** **

**U. S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

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** **

**FORM 10-Q**

** **
| **x**                                                         | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                                    | ** ** | ** **                                                                                    |
| **For the  quarterly period ended March 31, 2007, or**        |
| ** **                                                    | ** ** | ** **                                                                                    |
| **o**                                                         | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                    | ** ** | ** **                                                                                    |
| **For the  transition period from __________ to __________.** |

** **

**Commission File Number1-11860**

** **

**Focus Enhancements, Inc.**

(Name of Issuer in its Charter)

 

| **Delaware**                     |   | **04-3144936**       |
|----------------------------------|--------|----------------------|
| (State or Other  Jurisdiction of |   | (I.R.S. Employer     |
| Incorporation or  Organization)  |   | Identification  No.) |

** **

**1370 Dell Ave**

**Campbell, CA 95008**

(Address of Principal Executive Offices)

** **

**(408) 866-8300**

(Issuer’s Telephone Number, Including Area Code)

 

Check whether the Issuer (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such other shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.  Yes: x  No:o

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

Large accelerated filer:  o  Acceleratedfiler:  o  Non-acceleratedfiler:  x

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b02 of the Exchange Act).

Yes: o  No: x

As of May 9, 2007, there were 78,293,087 shares ofcommon stock outstanding.

 

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**FOCUS ENHANCEMENTS, INC.**

**INDEX**
|                                     | ** ** | ** **                                                                                  | ** ** | **PageNumber** |
|-------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|----------------|
| ** **                          | ** ** | ** **                                                                                  | ** ** | ** **     |
| **PART I - FINANCIAL  INFORMATION** | ** ** | ** **                                                                                  |
| ** **                          | ** ** | ** **                                                                                  | ** ** | ** **     |
| **Item 1.**                         |       | Financial Statements  (unaudited):                                                          |       |           |
|                                |       | Condensed  Consolidated Balance Sheets                                                      |       | 2              |
|                                |       | Condensed  Consolidated Statements of Operations                                            |       | 3              |
|                                |       | Condensed  Consolidated Statements of Cash Flows                                            |       | 4              |
|                                |       | Notes to  Condensed Consolidated Financial Statements                                       |       | 5              |
|                                |       |                                                                                        |       |           |
| **Item 2.**                         |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       | 15             |
|                                |       |                                                                                        |       |           |
| **Item 3.**                         |       | Quantitative  and Qualitative Disclosures about Market Risk                                 |       | 20             |
|                                |       |                                                                                        |       |           |
| **Item 4T.**                        |       | Controls and  Procedures                                                                    |       | 21             |
|                                |       |                                                                                        |       |           |
| **PART II - OTHER  INFORMATION**    | ** ** | ** **                                                                                  |
| ** **                          | ** ** | ** **                                                                                  | ** ** | ** **     |
| **Item 1.**                         |       | Legal Proceedings                                                                           |       | 22             |
|                                |       |                                                                                        |       |           |
| **Item 1A.**                        |       | Risk  Factors                                                                               |       | 22             |
|                                |       |                                                                                        |       |           |
| **Item 2.**                         |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                |       | 23             |
|                                |       |                                                                                        |       |           |
| **Item 3.**                         |       | Defaults  Upon Senior Securities                                                            |       | 23             |
|                                |       |                                                                                        |       |           |
| **Item 4.**                         |       | Submission  of Matters to a Vote of Security Holders                                        |       | 23             |
|                                |       |                                                                                        |       |           |
| **Item 5.**                         |       | Other Information                                                                           |       | 23             |
|                                |       |                                                                                        |       |           |
| **Item  6.**                        |       | Exhibits                                                                                    |       | 23             |
|                                |       |                                                                                        |       |           |
| **SIGNATURES**                      |       | 24                                                                                          |
|                                |       |                                                                                        |       |           |
| **CERTIFICATIONS**                  |       |                                                                                        |

 

 

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**PART I -FINANCIAL INFORMATION**

**Item1.    Financial Statements**

**Focus Enhancements, Inc.**

**CondensedConsolidated Balance Sheets**

(In thousands, exceptshare and per share amounts)

(Unaudited)
| ** **                                                                                                                                                                              | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                              |       |                     |       |                        |       |
|                                                                                                                                                                                    |       |                     |       |                        |       |
| Current assets:                                                                                                                                                                         |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                              |       | $                        | 2,215      |                        | $          | 5,969 |   |
| Accounts  receivable, net of allowances of $256 and $304, respectively                                                                                                                  |       | 4,050                    |       | 4,188                       |       |
| Inventories                                                                                                                                                                             |       | 4,091                    |       | 4,072                       |       |
| Prepaid expenses  and other current assets                                                                                                                                              |       | 1,451                    |       | 1,207                       |       |
| Total current  assets                                                                                                                                                                   |       | 11,807                   |       | 15,436                      |       |
|                                                                                                                                                                                    |       |                     |       |                        |       |
| Property and equipment,  net                                                                                                                                                            |       | 1,173                    |       | 980                         |       |
| Other assets                                                                                                                                                                            |       | 184                      |       | 187                         |       |
| Intangible assets, net                                                                                                                                                                  |       | 57                       |       | 186                         |       |
| Goodwill                                                                                                                                                                                |       | 13,191                   |       | 13,191                      |       |
|                                                                                                                                                                                    |       | $                        | 26,412     |                        | $          | 29,980 |   |
|                                                                                                                                                                                    |       |                     |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                          |       |                     |       |                        |       |
|                                                                                                                                                                                    |       |                     |       |                        |       |
| Current liabilities:                                                                                                                                                                    |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                        |       | $                        | 2,787      |                        | $          | 3,424 |   |
| Accrued  liabilities                                                                                                                                                                    |       | 4,347                    |       | 3,702                       |       |
| Current portion  of capital lease obligations                                                                                                                                           |       | 113                      |       | 10                          |       |
| Borrowings under  line of credit                                                                                                                                                        |       | —                   |       | 3,390                       |       |
| Term loan                                                                                                                                                                               |       | —                   |       | 2,500                       |       |
| Total current  liabilities                                                                                                                                                              |       | 7,247                    |       | 13,026                      |       |
|                                                                                                                                                                                    |       |                     |       |                        |       |
| Convertible notes                                                                                                                                                                       |       | 10,946                   |       | 10,946                      |       |
| Capital lease  obligations, net of current portion                                                                                                                                      |       | 93                       |       | —                      |       |
| Total  liabilities                                                                                                                                                                      |       | 18,286                   |       | 23,972                      |       |
|                                                                                                                                                                                    |       |                     |       |                        |       |
| Commitments and  contingencies (note 9)                                                                                                                                                 |       |                     |       |                        |       |
|                                                                                                                                                                                    |       |                     |       |                        |       |
| Stockholders’ equity:                                                                                                                                                              |       |                     |       |                        |       |
| Preferred stock,  $0.01 par value; authorized 3,000,000 shares; 3,161 shares issued and  outstanding at March 31, 2007 and December 31, 2006 (aggregate liquidation  preference $3,917) |       | —                   |       | —                      |       |
| Common stock,  $0.01 par value; 150,000,000 shares authorized, 78,807,596 and 73,210,870 shares  issued and outstanding at March 31, 2007 and December 31, 2006, respectively           |       | 778                      |       | 722                         |       |
| Treasury stock  at cost, 516,667 and 497,055 shares at March 31, 2007 and  December 31, 2006, respectively                                                                    |       | (775                     | )          | (750                        | )          |
| Additional  paid-in capital                                                                                                                                                             |       | 117,659                  |       | 111,203                     |       |
| Accumulated  other comprehensive income                                                                                                                                                 |       | 151                      |       | 130                         |       |
| Accumulated  deficit                                                                                                                                                                    |       | (109,687                 | )          | (105,297                    | )          |
|                                                                                                                                                                                    |       |                     |       |                        |       |
| Total  stockholders’ equity                                                                                                                                                        |       | 8,126                    |       | 6,008                       |       |
|                                                                                                                                                                                    |       | $                        | 26,412     |                        | $          | 29,980 |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

 

2

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**Focus Enhancements, Inc.**

**CondensedConsolidated Statements of Operations**

(In thousands, except pershare amounts)

