Table of Contents

 

 

 

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 March 31, 2012

 

or

 

o

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

 

For the transition period from             to            

 

Commission file number 001-33170

 

 

NETLIST, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

95-4812784

State or other jurisdiction of incorporation or organization

 

(I.R.S. Employer Identification No.)

 

51 Discovery, Suite 150

Irvine, CA 92618

 (Address of principal executive offices) (Zip Code)

 

(949) 435-0025

(Registrant’s telephone number, including area code)

 

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x  No  o

 

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

 

Large accelerated filer  o

 

Accelerated filer  o

 

 

 

Non-accelerated filer  o

 

Smaller reporting company  x

(Do not check if a smaller reporting company)

 

 

 

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

28,332,724 shares outstanding at April 30, 2012

 

 

 



Table of Contents

 

NETLIST, INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED MARCH 31, 2012

 

TABLE OF CONTENTS

 

 

 

Page

PART I.

FINANCIAL INFORMATION

3

Item 1.

Financial Statements

3

 

Condensed Consolidated Balance Sheets at March 31, 2012 (unaudited) and December 31, 2011 (audited)

3

 

Unaudited Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2012 and April 2, 2011

4

 

Unaudited Condensed Consolidated Statements of Comprehensive Loss for the Three Months Ended March 31, 2012 and April 2, 2011

5

 

Unaudited Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2012 and April 2, 2011

6

 

Notes to Unaudited Condensed Consolidated Financial Statements

7

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

30

Item 4.

Controls and Procedures

44

 

 

 

PART II.

OTHER INFORMATION

44

Item 1.

Legal Proceedings

44

Item 1A.

Risk Factors

44

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

67

Item 5.

Other Information

67

Item 6.

Exhibits

68

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

NETLIST, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands, except par value)

 

 

 

 

 

(audited)

 

 

 

(unaudited)
March 31,

 

December 
31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

13,874

 

$

10,535

 

Accounts receivable, net

 

10,333

 

11,399

 

Inventories

 

7,704

 

6,057

 

Prepaid expenses and other current assets

 

1,806

 

806

 

Total current assets

 

33,717

 

28,797

 

 

 

 

 

 

 

Property and equipment, net

 

2,563

 

2,771

 

Long-term investments in marketable securities

 

451

 

444

 

Other assets

 

128

 

161

 

Total assets

 

$

36,859

 

$

32,173

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

7,225

 

$

6,155

 

Accrued payroll and related liabilities

 

1,625

 

1,813

 

Accrued expenses and other current liabilities

 

1,191

 

460

 

Accrued engineering charges

 

450

 

450

 

Current portion of long-term debt

 

995

 

2,144

 

Total current liabilities

 

11,486

 

11,022

 

Long-term debt, net of current portion

 

1,850

 

1,118

 

Other liabilities

 

80

 

94

 

Total liabilities

 

13,416

 

12,234

 

Commitments and contingencies

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Common stock, $0.001 par value - 90,000 shares authorized; 28,275 (2012) and 26,390 (2011) shares issued and outstanding

 

28

 

26

 

Additional paid-in capital

 

97,285

 

92,709

 

Accumulated deficit

 

(73,821

)

(72,740

)

Accumulated other comprehensive loss

 

(49

)

(56

)

Total stockholders’ equity

 

23,443

 

19,939

 

Total liabilities and stockholders’ equity

 

$

36,859

 

$

32,173

 

 

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

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Net sales

 

$

13,967

 

$

12,000

 

Cost of sales(1)

 

8,531

 

8,196

 

Gross profit

 

5,436

 

3,804

 

Operating expenses:

 

 

 

 

 

Research and development(1)

 

3,842

 

3,684

 

Selling, general and administrative(1)

 

2,609

 

2,917

 

Total operating expenses

 

6,451

 

6,601

 

Operating loss

 

(1,015

)

(2,797

)

Other (expense) income:

 

 

 

 

 

Interest expense, net

 

(71

)

(25

)

Other income, net

 

5

 

 

Total other expense, net

 

(66

)

(25

)

Loss before provision for income taxes

 

(1,081

)

(2,822

)

Provision for income taxes

 

 

 

Net loss

 

$

(1,081

)

$

(2,822

)

Net loss per common share:

 

 

 

 

 

Basic and diluted

 

$

(0.04

)

$

(0.11

)

 

 

 

 

 

 

Weighted-average common shares outstanding:

 

 

 

 

 

Basic and diluted

 

26,729

 

24,881

 

 

 

 

 

 

 


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

 

 

 

 

 

 

 

 

 

 

 

Cost of sales

 

$

35

 

$

13

 

Research and development

 

192

 

142

 

Selling, general and administrative

 

296

 

198

 

 

See accompanying notes.

 

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NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Comprehensive Loss

(in thousands)

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Net loss

 

$

(1,081

)

$

(2,822

)

Other comprehensive loss:

 

 

 

 

 

Net unrealized gain on investments in marketable securities, net of tax

 

7

 

8

 

Total comprehensive loss

 

$

(1,074

)

$

(2,814

)

 

See accompanying notes.

 

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NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

 

 

 

Three Months
Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(1,081

)

$

(2,822

)

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

 

 

 

 

 

Depreciation and amortization

 

535

 

581

 

Stock-based compensation

 

523

 

353

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

1,066

 

(2,171

)

Inventories

 

(1,647

)

(2,793

)

Prepaid expenses and other current assets

 

(20

)

825

 

Other assets

 

33

 

90

 

Accounts payable

 

1,070

 

2,090

 

Accrued payroll and related liabilities

 

(188

)

108

 

Accrued expenses and other current liabilities

 

(83

)

(19

)

Accrued engineering charges

 

 

463

 

Net cash provided by (used in) operating activities

 

208

 

(3,295

)

Cash flows from investing activities:

 

 

 

 

 

Acquisition of property and equipment

 

(317

)

(110

)

Proceeds from maturities and sales of investments in marketable securities

 

 

825

 

Net cash (used in) provided by investing activities

 

(317

)

715

 

Cash flows from financing activities:

 

 

 

 

 

Borrowings on line of credit

 

 

500

 

Payments on line of credit

 

 

(500

)

Payments on debt

 

(607

)

(263

)

Proceeds from public offering, net

 

3,573

 

 

Proceeds from exercise of equity awards, net of taxes remitted for restricted stock

 

482

 

(6

)

Net cash provided by (used in) financing activities

 

3,448

 

(269

)

Increase (decrease) in cash and cash equivalents

 

3,339

 

(2,849

)

Cash and cash equivalents at beginning of period

 

10,535

 

14,210

 

Cash and cash equivalents at end of period

 

$

13,874

 

$

11,361

 

 

See accompanying notes.

 

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NETLIST, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2012

 

Note 1—Description of Business

 

Netlist, Inc. (the “Company”, “Netlist”or “our”) designs and manufactures a wide variety of high performance, logic-based memory subsystems for the global datacenter and high-performance computing and communications markets. The Company’s memory subsystems consist of combinations of dynamic random access memory integrated circuits (“DRAM ICs” or “DRAM”), NAND flash memory (“NAND”), application-specific integrated circuits (“ASICs”) and other components assembled on printed circuit boards (“PCBs”).  Netlist primarily markets and sells its products to leading original equipment manufacturer (“OEM”) customers.  The Company’s solutions are targeted at applications where memory plays a key role in meeting system performance requirements.  The Company leverages 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, reduced power consumption and low cost per bit.

 

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 (the “U.S.”) for interim financial information and with the instructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 8 of SEC Regulation S-X. These condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the U.S. for complete financial statements. Therefore, these 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 31, 2011, included in the Company’s Annual Report on Form 10-K filed with the SEC on February 28, 2012.

 

The condensed consolidated financial statements included herein as of March 31, 2012 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 condensed consolidated financial position of the Company and its wholly-owned subsidiaries as of March 31, 2012, and the condensed consolidated results of its operations, comprehensive loss, and cash flows for the three months ended March 31, 2012 and April 2, 2011.  The results of operations for the three months ended March 31, 2012 are not necessarily indicative of the results to be expected for the full year or any future interim periods.

 

Principles of Consolidation

 

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

 

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Fiscal Year

 

The Company operates under a 52/53-week fiscal year ending on the Saturday closest to December 31.  For fiscal 2012, the Company’s fiscal year is scheduled to end on December 29, 2012 and will consist of 52 weeks. Each of the Company’s first three quarters in a fiscal year is comprised of 13 weeks.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed 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 degree of uncertainty.  Significant estimates made by management include, among others, provisions for uncollectible receivables and sales returns, warranty liabilities, valuation of inventories, fair value of financial instruments, impairment of long-lived assets, stock-based compensation expense and realization of deferred tax assets. The Company bases its estimates on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information.  The Company reviews its estimates on an on-going basis. The actual results experienced by the Company may differ materially and adversely from its estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected.

 

Revenue Recognition

 

The Company’s revenues primarily consist of product sales of high-performance memory subsystems to OEMs. Revenues also include sales of excess component inventories to distributors and other users of memory integrated circuits (“ICs”).  Such sales amounted to less than $0.1 million for each of the three month periods ended March 31, 2012 and April 2, 2011.

 

The Company recognizes revenues in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 605.  Accordingly, the Company recognizes revenues when there is persuasive evidence of an arrangement, product delivery and acceptance have occurred, the sales price is fixed or determinable, and collectability 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. Shipping documents are used to verify delivery and customer acceptance. 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 component 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. 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.

 

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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.

 

Cash and Cash Equivalents

 

Cash and cash equivalents consist of cash and short-term investments with original maturities of three months or less, other than short-term investments in securities that lack an active market.

 

Investments in Marketable Securities

 

The Company accounts for its investments in marketable securities in accordance with ASC Topic 320.  The Company determines the appropriate classification of its investments at the time of purchase and reevaluates such designation at each balance sheet date. The Company’s investments in marketable securities have been classified and accounted for as available-for-sale based on management’s investment intentions relating to these securities. Available-for-sale securities are stated at fair value, generally based on market quotes, to the extent they are available. Unrealized gains and losses, net of applicable deferred taxes, are recorded as a component of other comprehensive income (loss). Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in other income, net in the unaudited condensed consolidated statements of operations.

 

The Company generally invests its excess cash in domestic bank-issued certificates of deposit which carry federal deposit insurance, money market funds and highly liquid debt instruments of U.S. municipalities, corporations and the U.S. government and its agencies. All highly liquid investments with stated maturities of three months or less from the date of purchase are classified as cash equivalents; all investments with stated maturities of greater than three months are classified as investments in marketable securities.

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist principally of cash and cash equivalents, investments in marketable securities, accounts receivable, accounts payable, accrued expenses and debt instruments.  Other than for certain investments in auction rate securities (see Note 4), the fair value of the Company’s cash equivalents and investments in marketable securities is determined based on quoted prices in active markets for identical assets or Level 1 inputs.  The Company recognizes transfers between Levels 1 through 3 of the fair value hierarchy at the beginning of the reporting period.  The Company believes that the carrying values of all other financial instruments approximate their current fair values due to their nature and respective durations.

 

Allowance for Doubtful Accounts

 

The Company evaluates the collectability of accounts receivable based on a combination of factors. In cases where the Company is aware of circumstances that may impair a specific customer’s ability to meet its financial obligations subsequent to the original sale, the Company will record an allowance against amounts due, and thereby reduce the net recognized receivable to the amount the Company reasonably believes will be collected. For all other customers, the Company records allowances for doubtful accounts based primarily on the length of time the receivables are past due based on the terms of the originating transaction, the current business environment and its historical experience.  Uncollectible accounts are charged against the allowance for doubtful accounts when all cost effective commercial means of collection have been exhausted.

