three and Six Months Ended July 4, 2009***

 

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

 

Thefollowing table presents net sales, cost of sales and gross profit for thethree and six months ended July 3, 2010 and July 4, 2009 (in thousands,except percentages):

 
| ** **    | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | ** ** | ** ** |
|---------------|------------|------------------------|------------|-------------|------------|------------|------------|
| ** **    | ** ** | **July 3,**            | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **    | ** ** | **2010**               | ** ** | **2009**    | ** ** | **Change** | ** ** | **Change** | ** ** |
|          |       |                   |       |        |       |       |       |   |   |
| Net sales     |       | $                      | 9,304      |        | $          | 3,173      |       | $ | 6,131 |   | 193 | % |
| Cost of sales |       | 7,486                  |       | 2,929       |       | 4,557      |       | 156 | % |
| Gross profit  |       | $                      | 1,818      |        | $          | 244        |       | $ | 1,574 |   | 645 | % |
| Gross margin  |       | 20                     | %          | 8           | %          | 12         | %          |   |   |

 
| ** **          | ** ** | **Six Months Ended** | ** ** | ** **       | ** ** | ** ** | ** ** |
|---------------------|------------|--------------------------------|------------|------------------|------------|------------|------------|
| ** **          | ** ** | **July 3,**               | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **          | ** ** | **2010**                       | ** ** | **2009**         | ** ** | **Change** | ** ** | **Change** | ** ** |
|                |       |                           |       |             |       |       |       |   |   |
| Net sales           |       | $                              | 17,194     |             | $          | 5,335      |       | $ | 11,859 |   | 222 | % |
| Cost of sales       |       | 13,558                         |       | 5,628            |       | 7,930      |       | 141 | % |
| Gross profit (loss) |       | $                              | 3,636      |             | $          | (293       | )          | $ | 3,929 |   | 1,341 | % |
| Gross margin        |       | 21                             | %          | (5               | )%         | 27         | %          |   |   |

 

*Net Sales.*** Overall, net sales of our RAID, data centeroptimization and industrial applications increased as a result of the selectionof our memory modules for inclusion in new product platforms.  Net sales in all product categories havebenefited from resurgence in technology investment, as general economicconditions have improved.  Shouldeconomic conditions erode positive sales trends may not continue.

 

Theincrease in net sales for the three months ended July 3, 2010 as compared withthe three months ended July 4, 2009 resulted primarily from increases ofapproximately (i) $3.3 million in sales of NetVaultTM non-volatile cache systemsused in RAID controller subsystems, including $2.4 million from the launch ofNetVaultTM NV, the flash-based cache system that became generally available in2010, and (ii) $2.3 million in sales of memory modules utilized in data centertargeted server applications.

 

Theincrease in net sales for the six months ended July 3, 2010 as compared with thesix months ended July 4, 2009 resulted from increases of approximately (i) $5.5million in sales of NetVaultTM products, including $2.6 million from NetVaultTMNV, (ii) $4.2 million in sales of memory modules utilized in data centertargeted server applications, and (iii) $1.2 million in sales of memory modulesdesigned for industrial applications.

 

*Gross Profit (Loss) and Gross Margin.*** The overall improvements in gross profit(loss) are due to increased sales and manufacturing volume.

 

Grossprofit for the three months ended July 3, 2010 as compared to the threemonths ended July 4, 2009 increased due to the 193% increase in net salesbetween the two periods, resulting in profits earned on each unit sold, as wellas an improved ability to absorb fixed manufacturing costs.  These volume based improvements are partiallyoffset by increased DRAM prices, which affected margins in some productcategories.  Gross profits for the sixmonths ended July 3, 2010 as compared to the six months ended July 4, 2009 wereimpacted by the same trends, including a 222% increase in net sales between thetwo periods.

