Table of Contents

 

 

** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **
| **(Mark  One)**                                                                                                                                                               |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                         | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                    | ** ** |
| **For the  quarterly period ended April 4, 2009**                                                                                                                        |
| ** **                                                                                                                                                                    | ** ** |
| **or**                                                                                                                                                                        |
| ** **                                                                                                                                                                    | ** ** |
| **o**                                                                                                                                                                         | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                          |   |
| **For the transition period from              to             ** |

 

**Commission file number001-33170**

** **

****

** **

**NETLIST, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**51 Discovery, Irvine, CA 92618**

(Address of principal executive offices) (Zip Code)

 

**(949) 435-0025**

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

** **

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 in Rule 12b-2of the Act).  Yes o   No x

 

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

 

Common Stock, par value $0.001 per share

19,855,411 shares outstanding at April 30, 2009

 

 

 

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**Table of Contents**

** **

**NETLIST, INC. ANDSUBSIDIARIES**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE THREE MONTHSENDED APRIL 4, 2009**

** **

**TABLE OF CONTENTS**

 
| ** **    | ** **                                                                                                                             | ** ** | **Page** |
|---------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I.  | FINANCIAL INFORMATION                                                                                                                  |       | 3        |
| Item 1.       | Financial Statements                                                                                                                   |       | 3        |
|          | Condensed  Consolidated Balance Sheets at April 4, 2009 (unaudited) and  January 3, 2009 (audited)                           |       | 3        |
|          | Unaudited  Condensed Consolidated Statements of Operations for the Three Months Ended  April 4, 2009 and March 29, 2008 |       | 4        |
|          | Unaudited  Condensed Consolidated Statements of Cash Flows for the Three Months Ended  April 4, 2009 and March 29, 2008      |       | 5        |
|          | Notes to  Unaudited Condensed Consolidated Financial Statements                                                                        |       | 6        |
| Item  2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                            |       | 18       |
| Item  3.      | Quantitative  and Qualitative Disclosures About Market Risk                                                                            |       | 28       |
| Item  4.      | Controls  and Procedures                                                                                                               |       | 28       |
| Item  4T.     | Controls  and Procedures                                                                                                               |       | 28       |
|          |                                                                                                                                   |       |     |
| PART II. | OTHER  INFORMATION                                                                                                                     |       | 29       |
| Item 1.       | Legal  Proceedings                                                                                                                     |       | 29       |
| Item 1A.      | Risk Factors                                                                                                                           |       | 29       |
| Item  2.      | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                           |       | 29       |
| Item  3.      | Defaults  Upon Senior Securities                                                                                                       |       | 29       |
| Item  4.      | Submission  of Matters to a Vote of Security Holders                                                                                   |       | 29       |
| Item 5.       | Other  Information                                                                                                                     |       | 29       |
| Item 6.       | Exhibits                                                                                                                               |       | 30       |

 

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**PART I. FINANCIALINFORMATION**

 

**Item1. Financial Statements**

 

**NETLIST, INC.AND SUBSIDIARIES**

**CondensedConsolidated Balance Sheets**

**(inthousands, except par value)**

** **
| ** **                                                                                       | ** ** | **(unaudited)**   | ** ** | **(audited)**       | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-------------------|------------|---------------------|------------|
| ** **                                                                                       | ** ** | **April 4,** | ** ** | **January 3,** | ** ** |
| ** **                                                                                       | ** ** | **2009**          | ** ** | **2009**            | ** ** |
| ** **                                                                                       | ** ** | ** **        | ** ** | ** **          | ** ** |
| **ASSETS**                                                                                       | ** ** | ** **        | ** ** | ** **          | ** ** |
| Current assets:                                                                                  |       |              |       |                |       |
| Cash and cash equivalents                                                                        |       | $                 | 8,563      |                | $          | 15,214 |   |
| Investments in marketable securities                                                             |       | 11,077            |       | 5,199               |       |
| Accounts receivable, net                                                                         |       | 895               |       | 1,917               |       |
| Inventories                                                                                      |       | 1,322             |       | 1,829               |       |
| Income taxes receivable                                                                          |       | 647               |       | 1,880               |       |
| Prepaid expenses and other current assets                                                        |       | 786               |       | 761                 |       |
| Total current assets                                                                             |       | 23,290            |       | 26,800              |       |
|                                                                                             |       |              |       |                |       |
| Property and equipment, net                                                                      |       | 6,272             |       | 6,939               |       |
| Long-term investments in marketable securities                                                   |       | 981               |       | 960                 |       |
| Other assets                                                                                     |       | 225               |       | 234                 |       |
| Total assets                                                                                     |       | $                 | 30,768     |                | $          | 34,933 |   |
|                                                                                             |       |              |       |                |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                    |       |              |       |                |       |
| Current liabilities:                                                                             |       |              |       |                |       |
| Accounts payable                                                                                 |       | $                 | 1,320      |                | $          | 1,786 |   |
| Current portion of long-term debt                                                                |       | 433               |       | 474                 |       |
| Current portion of deferred gain on sale and leaseback transaction                               |       | 118               |       | 118                 |       |
| Accrued expenses and other current liabilities                                                   |       | 2,045             |       | 2,083               |       |
| Total current liabilities                                                                        |       | 3,916             |       | 4,461               |       |
| Long-term debt, net of current portion                                                           |       | 48                |       | 130                 |       |
| Deferred gain on sale and leaseback transaction, net of current  portion                         |       | 78                |       | 108                 |       |
| Total liabilities                                                                                |       | 4,042             |       | 4,699               |       |
| Commitments and contingencies                                                                    |       |              |       |                |       |
| Stockholders’ equity:                                                                       |       |              |       |                |       |
| Common stock, $0.001 par value - 90,000 shares authorized; 19,855 shares  issued and outstanding |       | 20                |       | 20                  |       |
| Additional paid-in capital                                                                       |       | 69,690            |       | 69,383              |       |
| Accumulated deficit                                                                              |       | (42,960           | )          | (39,113             | )          |
| Accumulated other comprehensive loss                                                             |       | (24               | )          | (56                 | )          |
| Total stockholders’ equity                                                                  |       | 26,726            |       | 30,234              |       |
| Total liabilities and stockholders’ equity                                                  |       | $                 | 30,768     |                | $          | 34,933 |   |

** **

Seeaccompanying notes.

 

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**NETLIST, INC. AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Operations**

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

 
| ** **                                       | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                                       | ** ** | **2009**               | ** ** | **2008** | ** ** |
| ** **                                       | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net sales                                        |       | $                      | 2,162      |   | $ | 13,104 |   |
| Cost of sales(1)                                 |       | 2,699                  |       | 9,973 |   |
| Gross (loss) profit                              |       | (537                   | )          | 3,131 |   |
| Operating expenses:                              |       |                   |       |   |   |
| Research and development(1)                      |       | 1,614                  |       | 1,576 |   |
| Selling, general and administrative(1)           |       | 1,935                  |       | 3,468 |   |
| Total operating expenses                         |       | 3,549                  |       | 5,044 |   |
| Operating loss                                   |       | (4,086                 | )          | (1,913 | ) |
| Other income (expense):                          |       |                   |       |   |   |
| Interest income, net                             |       | 82                     |       | 239 |   |
| Other income (expense), net                      |       | 175                    |       | (91 | ) |
| Total other income, net                          |       | 257                    |       | 148 |   |
| Loss before provision (benefit) for income taxes |       | (3,829                 | )          | (1,765 | ) |
| Provision (benefit) for income taxes             |       | 18                     |       | (1,181 | ) |
| Net loss                                         |       | $                      | (3,847     | ) | $ | (584 | ) |
| Net loss per common share:                       |       |                   |       |   |   |
| Basic                                            |       | $                      | (0.19      | ) | $ | (0.03 | ) |
| Diluted                                          |       | $                      | (0.19      | ) | $ | (0.03 | ) |
| Weighted-average common shares outstanding:      |       |                   |       |   |   |
| Basic                                            |       | 19,855                 |       | 19,820 |   |
| Diluted                                          |       | 19,855                 |       | 19,820 |   |
|                                             |       |                   |       |   |   |

----

| (1)  Amounts include stock-based compensation expense as  follows: |   |   |   |   |   |
|-------------------------------------------------------------------------|--------|--------|--------|--------|--------|
|                                                                    |   |   |   |   |   |
| Cost of sales                                                           |   | $      | 29     |   | $      | 14 |   |
| Research and development                                                |   | 58     |   | 23     |   |
| Selling, general and administrative                                     |   | 220    |   | 207    |   |
|                                                                         |        |        |        |        |        |  |  |

 

See accompanying notes.

 

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**NETLIST, INC.AND SUBSIDIARIES**

**UnauditedCondensed Consolidated Statements of Cash Flows**

**(inthousands)**

 
| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                 | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                                                                                 | ** ** | **2009**               | ** ** | **2008** | ** ** |
|                                                                                       |       |                   |       |   |   |
| Cash flows from operating activities:                                                      |       |                   |       |   |   |
| Net loss                                                                                   |       | $                      | (3,847     | ) | $ | (584 | ) |
| Adjustments to reconcile net loss to net cash (used in) provided by operating  activities: |       |                   |       |   |   |
| Depreciation and amortization                                                              |       | 581                    |       | 527 |   |
| Amortization of deferred gain on sale and leaseback transaction                            |       | (30                    | )          | (30 | ) |
| Deferred income taxes                                                                      |       | —                 |       | (72 | ) |
| Gain on disposal of assets                                                                 |       | (168                   | )          | — |   |
| Stock-based compensation                                                                   |       | 307                    |       | 244 |   |
| Changes in operating assets and liabilities:                                               |       |                   |       |   |   |
| Accounts receivable                                                                        |       | 1,022                  |       | 4,133 |   |
| Inventories                                                                                |       | 507                    |       | (259 | ) |
| Income taxes receivable                                                                    |       | 1,233                  |       | (1,203 | ) |
| Prepaid expenses and other current assets                                                  |       | (25                    | )          | (271 | ) |
| Other assets                                                                               |       | 9                      |       | 10 |   |
| Accounts payable                                                                           |       | (466                   | )          | (3 | ) |
| Accured expenses and other current liabilities                                             |       | (38                    | )          | (395 | ) |
| Net cash (used in) provided by operating activities                                        |       | (915                   | )          | 2,097 |   |
| Cash flows from investing activities:                                                      |       |                   |       |   |   |
| Acquisition of property and equipment                                                      |       | (22                    | )          | (338 | ) |
| Proceeds from sales of equipment                                                           |       | 276                    |       | — |   |
| Purchase of investments in marketable securities                                           |       | (10,297                | )          | (6,377 | ) |
| Proceeds from maturities of investments in marketable securities                           |       | 3,400                  |       | 7,150 |   |
| Proceeds from sales of investments in marketable securities                                |       | 1,030                  |       | 1,025 |   |
| Net cash (used in) provided by investing activities                                        |       | (5,613                 | )          | 1,460 |   |
| Cash flows from financing activities:                                                      |       |                   |       |   |   |
| Borrowings on line of credit                                                               |       | 4,916                  |       | 18,191 |   |
| Payments on line of credit                                                                 |       | (4,916                 | )          | (19,829 | ) |
| Payments on debt                                                                           |       | (123                   | )          | (227 | ) |
| Tax benefit from exercise of warrants                                                      |       | —                 |       | 32 |   |
| Net cash used in financing activities                                                      |       | (123                   | )          | (1,833 | ) |
| (Decrease) increase in cash and cash equivalents                                           |       | (6,651                 | )          | 1,724 |   |
| Cash and cash equivalents at beginning of period                                           |       | 15,214                 |       | 7,182 |   |
| Cash and cash equivalents at end of period                                                 |       | $                      | 8,563      |   | $ | 8,906 |   |

 

Seeaccompanying notes.