 

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Concentration of Credit Risk

 

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

 

The Company invests its cash equivalents primarily in money market mutual funds.  Cash equivalents are maintained with high quality institutions, the composition and maturities of which are regularly monitored by management. The Company had $4.4 million of Federal Deposit Insurance Corporation and Securities Investor Protection Corporation insured cash and cash equivalents at March 31, 2012.  Investments in marketable securities are generally in high-credit quality debt instruments. Such investments are made only in instruments issued or enhanced by high-quality institutions.  The Company has not incurred any credit losses related to these investments.

 

The Company’s trade accounts receivable are primarily derived from sales to OEMs in the computer industry. The Company performs credit evaluations of its customers’ financial condition and limits the amount of credit extended when deemed necessary, but generally requires no collateral. The Company believes that the concentration of credit risk in its trade receivables is moderated by its credit evaluation process, relatively short collection terms, the high level of credit worthiness of its customers (see Note 3), foreign credit insurance and letters of credit issued on the Company’s behalf.  Reserves are maintained for potential credit losses, and such losses historically have not been significant and have been within management’s expectations.

 

Inventories

 

Inventories are valued at the lower of 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. At each balance sheet date, the Company evaluates its ending inventory quantities on hand and on order and records a provision for excess quantities and obsolescence. 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. In addition, the Company considers changes in the market value of components in determining the net realizable value of its inventory. Once established, lower of cost or market write-downs are considered permanent adjustments to the cost basis of the excess or obsolete inventories.  Provisions are made to reduce excess or obsolete inventories to their estimated net realizable values.

 

Property and Equipment

 

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

 

Impairment of Long-Lived Assets

 

The Company evaluates the recoverability of the carrying value of long-lived assets held and used by the Company for impairment on at least an annual basis or whenever events or changes in circumstances indicate that their carrying value may not be recoverable. When such factors and circumstances exist, the Company compares the projected undiscounted future net cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying

 

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amount. 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 value of the asset. The fair value of the asset or asset group is based on market value when available, or when unavailable, on discounted expected cash flows. The Company’s management believes there is no impairment of long-lived assets as of March 31, 2012. There can be no assurance, however, that market conditions will not change or demand for the Company’s products will continue, which could result in future impairment of long-lived assets.

 

Warranties

 

The Company offers warranties generally ranging from one to three years, depending on the product and negotiated terms of the purchase agreements with customers.  Such warranties require the Company to repair or replace defective product returned to the Company during the warranty period at no cost to the customer. Warranties are not offered on sales of excess component inventory.  The Company records an estimate for warranty-related costs at the time of sale based on its historical and estimated product return rates and expected repair or replacement costs (see Note 3). Such costs have historically been consistent between periods and within management’s expectations and the provisions established.

 

Stock-Based Compensation

 

The Company accounts for equity issuances to non-employees in accordance with ASC Topic 505.  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.

 

In accordance with ASC Topic 718, employee and director stock-based compensation expense recognized during the period is based on the value of the portion of stock-based payment awards that is ultimately expected to vest during the period.  Given that stock-based compensation expense recognized in the condensed consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. ASC Topic 718 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 Company’s estimated average forfeiture rates are based on historical forfeiture experience and estimated future forfeitures.

 

The fair value of common stock option 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, all of which affect the estimated fair values of the Company’s common stock option awards.  The expected term of options granted is calculated as the average of the weighted vesting period and the contractual expiration date of the option.  This calculation is based on the safe harbor method permitted by the SEC in instances where the vesting and exercise terms of options granted meet certain conditions and where limited historical exercise data is available.  The expected volatility is based on the historical volatility of the Company’s common stock.  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 dividend assumption is based on the Company’s history and management’s expectation regarding dividend payouts.   Compensation expense for common stock option awards with graded vesting schedules is recognized on a straight-line basis over the requisite service period for the last separately vesting portion of the award, provided that the accumulated cost recognized as of any date at least equals the value of the vested portion of the award.

 

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

 

Income Taxes

 

Under ASC Topic 270, the Company is required to adjust its effective tax rate each quarter to be consistent with the estimated annual effective tax rate. The Company is also required to record the tax impact of certain discrete items, unusual or infrequently occurring, including changes in judgment about valuation allowances and effects of changes in tax laws or rates, in the interim period in which they occur. In addition, jurisdictions with a projected loss for the year or a year-to-date loss where no tax benefit can be recognized are excluded from the estimated annual effective tax rate. The impact of such an exclusion could result in a higher or lower effective tax rate during a particular quarter, based upon the mix and timing of actual earnings versus annual projections.

 

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

 

ASC Topic 740 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 and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under ASC Topic 740 the Company may only recognize or continue to recognize tax positions that meet a “more likely than not” threshold.

 

Research and Development Expenses

 

Research and development expenditures are expensed in the period incurred.

 

Collaborative Arrangement

 

In 2011, the Company entered into two memory technology Collaboration Agreements.  The first agreement is a HyperCloud™ Technology Collaboration Agreement (the “IBM Agreement”) with International Business Machines (“IBM”).  Under the IBM Agreement, IBM and the Company have agreed to cooperate with respect to the qualification of HyperCloud™ technology for use with IBM servers and to engage in certain joint marketing efforts if qualification is achieved.  IBM and the Company have agreed to commit resources and funds in support of these activities.  The IBM Agreement is non-exclusive.

 

The second agreement is a Collaboration Agreement (the “HP Agreement”) with Hewlett-Packard Company (“HP”).  Under the HP Agreement, HP and the Company have agreed to cooperate with respect to the qualification of HyperCloud™ technology for use with HP servers and to engage in certain joint marketing efforts if qualification is achieved.  HP and the Company have agreed to commit

 

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resources and funds in support of these activities.  The HP Agreement is exclusive for a period of time.  HP and the Company agree to collaborate on the future use of HyperCloud™ load reduction and rank multiplication technologies for next generation server memory for HP.

 

In the fourth quarter of 2011, the Company reimbursed IBM and HP $0.2 million and $0.1 million, respectively, for the cost of certain qualification activities.  The Company reimbursed HP an additional $0.4 million in the quarter ended March 31, 2012.  The payments are included in research and development expense in the condensed consolidated statements of operations.  The Company expects to make additional payments of $0.8 million and $0.5 million to IBM and HP, respectively for joint HyperCloud™ marketing activities.  The $0.8 million payment to IBM is included in prepaid expenses and other accrued liabilities in the March 31, 2012 unaudited condensed consolidated balance sheet, as milestones that trigger the payment were achieved in March 2012.  The Company will amortize payments made to its OEM customers based on the greater of actual unit shipments to the OEM compared with estimated total shipments over the term of the Collaboration Agreement, or straight-line amortization over the term of the agreement.  The Company’s net sales will be determined after deduction of the amortization of customer allowances for marketing activities, in accordance with ASC 605-50.

 

There can be no assurance that the efforts undertaken under either of the IBM or HP collaboration agreements will result in any new revenues for the Company.

 

Comprehensive Loss

 

ASC Topic 220 establishes standards for reporting and displaying comprehensive income and its components in the condensed consolidated financial statements. Accumulated other comprehensive loss includes unrealized gains or losses on investments.

 

Risks and Uncertainties

 

The Company has invested and expects to continue to invest a significant portion of its research and development budget into the design of ASIC devices, including the HyperCloud™ memory subsystem. This new design and the products it is incorporated into are subject to increased risks as compared to the Company’s existing products.  The Company may be unable to achieve customer or market acceptance of the HyperCloud™ memory subsystem or other new products, or achieve such acceptance in a timely manner.  The Company has experienced a longer qualification cycle than anticipated with its HyperCloud™ memory subsystems, and as of March 31, 2012 the product has not generated significant revenue relative to the Company’s investment in the product.  The Company has entered into collaborative agreements with both HP and IBM pursuant to which these OEMs have agreed to cooperate with the Company in efforts to qualify HyperCloud™ for use in their respective products.  After qualification is achieved by one or both of these OEMs, the qualifying OEM will engage with the Company in joint marketing and further product development efforts.  The Company and each of the OEMs have committed financial and other resources toward the collaboration.  There can be no assurance that the efforts undertaken pursuant to either of the collaborative agreements will result in any new revenues for the Company.  Further delays or any failure in placing or qualifying this product with HP, IBM or other potential customers would adversely impact the Company’s results of operations.

 

The Company’s operations in the People’s Republic of China (“PRC”) are subject to various political, geographical and economic risks and uncertainties inherent to conducting business in China. These include, but are not limited to, (i) potential changes in economic conditions in the region, (ii) managing a local workforce that may subject the Company to uncertainties or certain regulatory

 

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policies, (iii) changes in other policies of the Chinese governmental and regulatory agencies, and (iv) changes in the laws and policies of the U.S. government regarding the conduct of business in foreign countries, generally, or in China, in particular.  Additionally, the Chinese government controls the procedures by which its local currency, the Chinese Renminbi (“RMB”), is converted into other currencies and by which dividends may be declared or capital distributed for the purpose of repatriation of earnings and investments.  If restrictions in the conversion of RMB or in the repatriation of earnings and investments through dividend and capital distribution restrictions are instituted, the Company’s operations and operating results may be negatively impacted.  Restricted net assets of the Company’s subsidiary in the PRC totaled $0.1 million and $0.6 million at March 31, 2012 and December 31, 2011, respectively.

 

Foreign Currency Remeasurement

 

The functional currency of the Company’s foreign subsidiary is the U.S. dollar. Local currency financial statements are remeasured into U.S. dollars at the exchange rate in effect as of the balance sheet date for monetary assets and liabilities and the historical exchange rate for nonmonetary assets and liabilities. Expenses are remeasured using the average exchange rate for the period, except items related to nonmonetary assets and liabilities, which are remeasured using historical exchange rates. All remeasurement gains and losses are included in determining net loss.  Transaction gains and losses were not significant in the three months ended March 31, 2012 or April 1, 2011.

 

Net Loss Per Share

 

Basic net loss per share is calculated by dividing net loss by the weighted-average common shares outstanding during the period, excluding unvested shares issued pursuant to restricted share awards under the Company’s share-based compensation plans.  Diluted net loss per share is calculated by dividing the net loss by the weighted-average shares and dilutive potential common shares outstanding during the period. Dilutive potential shares consist of dilutive shares issuable upon the exercise or vesting of outstanding stock options and restricted stock awards, respectively, computed using the treasury stock method.  In periods of losses, basic and diluted loss per share are the same, as the effect of stock options and unvested restricted share awards on loss per share is anti-dilutive.

 

New Accounting Pronouncements

 

In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-4, Fair Value Measurement (“ASU 11-4”).  ASU 11-4 amends existing guidance to achieve convergence in measurement and disclosure between U.S. Generally Accepted Accounting Standards (“GAAP”) and International Financial Reporting Standards (“IFRS”).  ASU 11-4 is effective for fiscal year 2012.  The adoption of ASU 11-4 did not impact the Company’s results of operations or its financial position.

 

In June 2011, the FASB issued ASU No. 2011-5, Comprehensive Income (“ASU 11-5”).  ASU 11-5 amends existing guidance to increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS.   ASU 11-5 is effective for fiscal year 2012.  The adoption of ASU 11-5 did not impact the Company’s results of operations or its financial position.

 

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Note 3—Supplemental Financial Information

 

Inventories

 

Inventories consist of the following (in thousands):

 

 

 

March 31,

 

December 
31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Raw materials

 

$

5,381

 

$

4,312

 

Work in process

 

951

 

237

 

Finished goods

 

1,372

 

1,508

 

 

 

$

7,704

 

$

6,057

 

 

Warranty Liabilities

 

The following table summarizes the activity related to the warranty liabilities (in thousands):

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Beginning balance

 

$

189

 

$

194

 

Estimated cost of warranty claims charged to cost of sales

 

54

 

98

 

Cost of actual warranty claims

 

(42

)

(104

)

Ending balance

 

201

 

188

 

Less current portion

 

(121

)

(103

)

Long-term warranty obligations

 

$

80

 

$

85

 

 

The allowance for warranty liabilities expected to be incurred within one year is included as a component of accrued expenses and other current liabilities in the accompanying condensed consolidated balance sheets.  The allowance for warranty liabilities expected to be incurred after one year is included as a component of other liabilities in the accompanying condensed consolidated balance sheets.

