UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 
 
 
 FORM
10-Q
  (Mark One)x
              
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For
the quarterly period ended September 30, 2008
 
 OR
   ̈
              
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For
the transition period
from                                                                to
 
 Commission
file number: 001-33517
 
 Data
Domain, Inc.
 (Exact
name of registrant as specified in its charter)
 
 
  Delaware
                  
                  94-3412175(State
      or Other Jurisdiction of Incorporation or Organization)
                  
                  (IRS
      Employer Identification No.)2421
      Mission College Blvd., Santa Clara, CA
                  
                  95054(Address
      of Principal Executive Offices)
                  
                  (Zip
      Code)Registrant’s
      Telephone Number, Including Area Code
                  
                  (408)
      980-4800
 
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.    Yes  x
    No   ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company. See the definitions of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check
one):
   ̈  Large
      accelerated filer
              
               ̈  Accelerated
      filer
              
              x  Non-accelerated
      filer
                (Do
      not check if a smaller reporting company)
              
               ̈  Smaller reporting
              company
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).    Yes   ̈    No  x
 
 The
number of outstanding shares of the registrant’s common stock as of October 31,
2008 was 59,855,018.
  
 
 
  
  
 
 
 
 Data
Domain, Inc.
 FORM
10-Q
 FOR
THE QUARTER ENDED
 September
30, 2008
 INDEX
  PART I. FINANCIAL
    INFORMATION
                                                                                  
                                                                                  Page No.Item 1.
                                                                                  
                                                                                  Financial Statements
      (unaudited)Condensed Consolidated Balance Sheets as of
      September 30, 2008 and December 31, 2007
                                                                                  
                                                                                  3Condensed Consolidated Statements of Operations
      for the three and nine months ended September 30, 2008 and
      2007
                                                                                  
                                                                                  4Condensed Consolidated Statements of Cash Flows
      for the nine months ended September 30, 2008 and
    2007
                                                                                  
                                                                                  5Notes to Condensed Consolidated Financial
      Statements
                                                                                  
                                                                                  6Item 2.
                                                                                  
                                                                                  Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
                                                                                  
                                                                                  14Item 3.
                                                                                  
                                                                                  Quantitative and Qualitative Disclosures About
      Market Risk
                                                                                  
                                                                                  20Item 4.
                                                                                  
                                                                                  Controls and Procedures
                                                                                  
                                                                                  21PART II. OTHER INFORMATIONItem 1.
                                                                                  
                                                                                  Legal Proceedings
                                                                                  
                                                                                  21Item 1A.
                                                                                  
                                                                                  Risk Factors
                                                                                  
                                                                                  22Item 2.
                                                                                  
                                                                                  Unregistered Sales of Equity Securities and Use of
      Proceeds
                                                                                  
                                                                                  25Item 6.
                                                                                  
                                                                                  Exhibits
                                                                                  
                                                                                  25
   2
  
 
 
 
 
 
 
 PART I.
FINANCIAL INFORMATION
  Item 1.
              Financial
      Statements
 
 Data
      Domain, Inc.Condensed
      Consolidated Balance Sheets(in
      thousands)(unaudited)September
      30,
                      
                      
                      December
      31,2008
                      
                      
                      2007Current
      assets:Cash
      and cash equivalents
                      
                      $
                      139,042
                      
                      
                      $
                      102,939Short-term
      investments
                      
                      
                      74,898
                      
                      
                      
                      104,197Accounts
      receivable (net of allowances of $21 and $0, respectively)
                      
                      
                      52,233
                      
                      
                      
                      35,320Inventories
                      
                      
                      3,922
                      
                      
                      
                      2,341Prepaid
      expenses and other current assets
                      
                      
                      4,811
                      
                      
                      
                      1,711Total
      current assets
                      
                      
                      274,906
                      
                      
                      
                      246,508Long-term
      investments
                      
                      
                      28,543
                      
                      
                      
                      —Intangible
      asset
                      
                      
                      167
                      
                      
                      
                      267Property,
      plant and equipment, net
                      
                      
                      33,176
                      
                      
                      
                      14,589Total
      assets
                      
                      $
                      336,792
                      
                      
                      $
                      261,364Current
      liabilities:Accounts
      payable
                      
                      $
                      10,206
                      
                      
                      $
                      7,251Accrued
      compensation and related benefits
                      
                      
                      13,807
                      
                      
                      
                      11,992Other
      accrued liabilities
                      
                      
                      9,124
                      
                      
                      
                      6,731Income
      taxes payable
                      
                      
                      303
                      
                      
                      
                      196Deferred
      revenue, current
                      
                      
                      31,553
                      
                      
                      
                      16,650Total
      current liabilities
                      
                      
                      64,993
                      
                      
                      
                      42,820Deferred
      revenue, non-current
                      
                      
                      23,164
                      
                      
                      
                      9,322Long-term
      exercised unvested stock options
                      
                      
                      341
                      
                      
                      
                      766Other
      liabilities
                      
                      
                      1,549
                      
                      
                      
                      594Stockholders'
      equity:Common
      stock and additional paid-in capital
                      
                      
                      282,284
                      
                      
                      
                      248,078Accumulated
      other comprehensive income (loss)
                      
                      
                      (2,943
                      )
                      
                      
                      47Accumulated
      deficit
                      
                      
                      (32,596
                      )
                      
                      
                      (40,263
                      )Total
      stockholders' equity
                      
                      
                      246,745
                      
                      
                      
                      207,862Total
      liabilities and stockholders' equity
                      
                      $
                      336,792
                      
                      
                      $
                      261,364See
      Notes to Condensed Consolidated Financial Statements
 
 
  3
  
 
 
 Data
      Domain, Inc.Condensed
      Consolidated Statements of Operations(in
      thousands)(unaudited)Three
      Months Ended
                    
                    
                    Nine
      Months EndedSeptember
      30,
                    
                    
                    September
      30,
                    
                    
                    September
      30,
                    
                    
                    September
      30,2008
                    
                    
                    2007
                    
                    
                    2008
                    
                    
                    2007Revenue:Product
                    
                    $
                    63,872
                    
                    
                    $
                    27,992
                    
                    
                    $
                    161,062
                    
                    
                    $
                    69,470Support
      and services
                    
                    
                    11,135
                    
                    
                    
                    4,000
                    
                    
                    
                    27,718
                    
                    
                    
                    8,975Ratable
      product and related support and services
                    
                    
                    23
                    
                    
                    
                    33
                    
                    
                    
                    76
                    
                    
                    
                    297Total
      revenue
                    
                    
                    75,030
                    
                    
                    
                    32,025
                    
                    
                    
                    188,856
                    
                    
                    
                    78,742Cost
      of revenue:Cost
      of product
                    
                    
                    16,739
                    
                    
                    
                    8,176
                    
                    
                    
                    41,808
                    
                    
                    
                    20,467Cost
      of support and services
                    
                    
                    4,226
                    
                    
                    
                    1,330
                    
                    
                    
                    9,851
                    
                    
                    
                    3,033Cost
      of ratable product and related support and services
                    
                    
                    1
                    
                    
                    
                    3
                    
                    
                    
                    3
                    
                    
                    
                    100Total
      cost of revenue
                    
                    
                    20,966
                    
                    
                    
                    9,509
                    
                    
                    
                    51,662
                    
                    
                    
                    23,600Gross
      profit
                    
                    
                    54,064
                    
                    
                    
                    22,516
                    
                    
                    
                    137,194
                    
                    
                    
                    55,142Operating
      expenses:Sales
      and marketing
                    
                    
                    32,150
                    
                    
                    
                    15,831
                    
                    
                    
                    82,867
                    
                    
                    
                    36,933Research
      and development
                    
                    
                    10,318
                    
                    
                    
                    6,111
                    
                    
                    
                    28,681
                    
                    
                    
                    16,273General
      and administrative
                    
                    
                    6,028
                    
                    
                    
                    2,816
                    
                    
                    
                    17,354
                    
                    
                    
                    6,904Total
      operating expenses
                    
                    
                    48,496
                    
                    
                    
                    24,758
                    
                    
                    
                    128,902
                    
                    
                    
                    60,110Operating
      income (loss)
                    
                    
                    5,568
                    
                    
                    
                    (2,242
                    )
                    
                    
                    8,292
                    
                    
                    
                    (4,968
                    )Other
      income (expense), net:Interest
      income
                    
                    
                    1,318
                    
                    
                    
                    1,614
                    
                    
                    
                    4,998
                    
                    
                    
                    1,950Other
      income (expense), net
                    
                    
                    (1,049
                    )
                    
                    
                    68
                    
                    
                    
                    74
                    
                    
                    
                    (41
                    )Total
      other income (expense), net
                    
                    
                    269
                    
                    
                    
                    1,682
                    
                    
                    
                    5,072
                    
                    
                    
                    1,909Income
      (loss) before provision for income taxes
                    
                    
                    5,837
                    
                    
                    
                    (560
                    )
                    
                    
                    13,364
                    
                    
                    
                    (3,059
                    )Provision
      for income taxes
                    
                    
                    2,605
                    
                    
                    
                    320
                    
                    
                    
                    5,697
                    
                    
                    
                    525Net
      income (loss)
                    
                    $
                    3,232
                    
                    
                    $
                    (880
                    )
                    
                    $
                    7,667
                    
                    
                    $
                    (3,584
                    )Net
      income (loss) per share, basic
                    
                    $
                    0.06
                    
                    
                    $
                    (0.02
                    )
                    
                    $
                    0.13
                    
                    
                    $
                    (0.15
                    )Net
      income (loss) per share, diluted
                    
                    $
                    0.05
                    
                    
                    $
                    (0.02
                    )
                    
                    $
                    0.12
                    
                    
                    $
                    (0.15
                    )Shares
      used in computing net income (loss) per share, basic
                    
                    
                    58,738
                    
                    
                    
                    51,880
                    
                    
                    
                    57,758
                    
                    
                    
                    23,721Shares
      used in computing net income (loss) per share, diluted
                    
                    
                    65,422
                    
                    
                    
                    51,880
                    
                    
                    
                    65,519
                    
                    
                    
                    23,721See
      Notes to Condensed Consolidated Financial Statements
 
  4
   
 
 
 
 
 Data
      Domain, Inc.Condensed
      Consolidated Statements of Cash Flows(in
      thousands)(unaudited)Nine
      Months Ended September 30,2008
                                      
                                      
                                      2007Operating
      activities:Net
      income (loss)
                                      
                                      $
                                      7,667
                                      
                                      
                                      $
                                      (3,584
                                      )Adjustments
      to reconcile net income (loss) to net cash provided by operating
      activities:Depreciation
      and amortization
                                      
                                      
                                      4,367
                                      
                                      
                                      
                                      1,188Stock-based
      compensation
                                      
                                      
                                      16,979
                                      
                                      
                                      
                                      6,706Tax
      benefit for excess stock option deduction
                                      
                                      
                                      5,057
                                      
                                      
                                      
                                      —Provision
      (release) for accounts receivable allowances
                                      
                                      
                                      21
                                      
                                      
                                      
                                      (10
                                      )Provision
      for inventories
                                      
                                      
                                      —
                                      
                                      
                                      
                                      264Amortization
      of evaluation units in inventory
                                      
                                      
                                      1,984
                                      
                                      
                                      
                                      1,870Changes
      in operating assets and liabilties:Increase
      in accounts receivable
                                      
                                      
                                      (16,934
                                      )
                                      
                                      
                                      (7,839
                                      )Increase
      in inventories
                                      
                                      
                                      (3,565
                                      )
                                      
                                      
                                      (4,988
                                      )Increase
      in prepaid expenses and other current assets
                                      
                                      
                                      (3,100
                                      )
                                      
                                      
                                      (1,708
                                      )Increase
      in accounts payable
                                      
                                      
                                      2,955
                                      
                                      
                                      
                                      1,216Increase
      in accrued compensation and related benefits
                                      
                                      
                                      1,815
                                      
                                      
                                      
                                      3,634Increase
      in other accrued liabilities
                                      
                                      
                                      3,337
                                      
                                      
                                      
                                      6,785Increase
      in income taxes payable
                                      
                                      
                                      107
                                      
                                      
                                      
                                      182Increase
      in deferred revenue
                                      
                                      
                                      28,745
                                      
                                      
                                      
                                      10,137Net
      cash provided by operating activities
                                      
                                      
                                      49,435
                                      
                                      
                                      
                                      13,853Investing
      activities:Purchase
      of property, plant and equipment
                                      
                                      
                                      (22,854
                                      )
                                      
                                      
                                      (6,197
                                      )Purchases
      of available-for-sale securities
                                      
                                      
                                      (86,637
                                      )
                                      
                                      
                                      (49,248
                                      )Proceeds
      from maturities of available-for-sale securities
                                      
                                      
                                      115,481
                                      
                                      
                                      
                                      6,800Purchases
      of long-term investments
                                      
                                      
                                      (31,000
                                      )
                                      
                                      
                                      —Net
      cash used in investing activities:
                                      
                                      
                                      (25,010
                                      )
                                      
                                      
                                      (48,645
                                      )Financing
      activities:Proceeds
      from issuance of common stock, net of repurchases
                                      
                                      
                                      11,757
                                      
                                      
                                      
                                      109,161Repayment
      of shareholder note receivable
                                      
                                      
                                      —
                                      
                                      
                                      
                                      15Payment
      for initial public offering costs
                                      
                                      
                                      —
                                      
                                      
                                      
                                      639Net
      cash provided by financing activities
                                      
                                      
                                      11,757
                                      
                                      
                                      
                                      109,815Effect
      of exchange rate changes on cash and cash equivalents
                                      
                                      
                                      (79
                                      )
                                      
                                      
                                      (49
                                      )Net
      increase in cash and cash equivalents
                                      
                                      
                                      36,103
                                      
                                      
                                      
                                      74,974Cash
      and cash equivalents at beginning of period
                                      
                                      
                                      102,939
                                      
                                      
                                      
                                      11,857Cash
      and cash equivalents at end of period
                                      
                                      $
                                      139,042
                                      
                                      
                                      $
                                      86,831Supplemental
      schedule of cash flow data:Cash
      paid for income taxes
                                      
                                      $
                                      574
                                      
                                      
                                      $
                                      374Non-cash
      operating activity:Issuance
      of common stock for settlement
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      3,319Non-cash
      financing activity:Conversation
      of mandatorily redeemable convertible preferred stock to common stock and
      additional paid in capital
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      41,514See
      Notes to Consolidated Financial Statements
 
  5
   
 DATA DOMAIN, INC.
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)
 
 1.
ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
 
 Organization
and Description of Business
 
 Data
Domain, Inc. was incorporated in the State of Delaware in October 2001. Our
appliances provide deduplication storage for disk-based backup and network–based
disaster recovery. We began selling our products and services in February 2004.
Our product sales generally include a software license, hardware, post-contract
customer support and, in some cases, installation services.
 
 
 Summary
of Significant Accounting Policies
 
 Basis
of Presentation
 
 The
condensed consolidated financial statements include our accounts and the
accounts of our wholly owned subsidiaries. Intercompany transactions and
balances have been eliminated. The accompanying condensed consolidated balance
sheet as of September 30, 2008, the condensed consolidated statements of
operations for the three and nine months ended September 30, 2008 and 2007, and
the condensed consolidated statements of cash flows for the nine months ended
September 30, 2008 and 2007 are unaudited. The condensed consolidated balance
sheet data as of December 31, 2007 was derived from the audited
consolidated financial statements which are included in our current report on
Form 10-K filed with the Securities and Exchange Commission, or SEC, on
February 29, 2008. The accompanying financial statements should be read in
conjunction with the audited consolidated financial statements and related notes
contained in such Form 10-K.
 
 The
accompanying condensed consolidated financial statements have been prepared in
accordance with United States generally accepted accounting principles, or GAAP,
pursuant to the rules and regulations of the SEC. They do not include all of the
financial information and footnotes required by GAAP for complete financial
statements. We believe the unaudited condensed consolidated financial statements
have been prepared on the same basis as the audited financial statements and
include all adjustments necessary for the fair presentation of our statement of
financial position as of September 30, 2008, our results of operations for the
three and nine months ended September 30, 2008 and 2007, and our cash flows for
the nine months ended September 30, 2008 and 2007. All such adjustments are of a
normal recurring nature. The results for the three and nine months ended
September 30, 2008 are not necessarily indicative of the results to be expected
for any subsequent quarter or for the fiscal year ending December 31,
2008.
 
 Other
than the adoption of the provisions of Statement of Financial Accounting
Standards, or SFAS, No. 157, Fair Value
Measurements, as discussed in “Recent Accounting Pronouncements” below,
there were no significant changes in our accounting policies during the nine
months ended September 30, 2008.
 
 Use
of Estimates
 
 The
preparation of financial statements in conformity with GAAP requires us to make
certain estimates and judgments that can affect the reported amounts of assets
and liabilities as of the date of the condensed consolidated financial
statements, as well as the reported amounts of revenue and expenses during the
periods presented. Significant estimates and assumptions made by management
include the determination of the fair value of stock awards, the allowance for
doubtful accounts, warranty reserve and inventory valuation. We believe that the
estimates and judgments upon which we rely are reasonable based upon information
available to us at the time that these estimates and judgments are made. To the
extent there are material differences between these estimates and actual
results, our condensed consolidated financial statements will be
affected.
 
 Revenue
Recognition
 
 We derive
our revenue from sales of our products and support services through third-party
value added resellers and distributors, or channel partners, and directly to
customers. Product revenue primarily consists of revenue from sales of our
appliances and expansion shelves. Shipping charges billed to customers are
included in product revenue and the related shipping costs are included in cost
of product revenue.
 
 Our
software is integrated with our industry standard appliance hardware and is
essential to the functionality of the integrated system product. We provide
unspecified software updates and enhancements related to our products through
support and services contracts. Accordingly, we recognize revenue in accordance
with the guidance provided under the American Institute of Certified Public
Accountants, or AICPA, Statement of Position, or SOP, No. 97-2,Software Revenue
Recognition, or SOP 97-2, and SOP No. 98-9,Modification of SOP No. 97-2
Software Revenue Recognition with Respect to Certain Transactions, or SOP
98-9. Product revenue is recognized when all of the following have occurred:
(1) we have entered into a legally binding arrangement with a customer;
(2) delivery has occurred, which is when the product title has transferred
to the customer; (3) customer payment is deemed fixed or determinable and
free of contingencies and significant uncertainties; and (4) collection is
probable. Our fees are considered fixed or determinable upon the establishment
of an arrangement that contains the final terms of sale including the
description, quantity and price of each product purchased. Our customer
arrangements do not include rights of return or acceptance provisions. We assess
the ability to collect from our customers based on a number of factors,
including creditworthiness and past transaction history of the customer. If the
customer is deemed not creditworthy, all revenue from the arrangement is
deferred until payment is received and all other revenue recognition criteria
have been met.  Accounts receivable are recorded net of allowance for
doubtful accounts and estimated customer trade-ins.
 