 

29

----

Table of Contents

 

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

 

Thefollowing table presents research and development expenses for the three andsix months ended July 3, 2010 and July 4, 2009 (in thousands, exceptpercentages):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | ** ** | ** ** |
|--------------------------|------------|------------------------|------------|-------------|------------|------------|------------|
| ** **               | ** ** | **July 3,**            | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **               | ** ** | **2010**               | ** ** | **2009**    | ** ** | **Change** | ** ** | **Change** | ** ** |
|                     |       |                   |       |        |       |       |       |   |   |
| Research and development |       | $                      | 3,190      |        | $          | 2,030      |       | $ | 1,160 |   | 57 | % |
|                          |            |                        |            |             |            |            |            |  |  |  |  |  |

 
| ** **               | ** ** | **Six Months Ended** | ** ** | ** **       | ** ** | ** ** | ** ** |
|--------------------------|------------|--------------------------------|------------|------------------|------------|------------|------------|
| ** **               | ** ** | **July 3,**               | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **               | ** ** | **2010**                       | ** ** | **2009**         | ** ** | **Change** | ** ** | **Change** | ** ** |
| Research and development |       | $                              | 6,198      |             | $          | 3,644      |       | $ | 2,554 |   | 70 | % |
|                          |            |                                |            |                  |            |            |            |  |  |  |  |  |

 

Theincrease in research and development expense in the three months endedJuly 3, 2010 as compared to the three months ended July 4, 2009 resultedprimarily from increases of (i) $0.3 million in engineering expenses as aresult of an increase in non-recurring engineering charges and both internalengineering headcount and outside contractors engaged in new productdevelopment activities in the first quarter of 2010, (ii) $0.4 million inlegal and professional fees as we continue to increase patent filing andprotection activities related to new and emerging markets and (iii) $0.4million in material expenses related to product builds and testing, primarilyrelated to our HyperCloudTM products.

 

Theincrease in research and development expense in the six months ended July 3,2010 as compared to the six months ended July 4, 2010 resulted primarily fromincreases of (i) $1.0 million in non-recurring engineering charges, headcount,and outside consultants, (ii) $1.0 million in patent related legal expense, and(iii) $0.5 million in product qualification builds and testing.

 

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

 

Thefollowing table presents selling, general and administrative expenses for thethree and six months ended July 3, 2010 and July 4, 2009 (in thousands,except percentages):

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | ** **  | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------------------|------------|-------------|------------|------------|------------|
| ** **                          | ** ** | **July 3,**            | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2010**               | ** ** | **2009**    | ** ** | **Change** | ** ** | **Change** | ** ** |
|                                |       |                   |       |        |       |       |       |   |   |
| Selling, general and administrative |       | $                      | 2,607      |        | $          | 2,120      |       | $ | 487 |   | 23 | % |
|                                     |            |                        |            |             |            |            |            |  |  |  |  |  |

 
| ** **                          | ** ** | **Six Months Ended** | ** ** | ** **       | ** ** | ** ** | ** ** |
|-------------------------------------|------------|--------------------------------|------------|------------------|------------|------------|------------|
| ** **                          | ** ** | **July 3,**               | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2010**                       | ** ** | **2009**         | ** ** | **Change** | ** ** | **Change** | ** ** |
| Selling, general and administrative |       | $                              | 5,177      |             | $          | 4,055      |       | $ | 1,122 |   | 28 | % |
|                                     |            |                                |            |                  |            |            |            |  |  |  |  |  |

 

Theincrease in selling, general and administrative expense in the three monthsended July 3, 2010 as compared to the three months ended July 4, 2009resulted primarily from increases of approximately (i) $0.2 million incommission expenses due to an increase in sales revenue, (ii) $0.1 million inpersonnel-related expenses primarily attributable to hiring personnel tosupport the development of  markets forHyperCloudTM and NetVaultTM NV, and (iii) $0.1 million in product samples andtravel costs as a result of activities related to the OEM qualification processfor HyperCloudTM and NetVaultTM NV.