 

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Computation of Net Loss Per Share

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Basic and diluted net loss per share:

 

 

 

 

 

Numerator: Net loss

 

$

(1,081

)

$

(2,822

)

Denominator: Weighted-average common shares outstanding, basic and diluted

 

26,729

 

24,881

 

Basic and diluted net loss per share

 

$

(0.04

)

$

(0.11

)

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

Common share equivalents

 

1,259

 

1,614

 

 

The above common share equivalents would have been included in the calculation of diluted earnings per share had the Company reported net income for the periods then ended.

 

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 net sales as follows:

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

Customer:

 

 

 

 

 

Customer A

 

85

%

70

%

 

The Company’s accounts receivable are concentrated with one customer at March 31, 2012 and December 31, 2011, representing approximately 91% and 80%, respectively, of aggregate gross receivables. A significant reduction in sales to, or the inability to collect receivables from, a significant customer could have a material adverse impact on the Company.  The Company mitigates risk associated with foreign receivables by purchasing comprehensive foreign credit insurance.

 

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Cash Flow Information

 

The following table sets forth supplemental disclosures of cash flow information and non-cash investing and financing activities (in thousands):

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Supplemental disclosure of non-cash investing and financing activities:

 

 

 

 

 

Purchase of equipment not paid for at the end of the period

 

$

 

$

25

 

Debt financed acquisition of assets

 

$

180

 

$

169

 

Change in unrealized gain (loss) from investments in marketable securities

 

$

7

 

$

8

 

Contractual marketing funds due to collaboration partners

 

$

800

 

$

 

 

Note 4—Fair Value Measurements

 

The following tables detail the fair value measurements within the fair value hierarchy of the Company’s assets (in thousands):

 

 

 

 

 

Fair Value Measurements at March 31, 2012 Using

 

 

 

 

 

Quoted Prices

 

Significant

 

 

 

 

 

 

 

in Active

 

Other

 

Significant

 

 

 

Fair Value at

 

Markets for

 

Observable

 

Unobservable

 

 

 

March 31,

 

Identical Assets

 

Inputs

 

Inputs

 

 

 

2012

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Money market mutual funds

 

$

5,602

 

$

5,602

 

$

 

$

 

Auction and variable floating rate notes

 

451

 

 

 

451

 

Total

 

$

6,053

 

$

5,602

 

$

 

$

451

 

 

 

 

 

 

Fair Value Measurements at December 31, 2011 Using

 

 

 

 

 

Quoted Prices

 

Significant

 

 

 

 

 

 

 

in Active

 

Other

 

Significant

 

 

 

Fair Value at

 

Markets for

 

Observable

 

Unobservable

 

 

 

December 31,

 

Identical Assets

 

Inputs

 

Inputs

 

 

 

2011

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Money market mutual funds

 

$

5,600

 

$

5,600

 

$

 

$

 

Auction and variable floating rate notes

 

444

 

 

 

444

 

Total

 

$

6,044

 

$

5,600

 

$

 

$

444

 

 

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The following tables summarize the Company’s assets measured at fair value on a recurring basis as presented in the Company’s condensed consolidated balance sheets at March 31, 2012 and December 31, 2011:

 

 

 

 

 

Fair Value Measurements at March 31, 2012 Using

 

 

 

 

 

Quoted Prices in

 

Significant Other

 

Significant

 

 

 

Fair Value at

 

Active Markets for

 

Observable

 

Unobservable

 

 

 

March 31,

 

Identical Assets

 

Inputs

 

Inputs

 

 

 

2012

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Cash equivalents

 

$

5,602

 

$

5,602

 

$

 

$

 

Long-term marketable securities

 

451

 

 

 

451

 

Total assets measured at fair value

 

$

6,053

 

$

5,602

 

$

 

$

451

 

 

 

 

 

 

Fair Value Measurements at December 31, 2011 Using

 

 

 

 

 

Quoted Prices in

 

Significant Other

 

Significant

 

 

 

Fair Value at

 

Active Markets for

 

Observable

 

Unobservable

 

 

 

December 31,

 

Identical Assets

 

Inputs

 

Inputs

 

 

 

2011

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Cash equivalents

 

$

5,600

 

$

5,600

 

$

 

$

 

Long-term marketable securities

 

444

 

 

 

444

 

Total assets measured at fair value

 

$

6,044

 

$

5,600

 

$

 

$

444

 

 

Fair value measurements using Level 3 inputs in the table above relate to the Company’s investments in auction rate securities. Level 3 inputs are unobservable inputs used to estimate the fair value of assets or liabilities and are utilized to the extent that observable inputs are not available (see Note 5).

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Beginning balance

 

$

444

 

$

890

 

Unrealized income included in other comprehensive loss

 

7

 

8

 

Ending balance

 

$

451

 

$

898

 

 

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Note 5—Investments in Marketable Securities

 

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

 

 

 

March 31, 2012

 

 

 

 

 

Net

 

 

 

 

 

Amortized

 

Unrealized

 

Fair

 

 

 

Cost

 

Loss

 

Value

 

 

 

 

 

 

 

 

 

Auction and variable floating rate notes

 

$

500

 

$

(49

)

$

451

 

 

 

 

December 31, 2011

 

 

 

 

 

Net

 

 

 

 

 

Amortized

 

Unrealized

 

Fair

 

 

 

Cost

 

Loss

 

Value

 

 

 

 

 

 

 

 

 

Auction and variable floating rate notes

 

$

500

 

$

(56

)

$

444

 

 

Realized gains and losses on the sale of investments in marketable securities are determined using the specific identification method.  Other than the sale of one of the Company’s auction rate securities in the second fiscal quarter of 2011, there were no sales of available-for-sale securities prior to maturity in 2012 or 2011.  Net realized gains and losses recorded were not significant in any of the periods reported upon.

 

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

 

 

 

March 31, 2012

 

 

 

Continuous Unrealized Loss

 

 

 

Less than 12 months

 

12 months or greater

 

 

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

 

 

Value

 

Loss

 

Value

 

Loss

 

 

 

 

 

 

 

 

 

 

 

Auction and variable floating rate notes

 

$

 

$

 

$

451

 

$

(49

)

 

 

 

December 31, 2011

 

 

 

Continuous Unrealized Loss

 

 

 

Less than 12 months

 

12 months or greater

 

 

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

 

 

Value

 

Loss

 

Value

 

Loss

 

 

 

 

 

 

 

 

 

 

 

Auction and variable floating rate notes

 

$

 

$

 

$

444

 

$

(56

)

 

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As of March 31, 2012 and December 31, 2011, the Company held one investment that was in an unrealized loss position.

 

Auction Rate Securities

 

Disruptions in the credit market continue to adversely affect the liquidity and overall market for auction rate securities. As of March 31, 2012 and December 31, 2011, the Company held one investment in a Baa1 rated auction rate debt security of a municipality with a total purchase cost of $0.5 million.  An additional A3 rated debt obligation backed by pools of student loans guaranteed by the U.S. Department of Education with a total purchase cost of $0.5 million was disposed of in June 2011 for a realized loss of approximately $59,000.

 

The Company does not believe that the current illiquidity of its auction rate security investment will materially impact its ability to fund its working capital needs, capital expenditures or other business requirements. The Company, however, remains uncertain as to when full liquidity will return to the auction rate markets, whether other secondary markets will become available or when the underlying security may be called by the issuer. Given these and other uncertainties, the Company’s auction rate security investment has been classified as long-term in the accompanying condensed consolidated balance sheets. To estimate their fair value the Company used a discounted cash flow model based on estimated interest rates, timing and amount of cash flows, the credit quality of the underlying security, and illiquidity consideration. The Company has concluded that the estimated gross unrealized loss on this investments, which totaled approximately $49,000 and $56,000 at March 31, 2012 and December 31, 2011, respectively, is temporary because (i) the Company believes that the liquidity limitations that have occurred are due to general market conditions, (ii) the auction rate security continues to be of a high credit quality and interest is paid as due and (iii) the Company has the intent and ability to hold this investment until a recovery in the market occurs.

 

Other Investments in Marketable Securities

 

The Company maintains an investment portfolio of various holdings, types and maturities. The Company invests in instruments that meet high quality credit standards, as specified in its investment policy guidelines. These guidelines generally limit the amount of credit exposure to any one issue, issuer or type of instrument.  Excluding its auction rate security, there were no unrealized gains or losses at March 31, 2012 or December 31, 2011.

 

The following table presents the amortized cost and fair value of the Company’s investments in marketable securities classified as available-for-sale at March 31, 2012 by contractual maturity (in thousands):

 

 

 

March 31, 2012

 

 

 

Amortized

 

Fair

 

 

 

Cost

 

Value

 

 

 

 

 

 

 

Maturity

 

 

 

 

 

Greater than two years*

 

$

500

 

$

451

 

 


*

Comprised of auction rate securities which generally have reset dates of 90 days or less but final contractual maturity dates in excess of 15 years.

 

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Note 6—Credit Agreement

 

On October 31, 2009, the Company entered into a credit agreement with Silicon Valley Bank, which was amended on March 24, 2010, June 30, 2010, September 30, 2010, May 11, 2011 August 10, 2011 and May 14, 2012 (as amended, the “Credit Agreement”).  Currently, the Credit Agreement provides that the Company can borrow up to the lesser of (i) 80% of eligible accounts receivable, or (ii) $10.0 million.  The Company has the option to increase credit availability to $15.0 million at any time through the maturity date of September 30, 2014, subject to the conditions of the Credit Agreement.

 

Prior to the May 14, 2012 amendment, the Credit Agreement contained an overall sublimit of $10.0 million to collateralize the Company’s contingent obligations under letters of credit and other financial services.  Amounts outstanding under the overall sublimit reduced the amount available pursuant to the Credit Agreement.  At March 31, 2012, letters of credit in the amount of $3.0 million were outstanding.  The letters of credit expire on October 31, 2012. As a result of the May 14, 2012 amendment, letters of credit and other financial services are no longer subject to borrowing base sublimits and will not reduce the amount that may be borrowed under the revolving line of credit. Rather, the Company has an additional credit facility for up to $3.0 million in letters of credit through September 30, 2014.

 

Interest on the line of credit provided by the Credit Agreement is payable monthly at either (i) prime plus 1.25%, as long as the Company maintains $8.5 million in revolving credit availability plus unrestricted cash on deposit with the bank, or (ii) prime plus 2.25%.   Additionally, the Credit Agreement requires payment of an unused line, as well as anniversary and early termination fees, as applicable.

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Interest expense

 

$

23

 

$

2

 

 

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Table of Contents

 

The following table presents details of the Company’s outstanding borrowings and availability under our line of credit as adjusted for the May 14, 2012 amendment described above (in thousands):

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

Availability under the revolving line of credit

 

$

7,224

 

$

7,797

 

Outstanding borrowings on the revolving line of credit

 

 

 

Amounts reserved under credit sublimits

 

 

(2,022

)

Unutilized borrowing availability under the revolving line of credit

 

$

7,224

 

$

5,775

 

 

In connection with the September 30, 2010 amendment to the Credit Agreement, Silicon Valley Bank extended a $1.5 million term loan under the Credit Agreement, bearing interest at a rate of prime plus 2.00% (“Term Loan I”).  The Company was required to make monthly principal payments of $41,666 over the 36 month term of the loan, or $0.5 million annually.  In May 2011, Silicon Valley Bank extended an additional $3.0 million term loan (“Term Loan II”), bearing interest at a rate of prime plus 2.75%. The Company was required to make monthly principal payments of $125,000 over the 24 month term of the loan, or $1.5 million annually.  In May 2012, Silicon Valley Bank consolidated both term loans and extended additional credit, resulting in a combined balance of $3.5 million (the “Consolidated Term Loan”).  The Consolidated Term Loan is payable in 36 installments of $97,222, beginning December 2012, and bears interest at a rate of prime plus 2.50%.  Interest is payable monthly from the date of funding through final payoff of the loan.