 Substantially
all of our products have been sold in combination with support and services,
which primarily consist of hardware and software support. Hardware support
includes repair or replacement in the event of breakage or failure, and
telephone and Internet access to technical information and support personnel
during the term of the support period. Software support provides customers with
rights to unspecified software updates and to maintenance releases and patches
released during the term of the support period. Installation services, when
provided, are also included in support and services revenue. We have established
vendor specific objective evidence, or VSOE, of fair value of our support and
services as measured by the renewal prices offered to and paid by our customers.
Accordingly, we use the residual method, as allowed by SOP 98-9, to determine
the amount of product revenue to be recognized. Under the residual method, the
fair value of the undelivered support and services, which is a specified dollar
amount, is deferred and the remaining portion of the arrangement is recognized
as product revenue. This product revenue is generally recognized upon shipment,
except for certain customers whose terms are FOB destination point wherein the
revenue is recognized upon delivery, based on freight terms of FOB shipping
point or FCA (Incoterms 2000) shipping point, assuming all other criteria for
revenue recognition discussed above have been met and, in the case of all
indirect channel sales, persuasive evidence of the identity of the customer has
been obtained. In all cases of direct or indirect channel sales, we recognize
revenue once a customer is identified and shipment has occurred, assuming all
other criteria for revenue recognition discussed above have been met. The fair
value of the support and services is recognized as support and services revenue
on a straight-line basis over the term of the related support period, which is
typically one to three years.
  6
  DATA
DOMAIN, INC.
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)
 
 
 Product
sales sometimes include installation services. Installation revenue is deferred
and recognized upon the earlier of customer notice that the installation is
complete or sixty days after shipment. We have established VSOE of fair value
for our installation services based on the price separately charged to our
customers. Revenue from installation, which is included in support and services
revenue, was $996,000 and $482,000 for the three months ended September 30, 2008
and 2007, respectively, and $2.8 million and $1.0 million for the nine months
ended September 30, 2008 and 2007, respectively.
 
 Stock-Based
Compensation
 
 Stock-based
compensation included in our condensed consolidated statements of operations for
the three and nine months ended September 30, 2008 and 2007 was as
follows:
 
 Three
      Months Ended
                  
                  
                  Nine
      Months EndedSeptember
      30,
                  
                  
                  September
      30,
                  
                  
                  September
      30,
                  
                  
                  September
      30,(in
      thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Cost
      of product
                  
                  $
                  198
                  
                  
                  $
                  74
                  
                  
                  $
                  536
                  
                  
                  $
                  116Cost
      of support and services
                  
                  
                  283
                  
                  
                  
                  90
                  
                  
                  
                  575
                  
                  
                  
                  204Sales
      and marketing
                  
                  
                  2,903
                  
                  
                  
                  1,698
                  
                  
                  
                  8,476
                  
                  
                  
                  2,993Research
      and development
                  
                  
                  1,424
                  
                  
                  
                  942
                  
                  
                  
                  4,096
                  
                  
                  
                  1,918General
      and administrative
                  
                  
                  1,254
                  
                  
                  
                  699
                  
                  
                  
                  3,296
                  
                  
                  
                  1,475Total
      stock-based compensation expense
                  
                  $
                  6,062
                  
                  
                  $
                  3,503
                  
                  
                  $
                  16,979
                  
                  
                  $
                  6,706
 
 
 We
account for share-based payments under the fair value recognition provisions of
SFAS No. 123(R), Share-Based
Payment, or SFAS 123(R). We estimate the grant date fair value of stock
option awards using the Black-Scholes option valuation model, which requires,
among other inputs, an estimate of the fair value of the underlying common stock
on the date of grant and the expected volatility of the stock over the expected
term of the related grants. We recognize this expense on a straight-line basis
over the optionees’ requisite service period which is generally the same as the
vesting schedule of the options.
 
 On
June 27, 2007, we implemented our 2007 Employee Stock Purchase Plan, or
ESPP. Under the ESPP, employees may purchase shares of common stock at a price
per share that is 85% of the lesser of the fair market value of our common stock
as of the beginning or the end of six-month purchase periods. The ESPP is
compensatory and has resulted in compensation expense amortized on a
straight-line basis.  The expense recognized in the three and nine
months ended September 30, 2008 was $725,000 and $2.4 million,
respectively.  The expense recognized in the three and nine months
ended September 30, 2007 was $858,000 and $873,000, respectively.
 
 
 The fair
value of options granted under our stock plans and the shares purchased under
the ESPP were determined using the following assumptions:
 
  Three
      Months Ended
                    
                    
                    Nine
      Months EndedOptions
      Granted
                    
                    September
      30,
                      2008
                    
                    
                    September
      30,
                      2007
                    
                    
                    September
      30,
                      2008
                    
                    
                    September
      30,
                      2007Average
      expected life in years
                    
                    
                    5.55
                    
                    
                    
                    4.45
                    
                    
                    
                    5.55
                    
                    
                    
                    4.25Weighted-average
      volatility
                    
                    
                    52
                    %
                    
                    
                    70
                    %
                    
                    
                    56
                    %
                    
                    
                    70
                    %Risk-free
      interest rate
                    
                    
                    2.97%
      - 3.26
                    %
                    
                    
                    4.01%
      - 4.68
                    %
                    
                    
                    2.51%
      - 3.57
                    %
                    
                    
                    4.0
      - 4.97
                    %ESPPAverage
      expected life in months
                    
                    
                    6
                    
                    
                    
                    7
                    
                    
                    
                    6
                    
                    
                    
                    7Weighted-average
      volatility
                    
                    
                    46
                    %
                    
                    
                    70
                    %
                    
                    
                    46%
      - 58
                    %
                    
                    
                    70
                    %Risk-free
      interest rate
                    
                    
                    1.94
                    %
                    
                    
                    4.95
                    %
                    
                    
                    1.94%
      - 2.25
                    %
                    
                    
                    4.95
                    %
 
 
 The
expected term represents the period that stock-based awards are expected to be
outstanding, giving consideration to the contractual terms of the stock-based
awards, vesting schedules and expectations of future employee behavior as
influenced by changes to the terms of our stock-based awards. For the three and
nine months ended September 30, 2008, the expected term was based on actual
data. For the three and nine months ended September 30, 2007, we elected to use
the simplified method of determining the expected term as permitted by SEC Staff
Accounting Bulletin 107. The computation of expected volatility for the three
and nine months ended September 30, 2008 and 2007 was based on the historical
volatility of comparable companies from a representative peer group selected
based on industry and market capitalization data. As required by SFAS 123(R),
management estimates expected forfeitures and recognizes compensation costs only
for those equity awards expected to vest.
 
 At
September 30, 2008, the total compensation cost related to stock-based awards
granted under SFAS 123(R) to employees and directors but not yet recognized was
approximately $61.6 million, net of estimated forfeitures. This cost will be
amortized on a straight-line basis over a weighted average period of
approximately 2.8 years.
 
 On
June 20, 2007, we granted 383,998 shares of restricted stock at fair value,
10,000 of which shares vested on June 27, 2007, with the remaining shares
vesting over a four-year period commencing on June 27, 2007. As of
September 30, 2008, 280,499 shares remained unvested.
 
 The
aggregate intrinsic value of outstanding stock options is calculated as the
difference between the exercise price of the stock option awards and the closing
price of our common stock on the Nasdaq Global Market. During the three and nine
months ended September 30, 2008, the aggregate intrinsic value of stock option
awards exercised was $10.7 million and $51.8 million, respectively, determined
at the date of option exercise.
 
 The
weighted-average exercise price of options granted in the three and nine months
ended September 30, 2008 was $21.43 and $21.74 per share, respectively, and the
weighted-average exercise price of options exercised in the three and nine
months ended September 30, 2008 was $2.72 and $1.72 per share, respectively. The
weighted-average exercise price of options granted in the three and nine months
ended September 30, 2007 was $26.76 and $10.86 per share, respectively, and the
weighted-average exercise price of options exercised in the three and nine
months ended September 30, 2007 was $0.64 and $7.64 per share,
respectively.
 
  At
September 30, 2008 and December 31, 2007, there were 699,000 and 1,219,000
shares, respectively, subject to repurchase under all common stock repurchase
agreements upon forfeiture or early termination of employment. The cash received
from the sale of these shares was initially recorded as a liability and is
subsequently reclassified to common stock as the shares vest. At September 30,
2008 and December 31, 2007, there was $341,000 and $766,000, respectively,
recorded in long-term liabilities related to the issuance of these
shares.
  7
  
 
 
 DATA
DOMAIN, INC.
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)
 
 Foreign
Currency Translation
 
 The
majority of our sales arrangements are denominated in United States dollars or
Euros, while a smaller portion of our sales agreements are denominated in
Canadian dollars and British sterling. In addition, we incur operating expenses
in local foreign currencies in those countries where we have sales and marketing
and administrative personnel. The functional currency of our foreign operations
is the local country’s currency. Consequently, expenses of operations outside
the United States are translated into United States dollars using average
exchange rates for the period reported while assets and liabilities of
operations outside the United States are translated into United States dollars
using end-of-period exchange rates. The effects of foreign currency translation
of the financial statements of our foreign operations are included in
stockholders’ equity as a component of accumulated other comprehensive income
(loss) in the accompanying condensed consolidated balance sheets. The effects of
foreign currency re-measurement for non-U.S. currency denominated assets and
liabilities related to our domestic operations are recognized in our condensed
consolidated statement of operations, and amounted to a net loss of ($1.0
million) and a net gain of $68,000 for the three months ended September 30, 2008
and 2007, respectively, and a net gain of $74,000 and a net loss of ($41,000)
for the nine months ended September 30, 2008 and 2007,
respectively.
 
 Allowance
for Doubtful Accounts
 
 We
perform credit evaluations of our customers’ financial condition and generally
do not require collateral from our customers. These evaluations require
significant judgment and are based on a variety of factors including, but not
limited to, current economic trends, historical payments, bad debt write-off
experience, and financial review of the customer.
  We
maintain an allowance for doubtful accounts for estimated losses resulting from
the inability or unwillingness of our customers to make required payments. When
we become aware that a specific customer is unable or unwilling to meet its
financial obligations, we record a specific allowance to reflect the level of
credit risk in the customer’s outstanding receivable balance. In addition, we
record additional allowances based on certain percentages of aged receivable
balances. We classify bad debt expenses as general and administrative expenses.
For the three and nine months ended September 30, 2008 and 2007, we did not have
any write-offs of accounts receivable.
 
 Inventory
Valuation
 
 Inventories
consist of hardware and related component parts and are stated at the lower of
cost (on a first-in, first-out basis) or market value. Finished goods constitute
a large portion of our inventory and include customer evaluation units which are
carried at cost less accumulated amortization. We amortize the cost of these
evaluation units on a straight-line basis over twelve months upon the initial
transfer of a unit into the evaluation pool. The cost of the amortization of
evaluation units is included in cost of product revenue. If an evaluation unit
is purchased, we record a sale pursuant to our revenue recognition policy. We
assess the valuation of our inventory on a quarterly basis and write down the
value for estimated excess and obsolete inventory based upon estimates of future
demand, including warranty requirements. Inherent in our estimates of market
value in determining inventory valuation are estimates related to economic
trends, future demand for our products and technological obsolescence of our
products.
 
 Inventory
write-downs are included in cost of product and have not been material. Spares
are expensed to cost of product as purchased. We do not allocate indirect
overhead costs to finished goods inventory as these amounts are not
material.
 
 We
outsource the assembly of our products to a third-party manufacturing facility
under an annual contract which renews automatically but may be terminated by
either party with 90 days of written notice. We also purchase some finished
products from a single source supplier under a three-year agreement that expires
in March 2010. At September 30, 2008, we had $3.2 million of non-cancellable
purchase commitments with our third-party manufacturing supplier and $881,000
from our single source supplier. In addition, we had $8.7 million of other
non-cancellable purchase commitments with other third-party
vendors.
 
 Warranty
Reserve
 
 Upon
shipment of products to our customers, we provide for the estimated cost to
repair or replace products that may be returned under warranty. Our warranty
period is typically 12 months from the date of shipment to the customer for
hardware and 90 days for software. For existing products, the warranty reserve
is based on actual historical experience. For new products, the warranty reserve
is based on historical experience of similar products until such time as
sufficient historical data has been collected for the new product.
 
 During
the three months ended March 31, 2007, we recorded an estimated charge of $1.2
million associated with a field replacement program that was initiated in April
2007 to replace a circuit board used in some of our appliances. During the three
months ended September 30, 2007, we recorded an additional charge of $450,000 to
expand this replacement program for additional circuit boards used in some of
our appliances. During the three months ended June 30, 2008, we recorded an
additional charge of $25,000 as we have revised our estimate of the costs of the
replacement program. To date, these circuit boards have experienced failures in
less than 1% of the appliances that we believe are potentially affected. Through
the replacement program, we are offering to exchange the circuit boards in all
of the appliances that we believe are potentially affected with circuit boards
manufactured by a particular fabricator. We believe our estimates and judgments
for the replacement program continue to be reasonable based upon information
available at this time. Our estimated charge associated with the replacement
program is based on the number of circuit boards we expect to replace under the
program, the anticipated cost of replacement and refurbishment and other
associated costs. This warranty charge does not assume any recovery from our
supplier because any recovery is uncertain at this time. As of September 30,
2008, we had incurred approximately $1.5 million of costs associated with these
field replacement programs and $97,000 remained in accrued liabilities to cover
future costs for the units potentially affected. To the extent there are
differences between our estimates and actual results, our consolidated financial
statements will be affected.
  8
  
 
 The
following table is a summary of our warranty activity for the nine months ended
September 30, 2008:
 
 (in
      thousands)Warranty
      reserve—December 31, 2007
                      
                      $
                      596Warranty
      expense
                      
                      
                      1,151Warranty
      usage
                      
                      
                      (857
                      )Warranty
      reserve—September 30, 2008
                      
                      $
                      890
 
 
 Income
Taxes
 
 We
account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Deferred income
taxes are recorded for the expected tax consequences of temporary differences
between the tax bases of assets and liabilities for financial reporting purposes
and amounts recognized for income tax purposes. We record a valuation allowance
to reduce our deferred tax assets to the amount of future tax benefit that is
more likely than not to be realized.
 
 
  9
  
 DATA
DOMAIN, INC.
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)
 
 Comprehensive
Income (Loss)
 
 Comprehensive
income (loss) was $2.2 million and ($929,000) for the three months ended
September 30, 2008 and 2007, respectively.  For the three months ended
September 30, 2008, comprehensive income included net income of $3.2 million,
partially offset by $1.0 million of unrealized loss on short-term and long-term
investments as well as minimal foreign currency translation losses. For the
three months ended September 30, 2007, comprehensive loss included a net loss of
$880,000 and minimal adjustments related to foreign currency
translation.
 
 Comprehensive
income (loss) was $4.7 million and ($3.6 million) for the nine months ended
September 30, 2008 and 2007, respectively. For the nine months ended September
30, 2008, comprehensive income included net income of $7.7 million as well as
minimal foreign currency translation gains, partially offset by $2.9 million of
unrealized loss on short-term and long-term investments. For the nine months
ended September 30, 2007, comprehensive loss included a net loss of $3.6 million
and minimal adjustments related to foreign currency translation.
 
 Accumulated
other comprehensive income (loss) was ($2.9 million) at September 30, 2008. The
loss at September 30, 2008 resulted from unrealized losses on our investments in
auction-rate securities of $2.5 million, unrealized losses on our short-term
investment portfolio of $419,000 and minimal cumulative foreign currency
translation losses. At September 30, 2008, we had an aggregate face value of
$31.0 million of auction-rate securities carried at a book value of $28.5
million classified as long-term investments. Accumulated other comprehensive
income was $47,000 at December 31, 2007 resulting from cumulative foreign
currency translation gains and unrealized gains on our short-term investment
portfolio.
 
 Recent
Accounting Pronouncements
 
 Effective
January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements, or SFAS 157. In
February 2008, the Financial Accounting Standards Board, or FASB, issued FASB
Staff Position No. FAS 157-2, Effective Date of
FASB Statement No. 157, which provides a one year deferral of the
effective date of SFAS 157 for non-financial assets and non-financial
liabilities, except those that are recognized or disclosed in the financial
statements at fair value at least annually. Therefore, we have adopted the
provisions of SFAS 157 with respect to our financial assets and liabilities
only. SFAS 157 defines fair value, establishes a framework for measuring fair
value under GAAP and enhances disclosures about fair value measurements. Fair
value is defined under SFAS 157 as the exchange price that would be received for
an asset or paid to transfer a liability (an exit price) in the principal or
most advantageous market for the asset or liability in an orderly transaction
between market participants on the measurement date. Valuation techniques used
to measure fair value under SFAS 157 must maximize the use of observable inputs
and minimize the use of unobservable inputs. The standard describes a fair value
hierarchy based on three levels of inputs, of which the first two are considered
observable and the last unobservable, that may be used to measure fair value
which are the following:
  ·
              Level
      1 - Quoted prices in active markets for identical assets or
      liabilities.
 
 ·
              Level
      2 - Inputs other than Level 1 that are observable, either directly or
      indirectly, such as quoted prices for similar assets or liabilities;
      quoted prices in markets that are not active; or other inputs that are
      observable or can be corroborated by observable market data for
      substantially the full term of the assets or
  liabilities.
 
 ·
              Level
      3 - Unobservable inputs that are supported by little or no market activity
      and that are significant to the fair value of the assets or
      liabilities.
 
 The
adoption of this statement did not have a material impact on our consolidated
results of operations and financial condition.
 
 In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities, including an amendment of FASB Statement
No. 115, or SFAS 159. SFAS 159 permits companies to choose to
measure many financial instruments and certain other items at fair value that
are not currently required to be measured at fair value and establishes
presentation and disclosure requirements designed to facilitate comparisons
between companies that choose different measurement attributes for similar
types of assets and liabilities.  We elected not to adopt the fair
value option on existing eligible financial instruments as of January 1, 2008.
However, because the SFAS 159 election is based on an instrument-by-instrument
election at the time the company first recognizes an eligible item or enters
into an eligible firm commitment, we may decide to exercise the option on new
items when business reason support doing so in the future. The adoption of SFAS
No. 159 did not have a significant impact on our consolidated results of
operations and financial condition.
 
 Fair
Value of Financial Instruments
 
 The
carrying amounts of cash and cash equivalents, short-term investments, accounts
receivable, accounts payable and income taxes payable approximate their fair
values due to the short-term maturity of these instruments.
 