 

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**NETLIST, INC.AND SUBSIDIARIES**

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

**April 4,2009**

** **

**Note 1—Descriptionof Business**

** **

Netlist, Inc. (the “Company” or “Netlist”) designs andmanufactures high performance memory subsystems for the server, highperformance computing and communications markets. The Company’s memorysubsystems consist of dynamic random access memory integrated circuits, NANDflash memory, or NAND, and other components assembled on a printed circuitboard. Headquartered in Irvine, California, Netlist’s solutions are targeted atapplications where memory plays a key role in meeting system performancerequirements. In 2007, the Company established a manufacturing facility in thePeople’s Republic of China, or PRC, which became operational in July 2007upon the successful qualification of certain key customers.

 

**Note 2—Summary ofSignificant Accounting Policies**

** **

*Basis of Presentation*

* *

The interimunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (the “U.S.”) for interim financial information and with theinstructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 8of SEC Regulation S-X. These financial statements do not include all of theinformation and footnotes required by accounting principles generally acceptedin the U.S. for complete financial statements. Therefore, these unauditedcondensed consolidated financial statements should be read in conjunction withthe Company’s audited consolidated financial statements and notes thereto forthe year ended January 3, 2009, included in the Company’s Annual Report onForm 10-K filed with the SEC on March 30, 2009.

 

The condensedconsolidated financial statements included herein as of April 4, 2009 areunaudited; however, they contain all normal recurring accruals and adjustmentsthat, in the opinion of the Company’s management, are necessary to presentfairly the consolidated financial position of the Company and its wholly ownedsubsidiaries as of April 4, 2009, the consolidated results of itsoperations for the three months ended April 4, 2009 and March 29,2008, and the consolidated cash flows for the three months ended April 4,2009 and March 29, 2008. All intercompany balances and transactions havebeen eliminated in consolidation. The results of operations for the threemonths ended April 4, 2009 are not necessarily indicative of the resultsto be expected for the full year or any future interim periods.

 

*Principlesof Consolidation*

* *

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

 

*Fiscal Year*

* *

The Companyoperates under a 52/53-week fiscal year ending on the Saturday closest to December 31.For fiscal 2009, the Company’s fiscal year end is scheduled to be January 2,2010 and will consist of 52 weeks. Each of the Company’s first three quartersin a fiscal year is comprised of 13 weeks.

 

*Use of Estimates*

* *

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

 

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*Revenue Recognition*

* *

TheCompany’s revenues primarily consist of product sales of high performancememory subsystems to original equipment manufacturers (“OEMs”). Revenues alsoinclude sales of excess inventories to distributors and other users of memoryintegrated circuits (“ICs”) totaling approximately $0.1 million and$0.1 million, for the three months ended April 4, 2009 and March 29,2008, respectively.

 

TheCompany recognizes revenues in accordance with the SEC’s Staff AccountingBulletin No. 104, *Revenue Recognition*(“SAB 104”). Under the provisions of SAB 104, 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 inventories, which contain noright-of-return privileges. Estimated returns are provided for at the time ofsale 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.

 

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

 

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

 

*Cash and Cash Equivalents*

* *

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

 

*Investments in MarketableSecurities*

* *

TheCompany accounts for its investments in marketable securities in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 115, *Accounting for Certain Investments in Debt and Equity Securities*,and Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”)Nos. 115-1 and 124-1, *The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments.*The Companydetermines the appropriate classification of its investments at the time ofpurchase and reevaluates such designation at each balance sheet date. TheCompany’s investments in marketable securities have been classified andaccounted for as available-for-sale based on management’s investment intentionsrelating to these securities. Available-for-sale securities are stated atmarket value, and are generally based on market quotes, to the extent they areavailable. Unrealized gains and losses, net of applicable deferred taxes, arerecorded as a component of other comprehensive income (loss). Realized gainsand losses and declines in value judged to be other than temporary are determinedbased on the specific identification method and are reported in other income,net in the unaudited condensed consolidated statements of operations.

 

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 liquidinvestments with stated maturities of three months or less from the date ofpurchase are classified as cash equivalents; all investments with statedmaturities of greater than three months are classified as investments inmarketable securities.

 

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* *

*Fair Value of FinancialInstruments*

* *

TheCompany’s financial instruments consist principally of cash and cashequivalents, investments in marketable securities, accounts receivable, accountspayable, accrued expenses and debt instruments. Effective December 30,2007, the Company adopted SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value in accordance with accounting principlesgenerally accepted in the U.S. and expands required disclosures about fairvalue measurements. Pursuant to SFAS 157, other than for certain investments inauction rate securities (see Note 4), the fair value of the Company’s cashequivalents and investments in marketable securities is determined based onquoted prices in active markets for identical assets or Level 1 inputs. TheCompany believes that the carrying values of all other financial instrumentsapproximate their current fair values due to their nature and respectivedurations.

 

*Allowancefor Doubtful Accounts*

* *

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

 

*Concentrationof Credit Risk*

* *

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

 

The Company invests primarily in money market funds and high qualitycommercial paper and other debt instruments. Cash equivalents are maintainedwith high quality institutions, the composition and maturities of which areregularly monitored by management. Investments in marketable securities aregenerally in high-credit quality debt instruments with an active resale market.Such investments are made only in instruments issued or enhanced byhigh-quality institutions. The U.S. Treasury through a Temporary GuaranteeProgram of Money Market funds has guaranteed money market investments on handas of September 19, 2008. These funds are guaranteed through September 18,2009. The Company had $5.3 million of U.S Treasury guaranteed money marketfunds and FDIC insured funds at April 4, 2009.  In addition, the Company had $3.5 million intreasury notes that are direct obligations of the US government. The Companyhas 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 require no collateral. TheCompany believes that the concentration of credit risk in its trade receivablesis moderated by its credit evaluation process, relatively short collectionterms and the high level of credit worthiness of its customers. Reserves aremaintained for potential credit losses, and such losses historically have notbeen significant and have been within management’s expectations.

 

*Inventories*

* *

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

 

*Propertyand Equipment*

* *

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

 

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* *

*Warranties*

* *

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

 

*Stock-Based Compensation*

* *

TheCompany accounts for equity issuances to non-employees in accordance withEmerging Issues Task Force Issue No. 96-18, *Accountingfor Equity Instruments that are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods and Services*. All transactionsin which goods or services are the consideration received for the issuance ofequity instruments are accounted for based on the fair value of theconsideration received or the fair value of the equity instrument issued,whichever is more reliably measurable. The measurement date used to determinethe fair value of the equity instrument issued is the earlier of the date onwhich the third-party performance is complete or the date on which it isprobable that performance will occur.

 

Inaccordance with SFAS No. 123(R), *Share-Based Payment*(“SFAS 123R”),employee and director stock-based compensation expense recognized during theperiod is based on the value of the portion of stock-based payment awards thatis ultimately expected to vest during the period. Stock-based compensationexpense recognized in the accompanying unaudited condensed consolidatedstatements of operations is based on the grant date fair value estimated inaccordance with the provisions of SFAS 123R. Given that stock-basedcompensation expense recognized in the unaudited condensed consolidatedstatements of operations is based on awards ultimately expected to vest, it hasbeen reduced for estimated forfeitures. SFAS 123R requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates. The estimated averageforfeiture rates used by the Company are based on historical forfeitureexperience and estimated future forfeitures.

 

The fair value ofcommon stock option awards to employees and directors is calculated using theBlack-Scholes option pricing model. The Black-Scholes model requires subjectiveassumptions regarding future stock price volatility and expected time toexercise, along with assumptions about the risk-free interest rate and expecteddividends, which affect the estimated fair values of these awards. The expectedterm of options granted is derived from historical data on employee exercisesand post-vesting employment termination behavior. The expected volatility isbased on the historical volatilities of the common stock of comparable publiclytraded companies based on the Company’s belief that it currently has limitedhistorical data regarding the volatility of its stock price on which to base ameaningful estimate of expected volatility. The risk-free rate selected tovalue any particular grant is based on the U.S. Treasury rate that correspondsto the expected term of the grant effective as of the date of the grant. Theexpected dividends assumption is based on the Company’s history and expectationof dividend payouts. These factors could change in the future, affecting thedetermination of stock-based compensation expense in future periods.

 

*Income Taxes*

* *

Under AccountingPrinciples Board Opinion No. 28, *Interim FinancialReporting* (“APB 28”), the Company is required to adjust itseffective tax rate each quarter to be consistent with the estimated annualeffective tax rate. The Company is also required to record the tax impact ofcertain discrete items, unusual or infrequently occurring, including changes injudgment about valuation allowances and effects of changes in tax laws orrates, in the interim period in which they occur. In addition, jurisdictionswith a projected loss for the year or a year-to-date loss where no tax benefitcan be recognized are excluded from the estimated annual effective tax rate.The impact of such an exclusion could result in a higher or lower effective taxrate during a particular quarter, based upon the mix and timing of actualearnings versus annual projections.

 

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

 

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

 

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*Researchand Development Expenses*

* *

Research and development expenditures are expensed in the period incurred.

 

*Comprehensive Income (Loss)*

* *

SFAS No. 130, *ReportingComprehensive Income*, establishes standards for reporting anddisplaying comprehensive income and its components in the consolidatedfinancial statements. Accumulated other comprehensive income (loss) includesunrealized gains or losses on investments.