(Unaudited)
| ** **                                                                | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Net revenue                                                               |       | $                                | 7,087      |   | $ | 7,133 |   |
| Cost of revenue                                                           |       | 3,921                            |       | 4,468 |   |
| Gross margin                                                              |       | 3,166                            |       | 2,665 |   |
|                                                                      |       |                             |       |   |   |
| Operating expenses:                                                       |       |                             |       |   |   |
| Sales, marketing  and support                                             |       | 2,125                            |       | 2,074 |   |
| General and  administrative                                               |       | 1,097                            |       | 915 |   |
| Research and  development                                                 |       | 3,938                            |       | 2,981 |   |
| Amortization of  intangible assets                                        |       | 105                              |       | 127 |   |
|                                                                      |       | 7,265                            |       | 6,097 |   |
| Loss from operations                                                      |       | (4,099                           | )          | (3,432 | ) |
| Interest  expense, net                                                    |       | (290                             | )          | (199 | ) |
| Value of  derivative liability                                            |       | —                           |       | (4,000 | ) |
| Change in value  of derivative liability                                  |       | —                           |       | 400 |   |
| Other income                                                              |       | 3                                |       | 70 |   |
| Loss before  income taxes                                                 |       | (4,386                           | )          | (7,161 | ) |
| Income tax  expense                                                       |       | 4                                |       | 9 |   |
| Net loss                                                                  |       | $                                | (4,390     | ) | $ | (7,170 | ) |
|                                                                      |       |                             |       |   |   |
| Net loss per share -  basic and diluted                                   |       | $                                | (0.06      | ) | $ | (0.11 | ) |
|                                                                      |       |                             |       |   |   |
| Weighted average common and common equivalent shares - basic and  diluted |       | 74,199                           |       | 68,155 |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

3

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**Focus Enhancements, Inc.**

**CondensedConsolidated Statements of Cash Flows**

(In thousands)

(Unaudited)
| ** **                                                                          | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                          | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Cash flows from  operating activities:                                              |       |                             |       |   |   |
| Net loss                                                                            |       | $                                | (4,390     | ) | $ | (7,170 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:        |       |                             |       |   |   |
| Depreciation and  amortization                                                      |       | 311                              |       | 370 |   |
| Stock-based  compensation                                                           |       | 228                              |       | 173 |   |
| Value of  derivative liability                                                      |       | —                           |       | 4,000 |   |
| Change in value  of derivative liability                                            |       | —                           |       | (400 | ) |
| Accrued interest  on convertible notes                                              |       | 277                              |       | 173 |   |
| Amortization of  debt issuance costs                                                |       | 2                                |       | — |   |
| Changes in  assets and liabilities:                                                 |       |                             |       |   |   |
| Accounts  receivable                                                                |       | 143                              |       | (1,236 | ) |
| Inventories                                                                         |       | (3                               | )          | (840 | ) |
| Prepaid expenses  and other assets                                                  |       | (212                             | )          | (96 | ) |
| Accounts payable                                                                    |       | (638                             | )          | 1,371 |   |
| Accrued  liabilities                                                                |       | 357                              |       | (627 | ) |
| Net cash used in  operating activities                                              |       | (3,925                           | )          | (4,282 | ) |
|                                                                                |       |                             |       |   |   |
| Cash flows from  investing activities:                                              |       |                             |       |   |   |
| Purchases of  property and equipment                                                |       | (142                             | )          | (101 | ) |
| Net cash used in  investing activities                                              |       | (142                             | )          | (101 | ) |
|                                                                                |       |                             |       |   |   |
| Cash flows from  financing activities:                                              |       |                             |       |   |   |
| Net proceeds  from private offerings of common stock                                |       | 6,205                            |       | — |   |
| Proceeds from  exercise of common stock options and warrants, net of issuance costs |       | 55                               |       | 357 |   |
| Proceeds from  issuance of convertible notes                                        |       | —                           |       | 10,000 |   |
| Repayment of  lines of credit                                                       |       | (3,390                           | )          | (2,966 | ) |
| Repayments of  term loan                                                            |       | (2,500                           | )          | (2,500 | ) |
| Repurchase of  common stock                                                         |       | (25                              | )          | — |   |
| Payments under  capital lease obligations                                           |       | (37                              | )          | (36 | ) |
| Payments on  notes payable to bank                                                  |       | —                           |       | (3 | ) |
| Net cash provided by financing  activities                                          |       | 308                              |       | 4,852 |   |
|                                                                                |       |                             |       |   |   |
| Effect of exchange rate  changes on cash and cash equivalents                       |       | 5                                |       | 1 |   |
|                                                                                |       |                             |       |   |   |
| Increase (decrease) in  cash and cash equivalents                                   |       | (3,754                           | )          | 470 |   |
| Cash and cash  equivalents at beginning of period                                   |       | 5,969                            |       | 637 |   |
| Cash and cash  equivalents at end of period                                         |       | $                                | 2,215      |   | $ | 1,107 |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

 

4

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**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

**1.**                                      **Description of Business**

FocusEnhancements, Inc. and its subsidiaries (the “Company” or “Focus”) wasincorporated in 1992 and develops and markets proprietary video technology intwo areas: semiconductor and systems. Semiconductor products include severalseries of Application Specific Integrated Circuits (“ASICs”), which address thewireless video and data market using Ultra Wideband (“UWB”) technology and thevideo convergence market. The UWB ASICs are targeted for the wireless USB(Universal Serial Bus) market while the video convergence chips are deployedinto portable media players, GPS navigation devices, video conferencingsystems, media center and interactive TV applications. Focus’ systems productsare designed to provide solutions for the professional video production marketparticularly for the video acquisition, media asset management and digitalsignage markets. Focus markets its systems products primarily through theprofessional channel. Focus production products include video scan converters,video mixers, standard and high definition digital video disk recorders, MPEG(Moving Picture Experts Group) recorders and file format conversion tools.Focus media asset management systems products include network-based videoservers, long-duration program monitors and capture/playout components. Focusdigital signage and retail media solutions products include standard and highdefinition MPEG players and servers. Focus markets its products globally tooriginal equipment manufacturers (“OEMs”), and dealers and distributors in theconsumer and professional channels.

**2.****                                      Basisof Presentation — Interim Financial Information**

Theaccompanying unaudited condensed consolidated financial statements of Focushave been prepared in conformity with accounting principles generally acceptedin the United States of America and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not contain all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements. The year-endcondensed consolidated balance sheet data was derived from audited consolidatedfinancial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States of America.

In the opinion ofmanagement, the condensed consolidated financial statements include alladjustments (consisting only of normal recurring adjustments) necessary for afair presentation of Focus’ financial position, operating results and cashflows for the periods presented. The results of operations and cash flows forthe three months ended March 31, 2007 are not necessarily indicative of theresults that may be expected for any future period. Certain items previouslyreported in specific financial statement captions have been reclassified. Suchreclassifications have not impacted previously reported total assets, totalstockholders’ equity or net loss amounts.

The condensedconsolidated financial statements of Focus as of March 31, 2007 and for thethree-month periods ended March 31, 2007 and 2006 are unaudited and should beread in conjunction with the audited consolidated financial statements for theyear ended December 31, 2006, included in Focus’ Annual Report on Form 10-K forthe year ended December 31, 2006.

**3.****                                     ****Equity-Based Compensation**

Focus accounts forequity-based compensation in accordance with Statement of Financial AccountingStandards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No.123R”), whichthe Company adopted as of January 1, 2006 using the modified prospectivemethod.

5

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The share-based compensation recognized for the threemonths ended March 31, 2007 and 2006, respectively, was:

| (In thousands, except per share data) | ** ** | ** ** | ** ** | **Three Months  Ended March 31,  2007** | ** ** | **Three Months  Ended March 31,  2006** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Stock-based  compensation expense by type of award:            |       |       |       |                                                   |       |
| Employee stock options                                         |       | $          | 132        |                                                   | $          | 151                                                    |       |
| Restricted stock awards                                        |       | 69         |       | 22                                                     |       |
| Total stock-based compensation                                 |       | 201        |       | 173                                                    |       |
|                                                           |       |       |       |                                                   |       |
| Tax effect on  stock-based compensation                        |       | —     |       | —                                                 |       |
| Effect on net  loss                                            |       | $          | 201        |                                                   | $          | 173                                                    |       |
|                                                           |       |       |       |                                                   |       |
| Effect on net  loss per share - basic and diluted              |       | $          | 0.00       |                                                   | $          | 0.00                                                   |       |

 

Stock Options

The exercise priceof each stock option equals the market price of Focus’ common stock on the dateof grant. Option grants generally vest over four years and expire 10 years fromthe grant date. The fair value of each option grant is estimated on the date ofgrant using the Black-Scholes option pricing model. The weighted averageassumptions used in the model are outlined in the following table:

|                                   | ** ** | **Three Months  Ended March 31,  2007** | ** ** | **Three Months  Ended March 31,  2006** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Average expected  term of options |       | 4 years                                                |       | 4 years                                                |       |
| Risk-free rate  of interest       |       | 4.56                                                   | %          | 4.56                                                   | %          |
| Volatility of  common stock       |       | 81                                                     | %          | 81                                                     | %          |
| Dividend yield                    |       | 0                                                      | %          | 0                                                      | %          |

 

Thedividend yield of zero is based on the fact that the Company has never paidcash dividends and has no present intention to pay cash dividends. Expectedvolatility is based on the combination of historical volatility of the Company’scommon stock and the expected moderation in future volatility over the periodcommensurate with the expected life of the options and other factors. Therisk-free interest rates are taken from the Daily Federal Yield Curve Rates asof the grant dates as published by the Federal Reserve and represent the yieldson actively traded Treasury securities for terms equal to the expected term ofthe options. The expected term calculation is based on the Company’s observedhistorical option exercise behavior and post-vesting forfeitures of options byemployees.

