NETLIST INC - Quarter Report: 2007 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

	x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the quarterly period ended September 29, 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 number 001-33170

 

 

NETLIST, INC.

(Exact name of registrant as specified in its charter)

 

 

51 Discovery, Irvine, CA 92618

(Address of principal executive offices) (Zip Code)

 

(949) 435-0025

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x    No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

 

Large Accelerated Filer     o

Accelerated Filer     o

Non-accelerated filer     x

 

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

 

The number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date:

 

Common Stock, par value $0.001 per share

19,717,646 shares outstanding at October 31, 2007

 

 

NETLIST, INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 29, 2007

 

TABLE OF CONTENTS

 

PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Condensed Consolidated Balance Sheets at September 29, 2007 and December 30, 2006
	Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 29, 2007 and September 30, 2006
	Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 29, 2007 and September 30, 2006
	Notes to Unaudited Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 1A.	Risk Factors
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Balance Sheets

(in thousands)

 

		September 29,			December 30,
		2007			2006
ASSETS
Current assets:
Cash and cash equivalents		$	6,450		$	30,975
Investments in marketable securities		16,079			5,267
Accounts receivable, net		16,338			23,703
Inventories		5,958			19,473
Deferred taxes		4,970			1,054
Prepaid expenses and other current assets		447			988
Total current assets		50,242			81,460
Property and equipment, net		8,071			3,830
Deferred taxes		1,237			576
Long-term investments in marketable securities		8,103			1,502
Other assets		690			326
Total assets		$	68,343		$	87,694
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	9,221		$	11,680
Revolving line of credit		10,280			19,238
Current portion of long-term debt		829			1,033
Current portion of deferred gain on sale and leaseback transaction		118			118
Income taxes payable		—			552
Accrued expenses and other current liabilities		2,739			3,255
Total current liabilities		23,187			35,876
Long-term debt, net of current portion		939			1,230
Deferred gain on sale and leaseback transaction, net of current portion		255			344
Total liabilities		24,381			37,450
Commitments and contingencies
Stockholders’ equity:
Common stock		20			20
Additional paid-in capital		67,653			66,557
Note receivable from stockholder		—			(1		)
Accumulated deficit		(23,729		)	(16,332		)
Accumulated other comprehensive income		18			—
Total stockholders’ equity		43,962			50,244
Total liabilities and stockholders’ equity		$	68,343		$	87,694

 

See accompanying notes.

 

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NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

 

		Three Months Ended						Nine Months Ended
		September 29,			September 30,			September 29,			September 30,
		2007			2006			2007			2006
Net sales		$	27,194		$	43,505		$	77,543		$	109,439
Cost of sales(1)		23,027			36,524			73,850			93,971
Gross profit		4,167			6,981			3,693			15,468
Operating expenses:
Research and development(1)		1,256			874			3,801			2,388
Selling, general and administrative(1)		4,040			2,583			11,589			6,494
Total operating expenses		5,296			3,457			15,390			8,882
Operating income (loss)		(1,129		)	3,524			(11,697		)	6,586
Other income (expense):
Interest income (expense), net		142			(565		)	256			(1,514		)
Other expense, net		(33		)	(87		)	(28		)	(82		)
Total other income (expense), net		109			(652		)	228			(1,596		)
Income (loss) before provision (benefit) for income taxes		(1,020		)	2,872			(11,469		)	4,990
Provision (benefit) for income taxes		(363		)	1,084			(4,227		)	1,896
Net income (loss)		$	(657	)	$	1,788		$	(7,242	)	$	3,094
Net income (loss) per common share:
Basic		$	(0.03	)	$	0.16		$	(0.37	)	$	0.28
Diluted		$	(0.03	)	$	0.12		$	(0.37	)	$	0.21
Weighted-average common shares outstanding:
Basic		19,689			11,235			19,655			11,072
Diluted		19,689			15,401			19,655			15,248

 

(1) Amounts include stock-based compensation expense as follows:

 

Cost of sales		$	53		$	46		$	161		$	60
Research and development		40			49			105			71
Selling, general and administrative		219			205			668			316

 

See accompanying notes.

 

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NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

 

		Nine Months Ended
		September 29,			September 30,
		2007			2006
Cash flows from operating activities:
Net income (loss)		$	(7,242	)	$	3,094
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		1,013			705
Amortization of deferred gain on sale and leaseback transaction		(89		)	(89		)
Deferred income taxes		(4,577		)	(54		)
Impairment of long-lived asset		257			—
Loss on disposal of assets		68			15
Loss on inventory adjustments		5,063			—
Facility relocation charge		150			—
Stock-based compensation		934			447
Amortization of debt discount		—			50
Changes in operating assets and liabilities:
Accounts receivable		7,365			(7,756		)
Inventories		8,452			(8,038		)
Income taxes receivable		—			259
Prepaid expenses and other current assets		541			(340		)
Other assets		(364		)	(169		)
Accounts payable		(2,442		)	8,700
Income taxes payable		(706		)	588
Accured expenses and other current liabilities		(666		)	1,155
Net cash provided by (used in) operating activities		7,757			(1,433		)
Cash flows from investing activities:
Acquisition of property and equipment		(5,530		)	(959		)
Proceeds from sale of equipment		—			45
Repayment of note receivable from stockholder		1			—
Purchase of investments in marketable securities		(50,944		)	—
Proceeds from maturities of investments in marketable securities		33,550			—
Net cash used in investing activities		(22,923		)	(914		)
Cash flows from financing activities:
Borrowings on lines of credit		86,740			106,972
Payments on lines of credit		(95,698		)	(105,264		)
Borrowings on debt		290			2,000
Payments on debt		(852		)	(676		)
Repayment of convertible notes		—			(950		)
Proceeds from exercise of stock options and warrants		161			110
Tax benefit from exercise of warrants		—			203
Net cash provided by (used in) financing activities		(9,359		)	2,395
Increase (decrease) in cash and cash equivalents		(24,525		)	48
Cash and cash equivalents at beginning of period		30,975			953
Cash and cash equivalents at end of period		$	6,450		$	1,001
Supplemental disclosure of non-cash investing activities:
Purchase of equipment through capitalized lease obligations		$	67		$	113

 

See accompanying notes.

 

5

 

NETLIST, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

September 29, 2007

 

NOTE 1—DESCRIPTION OF BUSINESS

 

Netlist, Inc. (the “Company” or “Netlist”) was incorporated on June 12, 2000 in Delaware. Netlist designs and manufactures high performance memory subsystems for the server, high performance computing and communications markets. The Company’s solutions are targeted at applications where memory plays a key role in meeting system performance requirements.