 In
accordance with SFAS 157, the following table represents our fair value
hierarchy for our financial assets (cash equivalents and short-term and
long-term investments) measured at fair value on a recurring basis as of
September 30, 2008 (in thousands):
 
 Level
      1
                  
                  
                  Level
      2
                  
                  
                  Level
      3
                  
                  
                  TotalMoney
      market funds
                  
                  $
                  71,754
                  
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  71,754Commercial
      paper
                  
                  
                  —
                  
                  
                  
                  22,176
                  
                  
                  
                  —
                  
                  
                  
                  22,176Municipal
      bonds
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  28,543
                  
                  
                  
                  28,543Corporate
      bonds
                  
                  
                  —
                  
                  
                  
                  15,675
                  
                  
                  
                  —
                  
                  
                  
                  15,675U.S.
      government agencies
                  
                  
                  —
                  
                  
                  
                  51,346
                  
                  
                  
                  —
                  
                  
                  
                  51,346Total
                  
                  $
                  71,754
                  
                  
                  $
                  89,197
                  
                  
                  $
                  28,543
                  
                  
                  $
                  189,494
 
  10
  
 
 
 DATA
DOMAIN, INC.
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)
 
 Level 3
assets consist of municipal bonds with an auction reset feature (“auction-rate
securities”) whose underlying assets are generally student loans that are
substantially backed by the federal government. In February 2008, auctions began
to fail for these securities and each auction since then has failed. An auction
failure means that the parties wishing to sell securities could not. As a
result, our ability to liquidate these investments and fully recover the
carrying value of our investments in the near term may be limited or not exist.
All of our auction-rate securities, including those subject to the failure, are
currently AAA-rated taxable municipal debt obligations, the highest rating by a
rating agency. Based on the overall failure rate of these auctions, the
frequency of the failures, and the underlying maturities of the securities, a
portion of which are up to 40 years, we have classified auction-rate securities
as long-term investments on our balance sheet. These investments were valued at
fair value as of September 30, 2008 and have a face value of $31.0 million. We
have classified these instruments as long-term investments. We currently
are reviewing a broad-based settlement proposal from UBS AG, which was received
in October 2008, in which we would have the right to sell the securities back to
affiliates of UBS at the par value of the securities during the period from June
30, 2010 to July 2, 2012 if liquidity does not return to the auction-rate
securities market sooner. The affiliates of UBS will retain the right to sell
our auction-rate securities on our behalf, without prior notification, at any
time prior to July 2, 2012 as long as we receive par value from such sale. We
have until November 14, 2008 to accept this offer from UBS AG, and as of the
date of this filing, we had not yet made a determination on whether to accept
this offer. We will continue to monitor these investments going forward and a
determination will be made regarding their asset classification. The following
table provides a summary of changes in fair value of our Level 3 financial
assets as of September 30, 2008 (in thousands):
 
 
 Auction-rate
      SecuritiesBalance
      at December 31, 2007
                      
                      $
                      29,577Unrealized
      loss included in other comprehensive income
                      
                      
                      (2,494
                      )Purchases
      of auction-rate securities
                      
                      
                      15,610Proceeds
      from sale of auction-rate securities
                      
                      
                      (14,150
                      )Balance
      at September 30, 2008
                      
                      $
                      28,543
 
 
 Cash
and cash equivalents and short and long-term investments
 
 The
following table summarizes our cash and investment portfolio (in
thousands):
 
 Amortized
      Cost
                                                    
                                                    
                                                    Gross
      Unrealized Gains
                                                    
                                                    
                                                    Gross
      Unrealized Losses
                                                    
                                                    
                                                    Fair
      ValueSeptember 30, 2008Cash
      and cash equivalents:Cash
                                                    
                                                    $
                                                    52,989
                                                    
                                                    
                                                    $
                                                    —
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    $
                                                    52,989Money
      market funds
                                                    
                                                    
                                                    71,754
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    71,754Commercial
      paper
                                                    
                                                    
                                                    14,317
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    (18
                                                    )
                                                    
                                                    
                                                    14,299Total
      cash and cash equivalents
                                                    
                                                    $
                                                    139,060
                                                    
                                                    
                                                    $
                                                    —
                                                    
                                                    
                                                    $
                                                    (18
                                                    )
                                                    
                                                    $
                                                    139,042Short-term
      investments:Commercial
      paper
                                                    
                                                    $
                                                    7,918
                                                    
                                                    
                                                    $
                                                    —
                                                    
                                                    
                                                    $
                                                    (41
                                                    )
                                                    
                                                    $
                                                    7,877Corporate
      bonds
                                                    
                                                    
                                                    15,919
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    (244
                                                    )
                                                    
                                                    
                                                    15,675U.S.
      government agencies
                                                    
                                                    
                                                    51,462
                                                    
                                                    
                                                    
                                                    6
                                                    
                                                    
                                                    
                                                    (122
                                                    )
                                                    
                                                    
                                                    51,346Total
      short-term investments
                                                    
                                                    $
                                                    75,299
                                                    
                                                    
                                                    $
                                                    6
                                                    
                                                    
                                                    $
                                                    (407
                                                    )
                                                    
                                                    $
                                                    74,898Long-term
      investments:Municipal
      bonds
                                                    
                                                    $
                                                    31,037
                                                    
                                                    
                                                    $
                                                    —
                                                    
                                                    
                                                    $
                                                    (2,494
                                                    )
                                                    
                                                    $
                                                    28,543Total
      long-term investments
                                                    
                                                    $
                                                    31,037
                                                    
                                                    
                                                    $
                                                    —
                                                    
                                                    
                                                    $
                                                    (2,494
                                                    )
                                                    
                                                    $
                                                    28,543Total
      cash and cash equivalents and short and long-term
    investments
                                                    
                                                    $
                                                    245,396
                                                    
                                                    
                                                    $
                                                    6
                                                    
                                                    
                                                    $
                                                    (2,919
                                                    )
                                                    
                                                    $
                                                    242,483December 31, 2007Cash
      and cash equivalents:Cash
                                                    
                                                    $
                                                    29,005
                                                    
                                                    
                                                    $
                                                    —
                                                    
                                                    
                                                    $
                                                    —
                                                    
                                                    
                                                    $
                                                    29,005Money
      market funds
                                                    
                                                    
                                                    66,543
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    66,543Commercial
      paper
                                                    
                                                    
                                                    7,392
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    (1
                                                    )
                                                    
                                                    
                                                    7,391Total
      cash and cash equivalents
                                                    
                                                    $
                                                    102,940
                                                    
                                                    
                                                    $
                                                    —
                                                    
                                                    
                                                    $
                                                    (1
                                                    )
                                                    
                                                    $
                                                    102,939Short-term
      investments:Commercial
      paper
                                                    
                                                    $
                                                    46,642
                                                    
                                                    
                                                    $
                                                    23
                                                    
                                                    
                                                    $
                                                    (4
                                                    )
                                                    
                                                    $
                                                    46,661Corporate
      bonds
                                                    
                                                    
                                                    17,426
                                                    
                                                    
                                                    
                                                    11
                                                    
                                                    
                                                    
                                                    (15
                                                    )
                                                    
                                                    
                                                    17,422Municipal
      bonds
                                                    
                                                    
                                                    29,577
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    29,577U.S.
      government agencies
                                                    
                                                    
                                                    10,529
                                                    
                                                    
                                                    
                                                    8
                                                    
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    10,537Total
      short-term investments
                                                    
                                                    $
                                                    104,174
                                                    
                                                    
                                                    $
                                                    42
                                                    
                                                    
                                                    $
                                                    (19
                                                    )
                                                    
                                                    $
                                                    104,197Total
      cash and cash equivalents and short-term investments
                                                    
                                                    $
                                                    207,114
                                                    
                                                    
                                                    $
                                                    42
                                                    
                                                    
                                                    $
                                                    (20
                                                    )
                                                    
                                                    $
                                                    207,136
 
 
 We
consider all highly liquid investments purchased with an original maturity of 90
days or less to be cash equivalents. Cash and cash equivalents are stated at
cost, which approximates fair value. We had restricted cash from a letter of
credit on our corporate headquarters lease for $209,000 that was part of our
cash balance at December 31, 2007.  In June 2008, we deposited an
additional $1.2 million as collateral for a letter of credit on a second
building in our corporate complex.  At September 30, 2008, all
restricted cash balances, which totaled $1.4 million, were classified as other
current assets.
 
 Cash and
cash equivalents consist primarily of highly liquid investments in time deposits
held at major banks, commercial paper and other money market securities with
original maturities of 90 days or less. The carrying value of cash and cash
equivalents at September 30, 2008 and December 31, 2007 was approximately
$139.0 million and $102.9 million, respectively, and the weighted average
interest rates were 2.5% and 4.8%, respectively.
 
 We
classify our portfolio of short-term investments as available for sale.
Short-term investments consist of corporate bonds, United States government
agency securities and commercial paper with original maturities of 90 to 365
days.  At September 30, 2008, municipal bonds, which are auction-rate
securities, were classified as long-term investments.  At September
30, 2008 and December 31, 2007, the value of long-term investments was $28.5
million and zero dollars, respectively. As of September 30, 2008 and
December 31, 2007, net unrealized losses on available-for-sale securities
of $2.9 million and net unrealized gains on available-for-sale securities of
$22,000, respectively, were included in accumulated other comprehensive
income.
  11
  
 DATA DOMAIN, INC.
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)
 
 
 2.
NET INCOME (LOSS) PER SHARE
 
 Basic net
income (loss) per share is computed by dividing net income (loss) by the
weighted average number of vested shares of common stock outstanding during the
period. Diluted net income (loss) per share is computed by giving effect to all
potential dilutive shares of common stock, including options and common stock
subject to repurchase.
 
 The
following table sets forth the computation of net income (loss) per
share:
 
 Three
      Months Ended
                                          
                                          
                                          Nine
      Months Ended(in
      thousands, except per share amounts)
                                          
                                          September 30,
      2008
                                          
                                          
                                          September 30,
      2007
                                          
                                          
                                          September 30,
      2008
                                          
                                          
                                          September 30,
      2007Net
      income (loss)
                                          
                                          $
                                          3,232
                                          
                                          
                                          $
                                          (880
                                          )
                                          
                                          $
                                          7,667
                                          
                                          
                                          $
                                          (3,584
                                          )Shares
      used in computing net income (loss) per share, basic
                                          
                                          
                                          58,738
                                          
                                          
                                          
                                          51,880
                                          
                                          
                                          
                                          57,758
                                          
                                          
                                          
                                          23,721Dilutive
      potential common shares:Stock
      options and ESPP
                                          
                                          
                                          6,684
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          7,761
                                          
                                          
                                          
                                          —Shares
      used to compute net income (loss) per share, diluted
                                          
                                          
                                          65,422
                                          
                                          
                                          
                                          51,880
                                          
                                          
                                          
                                          65,519
                                          
                                          
                                          
                                          23,721Net
      income (loss) per share, basic
                                          
                                          $
                                          0.06
                                          
                                          
                                          $
                                          (0.02
                                          )
                                          
                                          $
                                          0.13
                                          
                                          
                                          $
                                          (0.15
                                          )Net
      income (loss) per share, diluted
                                          
                                          $
                                          0.05
                                          
                                          
                                          $
                                          (0.02
                                          )
                                          
                                          $
                                          0.12
                                          
                                          
                                          $
                                          (0.15
                                          )
 
 
 The
following weighted average outstanding options and common stock subject to
repurchase were excluded from the computation of basic and diluted net income
(loss) per share for the periods presented because including them would have had
an antidilutive effect:
 
 Three
      Months Ended
                          
                          Nine
      Months Ended(in
      thousands)
                          
                          September 30,
                            2008
                          
                          September 30,
                            2007
                          
                          September 30,
                            2008
                          
                          September 30,
                            2007Options
      to purchase common stock
                          
                          
                          1,464
                          
                          13,026
                          
                          
                          1,281
                          
                          11,477Common
      stock subject to repurchase
                          
                          
                          699
                          
                          1,525
                          
                          
                          699
                          
                          1,268
 
 
 3.
INVENTORIES
 
 Inventories
consisted of the following:
 
 (in
      thousands)
                          
                          September 30,
      2008
                          
                          
                          December 31,
      2007Finished
      goods
                          
                          $
                          1,054
                          
                          
                          $
                          481Evaluation
      units
                          
                          
                          2,662
                          
                          
                          
                          1,289Raw
      materials and accessories
                          
                          
                          206
                          
                          
                          
                          571Total
                          
                          $
                          3,922
                          
                          
                          $
                          2,341
 
 
 Amortization
of evaluation units was approximately $758,000 and $739,000 for the three months
ended September 30, 2008 and 2007, respectively, and approximately $2.0 million
and $1.9 million for the nine months ended September 30, 2008 and 2007,
respectively.
   4.
DEFERRED REVENUE
 
 Deferred
revenue consisted of the following:
 
 September 30,
      2008
                      
                      
                      December 31,
      2007Product
      - current
                      
                      $
                      729
                      
                      
                      $
                      555Support
      and services
                      
                      
                      30,935
                      
                      
                      
                      16,152Rateable
      product and related support and services
                      
                      
                      7
                      
                      
                      
                      83Less:
      deffered cost of ratable product revenue and product revenue
                      
                      
                      (118
                      )
                      
                      
                      (140
                      )Deferred
      revenue, current
                      
                      $
                      31,553
                      
                      
                      $
                      16,650Support
      and services, non-current
                      
                      $
                      23,164
                      
                      
                      $
                      9,322Deferred
      revenue, non-current
                      
                      $
                      23,164
                      
                      
                      $
                      9,322
 
 
 
 Deferred
product revenue relates to arrangements where not all revenue recognition
criteria have been met. Deferred support and services revenue represents
customer payments made in advance for annual support and services contracts.
Support and services contracts are typically billed in advance on a per annum
basis and revenue is recognized ratably over the support period. Deferred
ratable product and related support and services revenue consists of revenue for
transactions prior to 2006 where VSOE of fair value of support and services had
not been established and, as a result, the entire arrangement was being
recognized ratably over the related support period. All customers are known to
us upon sale of our appliances.
 
 
  12
  
 
 DATA
DOMAIN, INC.
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
 (unaudited)
 
 5.
GUARANTEES
 
 Our
agreements with our channel partners and, less frequently, our customers,
generally include certain provisions for indemnifying the channel partners and
customers against liabilities if our products infringe a third party’s
intellectual property rights. To date, we have not incurred any material costs
as a result of such indemnification provisions and have not accrued any
liabilities related to such obligations in our consolidated financial
statements.
 
 Under the
terms of our lease for our former corporate headquarters, we are obligated to
provide a letter of credit for $136,000. As of September 30, 2008, this letter
of credit was not in place, and had not been required by our sub-lessor. Under
the terms of our lease for our current corporate headquarters, we have provided
a letter of credit for $1.4 million.
 
 As
permitted or required under Delaware law and to the maximum extent allowable
under that law, we have certain obligations to indemnify our officers, directors
and certain key employees for certain events or occurrences while the officer,
director or employee is or was serving at our request in such capacity. These
indemnification obligations are valid as long as the director, officer or
employee acted in good faith and in a manner the person reasonably believed to
be in or not opposed to the best interests of the corporation, and, with respect
to any criminal proceeding, had no reasonable cause to believe his or her
conduct was unlawful. The maximum potential amount of future payments we could
be required to make under these indemnification obligations is unlimited;
however, we have a director and officer insurance policy that mitigates our
exposure and generally enables us to recover a portion of any future amounts
paid.
 
  6.
INCOME TAXES
 
 We
account for income taxes under the provisions of SFAS No. 109, Accounting for Income Taxes.
Under this method, deferred tax assets and liabilities are recognized based on
the differences between the financial statement carrying amounts of existing
assets and liabilities and their respective tax bases and carryforwards of net
operating losses and tax credits. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. Valuation allowances are established, when necessary, to reduce
deferred tax assets to the amounts expected to be realized.
 
 Effective
January 1, 2007, we adopted FASB Interpretation No. 48, or FIN 48. FIN 48
prescribes a recognition threshold and measurement attribute for the financial
statement recognition and measurement of uncertain tax positions taken or
expected to be taken in a company’s income tax return, and also provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosure, and transition.  As a result of the
implementation of FIN 48, we recognized no change in the liability for
unrecognized tax benefits related to tax positions taken in prior periods, and
no corresponding change in retained earnings. Additionally, FIN 48 specifies
that tax positions for which the timing of the ultimate resolution is uncertain
should be recognized as long-term liabilities. We made no reclassifications
between current taxes payable and long-term taxes payable upon adoption of FIN
48. We engaged third party consultants to conduct a research and development
study. The result of the study has reduced the potential unrecognized tax
benefit in the amount of $427,000. We do not anticipate any material changes to
the unrecognized tax benefits over the next twelve months.
 
 Upon
adoption of FIN 48, our policy to include interest and penalties related to
unrecognized tax benefits within our provision for income taxes did not change.
The tax years 2002 through 2007 remain open to examination by the major domestic
taxing jurisdictions to which we are subject, and for the international
jurisdictions the tax years open to examination vary depending on the local tax
laws.
 
 On
October 3, 2008, the Emergency Economic Stabilization Act of 2008, Energy
Improvement and Extension Act of 2008 and Tax Extenders and Alternative Minimum
Tax Relief Act of 2008 (HR1424) was signed into law, which, as enacted, includes
a provision that retroactively extends the research tax credit to
January 1, 2008 through December 31, 2009. We have not yet completed our
analysis of the 2008 benefit, if any, which we may realize from this
legislation, and as such, any benefits will be recognized in the fourth quarter
of fiscal 2008.
 
 Effective
on September 30, 2008, California has enacted legislation suspending the net
operating loss (NOL) deduction and limiting the use of business credits to 50%
of a taxpayer’s liability for tax years 2008 and 2009. We file federal,
state, and foreign income tax returns in many jurisdictions in the United States
and abroad. For U.S. federal and California income tax purposes, the statute of
limitations currently remains open for all years since our inception due to
utilization of net operating losses and research and development tax credits
generated in prior years.
  
 7.
SEGMENT INFORMATION
 
 SFAS
No. 131,Disclosures
about Segments of an Enterprise and Related Information, establishes
standards for reporting information about operating segments. Operating segments
are defined as components of an enterprise about which separate financial
information is available that is evaluated regularly by the chief operating
decision maker, or decision making group, in deciding how to allocate resources
and in assessing performance. Our chief operating decision maker is our Chief
Executive Officer. Our Chief Executive Officer reviews financial information
presented on a consolidated basis, accompanied by information about revenue by
geographic region for purposes of allocating resources and evaluating financial
performance. We have one business activity and there are no segment managers who
are held accountable for operations, operating results and plans for levels or
components below the consolidated unit level. Accordingly, we consider ourselves
to be in a single reporting segment and operating unit structure.
 
 Revenue
by geography is based on the billing address of the end-user customer. The
following table sets forth revenue and long-lived assets by geographic
area:
 
 Revenue
 
 Three
      Months Ended
                                            
                                            
                                            Nine
      Months Ended(in
      thousands)
                                            
                                            September 30,
                                              2008
                                            
                                            
                                            September 30,
                                              2007
                                            
                                            
                                            September 30,
                                              2008
                                            
                                            
                                            September 30,
                                              2007North
      America
                                            
                                            $
                                            59,328
                                            
                                            
                                            $
                                            25,143
                                            
                                            
                                            $
                                            146,000
                                            
                                            
                                            $
                                            59,202Europe,
      Africa, Middle East and Other
                                            
                                            
                                            9,290
                                            
                                            
                                            
                                            4,775
                                            
                                            
                                            
                                            29,956
                                            
                                            
                                            
                                            14,216Japan
      and Asia
                                            
                                            
                                            6,412
                                            
                                            
                                            
                                            2,107
                                            
                                            
                                            
                                            12,900
                                            
                                            
                                            
                                            5,324Total
                                            
                                            $
                                            75,030
                                            
                                            
                                            $
                                            32,025
                                            
                                            
                                            $
                                            188,856
                                            
                                            
                                            $
                                            78,742
 
 Long-Lived
      Assets(in
      thousands)
                                September 30,
                                  2008
                                
                                December 31,
                                  2007North
      America
                                
                                $
                                32,899
                                
                                
                                $
                                14,456International
                                
                                
                                277
                                
                                
                                
                                133Total
                                
                                $
                                33,176
                                
                                
                                $
                                14,589
 
 8.
LEGAL MATTERS
 
 From time
to time, we may be involved in various legal proceedings arising in the ordinary
course of business. There were no legal matters at September 30, 2008 that, in
the opinion of management, might have a material adverse effect on our financial
position, results of operations or cash flows.
 