6

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Asummary of activity related to Focus’ stock option incentive plans for thethree months ended March 31, 2007 is presented below:
| ** **                                                            | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value  (000s)** | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------|------------|
| Options  outstanding at beginning of year                             |       | 5,479,537  |       | $                                      | 1.15       |                                                |       |                                    |       |   |
| Options granted                                                       |       | 994,941    |       | $                                      | 1.31       |                                                |       |                                    |       |   |
| Options  exercised                                                    |       | (21,418    | )          | $                                      | 1.16       |                                                |       |                                    |       |   |
| Options canceled                                                      |       | (218,513   | )          | $                                      | 1.10       |                                                |       |                                    |       |   |
|                                                                  |       |       |       |                                   |       |                                                |       |                                    |       |
| Options  outstanding at March 31, 2007                                |       | 6,234,547  |       | $                                      | 1.17       |                                                | 6.0        |                                    | $          | 1,207 |   |
|                                                                  |       |       |       |                                   |       |                                                |       |                                    |       |
| Options  exercisable and expected to be exercisable at March 31, 2007 |       | 5,931,584  |       | $                                      | 1.18       |                                                | 5.9        |                                    | $          | 1,131 |   |
|                                                                  |       |       |       |                                   |       |                                                |       |                                    |       |
| Options  exercisable at March 31, 2007                                |       | 3,625,292  |       | $                                      | 1.23       |                                                | 4.9        |                                    | $          | 624 |   |

 

The weighted average grant date fair value of optionsgranted during the three months ended March 31, 2007 and 2006 was $0.81 and$0.44 per share, respectively. The intrinsic value of options exercised duringthe three months ended March 31, 2007 was $7,000 and $49,000, respectively. AtMarch 31, 2007, Focus had $1,289,000 of unrecognized compensation expense, netof estimated forfeitures, related to unvested stock options, which will berecognized over the weighted average period of 2.3 years. Cash received fromstock option exercises was $25,000 and $367,000 for the three months endedMarch 31, 2007 and 2006, respectively

The options outstanding and exercisable at March 31,2007 were in the following exercise price ranges:
| ** **                                  | ** ** | **Options  Outstanding** | ** ** | **Options  Exercisable** | ** ** |
|---------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **               | ** ** | **Outstanding**          | ** ** | **Weighted  Average  Remaining Life  (Yrs)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $0.43-$0.97                                 |       | 1,194,029                |       | 6.44                     |       | $ | 0.71 |   | 616,594 |   | $ | 0.70 |   |
| $0.97-$1.43                                 |       | 4,148,451                |       | 6.08                     |       | $ | 1.19 |   | 2,168,589 |   | $ | 1.20 |   |
| $1.43-$1.97                                 |       | 803,203                  |       | 4.58                     |       | $ | 1.62 |   | 751,245 |   | $ | 1.63 |   |
| $1.97-$5.75                                 |       | 88,864                   |       | 5.25                     |       | $ | 2.47 |   | 88,864 |   | $ | 2.47 |   |
|                                        |       |                     |       |                     |       |   |   |   |   |   |   |
| Outstanding at  March 31, 2007              |       | 6,234,547                |       | 5.95                     |       | $ | 1.17 |   | 3,625,292 |   | $ | 1.23 |   |
|                                             |            |                          |            |                          |            |  |  |  |  |  |  |  |  |  |  |

 

At March 31, 2007, Focushad the ability to issue an additional 1,505,425 shares of common stock underits current stock option and incentive plans, which include restricted stock.

7

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Restricted Stock Awards

A summary ofactivity related to Focus’ restricted stock awards for the three months endedMarch 31, 2007 is presented below:

|                                                                      | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Non-vested  restricted stock shares outstanding at beginning of year |       | 730,307    |       | $                                                       | 0.79       |   |
| Restricted stock  shares granted                                     |       | 551,218    |       | $                                                       | 1.40       |   |
| Restricted stock  shares vested                                      |       | (188,516   | )          | $                                                       | 0.81       |   |
|                                                                 |       |       |       |                                                    |       |
| Non-vested  restricted stock shares outstanding at March 31, 2007    |       | 1,093,009  |       | $                                                       | 1.10       |   |

 

At March 31, 2007, Focus had $961,000 of unrecognizedcompensation expense, net of forfeitures, related to restricted stock awards,which will be recognized over the weighted average period of 3.3 years. Duringthe three months ended March 31, 2007, 188,516 shares of restricted stockvested with a fair market value of $246,000.

**4.**                                      **Net Loss per Share**

Basic net loss per share was computed by dividing thenet loss by the weighted average number of shares of common stock outstandingduring the period. Diluted net loss per share is computed by dividing the netloss by the weighted average number of shares of common stock and potentialcommon stock equivalents outstanding during the period, if dilutive. Options topurchase 6,234,547 and 6,995,992 shares of common stock, unvested shares ofrestricted stock of 1,093,009 and 718,926, warrants to purchase 4,332,406 and6,056,865 shares of common stock and 3,161 shares of preferred stockconvertible into 3,161,000 shares of common stock were outstanding at March 31,2007 and 2006, respectively, but were not included in the computation ofdiluted net loss per share as the effect would have been anti-dilutive. Inaddition, convertible notes that are convertible into 10,946,000 and 10,000,000shares of common stock were outstanding at March 31, 2007 and 2006,respectively, but were not included in the computation of diluted net loss pershare as the effect would have been anti-dilutive.

**5.**                                      Significant Customers

No one customer accounted for more than 10% of Focus’ revenue in thethree months ended March 31, 2007 or 2006.

Two customers had accounts receivable balances in excess of 10% of Focus’total accounts receivable at March 31, 2007. These customers accounted for 23%of Focus’ total accounts receivable at that date. As of December 31,2006, one customer represented approximately 19% of Focus’ accounts receivable.

8

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**6.             Goodwill and Intangible Assets**

Goodwillas of March 31, 2007 and December 31, 2006 included the following:

| (In thousands) | ** ** | ** ** | ** ** | **Goodwill** | ** ** |
|---------------------|------------|------------|------------|--------------|------------|
| Videonics           |       | $          | 5,070      |         |
| Tview               |       | 121        |       |
| COMO                |       | 1,104      |       |
| Visual Circuits     |       | 6,896      |       |
|                |       | $          | 13,191     |         |

 

Thefollowing tables provide a summary of the carrying amounts of intangibleassets:
| ** **              | ** ** | **March 31, 2007** | ** ** |
|-------------------------|------------|------------------------------|------------|
| **(In thousands)** | ** ** | ** **                   | ** ** | **Gross Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Existing  technology    |       | $                            | 3,945      |   | $ | (3,888 | ) | $ | 57 |   |
| Tradename               |       | 176                          |       | (176 | ) | — |   |
|                    |       | $                            | 4,121      |   | $ | (4,064 | ) | $ | 57 |   |
|                         |            |                              |            |  |  |  |  |  |  |  |  |  |

 
| ** **              | ** ** | **December 31, 2006** | ** ** |
|-------------------------|------------|---------------------------------|------------|
| **(In thousands)** | ** ** | ** **                      | ** ** | **Gross Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Existing  technology    |       | $                               | 3,945      |   | $ | (3,759 | ) | $ | 186 |   |
| Tradename               |       | 176                             |       | (176 | ) | — |   |
|                    |       | $                               | 4,121      |   | $ | (3,935 | ) | $ | 186 |   |
|                         |            |                                 |            |  |  |  |  |  |  |  |  |  |

 

The net intangibles assets balance at March 31, 2007 of$57,000 is expected to be fully amortized in the nine months ending December31, 2007.