 

Term Loan I and Term Loan II are classified in long-term debt in the accompanying condensed consolidated balance sheets.  The current portion of the term loans reflects the payment terms of the Consolidated Term Loan.

 

All obligations under the Credit Agreement are secured by a first priority lien on the Company’s tangible and intangible assets.  The Credit Agreement subjects the Company to certain affirmative and negative covenants, including financial covenants with respect to the Company’s liquidity and tangible net worth and restrictions on the payment of dividends.  As of March 31, 2012, the Company was in compliance with its financial covenants.

 

Note 7—Long-Term Debt

 

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

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Term Loan I

 

$

750

 

$

875

 

Term Loan II, net of unamortized issuance cost of $28 (2012) and $38 (2011)

 

1,722

 

2,087

 

Obligations under capital leases

 

252

 

300

 

Note payable to others

 

121

 

 

 

 

2,845

 

3,262

 

Less current portion

 

(995

)

(2,144

)

 

 

$

1,850

 

$

1,118

 

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Interest expense

 

$

51

 

$

26

 

 

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Table of Contents

 

Note 8—Income Taxes

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Provision for income taxes

 

$

 

$

 

Effective tax rate

 

%

%

 

The Company evaluates whether a valuation allowance should be established against its deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  Due to uncertainty of future utilization, the Company has provided a full valuation allowance as of March 31, 2012 and December 31, 2011. Accordingly, no benefit has been recognized for net deferred tax assets.

 

The Company had unrecognized tax benefits at March 31, 2012 and December 31, 2011 of approximately $0.02 million that, if recognized, would affect the Company’s annual effective tax rate.

 

Note 9—Commitments and Contingencies

 

Litigation and Patent Reexaminations

 

The Company owns numerous patents and intends to vigorously assert patent rights against infringers through civil litigation and to defense its patents against challenges made by way of reexamination requests with the United States Patent and Trademark Office (“USPTO”). The Company spends substantial resources in various activities to protect its intellectual property, and these activities may continue for the foreseeable future. There can be no assurance that any ongoing or future litigation or patent protection activities will be successful. The outcome of pending litigation and patent reexaminations, as well as any delay in their resolution, could affect the Company’s ability to license its intellectual property in the future or to protect against competition in the current and expected markets for its products.

 

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Table of Contents

 

Google Litigation

 

In May 2008, the Company initiated discussions with Google, Inc. (“Google”) regarding the Company’s claim that Google has infringed on a U.S. patent owned by the Company, U.S. Patent No. 7,289,386 (“the ‘386 patent”), which relates generally to rank multiplication in memory modules. Preemptively, Google filed a declaratory judgment lawsuit against the Company in the U.S. District Court for the Northern District of California (the “Northern District Court”), seeking a declaration that Google did not infringe the ‘386 patent and that the ‘386 patent is invalid. The Company filed a counterclaim for infringement of the ‘386 patent by Google. Claim construction proceedings were held in November 2009, and the Company prevailed on every disputed claim construction issue. In June 2010, the Company filed motions for summary judgment of patent infringement and dismissal of Google’s affirmative defenses. In May 2010, Google requested and was later granted an Inter Partes Reexamination of the ‘386 patent by the USPTO. The reexamination proceedings are described below. Pending the conclusion of the reexamination, the Northern District Court granted Google’s request to stay the litigation, and has therefore not ruled on the Company’s motions for summary judgement.

 

In December 2009, the Company filed a patent infringement lawsuit against Google in the Northern District Court, seeking damages and injunctive relief based on Google’s infringement of U.S. Patent No. 7,619,912 (“the ‘912 patent”), which is related to the ‘386 patent and relates generally to rank multiplication. In February 2010, Google answered the Company’s complaint and asserted counterclaims against the Company seeking a declaration that the patent is invalid and not infringed, and claiming that the Company committed fraud, negligent misrepresentation and breach of contract based on Netlist’s activities in the JEDEC standard-setting organization. The counterclaim seeks unspecified compensatory damages. Accruals have not been recorded for loss contingencies related to Google’s counterclaim because it is not probable that a loss has been incurred and the amount of any such loss cannot be reasonably estimated. In October 2010, Google requested and was later granted an Inter Partes Reexamination of the ‘912 patent by the USPTO. The reexamination proceedings are described below. In connection with the reexamination request, the Northern District Court granted the Company and Google’s joint request to stay the ‘912 patent infringement lawsuit against Google until the completion of the reexamination proceedings.

 

Inphi Litigation

 

In September 2009, the Company filed a patent infringement lawsuit against Inphi Corporation (“Inphi”) in the U.S. District Court for the Central District of California (the “Central District Court”). The complaint, as amended, alleges that Inphi is contributorily infringing and actively inducing the infringement of U.S. patents owned by the Company, including the ‘912 patent, U.S. Patent No. 7,532,537 (“the ‘537 patent”), which relates generally to memory modules with load isolation and memory domain translation capabilities, and U.S. Patent No. 7,636,274 (“the ‘274 patent”), which is related to the ‘537 patent and relates generally to load isolation and memory domain translation technologies. The Company is seeking damages and injunctive relief based on Inphi’s use of its patented technology. Inphi has denied infringement and has asserted to the court that the three patents are invalid. In April 2010, Inphi requested and was later denied an Inter Partes Reexaminations of the ‘912, ‘537 and ‘274 patents by the USPTO. In June 2010, Inphi submitted new requests and was later granted an Inter Partes Reexaminations of the ‘912, ‘537 and ‘274 patents by the USPTO. The reexamination proceedings are described below. In connection with the reexamination requests, Inphi filed a motion to stay proceedings with the Central District Court, which was granted and later extended through at least February 2012. The Central District Court has requested that the Company notify it within one week of any action taken by the USPTO in connection with the reexamination proceedings, at which time the Central District Court could decide to maintain or lift the stay.

 

In November 2009, Inphi filed a patent infringement lawsuit against the Company alleging infringement of two Inphi patents generally related to memory module output buffers. In April 2011 the court dismissed the entire case without prejudice pursuant to a joint stipulation filed by Inphi and the Company under which each party agreed to bear its own costs and attorney’s fees. The case is now closed.

 

‘386 Patent Reexamination

 

As noted previously, in May 2010, Google requested and was later granted an Inter Partes Reexamination of the ‘386 patent by the USPTO. In October 2010, Smart Modular, Inc. (“SMOD”) requested and was later granted an Inter Partes Reexamination of the ‘386 patent. The reexaminations requested by Google and SMOD were merged by the USPTO into a single proceeding. In April 2011, a Non-Final Action was issued by the USPTO, rejecting all claims in the patent. In July 2011, the Company responded by amending or canceling some of the claims, adding new claims, and making arguments as to the validity of the rejected claims in view of cited references. Both Google and SMOD filed their comments to the Company’s response in October 2011. The reexamination of the ‘386 patent remains pending and will continue in accordance with established procedures for merged reexamination proceedings.

 

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‘912 Patent Reexamination

 

As noted previously, in April 2010, Inphi requested and was later denied an Inter Partes Reexamination of the ‘912 patent by the USPTO. In June 2010, Inphi submitted a new request and was later granted an Inter Partes Reexamination of the ‘912 patent by the USPTO. In September 2010, the USPTO confirmed the patentability of all fifty-one claims of the ‘912 patent. However, in October 2010, Google and SMOD each filed and were later granted requests for reexamination of the ‘912 patent. In February 2011, the USPTO merged the Inphi, Google and SMOD ‘912 reexaminations into a single proceeding. In an April 2011 Non-Final Action in the merged reexamination proceeding, the USPTO rejected claims 1-20 and 22-51 and confirmed the patentability of claim 21 of the ‘912 patent. In July 2011, the Company responded by amending or canceling some of the claims, adding new claims, and making arguments as to the validity of the rejected claims in view of cited references. Inphi, Google, and SMOD filed their comments on the Company’s response in August 2011. In October 2011, the USPTO mailed a second Non-Final Action confirming the patentability of twenty claims of the ‘912 patent, including claims that were added in the reexamination process. In January 2012, the Company responded by amending or canceling some of the claims, adding new claims, and making arguments as to the validity of the rejected claims in view of cited references. Google, Inphi and SMOD filed their comments to the Company’s response in February 2012. The USPTO determined that SMOD comments to be defective, and issued a notice to SMOD to rectify and refile the comments within 15 days from the mailing date of the notice. SMOD filed corrected comments and a petition for the USPTO to withdraw the notice in March 2012.  The reexamination of the ‘912 patent remains pending and will continue in accordance with established procedures for merged reexamination proceedings.

 

‘627 Patent Reexamination

 

In September 2011, SMOD filed a request for reexamination of U.S. Pat. No. 7,864,627 (“the ‘627 patent”) issued to the Company on January 4, 2011. The ‘627 patent is related to the ‘912 patent. In November 2011, the USPTO granted SMOD’s request for reexamination of the ‘627 patent and concurrently issued a Non-Final Action confirming the patentability of three claims. In February 2012, the Company responded by amending or canceling some of the claims, adding new claims, and making arguments as to the validity of the rejected claims in view of cited references. SMOD filed its comments to the Company’s response in March 2012. The USPTO determined that SMOD’s comments are defective and issued a notice to SMOD to rectify and refile the comments within 15 days from the mailing date of the notice.  SMOD filed corrected comments and a petition for the USPTO to withdraw the notice in April 2012.  The reexamination of the ‘627 patent remains pending and will continue in accordance with established Inter Partes Reexamination procedures.

 

‘537 Patent Reexamination

 

As noted previously, in April 2010, Inphi requested and was later denied an Inter Partes Reexamination of the ‘537 patent by the USPTO. In June 2010, Inphi submitted a new request and was later granted an Inter Partes Reexamination of the ‘537 patent by the USPTO. In September 2010, the USPTO issued a Non-Final Action confirming the patentability of four claims. In October 2010, the Company responded by amending or canceling some of the claims, adding new claims, and making arguments as to the validity of the rejected claims in view of cited references. Inphi filed its comments on the Company’s response in January 2011. In June 2011, the USPTO issued an Action Closing Prosecution (“ACP”) which reconfirmed the patentability of the four claims. In August 2010, the Company responded by amending some of the claims and making arguments as to the validity of the rejected claims in view of cited references. Inphi filed its comments on the Company’s response in September 2011. The USPTO issued a Right of Appeal Notice (“RAN”) in February 2012, in which the claim rejections were withdrawn, thus confirming the patentability of all sixty (60) claims in view of all the previously submitted comments by both Inphi and the Company.  Inphi filed a notice of appeal in March 2012, and its opening appeal brief is due by May 2012.  The Company and the Examiner will have an opportunity to respond to Inphi’s appeal brief and, if the Examiner maintains his position, the Company and the USPTO examiner will jointly defend the patent in a hearing with the USPTO, in accordance with established procedures for Inter Partes Reexamination.

 

‘274 Patent Reexamination

 

As noted previously, in April 2010, Inphi requested and was later denied an Inter Partes Reexamination of the ‘274 patent by the USPTO. In June 2010, Inphi submitted a new request and was later granted an Inter Partes Reexamination of the ‘274 patent by the USPTO. In September 2011, the USPTO issued a Non-Final Action, confirming the patentability of six

 

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claims. The Company has responded by amending or canceling some of the claims, adding new claims, and making arguments as to the validity of the rejected claims in view of cited references. Inphi filed its comments on the Company’s response in November 2011. The USPTO issued an ACP in March 2012, which confirmed the patentability of one hundred and four (104) claims in view of all the previously submitted comments by both Inphi and the Company.  The Company is awaiting the issuance of a RAN with respect to the ‘274 patent.  The reexamination of the ‘274 patent remains pending and will continue in accordance with established Inter Partes Reexamination procedures.

 

Other Contingent 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 Company’s negligence or willful misconduct; (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 condensed consolidated balance sheets.