 

Theincrease in selling, general and administrative expense in the six months endedJuly 3, 2010 as compared to the six months ended July 4, 2009 resultedprimarily from increases of approximately (i) $0.4 million in commissionexpenses, (ii) $0.4 million in personnel-related expenses, and (iii) $0.3million in product samples and travel costs as a result of activities relatedto the OEM qualification process for HyperCloudTM and NetVaultTM NV.

 

30

----

 

Table of Contents

 

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

 

Thefollowing table presents other income for the three and six months endedJuly 3, 2010 and July 4, 2009 (in thousands, except percentages):

 
| ** **                        | ** ** | **Three Months Ended**         | ** ** | ** **       | ** ** | ** ** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|------------------|------------|------------|------------|
| ** **                        | ** ** | **July 3,**               | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                        | ** ** | **2010**                       | ** ** | **2009**         | ** ** | **Change** | ** ** | **Change** | ** ** |
|                              |       |                           |       |             |       |       |       |   |   |
| Interest income, net              |       | $                              | 3          |             | $          | 18         |       | $ | (15 | ) | (83 | )% |
| Other income (expense), net       |       | 4                              |       | (45              | )          | 49         |       | 109 | % |
| Total other income (expense), net |       | $                              | 7          |             | $          | (27        | )          | $ | 34 |   | 126 | % |
|                              |       |                           |       |             |       |       |       |   |   |
| ** **                        | ** ** | **Six Months Ended** | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **July 3,**               | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                        | ** ** | **2010**                       | ** ** | **2009**         | ** ** | **Change** | ** ** | **Change** | ** ** |
|                              |       |                           |       |             |       |       |       |   |   |
| Interest income, net              |       | $                              | 4          |             | $          | 100        |       | $ | (96 | ) | (96 | )% |
| Other income (expense), net       |       | 71                             |       | 130              |       | (59        | )          | (45 | )% |
| Total other income (expense), net |       | $                              | 75         |             | $          | 230        |       | $ | (155 | ) | (67 | )% |

 

Netinterest income for the three and six months ended July 3, 2010 wascomprised of nominal interest income, offset by nominal interest expense.  Net interest income for the three and sixmonths ended July 4, 2009 was comprised of interest income ofapproximately $0.2 million and $0.5 million, respectively, partially offset byinterest expense of approximately $0.1 million and $0.02 million,respectively.  The decrease in interestincome in the three and six months ended July 3, 2010 as compared to thethree and six months ended July 4, 2009 was due to a combination of ourlower average cash and investment balances and the decrease in the yield earnedon those balances due to lower interest rates. The decrease in interest expense during 2010 as compared to 2009resulted primarily from our lower average outstanding balances on our line ofcredit and debt balances during the current year.

 

Otherincome, net, for the six months ended July 3, 2010 was primarily comprisedof cash proceeds from the early termination of a sublease of our headquartersfacility.  Other income, net, for the sixmonths ended July 4, 2009 was primarily comprised of gains from the saleof equipment held for sale during the first quarter.

 

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

 

Thefollowing table presents the (benefit) provision for income taxes for the threeand six months ended July 3, 2010 and July 4, 2009 (in thousands,except percentages):

 
| ** **                           | ** ** | **Three Months Ended**         | ** ** | ** **       | ** ** | ** ** | ** ** |
|--------------------------------------|------------|--------------------------------|------------|------------------|------------|------------|------------|
| ** **                           | ** ** | **July 3,**               | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2010**                       | ** ** | **2009**         | ** ** | **Change** | ** ** | **Change** | ** ** |
|                                 |       |                           |       |             |       |       |       |   |   |
| Provision (benefit) for income taxes |       | $                              | 2          |             | $          | 31         |       | $ | (29 | ) | (94 | )% |
|                                 |       |                           |       |             |       |       |       |   |   |
| ** **                           | ** ** | **Six Months Ended** | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **July 3,**               | ** ** | **July 4,** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2010**                       | ** ** | **2009**         | ** ** | **Change** | ** ** | **Change** | ** ** |
|                                 |       |                           |       |             |       |       |       |   |   |
| Provision (benefit) for income taxes |       | $                              | (725       | )                | $          | 49         |       | $ | 774 |   | 1,580 | % |