**7.****                                      Inventories**

Inventories are stated atlower of cost (first-in, first-out) or market:
| **(In thousands)** | ** ** | ** ** | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|-------------------------|------------|------------|------------|------------------------------|------------|---------------------------------|------------|
| Raw materials           |       | $          | 1,181      |                         | $          | 1,286                           |       |
| Work in process         |       | 1,225      |       | 1,055                        |       |
| Finished goods          |       | 1,685      |       | 1,731                        |       |
|                    |       | $          | 4,091      |                         | $          | 4,072                           |       |

 

9

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**8.**                                      Borrowings
| **(In thousands)**                   | ** ** | ** ** | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|-------------------------------------------|------------|------------|------------|------------------------------|------------|---------------------------------|------------|
| Short-term debt:                          |       |       |       |                         |       |
| Accounts  receivable-based line of credit |       | $          | —     |                         | $          | 3,390                           |       |
| Term loan                                 |       | —     |       | 2,500                        |       |
|                                      |       | —     |       | 5,890                        |       |
| Long-term debt:                           |       |       |       |                         |       |
| Convertible  notes                        |       | 10,946     |       | 10,946                       |       |
|                                      |       | $          | 10,946     |                         | $          | 16,836                          |       |

** **

AccountsReceivable-Based Line of Credit

InNovember 2004, Focus obtained a $4.0 million line of credit from Greater Bay Bank (“the Bank”) under which itcan borrow up to 90% of its eligible outstanding accounts receivable. Thecredit line expires on February 23, 2008 as a result of an extension granted inFebruary 2007 and is collateralized by a personal guarantee from Carl Berg, aCompany director and shareholder. In connection with this credit line, the Bankhas obtained a first priority security interest in Focus’ accounts receivablethrough an agreement with Mr. Berg, which enables Mr. Berg to retain hisexisting security interest in all of Focus’ assets while subordinating hisinterest in Focus’ accounts receivable. In connection with the February 2007extension, Focus agreed to pay loan commitment fees of $22,500 and agreed toissue a warrant to the Bank to purchase 48,148 shares of common stock at anexercise price of $1.35 per share. In addition, Mr. Berg agreed to continue to personally guaranteeboth the $4.0 million account receivable-based line of credit and the$2.5 million term loan to the Bank. In connection with Mr. Berg’s continuedextension of his personal guarantee, Focus agreed to issue to Mr. Berg awarrant to purchase 48,148 shares of common stock at an exercise priceof $1.35 per share. The warrants were each valued at $26,000 using theBlack-Scholes option pricing model. The warrant issued to the Bank will beamortized to interest expense over the term of the line of credit and thewarrant issued to Mr. Berg was charged to general and administrative expense atthe time of issuance.

The credit line issubject to ongoing covenants including a covenant based on operating results.Borrowings under the credit line bear interest at a rate of prime plus 1%,which was 9.25% at March 31, 2007. At March 31, 2007, there was no outstandingbalance on this credit line and Focus had the ability to borrow the maximumavailable amount of $3.5 million.

TermLoan

On June28, 2005, Focus signed a term loan agreement with the Bank under which Focus can borrow up to$2.5 million. The term loan expires on February 23, 2008 as a result ofextensions granted in February and March 2007. Mr. Berg has personally guaranteed the loan, which is interest only untilmaturity and is in addition to Focus’ existing $4.0 million accounts receivablebased secured line of credit that Focus has with this Bank. Interest is payableunder this term loan at prime plus 1%, which was 9.25% at March 31,2007. At March 31, 2007, there wasno outstanding balance under this term loan.

**9.**                                      Commitments and Contingencies

Research and DevelopmentAgreements

In October 2004, Focus entered into a design servicescontract under which Focus agreed to pay $2.9 million to a third party for thedesign and development of high performance UWB integrated circuits. Thecontract amount was subsequently increased to $3.3 million. Payments are madeupon the completion of specific milestones by the third party, which areexpected to be completed in May 2007. For the three months ended March 31, 2007and 2006, $58,000 and $292,000, respectively, was charged to research anddevelopment expense based on the level of effort incurred by the third party.At March 31, 2007 and December 31, 2006, $258,000 and $141,000 respectively,was included within other accrued liabilities on the condensed consolidatedbalance sheets.

10

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Leases

Focus leases officefacilities and certain equipment under operating and capital leases. Under thelease agreements, Focus is obligated to pay for utilities, taxes, insurance andmaintenance.

Minimum lease commitments at March 31, 2007 wereas follows:
| **(In thousands)**             | ** ** | ** ** | ** ** | **Operating Lease  Commitments** | ** ** | **Capital Lease  Commitments** | ** ** |
|-------------------------------------|------------|------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| 2006                                |       | $          | 515        |                                  | $          | 86                                  |       |
| 2007                                |       | 261        |       | 129                                   |       |
| 2008                                |       | 190        |       | 10                                    |       |
| 2009                                |       | 114        |       | —                                |       |
|                                |       | $          | 1,080      |                                  | 225        |                                |
| Less: amount  representing interest |       |       |       | (19                                   | )          |
|                                |       |       |       | 206                                   |       |
| Less: current  portion              |       |       |       | (113                                  | )          |
| Long-term  portion                  |       |       |       | $                                     | 93         |                                |

 

Inventory PurchaseCommitments

Under contractmanufacturing arrangements, contract manufacturers procure inventory tomanufacture products based upon a forecast of customer demand provided byFocus. Focus is responsible for the financial impact on the contractmanufacturer of any reduction or product mix shift in the forecast relative tomaterials that the contract manufacturer had already purchased, and is unableto return, under a prior forecast. Such a variance in forecasted demand couldrequire a cash payment for finished goods in excess of current customer demandor for costs of excess or obsolete inventory.

At March 31, 2007, Focus had issuednon-cancelable purchase orders for approximately $3.5 million to purchasefinished goods from its contract manufacturers, and had not incurred anysignificant liability for finished goods in excess of current customer demand orfor the costs of excess or obsolete inventory.

Product Warranty Costs.

Focus’ warrantyperiod for its products is generally 90 days to two years. Focus accrues forwarranty costs, based on estimated warranty return rates and costs to repair,at the time revenue is recognized. At March 31, 2007 and December 31, 2006,Focus’ reserves for warranty costs were $188,000 and $191,000, respectively.

General

From time-to-time, Focusis party to certain other claims and legal proceedings that arise in theordinary course of business which, in the opinion of management, will not havea material adverse effect on Focus’ financial position or results of operation.

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**10.          Stockholders’ Equity**

As of March 31,2007, Focus was obligated under certain circumstances, to issue the followingadditional shares of common stock pursuant to derivative securities,instruments or agreements:

 

| (In thousands)                            | ** ** | ** ** | ** ** | **Shares of  Common Stock** | ** ** |
|------------------------------------------------|------------|------------|------------|---------------------------------------|------------|
| Options to  purchase common stock              |       | 6,235      |       |
| Warrants to  purchase common stock             |       | 4,332      |       |
| Preferred stock  convertible into common stock |       | 3,161      |       |
| Convertible  notes                             |       | 10,946     |       |
|                                           |       | 24,674     |       |

 

On February 20,2007, Focus entered into two separate transactions with certain investors,relating to the issuance and sale of (i) 4,500,000 shares of Focus common stockat a purchase price of $1.26 per share and warrants to purchase 450,000 sharesof common stock at an exercise price of $2.00 per share and (ii) 500,000 sharesof common stock at a purchase price of $1.26 per share and warrants to purchase50,000 shares of common stock at an exercise price of $2.00 per share. Inaggregate, Focus sold 5,000,000 shares of common stock and issued warrants topurchase an additional 500,000 shares of common stock. In connection with thistransaction Focus received net proceeds of approximately $6.2 million.

During the threemonths ended March 31, 2007, 45,418 shares of common stock were issued upon theexercise of options and warrants, for gross proceeds of approximately $55,000.

During the three monthsended March 31, 2007, Focus repurchased 19,612 shares of common stock for$25,000 and included the repurchased shares in treasury stock at March 31,2007. Such shares had originally been issued in connection with the Company’sstock compensation plans as restricted stock.

**11.****                               RelatedParty Transactions**

CarlBerg

In December 2002,Mr. Berg provided Samsung Semiconductor Inc., one of Focus’ contractedApplication Specific Integrated Circuit (“ASIC”) manufacturers, with a personalguarantee to secure Focus’ working capital requirements for ASIC purchase orderfulfillment. Mr. Berg agreed to provide the personal guarantee on Focus’ behalfwithout additional cost or collateral, as Mr. Berg maintains a secured priorityinterest in substantially all of Focus’ assets. At March 31, 2007, Focus owedSamsung $221,000, under net 30 terms.