 

Note 10—Stockholders’ Equity

 

Common Stock

 

In November 2011, the Company entered into a sales agreement with Ascendiant Capital Markets LLC (“Ascendiant”), whereby shares with a total value of up to $10.0 million may be released for sale to the public at the discretion of management at a price equal to the current market price in an “at-the-market” offering as defined in Rule 415 under the Securities Act of 1933.  Since November 2011, the Company has received net proceeds of approximately $5.5 million, including approximately $3.6 million raised through the sale of 1,036,830 shares in the three months ended March 31, 2012. In the three months ended March 31, 2012 the Company paid commissions to Ascendiant, in connection with these sales, of 3.5%, or approximately $130,000. The sales agreement with Ascendiant expires in November 2014.

 

During the three months ended March 31, 2012 and April 2, 2011, the Company cancelled 13,433 and 19,730 shares of common stock, respectively, valued at approximately $48,000 and $47,000, respectively, in connection with its obligation to holders of restricted stock to withhold the number of shares required to satisfy the holders’ tax liabilities in connection with the vesting of such shares.

 

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Stock-Based Compensation

 

The Company has stock-based compensation awards outstanding pursuant to the Amended and Restated 2000 Equity Incentive Plan (the “2000 Plan”) and the Amended and Restated 2006 Equity Incentive Plan (the “2006 Plan”), under which a variety of option and direct stock-based awards may be granted to employees and nonemployees of the Company.  Further grants under the 2000 Plan were suspended upon the adoption of the 2006 Plan.  In addition to awards made pursuant to the 2006 Plan, the Company periodically issues inducement grants outside the 2006 Plan to certain new hires.

 

Subject to certain adjustments, as of March 31, 2012, the Company was authorized to issue a maximum of 5,405,566 shares of common stock pursuant to awards under the 2006 Plan. That maximum number will automatically increase on the first day of each subsequent calendar year by the lesser of (i) 5.0% of the number of shares of common stock that are issued and outstanding as of the first day of the calendar year, and (ii) 1,200,000 shares of common stock, subject to adjustment for certain corporate actions.  At March 31, 2012, the Company had 78,965 shares available for grant under the 2006 Plan.  At March 31, 2012, an additional 301,250 shares were reserved for issuance upon exercise of inducement grants.  Options granted under the 2000 Plan, the 2006 Plan and outside the equity incentive plans primarily vest at a rate of at least 25% per year over four years and expire 10 years from the date of grant.  Restricted stock awards vest in eight equal increments at intervals of approximately six months from the date of grant.

 

A summary of the Company’s common stock option activity for the three months ended March 31, 2012 is presented below (shares in thousands):

 

 

 

Options Outstanding

 

 

 

 

 

Weighted-

 

 

 

Number

 

Average

 

 

 

of

 

Exercise

 

 

 

Shares

 

Price

 

Options outstanding at December 31, 2011

 

5,368

 

$

2.62

 

Options granted

 

1,522

 

3.50

 

Options exercised

 

(878

)

0.60

 

Options cancelled

 

(104

)

2.51

 

Options outstanding at March 31, 2012

 

5,908

 

$

3.16

 

 

The intrinsic value of options exercised in the three months ended March 31, 2012 was $2.4 million.

 

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A summary of the Company’s restricted stock awards as of and for the three months ended March 31, 2012 is presented below (shares in thousands):

 

 

 

Restricted Stock
Outstanding

 

 

 

 

 

Weighted-

 

 

 

 

 

Average

 

 

 

 

 

Grant-

 

 

 

 

 

Date

 

 

 

Number

 

Fair

 

 

 

of

 

Value

 

 

 

Shares

 

per Share

 

Balance outstanding at December 31, 2011

 

319

 

$

3.32

 

Restricted stock forfeited

 

(16

)

3.49

 

Restricted stock vested

 

(60

)

3.37

 

Balance outstanding at March 31, 2012

 

243

 

$

3.30

 

 

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:

 

 

 

Three Months Ended

 

 

 

March

 

 

 

 

 

31,

 

April 2,

 

 

 

2012

 

2011

 

Expected term (in years)

 

6.1

 

6.0

 

Expected volatility

 

127

%

136

%

Risk-free interest rate

 

1.12

%

2.19

%

Expected dividends

 

 

 

Weighted-average grant date fair value per share

 

$

3.11

 

$

2.02

 

 

The fair value per share of restricted stock grants is calculated based on the fair value of the Company’s common stock on the respective grant dates.  The grant date fair value of restricted stock vested was $0.2 million and $0.1 million in the three months ended March 31, 2012 and April 2, 2011, respectively.

 

At March 31, 2012, the amount of unearned stock-based compensation currently estimated to be expensed from fiscal 2012 through fiscal 2015 related to unvested common stock options and restricted stock awards is approximately $6.8 million, net of estimated forfeitures. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is approximately 3.3 years. If there are any modifications or cancellations of the underlying unvested awards, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense.

 

Note 11—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.

 

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At March 31, 2012 and December 31, 2011, approximately $1.3 million and $1.5 million of the Company’s long-lived assets, net of depreciation and amortization, respectively, were located in the PRC. Substantially all other long-lived assets were located in the U.S.

 

Note 12—Subsequent Events

 

As further described in Note 6, on May 14, 2012, the Company amended its Credit Agreement with Silicon Valley Bank.

 

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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 31, 2011  and subsequent reports on Form 8-K, which discuss our business in greater detail.

 

This report contains forward-looking statements regarding future events and our future performance.  These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those expected or projected.  These risks and uncertainties include, but are not limited to risks associated with the launch and commercial success of our products, programs and technologies; the success of product partnerships;continuing development, qualification and volume production of EXPRESSvault™, NVvault™, HyperCloud™ and VLP Planar-X RDIMM; the timing and magnitude of the anticipated decrease in sales to our key customer; our ability to leverage our NVvault™ technology in a more diverse customer base; the rapidly-changing nature of technology; risks associated with intellectual property, including the costs and unpredictability of litigation over infringement of our intellectual property and the possibility of our patents being reexamined by the USPTO; volatility in the pricing of DRAM ICs and NAND; changes in and uncertainty of customer acceptance of, and demand for, our existing products and products under development, including uncertainty of and/or delays in product orders and product qualifications; delays in our and our customers’ product releases and development; introductions of new products by competitors; changes in end-user demand for technology solutions; our ability to attract and retain skilled personnel; our reliance on suppliers of critical components and vendors in the supply chain; fluctuations in the market price of critical components; evolving industry standards; and the political and regulatory environment in the PRC.  Other risks and uncertainties are described under the heading “Risk Factors” in Part II, Item IA of this Quarterly Report on Form 10-Q, and similar discussions in our other SEC filings.  Except as required by law, we undertake no obligation to revise or update publicly any forward-looking statements for any reason.

 

Overview

 

We design, manufacture and sell high-performance, intelligent memory subsystems for datacenter server and high-performance computing and communications markets. Our memory subsystems consist of combinations of dynamic random access memory integrated circuits (“DRAM ICs” or “DRAM”), NAND flash memory (“NAND”), application-specific integrated circuits (“ASICs”) and other components assembled on printed circuit boards (“PCBs”).  We primarily market and sell our products to leading original equipment manufacturer (“OEM”) customers.  Our solutions are targeted at applications where memory plays a key role in meeting system performance requirements.  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.  Unless the context otherwise requires, all references in this Report to “we,” “us,” “our,” “the Company,” or “Netlist” refer to Netlist, Inc. and its subsidiaries.

 

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Our Products

 

Hypercloud T M

 

In November 2009, we introduced HyperCloud™ DDR3 memory technology.  HyperCloud™ utilizes an ASIC chipset that incorporates Netlist patented rank multiplication technology that increases memory capacity and load reduction technology that increases memory bandwidth.  We expect that these patented technologies will make possible improved levels of performance for memory intensive datacenter applications and workloads, including enterprise virtualization, cloud computing infrastructure, business intelligence real-time data analytics, and high performance computing.  In February 2012 and May 2012, we achieved memory qualification of HyperCloud™ at IBM and HP, respectively.

 

In November 2011, we introduced the world’s first 32GB two-virtual rank RDIMM integrating HyperCloud™ with our proprietary Planar-X technology.  The new memory modules enable up to 768GB of DRAM memory in next generation two-processor servers.  Additionally, we announced collaborative agreements with each of Hewlett-Packard Company (“HP”) and International Business Machines (“IBM”), pursuant to which these OEMs have agreed to cooperate with us in efforts to qualify HyperCloud™ memory products for use with their respective products.  HP and IBM have agreed to engage with us in joint marketing and further product development efforts.  We and each of the OEMs have committed financial and other resources toward the collaboration.  However, the efforts undertaken under either of the collaborative agreements may not result in any new revenues for us.

 

NVvault T M

 

In February 2010, we announced general availability of NVvault TM   battery-free, a non-volatile cache memory subsystem targeting RAID storage applications.  NVvault TM  battery-free provides server and storage OEMs a solution for enhanced datacenter fault recovery. Unlike our traditional battery-powered fault tolerant cache product which relied solely on batteries to power the cache, NVvault TM  battery-free utilizes a combination of DRAM for high throughput performance and flash for extended data retention.  The introduction of NVvault TM  battery-free, as well as the launch of the current version of the battery-powered module in connection with Dell introduction of the PERC 7 line of servers in December 2009, has resulted in RAID controller subsystem revenues of $10.8 million, or 77.5% of total revenues for the three months ended March 31, 2012.  We expect a decline in NVvault™ sales to Dell through 2013 following Intel’s launch of its Romley platform in the first quarter of 2012.  This reduction in sales could have a significant impact on our revenues and gross profit as soon as the second quarter of 2012.  In order to leverage our NVvault™ technology into a more diverse customer base, we continue to pursue additional qualifications of NVvault™ with other customers. We also introduced EXPRESSvault™in March 2011, and we are in the process of qualifying next generation DDR3NVvault™ with customers.  While, nearly 100% of 2010 sales were made to Dell, as a result of our diversification efforts, approximately 5% or revenues for each of the three month periods ended March 31, 2012 and April 2, 2011 were to other customers.

 

Specialty Memory Modules and Flash-Based Products

 

The remainder of our revenues arose primarily from OEM sales of specialty memory modules and flash-based products, the majority of which were utilized in data center and industrial applications.  When developing custom modules for an equipment product launch, we engage with our OEM

 

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customers from the earliest stages of new product definition, providing 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 speed, capacity and signal integrity, small form factor, attractive thermal characteristics and low cost per bit.  Revenues from our specialty modules and flash-based products are subject to fluctuation as a result of the life cycles of the products into which our modules are incorporated.  Our ability to continue to produce revenues from specialty memory modules and flash-based products is dependent on our ability to qualify our products on new platforms as current platforms reach the end of their lifecycles, and on the state of the global economy.

 

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. One customer represented approximately 85% and 70% of our net sales for the three months ended March 31, 2012 and April 2, 2011, respectively.

 

Key Business Metrics

 

The following describes certain line items in our condensed consolidated 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 and NAND. 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 and NAND to distributors and other users of memory ICs. As compared to previous years, component inventory sales remain a relatively small percentage of net sales as a result of our efforts to diversify both our customer and product line bases. This diversification effort has also allowed us to use components in a wider range of memory subsystems. We expect that component inventory sales will continue to represent a minimal portion of our net sales in future periods.

 

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 and NAND 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 and NAND. We attempt to pass through such DRAM IC and NAND flash memory cost fluctuations to our customers by frequently renegotiating pricing prior to the placement of their purchase orders. However, the sales prices of our memory subsystems can also fluctuate due to competitive situations unrelated to the pricing of DRAM ICs and NAND, which affects gross margins. The gross margin on our sales of excess component DRAM IC and NAND inventory is much lower than the gross margin on our sales of our memory subsystems. As a result, fluctuations in DRAM IC and NAND inventory sales as a percentage of our overall sales could impact our overall gross margin. We assess the valuation of our inventories on a quarterly basis and record a provision to cost of sales as necessary to reduce inventories to the lower of cost or net realizable value.