 
 
  13
   
 
 Item 2.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
 
 The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with the condensed consolidated
financial statements and related notes included elsewhere in this Form 10-Q. The
information in this Form 10-Q contains forward-looking statements within the
meaning of Section 27A of the Securities Act and Section 21E of the
Exchange Act. Such statements are based upon current expectations that involve
risks and uncertainties. Any statements contained herein that are not statements
of historical facts may be deemed to be forward-looking statements. For example,
words such as “may,” “will,” “should,” “estimates,” “predicts,” “potential,”
“continue,” “strategy,” “believes,” “anticipates,” “plans,” “expects,” “intends”
and similar expressions are intended to identify forward-looking statements. Our
actual results and the timing of certain events may differ significantly from
the results discussed in the forward-looking statements. Factors that might
cause or contribute to such a discrepancy include, but are not limited to, those
discussed elsewhere in this Form 10-Q in the section titled “Risk Factors.”
Except as required by law, we undertake no obligation to publicly release any
revisions to the forward-looking statements after the date of this Form
10-Q.
 
 Overview
 
 We were
founded in October 2001 with a mission to develop breakthrough compression
technology for disk-based deduplication storage. We began shipping our
appliances in February 2004 to address the backup and network-based disaster
recovery needs of enterprises. We sell our appliances to enterprises worldwide
in a variety of industries, including defense, education, entertainment,
finance, government, healthcare, technology, legal, media and retail. As of
September 30, 2008, our appliances had been purchased by over 2,500 customers
worldwide.
 
 We are
headquartered in Santa Clara, California. Our personnel are located throughout
the United States and in numerous countries worldwide. We expect to continue to
add personnel in the United States and internationally to provide additional
geographic sales and technical support coverage.
 
 Our
single product line of storage appliances is sold in different configurations
depending on a customer’s requirements for storage capacity and performance.
Variations in storage capacity and performance are delivered through the use of
a variety of interchangeable component parts such as internal disk drives and
central processing units. All of our appliances use our Global Compression
technology to deduplicate data and, therefore, reduce the storage capacity
required for backup and disaster recovery. When purchasing our appliances,
customers may license one or more of our software technologies embedded in our
appliances, including software that enables customers to utilize wide area
network, or WAN vaulting to replicate backup data offsite.
 
 Substantially
all of our appliances have been sold in combination with support and services
contracts. Our support and services contracts are typically offered for periods
of one to three years.
 
 We sell
our appliances through a network of channel partners and through our direct
sales force. In the three and nine months ended September 30, 2008 and the year
ended December 31, 2007, approximately 88%, 87% and 86%, respectively, of
our revenue was generated by sales through indirect channels. As of September
30, 2008, we had over 450 channel partners, and we expect that we will continue
to sell a substantial majority of our appliances through our channel partners.
We consider the continued development of indirect sales channels in domestic and
international markets important to future revenue growth and widespread
acceptance of our products.
 
 Growth of
our product revenue will depend on our ability to attract new customers and to
make additional sales to existing customers. Our growth will also depend on our
ability to introduce and achieve market acceptance of new products with higher
capacity and deduplication throughput performance and develop new products
designed to serve other sectors of the storage market beyond protection storage
that we believe will benefit from deduplication technology. Revenue from
existing customers increased as a percentage of total revenue, a trend we expect
to generally continue.  It is important to note, however, that our
revenue, including our revenue from existing customers, may be impacted by the
timing of large orders which tend to have a longer sales cycle and are more
difficult to forecast. The recent downturn of the global economy could
negatively impact the timing of these large orders and spending by our
customers’ IT departments generally. We also expect growth in international
markets to be a significant factor contributing to our revenue growth in future
periods. International revenue accounted for approximately 21% of our total
revenue in both the three months ended September 30, 2008 and 2007, and 23% and
25% of our total revenue in the nine months ended September 30, 2008 and 2007,
respectively. Even though international revenue was lower as a percentage of
total revenue during the nine months ended September 30, 2008 compared to the
nine months ended September 30, 2007, over time, we expect international revenue
to increase in absolute dollars and as a percentage of our total revenue, though
our international revenues will also be susceptible to any further deterioration
in global economic conditions. Our growth in support and services revenue will
depend upon increasing the number of systems under support and services
contracts. Any such increases will depend on a growing customer base and renewal
of existing support and services contracts. To date, no individual customer has
accounted for greater than 10% of our total revenue in any quarter or
year.
 
 Our
ability to sustain profitability will also be affected by the extent to which we
incur additional expenses to expand our sales, marketing, product development
and general and administrative capabilities. Personnel costs constitute the
largest component of our operating expenses. Personnel costs consist of
salaries, benefits, incentive compensation, including commissions for sales
personnel, and stock-based compensation expense. As we expand internationally,
we may incur additional costs to conform our products to comply with local laws
or local product specifications and to sell, support and ship our products to
our international customers.
 
 We
believe our operations are more efficient and flexible because we outsource
manufacturing of our products, and because we subcontract with third parties to
provide onsite hardware repair and replacement services for our appliances,
except in those instances where channel partners provide these services directly
to our customers.
 
 As a
consequence of the rapidly evolving nature of our business and our limited
operating history, we believe that period-to-period comparisons of revenue and
operating results, including gross margin and operating expenses as a percentage
of total revenue, are not necessarily meaningful and should not be relied upon
as indications of future performance. Although we have experienced significant
growth in our total revenue, you should not assume that our historical growth
rates are indicative of future growth.  Additional detail of the
composition of revenue, cost of revenue and operating expenses can be found in
our Annual Report on Form 10-K for the year ended December 31, 2007 that we
filed with the SEC on February 29, 2008.
   14
  Critical
Accounting Policies and Estimates
 
 Our
condensed consolidated financial statements are prepared in accordance with U.S.
generally accepted accounting principles, or GAAP. These accounting principles
require us to make certain estimates and judgments that can affect the reported
amounts of assets and liabilities as of the date of the condensed consolidated
financial statements, as well as the reported amounts of revenue and expenses
during the periods presented. We believe that the estimates and judgments upon
which we rely are reasonable based upon information available to us at the time
that these estimates and judgments are made. To the extent there are material
differences between these estimates and actual results, our condensed
consolidated financial statements will be affected. The accounting policies that
reflect our more significant estimates and judgments and that we believe are the
most critical to aid in fully understanding and evaluating our reported
financial results include revenue recognition, stock-based compensation,
inventory valuation, warranty reserve, short-term and long-term investments and
allowance for doubtful accounts.  Other than the adoption of SFAS No.
157, Fair Value
Measurements, as discussed in further detail in Note 1 to the Notes to
our Condensed Consolidated Financial Statements, there were no significant
changes to our critical accounting policies since the filing of our Annual
Report on Form 10-K for the year ended December 31, 2007 with the SEC on
February 29, 2008.
 
 
 Results
of Operations
 
 Three
and Nine months ended September 30, 2008 Compared to the Three and Nine months
ended September 30, 2007:
 
 Revenue
 
 The
following table sets forth each of our sources of revenue for the specified
periods and as a percentage of our total revenue for those periods.
 
 Three
      Months Ended
                    
                    
                    Nine
      Months Ended(dollars
      in thousands)
                    
                    September 30,
                      2008
                    
                    
                    September 30,
                      2007
                    
                    
                    September 30,
                      2008
                    
                    
                    September 30,
                      2007Total
      revenue
                    
                    $
                    75,030
                    
                    
                    $
                    32,025
                    
                    
                    $
                    188,856
                    
                    
                    $
                    78,742Total
      revenue by type:Product
                    
                    $
                    63,872
                    
                    
                    $
                    27,992
                    
                    
                    $
                    161,062
                    
                    
                    $
                    69,470Support
      and services
                    
                    
                    11,135
                    
                    
                    
                    4,000
                    
                    
                    
                    27,718
                    
                    
                    
                    8,975Ratable
      product and related support and services
                    
                    
                    23
                    
                    
                    
                    33
                    
                    
                    
                    76
                    
                    
                    
                    297%
      of revenue by type:Product
                    
                    
                    85
                    %
                    
                    
                    87
                    %
                    
                    
                    85
                    %
                    
                    
                    88
                    %Support
      and services
                    
                    
                    15
                    %
                    
                    
                    13
                    %
                    
                    
                    15
                    %
                    
                    
                    12
                    %Ratable
      product and related support and services
                    
                    
                    —
                    %
                    
                    
                    —
                    %
                    
                    
                    —
                    %
                    
                    
                    —
                    %Total
      revenue by geography:North
      America
                    
                    $
                    59,328
                    
                    
                    $
                    25,143
                    
                    
                    $
                    146,000
                    
                    
                    $
                    59,202Europe,
      Africa, Middle East and Other
                    
                    
                    9,290
                    
                    
                    
                    4,775
                    
                    
                    
                    29,956
                    
                    
                    
                    14,216Japan
      and Asia
                    
                    
                    6,412
                    
                    
                    
                    2,107
                    
                    
                    
                    12,900
                    
                    
                    
                    5,324%
      of revenue by geography:North
      America
                    
                    
                    79
                    %
                    
                    
                    79
                    %
                    
                    
                    77
                    %
                    
                    
                    75
                    %Europe,
      Africa, Middle East and Other
                    
                    
                    12
                    %
                    
                    
                    15
                    %
                    
                    
                    16
                    %
                    
                    
                    18
                    %Japan
      and Asia
                    
                    
                    9
                    %
                    
                    
                    6
                    %
                    
                    
                    7
                    %
                    
                    
                    7
                    %
 
 
 For the
three months ended September 30, 2008, product revenue increased $35.9 million
to $63.9 million from the $28.0 million reported for the three months ended
September 30, 2007. For the nine months ended September 30, 2008, product
revenue increased $91.6 million to $161.1 million from the $69.5 million
reported for the nine months ended September 30, 2007. These increases were due
to an increase in the number of units sold to new and existing customers,
facilitated by an increase in the number of personnel in our sales organization,
an increase in the number of our channel partners and the introduction of new
products. These products, which have higher capacity and higher performance,
were sold at higher average sales prices. We expect to continue to release new
products with higher capacity, higher performance and higher average selling
prices.
 
 For the
three months ended September 30, 2008, support and services revenue increased
$7.1 million to $11.1 million from the $4.0 million reported for the three
months ended September 30, 2007. For the nine months ended September 30,
2008, support and services revenue increased $18.7 million to $27.7 million from
the $9.0 million reported for the three months ended September 30, 2007. These
increases were the result of increased product sales and, to a lesser extent, an
increase in the renewal of support and services contracts by existing customers.
Substantially all of our customers purchase support and services contracts when
they purchase our appliances. As our customer base grows, we expect the revenue
we generate from support and services will continue to grow at a faster rate
than our product revenue, as a result of both an increase in new contracts and
higher renewal of existing contracts.
 
 International
revenue was 21% of total revenue for both the three months ended September 30,
2008 and 2007, and 23% and 25% of total revenue for the nine months ended
September 30, 2008 and 2007, respectively. Although revenue outside North
America increased in the three and nine months ended September 30, 2008 in
absolute amounts, the percentage of total revenue it represented in such periods
was flat for the three months ended September 30, 2008 and 2007, and declined in
the nine months ended September 30, 2008 and 2007 due to the higher growth rate
of sales in North America as new sales personnel were added more rapidly and
became productive more quickly in North America than elsewhere. As we continue
to expand into international locations and introduce our products in new
markets, we expect international revenue to increase in absolute dollars and as
a percentage of revenue.
 
 Cost
of Revenue, Gross Profit and Gross Margin
 
 The
following table sets forth each of our costs of revenue, gross profit and gross
margin for the specified periods.
  Three
      Months Ended
                            
                            
                            Nine
      Months Ended(in
      thousands)
                            
                            September 30,
                              2008
                            
                            
                            September 30,
                              2007
                            
                            
                            September 30,
                              2008
                            
                            
                            September 30,
                              2007Total
      revenue
                            
                            $
                            75,030
                            
                            
                            $
                            32,025
                            
                            
                            $
                            188,856
                            
                            
                            $
                            78,742Cost
      of product
                            
                            
                            16,739
                            
                            
                            
                            8,176
                            
                            
                            
                            41,808
                            
                            
                            
                            20,467Cost
      of support and services
                            
                            
                            4,226
                            
                            
                            
                            1,330
                            
                            
                            
                            9,851
                            
                            
                            
                            3,033Cost
      of ratable product and related support and services
                            
                            
                            1
                            
                            
                            
                            3
                            
                            
                            
                            3
                            
                            
                            
                            100Total
      cost of revenue
                            
                            
                            20,966
                            
                            
                            
                            9,509
                            
                            
                            
                            51,662
                            
                            
                            
                            23,600Gross
      profit
                            
                            $
                            54,064
                            
                            
                            $
                            22,516
                            
                            
                            $
                            137,194
                            
                            
                            $
                            55,142Gross
      margin
                            
                            
                            72
                            %
                            
                            
                            70
                            %
                            
                            
                            73
                            %
                            
                            
                            70
                            %
 
  15
  
 
 For the
three months ended September 30, 2008, cost of product revenue increased $8.5
million to $16.7 million from the $8.2 million reported for the three months
ended September 30, 2007. This increase was due to increased aggregate product
costs associated with an increased volume of shipments of our appliances to our
customers and, to a lesser extent, increased amortization of evaluation units
and increased personnel costs. Salaries and employee related benefits accounted
for $527,000 of the increase in cost of product revenue and stock-based
compensation accounted for $124,000 of the increase. For the nine months ended
September 30, 2008, cost of product revenue increased $21.3 million to $41.8
million from the $20.5 million reported for the nine months ended September 30,
2007. As noted above, this increase was due to increased aggregate product costs
associated with an increased volume of shipments of appliances to our customers,
increased amortization of evaluation units and increased personnel costs,
partially offset by lower warranty costs due to the $450,000 and $1.6 million
charges we recorded in the three and nine months ended September 30, 2007,
respectively, for the field replacement program to replace a circuit board used
in some of our appliances that we initiated in the second quarter of 2007 and
expanded in the third quarter of 2007. Salaries and employee related benefits
accounted for $1.1 million of the increase and stock-based compensation
accounted for $419,000 of the increase.  We expect the cost of product
revenue to continue to increase for the remainder of 2008.
 
 For the
three months ended September 30, 2008, cost of support and services revenue
increased $2.9 million to $4.2 million from the $1.3 million reported for the
three months ended September 30, 2007. This increase was due to increases in
installation costs and in our support personnel headcount from 18 at September
30, 2007 to 47 at September 30, 2008, which increased our salary expense and
employee-related benefits by $782,000. Included in the overall increase is
stock-based compensation which accounted for $193,000 of the increase and
increased outside service costs of $1.3 million related to third party logistics
support of the larger installed base of our products. For the nine months ended
September 30, 2008, cost of support and services revenue increased $6.9 million
to $9.9 million from the $3.0 million reported for the nine months ended
September 30, 2007. As noted above, this increase was due to increases in
installation costs and in our support personnel headcount from 18 at September
30, 2007 to 47 at September 30, 2008, which increased our salary expense and
employee-related benefits by $2.3 million. Included in the overall increase is
stock-based compensation which accounted for $372,000 of the increase, and
increased outside service costs of $2.4 million related to logistics support of
the larger installed base of our products. We expect the cost of support and
services revenue to continue to increase for the remainder of 2008 as our
installed base continues to grow.
 
 Over
time, we expect our total cost of revenue to grow at a slightly faster rate than
total revenue, causing gross margins to slightly decline in the
future.
 
 Sales
and Marketing Expenses
 
 Three
      Months Ended
                    
                    
                    Nine
      Months Ended(in
      thousands)
                    
                    September 30,
                      2008
                    
                    
                    September 30,
                      2007
                    
                    
                    September 30,
                      2008
                    
                    
                    September 30,
                      2007Sales
      and marketing expenses
                    
                    $
                    32,150
                    
                    
                    $
                    15,831
                    
                    
                    $
                    82,867
                    
                    
                    $
                    36,933Percent
      of total revenue
                    
                    
                    43
                    %
                    
                    
                    49
                    %
                    
                    
                    44
                    %
                    
                    
                    47
                    %Headcount
      at end of period
                    
                    
                    406
                    
                    
                    
                    199
                    
                    
                    
                    406
                    
                    
                    
                    199
 
 
 For the
three months ended September 30, 2008, sales and marketing expenses increased
$16.4 million to $32.2 million from the $15.8 million reported for the three
months ended September 30, 2007. This increase was primarily due to the increase
in the number of our sales and marketing employees, including the addition of 58
employees associated with our international operations. The increase in
employees resulted in higher salary expense, employee-related benefits expense
and fees for recruitment of new employees. In addition, commission expenses
increased due to the substantial increase in our total bookings and revenue and
the higher number of employees on commission plans. The total of the increase
from the above factors was $10.9 million. Stock-based compensation accounted for
$1.2 million of the increase and the remainder was the result of increased costs
from travel, tradeshow, facility and promotional activities.
 
 For the
nine months ended September 30, 2008, sales and marketing expenses increased
$46.0 million to $82.9 million from the $36.9 million reported for the nine
months ended September 30, 2007. As noted above, this increase was
primarily due to the increase in the number of our sales and marketing
employees. The increase in employees resulted in higher salary expense,
employee-related benefits expense and fees for recruitment of new employees. In
addition, commission expenses increased due to the substantial increase in our
total bookings and revenue and the higher number of employees on commission
plans. The total of the increase from the above factors was $29.4 million.
Stock-based compensation accounted for $5.5 million of the increase and the
remainder was the result of increased costs from travel, tradeshow, facility and
promotional activities.
 
 We
anticipate that sales and marketing expenses will increase in absolute dollars
during the remainder of 2008, but remain relatively stable as a percentage of
our total revenue, due to our plans to continue to expand our sales force, both
domestically and internationally, and to make significant investments in our
direct marketing campaigns.
 
 Research
and Development Expenses
 
 Three
      Months Ended
                    
                    
                    Nine
      Months Ended(in
      thousands)
                    
                    September 30,
                      2008
                    
                    
                    September 30,
                      2007
                    
                    
                    September 30,
                      2008
                    
                    
                    September 30,
                      2007Research
      and development
                    
                    $
                    10,318
                    
                    
                    $
                    6,111
                    
                    
                    $
                    28,681
                    
                    
                    $
                    16,273Percent
      of total revenue
                    
                    
                    14
                    %
                    
                    
                    19
                    %
                    
                    
                    15
                    %
                    
                    
                    21
                    %Headcount
      at end of period
                    
                    
                    165
                    
                    
                    
                    104
                    
                    
                    
                    165
                    
                    
                    
                    104
 
 
 For the
three months ended September 30, 2008, research and development expenses
increased $4.2 million to $10.3 million from the $6.1 million reported for the
three months ended September 30, 2007. Salaries, employee-related benefits and
fees for recruitments accounted for $2.3 million of the increase as the result
of increased headcount. Also contributing to the increase were increases in
stock-based compensation of $482,000, and facility related costs for equipment
and depreciation on capitalized equipment of $1.2 million. These increases were
the direct result of hiring additional personnel to support new product
introductions and broaden our product line.
 
 For the
nine months ended September 30, 2008, research and development expenses
increased $12.4 million to $28.7 million from the $16.3 million reported for the
nine months ended September 30, 2007. Salaries, employee-related benefits and
fees for recruitments accounted for $6.5 million of the increase as the result
of increased headcount. Also contributing to the increase were increases in
stock-based compensation of $2.2 million, and facility related costs for
equipment and depreciation on capitalized equipment of $3.2 million. These
increases were the direct result of hiring additional personnel to support new
product introductions and broaden our product line.
 