In November 2004,Focus secured a line of credit of up to $4.0 million under which Focus canborrow up to 90% of its eligible outstanding accounts receivable. This line ofcredit is secured by a personal guarantee from Mr. Berg. In connection withthis line of credit, the bank will obtain a priority security interest in Focus’accounts receivable. Mr. Berg will maintain his security interest in all Focus’assets, subject to the bank’s lien on accounts receivable.

OnMarch 19, 2007, Mr. Berg was awarded a warrant to purchase 48,148 shares ofcommon stock in connection with Mr. Berg maintaining his personal guarantee ofthe term loan and accounts receivable-based line of credit, which were both extendedto February 23, 2008. The warrant was issued at $1.35 per share and expires onMarch 19, 2012. The warrant was valued at $26,000 using the Black-Scholesoption pricing model and was charged to general and administrative expense atthe time of issuance.

In connection withthe $10.0 million convertible note financing completed in January 2006, Focusentered into an amendment to the Intercreditor Agreement by and among GreaterBay Bank, Mr. Berg and Focus, pursuant to which Greater Bay Bank, Mr. Berg andthe holders of the notes have defined their relative rights and priorities withrespect to the shared collateral, with Greater Bay Bank having a first prioritysecurity interest in certain specified collateral of Focus and an IntercreditorAgreement specifying the shared interests of the note holders and Mr. Berg inthe collateral securing both the notes (all of Focus’ assets) and Mr. Berg’sguaranty of Focus’ obligations to Greater Bay Bank, subject to the prioritysecurity interest of the Greater Bay Bank.

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Dolby Laboratories Inc.

N. William JasperJr., who is the Chairman of Focus’ Board of Directors, is also the Presidentand Chief Executive Officer of Dolby Laboratories, Inc. (“Dolby”), a signalprocessing technology company located in San Francisco, California. Focus isrequired to submit quarterly royalty payments to Dolby based on Dolbytechnology incorporated into certain products. For the three months ended March31, 2007 Focus paid Dolby $12,000 in royalties, which were recorded in cost ofrevenue. Focus did not pay any amounts to Dolby in the three months ended March31, 2006.

Norman Schlomka

Norman Schlomka, GeneralManager of COMO and an executive officer of Focus since February 2006, owns onethird of the building that COMO occupies. For both the three-month periodsended March 31, 2007 and 2006, Focus paid rent related to this building ofapproximately $22,000 and $15,000, respectively.

**12.          Business Segment Information**

Focus’ reportablesegments are Systems and Semiconductor. These reportable segments have distinctproducts — Systems consists of products designed to provide solutions inPC-to-TV scan conversion, video presentation, digital-video conversion, videoproduction and home theater markets and Semiconductor consists of ASICs. Focus’chief operating decision maker is the CEO.

Focus evaluates segmentperformance based on operating income (loss) and does not allocate netinterest, other income or taxes to operating segments. Additionally, Focus doesnot allocate assets by operating segment.
| ** **                        | ** ** | **Three Months Ended March 31, 2007** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                                    | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
| Net revenue                       |       | $                                                              | 5,853      |   | $ | 1,234 |   | $ | 7,087 |   |
| Cost of revenue                   |       | 3,361                                                          |       | 560 |   | 3,921 |   |
| Gross margin                      |       | 2,492                                                          |       | 674 |   | 3,166 |   |
|                              |       |                                                           |       |   |   |   |   |
| Operating  expenses:              |       |                                                           |       |   |   |   |   |
| Sales, marketing and support      |       | 1,313                                                          |       | 812 |   | 2,125 |   |
| General and administrative        |       | 707                                                            |       | 390 |   | 1,097 |   |
| Research and development          |       | 1,100                                                          |       | 2,838 |   | 3,938 |   |
| Amortization of intangible assets |       | 64                                                             |       | 41 |   | 105 |   |
|                              |       | 3,184                                                          |       | 4,081 |   | 7,265 |   |
| Loss from  operations             |       | $                                                              | (692       | ) | $ | (3,407 | ) | $ | (4,099 | ) |

 

13

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| ** **                        | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                                    | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
| Net revenue                       |       | $                                                              | 5,752      |   | $ | 1,381 |   | $ | 7,133 |   |
| Cost of revenue                   |       | 3,673                                                          |       | 795 |   | 4,468 |   |
| Gross margin                      |       | 2,079                                                          |       | 586 |   | 2,665 |   |
|                              |       |                                                           |       |   |   |   |   |
| Operating  expenses:              |       |                                                           |       |   |   |   |   |
| Sales, marketing and support      |       | 1,583                                                          |       | 491 |   | 2,074 |   |
| General and administrative        |       | 605                                                            |       | 310 |   | 915 |   |
| Research and development          |       | 656                                                            |       | 2,325 |   | 2,981 |   |
| Amortization of intangible assets |       | 82                                                             |       | 45 |   | 127 |   |
|                              |       | 2,926                                                          |       | 3,171 |   | 6,097 |   |
| Loss from operations              |       | $                                                              | (847       | ) | $ | (2,585 | ) | $ | (3,432 | ) |

 

**13.          Income Taxes**

On January 1,2007, the Company adopted the provision of Financial Accounting Standards Board(“FASB”) Interpretation No. 48, “Accounting for Uncertain Income Taxes – AnInterpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an entity’s financial statements inaccordance with FASB Statement No. 109, “Accounting for Income Taxes” (“FAS109”) and prescribes a recognition threshold and measurement attributes forfinancial statement disclosure of tax positions taken or expected to be takenon a tax return.  Under FIN 48, theimpact of an uncertain income tax position on the income tax return must berecognized at the largest amount that is more-likely-than-not to be sustainedupon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less thana 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on de-recognition,classification, interest and penalties, accounting in interim periods,disclosure and transition.  

As a result of theadoption of FIN 48, there was no impact to the Company’s consolidated financialposition, results of operations or cash flows for the three month period endedMarch 31, 2007. In accordance with FIN 48, the Company recognizes interest andpenalties related to unrecognized tax benefits as a component of income taxes.At March 31, 2007 no interest or penalties related to unrecognized tax benefitshad been recorded.  There was no changeto the Company’s unrecognized tax benefits for the three month period endedMarch 31, 2007.

The Company andcertain of its subsidiaries are subject to taxation in the U.S. and variousstates and foreign jurisdictions.  Allthe Company’s tax years will be open to examination by the U.S. federal andcertain state tax authorities due to the Company’s net operating loss andoverall credit carryforward position. With few exceptions, the Company is not subject to examination byforeign tax authorities for years before 2004.

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#### **Item  2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

The following informationshould be read in conjunction with the condensed consolidated financial statementsand notes thereto in Part I, Item 1 of this Quarterly Report and withManagement’s Discussion and Analysis of Financial Condition and Results ofOperations contained in Focus’ Annual Report on Form 10-K for the year endedDecember 31, 2006 and Item 1A—”Risk Factors”—contained therein.

**Certain Factors That May AffectFuture Results**

Discussions of certain matters in this Quarterly Report on Form 10-Q mayconstitute forward-looking statements within the meaning of the Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the Securities and ExchangeAct of 1934, as amended (the “Exchange Act”), and as such, may involve risksand uncertainties.  Forward-lookingstatements, which are based on certain assumptions and describe future plans,strategies, and expectations, are generally identifiable by the use of words orphrases such as “believe”, “plan”, “expect”, “intend”, “anticipate”, “estimate”,“project”, “forecast”, “may increase”, “may fluctuate”, “may improve” andsimilar expressions or future or conditional verbs such as “will”, “should”, “would”,and “could”.

In particular, statements contained in this document that are nothistorical facts (including, but not limited to, statements concerninganticipated revenues, anticipated operating expense levels, capital resourcesand needs and liquidity outlook, potential new products and orders, and suchexpense levels relative to our total revenues) constitute forward-lookingstatements and are made under the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. Our actual results of operations andfinancial condition have varied and may in the future vary significantly andmaterially from those stated in any forward-looking statements. Factors thatmay cause such differences include, without limitation, the availability ofcapital to fund our future cash needs, reliance on major customers, history ofoperating losses, market acceptance of our products, technologicalobsolescence, competition, successful integration of acquisitions, componentsupply problems and protection of proprietary information, the unpredictabilityof costs to develop new technologies, as well as the accuracy of our internalestimates of revenue and operating expense levels.  For a discussion of these factors and some ofthe factors that might cause such a difference see also Item 1A of our Form10-K under the heading “Risk Factors” and those described from time to time inour other reports filed with the Securities and Exchange Commission.  These factors should be considered inevaluating the forward-looking statements, and undue reliance should not beplaced on such statements. We do not undertake, and specifically disclaim anyobligation, to update any forward-looking statements to reflect occurrences orunanticipated events or circumstances after the date of such statements exceptas required by law.