 

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Research and Development.   Research and development expense consists primarily of employee and independent contractor compensation and related costs, stock-based compensation, non-recurring engineering fees, computer-aided design software licenses, reference design development costs, patent filing and protection legal 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. We anticipate that research and development expenditures will increase in future periods as we seek to expand new product opportunities, increase our activities related to new and emerging markets and continue to develop additional proprietary technologies.

 

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 effort is directed at building relationships with OEMs and other customers 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 establish new customers, we anticipate that our sales and marketing expenses will increase.

 

Critical Accounting Policies

 

The preparation of our condensed consolidated financial statements in conformity with accounting principles generally accepted in the U.S. 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 condensed 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 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 our more significant assumptions and estimates used in the preparation of our condensed consolidated financial statements:

 

Revenue Recognition.   We recognize revenues in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 605. Accordingly, we recognize revenues when there is persuasive evidence that an arrangement exists, 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 component inventories, which contain no right-of-return privileges.

 

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Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. We offer a standard product warranty to our customers and have no other post-shipment obligations. 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.

 

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.

 

Fair Value of Financial Instruments.   Our financial instruments consist principally of cash and cash equivalents, investments in marketable securities, accounts receivable, accounts payable, accrued expenses and debt instruments.  Other than for certain investments in auction rate securities, the fair value of our cash equivalents and investments in marketable securities is determined based on quoted prices in active markets for identical assets or Level 1 inputs.  The fair value of our auction rate securities is determined based on Level 3 inputs. We recognize transfers between Levels 1 through 3 of the fair value hierarchy at the beginning of the reporting period.  We believe that the carrying values of all other financial instruments approximate their current fair values due to their nature and respective durations.

 

Allowance for Doubtful Accounts.   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 evaluate the collectibility of accounts receivable based on a combination of factors. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet its financial obligations subsequent to the original sale, we will record an allowance against amounts due, and thereby reduce the net recognized receivable to the amount that we reasonably believe will be collected. For all other customers, we record allowances for doubtful accounts based primarily on the length of time the receivables are past due based on the terms of the originating transaction, the current business environment and our historical experience. Uncollectible accounts are charged against the allowance for doubtful accounts when all cost effective commercial means of collection have been exhausted.  Generally, our 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 collectability 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. At each balance sheet date, we evaluate ending inventory quantities on hand and record a provision for excess quantities and obsolescence. Among other factors, we consider 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. In addition, we consider changes in the market value of DRAM ICs and NAND in determining the net realizable value of our raw material inventory. Once established, any write downs are considered permanent adjustments to the cost basis of our excess or obsolete inventories.

 

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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 or NAND decrease significantly, we may be required to lower our selling prices to reflect the lower current cost of our raw materials. If such price decreases reduce the net 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 or NAND could have a material effect on the value of our inventories and our reported operating results.

 

Impairment of Long-Lived Assets.   We evaluate the recoverability of the carrying value of long-lived assets held and used in our operations for impairment on at least an annual basis or whenever events or changes in circumstances indicate that their carrying value may not be recoverable. When such factors and circumstances exist, we compare the projected undiscounted future net cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. 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 value of the asset. The fair value of the asset or asset group is based on market value when available, or when unavailable, on discounted expected cash flows.

 

Warranty Reserve.   We offer product warranties 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 the warranty period at no cost to the customer. Warranties are not offered on sales of excess inventory. 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 consistent between periods and within our expectations and the provisions established, unexpected changes in failure rates could have a material adverse impact on us, requiring additional warranty reserves, and adversely affecting our gross profit and gross margins.

 

Stock-Based Compensation.   We account for equity issuances to non-employees in accordance with ASC Topic 505.  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.

 

In accordance with ASC Topic 718, employee and director stock-based compensation expense recognized during the period is based on the value of the portion of stock-based payment awards that is ultimately expected to vest during the period.  Given that stock-based compensation expense recognized in the condensed consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. ASC Topic 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Our estimated average forfeiture rates are based on historical forfeiture experience and estimated future forfeitures.

 

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The fair value of common stock option 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, all of which affect the estimated fair values of our common stock option awards. The expected term of options granted is calculated as the average of the weighted vesting period and the contractual expiration date of the option.  This calculation is based on the safe harbor method permitted by the SEC in instances where the vesting and exercise terms of options granted meet certain conditions and where limited historical exercise data is available.  The expected volatility is based on the historical volatility of our common stock.  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 our expectations regarding dividend payouts. We evaluate the assumptions used to value our common stock option 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 prior periods.  Compensation expense for common stock option awards with graded vesting schedules is recognized on a straight-line basis over the requisite service period for the last separately vesting portion of the award, provided that the accumulated cost recognized as of any date at least equals the value of the vested portion of the award.

 

We recognize the fair value of restricted stock awards issued to employees and outside directors as stock-based compensation expense on a straight-line basis over the vesting period for the last separately vesting portion of the awards.  Fair value is determined as the difference between the closing price of our common stock on the grant date and the purchase price of the restricted stock award, if any, reduced by expected forfeitures.

 

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

 

Income Taxes.   Deferred tax assets and liabilities are recognized to reflect the estimated future tax effects of future deductible or taxable amounts attributable to events that have been recognized on a cumulative basis in the condensed consolidated financial statements, calculated at enacted tax rates for expected periods of realization. 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. Because we have operated at a loss for an extended period of time, we did not recognize deferred tax assets related to losses incurred in 2012 or 2011.  In the future, if we realize a deferred tax asset that currently carries a valuation allowance, we may record an income tax benefit or a reduction to income tax expense in the period of such realization.

 

ASC Topic 740 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 and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under ASC Topic 740 we may only recognize or continue to recognize tax positions that meet a “more likely than not” threshold.

 

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

 

Results of Operations

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Net sales

 

100

%

100

%

Cost of sales

 

61

 

68

 

Gross profit

 

39

 

32

 

Operating expenses:

 

 

 

 

 

Research and development

 

27

 

31

 

Selling, general and administrative

 

19

 

24

 

Total operating expenses

 

46

 

55

 

Operating loss

 

(7

)

(23

)

Other (expense) income:

 

 

 

 

 

Interest expense, net

 

(1

)

(1

)

Other income, net

 

 

 

Total other expense, net

 

(1

)

(1

)

Loss before provision for income taxes

 

(8

)

(24

)

Provision for income taxes

 

 

 

Net loss

 

(8

)%

(24

)%

 

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Three Months Ended March 31, 2012 Compared to Three Months Ended April 2, 2011

 

Net Sales, Cost of Sales and Gross Profit

 

The following table presents net sales, cost of sales and gross profit for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages):

 

 

 

Three Months Ended

 

 

 

 

 

 

 

March 31,

 

April 2,

 

 

 

%

 

 

 

2012

 

2011

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

13,967

 

$

12,000

 

$

1,967

 

16

%

Cost of sales

 

8,531

 

8,196

 

335

 

4

%

Gross profit

 

$

5,436

 

$

3,804

 

$

1,632

 

43

%

Gross margin

 

39

%

32

%

7

%

 

 

 

Net Sales.   The increase in net sales for the three months ended March 31, 2012 as compared with the three months ended April 2, 2011 resulted primarily from increases of approximately (i) $3.2 million in sales of NVvault™ non-volatile cache systems used in RAID controller subsystems, including $1.6  million from NVvault™ battery-free, the flash-based cache system that became generally available in 2010, (ii) $0.4 million in sales of HyperCloud™ memory modules and (iii) $0.3 million in sales of VLP RDIMM products, resulting from existing and new customer qualifications, offset by a decrease of $1.9 million of specialty memory module sales primarily used in industrial applications as one customer slowed production as a result of its product nearing the end of its life.

 

Gross Profit and Gross Margin.  The overall improvements in gross profit are due to increased sales and manufacturing volume, as well as a shift in sales toward higher margin products.  Gross profit for the three months ended March 31, 2012 as compared to the three months ended April 2, 2011 increased due to the 16% increase in net sales between the two periods, resulting in an improved ability to absorb fixed manufacturing costs.  These volume-based improvements were augmented by decreased DRAM prices, which positively affected margins in some product categories. As noted previously, the expected decline in Dell NVvault™ sales could have a significant impact on our revenue and gross profit as early as the second quarter of 2012.

 

Research and Development .

 

The following table presents research and development expenses for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages):

 

 

 

Three Months Ended

 

 

 

 

 

 

 

March

 

 

 

 

 

 

 

 

 

31,

 

April 2,

 

 

 

%

 

 

 

2012

 

2011

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

$

3,842

 

$

3,684

 

$

158

 

4

%

 

The increase in research and development expense in the three months ended March 31, 2012 as compared to the three months ended April 2, 2011  resulted primarily from increases of (i) $0.3 million in internal engineering headcount costs, as the we invested in further development of our HyperCloud™ products and (ii) $0.3 million in material expenses related to product builds and testing, primarily related to our HyperCloud™ products, partially offset by decreases of (i) $0.3 million in non-recurring engineering charges for supply partners engaged in new product development activities (ii) $0.1 million in professional and outside services.

 

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Selling, General and Administrative .

 

The following table presents selling, general and administrative expenses for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages):

 

 

 

Three Months Ended

 

 

 

 

 

 

 

March

 

 

 

 

 

 

 

 

 

31,

 

April 2,

 

 

 

%

 

 

 

2012

 

2011

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

$

2,609

 

$

2,917

 

$

(308

)

(11

)%

 

Selling, general and administrative expense decreased by $0.3 million for the three months ended March 31, 2012 as compared to the three months ended April 2, 2011, as we improved operating efficiency.

 

Other (Expense) Income.

 

The following table presents other (expense) income for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages):

 

 

 

Three Months Ended

 

 

 

 

 

 

 

March

 

 

 

 

 

 

 

 

 

31,

 

April 2,

 

 

 

%

 

 

 

2012

 

2011

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

Interest expense, net

 

$

(71

)

$

(25

)

$

(46

)

184

%

Other income, net

 

5

 

 

5

 

%

Total other expense, net

 

$

(66

)

$

(25

)

$

(41

)

164

%

 

The increase in interest expense for the three months ended March 31, 2012 compared with the three months ended April 2, 2011 was the result of the term loan that originated in May 2011.

 

Other income, net, for the three months ended March 31, 2012 was insignificant.

 

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Provision for Income Taxes .

 

The following table presents the provision for income taxes for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages):

 

 

 

Three Months Ended

 

 

 

 

 

 

 

March
31,

 

April 2,

 

 

 

%

 

 

 

2012

 

2011

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

$

 

$

 

$

 

%

 

We did not record a benefit of income taxes for the three months ended March 31, 2012 and April 2, 2011, as tax benefits resulting from operating losses generated were fully reserved.

 

Liquidity and Capital Resources

 

We have historically financed our operations primarily through issuances of equity and debt securities and cash generated from operations.  We have also funded our operations with a revolving line of credit and term loans under our bank credit facility, capitalized lease obligations and from the sale and leaseback of our former domestic manufacturing facility.

 

Working Capital and Cash and Marketable Securities

 

The following table presents working capital, cash and cash equivalents and investments in marketable securities (in thousands):

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

Working Capital

 

$

22,231

 

$

17,775

 

 

 

 

 

 

 

Cash and cash equivalents(1)

 

$

13,874

 

$

10,535

 

Long-term marketable securities

 

451

 

444

 

 

 

$

14,325

 

$

10,979

 

 


(1) Included in working capital

 

Our working capital increased in the three months ended March 31, 2012 primarily as a result of $3.6 million in funds raised through sales of our common stock through our sales agreement with Ascendiant, and the renegotiated payment structure of our term loans, which resulted in a $1.3 million reduction in the current portion of long-term debt. Both of these transactions are described under Capital Resources below.