 

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The interim unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X. These financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. Therefore, these interim unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto for the year ended December 30, 2006, included in the Company’s Annual Report on Form 10-K filed with the SEC on February 28, 2007.

 

The condensed consolidated financial statements included herein are unaudited; however, they contain all normal recurring accruals and adjustments that, in the opinion of the Company’s management, are necessary to present fairly the consolidated financial position of the Company and its wholly owned subsidiaries as of September 29, 2007 and December 30, 2006, the consolidated results of its operations for the three and nine months ended September 29, 2007 and September 30, 2006, and the consolidated cash flows for the nine months ended September 29, 2007 and September 30, 2006. All intercompany balances and transactions have been eliminated in consolidation. The results of operations for the three and nine months ended September 29, 2007 are not necessarily indicative of the results to be expected for the full year or any future interim periods.

 

Fiscal Year

 

Effective January 1, 2003, the Company changed its fiscal year from a calendar year to a 52/53-week fiscal year ending on the Saturday closest to December 31. Each of the Company’s first three quarters in a fiscal year end on the Saturday closest to March 31, June 30 and September 30, respectively.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of the assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates made by management include, among others, provisions for uncollectible receivables and sales returns, warranty liabilities, valuation of inventories, recoverability of long-lived assets, realization of deferred tax assets and stock-based compensation expense. Actual results could differ from these estimates.

 

Revenue Recognition

 

The Company’s revenues primarily consist of product sales of high performance memory subsystems to original equipment manufacturers (“OEMs”). Revenues also include sales of excess component inventories to distributors and other users of memory integrated circuits (“ICs”) totaling approximately $0.4 million and $1.8 million, respectively, for the three and nine months ended September 29, 2007 and approximately $2.7 million and $10.2 million, respectively, for the three and nine months ended September 30, 2006.

 

The Company recognizes revenues in accordance with the SEC’s Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition (“SAB No. 104”). In accordance with the provisions of SAB No. 104, the Company recognizes revenues when

 

6

 

there is persuasive evidence of an arrangement, product delivery and acceptance have occurred, the sales price is fixed or determinable, and collectibility of the resulting receivable is reasonably assured.

 

The Company generally uses customer purchase orders and/or contracts as evidence of an arrangement. Delivery occurs when goods are shipped for customers with FOB Shipping Point terms and upon receipt for customers with FOB Destination terms, at which time title and risk of loss transfer to the customer. The Company assesses whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund. Customers are generally allowed limited rights of return for up to 30 days, except for sales of excess inventories, which contain no right-of-return privileges. Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. Returns from customers have not been material in any period as the Company’s principal customers have adopted build-to-order manufacturing models or just-in-time management processes. The Company offers a standard product warranty to its customers and has no other post-shipment obligations. The Company assesses collectibility based on the creditworthiness of the customer as determined by credit checks and evaluations, as well as the customer’s payment history.

 

A portion of the Company’s international shipments are made to third-party inventory warehouses, or hubs, and the Company recognizes revenue when the inventory is pulled from the hub for use in production by the customer.

 

All amounts billed to customers related to shipping and handling are classified as revenues, while all costs incurred by the Company for shipping and handling are classified as cost of sales.

 

Inventories

 

Inventories are valued at the lower of cost or net realizable value. Cost is determined on an average cost basis which approximates actual cost on a first-in, first-out basis and includes raw materials, labor and manufacturing overhead. At each balance sheet date, the Company evaluates its ending inventories for excess quantities and obsolescence. This evaluation includes an analysis of sales levels by product type. Among other factors, the Company considers historical demand and forecasted demand in relation to the inventory on hand, competitiveness of product offerings, market conditions and product life cycles when determining obsolescence and net realizable value. Provisions are made to reduce excess or obsolete inventories to their estimated net realizable values. Once established, write-downs are considered permanent adjustments to the cost basis of the excess or obsolete inventories.

 

Warranties

 

The Company offers warranties generally ranging from one to three years to its customers, other than on sales of excess inventory, depending on the product and negotiated terms of purchase agreements. Such warranties require the Company to repair or replace defective product returned to the Company during such warranty period at no cost to the customer. An estimate by the Company for warranty-related costs is recorded by the Company at the time of sale based on its historical and estimated product return rates and expected repair or replacement costs. Such costs have historically been consistent between periods and in-line with management’s expectations. The Company’s warranty liability is included as a component of accrued expenses and other current liabilities in the accompanying unaudited condensed consolidated balance sheets.

 

The following table summarizes the activity related to the warranty liability for the nine months ended September 29, 2007 (in thousands):

 

Beginning balance, December 30, 2006		$	298
Charged to costs and expenses		173
Usage		(114		)
Ending balance, September 29, 2007		$	357

 

Stock-Based Compensation

 

The Company accounts for equity issuances to non-employees in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”), and Emerging Issues Task Force (“EITF”) No. 
96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date used to determine the fair value of the equity instrument issued is the earlier of the date on which the third-party performance is complete or the date on which it is probable that performance will occur.

 

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In accordance with SFAS No. 123(R), Share-Based Payment (“SFAS No. 123(R)”), employee and director stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the accompanying unaudited condensed consolidated statements of operations includes compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Given that stock-based compensation expense recognized in the unaudited condensed consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

The fair value of stock-based awards to employees and directors is calculated using the Black-Scholes option pricing model. The Black-Scholes model requires subjective assumptions regarding future stock price volatility and expected time to exercise, along with assumptions about the risk-free interest rate and expected dividends, which affect the estimated fair values of the Company’s stock-based awards. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The expected volatility is based on the historical volatilities of the common stock of comparable publicly traded companies based on the Company’s belief that it currently has limited historical data regarding the volatility of its stock price on which to base a meaningful estimate of expected volatility. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the expected term of the grant effective as of the date of the grant. The expected dividends assumption is based on the Company’s history and expectation of dividend payouts. These factors could change in the future, affecting the determination of stock-based compensation expense in future periods.

 

Net Income (Loss) Per Share

 

Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted-average common shares outstanding during the period. Diluted net income (loss) per share is calculated by dividing the net income (loss) by the weighted-average common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of dilutive shares issuable upon the exercise of outstanding stock options and warrants computed using the treasury stock method. During fiscal 2006 and prior years, in addition to outstanding stock options and warrants, dilutive potential common shares also consisted of shares issuable upon the conversion of convertible notes payable and convertible preferred stock using the “if-converted” method.