 We
anticipate that research and development expenses as a percentage of our total
revenue will remain relatively stable for the remainder of 2008, but expect that
the absolute dollar amount will increase as we continue to invest in research,
new product development and enhancements to our existing appliances and hire
additional research and development personnel, particularly at our Research
Triangle Park, North Carolina facility.
  General
and Administrative Expenses
 
 Three
      Months Ended
                    
                    
                    Nine
      Months Ended(in
      thousands)
                    
                    September 30,
                      2008
                    
                    
                    September 30,
                      2007
                    
                    
                    September 30,
                      2008
                    
                    
                    September 30,
                      2007General
      and administrative
                    
                    $
                    6,028
                    
                    
                    $
                    2,816
                    
                    
                    $
                    17,354
                    
                    
                    $
                    6,904Percent
      of total revenue
                    
                    
                    8
                    %
                    
                    
                    9
                    %
                    
                    
                    9
                    %
                    
                    
                    9
                    %Headcount
      at end of period
                    
                    
                    63
                    
                    
                    
                    31
                    
                    
                    
                    63
                    
                    
                    
                    31
 
  16
  For the
three months ended September 30, 2008, general and administrative expenses
increased $3.2 million to $6.0 million from the $2.8 million reported for the
three months ended September 30, 2007. This increase was primarily the result of
increases in personnel costs associated with increased headcount, which
accounted for $1.5 million of the increase. Professional service fees accounted
for $416,000 of the increase, stock-based compensation accounted for $555,000
and the remainder of the increase was from increased consulting and facility
costs.
 
 For the
nine months ended September 30, 2008, general and administrative expenses
increased $10.5 million to $17.4 million from the $6.9 million reported for the
nine months ended September 30, 2007. This increase was primarily the result of
increases in personnel costs associated with increased headcount, which
accounted for $4.2 million of the increase. Professional service fees accounted
for $1.8 million of the increase, stock-based compensation accounted for $1.8
million and the remainder of the increase was from increased consulting and
facility costs.
 
 For both
periods, the additional personnel and professional service fees were the result
of our ongoing efforts to build our legal, finance, human resources, recruiting
and information technology functions, and additional professional service fees
were necessitated by our public company status. We expect the absolute amount of
our general and administrative expenses to increase in the future as we expand
our finance function to manage our expected growth and as we incur additional
costs associated with being a public company, but our aggregate general and
administrative expenses should remain relatively stable as a percentage of our
total revenue.
 
 Other
Income (Expense), Net
 
 Three
      Months Ended
                      
                      Nine
      Months Ended(in
      thousands)
                      September 30,
                        2008
                      
                      September 30,
                        2007
                      
                      September 30,
                        2008
                      
                      September 30,
                        2007Interest
      income
                      
                      $
                      1,318
                      
                      
                      $
                      1,614
                      
                      
                      $
                      4,998
                      
                      
                      $
                      1,950Other
      income (expense), net
                      
                      
                      (1,049
                      )
                      
                      
                      68
                      
                      
                      
                      74
                      
                      
                      
                      (41
                      )Total
      other income (expense), net
                      
                      $
                      269
                      
                      
                      $
                      1,682
                      
                      
                      $
                      5,072
                      
                      
                      $
                      1,909
 
 
 For the
three months ended September 30, 2008, total other income (expense), net
decreased $1.4 million to $269,000 from the $1.7 million reported for the three
months ended September 30, 2007. This decrease was the result of the unfavorable
revaluation of foreign exchange transactions during the period as well as a
decrease in the interest rate earned from our cash equivalents, short-term and
long-term investments from 5.2% in the three months ended September 30, 2007 to
2.2% in the three months ended September 30, 2008. This was partially offset by
increased interest earned in the three months ended September 30, 2008 resulting
from higher cash and investment balances as compared to three months ended
September 30, 2007 due primarily to our secondary public offering that occurred
in the fourth quarter of 2007.
 
 For the
nine months ended September 30, 2008, total other income (expense), net
increased $3.2 million to $5.1 million from the $1.9 million reported for the
nine months ended September 30, 2007. This increase was the result of income
earned from the investment of net proceeds from our initial public offering, or
IPO, and secondary offering and other funds as well as favorable increases in
our revaluation of Euro denominated cash balances.
 
 Foreign
currency net losses for the three months ended September 30, 2008 as compared to
the three months ended September 30, 2007 increased $981,000 due to an
unfavorable revaluation of Euro and other foreign currency denominated cash
balances and losses on foreign exchange transactions during the period. Foreign
currency net gains for the nine months ended September 30, 2008 as compared to
the nine months ended September 30, 2007 increased $115,000 due to increases in
our favorable revaluation of Euro denominated cash balances. We are evaluating
the desirability of entering into foreign currency hedging contracts, primarily
Euro-based revenue contracts, to reduce our exposure to fluctuations in currency
exchange rates.
 
 Provision
for Income Taxes
 
 Our
provision for income taxes increased $2.3 million to $2.6 million in the three
months ended September 30, 2008 compared to $320,000 for the three months ended
September 30, 2007 and increased $5.2 million to $5.7 million in the nine months
ended September 30, 2008 compared to $525,000 for the nine months ended
September 30, 2007. These increases were primarily due to the change in
California legislation on the suspension of net operating losses and limitation
on the utilization of tax credit to 50% of California taxable income for the tax
years of 2008 and 2009, as well as due to our increased international
activities resulting in increased foreign taxes, as well as increases in state
income taxes.
 
 The
effective tax rate for the three months ended September 30, 2008 was 45%
compared with (57%) for the comparable period ended September 30, 2007. This
change in the effective rate was primarily due to our conversion from a pre-tax
loss in the 2007 period to pre-tax income in the 2008 period. The effective tax
rate for the third quarter of 2008 differs from the U.S. federal statutory rate
of 35% primarily due to the unfavorable impact of stock-based compensation and
increases in foreign taxes based on our expansion into new foreign markets, and
due to unbenefitted foreign losses.  The effective tax rate for the third
quarter of 2007 differed from the U.S. federal statutory rate of 35% primarily
due to the fact that we had no regular tax expense for Federal and California
provision due to net operating loss utilization except for foreign taxes for our
overseas taxable activities in various jurisdictions.
 
 Effective
on September 30, 2008, California enacted legislation suspending the net
operating loss deduction and limiting the use of business credits to 50% of a
taxpayer’s liability for tax years 2008 and 2009. This change in the California
state tax laws will have an accumulated negative impact of $734,000 for the
third quarter of 2008.
 
 There
have been no material changes to the balance of unrecognized tax benefits
reported at December 31, 2007.  We do not anticipate any material
changes to the unrecognized tax benefits over the next twelve
months.
 
 Liquidity
and Capital Resources
 
  (in
      thousands)
                      
                      September 30,
      2008
                      
                      
                      December
      31, 2007Working
      capital
                      
                      $
                      209,913
                      
                      
                      $
                      203,688Cash
      and cash equivalents
                      
                      $
                      139,042
                      
                      
                      $
                      102,939Short-term
      investments
                      
                      $
                      74,898
                      
                      
                      $
                      104,197
 
  17
  Working
capital consists principally of cash and cash equivalents, short-term
investments, accounts receivable, inventories, prepaid expenses and other
current assets, net of accounts payable, accrued compensation and related
benefits, other accrued liabilities, income taxes payable and current deferred
revenue. Working capital at September 30, 2008 increased $6.2 million from
December 31, 2007 due primarily to positive operating cash flows from
operations of $49.4 million, partially offset by reclassifying $28.5 million of
our investments in auction-rate securities as long-term investments. Other
changes of note are:
 
 ·
              The
      increase in cash was the result of improved collections from accounts
      receivable reflected in our decrease in days’ sales outstanding from an
      average of 71 days as of December 31, 2007 to an average of 63 days
      as of September 30, 2008, computed based on the respective revenue from
      the immediately preceding quarter. We anticipate that accounts receivable
      will comprise a significant portion of working capital as we continue to
      grow revenue because a substantial portion of our sales, and therefore our
      shipping and billing, occurs near the end of each
  quarter.
 
 ·
              Short-term
      investments decreased due to the reclassification of investments in
      auction-rate securities to long-term investments due to the overall
      failure rate of these auctions, the frequency of the failures, and the
      underlying maturities of the securities, a portion of which are up to 40
      years. For additional information, please see Note 1 to the Notes to
      the Condensed Consolidated Financial
Statements.
 
 ·
              Inventory
      increased due to an increase in finished goods and the number of units
      held in the evaluation inventory pool, partially offset by a decrease in
      raw materials.
 
 ·
              Prepaid
      expenses and other current assets increased for prepaid maintenance
      contracts, insurance, tradeshows, rent and other deposits, as well as due
      to restricted cash funded as required by our lease for our corporate
      headquarters.
 
 ·
              Accounts
      payable increased due to increased purchases of inventory and property,
      plant and equipment to support increased headcount and research and
      development spending.
 
 ·
              Current
      deferred revenue increased due to higher product revenue and the related
      support that we recognize over the maintenance and support
      life.
 
 ·
              Accrued
      compensation increased due to higher accrued commissions from higher net
      bookings, an increase in accrued vacation from the increase in employees,
      partially offset by a reduction of accrued ESPP due to the purchase of
      shares from our employee stock purchase plan on July 31,
    2008.
 
 ·
              Other
      accrued liabilities decreased due to lower accruals that were offset by an
      increase in accounts payable, partially offset by higher accrued travel
      and professional services costs
 
 
 We
commenced our IPO of common stock on June 27, 2007, and the offering was
completed on July 2, 2007. We sold and issued 8,108,500 shares of our
common stock in our IPO, including 1,108,500 shares sold by us pursuant to the
underwriters’ full exercise of their option to purchase additional shares, at an
issue price of $15.00 per share. We raised approximately $109.2 million in
net proceeds after deducting underwriting discounts and commissions of $8.5
million and other offering costs of $3.9 million, and such proceeds were
received on July 2, 2007. Upon the closing of the IPO, all shares of our
mandatorily redeemable convertible preferred stock outstanding automatically
converted into 34,780,625 shares of common stock.
 
 We
completed a follow-on offering of common stock on December 3, 2007. We sold
and issued 3,051,114 shares of our common stock, including 251,114 shares sold
by us pursuant to the underwriters’ partial exercise of their option to purchase
additional shares, at an issue price of $27.00 per share. We raised
approximately $77.8 million in net proceeds after deducting underwriting
discounts and commissions of $3.4 million and other offering costs of $1.2
million, which were received on November 21, 2007 and December 3,
2007.
 
 We have
funded operations since our IPO from internal cash generated from
operations.  Through the date of this filing, we have not used funds
raised from our IPO and secondary offering in operations.  Due to
these factors, and based on our expectations of future performance, we believe
we have sufficient ability to fund our operations for at least the next twelve
months.
 
 Cash
and Cash Equivalents
 
 Cash and
cash equivalents consist of highly liquid investments in time deposits held at
major banks, commercial paper, money market mutual funds and other money market
securities with original maturities of 90 days or less.
 
 Since
2005, we have expanded our operations internationally. Our sales contracts are
mainly denominated in United States dollars for sales in Asia and Japan,
denominated in Euros and British sterling for sales in Europe, denominated in
Australian dollars for sales in Australia and denominated in Canadian dollars
for certain sales in Canada. We are evaluating the desirability of entering into
foreign currency hedging contracts, primarily Euro-based revenue contracts, to
reduce our exposure to fluctuations in currency exchange rates. We currently do
not hedge the operating expenses that are primarily denominated in foreign
currency in countries where we have sales or operating personnel because we
believe those situations create natural hedges. We may begin to sell our
products in local currency in other locations. As we fund our international
operations, our cash and cash equivalents are affected by changes in exchange
rates for those expenses. The foreign currency effect on our cash and cash
equivalents and working capital was a loss of ($1.0 million) compared to a gain
of $68,000 in the three months ended September 30, 2008 and 2007, respectively,
and a gain of $74,000 compared to a loss of ($41,000) in the nine months ended
September 30, 2008 and 2007, respectively.
 
 Short-term
and Long-term Investments
 
 Short-term
investments consist of commercial paper, corporate bonds, and investments in
U.S. government agencies with original maturities of 90 to 365
days.
 
 Effective
January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements, or
SFAS 157, with respect to our financial assets and liabilities
only.  SFAS 157 defines fair value, establishes a framework for
measuring fair value under U.S. generally accepted accounting principles and
enhances disclosures about fair value measurements. Fair value is defined under
SFAS 157 as the exchange price that would be received for an asset or paid to
transfer a liability (an exit price) in the principal or most advantageous
market for the asset or liability in an orderly transaction between market
participants on the measurement date. Valuation techniques used to measure fair
value under SFAS 157 must maximize the use of observable inputs and minimize the
use of unobservable inputs. The standard describes a fair value hierarchy based
on three levels of inputs, of which the first two are considered observable and
the last unobservable, that may be used to measure fair value which are the
following:
  18
  
 ·
              Level
      1 - Quoted prices in active markets for identical assets or
      liabilities.
 
 ·
              Level
      2 - Inputs other than Level 1 that are observable, either directly or
      indirectly, such as quoted prices for similar assets or liabilities;
      quoted prices in markets that are not active; or other inputs that are
      observable or can be corroborated by observable market data for
      substantially the full term of the assets or
  liabilities.
 
 ·
              Level
      3 - Unobservable inputs that are supported by little or no market activity
      and that are significant to the fair value of the assets or
      liabilities.
 
 Level 3
assets consist of municipal bonds with an auction reset feature (“auction-rate
securities”) whose underlying assets are generally student loans which are
substantially backed by the federal government. In February 2008, auctions began
to fail for these securities and each auction since then has failed. An auction
failure means that the parties wishing to sell securities could not. As a
result, our ability to liquidate these investments and fully recover the
carrying value of our investment in the near term may be limited or not exist.
All of our auction-rate securities, including those subject to the failure, are
currently AAA-rated taxable municipal debt obligations, the highest rating by a
rating agency. Based on the overall failure rate of these auctions, the
frequency of the failures, and the underlying maturities of the securities, a
portion of which are up to 40 years, we have classified auction-rate securities
as long-term assets on our balance sheet. At September 30, 2008, we had $28.5
million of such securities classified as a long-term asset on the balance
sheet.  At December 31, 2007, our investment in auction-rate
securities was $29.6 million and was classified as short-term investments
because there existed an active market for auction-rate securities at that time.
We have recorded a $2.5 million unrealized loss to other comprehensive income
(loss) on our investments in auction-rate securities. At September 30, 2008, we
had $31.0 million of auction rate securities carried at a book value of $28.5
million classified as long-term investments. We are currently reviewing a
broad-based settlement proposal from UBS AG, which we received in October 2008,
in which we would have the right to sell the securities back to affiliates of
UBS at the par value of the securities during the period from June 30, 2010 to
July 2, 2012 if liquidity does not return to the auction-rate securities market
sooner. The affiliates of UBS will retain the right to sell our auction-rate
securities on our behalf, without prior notification, at any time prior to July
2, 2012 as long as we receive par value from such sale.  We have until
November 14, 2008 to accept this offer from UBS AG, and as of the date of this
filing, we had not yet made a determination on whether to accept the
offer.  We will continue to monitor these investments going forward
and a determination will be made regarding their asset classification. Given the
settlement proposal for the principal value, we do not believe that there has
been an other-than-temporary impairment for these investments.
 
 
 Cash
Flows
 Nine
      Months Ended September 30,(in
      thousands)
                            
                            2008
                            
                            
                            2007Net
      cash provided by operating activities
                            
                            $
                            49,435
                            
                            
                            $
                            13,853Net
      cash used in investing activities
                            
                            $
                            (25,010
                            )
                            
                            $
                            (48,645
                            )Net
      cash provided by financing activities
                            
                            $
                            11,757
                            
                            
                            $
                            109,815
 
 
 Cash
Flows from Operating Activities
 
 Our cash
flows from operating activities will continue to be affected principally by our
sales and associated collection of accounts receivable, and by the extent to
which we spend on increasing personnel, primarily in sales and marketing and
research and development, in order to grow our business. The timing of hiring
sales personnel in particular affects cash flows as there is a lag between the
hiring of sales personnel and the generation of revenue and cash flows from such
recently hired sales personnel. Our largest source of cash flows from operating
activities is cash collections from our customers. Our primary uses of cash from
operating activities are for personnel-related expenditures, rent payments,
inventory purchases to support our revenue growth and research and development
costs.
 
 Cash
provided by operating activities increased in the nine months ended September
30, 2008 as compared to the nine months ended September 30, 2007 due to
increased sales activity and an increase in deferred revenue resulting from
payments on support and services contracts. Based on our expectations of future
revenue levels, we believe we will be able to continue to generate positive cash
flows from operating activities in the near term even as we continue to add
personnel, increase inventory purchases, increase research and development
activities and invest in functions associated with being a public
company.
 
 Cash
Flows from Investing Activities
 
 Cash
flows from investing activities primarily relate to capital expenditures to
support employee headcount growth, and net proceeds from the purchase and sale
of investment securities. Cash used in investing activities was $25.0 million in
the nine months ended September 30, 2008 as compared to cash used of $48.6
million for the nine months ended September 30, 2007. Cash used in investing
activities in the nine months ended September 30, 2008 included purchases, net
of maturities of investments of $2.2 million as well as $22.9 million for
purchases of property, plant and equipment, driven by our increase in headcount
of 266 in the period and investments in computer equipment, lab equipment for
research and development, leasehold improvements for our corporate headquarters
and new system infrastructure. The $48.6 million of cash used in investing
activities in the nine months ended September 30, 2007 included an investment of
some of our IPO net proceeds in short-term investments of $42.4 million, along
with $6.2 million for purchases of property, plant and equipment, reflecting our
increase in headcount of 184 in the period, and investments in computer
equipment, lab equipment for research and development and new system
infrastructure.
 
  Cash
Flows from Financing Activities
 
 Cash flow
provided by financing activities in the nine months ended September 30, 2008 of
$11.8 million resulted from the proceeds of the cash exercise of stock options
to purchase 2,590,000 shares of our common stock by our employees as well as the
purchase of 486,000 shares of our common stock by our employees through our
employee stock purchase plan, partially offset by our repurchase of 5,000
restricted shares of our common stock from former employees. Cash flow provided
by financing activities in the nine months ended September 30, 2007 of $109.8
million resulted from the net proceeds from our IPO and proceeds of $639,000
from the cash exercise of stock options to purchase 460,000 shares of our common
stock by our employees, net of 88,000 restricted shares of our common stock
repurchased by us from former employees, and the cash we received in connection
with the purchase of common stock awarded to one of our non-employee
directors.
 
 Contractual
Obligations
 
 The
following is a summary of our contractual obligations as of September 30,
2008:
 
 (in
      thousands)
                              
                              Total
                              
                              
                              Less
      than One
                                Year
                              
                              
                              1-3
      Years
                              
                              
                              3-5
      Years
                              
                              
                              More
      Than 5
                                YearsOperating
      leases (1)
                              
                              $
                              47,118
                              
                              
                              $
                              5,011
                              
                              
                              $
                              9,088
                              
                              
                              $
                              9,642
                              
                              
                              $
                              23,377Purchase
      obligations (2)
                              
                              
                              12,697
                              
                              
                              
                              12,697
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —Total
      contractual obligations
                              
                              $
                              59,815
                              
                              
                              $
                              17,708
                              
                              
                              $
                              9,088
                              
                              
                              $
                              9,642
                              
                              
                              $
                              23,377
 
 (1)
              In
      July 2007, we entered into an operating lease for our corporate
      headquarters.  In January 2008, we entered in to an agreement to
      lease office space adjacent to our existing corporate
      facility.(2)
              Represents
      amounts associated with agreements that are enforceable, legally binding
      and specify terms, including: fixed or minimum quantities to be
      purchased;     fixed, minimum or variable price
      provisions; and the approximate timing of payment. Obligations under
      contracts that we can cancel without a significant penalty are not
      included in the table above.
 