 

On an interim basis, weestimate what our effective tax rate will be in each jurisdiction for the fullfiscal year and record a quarterly income tax (benefit) provision in accordancewith the anticipated blended annual rate. We are also required to record thetax impact of certain discrete items, unusual or infrequently occurring,including changes in judgment about valuation allowances and effects of changesin tax laws or rates, in the interim period in which they occur.  During the six 

 

31

----

Table of Contents

 

months ended July 3,2010, we carried back approximately $1.7 million of gross net operating lossesunder the Worker, Homeownership, and Business Act and recorded a tax benefitand income tax receivable of approximately $0.7 million, which was received in April 2010.  In addition, jurisdictions with a projectedloss for the year or a year-to-date loss where no tax benefit can be recognizedare excluded from the estimated annual effective tax rate.  The impact of such an exclusion could resultin a higher or lower effective tax rate during a particular quarter, based uponthe mix and timing of actual earnings versus annual projections.

 

We evaluate whether avaluation allowance should be established against our deferred tax assets basedon the consideration of all available evidence using a “more likely than not”standard.  Due to uncertainty of futureutilization, we have provided a full valuation allowance as of July 3,2010 and January 2, 2010. Accordingly, no benefit has been recognized for net deferred tax assets,including net operating losses that cannot be realized currently via carrybackto periods of taxable income.

 

Our income tax benefit of$0.7 million for the six months ended July 3, 2010 was the result of aspecial carryback of operating losses that was made available throughlegislative changes.  We recorded aprovision for income taxes for the quarters ended July 3, 2010 andJuly 4, 2009 and for the six months ended July 4, 2009 due to stateminimum taxes.

 

**Liquidity and Capital Resources**

 

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

 

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

 

Thefollowing table presents working capital, cash and cash equivalents andinvestments in marketable securities (in thousands): 

 
| ** **                          | ** ** | **July 3,** | ** ** | **January 2,** | ** ** |
|-------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                          | ** ** | **2010**         | ** ** | **2010**            | ** ** |
| Working Capital                     |       | $                | 24,172     |                | $          | 13,379 |   |
|                                |       |             |       |                |       |
| Cash and cash equivalents(1)        |       | $                | 16,993     |                | $          | 9,942 |   |
| Short-term marketable securities(1) |       | 5,211            |       | 3,949               |       |
| Long-term marketable securities     |       | 902              |       | 941                 |       |
|                                |       | $                | 23,106     |                | $          | 14,832 |   |

 

----

(1) Includedin working capital

 

Ourworking capital increased in the six months ended July 3, 2010 primarilyas a result of our increase in cash, cash equivalents and short-term marketablesecurities resulting from our public offering of our shares of commonstock.  Additionally, we experiencedincreases in certain operating assets, offset by increases in certain operatingliabilities resulting from our increase in sales of our legacy products andproduction ramp up for HyperCloudTM and NetVaultTM NV.

 

***Cash Provided and Used in the Six Months Ended July 3,2010 and July 4, 2009***

 

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

 
| ** **                                            | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                            | ** ** | **July 3,**               | ** ** | **July 4,** | ** ** |
| ** **                                            | ** ** | **2010**                       | ** ** | **2009** | ** ** |
|                                                  |       |                           |       |   |   |
| **Net cash provided by (used in):**                   |       |                           |       |   |   |
| Operating activities                                  |       | $                              | (7,530     | ) | $ | (3,429 | ) |
| Investing activities                                  |       | (1,662                         | )          | (3,592 | ) |
| Financing activities                                  |       | 16,243                         |       | 1,913 |   |
| Net increase (decrease) in cash and cash  equivalents |       | $                              | 7,051      |   | $ | (5,108 | ) |

 