 

NOTE 3—SUPPLEMENTAL FINANCIAL INFORMATION

 

Inventories

 

Inventories consist of the following (in thousands):

 

		September 29,			December 30,
		2007			2006
Raw materials		$	3,001		$	10,513
Work in process		1,889			3,343
Finished goods		1,068			5,617
		$	5,958		$	19,473

 

During the nine months ended September 29, 2007, the Company incurred a loss of approximately $5.1 million due to slow moving and lower-of-cost-or-market-value inventory adjustments.

 

8

 

Comprehensive Income (Loss)

 

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

 

		Three Months Ended						Nine Months Ended
		September 29,			September 30,			September 29,			September 30,
		2007			2006			2007			2006
Net income (loss)		$	(657	)	$	1,788		$	(7,242	)	$	3,094
Other comprehensive income:
Change in net unrealized gain on investments		25			—			18			—
Total comprehensive income (loss)		$	(632	)	$	1,788		$	(7,224	)	$	3,094

 

Accumulated other comprehensive income reflected on the unaudited condensed consolidated balance sheet at September 29, 2007 represents accumulated net unrealized gains on investments in marketable securities.

 

Computation of Net Income (Loss) Per Share

 

The following table sets forth the computation of basic and diluted net income (loss) per share, including the reconciliation of the numerator and denominator used in the calculation of basic and diluted net income (loss) per share (in thousands, except per share data):

 

		Three Months Ended						Nine Months Ended
		September 29,			September 30,			September 29,			September 30,
		2007			2006			2007			2006
Basic net income (loss) per share:
Numerator: Net income (loss)		$	(657	)	$	1,788		$	(7,242	)	$	3,094
Denominator: Weighted-average common shares outstanding, basic		19,689			11,235			19,655			11,072
Basic net income (loss) per share		$	(0.03	)	$	0.16		$	(0.37	)	$	0.28
Diluted net income (loss) per share:
Net income (loss)		$	(657	)	$	1,788		$	(7,242	)	$	3,094
Convertible notes interest expense (net of tax)		—			20			—			60
Numerator: Adjusted net income (loss) available to common stockholders		$	(657	)	$	1,808		$	(7,242	)	$	3,154
Weighted-average common shares outstanding, basic		19,689			11,235			19,655			11,072
Effect of dilutive securities:
Stock options and warrants		—			2,089			—			2,099
Convertible preferred stock		—			1,000			—			1,000
Convertible notes payable		—			1,077			—			1,077
Denominator: Weighted-average common shares outstanding, diluted		19,689			15,401			19,655			15,248
Diluted net income (loss) per share		$	(0.03	)	$	0.12		$	(0.37	)	$	0.21

 

All potentially dilutive common share equivalents of approximately 1.1 million and 1.5 million shares have been excluded from the diluted net loss per share calculations for the three and nine months ended September 29, 2007, respectively, as their effect would be anti-dilutive for the periods then ended.

 

9

 

Major Customers

 

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

 

		Three Months Ended				Nine Months Ended
		September 29,		September 30,		September 29,		September 30,
		2007		2006		2007		2006
Customer:
A		75	%	45	%	53	%	37	%
B		—	%	36	%	—	%	41	%
C		—	%	—	%	21	%	—	%

 

The Company’s accounts receivable are concentrated with two customers at September 29, 2007, representing approximately 70% and 10% of aggregate gross receivables. At December 30, 2006, accounts receivable are concentrated with four customers representing approximately 32%, 19%, 14% and 13% of aggregate gross receivables. A significant reduction in sales to, or the ability to collect receivables from, a significant customer could have a material adverse impact on the Company.

 

NOTE 4—CREDIT AGREEMENT

 

In April 2007, the Company executed the Seventh Amendment to the Amended and Restated Credit and Security Agreement (the “Seventh Amendment”). The Seventh Amendment, which was effective as of March 21, 2007, allows the Company to, at its election, increase its line of credit from $25 million, in $2.5 million increments, up to a total of $40 million at the prime rate of interest, which was 7.75% at September 29, 2007 and 8.25% at December 30, 2006. In addition, the Seventh Amendment (i) extends the maturity date of the line of credit to July 31, 2009, (ii) establishes an equipment advance line of $3 million, (iii) increases the sublimit for letters of credit to $5 million, (iv) sets an inventory sublimit of $7 million, with the ability to increase to $10 million if certain financial targets are met, (v) provides for the reduction in interest rates on borrowings if certain borrowing amounts and financial performance targets are met and (vi) revised certain financial covenants.

 

In July 2007, the Company executed the Eighth Amendment to the Amended and Restated Credit and Security Agreement (the “Eighth Amendment”), which was effective as of June 29, 2007. Among other things, the Eighth Amendment added certain minimum profitability financial covenant requirements. As of September 29, 2007, the Company was in compliance with all financial covenants.

 

Borrowings on the line of credit are limited to 85% of eligible accounts receivable, plus the least of (i) a percentage of eligible inventory determined from time to time by the Company’s bank, (ii) 80% of the orderly liquidation value, as defined, of eligible inventories, and (iii) $7 million. Interest is payable monthly, at the Company’s option, either at prime rate plus 0.50% or LIBOR plus 3%. The interest rate was reduced to the prime rate or LIBOR plus 2.50% in December 2006 concurrent with the Company’s raise of capital through an initial public offering.

 

Interest on the equipment advances is payable monthly, at the Company’s option, either at the prime rate or LIBOR plus 2.50%. Interest only payments were required on the equipment advances through January 31, 2007. Commencing February 1, 2007, the Company is required to repay the equipment advances in 42 equal monthly installments. The outstanding balance on this loan was approximately $1.1 million and $1.1 million at September 29, 2007 and December 30, 2006, respectively (see Note 5).

 

Any borrowings on the line of credit are collateralized by a general first priority lien against all Company assets, both tangible and intangible.

 

10

 

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

 

		Three Months Ended						Nine Months Ended
		September 29,			September 30,			September 29,			September 30,
		2007			2006			2007			2006
Interest expense		$	163		$	290		$	712		$	847

 

		September 29,			December 30,
		2007			2006
Outstanding borrowings on the line of credit		$	10,280		$	19,238
Borrowing availability under the line of credit		$	5,460		$	4,872

 

NOTE 5—LONG-TERM DEBT

 

Long-term debt consists of the following (in thousands):

 

		September 29,			December 30,
		2007			2006
Obligations under capital leases		$	541		$	802
Equipment note payable to bank (see Note 4)		1,137			1,072
Notes payable to others		90			389
		1,768			2,263
Less current portion		(829		)	(1,033		)
		$	939		$	1,230

 

Notes Payable to Others

 

In November 2002, the Company entered into a $100,000 unsecured loan agreement with an individual, bearing interest at 7% payable annually, principal due, as amended, in June 2006. In January 2004, $4,000 of the principal amount was used to exercise certain stock options. The balance of this note was $96,000 at December 30, 2006, which, along with accrued interest, was repaid in full in January 2007.