  19
  
 We
purchase all of our appliances from our contract manufacturer, Flextronics
International, which became our contract manufacturer through its acquisition of
Solectron Corporation. We provide Flextronics with a rolling six-month forecast
for planning purposes and place firm purchase orders for 30 days of expected
purchases which we are contractually committed to purchase. As of September 30,
2008, we had $3.2 million in aggregate, non-cancellable purchase commitments
placed with Flextronics which are included in the table above. In addition, as
of September 30, 2008, we had an additional $9.5 million of other
non-cancellable purchase commitments with other third-party vendors which are
included in the table above. Under the terms of the lease for our former
corporate headquarters, we are obligated to provide a letter of credit for
$136,000. To date, this letter of credit is not in place and has not been
required by our sub-lessor.
 
 On
July 10, 2007, we entered into a lease for office space for our corporate
headquarters. The term of the lease runs from November 1, 2007 to
October 31, 2017 and the approximate aggregate rent due over the term of
the lease is $23.0 million. Under the terms of the lease, we are obligated to
provide a letter of credit for $209,000, which we have funded.  We have
spent approximately $13.1 million for leasehold improvements, equipment and
furniture for the building through September 30, 2008. All of our Santa Clara
based employees have relocated to this facility.
 
 In
January 2008, we signed an agreement to lease approximately 100,000 square feet
of office space adjacent to our existing corporate facility. The new lease takes
effect on October 1, 2008. Future minimum lease payments will be $24.3 million,
commencing in January 2009 and continuing through June 2018. As part of signing
the lease, we are obligated to provide a letter of credit for $1.2 million,
which we have funded.  We have spent approximately $3.4 million
for leasehold improvements, equipment and furniture for the building through
September 30, 2008.
 
 The lease
for our former corporate headquarters in Santa Clara expires in February
2009.  We entered in to an agreement to sub-lease this space through
November 30, 2008 with an option for the sub-lessee to extend the sub-lease to
the end of the lease term, which was exercised during the third quarter of
2008.
 
 Our
agreements with our channel partners and, less frequently, our customers,
generally include certain provisions for indemnifying the channel partners and
customers against liabilities if our products infringe a third party’s
intellectual property rights. To date, we have not incurred any material costs
as a result of such indemnification provisions and have not accrued any
liabilities related to such obligations in our consolidated financial
statements.
 
 Also, as
discussed in Note 6 of the Notes to our Condensed Consolidated Financial
Statements, effective January 1, 2007, we adopted the provisions of SFAS
Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an
Interpretation of SFAS Statement No. 109.” At September 30, 2008, we had a
liability for interest related to unrecognized tax benefits totaling $1.6
million, of which none is expected to be paid within one year. Due to
uncertainties related to these tax matters, we are unable to make a reasonably
reliable estimate when cash settlements with the taxing authority will
occur.
 
 Off-Balance
Sheet Arrangements
 
 At
September 30, 2008 and December 31, 2007, we did not have any relationships
with unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes.
  Recent
Accounting Pronouncements
 
 See Note
1 of the Notes to our Condensed Consolidated Financial Statements for recent
accounting pronouncements that could have an effect on us.
  Item 3.
              Quantitative
      and Qualitative Disclosures About Market
Risk
 
 Foreign
Currency Risk
 
 Our
European revenue is denominated in Euros and British sterling. As a result, our
European revenue is subject to foreign currency risk due to fluctuations in the
value of the Euro and British sterling compared to the U.S. dollar. We had
Euro-denominated revenue of approximately $7.5 million and $4.8 million for the
three months ended September 30, 2008 and 2007, respectively, and $25.4 million
and $14.2 million for the nine months ended September 30, 2008 and 2007,
respectively.  We had British sterling denominated revenue of $1.5
million and zero dollars for the three months ended September 30, 2008 and 2007,
respectively, and $4.3 million and zero dollars for the nine months ended
September 30, 2008 and 2007, respectively.
 
 We also
have revenue denominated in the Canadian dollar and the Australian dollar,
which subjects us to foreign currency risk due to fluctuations in the value of
the Canadian dollar and Australian dollar compared to the U.S.
dollar.  We had $737,000 and $405,000 dollars in Canadian dollar
denominated revenue for the three months ended September 30, 2008 and 2007,
respectively, and $1.5 million and $622,000 for the nine months ended September
30, 2008 and 2007, respectively.  We had Australian dollar denominated
revenue of $41,000 and zero dollars in both the three and nine months ended
September 30, 2008 and 2007, respectively.
 
 Our
international sales and marketing operations incur expenses that are denominated
in foreign currencies. As a result, our operating expenses and cash flows are
subject to fluctuations in the value of the U.S. dollar compared to the British
sterling, Euro, Canadian dollar and, to a lesser extent, the Australian and
Singapore dollar, and Danish, Chinese, Korea and Swedish currencies. We had
foreign currency denominated expenses of approximately $7.7 million and $4.3
million for the three months ended September 30, 2008 and 2007, respectively,
and $21.9 million and $9.1 million for the nine months ended September 30, 2008
and 2007, respectively.
 
 As of
September 30, 2008, we had approximately $6.0 million and $1.7 million in
accounts receivable denominated in Euros and British sterling,
respectively.  As of September 30, 2008, we had approximately $8.7
million in cash denominated in foreign currencies, primarily in Euros. Changes
in currency exchange rates could adversely affect our revenue and profitability,
and require us to reduce our prices to remain competitive in foreign markets,
which could also have a material adverse effect on our results of operations. We
are presently evaluating the desirability of entering into foreign currency
hedging contracts, primarily Euro-based revenue contracts, to reduce our
exposure to fluctuations in currency exchange rates.  Other income
(expense), net for the nine months ended September 30, 2008 included $74,000 of
net gain.  We have transferred some Euro-denominated cash to U.S.
dollars to address the risk of foreign currency fluctuation.
  20
  
 Interest
Rate Sensitivity
 
 We had
cash and cash equivalents totaling $139.0 million and $86.6 million as of
September 30, 2008 and 2007, respectively. These amounts were invested primarily
in money market funds and also in commercial paper. We have invested the funds
from our IPO and follow-on offering according to our investment policy. The
unrestricted cash and cash equivalents are held for working capital purposes. We
do not enter into investments for trading or speculative purposes. We believe
that we do not have any material exposure to changes in fair value as a result
of changes in interest rates. Declines in interest rates, however, will reduce
future investment income. If overall interest rates fell by 10% in the three
months ended September 30, 2008 and 2007, our interest income would have
declined approximately $132,000 and $161,000, respectively, and $500,000 and
$195,000 in the nine months ended September 30, 2008 and 2007, respectively,
assuming consistent investment levels.
 
 We had
short-term investments of $74.9 million as of September 30, 2008. The
primary objective of our investment activities is to preserve principal while at
the same time maximizing the income we receive from our investments without
significantly increasing risk. To achieve this objective, these amounts were
invested primarily in auction-rate securities, corporate bonds, government
agency securities and commercial paper. These investments are classified as
available for sale and held for working capital purposes. On September 30,
2008, we had $28.5 million of auction-rate securities. On February 14,
2008, the majority of these auction-rate securities failed to auction, causing
access to these funds to be restricted, and each auction since then has failed.
An auction failure means that the parties wishing to sell securities could not.
At September 30, 2008, we had $31.0 million of auction-rate securities carried
at a book value of $28.5 million classified as long-term investments. We
currently are reviewing a broad-based settlement proposal from UBS AG, which we
received in October 2008, in which we would have the right to sell the
securities back to affiliates of UBS at the par value during the period from
June 30, 2010 to July 2, 2012 if liquidity does not return to the auction rate
securities market sooner. The affiliates of UBS will retain the right to sell
our auction rate securities on our behalf, without prior notification, at any
time prior to July 2, 2012 as long as we receive par value from such
sale.  We have until November 14, 2008 to accept this offer from UBS
AG, and as of the date of this filing, we had not yet made a determination of
whether to accept this offer. We will continue to monitor these investments
going forward and a determination will be made regarding their asset
classification. All of our auction-rate securities are currently AAA-rated
taxable municipal debt obligations, the highest rating by a rating agency. Based
on our expected operating cash flows, and our other sources of cash, we do not
anticipate the potential lack of liquidity on these investments will affect our
ability to execute our current business plan.
 
 Item 4.
              Controls
      and Procedures
 
 Evaluation
of Disclosure Controls and Procedures
 
 An
evaluation was carried out under the supervision and with the participation of
our management, including our principal executive officer and principal
financial officer, of the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934) as of the end of the period covered
by this report. Based upon that evaluation, our principal executive officer
and principal financial officer concluded that those disclosure controls and
procedures were effective to ensure that information required to be disclosed by
us in the reports that we file or submit under the Exchange Act is
(i) recorded, processed, summarized and reported, within the time periods
specified in the Commission’s rules and forms and (ii) accumulated and
communicated to our management, including our principal executive officer and
principal financial officer, as appropriate to allow timely decisions regarding
required disclosure.
 
 Changes
in Internal Control over Financial Reporting
 
 There
were no changes in our internal control over financial reporting during our most
recent fiscal quarter that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.
 
 Inherent
Limitations of Internal Controls
 
 Our
management, including our Chief Executive Officer and Chief Financial Officer,
does not expect that our disclosure controls and procedures or our internal
control over financial reporting will prevent all errors and all fraud. A
control system, no matter how well conceived and operated, can provide only
reasonable, not absolute, assurance that the objectives of the control system
are met. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within the company have been detected. These
inherent limitations include the realities that judgments in decision-making can
be faulty, and that breakdowns can occur because of simple error or mistake.
Additionally, controls can be circumvented by the individual acts of some
persons, by collusion of two or more people, or by management override of the
control. The design of any system of controls also is based in part upon certain
assumptions about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential
future conditions. Over time, controls may become inadequate because of changes
in conditions, or the degree of compliance with the policies or procedures may
deteriorate. Because of the inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and not be detected.
 
 PART
II. OTHER INFORMATION
  Item 1.
              Legal
      Proceedings
 
 We are
subject to various claims, complaints and legal actions in the normal course of
business from time to time. We do not believe we are party to any currently
pending legal proceedings the outcome of which will have a material adverse
effect on our operations or financial position. There can be no assurance that
existing or future legal proceedings arising in the ordinary course of business
or otherwise will not have a material adverse effect on our business,
consolidated financial position, results of operations or cash
flow.
   21
  
 
 
 
 Item 1A.
              Risk
      Factors
 
 Set
forth below and elsewhere in this quarterly report on Form 10-Q, and in other
documents we file with the SEC, are risks and uncertainties that could cause
actual results to differ materially from the results contemplated by the
forward-looking statements contained in this quarterly report on Form 10-Q.
Because of the following factors, as well as other variables affecting our
operating results, past financial performance should not be considered as a
reliable indicator of future performance and investors should not use historical
trends to anticipate results or trends in future periods.
 
 Risks
Related to Our Business and Industry
 
 We
derive all of our revenue from sales of a single line of systems and related
customer support and services, and if demand for these systems does not continue
to grow, our business, results of operations and financial condition would be
harmed.
 
 We derive
all of our revenue from sales of a single line of deduplication storage systems
and associated customer support and services. As a result, we are vulnerable to
fluctuations in demand for these systems, whether as a result of competing
technologies and products, weakening economic conditions, decreases or delays in
corporate spending for information technologies, product obsolescence, lack of
customer acceptance, technological change, customer budgetary constraints or
other factors. If demand for our systems does not continue to grow, our
business, results of operations and financial condition would be
harmed.
 
 Our
business could be harmed as a result of deteriorating general economic and
market conditions that lead to reduced spending on information technology
products.
 
 Our
business depends on the overall demand for information technology, in particular
for deduplication storage appliances for backup storage and network-based
disaster recovery. Information technology spending has historically declined as
general economic and market conditions have worsened, and if the domestic and
global economy continues to undergo a significant downturn and remains depressed
for an extended period of time, or if our customers believe such a downturn will
continue for the foreseeable future or become more severe, our customers would
likely reduce, and could reduce significantly, their information technology
budgets. We may be particularly susceptible to reductions in information
technology spending because the purchase of our appliances is often
discretionary and may involve a significant commitment of capital and other
resources. Many of our target customers have not purchased products similar to
ours and might not have a specific budget for the purchase of our appliances.
Delays in or a reduction in information technology spending, domestically or
internationally, would harm our business, results of operations and financial
condition in a number of ways, including by leading to longer sales cycles,
lower prices for our appliances and reduced unit sales.
 
 We
face significant competition and expect this competition to intensify, which
could prevent us from increasing our revenue, reduce our gross margins and
result in the loss of market share.
 
 The
market for our products is highly competitive and we expect competition to
intensify in the future. Other companies have introduced and may in the future
introduce new products in the same markets we serve or intend to enter. New
competitive offerings have been recently announced or introduced in our
marketplace by our competitors EMC Corporation, Hewlett-Packard Company and
International Business Machines Corporation, and we anticipate additional
offerings by our competitors may be announced or introduced in 2008 and 2009.
Competition in the past has resulted in pricing pressure on our products and
services, and we anticipate that pricing pressure will increase in the future.
Competition has in some instances resulted in a negative impact on the length of
our sales cycle, and we may experience longer sales cycles in future periods due
to increased competition. In particular, if a large number of orders, or a large
dollar value order, is delayed or cancelled, our financial results may be
harmed. Competition may result in reduced gross margins for our appliances,
increased sales and marketing expenses and a failure to increase, or the loss
of, market share.
 
 Competitive
products may have better performance, lower prices and broader acceptance than
our appliances. Many of our current or potential competitors have longer
operating histories, greater name recognition, larger customer bases and
significantly greater financial, technical, sales, marketing and other resources
than we have. Potential customers may prefer to purchase from their existing
vendors rather than a new vendor regardless of product performance or features.
In addition, our competitors may be able to bundle products and services that we
do not offer together with products that compete with ours at a combined price
that is more attractive than the price we charge for our appliances. Currently,
we face competition from traditional providers of tape-based storage systems
such as Sun Microsystems, Inc. and Quantum Corporation as well as a number of
established storage companies that offer a variety of different disk-based
storage products, including EMC Corporation and Network Appliance, Inc. and, to
a lesser extent, Hitachi Data Systems Corporation, Hewlett-Packard Company and
International Business Machines Corporation. Some of our competitors sell, or
have announced plans to sell, deduplication storage products that compete
directly with our appliances, and additional competitors may introduce
deduplication storage products in the future. Pursuant to a cross-license
agreement with Quantum, we have licensed our current, and certain future,
patents relating to data storage or data transmission, which could assist
Quantum in competing with us. We also compete with a number of emerging hardware
and software companies that may become more significant competitors in the
future. In addition, at the low-end of our product line, we may compete with WAN
acceleration and backup software providers that incorporate deduplication
capabilities in their products.
 
 We expect
increased competition from other established and emerging companies if our
market continues to develop and expand. Some of our channel partners currently
market products and services that compete with our appliances. If these channel
partners cease to distribute our appliances for competitive reasons, our sales
may decrease or not grow as quickly. In addition, some of our competitors have
made acquisitions or entered into partnerships or other strategic relationships
with one another to offer a more comprehensive solution than they individually
are able to offer. We believe additional consolidation or partnerships are
likely to occur in the future as companies attempt to strengthen or maintain
their market positions in an evolving industry. The companies resulting from
these consolidations or partnerships could significantly change the competitive
landscape and adversely affect our ability to compete effectively. Some of our
competitors have also entered into relationships with original equipment
manufacturers, or OEMs, that could provide those competitors with sales,
marketing, distribution and other advantages.
 
 With
the recent volatility in the capital markets, there is a risk that we could
suffer a loss of principal in our cash and cash equivalents and short-term
investments and suffer a reduction in our interest or return on
investments.
 
 We invest
our cash and cash equivalents and short-term investments pursuant to our
investment policy in cash, auction-rate securities, money market funds,
commercial paper, corporate bonds and government agency certificates, and we
actively manage our portfolio with an objective of capital preservation. Certain
of these investments are subject to general credit, liquidity, market and
interest rate risks, which may be exacerbated by the continuing deterioration of
global economic conditions. To date, we have determined that any declines in the
market value of our investments have been temporary. There could be future
declines in the value of these investments, which we may determine to be
other-than-temporary. These market risks associated with our investment
portfolio may have a negative adverse effect on our results of operations,
liquidity and financial condition.
  22
  
 At
December 31, 2007 and September 30, 2008, we had $29.6 million and $31.0
million of principal in auction-rate securities, respectively. In January 2008,
these securities, which consist of AAA-rated, taxable municipal debt
obligations, had auctioned successfully. On February 14, 2008, the majority
of these auction-rate securities failed to auction, causing access to these
funds to be restricted, and each auction since then has failed. An auction
failure means that the parties wishing to sell securities could not. As of
September 30, 2008, we have recorded a temporary impairment provision of ($2.5)
million which has been included in other comprehensive income
(loss).  At September 30, 2008, we had $31.0 million of auction-rate
securities carried at a book value of $28.5 million and classified as long-term
investments. We are currently reviewing a broad-based settlement proposal from
UBS AG, which we received in October 2008, in which we would have the right to
sell the securities back to affiliates of UBS at par value during the period
from June 30, 2010 to July 2, 2012 if liquidity does not return to the auction
rate securities market sooner. The affiliates of UBS will retain the right to
sell our auction rate securities on our behalf, without prior notification, at
any time prior to July 2, 2012 as long as we receive par value from such
sale.  We have until November 14, 2008 to accept this offer from UBS
AG, and as of the date of this filing, we had not yet made a determination
whether to accept this offer. We will continue to monitor these investments
going forward and a determination will be made regarding their asset
classification.  We  have determined any declines in the market value
of our investments as temporary and have recorded the temporary impairment in
other comprehensive income (loss).
 
 We
experience quarterly fluctuations in our operating results due to a number of
factors, which makes our future results difficult to predict and could cause our
operating results to fall below expectations or our guidance.
 
 Our
quarterly operating results may fluctuate due to a variety of factors, many of
which are outside of our control. As a result, comparing our operating results
on a period-to-period basis may not be meaningful. You should not rely on our
past results as an indication of our future performance. If our revenue or
operating results fall below the expectations of investors or securities
analysts, or below any guidance we may provide to the market, the price of our
common stock could decline substantially.
 