 

*Risks and Uncertainties*

* *

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

 

*Foreign CurrencyRemeasurement*

* *

The functionalcurrency of the Company’s foreign subsidiaries is the U.S. dollar. Localcurrency financial statements are remeasured into U.S. dollars using thecurrent exchange rate for monetary assets and liabilities and the historicalexchange rate for nonmonetary assets and liabilities. Expenses are remeasuredusing the average exchange rate for the period, except items related tononmonetary assets and liabilities, which are remeasured using historicalexchange rates. All remeasurement gains and losses are included in determiningnet income (loss).

 

*Net Income(Loss) Per Share*

* *

Basic net income (loss) per share is calculated by dividing net income(loss) by the weighted-average common shares outstanding during the period.Diluted net income (loss) per share is calculated by dividing the net income(loss) by the weighted-average shares and dilutive potential common sharesoutstanding during the period. Dilutive potential shares consist of dilutiveshares issuable upon the exercise of outstanding stock options and warrantscomputed using the treasury stock method.

 

*New AccountingPronouncements*

* *

InApril 2009, the FASB issued FSP FAS 157-4, *DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transactions That Are Not Orderly*(“FSPFAS 157-4”), which provides additional guidance for estimating fair value inaccordance with SFAS 157.  FSP FAS 157-4states that a significant decrease in the volume and level of activity for theasset or liability when compared with normal market activity is an indicationthat transactions or quoted prices may not be determinative of fair valuebecause there may be increased instances of transactions that are not orderlyin such market conditions.  Accordingly,further analysis of transactions or quoted prices is needed, and a significantadjustment to the transactions or quoted prices may be necessary to estimatefair value.  FSP FAS 157-4 is effectivefor the Company in its second quarter of fiscal 2009.  The Company is currently in the process ofdetermining the effect of the adoption of FSP FAS 157-4 on its consolidatedfinancial statements.

 

InApril 2009, the FASB issued FSP FAS 107-1 and APB 28-1, *Interim Disclosures about Fair Value of Financial Instruments*(“FSP FAS 107-1 and APB 28-1”), which requires disclosures about the fair valueof the Company’s financial instruments for which it is practicable to estimatethat value, whether recognized or not recognized in the balance sheets, in theinterim reporting periods as well as in the annual reporting periods. Inaddition, FSP FAS 107-1 and APB 28-1 requires disclosures of the methods andsignificant assumptions used to estimate the fair value of those financialinstruments.  FSP FAS 107-1 and APB 28-1is effective for the Company in its second quarter of fiscal 2009.  The Company is currently in the process ofdetermining the effect of the adoption of FSP FAS 107-1 and APB 28-1 on itsconsolidated financial statements.

 

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InApril 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, *Recognition and Presentation of Other-Than-Temporary Impairments*(“FSP FAS 115-2 and FAS 124-2”), which establishes a new method of recognizingand reporting other-than-temporary impairments of debt securities and requiresadditional disclosures related to debt and equity securities.  FSP FAS 115-2 and FAS 124-2 does not changeexisting recognition and measurement guidance related to other-than-temporaryimpairments of equity securities. FSP FAS 115-2 and FAS 124-2 is effective forthe Company in its second quarter of fiscal 2009.  The Company is currently in the process ofdetermining the effect of the adoption of FSP FAS 157-4 on its consolidatedfinancial statements.

 

In December 2007, the FASB issued SFAS No. 141(R),*Business Combinations* (“SFAS 141(R)”),which replaces SFAS 141. The provisions of SFAS 141(R) aresimilar to those of SFAS 141; however, SFAS 141(R) requirescompanies to record most identifiable assets, liabilities, noncontrolling interests,and goodwill acquired in a business combination at “full fair value.”SFAS 141(R) also requires companies to record fair value estimates ofcontingent consideration and certain other potential liabilities during theoriginal purchase price allocation and to expense acquisition costs asincurred. This statement applies to all business combinations, includingcombinations by contract alone. Further, under SFAS 141(R), all businesscombinations will be accounted for by applying the acquisition method. SFAS 141(R) iseffective for fiscal years beginning on or after December 15, 2008. TheCompany expects SFAS 141(R) will have an impact on its consolidatedfinancial statements, but the nature and magnitude of the specific effects willdepend upon the nature, terms and size of the acquisitions that the Companyconsummates.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements* (“SFAS 160”), which will requirenoncontrolling interests (previously referred to as minority interests) to betreated as a separate component of equity, not as a liability or other itemoutside of permanent equity. This Statement applies to the accounting fornoncontrolling interests and transactions with non-controlling interest holdersin consolidated financial statements. SFAS 160 will be appliedprospectively to all noncontrolling interests, including any that arose beforethe effective date except that comparative period information must be recast toclassify noncontrolling interests in equity, attribute net income and othercomprehensive income to noncontrolling interests, and provide other disclosuresrequired by SFAS 160. SFAS 160 is effective for periods beginning onor after December 15, 2008. The adoption of SFAS 160 did not have amaterial impact on the Company’s consolidated financial position, results ofoperations or liquidity.

 

**Note3—Supplemental Financial Information**

** **

*Inventories*

 

Inventoriesconsist of the following (in thousands):

 
| ** **      | ** ** | **April 4,** | ** ** | **January 3,** | ** ** |
|-----------------|------------|-------------------|------------|---------------------|------------|
| ** **      | ** ** | **2009**          | ** ** | **2009**            | ** ** |
|            |       |              |       |                |       |
| Raw materials   |       | $                 | 362        |                | $          | 976 |   |
| Work in process |       | 193               |       | 111                 |       |
| Finished goods  |       | 767               |       | 742                 |       |
|            |       | $                 | 1,322      |                | $          | 1,829 |   |

** **

*WarrantyLiability*

 

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

 
| ** **                    | ** ** | **Three Months Ended** | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                    | ** ** | **2009**               | ** ** | **2008** | ** ** |
|                          |       |                   |       |   |   |
| Beginning balance             |       | $                      | 277        |   | $ | 353 |   |
| Charged to costs and expenses |       | 29                     |       | 26 |   |
| Usage                         |       | (29                    | )          | (16 | ) |
| Ending balance                |       | $                      | 277        |   | $ | 363 |   |

** **

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

 

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* *

*FacilityRelocation Costs*

 

The followingtable summarizes the activity related to the Company’s accrual for facilityrelocation costs during the three months ended April 4, 2009 and March 39,2008 (in thousands):

 
| ** **                    | ** ** | **Three Months Ended** | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                    | ** ** | **2009**               | ** ** | **2008** | ** ** |
|                          |       |                   |       |   |   |
| Beginning balance             |       | $                      | 80         |   | $ | 103 |   |
| Charged to costs and expenses |       | —                 |       | — |   |
| Net payments                  |       | (1                     | )          | (14 | ) |
| Ending balance                |       | $                      | 79         |   | $ | 89 |   |

** **

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

 

*Comprehensive Loss*

* *

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

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                                                              | ** ** | **2009**               | ** ** | **2008** | ** ** |
|                                                                    |       |                   |       |   |   |
| Net loss                                                                |       | $                      | (3,847     | ) | $ | (584 | ) |
| Other comprehensive loss:                                               |       |                   |       |   |   |
| Change in net unrealized gain (loss) on investments, net of tax         |       | 32                     |       | (45 | ) |
| Reclassification adjustment for net realized gain included in net  loss |       | —                 |       | (13 | ) |
| Total comprehensive loss                                                |       | $                      | (3,815     | ) | $ | (642 | ) |

 

Accumulated othercomprehensive loss reflected on the condensed consolidated balance sheets at April 4,2009 and January 3, 2009, represents accumulated net unrealized losses oninvestments in marketable securities.

 

*Computationof Net Loss Per Share*

 

Basic and dilutednet loss per share is calculated by dividing net loss by the weighted-averagecommon shares outstanding during the period. The following table sets forth thecomputation of net loss per share (in thousands, except per share data):

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                     | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                                                     | ** ** | **2009**               | ** ** | **2008** | ** ** |
| ** **                                                     | ** ** | ** **             | ** ** | ** ** | ** ** |
| Numerator: Net loss                                            |       | $                      | (3,847     | ) | $ | (584 | ) |
| Denominator: Weighted-average common shares outstanding, basic |       | 19,855                 |       | 19,820 |   |
| Net loss per share, basic and diluted                          |       | $                      | (0.19      | ) | $ | (0.03 | ) |

** **

The following tablesets forth potentially dilutive common share equivalents, consisting of sharesissuable upon the exercise of outstanding stock options and warrants computedusing the treasury stock method, which have been excluded from the diluted netloss per share calculations above as their effect would be anti-dilutive forthe periods then ended (in thousands):

 
| ** **               | ** ** | **Three Months Ended** | ** ** |
|--------------------------|------------|------------------------|------------|
| ** **               | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **               | ** ** | **2009**               | ** ** | **2008** | ** ** |
| Common share equivalents |       | 121                    |       | 840 |   |

** **

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

 

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*MajorCustomers*

 

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

 
| ** **             | ** ** | **Three Months Ended** | ** ** |
|------------------------|------------|------------------------|------------|
| ** **             | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **             | ** ** | **2009**               | ** ** | **2008** | ** ** |
| **Customer:**          | ** ** | ** **             | ** ** | ** ** | ** ** |
| Dell                   |       | 33                     | %          | 74 | % |
| Hewlett Packard        |       | *                      | %          | 17 | % |
| Arrow Electronics Inc. |       | 21                     | %          | — | % |

 

----

*  less than 10%of net sales

** **

The Company’saccounts receivable are concentrated with two customers at April 4, 2009representing approximately 44% 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.