 

In January 2003, the Company entered into a $300,000 loan agreement with a financing company, collateralized by assets owned by an employee related to the majority stockholder. This note bears interest at 14% per annum and matures in January 2009. Principal and interest payments of approximately $6,000 are due and payable monthly. The balance of this note was approximately $90,000 and $133,000 at September 29, 2007 and December 30, 2006, respectively.

 

In August 2005, the Company entered into an agreement with a financing company in connection with financing certain insurance policies. The financing agreement required monthly principal and interest payments of approximately $25,000 through maturity on June 30, 2006. Interest was payable at 8.55% per annum. The outstanding principal balance on this financing was $142,000 at December 31, 2005. During the year ended December 30, 2006, the balance was repaid in full. In August 2006, the Company entered into an agreement with a financing company to finance its insurance policies. The financing agreement required monthly principal and interest payments of approximately $32,000 through maturity on June 30, 2007, with interest payable at 9.45% per annum. The principal balance was repaid in full as of June 30, 2007. The outstanding principal balance at December 30, 2006 was approximately $160,000.

 

Capital Leases

 

The Company has acquired certain manufacturing and computer equipment through the use of various capital leases. As of September 29, 2007, these leases require aggregate monthly payments of approximately $36,000 and mature at various dates through May 2011. The interest rates on these leases vary between 4.3% and 9.4%.

 

11

 

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

 

		Three Months Ended						Nine Months Ended
		September 29,			September 30,			September 29,			September 30,
		2007			2006			2007			2006
Interest expense		$	58		$	42		$	166		$	145

 

NOTE 6—INCOME TAXES

 

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

 

		Three Months Ended						Nine Months Ended
		September 29,			September 30,			September 29,			September 30,
		2007			2006			2007			2006
Provision (benefit) for income taxes		$	(363	)	$	1,084		$	(4,227	)	$	1,896
Effective tax rate		(36		)%	38		%	(37		)%	38		%

 

The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), on December 31, 2006, the first day of fiscal 2007. As a result of the implementation of FIN 48, the Company recorded an increase in the net liability for unrecognized tax positions of approximately $0.2 million, which was recorded as an adjustment to the beginning balance of accumulated deficit as of December 31, 2006. Including the increase in the net liability, at December 31, 2006 the Company had approximately $0.5 million of total unrecognized tax benefits. Included in this balance were approximately $0.5 million of tax positions that, if recognized, would affect the effective tax rate.

 

The Company’s continuing practice is to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. This policy did not change as a result of the adoption of FIN 48. The Company had approximately $30,000 accrued for interest and $0 accrued for penalties at December 31, 2006.

 

The Company files tax returns with federal and state jurisdictions. The Company is no longer subject to IRS or state examinations prior to fiscal 2003, although certain carryforward attributes that were generated prior to fiscal 2003 may still be adjusted by the IRS if they either have been or will be used in a future period.

 

NOTE 7—COMMITMENTS AND CONTINGENCIES

 

Federal Securities Class Action

 

Beginning in May 2007, the Company and certain of its officers and directors (the “Individuals”) were named as defendants in four purported class action shareholder complaints, two of which were filed in the U.S. District Court for the Southern District of New York (Tran v. Netlist, Inc., Case No. 07 CV 3754; Benjamin v. Netlist, Inc., Case No. 07 CV5518) (the “New York Actions”), and two of which were filed in the U.S. District Court for the Central District of California (Belodoff v. Netlist, Inc., Case No. SACV07-677 DOC (MLGx); Swofford v. Netlist, Inc., Case No. CV07-04006 PSG (FMOx) (the “California Actions”). These purported class action lawsuits were filed on behalf of persons and entities who purchased or otherwise acquired the Company’s common stock pursuant or traceable to the Company’s November 30, 2006 Initial Public Offering (the “IPO”). The complaints allege that the Registration Statement and Prospectus issued by the Company in connection with the IPO contained untrue statements of material fact or omissions of material fact in violation of Sections 11, 12(a)(2) and 15 of Securities Act of 1933. The actions seek unspecified monetary damages and other relief.

 

On September 5, 2007, the California Actions were consolidated by the U.S. District Court for the Central District of California. At that time, the court also designated Belodoff v. Netlist, Inc., Case No. SACV07-677 DOC (MLGx), as the lead case in this matter and appointed Iron Workers Local No. 25 Pension Fund to serve as lead plaintiff.

 

On September 12, 2007, the New York Actions were consolidated by the U.S. District Court for the Southern District of New York and Iron Workers Local No. 25 Pension Fund was again appointed to serve as lead plaintiff. The court also ordered, at the request of the parties, that the consolidated New York action be transferred to the U.S. District Court for the Central District of California and consolidated into the lead case there.

 

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Now that all four actions have been consolidated into one lead action in the Central District of California, and pursuant to a previous court order, the lead plaintiff has sixty days from the order appointing lead plaintiff to file a consolidated complaint. Once the consolidated complaint is filed and served on the defendants, defendants will have sixty days to respond. The Company believes these lawsuits lack merit and intends to vigorously defend against them. However, it is impossible at this time to assess whether or not the outcome of these proceedings will or will not have a material adverse effect on the Company. The Company has not recorded any accrual for a contingent liability associated with this legal proceeding based on its belief that a liability, while possible, is not probable and any range of potential future charge cannot be reasonably estimated at this time.

 

California Derivative Action

 

In August 2007, a derivative lawsuit was filed in California Superior Court for County of Orange - Smith v. Hong, Case No. 07CC01359 - against certain of the Company’s current officers and directors. This action contains factual allegations similar to those of the federal lawsuit mentioned above, but the plaintiff in this case asserts claims, on behalf of Netlist, for violations of California’s insider trading laws, breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment. The plaintiff in this action seeks unspecified damages, equitable and/or injunctive relief and disgorgement of all profits, benefits and other compensation obtained by the defendants. As this action contains factual allegations similar to those averred in the federal securities class action, the parties have agreed to temporarily stay this action pending a final judicial determination on the Defendants’ anticipated motions to dismiss in the federal action. Accordingly, no response by any Defendant in this action is required at this time. The Company believes that this lawsuit lacks merit and intends to vigorously defend against it. However, it is impossible at this time to assess whether or not the outcome of this proceeding will or will not have a material adverse effect on the Company. The Company has not recorded any accrual for a contingent liability associated with this legal proceeding based on its belief that a liability, while possible, is not probable and any range of potential future charge cannot be reasonably.