32

----

Table of Contents

 

*Operating Activities.* Net cash used in operatingactivities for the six months ended July 3, 2010 was primarily a result of(i) net loss of approximately $6.9 million and (ii) cash used bychanges in operating assets and liabilities of approximately $2.5 million,partially offset by approximately $1.9 million in net non-cash operatingexpenses, primarily consisting of depreciation and amortization and stock-basedcompensation expense.  Net cash used inoperating activities for the six months ended July 4, 2009 was primarily aresult of a net loss of approximately $7.8 million, partially offset by(i) approximately $2.8 million in net cash provided by changes inoperating assets and liabilities, and (ii) approximately $1.6 million innet non-cash operating expenses, primarily comprising depreciation andamortization and stock-based compensation.

 

Accountsreceivable increased approximately $2.8 million during the six months endedJuly 3, 2010 primarily as a result of the increase in our net sales duringthe period. During the same period, we were successful in collecting cash fromsales to our customers substantially in accordance with our standard paymentterms with those customers.  Inventoriesincreased approximately $2.0 million during the six months ended July 3,2010 as we prepare for production of our HyperCloudTM products and initiatedproduction of our NetVaultTM NV products. During the six months ended July 3, 2010, we were able to partiallyfund the growth in our accounts receivable and inventory through an increase inaccounts payable of $2.1 million, primarily from component vendors.

 

*Investing Activities.* Net cash used in investingactivities for the six months ended July 3, 2010 was primarily the resultof purchases of $2.4 million of investments in marketable securities, offset bysales of $1.1 million.  Additionally, weacquired $0.4 million in property and equipment.  Net cash used in investing activities for thesix months ended July 4, 2009 was primarily a result of purchases ofadditional investments in marketable securities of approximately $10.2 million,partially offset by (i) proceeds received from maturities and sales ofcertain investments in marketable securities of approximately $6.3 million and(ii) proceeds from the sale of equipment of $0.3 million.

 

*Financing Activities.* Net cash provided byfinancing activities for the six months ended July 3, 2010 was a result ofthe net proceeds of $16.2 million from the sale of 4,594,250 shares of ourcommon stock in a registered public offering, which closed on March 24,2010.  Net cash provided by financingactivities for the six months ended July 4, 2009 was a result of netborrowing on our credit facility of approximately $2.2 million, partiallyoffset by repayment of approximately $0.2 million on our long-term debt.

 

***Capital Resources***

 

OnOctober 31, 2009, we entered into a revolving credit agreement withSilicon Valley Bank.  Under the original terms of the credit agreement, wecould borrow up to the lesser of (i) 80% of eligible accounts receivable,minus $1.0 million, or (ii) $5.0 million.  The revolving creditagreement was amended on March 24, 2010 to allow for increased accountsreceivable eligibility and to remove the $1.0 million reduction from thecalculated accounts receivable borrowing base and further amended on June 30,2010 to modify certain financial covenants. The credit agreement contains an overall sublimit of $2.5 million tocollateralize our contingent obligations under letters of credit, foreignexchange contracts and cash management services.  Amounts outstandingunder the overall sublimit reduce the amount available pursuant to the creditagreement.  Interest is payable monthlyat either (i) prime plus 1.25%, as long as we maintain $8.5 million inrevolving credit availability plus unrestricted cash on deposit with thefinancial 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.  At July 3, 2010, letters of credit inthe amount of $1.8 million were outstanding.

 

Thefollowing table presents details of outstanding borrowings and availabilityunder our line of credit (in thousands):

 
| ** **                                                 | ** ** | **July 3,** | ** ** | **January 2,** | ** ** |
|------------------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | **2010**         | ** ** | **2010**            | ** ** |
| Outstanding borrowings on the revolving line of  credit    |       | $                | —     |                | $          | — |   |
| Borrowing availability under the revolving line of  credit |       | $                | 3,200      |                | $          | — |   |

 

Obligationsunder our revolving credit agreement are secured by a first priority lien onour tangible and intangible assets.  Inconnection with the revolving credit agreement, we entered into an IntercompanySubordination Agreement, which provided that Netlist Technology Texas, LP, oneof our subsidiaries, is an additional obligor on the revolving creditagreement.