 In
addition to other risk factors listed in this “Risk Factors” section, factors
that may affect our quarterly operating results include:
 
 ·
              fluctuations
      in demand for our appliances;
 
 ·
              fluctuations
      in sales cycles and prices for our appliances, particularly for large
      orders which tend to have a longer sales
cycle;
 
 ·
              reductions
      in customers’ budgets for information technology purchases and delays in
      their purchasing cycles;
 
 ·
              the
      timing of recognizing revenue in any given quarter as a result of revenue
      recognition rules;
 
 ·
              our
      ability to develop, introduce and ship in a timely manner new products and
      product enhancements that meet customer
  requirements;
 
 ·
              the
      timing of product releases or upgrades by us or by our
      competitors;
 
 ·
              our
      ability to hire additional sales personnel and the length of time required
      for any such additional personnel to generate significant
      revenue;
 
 ·
              any
      lack of availability of, delay in the availability of, or quality problems
      with, any components we acquire from third-party suppliers, particularly
      any components we acquire from a third-party that is our sole source of
      supply for the components;
 
 ·
              any
      significant changes in the competitive dynamics of our market, including
      new entrants or substantial discounting of
  products;
 
 ·
              our
      ability to control costs, including our operating expenses and the costs
      of the components we purchase;
 
 ·
              our
      experience with product reliability and associated warranty claims;
      and
 
 ·
              general
      economic conditions in our domestic and international
    markets.
 
 
 In
addition, we may experience seasonality in the sales of our appliances. We
believe our rapid growth and limited operating history may have masked the
nature or magnitude of seasonal or cyclical factors that might have influenced
our business to date. Seasonal variations in our sales may lead to significant
fluctuations in our quarterly operating results.
 
 Our
international sales and operations subject us to additional risks that may harm
our operating results.
 
 In the
year ended December 31, 2007, we derived approximately 28% of our revenue
from international customers. In the three and nine months ended September 30,
2008, we derived approximately 21% and 23%, respectively, of our revenue from
international customers. We have sales personnel in numerous countries
worldwide. We expect to continue to add personnel in additional countries. Our
international operations subject us to a variety of risks,
including:
  ·
              the
      difficulty of managing and staffing international offices and the
      increased travel, infrastructure and legal compliance costs associated
      with multiple international
locations;
 
 ·
              the
      management of our relationships with channel partners outside the United
      States, whose sales and lead generation activities are very important to
      our international operations;
 
 ·
              difficulties
      in enforcing contracts and collecting accounts receivable, and longer
      payment cycles, especially in emerging
markets;
 
 ·
              tariffs
      and trade barriers and other regulatory limitations on our ability to sell
      our appliances in certain foreign
markets;
 
 ·
              increased
      exposure to foreign currency exchange rate
risk;
 
 ·
              increased
      exposure to possible violations of, or non-compliance with, the Foreign
      Corrupt Practices Act;
 
 ·
              increased
      exposure to possible violations of U.S. laws regulating the export of our
      products, and to other U.S. and foreign laws affecting the conduct of
      business globally such as product certification, environmental and waste
      management and data privacy laws;
 
 ·
              reduced
      protection for intellectual property rights in some countries;
      and
 
 ·
              political
      and economic instability.
  23
  
 Sales to
international customers may also result in greater shipping costs and additional
expenses to conform our appliances to the requirements of local laws or local
product specifications. As we continue to expand our business internationally,
our success will depend, in large part, on our ability to anticipate and
effectively manage these and other risks associated with our international
operations. Our failure to manage any of these risks successfully could harm our
international operations, reduce or delay our international sales, and result in
fines and penalties.
 
 We
have a history of losses and we may not be able to sustain profitability in the
future.
 
 Although
we achieved a net profit of approximately $3.2 million and $7.7 million for
the three and nine months ended September 30, 2008, respectively, we have not
yet achieved profitability for any fiscal year. As of September 30, 2008, our
accumulated deficit was approximately $32.6 million and we may incur additional
losses in the future. We expect to make significant expenditures related to the
development of our business, including expenditures to hire additional personnel
relating to sales and marketing and product development. In addition, we will
continue to incur significant legal, accounting and other expenses that we did
not incur as a private company. Our operating expenses are largely based on
anticipated revenue trends, which could be negatively impacted by deteriorating
global economic conditions, and a high percentage of our expenses are, and will
continue to be, fixed in the short term. As a result, a delay in generating or
recognizing revenue could cause significant variations in our operating results
from quarter to quarter and annually and could result in substantial operating
losses. Our revenue growth trends in prior periods are not likely to be
sustainable, and we may not generate sufficient revenue to maintain
profitability. We may incur significant losses in the future for a number of
reasons, including those discussed in other risk factors and factors that we
cannot foresee.
 
 Our
sales are difficult to predict, even in the near term, and a substantial portion
of our quarterly sales typically occurs during the last several weeks of the
quarter.
 
 A
substantial portion of our quarterly sales typically occurs during the last
several weeks of the quarter, which we believe largely reflects customer buying
patterns of products similar to ours and other products in the technology
industry generally. In addition, a significant portion of our sales in any
quarter is not forecast at the start of the quarter and is generated by sales
activity initiated within the quarter. Similarly, we have little visibility at
the start of any quarter as to which existing customers, if any, will make
additional purchases and when any additional purchases may occur, if at all. As
a result, our quarterly operating results are difficult to predict even in the
near-term.
 
 The
market we serve is emerging and the purchase of our appliances by new customers
may involve material changes to established purchasing patterns and policies.
Our sales efforts involve educating potential customers about the uses and
benefits of our appliances, including their technical capabilities and potential
cost savings. Potential customers may undertake a significant evaluation process
that has in the past resulted in a longer sales cycle. In addition, our sales
cycle may be extended if potential customers decide to re-evaluate other aspects
of their backup storage infrastructure at the same time they are considering a
purchase of our appliances. We spend substantial time, money and other resources
in our sales process without any assurance that our efforts will produce any
sales. In addition, customer purchases are frequently subject to budget
constraints, which could be negatively impacted by deteriorating global economic
conditions, multiple approvals and unplanned administrative, processing and
other delays. If sales expected from a specific customer for a particular
quarter are not realized in that quarter, or at all, our business may
suffer.
  We
have a limited operating history and compete in a new and rapidly evolving
market, which makes our future operating results difficult to
predict.
 
 We were
incorporated in October 2001 and first shipped our appliances in February 2004.
We have a limited operating history in an industry characterized by rapid
technological change, changing customer needs, evolving industry standards and
frequent introductions of new products and services. As we encounter rapidly
changing customer requirements and increasing competitive pressures, we likely
will be required to reposition our product and service offerings and introduce
new products and services. We may not be successful in doing so in a timely and
appropriately responsive manner, or at all. Furthermore, because we compete in
an early stage market, many of our target customers have not purchased products
similar to ours and might not have a specific budget for the purchase of our
appliances. Historically, enterprises have relied on non-deduplication,
tape-based technologies for backup and recovery, and we might not succeed in
generating increased demand for our products. All of these factors make it
difficult to predict our future operating results, which may impair our ability
to manage our business and investors’ ability to assess our
prospects.
 
 If
we lose key personnel or are unable to attract and retain qualified personnel on
a cost-effective basis, our business would be harmed.
 
 Our
success is substantially dependent upon the performance of our senior management
and key technical and sales personnel. Our management and employees can
terminate their employment at any time, and the loss of the services of one or
more of our executive officers or other key employees could harm our business.
Our success also is substantially dependent upon our ability to attract
additional personnel for all areas of our organization, particularly in our
sales and research and development departments. Our dependence on attracting and
retaining qualified personnel is particularly significant as we attempt to grow
our organization. Competition for qualified personnel in our industry is
intense, and we may not be successful in attracting and retaining such personnel
on a timely basis, on competitive terms, or at all. If we are unable to attract
and retain the necessary technical, sales and other personnel on a
cost-effective basis, our business would be harmed.
 
 If
we fail to manage future growth effectively, our business would be
harmed.
 
 We have
expanded our operations significantly since inception and anticipate that
further significant expansion of our operations and headcount will be required.
For example, our headcount increased from 363 employees as of September 30, 2007
to 705 employees as of September 30, 2008, and we have recently established an
operations center in North Carolina’s Research Triangle Park. The new
facility houses additional engineering, customer support and sales personnel.
Our growth has placed, and is expected to continue to place, significant demands
on our management, infrastructure and other resources. To manage our expected
growth, we will need to hire, train, integrate and retain a large number of
highly skilled and motivated employees. We will also need to continue to improve
our financial and management controls and reporting systems and procedures. We
implemented new enterprise resource planning software for our finance and
inventory management processes in October 2007, and we may in the future upgrade
other finance, sales and inventory management systems. We could encounter delays
or difficulties in implementing any of these systems. If we do not effectively
hire, train, integrate and retain sufficient highly qualified personnel to
support and continue our growth, and if we do not effectively manage our
expected growth and the associated increase in expenses, our business, results
of operations and financial condition would be harmed.
 
 Our
financial results would suffer if demand for deduplication storage appliances
does not continue to grow.
 
 Our
products are disk-based deduplication storage appliances for backup and
network-based disaster recovery. Deduplication is a relatively new and emerging
technology. Historically, enterprises have relied on non-deduplication
tape-based technologies for backup and recovery. A reduction in demand for
deduplication storage appliances for backup storage or network-based disaster
recovery could be caused by, among other things, weakening economic conditions,
decreases in information technology spending, lack of customer acceptance or
competing technologies and products. Our future financial results would suffer
if the demand for deduplication storage appliances does not continue to
grow.
 
 If
we fail to predict accurately our manufacturing and component requirements, we
could incur additional costs or experience manufacturing delays which would harm
our business.
 
 Our
agreement with our contract manufacturer, Flextronics, does not provide for
specific quantities or inventory levels for our appliances or the components
used in our appliances. Instead, we provide purchase orders to Flextronics on a
monthly basis. If we overestimate our manufacturing needs, Flextronics may
assess charges or we may have liabilities for excess or obsolete
inventory.  Conversely, because lead times for required materials and
components vary significantly and depend on factors such as the specific
supplier, contract terms and demand for the particular component at any given
time, if we underestimate our requirements, Flextronics may have inadequate
materials and components required to produce our appliances. In that event, the
manufacturing of our appliances could be interrupted, shipments could be delayed
and revenue could be deferred or lost. Flextronics generally carries very little
inventory of components for our appliances, and we rely on suppliers to deliver
necessary components to Flextronics in a timely manner based on forecasts
provided to the suppliers.
  24
  
 Any
shortages in components used in our appliances could delay shipment of our
appliances or increase our product costs, which could harm our
business.
 
 We may
experience shortages in components that we use in our appliances, and we may not
accurately predict the availability of and demand for such components. We rely
on Flextronics to procure a majority of the components used in our appliances.
As a result, any disruption in Flextronics’s ability to timely procure necessary
components in the quantities required, or at reasonable prices, could result in
a delay in the shipment of our appliances. Due to technological, pricing or
business reasons, some of the components used in our appliances are available
only from a single or limited source of supply. Flextronics generally carries
very little inventory of components for our appliances, and we rely on suppliers
to deliver necessary components to Flextronics in a timely manner based on
forecasts provided to the suppliers. Our capacity expansion shelves and the
chassis for our DD 690 appliance are currently supplied exclusively by a single
vendor, Xyratex Technology Limited. Neither our agreement with Xyratex, nor any
agreement between Flextronics and Xyratex, provides for specific quantities or
inventory levels of expansion shelves or the DD 690 chassis. Instead,
Flextronics provides purchase orders to Xyratex on a monthly basis based on
purchase orders we place with Flextronics, and our forecasts.  If
Flextronics is unable to acquire the expansion shelves or DD 690 chassis from
Xyratex for whatever reason, the manufacturing of our expansion shelves and DD
690 appliance could be interrupted and shipments could be delayed and revenue
could be deferred or lost. Our agreement with Xyratex for expansion shelves has
a three-year term ending in March 2010, subject to early termination by either
party under certain circumstances. Our appliances depend on NVRAM cards that
currently are only available from a single vendor, Curtiss-Wright Corporation.
Neither we nor Flextronics has an agreement with Curtiss-Wright Corporation
providing for specific quantities or inventory levels of NVRAM cards, and either
we or Flextronics order NVRAM cards under a standard purchase order arrangement
with Curtiss-Wright Corporation or its distributor. We acquire the chassis used
in our appliances other than the DD 690 from a single vendor. Neither we nor
Flextronics has an agreement with this chassis supplier providing for specific
quantities or inventory levels of chassis, and either we or Flextronics order
chassis under a standard purchase order arrangement with this chassis supplier
or its distributor. Significant time and effort would be required to locate new
vendors for any of these components, if available at all, to qualify replacement
components or to develop our appliances using alternative suppliers. The
unavailability of any of these or other necessary components could delay or
prevent us from shipping our appliances. Component suppliers may be vulnerable
to pressure from large purchasers of their products, who may be competitors of
ours, to allocate available component supplies to them. In addition, increased
demand generally by third parties for the components we use in our appliances
may lead to decreased availability and higher prices for those
components.
 
 We
are dependent on a single contract manufacturer and changes to that relationship
may result in delays or disruptions that could harm our business.
 
 We rely
on a single independent contract manufacturer, Flextronics, to manufacture and
assemble our appliances. We currently have an agreement in place with
Flextronics that is subject to automatic extensions in one-year increments
absent notice of termination by us or Flextronics. However, either party can
terminate the agreement for any reason at any time with at least 90 days’
advance written notice. We may not be able to effectively manage our
relationship with Flextronics, and Flextronics may not meet our future
requirements for timely delivery. Our orders represent only a small percentage
of the overall orders received by Flextronics from its customers. As a result,
fulfilling our orders may not be considered a priority by Flextronics in the
event it is constrained in its ability to fulfill all of its customer
obligations in a timely manner. Although the services required to manufacture
and assemble our appliances may be readily available from a number of other
established contract manufacturers, it would be time consuming and costly to
qualify and implement a new contract manufacturer relationship. Although we have
a contingency plan in place with Flextronics in the event that its capacity at
the location used to manufacture and assemble our appliances is reduced or
temporarily eliminated, any event that disrupts the manufacturing and assembly
process could harm our business. If Flextronics suffers an interruption in its
business, or experiences delays, disruptions or quality control problems in its
manufacturing operations, or if we have to change or add additional contract
manufacturers, our ability to manufacture and ship appliances to our customers
would be delayed and our business would suffer.
  If
we do not successfully anticipate market needs and develop products and product
enhancements that meet those needs, or if those products do not gain market
acceptance, our business will suffer.
 
 The
market in which we currently operate is rapidly developing. We may not be able
to anticipate future market needs or be able to develop new products or product
enhancements to meet such needs, either in a timely manner or at all. We also
may not be able to develop our products in a manner that enables us to
successfully address the needs of other parts of the enterprise storage market.
For example, we have recently introduced products for classes of applications
other than backup and disaster recovery. These nearline classes of applications,
such as archival storage and fixed-content data storage, manage largely static
files and benefit from the fast storage and retrieval of disk-based systems, but
do not require the performance characteristics of primary storage. Our failure
to extend our deduplication technology into these nearline applications,
particularly if our competitors are able to do so, could harm our business. In
addition, any new products or product enhancements that we introduce may not
achieve any significant degree of market acceptance or be accepted into our
sales channel by our channel partners, which would harm our
business.
 
 If
we fail to offer high quality customer support and services, our business would
suffer.
 
 Once our
appliances are deployed within our customers’ networks, our customers depend on
our support organization to resolve any issues relating to our appliances. A
high level of customer support and services is important for the successful
marketing and sale of our appliances. If we or our channel partners do not help
our customers quickly resolve post-deployment issues and provide effective
ongoing support, our ability to sell our appliances to existing customers would
suffer and our reputation with potential customers would be harmed. Some of our
international channel partners offer primary support for the appliances they
sell to customers, and we rely on third parties to provide onsite hardware
repair and replacement services for most of our customers. If the third parties
fail to provide timely and effective services, our business could be harmed. As
we expand our sales, we will be required to hire and train additional support
personnel. In addition, as we expand our operations internationally, our support
organization will face additional challenges including those associated with
delivering support, training and documentation in languages other than English.
If we fail to maintain high quality customer support or to grow our support
organization to match any future sales growth, our business
will suffer.
 
 If
we elect to discount our support and services pricing to attract or retain
customers, we may be required to defer a portion of our revenue to future
periods.
 
 If we
elect to discount our support and services pricing or otherwise introduce
significant variability in our support and services arrangements, this
variability may require us to defer the recognition of revenue from sales of our
appliances. We recognize revenue for our appliances using the residual method as
allowed by the American Institute of Certified Public Accountants, or AICPA,
Statement of Position, or SOP, No. 98-9,Modification of SOP
No. 97-2, Software Revenue Recognition, with Respect to Certain
Transactions , or SOP 98-9. Under this method, in order to recognize
product revenue upon shipment, we must establish sufficient evidence, which is
referred to as vendor specific objective evidence, or VSOE, of the fair value of
our undelivered support and services. We have established VSOE of fair value of
our support and services based on the price charged when support and services
are sold separately. If we are required to change the pricing of support and
services through discounting, or otherwise introduce variability in the pricing
of support and services on certain transactions to attract or retain customers,
we may be unable to maintain VSOE of the fair value of support and services for
similar types of transactions. As a result, we could be required to defer all
revenue for these transactions and recognize revenue ratably over the term of
the related support and services contracts, which is typically one to three
years. If this were to occur, our revenue would decline and our operating
results would be negatively impacted.
  Our
appliances handle mission-critical data for our customers and are highly
technical in nature. If customer data is lost or corrupted, or our appliances
contain software errors or hardware defects, we could have product liability
exposure and our reputation and business could be harmed.
 
 Our
appliances are involved in storing and replicating mission-critical data for our
customers. The process of storing and replicating that data is highly technical
and complex. If any data is lost or corrupted in connection with the use of our
appliances, our reputation could be seriously harmed and market acceptance of
our appliances could suffer. In addition, our appliances have contained and may
in the future contain software errors, hardware defects or security
vulnerabilities. We rely on our suppliers to deliver high quality components for
use in our products and we have limited or no control over our suppliers’
product development and production processes. Some software errors or defects in
the hardware components of our appliances may only be discovered after an
appliance has been installed and used by customers. In April 2007, we initiated
a field replacement program to replace a circuit board used in some of our
appliances. To date, these circuit boards have experienced failures in less than
1% of the appliances that we believe are potentially affected. All of the
circuit boards that have failed were manufactured by fabricators that are no
longer supplying parts for use in our appliances. Through the replacement
program, we are offering to replace the potentially affected circuit boards with
circuit boards manufactured by a particular fabricator. We accrued estimated
warranty costs of $1.2 million in the first quarter of 2007 for this replacement
program. We accrued an additional $450,000 in the third quarter 2007 to expand
this program for additional circuit boards used in some of our appliances.
During the second quarter 2008, we recorded an additional charge of $25,000 as
we have revised our estimate of the costs of the replacement program. These
estimates were based on the number of circuit boards we expect to replace under
the program, the anticipated cost of replacement and refurbishment and other
associated costs. As of September 30, 2008, we had incurred approximately $1.5
million of costs associated with these field replacement programs and $97,000
remained in accrued liabilities to cover future costs for the units potentially
affected. Although we believe our estimates and judgments for the replacement
program are reasonable, if the problem is more extensive than we currently
believe or the actual costs of the program otherwise exceed our estimate, our
operating results will be negatively impacted. Any such errors, defects or
security vulnerabilities discovered in our appliances after commercial release
could result in loss of revenue, loss of customers, increased service and
warranty cost, harm to our reputation and diversion of attention of our
management and technical personnel, any of which could significantly harm our
business. In addition, we could face claims for product liability, tort or
breach of warranty. Defending a lawsuit, regardless of its merit, is costly and
may divert management’s attention and adversely affect the market’s perception
of us and our appliances.
 