 

Other Obligations

 

During its normal course of business, the Company has made certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These include (i) intellectual property indemnities to the Company’s customers and licensees in connection with the use, sales and/or license of Company products; (ii) indemnities to vendors and service providers pertaining to claims based on the negligence or willful misconduct of the Company; (iii) indemnities involving the accuracy of representations and warranties in certain contracts; (iv) indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware; and (v) certain real estate leases, under which the Company may be required to indemnify property owners for environmental and other liabilities, and other claims arising from the Company’s use of the applicable premises. The duration of these indemnities, commitments and guarantees varies and, in certain cases, may be indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential for future payments the Company could be obligated to make. Historically, the Company has not been obligated to make significant payments for these obligations, and no liabilities have been recorded for these indemnities, commitments and guarantees in the accompanying unaudited condensed consolidated balance sheets.

 

In April 2007, the Company entered into a four year facility lease agreement for approximately 28,700 rentable square feet in Irvine, California. The Company began its occupation of the new facility in July 2007, which allows for the consolidation of its headquarters and domestic manufacturing operations into a single location. The total base rent for the term of the lease is approximately $1.7 million, with monthly rent payments ranging from approximately $33,000 to $37,000 during the term of the lease.

 

NOTE 8—RELATED PARTY TRANSACTIONS

 

In February 2003, the Company loaned an employee $19,900 to exercise a portion of his then-vested common stock options. This full recourse note bore interest at a rate of 7% payable annually, and was due on February 17, 2008. In December 2006, the employee repaid $23,000 of the note, and thus as of December 30, 2006, the remaining amount outstanding was approximately $1,000, which was recorded as a reduction of stockholders’ equity in the consolidated balance sheet. In May 2007, the remaining $1,000 was repaid to the Company in full.

 

NOTE 9—IMPAIRMENT OF LONG-LIVED ASSET

 

During fiscal 2006, the Company acquired certain laser soldering equipment (the “Equipment”) primarily intended for use in connection with a new product technology to be developed for a customer. In the first quarter of 2007, management

 

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determined that certain alternative equipment and related design processes were a more appropriate complement to the development of this technology. As a result, the Company determined the extent to which it expected to utilize the Equipment in the future had decreased from its original estimates, and thus the Company concluded that the carrying value of the Equipment of approximately $0.3 million was no longer recoverable and was in fact impaired. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, during the first quarter of 2007, the Company estimated the current fair value of the Equipment primarily using market prices for comparable machinery and equipment. As a result of its analysis, the Company recorded an impairment charge of approximately $0.1 million to write down the carrying value of the Equipment to its estimated fair value during the three months ended March 31, 2007. Subsequently, during the quarter ended June 30, 2007, management determined that, due primarily to the highly customized nature of the Equipment, the likelihood of alternative uses or disposal through a sale were significantly remote, and therefore recorded an additional charge of approximately $0.2 million to write-off the remaining carrying value of the Equipment as of June 30, 2007. These charges are included as a component of research and development expense in the accompanying unaudited condensed consolidated statement of operations for the nine months ended September 29, 2007.

 

NOTE 10— FACILITY RELOCATION COSTS

 

As a result the relocation of its new domestic headquarters and manufacturing facility during the third quarter of 2007, in September 2007 the Company vacated its previous manufacturing facility. The Company is currently obligated under a noncancellable operating lease of this facility through November 2010, and has thus recorded a one-time charge and related liability of approximately $150,000, which is equal to the estimated fair value of the net remaining lease payments in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This charge is included as a component of selling, general and administrative expense in the accompanying unaudited condensed consolidated statements of operations for the three and nine months ended September 29, 2007. The related liability is included as a component of accrued expenses and other current liabilities in the accompanying unaudited condensed consolidated balance sheet at September 29, 2007.

 

NOTE 11—STOCK OPTIONS AND WARRANTS

 

Common Stock Options

 

A summary of common stock option activity as of and for the nine months ended September 29, 2007 is presented below (shares in thousands):

 

				Weighted-
				Average
		Number of		Exercise
		Shares		Price
Options outstanding at December 30, 2006		3,318		$	3.34
Options granted		1,098		3.18
Options exercised		(126	)	1.28
Options cancelled		(392	)	5.57
Options outstanding at September 29, 2007		3,898		$	3.14

 

In September 2007, the Company granted options to purchase approximately 380,000 shares of its common stock to employees, including 100,000 options granted to the Company’s chief executive officer, as a result of the Company’s semi-annual employee performance review program. The Company also granted options to purchase 10,000 shares of its common stock to each of its five non-employee directors in connection with Company’s annual non-employee director compensation program. Additionally, the Company granted an option to purchase 200,000 shares of its common stock to its new chief financial officer in connection with her employment by the Company. The securities underlying this option grant are issuable pursuant to an individual option agreement issued by the Company, and are not issued under the Company’s 2006 Equity Incentive Plan.

 

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The following table presents details of the assumptions used to calculate the weighted-average grant date fair value of common stock options granted by the Company:

 

		Nine Months Ended
		September 29,			September 30,
		2007			2006
Expected term (in years)		5.4			6
Expected volatility		80		%	40		%
Risk-free interest rate		4.46		%	4.91		%
Expected dividends		—			—
Weighted-average grant date fair value per share		$	2.20		$	2.91

 

At September 29, 2007, the amount of unearned stock-based compensation currently estimated to be expensed from fiscal 2007 through fiscal 2011 related to unvested common stock options is approximately $3.7 million, net of estimated forfeitures. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is approximately 3 years. If there are any modifications or cancellations of the underlying unvested common stock options, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that the Company grants additional common stock options or other equity awards.

 

Warrants

 

At September 29, 2007, certain non-employees held outstanding warrants to purchase shares of the Company’s common stock. A summary of the warrant activity as of and for the nine months ended September 29, 2007 is presented below (shares in thousands):

 

				Weighted-
				Average
		Number of		Exercise
		Shares		Price
Warrants outstanding at December 30, 2006		398		$	1.35
Warrants granted		—		—
Warrants exercised		(23	)	1.25
Warrants cancelled		(46	)	3.10
Warrants outstanding at September 29, 2007		329		$	1.12
Warrants exercisable at September 29, 2007		329

 

In July 2007, a warrant holder exercised 42,000 warrants to purchase shares of the Company’s common stock, whereby the Company issued approximately 23,000 shares of common stock pursuant to a net issue election and effectively received approximately 19,000 shares back from the warrant holder as consideration in lieu of cash for the exercised warrants. The 19,000 shares were forfeited on the exercise date.