 

**Note4—Fair Value Measurements**

** **

In accordance withSFAS 157, the following table details the fair value measurements within thefair value hierarchy of the Company’s investments in marketable securities (inthousands):

 
| ** **                           | ** ** | ** **        | ** ** | **Fair Value Measurements at April 4, 2009 Using** | ** ** |
|--------------------------------------|------------|-------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | ** **        | ** ** | **Quoted Prices in**                                    | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                           | ** ** | **Fair Value at** | ** ** | **Active Markets for**                                  | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                           | ** ** | **April 4,** | ** ** | **Identical Assets**                                    | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                           | ** ** | **2009**          | ** ** | **(Level 1)**                                           | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                           | ** ** | ** **        | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Investments in marketable securities |       | $                 | 12,058     |                                                    | $          | 11,077 |   | $ | — |   | $ | 981 |   |
|                                      |            |                   |            |                                                         |            |  |  |  |  |  |  |  |  |

 

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

 

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

 
| ** **                                                       | ** ** | **Three Months  Ended** | ** ** |
|------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                       | ** ** | **April 4,**       | ** ** |
| ** **                                                       | ** ** | **2009**                | ** ** |
| ** **                                                       | ** ** | ** **              | ** ** |
| Beginning balance                                                |       | $                       | 960        |   |
| Transfers into Level 3                                           |       | —                  |       |
| Unrealized gain included in accumulated other comprehensive loss |       | 21                      |       |
| Purchases, sales, issuances and settlements, net                 |       | —                  |       |
| Ending balance                                                   |       | $                       | 981        |   |

 

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*AuctionRate Securities*

 

The recentdisruptions in the credit market continue to adversely affect the liquidity andoverall market for auction rate securities. As of April 4, 2009, theCompany held two investments in auction rate securities with a total purchasedcost of $1.0 million. These two investments represent (i) a fully insureddebt obligation of a municipality and (ii) a Baa1 and A3 rated debtobligations backed by pools of student loans guaranteed by the U.S. Departmentof 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. The Company hasestimated the fair value of these investments using a discounted cash flowmodel which included assumptions about the credit quality and expected durationof the investments, along with discount rates affected for the general lack ofliquidity. These assumptions reflect the Company’s estimates about thereasonable assumptions market participants would likely use in valuing theinvestments, including assumptions about risk, developed based on the bestinformation available in the circumstances.

 

The Company doesnot believe that the current illiquidity of its investments in auction ratesecurities will materially impact its ability to fund its working capitalneeds, capital expenditures or other business requirements. The Company,however, remains uncertain as to when liquidity will return to the auction ratemarkets, whether other secondary markets will become available or when theunderlying securities may be called by the issuer. Given these and otheruncertainties, the Company’s investments in auction rate securities have beenclassified as long-term investments in marketable securities in theaccompanying unaudited condensed consolidated balance sheet as of April 4,2009. The Company has concluded that the estimated gross unrealized losses onthese investments, which totaled approximately $21,000 at April 4, 2009,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 high credit quality and interest ispaid as due and (iii) the Company has the intent and ability to hold theseinvestments until a recovery in the market occurs.

 

*OtherInvestments in Marketable Securities*

 

Excluding itsauction rate securities, the gross unrealized losses on the Company’s otherinvestments in marketable securities totaled approximately $2,000 as of April 4,2009, and are generally due to the ongoing uncertainties in the credit andfinancial markets, as well as the overall current economic environment. Thefair value of these investments was determined based on Level 1 inputs,consisting of quoted prices from actual market transactions for identicalinvestments. The Company has determined that the unrealized losses on theseinvestments as of April 4, 2009 are temporary in nature. Factorsconsidered in determining whether impairments are other than temporary include (i) thelength of time and extent to which fair value has been less than the amortizedcost basis, (ii) the financial condition and near-term prospects of theinvestee and (iii) the Company’s intent and ability to hold an investmentfor a period of time sufficient to allow for any anticipated recovery in marketvalue. The fair value of the Company’s investments in marketable securitiescould change significantly in the future and the Company may be required torecord other-than-temporary impairment charges or additional unrealized lossesin future periods.

 

**Note5—Credit Agreement**

 

Under the Company’s revolving line of credit agreementwith its bank, the Company may borrow up to the greater of 85% of eligibleaccounts receivable plus the least of (i) a percentage of eligibleinventory determined from time to time by the Company’s bank, (ii) 80% ofthe orderly liquidation value, as defined, of eligible inventories, and (iii) $1 million.Interest is payable monthly at the greater of (i) the sum of prime rateplus 3%, (ii) LIBOR plus 6% or (iii) 8%. This line of credit expireson July 31, 2009.

 

In connection with its credit agreement, the Companywas provided an equipment line of credit allowing it to borrow up to $3.9million through January 3, 2009. The Company is required to repay theequipment advances in monthly installments of $32,440. Interest on the equipmentadvances is payable monthly, at the Company’s option, at the greater of (i) thesum of prime rate plus 3%, (ii) LIBOR plus 6% or (iii) 8%.

 

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

 
| ** **       | ** ** | **Three Months Ended** | ** ** |
|------------------|------------|------------------------|------------|
| ** **       | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **       | ** ** | **2009**               | ** ** | **2008** | ** ** |
| Interest expense |       | $                      | 3          |   | $ | 60 |   |
|                  |            |                        |            |  |  |  |  |

 
| ** **                                                 | ** ** | **April 4,** | ** ** | **January 3,** | ** ** |
|------------------------------------------------------------|------------|-------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | **2009**          | ** ** | **2009**            | ** ** |
| Outstanding borrowings on the revolving  line of credit    |       | $                 | —     |                | $          | — |   |
| Borrowing availability under the revolving  line of credit |       | $                 | 655        |                | $          | 4,047 |   |

 

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

 

As of April 4,2009, the Company was in compliance with its financial covenants.

 

**Note 6—Long-TermDebt**

** **

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

 
| ** **                       | ** ** | **April 4,** | ** ** | **January 3,** | ** ** |
|----------------------------------|------------|-------------------|------------|---------------------|------------|
| ** **                       | ** ** | **2009**          | ** ** | **2009**            | ** ** |
| Obligations under capital leases |       | $                 | 128        |                | $          | 148 |   |
| Equipment note payable to bank   |       | 353               |       | 450                 |       |
| Note payable to others           |       | —            |       | 6                   |       |
|                             |       | 481               |       | 604                 |       |
| Less current portion             |       | (433              | )          | (474                | )          |
|                             |       | $                 |  48   |                | $          | 130 |   |

 

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

 
| ** **       | ** ** | **Three Months Ended** | ** ** |
|------------------|------------|------------------------|------------|
| ** **       | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **       | ** ** | **2009**               | ** ** | **2008** | ** ** |
| Interest expense |       | $                      | 11         |   | $ | 37 |   |
|                  |            |                        |            |  |  |  |  |

 

**Note 7—Income Taxes**

** **

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

 
| ** **                           | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                           | ** ** | **2009**               | ** ** | **2009** | ** ** |
| Provision (benefit) for income taxes |       | $                      | 18         |   | $ | (1,181 | ) |
| Effective tax rate                   |       | —                 | %          | 67 | % |
|                                      |            |                        |            |  |  |  |  |

 

UnderAPB 28, *Interim Financial Reporting*, theCompany is required to adjust its effective tax rate each quarter to beconsistent with the estimated annual effective tax rate.  The Company is 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.

 

Inaccordance with SFAS No. 109, *Accounting for IncomeTaxes*, the Company evaluates whether a valuation allowance should beestablished against its deferred tax assets based on the consideration of allavailable evidence using a “more likely than not” standard.

 

Asof April 4, 2009, the Company has provided a full valuation allowance andno benefit has been recognized for net operating losses and other deferred taxassets due to uncertainty of future utilization.

 

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**Note8—Commitments and Contingencies**

** **

*Litigation*

 

*Federal Securities Class Action*

 

Beginning in May 2007, the Company,certain of its officers and directors, and the Company’s underwriters werenamed as defendants in four purported class action shareholder complaints, twoof which were filed in the U.S. District Court for the Southern District of NewYork, and two of which were filed in the U.S. District Court for the CentralDistrict of California. These purported class action lawsuits were filed onbehalf of persons and entities who purchased or otherwise acquired the Company’scommon stock pursuant or traceable to the Company’s November 30, 2006Initial Public Offering (the “IPO”). The lawsuits were consolidated into asingle action—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 on November 5, 2007. Defendantsfiled their motions to dismiss the Consolidated Complaint on January 9,2008. The motions to dismiss were taken under submission on April 28, 2008and on May 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 (the “AmendedComplaint”) on July 15, 2008. Generally, the Amended Complaint allegedthat the Registration Statement issued by the Company in connection with theIPO contained untrue statements of material fact or omissions of material factin violation of Sections 11 and 15 of Securities Act of 1933. Thedefendants filed motions to dismiss the Amended Complaint on January 9,2009, and on April 17, 2009, the Court granted defendants’ motions todismiss.  However, plaintiffs were againgranted the right to amend their complaint. Plaintiffs’ second amended complaint is due on or before May 21,2009.  Defendants’ responses to thatcomplaint are due June 22, 2009. The Company believes that the allegationslack merit and intends to vigorously defend all claims asserted. However, atthis time, the Company is unable to form a professional judgment that anunfavorable outcome is either probable or remote, and it is not possible toassess whether or not the outcome of these proceedings will or will not have amaterial adverse effect on the Company. If an unfavorable outcome shouldeventually occur, the Company is not at this time able to estimate the amountor range of possible loss.

 

*California Derivative Action*

 

In August 2007, a derivative lawsuit wasfiled in California Superior Court for County of Orange—Smith v. Hong, Case No. 07CC01359—againstcertain of the Company’s officers and directors. This action contains factualallegations similar to those of the federal class action lawsuit describedabove, but the plaintiff in this case also asserts claims for violations ofCalifornia’s insider trading laws, breaches of fiduciary duty, abuse ofcontrol, gross mismanagement, waste of corporate assets, and unjust enrichment.The plaintiff seeks unspecified damages, equitable and/or injunctive relief anddisgorgement of all profits, benefits and other compensation obtained by thedefendants. The defendants in this action have not responded to the complaint.Pursuant to a stipulation, the parties agreed to temporarily stay the actionpending the ultimate decision on the defendants’ motions to dismiss in thefederal securities class action. The parties also agreed that twenty days afterthe court in the federal securities class action issues a final ruling as tothe motions to dismiss brought in that action, the parties will meet and conferregarding the time for defendants to respond to the complaint in thisderivative action. The Company believes that the allegations lack merit andintends to vigorously defend all claims asserted. At this time, however, theCompany is unable to form a professional judgment that an unfavorableoutcome is either probable or remote. Moreover, if an unfavorable outcomeshould eventually occur, the Company is not at this time able to estimate theamount or range of possible loss. In addition, the Company receivedcorrespondence from counsel for a purported shareholder requesting that theCompany take actions to investigate and remedy alleged wrongdoing byunidentified former and current officers and/or directors based on allegationssimilar to those in the Smith v. Hong derivative case. The Company, through itsBoard of Directors, has evaluated and rejected this request.

 

*Patent Claims*

 

In May 2008, the Company initiateddiscussions with Google, Inc. regarding the Company’s claims that Googlehas infringed on a U.S. Patent assigned to the Company relating generally to “rankmultiplication” in memory modules. On August 29, 2008, Google filed adeclaratory judgment lawsuit against the Company in United States DistrictCourt for the Northern District of California, seeking a declaration thatGoogle did not infringe on the Company’s patent, and that the Company’s patentis invalid. Google is not seeking any monetary damages. On November 18,2008, the Company filed a counterclaim for infringement of the patent byGoogle. The Company expects to vigorously pursue its claim against Google andto vigorously defend against Google’s claim of invalidity.