**RESULTS OF OPERATIONS**

#### Net revenue

| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **                   | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|----------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                       | ** ** | **March 31, 2007** | ** ** | **March 31, 2006** | ** ** | **Increase  (decrease)** | ** ** | **% Increase  (decrease)** | ** ** |
| Systems products                     |       | $                                | 5,853      |                         | $          | 5,752                        |       | $ | 101 |   | 1.8 |  % |
| Semiconductor  products              |       | 1,234                            |       | 1,381                        |       | (147                         | )          | (10.6 | )% |
|                                 |       | $                                | 7,087      |                         | $          | 7,133                        |       | $ | (46 | ) | (0.6 | )% |
|                                      |            |                                  |            |                              |            |                              |            |  |  |  |  |  |  |  |

 

Revenue for the threemonths ended March 31, 2007 was approximately $7.1 million, a decrease of$46,000 from the three months ended March 31, 2006.

For the three monthsended March 31, 2006, net sales of systems products to distributors, retailersand Value Added Resellers, were approximately $5.9 million compared to $5.8million for the same period in 2006, an increase of $101,000.

Sales of semiconductor productsto distributors and OEM customers were approximately $1.2 million in the threemonths ended March 31, 2007, compared to $1.4 million for the same period in2006, a decrease of $147,000. This decrease is primarily related to the timingof purchases by our customers.

15

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As of March 31, 2007, wehad a sales order backlog of approximately $2.3 million, a decrease of $53,000when compared to December 31, 2006.

No customer accounted for more than 10% of our revenue in the threemonths ended March 31, 2007 and 2006.

#### Gross margin

| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                       | ** ** | **March 31, 2007** | ** ** | **March 31, 2006** | ** ** | **Increase** | ** ** |
| Gross margin                         |       | $                                | 3,166      |                         | $          | 2,665 |   | $ | 501 |   |
| Gross margin rate                    |       | 44.7                             | %          | 37.4                         | %          | 7.3 percentage points |   |
|                                      |            |                                  |            |                              |            |  |  |  |  |  |  |  |

 

Our gross marginrate for the three months ended March 31, 2007 increased to 44.7% from 37.4%for the three months ended March 31, 2006, an increase of 7.3 percentagepoints. This increase in the gross margin rate mainly reflects the shift to thehigher margin products that were introduced in 2006.

**Operatingexpenses**
| ** **                         | ** ** | **Three Months Ended**       | ** ** | ** **                   | ** ** |
|------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                         | ** ** | **March 31, 2007** | ** ** | **March 31, 2006** | ** ** | **Increase / (decrease)** | ** ** |
| **(Dollars in  thousands)**        | ** ** | ** **                   | ** ** | ** **                   | ** ** | **% of  revenue** | ** ** | ** ** | ** ** | **% of  revenue** | ** ** | ** ** | ** ** | **% of  revenue** | ** ** |
| Sales, marketing  and support      |       | $                            | 2,125      |                         | 30.0       | % | $ | 2,074 |   | 29.1 | % | $ | 51 |   | 0.9 |  % |
| General and  administrative        |       | 1,097                        |       | 15.5                         | %          | 915 |   | 12.8 | % | 182 |   | 2.7 |  % |
| Research and  development          |       | 3,938                        |       | 55.6                         | %          | 2,981 |   | 41.8 | % | 957 |   | 13.8 |  % |
| Amortization of  intangible assets |       | 105                          |       | 1.5                          | %          | 127 |   | 1.8 | % | (22 | ) | (0.3 | )% |
|                               |       | $                            | 7,265      |                         | 102.5      | % | $ | 6,097 |   | 85.5 | % | $ | 1,168 |   | 17.0 |  % |
|                                    |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

Sales, marketing andsupport 

Sales, marketing andsupport expenses for the three months ended March 31, 2007 were $2.1 million,an increase of $51,000 from the three months ended March 31, 2006.

The increase in sales,marketing and support expenses mainly reflects an increase in trade showexpenses due to an increased trade show presence at the Consumer andElectronics Show (CES) in January 2007 and expenses associated with our Koreanand Japanese subsidiaries opened in mid-2006.

General and administrative

General andadministrative expenses for the three months ended March 31, 2007 were $1.1million, an increase of $182,000 from $915,000 for the three months ended March31, 2006.

The increase in generaland administrative expenses was mainly due to an increase in payroll andpayroll related expenses of $90,000, consulting fees of $66,000, associatedwith the implementation of the requirements of the Sarbanes-Oxley Act andincreased stock based compensation charges of $26,000 associated with the issuanceof warrants related to the extension of our credit facilities.

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Research and development 

Research and developmentexpenses for the three months ended March 31, 2007 were $3.9 million, anincrease of $957,000 from $3.0 million for the three months ended March 31,2006.

The increase in researchand development expenses mainly reflects an increase in payroll and payrollrelated expenses of $601,000 primarily related to the hiring of nine additionalemployees and increased consulting expenses of $288,000 related to ongoingdevelopment projects.

Amortization

Amortizationexpense was recorded as follows:
| ** **              | ** ** | **Three Months Ended** | ** ** | ** **                   | ** ** |
|-------------------------|------------|----------------------------------|------------|------------------------------|------------|
| **(In thousands)** | ** ** | ** **                       | ** ** | **March 31, 2007** | ** ** | **March 31, 2006** | ** ** | **Decrease** | ** ** |
| Cost of revenue         |       | $                                | 24         |                         | $          | 45 |   | $ | (21 | ) |
| Operating  expenses     |       | 105                              |       | 127                          |       | (22 | ) |
|                    |       | $                                | 129        |                         | $          | 172 |   | $ | (43 | ) |
|                         |            |                                  |            |                              |            |  |  |  |  |  |  |  |

 

Amortization expense forthe three months ended March 31, 2007 was $129,000, a decrease of $43,000 from$172,000 for the three months ended March 31, 2006. The decrease inamortization expense reflects the completion of amortization for certainintangible assets associated with our acquisition of COMO Computer & MotionGmbH in February 2004.

**Interest expense, net, Value ofderivative liability, Change in value of derivative liability and Other income,net**
| ** **                               | ** ** | **Three Months Ended** | ** ** | ** **               | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------|------------|
| **(Dollars in thousands)**     | ** ** | ** **                       | ** ** | **March 31,  2007** | ** ** | **March 31,  2006** | ** ** | **Increase  (Decrease)** | ** ** |
| Interest  expense, net                   |       | $                                | (290       | )                        | $          | (199 | ) | $ | 91 |   |
| Value of  derivative liability           |       | $                                | —     |                     | $          | (4,000 | ) | $ | (4,000 | ) |
| Change in value  of derivative liability |       | $                                | —     |                     | $          | 400 |   | $ | (400 | ) |
| Other income, net                        |       | $                                | 3          |                     | $          | 70 |   | $ | (67 | ) |
|                                          |            |                                  |            |                          |            |  |  |  |  |  |  |  |

 

Net interest expense forthe three months ended March 31, 2007 was $290,000, compared to $199,000 in thethree months ended March 31, 2006. The increase in net interest expense mainlyreflects an increase in the convertible note balance by $946,000 betweencomparison periods and that the convertible notes were issued on January 27,2006 and were therefore not outstanding for the entire 2006 comparative threemonth period.

The $4.0 millionderivative liability represents the fair value of the conversion optioncalculated in connection with the $10.0 million convertible notes issued inJanuary 2006. The value of the conversion option was bifurcated from the debthost contract and recorded as a derivative liability, which resulted in adiscount to the initial carrying amount of the convertible notes. The $4.0million discount was immediately expensed in the condensed consolidatedstatements of operations as value of derivative security as the notes may beconverted to common stock at any time after issuance.

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At March 31, 2006,Focus revalued the derivative liability based on the closing price of Focus’common stock of $0.66, a remaining term coinciding with the contract and avolatility of 87%. For the three months ended March 31, 2006, due in part to adecrease in the market value of Focus’ common stock, Focus recorded a $400,000gain for the change in the fair value of the derivative liability. The changein value of the derivative security represents the difference between the fairvalue of the derivative liability when the convertible notes were issued andthe fair value of the derivative liability at March 31, 2006. The revaluationof the derivative liability resulted in a $400,000 gain in the three monthsended March 31, 2006. Effective June 28, 2006, we amended certain agreementsassociated with the $10.0 million convertible notes, eliminating the derivativecomponent.