 

In August 2007, approximately 27,000 outstanding unvested warrants held by a consulting firm were deemed cancelled  pursuant to the terms of their governing agreements as a result of the termination of a resource agreement between the Company and the firm in connection with the resignation of the Company’s former chief financial officer. As of September 29, 2007, the firm continues to hold approximately 11,000 exercisable warrants with a per share weighted-average exercise price of $4.10. These outstanding warrants will be deemed cancelled pursuant to the terms of their governing agreements 90 days subsequent to the termination of the resource agreement if they remain unexercised at that time.

 

NOTE 12—SEGMENT AND GEOGRAPHIC INFORMATION

 

The Company operates in one reportable segment: the design and manufacture of high-performance memory subsystems for the server, high-performance computing and communications markets. The Company evaluates financial performance on a Company-wide basis. To date, all the Company’s international sales relate to shipments of products to its U.S. customers’ international manufacturing sites or third-party hubs and have been denominated in U.S. dollars.

 

At September 29, 2007, approximately $2.8 million of the Company’s long-lived assets were located outside the United States in the People’s Republic of China.

 

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Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Cautionary Statement

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Unaudited Condensed Consolidated Financial Statements and the related notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K for the fiscal year ended December 30, 2006 and subsequent reports on Form 10-Q and Form 8-K, which discuss our business in greater detail.

 

The section entitled “Risk Factors” set forth in Part II, Item 1A, and similar discussions in our other SEC filings, describe some of the important risk factors that may affect our business, results of operations and financial condition. You should carefully consider those risks, in addition to the other information in this Quarterly Report on Form 10-Q and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.

 

This report contains forward-looking statements that involve risks, uncertainties, estimates and assumptions. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, including but not limited to those identified under the heading “Risk Factors” set forth in Part II, Item 1A. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

 

Overview

 

We design, manufacture and sell high performance memory subsystems for the server, high performance computing and communications markets. Our memory subsystems consist of dynamic random access memory integrated circuits, or DRAM ICs, and other components assembled on a printed circuit board, or PCB. We engage with our original equipment manufacturer, or OEM, customers from the earliest stages of new product definition, which provides us unique insight into their full range of system architecture and performance requirements. This close collaboration has also allowed us to develop a significant level of systems expertise. We leverage a portfolio of proprietary technologies and design techniques, including efficient planar design, alternative packaging techniques and custom semiconductor logic, to deliver memory subsystems with high memory density, small form factor, high signal integrity, attractive thermal characteristics and low cost per bit.

 

Consistent with the concentrated nature of the OEM customer base in our target markets, a small number of large customers have historically accounted for a significant portion of our net sales. Net sales to Dell, Hewlett Packard and IBM represented approximately 53%, 21% and 9%, respectively, for the nine month period ended September 29, 2007, and approximately 36%, 1% and 41%, respectively, for the nine month period ended September 30, 2006. Net sales to some of our OEM customers include memory modules that are qualified by us directly with the OEM customer and sold to electronic manufacturing services providers, or EMSs, for incorporation into products manufactured exclusively for the OEM customer. These net sales to EMSs have historically fluctuated quarter by quarter as a portion of the total net sales to these OEM customers. Net sales to Hon Hai Precision Industry Co. Ltd., or Hon Hai, an EMS that purchases memory modules from us for incorporation into products manufactured exclusively for Dell, represented approximately 58% of net sales to Dell for the nine month period ended September 29, 2007 and approximately 27% of net sales to Dell for the nine month period ended September 30, 2006. Net sales to Kingston Technology Company, Inc., or Kingston, and to International Systems Technology Co. Ltd., or IST, both EMSs that purchase memory modules from us for incorporation into products manufactured exclusively for IBM, represented approximately 42% and 21%, respectively, of net sales to IBM for the nine month period ended September 29, 2007 and approximately 57% and 22%, respectively, of net sales to IBM for the nine month period ended September 30, 2006.

 

For the nine months ended September 29, 2007, the market price for mainstream DRAM ICs decreased by approximately 77%. This decline has adversely affected the selling prices of many of our products and contributed to lower revenues, lower gross margin and reduced inventory value during this period. Should the decline in the DRAM IC market continue, it would result in lower net sales, lower gross margin and reduced inventory value in subsequent periods.

 

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Key Business Metrics

 

The following describes certain line items in our statements of operations that are important to management’s assessment of our financial performance:

 

Net Sales.   Net sales consist primarily of sales of our high performance memory subsystems, net of a provision for estimated returns under our right of return policies, which generally range up to 30 days. We generally do not have long-term sales agreements with our customers. Although OEM customers typically provide us with non-binding forecasts of future product demand over specific periods of time, they generally place orders with us approximately two weeks in advance of scheduled delivery. Selling prices are typically negotiated monthly, based on competitive market conditions and the current price of DRAM ICs. Purchase orders generally have no cancellation or rescheduling penalty provisions. We often ship our products to our customers’ international manufacturing sites. All of our sales to date, however, are denominated in U.S. dollars. We also sell excess component inventory of DRAM ICs to distributors and other users of memory ICs. These sales accounted for approximately $0.4 million and $1.8 million, respectively, of our net sales for the three and nine months ended September 29, 2007 and approximately $2.7 million and $10.2 million, respectively, of our net sales for the three and nine months ended September 30, 2006. We expect that component inventory sales will continue to decrease as a percentage of net sales in future periods as we diversify our customer base and therefore are able to use components in a wider range of memory subsystems.

 

Cost of Sales.   Our cost of sales includes the cost of materials, manufacturing costs, depreciation and amortization of equipment, inventory valuation provisions, stock-based compensation and occupancy costs and other allocated fixed costs. The DRAM ICs incorporated into our products constitute a significant portion of our cost of sales, and thus our cost of sales will fluctuate based on the current price of DRAM ICs. We attempt to pass through such DRAM IC cost fluctuations to our customers by frequently renegotiating pricing prior to the placement of their purchase orders. To the extent we are successful, a large majority of our product cost is variable, and thus our cost of sales and gross margin percentages may not be significantly impacted by changes in sales volume. However, the sales prices of our memory subsystems can also fluctuate due to competitive situations unrelated to the pricing of DRAM ICs, which will affect gross margins. The gross margin on our sales of excess component DRAM IC inventory is much lower than the gross margin on our sales of our memory subsystems. As a result, a decrease in DRAM IC inventory sales as a percentage of our overall sales would result in an improved overall gross margin. We assess the valuation of our inventories on a monthly basis and record a provision to cost of sales as necessary to reduce inventories to the lower of cost or net realizable value.