 

On March 17, 2009, the Company filed acomplaint for patent infringement against MetaRAM, Inc. for itsinfringement of one of the Company’s patents. On March 26, 2009 MetaRAMfiled a complaint against the Company for patent infringement. The Companyexpects to vigorously pursue its claim against MetaRAM and to vigorously defendagainst MetaRAM’s separate claim.

 

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*Trade Secret Claim*

 

On November 18, 2008, the Company fileda claim for trade secret misappropriation against Texas Instruments (TI) inSanta Clara County Superior Court, based in TI’s disclosure of confidentialCompany materials to the JEDEC standard-setting body.  On February 20, 2009, TI filed itsanswer.  The parties are currentlyengaged in settlement discussions.  Ifthose discussions are unsuccessful, the Company expects to vigorously pursueits claims against TI.

 

*Other Contingent Obligations*

 

During its normal course of business, theCompany has made certain indemnities, commitments and guarantees under which itmay be required to make payments in relation to certain transactions. Theseinclude (i) intellectual property indemnities to the Company’s customersand licensees in connection with the use, sales and/or license of Companyproducts; (ii) indemnities to vendors and service providers pertaining toclaims based on the Company’s negligence or willful misconduct; (iii) indemnitiesinvolving the accuracy of representations and warranties in certain contracts; (iv) indemnitiesto directors and officers of the Company to the maximum extent permitted underthe laws of the State of Delaware; and (v) certain real estate leases,under which the Company may be required to indemnify property owners forenvironmental and other liabilities, and other claims arising from the Company’suse of the applicable premises. The duration of these indemnities, commitmentsand guarantees varies and, in certain cases, may be indefinite. The majority ofthese indemnities, commitments and guarantees do not provide for any limitationof the maximum potential for future payments the Company could be obligated tomake. Historically, the Company has not been obligated to make significantpayments for these obligations, and no liabilities have been recorded for theseindemnities, commitments and guarantees in the accompanying consolidatedbalance sheets.

 

**Note9—Stock Options and Warrants**

** **

*Common Stock Options*

* *

A summary of theCompany’s common stock option activity as of and for the three months ended April 4,2009 is presented below (shares in thousands):

 
| ** **                                  | ** ** | ** **    | ** ** | **Weighted-** | ** ** |
|---------------------------------------------|------------|---------------|------------|---------------|------------|
| ** **                                  | ** ** | ** **    | ** ** | **Average**   | ** ** |
| ** **                                  | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                  | ** ** | **Shares**    | ** ** | **Price**     | ** ** |
| Options outstanding at January 3, 2009 |       | 4,281         |       | $             | 2.64       |   |
| Options granted                             |       | —        |       | —        |       |
| Options exercised                           |       | —        |       | —        |       |
| Options cancelled                           |       | (141          | )          | 2.93          |       |
| Options outstanding at April 4, 2009   |       | 4,140         |       | $             | 2.63       |   |

 

*At April 4,2009, the amount of unearned stock-based compensation currently estimated to beexpensed from fiscal 2009 through fiscal 2012 related to unvested common stockoptions is approximately $1.6 million, net of estimated forfeitures. Theweighted-average period over which the unearned stock-based compensation isexpected to be recognized is approximately 1.9 years. If there are anymodifications or cancellations of the underlying unvested common stock options,the Company may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense. Future stock-based compensationexpense and unearned stock-based compensation will increase to the extent thatthe Company grants additional common stock options or other stock-based awards.*

 

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*Warrants*

* *

A summary ofactivity with respect to outstanding warrants to purchase shares of the Company’scommon stock as of and for the three months ended April 4, 2009 ispresented below (shares in thousands):

 
| ** **                                                  | ** ** | ** **    | ** ** | **Weighted-** | ** ** |
|-------------------------------------------------------------|------------|---------------|------------|---------------|------------|
| ** **                                                  | ** ** | ** **    | ** ** | **Average**   | ** ** |
| ** **                                                  | ** ** | **Number of** | ** ** | **Exercise**  | ** ** |
| ** **                                                  | ** ** | **Shares**    | ** ** | **Price**     | ** ** |
| Warrants outstanding at January 3,  2009               |       | 18            |       | $             | 1.25       |   |
| Warrants granted                                            |       | —        |       | —        |       |
| Warrants exercised                                          |       | —        |       | —        |       |
| Warrants cancelled                                          |       | —        |       | —        |       |
| Warrants outstanding and exercisable at  April 4, 2009 |       | 18            |       | $             | 1.25       |   |

 

**Note10—Segment and Geographic Information**

** **

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

 

At April 4,2009, approximately $3.9 million of the Company’s net long-lived assets werelocated outside the U.S., primarily in the PRC.

 

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

** **

**CautionaryStatement**

** **

*The following discussion and analysis of our financial condition andresults of operations should be read in conjunction with our Unaudited CondensedConsolidated Financial Statements and the related notes thereto contained in Part I,Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Qis not a complete description of our business or the risks associated with aninvestment in our common stock. We urge you to carefully review and considerthe various disclosures made by us in this Report and in our other reportsfiled with the Securities and Exchange Commission, or SEC, including our AnnualReport on Form 10-K for the fiscal year ended January 3, 2009 andsubsequent reports on Form 8-K, which discuss our business in greaterdetail.*

 

*The section entitled “Risk Factors” set forth in Part II, Item 1A,and similar discussions in our other SEC filings, describe some of the importantrisk factors that may affect our business, results of operations and financialcondition. You should carefully consider those risks, in addition to the otherinformation in this Report and in our other filings with the SEC, beforedeciding to purchase, hold or sell our common stock.*

 

*This Report contains forward-looking statements that involve risks,uncertainties, estimates and assumptions. These statements are not guaranteesof future performance and are subject to certain risks, uncertainties andassumptions that are difficult to predict. Therefore, our actual results coulddiffer materially and adversely from those expressed in any forward-lookingstatements as a result of various factors, including but not limited to thoseidentified under the heading “Risk Factors” set forth in Part II, Item1A.  We undertake no obligation to reviseor update publicly any forward-looking statements for any reason.*

 

**Overview**

** **

We design, manufacture and sell highperformance memory subsystems for the server, high performance computing andcommunications markets. Our memory subsystems consist of dynamic random accessmemory integrated circuits, or DRAM ICs, NAND flash memory, or NAND, and othercomponents assembled on a printed circuit board, or PCB. We also design customsemiconductor logic devices which are integrated into our memory subsystems inorder to increase their performance. We engage with our original equipmentmanufacturer, or OEM, customers from the earliest stages of new productdefinition, which provides us unique insight into their full range of systemarchitecture and performance requirements. This close collaboration has alsoallowed us to develop a significant level of systems expertise. We leverage aportfolio of proprietary technologies and design techniques, including efficientplanar design, alternative packaging techniques and custom semiconductor logic,to deliver memory subsystems with high memory density, small form factor, highsignal integrity, attractive thermal characteristics and low cost per bit.

 

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ConsistentwiththeconcentratednatureoftheOEMcustomerbaseinourtargetmarkets,asmallnumberoflargecustomershavehistoricallyaccountedforasignificantportionofournetsales.DellandArrowElectronicsrepresentedapproximately33%and21%,respectively,ofournetsalesforthethreemonthsendedApril4,2009.DellandHewlettPackardrepresentedapproximately74%and17%,respectively,ofournetsalesforthethreemonthsendedMarch29,2008.NetsalestosomeofourOEMcustomersincludememorymodulesthatarequalifiedbyusdirectlywiththeOEMcustomerandsoldtoelectronicmanufacturingservicesproviders,orEMSs,forincorporationintoproductsmanufacturedexclusivelyfortheOEMcustomer.ThesenetsalestoEMSshavehistoricallyfluctuatedperiodbyperiodasaportionofthetotalnetsalestotheseOEMcustomers.NetsalestoHonHaiPrecisionIndustryCo.Ltd.,anEMSthatpurchasesmemorymodulesfromusforincorporationintoproductsmanufacturedexclusivelyforDell,representedapproximately67%ofnetsalestoDellforthethreemonthsendedApril4,2009andapproximately35%ofnetsalestoDellforthethreemonthsendedMarch29,2008.

 

**Key BusinessMetrics**

** **

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

 

*Net Sales.*  Net sales consist primarily of sales of ourhigh performance memory subsystems, net of a provision for estimated returnsunder our right of return policies, which generally range up to 30 days.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 placeorders with us approximately two weeks in advance of scheduled delivery.Selling prices are typically negotiated monthly, based on competitive marketconditions and the current price of DRAM ICs and NAND. Purchase ordersgenerally have no cancellation or rescheduling penalty provisions. We oftenship our products to our customers’ international manufacturing sites. All ofour sales to date, however, are denominated in U.S. dollars. We also sellexcess component inventory of DRAM ICs and NAND to distributors and other usersof memory ICs. As compared to previous years, component inventory sales havesignificantly decreased as a percentage of net sales as a result of our effortsto diversify both our customer and product line bases. This diversificationeffort has also allowed us to use components in a wider range of memory subsystems.We expect that component inventory sales will continue to represent a minimalportion of our net sales in future periods.

 

*Cost of Sales.*  Our cost of sales includes the cost ofmaterials, manufacturing costs, depreciation and amortization of equipment,inventory valuation provisions, stock-based compensation and occupancy costsand other allocated fixed costs. The DRAM ICs and NAND incorporated into ourproducts constitute a significant portion of our cost of sales, and thus ourcost of sales will fluctuate based on the current price of DRAM ICs and NAND.We attempt to pass through such DRAM IC and NAND cost fluctuations to ourcustomers by frequently renegotiating pricing prior to the placement of theirpurchase orders. To the extent we are successful, a large majority of ourproduct cost is variable, and thus our cost of sales and gross marginpercentages may not be significantly impacted by changes in sales volume.However, the sales prices of our memory subsystems can also fluctuate due 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. As a result, a decrease in DRAM IC and NAND inventory sales as apercentage of our overall sales could result in an improved overall grossmargin. We assess the valuation of our inventories on a monthly basis andrecord a provision to cost of sales as necessary to reduce inventories to thelower of cost or net realizable value.