 

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Cash Provided by and Used in the Three Months Ended March 31, 2012 and April 2, 2011

 

The following table summarizes our cash flows for the periods indicated (in thousands):

 

 

 

Three Months Ended

 

 

 

March 31,

 

April 2,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Net cash provided by (used in):

 

 

 

 

 

Operating activities

 

$

208

 

$

(3,295

)

Investing activities

 

(317

)

715

 

Financing activities

 

3,448

 

(269

)

Net increase (decrease) in cash and cash equivalents

 

$

3,339

 

$

(2,849

)

 

Operating Activities.   Net cash provided by operating activities for the three months ended March 31, 2012 was primarily the result of cash provided by changes in operating assets and liabilities of approximately $0.2 million.  Net losses of $1.1 million were offset by $1.1 million in non-cash operating expense, primarily comprised of depreciation and amortization and stock-based compensation, resulting in a neutral effect on our cash position.  Net cash used in operating activities for the three months ended April 2, 2011 was primarily a result of (i) net loss of approximately $2.8 million and (ii) cash used by changes in operating assets and liabilities of approximately $1.4 million, partially offset by approximately $0.9 million in net non-cash operating expenses, primarily comprising depreciation and amortization and stock-based compensation.

 

Accounts receivable decreased approximately $1.1 million during the three months ended March 31, 2012 primarily as a result of the decrease in our net sales during the period compared with the fourth quarter of 2011. We continue to be successful in collecting cash from sales to our customers substantially in accordance with our standard payment terms with those customers.  Inventories increased approximately $1.6 million during the three months ended March 31, 2012 as we continued the qualification process and prepared for production of our HyperCloud™ and high-density VLP products.  During the three months ended March 31, 2012 and April 2, 2011, we were able to partially fund the growth in our current assets through an increase in accounts payable of $1.1 million and $2.1 million, respectively, primarily from component vendors.

 

Investing Activities. Net cash used in investing activities for the three months ended March 31, 2012 was the result of the acquisition of $0.3 million in property and equipment. Net cash provided by investing activities for the three months ended April 2, 2011 was primarily the result of sales of marketable securities of $0.8 million, offset by the acquisition of $0.1 million in property and equipment.

 

Financing Activities. Net cash provided by financing activities for the three months ended March 31, 2012 was primarily the result of net proceeds of $3.6 million from the sale of 1,036,830 shares of our common stock through our sales agreement with Ascendiant, described below under the caption Capital Resources , and $0.5 million in proceeds from the exercise of equity awards under our stock option plan, offset by repayment of bank debt, capital leases and other notes payable of $0.6 million.  Net cash used in financing activities for the three months ended April 2, 2011 was a result of repayment of bank debt, capital leases and other notes payable of $0.3 million.

 

Capital Resources

 

On October 31, 2009, we entered into a credit agreement with Silicon Valley Bank, which was amended on March 24, 2010, June 30, 2010, September 30, 2010, May 11, 2011, August 10, 2011 and May 14, 2012.  Currently, the credit agreement provides for a line of credit pursuant to which we can borrow up to the lesser of (i) 80% of eligible accounts receivable, or (ii) $10.0 million.  We have the option to increase credit availability to $15.0 million at any time through the maturity date of September 30, 2014, subject to the conditions of the credit agreement.

 

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Prior to the May 14, 2012 amendment the credit agreement contained an overall sublimit of $10.0 million to collateralize our contingent obligations under letters of credit and other finanicial services.  Amounts outstanding under the overall sublimit reduce the amount available under the line. At March 31, 2012, letters of credit in the amount of $3.0 million were outstanding.  The letters of credit expire on October 31, 2012. As a result of the May 14, 2012 amendment, letters of credit and other financial services are no longer subject to borrowing base sublimits, and do not reduce the amount available under the line of credit. Rather, the Company has an additional credit facility for up to $3.0 million in letters of credit through September 30, 2014.

 

Interest on the line of credit is payable monthly at either (i) prime plus 1.25%, as long as we maintain $8.5 million in revolving credit availability plus unrestricted cash on deposit with the bank, or (ii) prime plus 2.25%.  Additionally, the credit agreement requires payment of an unused line, as well as anniversary and early termination fees, as applicable.

 

The following table presents details of outstanding borrowings and availability under our line of credit as adjusted for the May 14, 2012 amendment described above (in thousands):

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

Availability under the revolving line of credit

 

$

7,224

 

$

7,797

 

Outstanding borrowings on the revolving line of credit

 

 

 

Amounts reserved under credit sublimits

 

 

(2,022

)

Unutilized borrowing availability under the revolving line of credit

 

$

7,224

 

$

5,775

 

 

We made no borrowings under the Silicon Valley Bank line of credit in the three months ended March 31, 2012.  Outstanding borrowings under the line of credit did not exceed $0.5 million at any time during the year ended December 31, 2011.

 

In connection with the September 30, 2010 amendment, Silicon Valley Bank extended a $1.5 million term loan under the credit agreement, bearing interest at a rate of prime plus 2.00%.  We were required to make equal monthly principal payments over the 36 month term, which totaled $0.5 million annually.  In May 2011, Silicon Valley Bank extended an additional $3.0 million term loan, bearing interest at a rate of prime plus 2.75%.  We were required to make equal monthly principal payments over the 24 month term of the loan, totaling $1.5 million annually.  As of March 31, 2012, $2.5 million was outstanding under the term loans. In May 2012, Silicon Valley Bank consolidated the term loans and extended additional credit, resulting in a combined term loan balance of $3.5 million.  We will be required to make equal monthly principal payments over a 36 month period, beginning in December 2012, and monthly interest payments from the date of the funding through the final payoff of the loan.  The consolidated loan bears interest at a rate of prime plus 2.50%.

 

All obligations under the credit agreement are secured by a first priority lien on our tangible and intangible assets.  The only restriction on the use of funds under the revolving line of credit is that we must be in compliance with the covenants of the credit agreement.  The credit agreement includes affirmative and negative covenants, including financial covenants with respect to our liquidity and tangible net worth.  As of March 31, 2012, we were in compliance with all financial covenants and expect to maintain compliance for the foreseeable future.  However, we have in the past been in violation of one or more covenants of other credit agreements, and we could violate one or more covenants in the future. If we were to be in violation of covenants under our credit agreement, our lender

 

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could choose to accelerate payment on all outstanding loan balances and we could lose vendor credit should the letters of credit issued under the credit agreement become unavailable. If that were to occur, we may be unable to quickly obtain equivalent or suitable replacement financing. If we were not able to secure alternative sources of funding, such acceleration would have a material adverse impact on our financial condition.

 

On November 21, 2011, we entered into a sales agreement with Ascendiant as sales agent. In accordance with the terms of the sales agreement, we may issue and sell shares of our common stock having an aggregate offering price of up to $10.0 million. Sales of shares of our common stock may be made in a series of transactions from time to time as we may direct Ascendiant in sales deemed to be an “at the market” offering as defined in Rule 415 under the Securities Act of 1933.  Such sales are made pursuant to our effective $40 million shelf registration statement filed with the SEC in September 2011.  Since November 2011, we have received net proceeds of approximately $5.5 million, including approximately $3.6 million raised through the sale of approximately 1,036,830 shares in the three months ended March 31, 2012.  We may terminate the sales agreement with Ascendiant at any time.  In the event of such termination, we would expect to make available any remaining unsold portion of the $10.0 million in aggregate offering price for other sources of financing that are permitted under the effective shelf registration statement.  The sales agreement with Ascendiant does not preclude us from pursuing other sources of financing.

 

We have in the past utilized equipment leasing arrangements to finance certain capital expenditures.  Equipment leases continue to be a financing alternative that we expect to pursue in the future.

 

We believe our existing cash balances, borrowing availability under our bank credit facility, proceeds available under the sales agreement with Ascendiant and the cash expected to be generated from operations, will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our levels of net sales, the timing and extent of expenditures to support research and development activities, the expansion of manufacturing capacity both domestically and internationally and the continued market acceptance of our products. We could be required, or may choose, to seek additional funding through public or private equity or debt financings. In addition, in connection with any future acquisitions, we may require additional funding which may be provided in the form of additional debt or equity financing or a combination thereof. These additional funds may not be available on terms acceptable to us, or at all.

 

New Accounting Pronouncements

 

In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-4, Fair Value Measurement (“ASU 11-4”).  ASU 11-4 amends existing guidance to achieve convergence in measurement and disclosure between U.S. Generally Accepted Accounting Standards (“GAAP”) and International Financial Reporting Standards (“IFRS”).  ASU 11-4 is effective for fiscal year 2012.  The adoption of ASU 11-4 did not impact the Company’s results of operations or its financial position.

 

In June 2011, the FASB issued ASU No. 2011-5, Comprehensive Income (“ASU 11-5”).  ASU 11-5 amends existing guidance to increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS.  ASU 11-5 is effective for fiscal year 2012.  The adoption of ASU 11-5 did not impact the Company’s results of operations or its financial position.

 

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Off-Balance Sheet Arrangements

 

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

 

Item 4.                        Controls and Procedures

 

(a) Evaluation of Disclosure Controls and Procedures. We carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, (“Exchange Act”)) as of the end of our fiscal quarter ended March 31, 2012.  Based upon that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) is accumulated and communicated to our management, including our principal executive officer and principal financial officer as appropriate to allow timely decisions regarding required disclosure.

 

(b) Change in internal controls over financial reporting. During the fiscal quarter that ended March 31, 2012, there were no changes in our internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1.                         Legal Proceedings

 

The information set forth in the sections entitled Litigation and Patent Rexaminations under Note 9 of Notes to Unaudited Condensed Consolidated Financial Statements, included in Part I, Item I of this Report, is incorporated herein by reference.

 

Item 1A.                Risk Factors

 

You should consider each of the following factors as well as the other information in this Report in evaluating our business and our prospects.  The risks described below are not the only ones we face. Additional risks we are not presently aware of or that we currently believe are immaterial may also impair our business operations. The trading price of our common stock could decline due to any of these risks, and you could lose all or part of your investment. In assessing these risks, you should also refer to the other information contained or incorporated by reference in this Report, including our consolidated financial statements and related notes.

 

Risks related to our business

 

We expect a number of factors to cause our operating results to fluctuate on a quarterly and annual basis, which may make it difficult to predict our future performance.

 

Our operating results have varied significantly in the past and will continue to fluctuate from quarter-to-quarter or year-to-year in the future due to a variety of factors, many of which are beyond our control. Factors relating to our business that may contribute to these quarterly and annual fluctuations include the following factors, as well as other factors described elsewhere in this Report:

 

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·                   general economic conditions, including the possibility of a prolonged period of limited economic growth in the U.S. and Europe; disruptions to the credit and financial markets in the U.S., Europe and elsewhere;

 

·                   our inability to develop new or enhanced products that achieve customer or market acceptance in a timely manner, including our HyperCloud™ memory module and our flash-based memory products;

 

·                   our failure to maintain the qualification of our products with our current customers or to qualify current and future products with our current or prospective customers in a timely manner or at all;

 

·                   the timing of actual or anticipated introductions of competing products or technologies by us or our competitors, customers or suppliers;

 

·       the loss of, or a significant reduction in sales to, a key customer;

 

·                   the cyclical nature of the industry in which we operate;

 

·                   a reduction in the demand for our high performance memory subsystems or the systems into which they are incorporated;

 

·                   our customers’ failure to pay us on a timely basis;

 

·                   costs, inefficiencies and supply risks associated with outsourcing portions of the design and the manufacture of integrated circuits;

 

·                   our ability to absorb manufacturing overhead if our revenues decline or vary from our projections;

 

·                   delays in fulfilling orders for our products or a failure to fulfill orders;

 

·                   our ability to procure an adequate supply of key components, particularly DRAM ICs and NAND;

 

·                   dependence on large suppliers who are also competitors and whose manufacturing priorities may not support our production schedules;

 

·                   changes in the prices of our products or in the cost of the materials that we use to build our products, including fluctuations in the market price of DRAM ICs and NAND;

 

·                   our ability to effectively operate our manufacturing facility in the PRC;

 

·                   manufacturing inefficiencies associated with the start-up of new manufacturing operations, new products and initiation of volume production;

 

·                   our failure to produce products that meet the quality requirements of our customers;

 

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·                   disputes regarding intellectual property rights and the possibility of our patents being reexamined by the USPTO;

 

·                   the costs and management attention diversion associated with litigation;

 

·                   the loss of any of our key personnel;

 

·                   changes in regulatory policies or accounting principles;

 

·                   our ability to adequately manage or finance internal growth or growth through acquisitions;

 

·                   the effect of our investments and financing arrangements on our liquidity; and

 

·                   the other factors described in this “Risk Factors” section and elsewhere in this report.