 

Research and Development.   Research and development expense consists primarily of employee and independent contractor compensation and related costs, stock-based compensation, computer-aided design software licenses, reference design development costs, patent-related fees, depreciation or rental of evaluation equipment, and occupancy and other allocated overhead costs. Also included in research and development expense are the costs of material and overhead related to the production of engineering samples of new products under development or products used solely in the research and development process. Our customers typically do not separately compensate us for design and engineering work involved in developing application-specific products for them. All research and development costs are expensed as incurred. As we continue to develop additional proprietary technologies, we anticipate that research and development expenditures will increase.

 

Selling, General and Administrative.   Selling, general and administrative expenses consist primarily of employee salaries and related costs, stock-based compensation, independent sales representative commissions, professional services, promotional and other selling and marketing expenses, and occupancy and other allocated overhead costs. A significant portion of our selling efforts is directed at building relationships with OEMs and working through the product approval and qualification process with them. Therefore, the cost of material and overhead related to products manufactured for qualification is included in selling expenses. As we continue to service existing and penetrate new OEM customers, we anticipate that our sales and marketing expenses will increase. We also anticipate that our general and administrative expenses will increase as a percentage of net sales as we incur accounting and legal expenses associated with our ongoing public reporting obligations and compliance with the requirements of the Sarbanes-Oxley Act of 2002.

 

Provision (Benefit) for Income Taxes.   Our income tax provision (benefit) is based on the statutory federal tax rate of 35% and is typically impacted by state taxes and permanent book-tax differences.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of net sales and expenses during the reporting period. By their nature, these estimates and assumptions are subject to an inherent

 

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degree of uncertainty. We base our estimates on our historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. We review our estimates on an on-going basis. Actual results may differ from these estimates, which may result in material adverse effects on our operating results and financial position. We believe the following critical accounting policies involve the more significant assumptions and estimates used in the preparation of our consolidated financial statements:

 

Revenue Recognition.   We recognize revenues in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, Revenue Recognition, or SAB No. 104. Under the provisions of SAB No. 104, we recognize revenues when there is persuasive evidence of an arrangement, product delivery and acceptance have occurred, the sales price is fixed or determinable, and collectibility of the resulting receivable is reasonably assured.

 

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

 

Customers are generally allowed limited rights of return for up to 30 days, except for sales of excess inventories, which contain no right-of-return privileges. Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. Returns from customers have not been material in any period as our principal customers have adopted build-to-order manufacturing models or just-in-time management processes. While these returns have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience similar return rates in the future. We offer a standard product warranty to our customers and have no other post-shipment obligations. Any significant increase in product failure rates and the resulting product returns could have a material adverse effect on our operating results for the period or periods in which such returns materialize.

 

We assess collectibility based on the creditworthiness of the customer as determined by credit checks and evaluations, as well as the customer’s payment history. Most of our international shipments are made to third- party inventory warehouses, or hubs, and we recognize revenue when the inventory is pulled from the hub for use in production by the customer. We receive a report from the customer on a daily basis indicating the inventories pulled from a hub for use by the customer, and perform a daily reconciliation of inventories shipped to and pulled by the customer to those inventories reflected on the customer’s reports to ensure that sales are recognized in the appropriate periods.

 

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

 

Warranty Reserve.   We offer warranties on our memory subsystems generally ranging from one to three years, depending on the product and negotiated terms of purchase agreements with our customers. Such warranties require us to repair or replace defective product returned to us during such warranty period at no cost to the customer. Our estimates for warranty-related costs are recorded at the time of sale based on historical and estimated future product return rates and expected repair or replacement costs. While such costs have historically been within our expectations and the provisions established, unexpected changes in failure rates could have a material adverse impact on us.

 

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

 

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

 

Inventories.   We value our inventories at the lower of the actual cost to purchase or manufacture the inventory or the net realizable value of the inventory. Cost is determined on an average cost basis which approximates actual cost on a first-in, first-out basis and includes raw materials, labor and manufacturing overhead. We regularly review inventory quantities on hand and on order and record a provision for excess and obsolete inventories based primarily on our estimated forecast of product demand and production requirements for the next three to six months. In addition, we consider changes in the market

 

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value of DRAM ICs in determining the realizable value of our raw material inventory. Once established, any write-downs are considered permanent adjustments to the cost basis of our inventories. A significant decrease in demand for our products could result in an increase in the amount of excess inventory quantities on hand. In addition, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventory. In the future, if our inventories are determined to be overvalued, we would be required to recognize additional expense in our cost of sales at the time of such determination. Likewise, if our inventories are determined to be undervalued, we may have over-reported our costs of sales in previous periods and would be required to recognize additional gross profit at the time such inventories are sold. In addition, should the market value of DRAM ICs decrease significantly, we may be required to lower our selling prices to reflect the lower cost of our raw materials. If such price decreases reduce the realizable value of our inventories to less than our cost, we would be required to recognize additional expense in our cost of sales in the same period. Although we make every reasonable effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand, technological developments or the market value of DRAM ICs could have a material effect on the value of our inventories and our reported operating results.

 

Long-Lived Assets.   We review the recoverability of the carrying value of long-lived assets on an annual basis or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is determined based upon the forecasted undiscounted future net cash flows from the operations to which the assets relate, utilizing our best estimates, appropriate assumptions and projections at the time. These projected future cash flows may vary significantly over time as a result of increased competition, changes in technology, fluctuations in demand, consolidation of our customers and reductions in average selling prices. If the carrying value is determined not to be recoverable from future operating cash flows, the asset is deemed impaired and an impairment loss is recognized to the extent the carrying value exceeds the estimated fair market value of the asset.

 

Stock-Based Compensation.   We account for equity issuances to non-employees in accordance with Statement of Financial Accounting Standards, or SFAS, No. 123, Accounting for Stock Based Compensation, and Emerging Issues Task Force, or EITF, Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date used to determine the fair value of the equity instrument issued is the earlier of the date on which the third-party performance is complete or the date on which it is probable that performance will occur.

 

Prior to January 1, 2006, we accounted for stock-based compensation issued to employees and directors using the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related pronouncements. Under this method, compensation expense was recognized over the respective vesting period based on the excess, on the date of grant, of the fair value of our common stock over the grant price, net of forfeitures. Deferred stock-based compensation was amortized on a straight-line basis over the vesting period of each grant.

 

On January 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment, or SFAS No. 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors based on estimated fair values. We adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal year 2006. Our consolidated financial statements as of and for the year ended December 30, 2006 reflect the impact of adopting SFAS No. 123(R). In accordance with the modified prospective transition method, our consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R).