 

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

 

*Selling, General and Administrative.*  Selling, general and administrative expensesconsist primarily of employee salaries and related costs, stock-basedcompensation, independent sales representative commissions, professionalservices, promotional and other selling and marketing expenses, and occupancyand other allocated overhead costs. A significant portion of our sellingefforts is directed at building relationships with OEMs and 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. Beginning in fiscal 2009, we anticipatebeing subject to attestation services requirements with respect to our internalcontrol over financial reporting, the result of which will increase legal andaccounting expenses in future periods.

 

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*Provision (Benefit) forIncome Taxes.* Under Accounting Principles Board Opinion No. 28, *Interim Financial Reporting*, we are required to adjust oureffective tax rate each quarter to be consistent with the estimated annualeffective tax rate.  We are also  required to record the tax impact of certaindiscrete items, unusual or infrequently occurring, including changes injudgment about valuation allowances and effects of changes in tax laws orrates, 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.

 

Inaccordance with Statements of Financial Accounting Standards No. 109, *Accounting for Income Taxes*, we evaluate whether a valuationallowance should be established against its deferred tax assets based on theconsideration of all available evidence using a “more likely than not”standard.

 

Asof April 4, 2009, the we have provided a full valuation allowance and nobenefit has been recognized for net operating losses and other deferred taxassets due to uncertainty of future utilization.

 

**CriticalAccounting Policies**

** **

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

 

*Revenue Recognition.*We recognize revenues in accordance with the SEC’s Staff Accounting Bulletin No. 104,*Revenue Recognition*, or SAB 104.Under the provisions of SAB 104, we recognize revenues when there ispersuasive evidence of an arrangement, product delivery and acceptance haveoccurred, the sales price is fixed or determinable, and collectibility of the resultingreceivable is reasonably assured.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

*Inventories.*We value our inventories at the lower of the actual cost to purchase ormanufacture the inventory or the net realizable value of the inventory. Cost isdetermined on an average cost basis which approximates actual cost on a first-in,first-out basis and includes raw materials, labor and manufacturing overhead.We regularly review inventory quantities on hand and on order and record aprovision for excess and obsolete inventories based primarily on our estimatedforecast of product demand and production requirements for the next three tosix months. In addition, we consider changes in the market value of DRAM ICsand NAND in determining the net realizable value of our raw material inventory.Once established, any write downs are considered permanent adjustments to thecost basis of our inventories. A significant decrease in demand for ourproducts could result in an increase in the amount of excess inventoryquantities on hand. In addition, our estimates of future product demand mayprove to be inaccurate, in which case we may have understated or overstated theprovision required for excess and obsolete inventory. In the future, if ourinventories are determined to be overvalued, we would be required to recognizeadditional expense in our cost of sales at the time of such determination.Likewise, if our inventories are determined to be undervalued, we may haveover-reported our costs of sales in previous periods and would be required torecognize additional gross profit at the time such inventories are sold. Inaddition, should the market value of DRAM ICs and NAND decrease significantly,we may be required to lower our selling prices to reflect the lower cost of ourraw 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 and NAND could have a materialeffect on the value of our inventories and our reported operating results.

 

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

 

*Stock-Based Compensation.*We account for equity issuances to non-employees in accordance with EmergingIssues Task Force Issue No. 96-18, *Accountingfor Equity Instruments that are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods and Services*. All transactionsin which goods or services are the consideration received for the issuance ofequity instruments are accounted for based on the fair value of theconsideration received or the fair value of the equity instrument issued,whichever is more reliably measurable. The measurement date used to determinethe fair value of the equity instrument issued is the earlier of the date onwhich the third-party performance is complete or the date on which it isprobable that performance will occur.

 

On January 1,2006, we adopted Statements of Financial Accounting Standards, or SFAS, No. 123R,*Share-Based Payment*, (“SFAS 123R”),which requires the measurement and recognition of compensation expense for allstock-based payment awards made to our employees and directors based onestimated fair values.

 

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We currently usethe Black-Scholes option pricing model to estimate the fair value of our commonstock option awards. While this model meets the requirements of SFAS 123R,the estimated fair values generated by it may not be indicative of the actualfair values of these awards as it does not consider certain factors importantto those awards to employees, such as continued employment and periodic vestingrequirements as well as limited transferability. The Black-Scholes modelrequires subjective assumptions regarding future stock price volatility andexpected time to exercise, along with assumptions about the risk-free interestrate and expected dividends, all of which affect the estimated fair values ofour common stock option awards. The expected term of options granted is derivedfrom historical data on employee exercises and post-vesting employmenttermination behavior. The expected volatility is based on the historicalvolatilities of the common stock of comparable publicly traded companies basedon our belief that we currently have limited historical data regarding thevolatility of our stock price on which to base a meaningful estimate ofexpected volatility. The risk-free rate selected to value any particular grantis based on the U.S. Treasury rate that corresponds to the expected term of thegrant effective as of the date of the grant. The expected dividends assumptionis based on our history and expectation of dividend payouts. We evaluate theassumptions used to value our common stock option awards on a quarterly basis.If factors change and we employ different assumptions, stock-based compensationexpense may differ significantly from what we have recorded in prior periods.

 

The value of theportion of stock-based awards that are ultimately expected to vest isrecognized as expense over the requisite service periods in our consolidatedfinancial statements. Given that stock-based compensation expense recognized inour consolidated financial statements is based on awards ultimately expected tovest, it has been reduced for estimated forfeitures.SFAS 123R requires forfeitures to be estimated at the time of grantand revised, if necessary, in subsequent periods if actual forfeitures differfrom those estimates. If there are any modifications or cancellations of theunderlying unvested stock-based awards, we may be required to accelerate,increase or cancel any remaining unearned stock-based compensation expense.Future stock-based compensation expense and unearned stock-based compensationwill increase to the extent that we grant additional common stock options orother stock-based awards.

 

*Income Taxes.***Under AccountingPrinciples Board Opinion No. 28, *Interim FinancialReporting*, we are required to adjust our effective tax rate eachquarter to be consistent with the estimated annual effective tax rate. We arealso 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 theyear, or a year-to-date loss where no tax benefit can be recognized, are excludedfrom our estimated annual effective tax rate. The impact of excluding theseitems could result in a higher or lower effective tax rate during a particularquarter, based upon the mix and timing of actual earnings versus annualprojections.

 

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

 

We adoptedFinancial Accounting Standards Board, or FASB, Interpretation No. 48, *Accounting for Uncertainty in Income Taxes—An Interpretation of FASBStatement No. 109*, or FIN 48, on December 31, 2006, thefirst day of fiscal 2007. FIN 48 seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. FIN 48 prescribes a recognition threshold and measurementrequirement for the financial statement recognition of a tax position that hasbeen taken or is expected to be taken on a tax return and also providesguidance on de-recognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition. Under FIN 48 we may onlyrecognize or continue to recognize tax positions that meet a “more likely thannot” threshold.

 

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

 

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**Results ofOperations**

** **

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

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                                        | ** ** | **2009**               | ** ** | **2008** | ** ** |
| ** **                                        | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net sales                                         |       | 100                    | %          | 100 | % |
| Cost of sales                                     |       | 125                    |       | 76 |   |
| Gross (loss) profit                               |       | (25                    | )          | 24 |   |
| Operating expenses:                               |       |                   |       |   |   |
| Research and development                          |       | 75                     |       | 12 |   |
| Selling, general and administrative               |       | 89                     |       | 26 |   |
| Total operating expenses                          |       | 164                    |       | 38 |   |
| Operating loss                                    |       | (189                   | )          | (15 | ) |
| Other income (expense):                           |       |                   |       |   |   |
| Interest income, net                              |       | 4                      |       | 2 |   |
| Other income (expense), net                       |       | 8                      |       | (1 | ) |
| Total other income, net                           |       | 12                     |       | 1 |   |
|                                              |       |                   |       |   |   |
| Loss before provision (benefit) for income  taxes |       | (177                   | )          | (13 | ) |
| Provision (benefit) for income taxes              |       | 1                      |       | (9 | ) |
| Net loss                                          |       | (178                   | )%         | (4 | )% |

 

***Three Months Ended April 4,2009 Compared to Three Months Ended March 29, 2008***

*** ***

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

 

*The following table presents net sales, cost of sales andgross profit for the three months ended April 4, 2009 and March 29,2008 (in thousands, except percentages):*

* *
| ** **          | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **     | ** ** |
|---------------------|------------|------------------------|------------|--------------------|------------|----------------|------------|
| ** **          | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **          | ** ** | **2009**               | ** ** | **2008**           | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
|                |       |                   |       |               |       |           |       |   |   |
| Net sales           |       | $                      | 2,162      |               | $          | 13,104         |       | $ | (10,942 | ) | (84 | )% |
| Cost of sales       |       | 2,699                  |       | 9,973              |       | (7,274         | )          | (73 | )% |
| Gross (loss) profit |       | $                      | (537       | )                  | $          | 3,131          |       | $ | (3,668 | ) | (117 | )% |
| Gross margin        |       | (25                    | )%         | 24                 | %          | (49            | )%         |   |   |

 

*Net Sales.*** The overall decrease in our net sales wasprimarily driven by a sharp reduction in demand from our current customer base,ramp down of certain products and the slower than expected growth in sales of ourflash products. The Company continues to transition to a new business strategyfocused on the development of high-margin subsystems based on custom logicdevices.

 

The decrease in net salesin the three months ended April 4, 2009 as compared to the three monthsended March 29, 2008 resulted primarily from decreases of approximately (i) $1.8million in sales of laptop personal computer memory subsystems, (ii) $3.2million in sales of memory subsystems used to control Redundant Arrays ofIndependent Disks, or RAIDs, and (iii) $6.2 million in sales of our highdensity server modules.

 

Sales of our componentinventory to distributors and other users of memory ICs representedapproximately 2.8% and 0.4% of net sales for the three months ended April 4,2009 and March 29, 2008, respectively. Component inventory sales havedecreased as a percentage of net sales as a result of our ability to use thesame components across a wider range of memory subsystems.

 

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*Gross (Loss) Profit andGross Margin.*** Gross (loss)profit for the three months ended April 4, 2009 as compared to the threemonths ended March 29, 2008 decreased primarily due to the 84% decrease innet sales between the two periods. The decrease in gross margin for the threemonths ended April 4, 2009 as compared to the three months ended March 29,2008 is mostly due to the inability to absorb manufacturing costs caused by thesignificant drop in units manufactured and sold during the recent quarter.