 

33

----

Table of Contents

 

Theonly restriction on the use of these funds is that we must be in compliancewith the covenants of the revolving credit agreement.  The credit agreement includes affirmative andnegative covenants, including financial covenants with respect to our liquidityand profitability.  As of July 3,2010, we were in compliance with all financial covenants and expect to maintaincompliance for the foreseeable future. However, we have in the past been in violation of one or more covenantsof other credit agreements, and we could violate one or more covenants in thefuture. If we were to be in violation of covenants under our credit agreement,our lender could choose to accelerate payment on all outstanding loan balances.If that were to occur, we may be unable to quickly obtain equivalent orsuitable replacement financing. If we were not able to secure alternativesources of funding, such acceleration would have a material adverse impact onour financial condition.

 

Wehave in the past utilized equipment leasing arrangements to finance certaincapital expenditures.  Equipment leasescontinue to be a financing alternative that we expect to pursue in the future.

 

Webelieve our existing cash balances, borrowing availability under our bankcredit facility, and the cash expected to be generated from operations, will besufficient to meet our anticipated cash needs for at least the next12 months. Our future capital requirements will depend on many factors, includingour levels of net sales, the timing and extent of expenditures to supportresearch and development activities, the expansion of manufacturing capacityboth domestically and internationally and the continued market acceptance ofour products. We could be required, or may choose, to seek additional fundingthrough public or private equity or debt financings. In addition, in connectionwith any future acquisitions, we may require additional funding which may beprovided in the form of additional debt or equity financing or a combinationthereof. These additional funds may not be available on terms acceptable to us,or at all.

 

***New Accounting Pronouncements***

 

InSeptember 2009, the FASB issued Accounting Standards Update (“ASU”)2009-13, *Multiple-Deliverable Revenue Arrangements*(“ASU 2009-13”), which amends the revenue guidance under ASC Topic 605, whichdescribes the accounting for multiple element arrangements.  ASU 2009-13 addresses how to determinewhether an arrangement involving multiple deliverables contains more than oneunit of accounting and how arrangement consideration shall be measured andallocated to the separate units of accounting in the arrangement.  ASU 2009-13 is effective on a prospectivebasis for the Company’s fiscal year 2011, with earlier adoption permitted.  We are currently evaluating the adoption ofASU 2009-13 and the impact that ASU 2009-13 will have on our condensedconsolidated financial statements.

 

InSeptember 2009, the FASB issued ASU 2009-14, *CertainRevenue Arrangements That Include Software Elements* (“ASU 2009-14”),which excludes tangible products containing software components andnon-software components that function together to deliver the product’sessential functionality from the scope of ASC Topic 985, which describes theaccounting for software revenue recognition. ASU 2009-14 is effective on a prospective basis for our fiscal year2011, with earlier adoption permitted. We are currently evaluating the impact that ASU 2009-14 will have on itscondensed consolidated financial statements.

 

***Off-Balance Sheet Arrangements***

 

Wedo not have any relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. In addition, we do not have any undisclosed borrowings ordebt, and we have not entered into any synthetic leases. We are, therefore, notmaterially exposed to any financing, liquidity, market or credit risk thatcould arise if we had engaged in such relationships.