 

We currently use the Black-Scholes option pricing model to estimate the fair value of stock-based awards. While this model meets the requirements of SFAS No. 123(R), the estimated fair values generated by it may not be indicative of the actual fair values of our stock-based awards as it does not consider certain factors important to those awards to employees, such as continued employment and periodic vesting requirements as well as limited transferability. The Black-Scholes model requires subjective assumptions regarding future stock price volatility and expected time to exercise, along with assumptions about the risk-free interest rate and expected dividends, all of which affect the estimated fair values of the Company’s stock-based awards. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The expected volatility is based on the historical volatilities of the common stock of comparable publicly traded companies based on the Company’s belief that it currently has limited historical data regarding the volatility of its stock price on which to base a meaningful estimate of expected volatility. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the expected term of the grant effective as of the date of the grant. The expected dividends assumption is based on our history and expectation of dividend payouts. We

 

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evaluate the assumptions used to value stock-based awards on a quarterly basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past.

 

The value of the portion of stock-based awards that are ultimately expected to vest is recognized as expense over the requisite service periods in our financial statements in fiscal 2006 and thereafter. As stock-based compensation expense recognized in our financial statements is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. If there are any modifications or cancellations of the underlying unvested stock-based awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that we grant additional stock-based awards.

 

Income Taxes.   We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying values and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance, when determined necessary, based on historical taxable income, projected future taxable income, and the expected timing of the reversals of existing temporary differences. If we operate at a loss for an extended period of time or are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to record a valuation allowance against all or a significant portion of our deferred tax assets which could substantially increase our effective tax rate for such period. Any significant changes in statutory tax rates or the amount of our valuation allowance could have a material effect on the value of our deferred tax assets and liabilities, and our reported financial results. Additionally, we adopted Financial Accounting Standards Board, or FASB, Interpretation No. 48, Accounting for Uncertainty in Income Taxes, or FIN 48, on December 31, 2006, the first day of fiscal 2007. FIN 48 is an interpretation of SFAS No. 109, Accounting for Income Taxes, and seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. FIN 48 prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return. FIN 48 provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under FIN 48 we may only recognize or continue to recognize tax positions that meet a “more likely than not” threshold. Refer to Note 6, “Income Taxes,” of Notes to Unaudited Condensed Consolidated Financial Statements for additional information.

 

Results of Operations

 

The following table sets forth certain consolidated statements of operations data as a percentage of net sales for the periods indicated:

 

		Three Months Ended				Nine Months Ended
		September 29,		September 30,		September 29,		September 30,
		2007		2006		2007		2006
Net sales		100	%	100	%	100	%	100	%
Cost of sales		85		84		95		86
Gross profit		15		16		5		14
Operating expenses:
Research and development		5		2		5		2
Selling, general and administrative		15		6		15		6
Total operating expenses		19		8		20		8
Operating income (loss)		(4	)	8		(15	)	6
Other income (expense):
Interest income (expense), net		1		(1	)	—		(1	)
Other expense, net		—		—		—		—
Total other income (expense), net		1		(1	)	—		(1	)
Income (loss) before provision (benefit) for income taxes		(4	)	7		(15	)	5
Provision (benefit) for income taxes		(1	)	2		(5	)	2
Net income (loss)		(2	)%	5	%	(9	)%	3	%

 

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Three and Nine Months Ended September 29, 2007 Compared to Three and Nine Months Ended September 30, 2006

 

Net Sales, Cost of Sales and Gross Profit

 

The following tables present net sales, cost of sales and gross profit for the three and nine months ended September 29, 2007 and September 30, 2006 (in thousands, except percentages):

 

		Three Months Ended
		September 29,			September 30,			Increase			%
		2007			2006			(Decrease)			Change
Net sales		$	27,194		$	43,505		$	(16,311	)	(37	)%
Cost of sales		23,027			36,524			(13,497		)	(37	)%
Gross profit		$	4,167		$	6,981		$	(2,814	)	(40	)%
Gross margin		15		%	16		%	(1		)%

 

		Nine Months Ended
		September 29,			September 30,						%
		2007			2006			Decrease			Change
Net sales		$	77,543		$	109,439		$	(31,896	)	(29	)%
Cost of sales		73,850			93,971			(20,121		)	(21	)%
Gross profit		$	3,693		$	15,468		$	(11,775	)	(76	)%
Gross margin		5		%	14		%	(9		)%

 

Net Sales.   Net sales for the three and nine months ended September 29, 2007 were adversely impacted by two primary factors. First, the significant decrease in DRAM IC market prices during the period, which was primarily driven by continued oversupply in the DRAM market, forced us to significantly reduce our selling prices on many of our products. Additionally, we experienced decreases in demand as falling market prices caused certain customers to delay purchases during the period.

 

The decrease in net sales in the three and nine months ended September 29, 2007 as compared to the three and nine months ended September 30, 2006 resulted primarily from decreases of approximately $12.6 million and $36.8 million, respectively, in sales of our very low profile memory subsystems, decreases of approximately $7.4 million and $14.6 million, respectively, in sales of Double Data Rate, or DDR and DDR2 memory subsystems and decreases of approximately $7.1 million and $16.3 million, respectively, in certain other memory products. These decreases were slightly offset by an increase in net sales for the three and nine months ended September 29, 2007 as compared to the three and nine months ended September 30, 2006 of approximately $8.7 million and $23.0 million, respectively, in sales of laptop personal computer memory subsystems and increases of approximately $2.4 million and $14.9 million, respectively, in sales of memory subsystems used to control Redundant Arrays of Independent Disks, or RAIDs. The overall decreases in net sales are primarily attributable to (i) the market-driven reductions in selling prices of our products and lower customer demand as described above, particularly on our high volume products with lower average selling prices and (ii) overall lower than expected demand from OEM products in which our products are incorporated, such as blade servers that use our very low profile memory subsystems.

 

Should market price declines for DRAM ICs continue, our overall revenues could be adversely impacted as we lower prices on some products to meet market conditions.

 

Sales of our component inventory to distributors and other users of memory ICs represented approximately 2% and 6% of net sales for the three months ended September 29, 2007 and September 30, 2006, respectively, and approximately 2% and 9% of net sales for the nine months ended September 29, 2007 and September 30, 2006, respectively. We expect that component inventory sales will continue to represent a relatively small percentage of net sales in future periods as we diversify our customer base and therefore are able to use components in a wider range of memory subsystems.

 

Gross Profit and Gross Margin.   Gross profit for the three months ended September 29, 2007 as compared to the three months ended September 30, 2006 decreased primarily due to the 37% decrease in net sales between the two periods. Gross margin for the three months ended September 29, 2007 was relatively consistent with that for the three months ended September 30, 2006. The decrease in gross profit and gross margin for the nine months ended September 29, 2007 as

 

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