 

***Researchand Development****.*

 

The following tablepresents research and development expenses for the three months ended April 4,2009 and March 29, 2008 (in thousands, except percentages):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **   | ** ** |
|--------------------------|------------|------------------------|------------|--------------------|------------|--------------|------------|
| ** **               | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **               | ** ** | **2009**               | ** ** | **2008**           | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Research and development |       | $                      | 1,614      |               | $          | 1,576        |       | $ | 38 |   | 2 | % |
|                          |            |                        |            |                    |            |              |            |  |  |  |  |  |

 

The increase in researchand development expense in the three months ended April 4, 2009 ascompared to the three months ended  March 29,2008 resulted primarily from increases of (i) $0.3 million inpersonnel-related expenses as a result of an increase in the number of outsidecontractors engaged in research and development activities during the firstquarter of 2009 and (ii) $0.1 million in legal and professional servicesas we continue to increase activities related to new and emerging markets in2009. The above increases were offset by a decrease of approximately $0.4million in expenses related to product qualification builds and testing.

 

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

 

The following tablepresents selling, general and administrative expenses for the three monthsended April 4, 2009 and March 29, 2008 (in thousands, exceptpercentages):

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **   | ** ** |
|-------------------------------------|------------|------------------------|------------|--------------------|------------|--------------|------------|
| ** **                          | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2009**               | ** ** | **2008**           | ** ** | **Decrease** | ** ** | **Change** | ** ** |
| Selling, general and administrative |       | $                      | 1,935      |               | $          | 3,468        |       | $ | (1,533 | ) | (44 | )% |
|                                     |            |                        |            |                    |            |              |            |  |  |  |  |  |

 

The decrease in selling,general and administrative expense in the three months ended April 4, 2009as compared to the three months ended March 29, 2008 resulted primarilyfrom decreases of (i) $1.0 million in personnel-related expenses primarilyattributable to a decrease in the number of employees and outside contractorsengaged in selling, general and administrative functions of approximately 42%during the 2009 quarter as compared to the 2008 quarter , (ii) $0.2million in commission expenses due to a decline in sales revenue during themost recent quarter, (iii) $0.2 million in legal and professional fees dueto the unreimbursed costs incurred during the prior quarter ended March 29,2008 paid out to defend against a pending shareholder claim, (iv) $0.2million in product qualification expense and related travel costs as a resultof a decrease in the number of sales personnel during the most recent quarter.

 

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

 

The following table presents other income (expense) for the threemonths ended April 4, 2009 and March 29, 2008 (in thousands, exceptpercentages):

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **     | ** ** |
|-----------------------------|------------|------------------------|------------|--------------------|------------|----------------|------------|
| ** **                  | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** | **Increase**   | ** ** | **%** | ** ** |
| ** **                  | ** ** | **2009**               | ** ** | **2008**           | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Interest income, net        |       | $                      | 82         |               | $          | 239            |       | $ | (157 | ) | 66 | % |
| Other income (expense), net |       | 175                    |       | (91                | )          | 266            |       | (292 | )% |
| Total other income, net     |       | $                      | 257        |               | $          | 148            |       | $ | 109 |   | (74 | )% |

 

Net interest income forthe three months ended April 4, 2009 was comprised of interest income ofapproximately $0.1 million, offset by interest expense of approximately $0.03million. Net interest income for the three months ended March 29, 2008 wascomprised of interest income of approximately $0.3 million, partially offset byinterest expense of approximately $0.1 million. The decrease in interest incomein the three months ended April 4, 2009 as compared to the three monthsended March 29, 2008 was due to a combination of our lower overall cashand investment balances and the decrease in the yield earned on those balancesdue to lower interest rates.  Thedecrease in interest expense during 2009 as compared to 2008 resulted primarilyfrom our lower average outstanding balances on our line of credit and debtbalances during the current year.

 

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Other income (expense),net, for the three months ended April 4, 2009 is primarily comprised ofgains from the sale of equipment held for sale during the current quarter.  Other income (expense), net for the firstquarter of 2008 is primarily comprised of losses on certain foreign currencyremeasurement transactions partially offset by realized gains on the sale ofcertain investments in marketable securities.

 

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

 

The following tablepresents the provision (benefit) for income taxes for the three months ended April 4,2009 and March 29, 2008 (in thousands, except percentages):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **   | ** ** |
|--------------------------------------|------------|------------------------|------------|--------------------|------------|--------------|------------|
| ** **                           | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** | ** **   | ** ** | **%** | ** ** |
| ** **                           | ** ** | **2009**               | ** ** | **2008**           | ** ** | **Increase** | ** ** | **Change** | ** ** |
| Provision (benefit) for income taxes |       | $                      | 18         |               | $          | (1,181       | )          | $ | 1,199 |   | (102 | )% |
|                                      |            |                        |            |                    |            |              |            |  |  |  |  |  |

 

On an interimbasis, we estimate what our effective tax rate will be in each jurisdiction forthe full fiscal year and record a quarterly income tax provision (benefit) inaccordance with the anticipated blended annual rate. We discontinued recordingincome tax benefits in the consolidated financial statements until it isdetermined that it is more likely than not that we will generate sufficienttaxable income to realize our deferred tax assets.  We recorded a provision for income taxes forthe three months ended April 4, 2009 due to state minimum taxes.  During the three months ended March 29,2008 we recorded a benefit forincome taxes which was reserved against during the third quarter of fiscal 2008when we recorded a net charge to income tax expense of approximately $4.5million related to establishing a partial valuation allowance against ourdeferred income tax assets.  Ourdetermination to record a valuation allowance was based on our recent historyof cumulative losses as well as uncertainty of the utilization of deferred taxassets in the near future.

 

**Liquidity andCapital Resources**

** **

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

 

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

 

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

 
| ** **                          | ** ** | **April 4,** | ** **   | **January 3,** | ** ** |
|-------------------------------------|------------|-------------------|--------------|---------------------|------------|
| ** **                          | ** ** | **2009**          | ** **   | **2009**            | ** ** |
| Working Capital                     |       | $                 | 19,374       |                | $          | 22,339 |   |
|                                |       |              |         |                |       |
| Cash and cash equivalents(1)        |       | $                 | 8,563        |                | $          | 15,214 |   |
| Short-term marketable securities(1) |       | 11,077            |         | 5,199               |       |
| Long-term marketable securities     |       | 981               |         | 960                 |       |
|                                |       | $                 |  20,621 |                | $          | 21,373 |   |

 

----

*(1) Included in workingcapital*

 

*Our working capital decreased in the three months ended April 4,2009 primarily as a result of declines in certain operating assets andliabilities, mainly due to the overall decline in net sales during thequarter.  Cash and cash equivalentsdecreased during the quarter as cash and cash equivalents were invested inshort term marketable securities bearing a slightly higher rate of return andas the result of the use of approximately $0.9 million in cash used foroperations.*

 

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***CashProvided and Used in the Three Months Ended April 4, 2009 and March 29,2008***

 

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

* *
| ** **                                           | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **April 4,**      | ** ** | **March 29,** | ** ** |
| ** **                                           | ** ** | **2009**               | ** ** | **2008** | ** ** |
| **Net cash provided by (used in):**                  |       |                   |       |   |   |
| Operating activities                                 |       | $                      | (915       | ) | $ | 2,097 |   |
| Investing activities                                 |       | (5,613                 | )          | 1,460 |   |
| Financing activities                                 |       | (123                   | )          | (1,833 | ) |
| Net increase (decrease) in cash and cash equivalents |       | $                      | (6,651     | ) | $ | 1,724 |   |

 

*Operating Activities.* Net cash used by operating activitiesfor the three months ended April 4, 2009 was primarily a result of a netloss of approximately $3.8 million for the three months ended April 4,2009 partially offset by (i) approximately $2.2 million in net cash providedby changes in operating assets and liabilities, and (ii) approximately$0.7 million in net non-cash operating expenses, primarily comprisingdepreciation and amortization, stock-based compensation and gain on disposal ofassets.   Net cash provided by operatingactivities for the three months ended March 29, 2008 was primarily aresult of (i) approximately $2.0 million in net cash provided by changesin operating assets and liabilities and (ii) approximately $0.7 million innet non-cash operating expenses, primarily comprising depreciation andamortization, deferred income taxes, stock-based compensation and impairment oflong-lived assets, partially offset by a net loss of approximately $0.6 millionfor the three months ended March 29, 2008.

 

Accounts receivabledecreased approximately $1.0 million during the three months ended April 4,2009 primarily as a result of the decline in our net sales during the period.During the same period, we were successful in collecting cash from sales to ourcustomers substantially in accordance with our standard payment terms withthose customers.

 

*Investing Activities.* Net cash used in investing activitiesfor the three months ended April 4, 2009 was primarily a result ofpurchases of additional investments in marketable securities of approximately$10.3 million, partially offset by (i) proceeds received from maturitiesand sales of certain investments in marketable securities of approximately $4.4million and (ii) proceeds from the sale of equipment. Net cash provided byinvesting activities for the three months ended March 29, 2008 wasprimarily a result of proceeds received from maturities of certain investmentsin marketable securities of approximately $8.2 million, partially offset bypurchases of additional investments in marketable securities during the periodof approximately $6.4 million and (ii) purchases of additional propertyand equipment.

 

Due to recentdisruptions of, and the resulting reduced liquidity in certain financialmarkets, two of our marketable securities investments in Baa1 and A3 ratedauction rate securities with a total purchased cost of $1.0 million beganto experience failed auctions during the fourth quarter of 2007 and havecontinued to the first quarter of 2009. Due to the failed auctions, we havebeen unable to sell the securities at their respective costs, resulting in adecrease in fair value which has been recorded as a component of accumulatedother comprehensive loss. These investments have been classified as long-terminvestments in marketable securities in our consolidated balance sheets as of April 4,2009 and March 29, 2008. As of April 4, 2009 and March 29, 2008,the unrealized losses on these two investments totaled approximately $.02million and $0.2 million, respectively. We have concluded that the unrealizedlosses on these investments are temporary because (i) we believe that thedecline in market value that has occurred is due to general market conditions, (ii) theauction rate securities continue to be of a high credit quality and interest ispaid as due and (iii) we have the intent and ability to hold theseinvestments until a recovery in market value occurs. The fair value of thesesecurities could change significantly in the future and we may be required torecord other-than-temporary impairment charges or additional unrealized lossesin future periods.

 

*Financing Activities.* Net cash used in financing activitiesfor the three months ended April 4, 2009 was a result of repayment ofapproximately $0.1 million on our long term debt.   Net cash used in financing activities forthe three months ended March 29, 2008 was primarily a result of (i) netrepayments on our outstanding revolving line of credit of approximately $1.6million and (ii) repayment of approximately $0.2 million on our long termdebt.