 Changes
in existing technologies or the emergence of new products or technologies could
reduce demand for our appliances and significantly harm our
business.
 
 Changes
in existing technologies could cause demand for our appliances to decline. For
example, if changes in technology result in a significant reduction in the price
for hard disk drives, enterprises may not need to utilize deduplication storage
in order to cost-effectively backup and protect their data. One or more new
technologies also could be introduced that compete favorably with our appliances
or that cause our appliances to no longer be of significant benefit to our
customers. In addition, because our appliances work with enterprise backup
software applications to transfer and store data in the protection storage
environment, we are dependent on enterprises’ use of these applications for data
protection and disaster recovery purposes. If enterprises adopt products or
technologies that enable them to protect and recover their data without the need
for backup software, demand for our appliances would be reduced
significantly.
 
 The
inability of our appliances to interoperate with backup software applications
would cause our business to suffer.
 
 We have
designed our appliances to interoperate with the leading enterprise backup
software applications available in the market. If our appliances are not
compatible with the leading backup software applications, demand for our
appliances will decline. Some backup software providers currently offer products
that compete with ours and other providers may do so in the future. Backup
software providers may in the future make changes that would diminish the
ability of our appliances to interoperate with their applications. If this were
to occur, we may need to spend significant time and effort to ensure the
continued compatibility of our appliances, which may not be possible at all. Any
of these developments could significantly harm our business.
 
 Data
formats may change in a way that reduces the value of our compression
technologies.
 
 Our
compression technologies have been designed to work well for data formats
commonly seen in customer data centers today. The format of data stored on our
appliances may change in ways that reduce the benefit of our compression
technologies. Such format changes could result from changes in the applications
that create or transmit the data, changes in the systems that store the data, or
changes in policies concerning data encryption, compression, or encoding. For
example, some potential customers in the past have employed encryption or
compression technologies that they were unable or unwilling to disable and
therefore did not find the benefits of our Global Compression technologies
compelling. If the number of such potential customers were to increase
significantly in the future, our business could suffer.
 
 We
rely on channel partners to sell our appliances, and disruptions to, or our
failure to develop and manage our channel partners would harm our
business.
 
 Our
future success is dependent upon establishing and maintaining successful
relationships with a large number of channel partners. A substantial majority of
our revenue is generated by sales through our channel partners, and we expect
channel sales to continue to make up a significant portion of our total revenue
in the future, particularly outside the United States. In the three and nine
months ended September 30, 2008 and the year ended December 31, 2007,
approximately 88%, 87% and 86%, respectively, of our revenue was generated by
sales through our channel partners. Accordingly, our revenue depends in large
part on the effective sales and lead generation activities of these channel
partners.
 
 Recruiting
and retaining qualified channel partners and training them in our technology and
product offerings requires significant time and resources. In order to develop
and expand our distribution channel, we must continue to scale and improve our
processes and procedures that support our channel, including investment in
systems and training. Those processes and procedures may become increasingly
complex and difficult to manage as we grow our organization. We have no minimum
purchase commitments from any of our channel partners, and our contracts with
these channel partners do not prohibit them from offering products or services
that compete with ours. Our competitors may provide incentives to existing and
potential channel partners to favor their products or to prevent or reduce sales
of our appliances. Our channel partners may choose not to offer our appliances
exclusively or at all. Establishing relationships with channel partners who have
a history of selling our competitors’ products may also prove to be difficult.
In addition, some of our channel partners are also competitors. Our failure to
establish and maintain successful relationships with channel partners would
seriously harm our business and operating results.
 
 TheU.S.government has
become an important customer for us, and if it or
individual agencies within theU.S.government
reduce or shift their capital spending pattern, our financial results may be
harmed.
  The
U.S. government has become an important customer for
us.  Government agencies are subject to budgetary processes and
expenditure constraints, which constraints could increase due to current
economic conditions, that could lead to delays or decreased capital expenditures
in information technology spending on infrastructures. If the
U.S. government or individual agencies within the U.S. government
reduce or shift their capital spending pattern, our financial results may be
harmed.  Our sales to the U.S. government may involve longer sales
cycles than is typical of our non-government customers, increasing the
likelihood that an order may not occur in the quarter in which we had
anticipated the sale, if any all.  In addition, our sales to the U.S.
government require us to comply with U.S. laws applicable to enterprises and
products that are offered for sale to the U.S. government.  Any
failure by us to comply with and manage these obligations could result in a
reduction or delay in sales to the U.S government, or result in fines and
penalties.
 
 If
we fail to establish and maintain proper and effective internal control over
financial reporting, our operating results and our ability to operate our
business could be harmed.
 
 The
Sarbanes-Oxley Act of 2002 requires, among other things, that we establish and
maintain internal control over financial reporting and disclosure controls and
procedures. In particular, under the current rules of the SEC, beginning with
the year ending December 31, 2008, we must perform system and process
evaluation and testing of our internal control over financial reporting to allow
management to report on the effectiveness of our internal control over financial
reporting, as required by Section 404 of the Sarbanes-Oxley Act. Our
independent registered public accounting firm will also be required to report on
our internal control over financing reporting. Our and our auditor’s testing may
reveal deficiencies in our internal control over financial reporting that are
deemed to be material weaknesses and render our internal control over financial
reporting ineffective. We have incurred, and expect to continue to incur
substantial accounting and auditing expense and have expended, and expect to
continue to expend, significant management time in complying with the
requirements of Section 404. If we are not able to comply with the
requirements of Section 404 in a timely manner, or if we or our independent
registered public accounting firm identify deficiencies in our internal control
over financial reporting that are deemed to be material weaknesses, the market
price of our stock could decline and we could be subject to investigations or
sanctions by the SEC, The NASDAQ Stock Market, or NASDAQ, or other regulatory
authorities or subject to litigation. Our independent registered public
accounting firm identified a material weakness in our financial statement close
process as of December 31, 2006, and we implemented additional formal
policies, procedures and processes, hired additional accounting personnel and
increased management review and oversight over the financial statement close and
reporting processes in order to remediate this material weakness. To the extent
any material weaknesses in our internal control over financial reporting are
identified in the future, we could be required to expend significant management
time and financial resources to correct such material weaknesses or to respond
to any resulting regulatory investigations or proceedings.
 
 If
we are unable to protect our intellectual property rights, our competitive
position could be harmed, and we could be required to incur significant expenses
to enforce our rights.
 
 We depend
on our ability to protect our proprietary technology. We rely on trade secret,
patent, copyright and trademark laws and confidentiality agreements with
employees and third parties, all of which offer only limited protection. Despite
our efforts, the steps we have taken to protect our proprietary rights may not
be adequate to preclude misappropriation of our proprietary information or
infringement of our intellectual property rights, and our ability to police such
misappropriation or infringement is uncertain, particularly in countries outside
of the United States. Further, we do not know whether any of our pending patent
applications will result in the issuance of patents or whether the examination
process will require us to narrow our claims. Even issued patents may be
contested, circumvented or invalidated. Moreover, the rights granted under any
issued patents may not provide us with proprietary protection or competitive
advantages, and, as with any technology, competitors may be able to develop
similar or superior technologies to our own now or in the future. In addition,
we have entered into a cross-license agreement with Quantum Corporation, a
competitor of ours, that provides Quantum and its controlled affiliates a
license to our current and future patents that relate to or are useful with
respect to data transmission or data storage and that are or may be issued or
applied for (or otherwise entitled to a priority date) on or prior to
January 1, 2012. As a result of this agreement, we will not be able to
assert our existing patent rights and many or all of our future patent rights
against Quantum or its controlled affiliates for the foreseeable future, and
Quantum has certain rights to assign this license to an acquirer of Quantum. It
is also possible that we may find it necessary or advantageous to enter into
similar cross licenses in the future with other actual or potential
competitors.
 
 Protecting
against the unauthorized use of our patents, trademarks and other proprietary
rights is expensive, difficult and, in some cases, impossible. Litigation may be
necessary in the future to enforce or defend our intellectual property rights,
to protect our trade secrets or to determine the validity and scope of the
proprietary rights of others. Such litigation could be costly and divert
management resources, either of which could harm our business. Furthermore, many
of our current and potential competitors have the ability to dedicate
substantially greater resources to enforce their intellectual property rights
than we do. Accordingly, despite our efforts, we may not be able to prevent
third parties from infringing upon or misappropriating our intellectual
property.
 
 
 Claims
by others that we infringe their proprietary technology could harm our
business.
 
 Third
parties could claim that our appliances or technology infringe their proprietary
rights. We expect that infringement claims may increase as the number of
products and competitors in our market increases and overlaps occur. In
addition, to the extent that we gain greater visibility and market exposure as a
public company, we face a higher risk of being the subject of intellectual
property infringement claims. Any claims of infringement by a third party, even
those without merit, could cause us to incur substantial costs defending against
the claim, and could distract our management from our business. Furthermore, a
party making such a claim, if successful, could secure a judgment that requires
us to pay substantial damages. A judgment could also include an injunction or
other court order that could prevent us from offering our appliances. In
addition, we might be required to seek a license for the use of such
intellectual property, which may not be available on commercially reasonable
terms or at all. Alternatively, we may be required to develop non-infringing
technology, which could require significant effort and expense and may
ultimately not be successful. Any of these events could seriously harm our
business.
 
 Third
parties may also assert infringement claims relating to our appliances against
our customers and channel partners. Any of these claims may require us to
initiate or defend potentially protracted and costly litigation on their behalf,
regardless of the merits of these claims, because we generally are obligated to
indemnify our channel partners and, less frequently, our customers, from claims
of infringement of proprietary rights of third parties. If any of these claims
succeed, we may be forced to pay damages to, or on behalf of, our customers or
channel partners, which could seriously harm our business.
 
 Our
use of open source software could impose limitations on our ability to
commercialize our appliances.
 
 We
incorporate open source software into our appliances. The terms of many open
source licenses have not been interpreted by United States courts, and there is
a risk that such licenses could be construed in a manner that could impose
unanticipated conditions or restrictions on our ability to commercialize our
appliances. In that event, we could be required to seek licenses from third
parties in order to continue offering our appliances, to re-engineer our
appliances, to discontinue the sale of our appliances in the event
re-engineering cannot be accomplished on a timely basis or to litigate any
disputes relating to our use of open source software, any of which could harm
our business.
 
 Our
business is subject to increasingly complex environmental legislation that has
increased both our costs and the risk of noncompliance and may continue to do so
in the future.
 
 We face
increasing complexity in the design and manufacture of our appliances as we
adjust to new and upcoming requirements relating to the materials composition of
many of our appliances. For example, the European Union, or EU, has adopted
certain directives to facilitate the recycling of electrical and electronic
equipment sold in the EU, including the Restriction on the Use of Certain
Hazardous Substances in Electrical and Electronic Equipment, or RoHS, directive.
The RoHS directive restricts the use of lead, mercury and certain other
substances in electrical and electronic products placed on the market in the EU.
A companion EU directive, the Waste Electrical and Electronic Equipment
Directive imposes responsibility for the collection, recycling and recovery for
certain electrical and electronic products on the manufacturers of such
equipment.
 
 We have
incurred costs to comply with these regulations in the past and could incur
additional costs in the future. In addition, compliance with these regulations
could disrupt our operations and logistics. We will need to ensure that we can
design and manufacture compliant appliances and that we can be assured a supply
of compliant components from suppliers. Similar laws and regulations have been
proposed or may be enacted in other regions, including the United States,
Australia, Canada, China, Korea and Japan. These and other environmental
regulations may require us to reengineer our appliances to utilize new
components that are compatible with these regulations, which may result in
additional costs to us.
 
 We
may not generate positive returns on our research and development
investments.
 
 Developing
our products is expensive, and our investment in product development may involve
a long investment return cycle. For the year ended December 31, 2007, our
research and development expenses were $23.5 million, or approximately 19% of
revenue. For the three months ended September 30, 2008 and 2007, our research
and development expenses were $10.3 million and $6.1 million, or approximately
14% and 19% of revenue, respectively. For the nine months ended September 30,
2008 and 2007, our research and development expenses were $28.7 million and
$16.3 million, or approximately 15% and 21% of revenue,
respectively.  Our future plans include significant investments in
research and development and related product opportunities. We believe that we
must continue to dedicate a significant amount of resources to our research and
development efforts to maintain our competitive position. These investments may
not generate positive returns in the near term, or at all.
  We
may engage in future acquisitions that could disrupt our business, cause
dilution to our stockholders and harm our business, operating results and
financial condition.
 
 In the
future we may acquire other businesses, products or technologies. We have not
made any acquisitions to date and, as a result, our ability as an organization
to make acquisitions is unproven. We may not be able to find suitable
acquisition candidates and we may not be able to complete acquisitions on
favorable terms, if at all. If we do complete acquisitions, we may not
ultimately strengthen our competitive position or achieve our goals, and any
acquisitions we complete could be viewed negatively by customers, financial
markets or investors. In addition, any acquisitions that we make could lead to
difficulties in integrating personnel and operations from the acquired
businesses and in retaining and motivating key personnel from these businesses.
Acquisitions may disrupt our ongoing operations, divert management from
day-to-day responsibilities, increase our expenses and harm our business. Future
acquisitions may also reduce our cash available for operations and other uses
and could result in an increase in amortization expense related to identifiable
assets acquired, potentially dilutive issuances of equity securities or the
incurrence of debt.
 
 We
have incurred, and will continue to incur, significant costs as a result of
operating as a public company, and our management is required to devote
substantial time to compliance efforts.
 
 As a
public company, we incur significant legal, audit, accounting and other expenses
that we did not incur as a private company. The Sarbanes-Oxley Act, as well as
rules subsequently implemented by the SEC and NASDAQ, impose additional
requirements on public companies, including enhanced corporate governance
practices. For example, the NASDAQ listing requirements require that listed
companies satisfy certain corporate governance requirements relating to
independent directors, audit committees, distribution of annual and interim
reports, stockholder meetings, stockholder approvals, solicitation of proxies,
conflicts of interest, stockholder voting rights and codes of business conduct.
Our management and other personnel are required to devote a substantial amount
of time to these requirements. Moreover, these rules and regulations have
increased our legal and financial compliance costs and have made some activities
more time-consuming and costly. These rules and regulations could also make it
more difficult for us to attract and retain qualified persons to serve on our
board of directors and board committees or as executive officers.
 
 Our
business is subject to the risks of earthquakes, fire, floods and other natural
catastrophic events, and to interruption by man-made problems such as computer
viruses or terrorism.
 
 Our
corporate headquarters and the operations of the contract manufacturer for our
appliances are located in the San Francisco Bay Area, a region known for seismic
activity. A significant natural disaster, such as an earthquake, fire or a
flood, could harm our business. In addition, our servers are vulnerable to
computer viruses, break-ins and similar disruptions from unauthorized tampering
with our computer systems. In addition, acts of terrorism or war could cause
disruptions in our or our customers’ business or the economy as a whole. To the
extent that such disruptions result in delays or cancellations of customer
orders, or delay the manufacture and shipment of our appliances, our business
would be harmed.
 
 
 Risks
Related to Ownership of Our Common Stock
 
 The
trading price of our common stock has been volatile and is likely to be volatile
in the future.
 
 The
trading prices of our common stock as well as the securities of other technology
companies have been highly volatile, particularly in the last several months as
a result of deteriorating economic conditions. Further, our common stock has a
limited trading history. Factors affecting the trading price of our common stock
could include:
 
 ·
              variations
      in our operating results;
 
 ·
              announcements
      of technological innovations, new products and services, strategic
      alliances or significant agreements by us or by our
      competitors;
 
 ·
              recruitment
      or departure of key personnel;
 
 ·
              changes
      in the estimates of our operating results or changes in recommendations by
      any securities analysts that elect to follow our common
    stock;
 
 ·
              market
      conditions in our industry, the industries of our customers and the
      economy as a whole; and
 
 ·
              adoption
      or modification of regulations, policies, procedures or programs
      applicable to our business.
 
 In
addition, if the market for technology stocks or the stock market in general
continues to experience a loss of investor confidence, the trading price of our
common stock could continue to decline for reasons unrelated to our business,
operating results or financial condition. The trading price of our common stock
might also decline in reaction to events that affect other companies in our
industry even if these events do not directly affect us, or in reaction to
reports from industry analysts about us or our competitors or others in the
technology industry generally. Some companies that have had volatile market
prices for their securities have had securities class actions filed against
them. A suit filed against us, regardless of its merits or outcome, could cause
us to incur substantial costs and could divert management’s
attention.
 
 Anti-takeover
provisions in our charter documents and Delaware law could discourage, delay or
prevent a change in control of our company and may affect the trading price of
our common stock.
 
 We are a
Delaware corporation and the anti-takeover provisions of the Delaware General
Corporation Law may discourage, delay or prevent a change in control by
prohibiting us from engaging in a business combination with an interested
stockholder for a period of three years after the person becomes an interested
stockholder, even if a change in control would be beneficial to our existing
stockholders. In addition, our restated certificate of incorporation and amended
and restated bylaws may discourage, delay or prevent a change in our management
or control over us that stockholders may consider favorable. Our restated
certificate of incorporation and amended and restated bylaws:
 
 ·
              authorize
      the issuance of “blank check” preferred stock that could be issued by our
      board of directors to thwart a takeover
attempt;
 
 ·
              establish
      a classified board of directors, as a result of which the successors to
      the directors whose terms have expired will be elected to serve from the
      time of election and qualification until the third annual meeting
      following their election;
 
 ·
              require
      that directors only be removed from office for
  cause;
 
 ·
              provide
      that vacancies on the board of directors, including newly created
      directorships, may be filled only by a majority vote of directors then in
      office;
 
 ·
              limit
      who may call special meetings of
stockholders;
 
 ·
              prohibit
      stockholder action by written consent, requiring all actions to be taken
      at a meeting of the stockholders;
and
 
 ·
              require
      supermajority stockholder voting to effect certain amendments to our
      restated certificate of incorporation and amended and restated
      bylaws.
 
 Item 2.
              Unregistered
      Sales of Equity Securities and Use of
Proceeds
 
 The
effective date of the registration statement for our initial public offering was
June 26, 2007. As a result of our initial public offering, we raised a total of
$109.3 million in net proceeds after deducting underwriting discounts and
commissions of $8.5 million and offering expenses of approximately $3.8 million.
In the first nine months of 2008, we used none of the proceeds from our initial
public offering for working capital purposes. None of the payments were made,
directly or indirectly, to our directors, officers or persons owning 10% or more
of our common stock.
 
 Item 6.
              EXHIBITS
  Exhibit No.
              
              Description31.1
              
              Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
              
              Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32.1
              
              Certification
      of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.32.2
              
              Certification
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.
 
 The
certifications attached as Exhibits 32.1 and 32.2 that accompany this Quarterly
Report on Form 10-Q are not deemed filed with the Securities and Exchange
Commission and are not to be incorporated by reference into any filing of Data
Domain, Inc. under the Securities Act of 1933 or the Securities Exchange Act of
1934, whether made before or after the date of this Quarterly Report on Form
10-Q, irrespective of any general incorporation language contained in such
filing.
 
 
 
  25
  
 
 
 
 
 
 
 SIGNATURES
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
  Data
      Domain, Inc.Date:
      November 7, 2008
              
              /s/
      Michael P. ScarpelliMichael
      P. Scarpelli, Senior Vice President and Chief Financial
      Officer(Principal
      Financial and Accounting Officer)
   26