Other income for thethree months ended March 31, 2007 consists mainly of income associated withexchange rate differences related to transactions denominated in Euros.

**LIQUIDITYAND CAPITAL RESOURCES**

The accompanyingcondensed consolidated financial statements have been prepared on a goingconcern basis, which contemplates the realization of assets and the satisfactionof liabilities in the normal course of business. For the three months endedMarch 31, 2007 and the year ended December 31, 2006, we incurred net losses of$4.4 million and $15.9 million, respectively, and used cash in operatingactivities of $3.9 million, and $8.3 million, respectively. Absent continuedaccess to capital from the sale of securities or other sources, we maypotentially be unable to continue as a going concern.

The condensedconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or the amountsand classification of liabilities that might be necessary should we be unableto continue as a going concern. Continuing as a going concern depends upon ourability to generate sufficient positive cash flows to meet our obligations on atimely basis, to obtain additional financing as may be required, and ultimatelyto return to profitability.

Since inception, we havefinanced our operations primarily through the public and private sale of commonstock and other convertible debt securities, lines of credit and debtborrowings from financial institutions, proceeds from the exercise of optionsand warrants, short-term borrowings or guarantees from private lenders(including individuals) and credit arrangements with vendors and suppliers.
| **(Dollars in thousands)** | ** ** | ** ** | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------------------|------------|------------|------------|------------------------------|------------|---------------------------------|------------|
| Cash and cash  equivalents           |       | $          | 2,215      |                         | $          | 5,969                           |       |
| Working capital                      |       | $          | 4,560      |                         | $          | 2,410                           |       |
| Days sales  outstanding (DSO)        |       | 52.3       |       | 48.2                         |       |
| Inventory turns -  annualized        |       | 3.8        |       | 5.1                          |       |

 
| ** **                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| ** **                                 | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Net cash used in  operating activities     |       | $                                | (3,925     | ) | $ | (4,282 | ) |
| Net cash used in  investing activities     |       | $                                | (142       | ) | $ | (101 | ) |
| Net cash provided by  financing activities |       | $                                | 308        |   | $ | 4,852 |   |

** **

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Net cash used inoperating activities
| ** **                             | ** ** | **Three Months Ended,** | ** ** | ** **                     | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **March 31, 2007**      | ** ** | **March 31, 2006**   | ** ** | **Change in** | ** ** |
| **(In thousands)**                | ** ** | ** **                        | ** ** | **cash (used)  provided** | ** ** | **cash (used)  provided** | ** ** | **cash (used)  provided** | ** ** |
| Net loss                               |       | $                                 | (4,390     | )                              | $          | (7,170 | ) | $ | 2,780 |   |
| Non-cash income  statement items       |       | 818                               |       | 4,316                          |       | (3,498 | ) |
| Adjusted net  loss                     |       | (3,572                            | )          | (2,854                         | )          | (718 | ) |
| Changes in  working capital            |       | (353                              | )          | (1,428                         | )          | 1,075 |   |
| Net cash used in  operating activities |       | $                                 | (3,925     | )                              | $          | (4,282 | ) | $ | 357 |   |
|                                        |            |                                   |            |                                |            |  |  |  |  |  |  |  |

 

Net cash used in operatingactivities for the three months ended March 31, 2007 and 2006 was $3.9 millionand $4.3 million, respectively. The decrease in net cash used in operatingactivities mainly reflects a decrease in cash used for accounts receivable,inventories and accrued liabilities, partially offset by an increase in netloss adjusted for non-cash items and a decrease in accounts payable.

Two customers had accounts receivable balances in excess of 10% of ourtotal accounts receivable at March 31, 2007. These customers accounted for 23%of our total accounts receivable at that date.

We expect that ouroperating cash flows may fluctuate in future periods as a result offluctuations in our operating results, shipment timetable and accountsreceivable collections, inventory management, and the timing of payments amongother factors.

Net cash used ininvesting activities

Net cash used ininvesting activities was $142,000 for the three months ended March 31, 2007,compared to $101,000 used in the three months ended March 31, 2006. Theincrease in cash used in investing activities mainly reflects the timing ofpurchases of equipment and design tools related to our investment in UWBtechnology.

Net cash provided byfinancing activities

Net cash provided byfinancing activities was $308,000 for the three months ended March 31, 2007,compared to $4.9 million for the three months ended March 31, 2006. The netcash provided by financing activities in the three months ended March 31, 2007mainly consists of net proceeds of $6.2 million from the issuance of stock in aprivate placement, partially offset by the repayment of a $3.4 millionaccounts-receivable based line of credit and a $2.5 million term loan. The netcash provided by financing activities in the three months ended March 31, 2006mainly consists of proceeds of $10.0 million from the issuance of convertiblenotes, partially offset by the repayment of a $3.0 million accounts-receivablebased line of credit and a $2.5 million term loan.

**CapitalResources and Liquidity Outlook**

We have incurred lossesand used net cash in operating activities for the three months ended March 31,2007 and each of the two years in the period ended December 31, 2006, and assuch, have been dependent upon raising money for short- and long-term cashneeds through the issuance of debt, proceeds from the exercise of options andwarrants, and the sale of our common stock in private placements.

In November 2004, weobtained a revolving $4.0 million bank credit line under which we can borrow upto 90% of our eligible outstanding accounts receivable, excluding accountsreceivable of COMO. Carl Berg, a Company director and shareholder, provided apersonal guarantee to secure this credit line. In connection with this creditline, Greater Bay Bank (“the Bank”) obtained a first priority security intereston our accounts receivable through an agreement with Mr. Berg, which enabledMr. Berg to retain his existing security interest in all of our assets whilesubordinating to the Bank his security interest in our accounts receivable. TheBank credit line is subject to ongoing covenants, including a covenant relatedto operating results.

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Interest is payable under this loan at prime plus 1%. At March31, 2007, there was no outstanding balance on this credit line and the maximumamount of $3.5 million was available to borrow. The credit line expires onFebruary 23, 2008.

On June 28, 2005, wesigned a term loan agreement with Greater Bay Bank under which we can borrow up to $2.5million. The term loan has a maturity date of February 23, 2008, is interestonly until maturity and is in addition to our existing $4.0 million accountsreceivable based secured line of credit facility described above with this samebank. Interest is payable under this loan at prime plus 1%. At March 31, 2007,there was no outstanding balance under this term loan and the maximum amount of$2.5 million was available to borrow.

On January 27, 2006, we raised gross proceeds of$10.0 million from the issuance of secured convertible notes to a group ofprivate investors. Interest accrues on the principal amount of the notes at arate of 10% per annum, payable semi-annually. The notes are convertible intoshares of Focus common stock at a conversion price of $1.00 per share. Thenotes are due January 1, 2011 and are secured by all of the assets of Focus.Under certain circumstances, including a change in control or our failure tocontinue to be listed on the Nasdaq Stock Market, the due date of the notes maybe accelerated. On June 30, 2006 and December 30, 2006, in accordance with theterms of the secured convertible notes, we issued an additional $425,000 and$521,000 of convertible notes in lieu of a cash interest payment due on June30, 2006 and December 30, 2006, respectively. We are permitted to issue anadditional note to satisfy our interest obligations under the securedconvertible notes for the interest payment due June 30, 2007.

In February 2007, we received net proceeds of$6.2 million from the issuance of common stock to a group of private investors.While we believe that these funds, along with the cash flow generated by ouranticipated growth in our Semiconductor and Systems businesses, should beadequate to enable us to complete our UWB engineering development and launchcommercialization of UWB products, depending upon the results and timing of ourUWB initiative and the growth of our Semiconductor and Systems businesses, wemay need to raise further capital in 2007 or in subsequent years. 2007 andfuture capital requirements will depend on many factors, including cash flowfrom operations, maintaining our gross margins at current levels, continuedprogress in research and development programs, competing technological andmarket developments, and our ability to market our products successfully.