 

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***Capital Resources***

*** ***

Under our revolving line of credit, we may borrow upto the greater of 85% of eligible accounts receivable plus the least of (i) apercentage of eligible inventory determined from time to time by the Company’sbank, (ii) 80% of the orderly liquidation value, as defined, of eligibleinventories, and (iii) $1 million. Interest is payable monthly at thegreater of (i) the sum of prime rate plus 3%, (ii) LIBOR plus 6% or (iii) 8%.

 

In connection with its credit agreement, the Companywas provided an equipment line of credit allowing it to borrow up to $3.9million through January 3, 2009. The Company is required to repay theequipment advances in monthly installments of $32,440. Interest on theequipment advances is payable monthly, at the Company’s option, at the greaterof (i) the sum of prime rate plus 3%, (ii) LIBOR plus 6% or (iii) 8%.

 

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

 
| ** **                                                | ** ** | **April 4,** | ** ** | **January 3,** | ** ** |
|-----------------------------------------------------------|------------|-------------------|------------|---------------------|------------|
| ** **                                                | ** ** | **2009**          | ** ** | **2009**            | ** ** |
| Outstanding borrowings on the revolving line of credit    |       | $                 | —     |                | $          | — |   |
| Outstanding borrowings on the equipment line of credit    |       | $                 | —     |                | $          | — |   |
| Borrowing availability under the revolving line of credit |       | $                 | 655        |                | $          | 4,047 |   |

 

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

 

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

 

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

 

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

 

*NewAccounting Pronouncements*

 

InApril 2009, the FASB issued FSP FAS 157-4, *DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transactions That Are Not Orderly*(“FSPFAS 157-4”), which provides additional guidance for estimating fair value inaccordance with SFAS 157.  FSP FAS 157-4states that a significant decrease in the volume and level of activity for theasset or liability when compared with normal market activity is an indicationthat transactions or quoted prices may not be determinative of fair valuebecause there may be increased instances of transactions that are not orderlyin such market conditions.  Accordingly,further analysis of transactions or quoted prices is needed, and a significantadjustment to the transactions or quoted prices may be necessary to estimatefair value.  FSP FAS 157-4 is effectivefor the Company in its second quarter of fiscal 2009.  The Company is currently in the process ofdetermining the effect of the adoption of FSP FAS 157-4 on its consolidatedfinancial statements.

 

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InApril 2009, the FASB issued FSP FAS 107-1 and APB 28-1, *Interim Disclosures about Fair Value of Financial Instruments*(“FSP FAS 107-1 and APB 28-1”), which requires disclosures about the fair valueof the Company’s financial instruments for which it is practicable to estimatethat value, whether recognized or not recognized in the balance sheets, in theinterim reporting periods as well as in the annual reporting periods. Inaddition, FSP FAS 107-1 and APB 28-1 requires disclosures of the methods andsignificant assumptions used to estimate the fair value of those financialinstruments.  FSP FAS 107-1 and APB 28-1is effective for the Company in its second quarter of fiscal 2009.  The Company is currently in the process ofdetermining the effect of the adoption of FSP FAS 107-1 and APB 28-1 on itsconsolidated financial statements.

 

InApril 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, *Recognition and Presentation of Other-Than-Temporary Impairments*(“FSP FAS 115-2 and FAS 124-2”), which establishes a new method of recognizingand reporting other-than-temporary impairments of debt securities and requiresadditional disclosures related to debt and equity securities.  FSP FAS 115-2 and FAS 124-2 does not changeexisting recognition and measurement guidance related to other-than-temporaryimpairments of equity securities. FSP FAS 115-2 and FAS 124-2 is effective forthe Company in its second quarter of fiscal 2009.  The Company is currently in the process ofdetermining the effect of the adoption of FSP FAS 157-4 on its consolidatedfinancial statements.

 

In December 2007, the FASB issued SFAS No. 141(R),*Business Combinations* (“SFAS 141(R)”),which replaces SFAS 141. The provisions of SFAS 141(R) aresimilar to those of SFAS 141; however, SFAS 141(R) requirescompanies to record most identifiable assets, liabilities, noncontrollinginterests, and goodwill acquired in a business combination at “full fair value.”SFAS 141(R) also requires companies to record fair value estimates ofcontingent consideration and certain other potential liabilities during theoriginal purchase price allocation and to expense acquisition costs asincurred. This statement applies to all business combinations, includingcombinations by contract alone. Further, under SFAS 141(R), all businesscombinations will be accounted for by applying the acquisition method.SFAS 141(R) is effective for fiscal years beginning on or after December 15,2008. The Company expects SFAS 141(R) will have an impact on itsconsolidated financial statements, but the nature and magnitude of the specificeffects will depend upon the nature, terms and size of the acquisitions thatthe Company consummates.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements* (“SFAS 160”), which will requirenoncontrolling interests (previously referred to as minority interests) to betreated as a separate component of equity, not as a liability or other itemoutside of permanent equity. This Statement applies to the accounting fornoncontrolling interests and transactions with non-controlling interest holdersin consolidated financial statements. SFAS 160 will be appliedprospectively to all noncontrolling interests, including any that arose beforethe effective date except that comparative period information must be recast toclassify noncontrolling interests in equity, attribute net income and othercomprehensive income to noncontrolling interests, and provide other disclosuresrequired by SFAS 160. SFAS 160 is effective for periods beginning onor after December 15, 2008. The adoption of SFAS 160 did not have amaterial impact on the Company’s consolidated financial position, results ofoperations or liquidity.

 

***Off-Balance SheetArrangements***

*** ***

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

*** ***

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

** **

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

*** ***

**Item 4.**         Controlsand Procedures

** **

***Not Applicable.***

*** ***

**Item 4T.**      Controlsand Procedures

** **

*(a) Evaluation ofDisclosure Controls and Procedures.* We carried out an evaluation, under the supervisionand with the participation of our management, including our principal executiveofficer and principal financial officer, of the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934, (“Exchange Act”)) as ofthe end of our fiscal quarter ended April 4, 2009. Based upon thatevaluation, our principal executive officer and principal financial officerconcluded that our disclosure controls and procedures are effective to providereasonable assurance that information required to be disclosed by us in reportsthat we file or submit under the Exchange Act (i) is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms and (ii) is accumulated and communicated to our management,including our principal executive officer and principal financial officer as appropriateto allow timely decisions regarding required disclosure.

 

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*(b) Change ininternal controls over financial reporting.* During the fiscal quarter that ended April 4,2009, there have not been any changes in our internal controls over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) that have materially affected, or are reasonably likely tomaterially affect, our internal controls over financial reporting.

 

***Inherent Limitations on InternalControl***

 

A controlsystem, no matter how well conceived and operated, can provide only reasonable,not absolute, assurance that the objectives of the control system are met.Further, the benefits of controls must be considered relative to their costs.Because of the inherent limitations in all control systems, no evaluation ofcontrols can provide absolute assurance that all control issues and instancesof fraud, if any, have been detected. These inherent limitations include therealities that judgments in decision making can be faulty, and that breakdownscan occur because of simple errors. Additionally, controls can be circumventedby the individual acts of some persons, by collusion of two or more people, orby management override of the control. The design of any system of controls isalso based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions. Because of the inherentlimitations in a cost-effective control system, misstatements due to error orfraud may occur and not be detected.

 

**PART II. OTHER INFORMATION**

 

**Item 1.**         LegalProceedings

** **

The informationset forth in the sections entitled Federal Securities Class Action, CaliforniaDerivative Action and Patent Claims under Note 8 of Notes to UnauditedCondensed Consolidated Financial Statements, included in Part I, Item I ofthis Report, is incorporated herein by reference.

 

**Item 1A.**      RiskFactors

** **

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

*** ***

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

 

Recentlygeneral worldwide economic conditions have experienced a downturn due to thecredit conditions impacted by the subprime-mortgage turmoil and other factors,slower economic activity, concerns about inflation and deflation, increasedenergy costs, decreased consumer confidence, reduced corporate profits andcapital spending, adverse business conditions and liquidity concerns in thememory market, recent international conflicts and the impact of naturaldisasters and public health emergencies. These conditions make it extremelydifficult for our customers, our vendors and us to accurately forecast and planfuture business activities, and they could cause U.S. and foreignbusinesses to further slow spending on our products and services, which wouldfurther delay and lengthen sales cycles. Furthermore, during continuingchallenging economic times our customers may face issues gaining timely accessto sufficient credit, which could result in an impairment of their ability tomake timely payments to us. If that were to occur, we may be required toincrease our allowance for doubtful accounts and our days sales outstandingwould be negatively impacted. We cannot predict the timing, strength orduration of the current economic slowdown or subsequent economic recovery,worldwide, or in the memory market and related semiconductor industry. If theeconomy or markets in which we operate continue to worsen, our business,financial condition and results of operations will likely be materially andadversely affected. Additionally, the combination of our lengthy sales cyclecoupled with challenging macroeconomic conditions could compound the negativeimpact on the results of our operations.

 

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

** **

None.

 

**Item 3.**         DefaultsUpon Senior Securities

** **

None.

 

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

** **

None.

 

**Item 5.**         OtherInformation

** **

None.

 

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**Item 6.**        Exhibits

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                     |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description of Document**                                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                           |
| 3.1(1)      |       | Restated Certificate of Incorporation of Netlist, Inc.                                                                                                                                                                                    |
|        |       |                                                                                                                                                                                                                                           |
| 3.2(1)      |       | Amended and Restated Bylaws of Netlist, Inc.                                                                                                                                                                                              |
|        |       |                                                                                                                                                                                                                                           |
| 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. |

 

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(1)   Incorporated byreference to the corresponding exhibit number of the registration statement on Form S-1of the registrant (No. 333-136735) filed with the Securities and ExchangeCommission on October 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.

 

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**SIGNATURES**

 

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

 
| Date: May  15, 2009 |   | NETLIST, INC.                               |
|-------------------------------|--------|---------------------------------------------|
|                          |   | a Delaware corporation                      |
|                          |   | (Registrant)                                |
|                          |   |                                        |
|                          | By:    | /s/ Chun K. Hong                            |
|                          |   | **Chun K. Hong**                            |
|                          |   | **President, Chief Executive  Officer and** |
|                          |   | **Chairman of the Board**                   |
|                          |   | **(Principal Executive Officer)**           |
|                          |   |                                        |
|                          |   |                                        |
|                          | By:    | /s/ Gail Itow                               |
|                          |   | **Gail Itow**                               |
|                          |   | **Vice President and Chief  Financial**     |
|                          |   | **Officer**                                 |
|                          |   | **(Principal Financial Officer)**           |

 

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**EXHIBIT INDEX**

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

 

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