 

Due to the various factors mentioned above, and others, the results of any prior quarterly or annual periods should not be relied upon as an indication of our future operating performance. In one or more future periods, our results of operations may fall below the expectations of securities analysts and investors. In that event, the market price of our common stock would likely decline. In addition, the market price of our common stock may fluctuate or decline regardless of our operating performance.

 

We have historically incurred losses and may continue to incur losses.

 

Since the inception of our business in 2000, we have only experienced one fiscal year (2006) with profitable results. In order to regain profitability, or to achieve and sustain positive cash flows from operations in the future, we must further reduce operating expenses and/or increase our revenues. Although we have in the past engaged in a series of cost reduction actions, and believe that we could reduce our current level of expenses through elimination or reduction of strategic initiatives, such expense reductions alone may not make us profitable or allow us to sustain profitability if it is achieved. Our ability to achieve profitability will depend on increased revenue growth from, among other things, increased demand for our memory subsystems and related product offerings, as well as our ability to expand into new and emerging markets. We may not be successful in achieving the necessary revenue growth or the expected expense reductions. Moreover, we may be unable to sustain past or expected future expense reductions in subsequent periods. We may not achieve profitability or sustain such profitability, if achieved, on a quarterly or annual basis in the future.

 

Any failure to achieve profitability could result in increased capital requirements and pressure on our liquidity position. We believe our future capital requirements will depend on many factors, including our levels of net sales, the timing and extent of expenditures to support sales, marketing, research and development activities, the expansion of manufacturing capacity both domestically and internationally and the continued market acceptance of our products. Our capital requirements could result in our having to, or otherwise choosing to, seek additional funding through public or private equity offerings or debt financings.  Such funding may not be available on terms acceptable to us, or at all, either of which could result in our inability to meet certain of our financial obligations and other related commitments.

 

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Our revenues and results of operations are substantially dependent on NVvault™.

 

For the three months ended March 31, 2012 our NVvault™ non-volatile RDIMM used in cache —protection and data logging applications, including our NVvault™ battery-free, the flash-based cache system, accounted for 74% of total revenues.  W e expect a decline of Dell NVvault ™ sales through 2013 following Intel’s launch of its Romley platform in the first quarter of 2012.  Although we cannot predict the rate of decline in our sales to Dell, it is possible that we will experience a rapid decline in sales as early as the second quarter of 2012. This reduction in sales could have a significant impact on our revenues and gross profit.  In order to leverage our NVvault™ technology and diversify our customer base, we continue to pursue additional qualifications of NVvault™ with other OEMs.  We also introduced EXPRESSvault™ in March 2011 and we are in the process of qualifying next generation DDR3 NVvault™ with customers.  Our future operating results will depend on our ability to commercialize these NVvault™ product extensions, as well as other new products such as HyperCloud™.  We may not be successful in marketing any new or enhanced products.  If we are not successful in generating sales of other products, t he expected reduction in sales of NVvault™ products to Dell will significantly reduce our revenues and negatively affect our results of operations.

 

We are subject to risks relating to our focus on developing our HyperCloud™ product and lack of market diversification.

 

We have historically derived a substantial portion of our net sales from sales of our high performance memory subsystems for use in the server market. We expect these memory subsystems to continue to account for a significant portion of our net sales in the near term. Continued market acceptance of these products for use in servers is critical to our success.

 

In an attempt to set our products apart from those of our competitors, we have invested a significant portion of our research and development budget into the design of ASIC devices, including the HyperCloud™ memory subsystem, introduced in November 2009. This design and the products it is incorporated into are subject to increased risks as compared to our other products. For example:

 

·                   we may be unable to achieve customer or market acceptance of the HyperCloud™ memory subsystem or other new products, or achieve such acceptance in a timely manner;

 

·                   the HyperCloud™ memory subsystem or other new products may contain currently undiscovered flaws, the correction of which would result in increased costs and time to market;

 

·                   we are dependent on a limited number of suppliers for both the DRAM ICs and the ASIC devices that are essential to the functionality of the HyperCloud™ memory subsystem, and could experience supply chain disruption as a result of business issues that are specific to our suppliers or the industry as a whole; and

 

·                   we are required to demonstrate the quality and reliability of the HyperCloud™ memory subsystem or other new products to our customers, and are required to qualify these new products with our customers, both of which have required and will continue to require a significant investment of time and resources prior to the receipt of any revenue from such customers.

 

We have experienced a longer qualification cycle than anticipated with our HyperCloud™ memory subsystems, and as of March 31, 2012 we have not generated significant HyperCloud™ product revenues relative to our investment in the product.  We have entered into collaborative agreements with both HP and IBM pursuant to which these OEMs have agreed to cooperate with us in efforts to qualify HyperCloud™ for use with their products.  Qualification has been completed and

 

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Hypercloud has been available to order since March 6, 2012 from IBM and as of May 14, 2012 from HP.  We are working with both OEMs in joint marketing and further product development efforts.  The Company and each of the OEMs have committed financial and other resources toward the collaboration.  However, the efforts undertaken pursuant to either of the collaborative agreements may not result in any new revenues for the Company.  Failure to maintain qualification of this product with HP, IBM or other potential customers could adversely impact our results of operations.

 

Additionally, if the demand for servers deteriorates or if the demand for our products to be incorporated in servers declines, our operating results would be adversely affected, and we would be forced to diversify our product portfolio and our target markets. We may not be able to achieve this diversification, and our inability to do so may adversely affect our business.

 

We may lose our competitive position if we are unable to timely and cost-effectively develop new or enhanced products that meet our customers’ requirements and achieve market acceptance.

 

Our industry is characterized by intense competition, rapid technological change, evolving industry standards and rapid product obsolescence. Evolving industry standards and technological change or new, competitive technologies could render our existing products obsolete. Accordingly, our ability to compete in the future will depend in large part on our ability to identify and develop new or enhanced products on a timely and cost-effective basis, and to respond to changing customer requirements. In order to develop and introduce new or enhanced products, we need to:

 

·                   identify and adjust to the changing requirements of our current and potential customers;

 

·                   identify and adapt to emerging technological trends and evolving industry standards in our markets;

 

·                   design and introduce cost-effective, innovative and performance-enhancing features that differentiate our products from those of our competitors;

 

·                   develop relationships with potential suppliers of components required for these new or enhanced products;

 

·                   qualify these products for use in our customers’ products; and

 

·                   develop and maintain effective marketing strategies.

 

Our product development efforts are costly and inherently risky. It is difficult to foresee changes or developments in technology or anticipate the adoption of new standards. Moreover, once these things are identified, if at all, we will need to hire the appropriate technical personnel or retain third party designers, develop the product, identify and eliminate design flaws, and manufacture the product in production quantities either in-house or through third-party manufacturers. As a result, we may not be able to successfully develop new or enhanced products or we may experience delays in the development and introduction of new or enhanced products. Delays in product development and introduction could result in the loss of, or delays in generating, net sales and the loss of market share, as well as damage to our reputation. Even if we develop new or enhanced products, they may not meet our customers’ requirements or gain market acceptance.

 

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Our customers require that our products undergo a lengthy and expensive qualification process without any assurance of net sales.

 

Our prospective customers generally make a significant commitment of resources to test and evaluate our memory subsystems prior to purchasing our products and integrating them into their systems. This extensive qualification process involves rigorous reliability testing and evaluation of our products, which may continue for six months or longer and is often subject to delays. In addition to qualification of specific products, some of our customers may also require us to undergo a technology qualification if our product designs incorporate innovative technologies that the customer has not previously encountered. Such technology qualifications often take substantially longer than product qualifications and can take over a year to complete. Qualification by a prospective customer does not ensure any sales to that prospective customer. Even after successful qualification and sales of our products to a customer, changes in our products, our manufacturing facilities, our production processes or our component suppliers may require a new qualification process, which may result in additional delays.

 

In addition, because the qualification process is both product-specific and platform-specific, our existing customers sometimes require us to requalify our products, or to qualify our new products, for use in new platforms or applications. For example, as our OEM customers transition from prior generation DDR2 DRAM architectures to current generation DDR3 DRAM architectures, we must design and qualify new products for use by those customers. In the past, the process of design and qualification has taken up to six months to complete, during which time our net sales to those customers declined significantly. After our products are qualified, it can take several months before the customer begins production and we begin to generate net sales from such customer.

 

Likewise, when our memory component vendors discontinue production of components, it may be necessary for us to design and qualify new products for our customers.  Such customers may require of us or we may decide to purchase an estimated quantity of discontinued memory components necessary to ensure a steady supply of existing products until products with new components can be qualified.  Purchases of this nature may affect our liquidity.  Additionally, our estimation of quantities required during the transition may be incorrect, which could adversely impact our results of operations through lost revenue opportunities or charges related to excess and obsolete inventory.

 

We must devote substantial resources, including design, engineering, sales, marketing and management efforts, to qualify our products with prospective customers in anticipation of sales. Significant delays in the qualification process, such as those experienced with our HyperCloud™ product, could result in an inability to keep up with rapid technology change or new, competitive technologies.  If we delay or do not succeed in qualifying a product with an existing or prospective customer, we will not be able to sell that product to that customer, which may result in our holding excess and obsolete inventory and harm our operating results and business.

 

Sales to a limited number of customers represent a significant portion of our net sales and the loss of, or a significant reduction in sales to, any one of these customers could materially harm our business.

 

Sales to certain of our OEM customers have historically represented a substantial majority of our net sales.  Approximately 85% and 70% of our net sales in the three months ended March 31, 2012 and April 2, 2011, respectively were to one of our customers. We currently expect that sales to major OEM customers will continue to represent a significant percentage of our net sales for the foreseeable future. We do not have long-term agreements with our OEM customers, or with any other customer. Any one of

 

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these customers could decide at any time to discontinue, decrease or delay their purchase of our products. In addition, the prices that these customers pay for our products could change at any time. The loss of any of our OEM customers, or a significant reduction in sales to any of them, could significantly reduce our net sales and adversely affect our operating results.

 

Our ability to maintain or increase our net sales to our key customers depends on a variety of factors, many of which are beyond our control. These factors include our customers’ continued sales of servers and other computing systems that incorporate our memory subsystems and our customers’ continued incorporation of our products into their systems.  Because of these and other factors, net sales to these customers may not continue and the amount of such net sales may not reach or exceed historical levels in any future period. Because these customers account for a substantial portion of our net sales, the failure of any one of these customers to pay on a timely basis would negatively impact our cash flow. In addition, while we may not be contractually obligated to accept returned products, we may determine that it is in our best interest to accept returns in order to maintain good relations with our customers.

 

A limited number of relatively large potential customers dominate the markets for our products.

 

Our target markets are characterized by a limited number of large companies. Consolidation in one or more of our target markets may further increase this industry concentration. As a result, we anticipate that sales of our products will continue to be concentrated among a limited number of large customers in the foreseeable future. We believe that our financial results will depend in significant part on our success in establishing and maintaining relationships with, and effecting substantial sales to, these potential customers. Even if we establish these relationships, our financial results will be largely dependent on these customers’ sales and business results.

 

If a standardized memory solution which addresses the demands of our customers is developed, our net s