 

**Item 4T.****                ****Controlsand Procedures**

 

*(a) Evaluation of Disclosure Controls and Procedures.* We carried outan evaluation, under the supervision and with the participation of ourmanagement, including our principal executive officer and principal financialofficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934, (“Exchange Act”)) as ofthe end of our fiscal quarter ended July 3, 2010.  Based upon that evaluation, our principalexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures are effective to provide reasonable assurance thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act (i) is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms and(ii) 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 in internal controls over financial reporting.* During thefiscal quarter that ended July 3, 2010, there were no changes in ourinternal controls over financial reporting (as defined inRules 13a-15(f) and 15d-15(f) under the Exchange Act) that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

 

34

----

Table of Contents

 

***Inherent Limitations on Internal Control***

 

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

 

**PART II. OTHER INFORMATION**

 

**Item 1.****                         ****LegalProceedings**

 

Theinformation set forth in the sections entitled Federal SecuritiesClass Action, Patent Claims and Trade Secret Claim under Note 9 of Notesto Unaudited Condensed Consolidated Financial Statements, included inPart I, Item I of this Report, is incorporated herein by reference.

 

**Item 6.****                        ****Exhibits**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                     |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description of Document**                                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                           |
| 3.1(1)      |       | Restated  Certificate of Incorporation of Netlist, Inc.                                                                                                                                                                                   |
|        |       |                                                                                                                                                                                                                                           |
| 3.2(1)      |       | Amended  and Restated Bylaws of Netlist, Inc.                                                                                                                                                                                             |
|        |       |                                                                                                                                                                                                                                           |
| 10.1(2)#    |       | Amended  and Restated 2006 Equity Incentive Plan                                                                                                                                                                                               |
|        |       |                                                                                                                                                                                                                                           |
| 10.2(2)     |       | Amendment  to Loan Documents entered into as of June 30, 2010, by and between  Silicon Valley Bank and Netlist, Inc., a Delaware Corporation.                                                                                        |
|        |       |                                                                                                                                                                                                                                           |
| 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 correspondingexhibit number of the registration statement on Form S-1 of the registrant(No. 333-136735) filed with the Securities and Exchange Commission onOctober 23, 2006.

 

(2)          Filed herewith.

 

(3)          The information in Exhibit 32 shall not bedeemed “filed” for purposes of Section 18 of the Securities Exchange Actof 1934, as amended, (the “Exchange Act”), or otherwise subject to theliabilities of that section, nor shall they be deemed incorporated by referencein any filing under the Securities Act of 1933, as amended, or the Exchange Act(including this Report), unless the registrant specifically incorporates theforegoing information into those documents by reference.

 

#                 Managementcontract or compensatory plan or arrangement

 

35

----

Table of Contents

 

**SIGNATURES**

 

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

 
| Date:  August 12, 2010 |       | 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 M. Sasaki                         |
| ** **                  | ** ** | **Gail M. Sasaki**                         |
| ** **                  | ** ** | **Vice President and Chief Financial**     |
| ** **                  | ** ** | **Officer**                                |
| ** **                  | ** ** | **(Principal Financial Officer)**          |

 

36

----

Table of Contents

 

**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.                                                                                                                                                                                             |
|        |       |                                                                                                                                                                                                                                           |
| 10.1(2)#    |       | Amended  and Restated 2006 Equity Incentive Plan                                                                                                                                                                                               |
|        |       |                                                                                                                                                                                                                                           |
| 10.2(2)     |       | Amendment  to Loan Documents entered into as of June 30, 2010, by and between  Silicon Valley Bank and Netlist, Inc., a Delaware Corporation.                                                                                        |
|        |       |                                                                                                                                                                                                                                           |
| 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 correspondingexhibit number of the registration statement on Form S-1 of the registrant(No. 333-136735) filed with the Securities and Exchange Commission onOctober 23, 2006.

 

(2)          Filed herewith.

 

(3)          The information in Exhibit 32 shall not bedeemed “filed” for purposes of Section 18 of the Securities Exchange Actof 1934, as amended, (the “Exchange Act”), or otherwise subject to theliabilities of that section, nor shall they be deemed incorporated by referencein any filing under the Securities Act of 1933, as amended, or the Exchange Act(including this Report), unless Netlist, Inc. specifically incorporatesthe foregoing information into those documents by reference.

 

#                 Managementcontract or compensatory arrangement

 

37

----