Summary of Certain Contractual Obligations as of March 31, 2007
| **(In thousands)**                            | ** ** | ** ** | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|------------|------------|---------------------------|------------|--------------------|------------|--------------------|------------|-----------|------------|
| Capital and  operating leases (including interest) |       | $          | 681        |                      | $          | 624                |       | $                  | —     |      | $          | 1,305 |   |
| Inventory  purchase commitments                    |       | 3,542      |       | —                    |       | —             |       | 3,542              |       |
| Convertible  notes                                 |       | —     |       | —                    |       | 10,946             |       | 10,946             |       |
| Interest on  convertible notes                     |       | 1,136      |       | 3,161                     |       | —             |       | 4,297              |       |
|                                               |       | $          | 5,359      |                      | $          | 3,785              |       | $                  | 10,946     |      | $          | 20,090 |   |

 

**Item 3.Quantitative and Qualitative Disclosures about Market Risk**

**Interest Rate Risk**

AtMarch 31, 2007, we did not hold any short-term investments that would beexposed to market risk from adverse movements in interest rates.

At March 31, 2007, our outstanding debt obligations consisted of secured convertible notes of $10.9 million — see Note 8, “Borrowings”. A fixed interest rate is applicable to these debt obligations of 10.0% per annum.

**Foreign Currency Risk**

Gains or losses related to foreign exchange currency transactions werenot material for the periods ended March 31, 2007 and 2006.

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**Item 4T.Controls and Procedures**

Management of theCompany, with the participation of the President and Chief Executive Officerand the Chief Financial Officer (its principal executive officer and principalfinancial officer, respectively), evaluated our disclosure controls and proceduresas of the end of the period covered by this Report.

Based on thatevaluation, the President and Chief Executive Officer and the Chief FinancialOfficer have concluded that, as of the end of the period covered by thisReport, our disclosure controls and procedures are effective.

There was no change inour internal control over financial reporting that occurred during our firstquarter of 2007 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

We will berequired to evaluate our internal controls over financial reporting and preparea management assessment on our internal controls in order to comply with therequirements of the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002requires that the management assessment of our internal controls be audited. Weestimate the cost of meeting these requirements will be approximately $650,000.We will be required to meet these requirements by December 31, 2007.

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**PART II - OTHER INFORMATION**

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

From time to time, Focus is party to certain otherclaims and legal proceedings that arise in the ordinary course of business ofwhich, in the opinion of management, do not have a material adverse effect onFocus’ financial position or results of operations.

**Item 1A.****                          RiskFactors**

**Except as described below, there have been no materialchanges to our risk factors disclosed in our Annual Report on Form 10-K for theyear ended December 31, 2006. You should carefully consider the risksidentified therein any of which could materially affect our business, financialcondition or future results.**

**We will need to raiseadditional capital, which, if through equity securities placements, will resultin further dilution of existing and future stockholders.**

Historically, we have met our short- and long-term cash needs throughdebt issuances and the sale of common stock in private placements, because cashflow from operations has been insufficient to fund our operations. Set forthbelow is information regarding net proceeds received recently through privateplacements of our convertible debt, common stock and through the exercise ofstock options and warrants:
| (In thousands) | ** ** | ** ** | ** ** | **Private Placement of  Convertible Debt** | ** ** | **Private Placements of  Common Stock** | ** ** | **Exercise of Stock  Options and Warrants** | ** ** |
|---------------------|------------|------------|------------|-----------------------------------------------------------|------------|--------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| 2007                |       | —     |       | $                                                         | 6,205      |                                                   | $          | 55                                                              |       |
| 2006                |       | $          | 10,000     |                                                      | —     |                                                   | $          | 3,843                                                           |       |
| 2005                |       | —     |       | $                                                         | 4,531      |                                                   | $          | 152                                                             |       |
|                     |            |            |            |                                                           |            |                                                        |            |                                                                 |            |  |  |  |

 

We received net proceeds of $6.2 million from the issuance of commonstock to a group of private investors in February 2007. While we believethat these funds, along with the cash flow generated by our anticipated growthin our Semiconductor and Systems businesses, should be adequate to enable us tocomplete our UWB engineering development and launch commercialization of UWBproducts, depending upon the results and timing of our UWB initiative and thegrowth of our Semiconductor and Systems businesses, we may need to raisefurther capital in 2007 or in subsequent years. 2007 and future capitalrequirements will depend on many factors, including cash flow from operations,maintaining our gross margins at current levels, continued progress in researchand development programs, competing technological and market developments, andour ability to market our products successfully.  There can be no assurance that additionalequity or debt financing, if required, will be available on acceptable terms orat all. Moreover, any equity financing or convertible debt financing wouldresult in dilution to our existing stockholders and could have a negativeeffect on the market price of our common stock.

**We have a significantamount of convertible securities that will dilute existing stockholders uponconversion.**

At May 9, 2007, we had 3,161 shares of preferred stock issued andoutstanding, 4,332,406 warrants and 6,124,673 options outstanding, and $10.9million of convertible notes, which are all exercisable or convertible intoshares of common stock. The 3,161 shares of preferred stock are convertible into3,161,000 shares of our voting common stock and the convertible notes areconvertible into 10,946,000 shares of common stock. Furthermore, at May 9,2007, 1,537,539 additional shares of common stock were available for grant toour employees, officers, directors and consultants under our current stockoption and incentive plans. We also may issue additional shares inacquisitions. Any additional grant of options under existing or future plans orissuance of shares in connection with an acquisition will further diluteexisting stockholders.

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

(a) to (e)                         None.

**Item 3.****                                   DefaultsUpon Senior Securities**

None.

#### **Item4.****                                   Submissionof Matters to a Vote of Security Holders**

#### None.

**Item 5.****                                   OtherInformation**

None.

**Item 6.****                                   Exhibits**
| 4.1  |   | Warrant to Greater Bay Bank dated March 19, 2007  (incorporated by reference to Form 8-K filed on March 23, 2007)                                                                                                                                  |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.2  |   | Warrant to Carl Berg dated March 19, 2007  (incorporated by reference to Form 8-K filed on March 23, 2007)                                                                                                                                    |
| 10.1 |   | Form of Securities Purchase Agreement between the  Company and the investor signatories thereto (Sale of 4,500,000 shares of  common stock) (incorporated by reference to Form 8-K filed on February 22,  2007).                                   |
| 10.2 |   | Form of Securities Purchase Agreement between the  Company and the investor signatories thereto (Sale of 500,000 shares of  common stock). (incorporated by reference to Form 8-K filed on February 22,  2007)                                     |
| 10.3 |   | Firth Amendment to Loan and Security Agreement  between Venture Banking Group, a division of Greater Bay Bank N.A. and Focus  Enhancements Inc., dated February 21, 2007 (incorporated by reference to  Form 8-K filed on February 22, 2007). |
| 10.4 |   | Sixth Amendment to Loan and Security Agreement  between Venture Banking Group, a division of Greater Bay Bank N.A. and Focus  Enhancements Inc., dated March 19, 2007 (incorporated by reference to  Form 8-K filed on March 23, 2007).       |
| 10.5 |   | Registration Rights Agreement between Venture  Banking Group, a division of Greater Bay Bank N.A. and Focus Enhancements  Inc., dated March 19, 2007 (incorporated by reference to Form 8-K  filed on March 23, 2007).                        |
| 10.6 |   | Registration Rights Agreement between Carl Berg and  Focus Enhancements Inc., dated March 19, 2007 (incorporated by reference  to Form 8-K filed on March 23, 2007).                                                                               |
| 10.7 |   | Affirmation of Guaranty and Intercreditor Agreement  between Venture Banking Group, a division of Greater Bay Bank N.A., Focus  Enhancements Inc. and Carl Berg (incorporated by reference to Form 8-K  filed on March 23, 2007).                  |
| 31.1 |   | Rule 13a-14(a) Certification  of CEO                                                                                                                                                                                                                         |
| 31.2 |   | Rule 13a-14(a) Certification  of CFO                                                                                                                                                                                                                         |
| 32.1 |   | CEO 906 Certification                                                                                                                                                                                                                                        |
| 32.2 |   | CFO 906 Certification                                                                                                                                                                                                                                        |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
| May 14, 2007 |   |   |   | Focus Enhancements, Inc. |
|--------------|--------|--------|--------|--------------------------|
| Date         |   |   |   |                     |   |   | Registrant |
|         |   |   |   |                     |   |   |   |
|         |   |   |   |                     |   |   |   |
|         |   |   |   | By:                      |   | /s/ | Brett A. Moyer |
|         |   |   |   |                     |   |   | Brett A. Moyer  Chief Executive Officer and President  (Principal Executive Officer) |
|         |   |   |   |                     |   |   |   |
|         |   |   |   |                     |   |   |   |
|         |   |   |   | By:                      |   | /s/ | Gary L. Williams |
|         |   |   |   |                     |   |   | Gary L. Williams |
|         |   |   |   |                     |   |   | Executive Vice President of Finance,  Chief Financial Officer  (Principal Accounting Officer) |

 

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