The following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions that are difficult to predict. Words and expressions reflecting optimism, satisfaction or disappointment with current prospects, as well as words such as “believes,” “hopes,” “intends,” “estimates,” “expects,” “projects,” “plans,” “anticipates” and variations thereof, or the use of future tense, identify forward-looking statements, but their absence does not mean that a statement is not forward-looking. Such forward-looking statements are not guarantees of performance and our actual results could differ materially from those contained in such statements. In evaluating such statements we urge you to specifically consider various factors identified in this report, including the matters set forth under the heading “Risk Factors” in Part I, Item 1A of this report, any of which could cause actual results to differ materially from those indicated by such forward-looking statements. Forward-looking statements speak only as of the date of this report and we undertake no obligation to publicly update any forward-looking statements to reflect new information, events or circumstances after the date of this report. Per share amounts herein have been adjusted to give effect to the December 8, 2009 one-for-three reverse stock split.

We are a trusted global provider of unified data management and data protection solutions designed to enable SMEs, corporate departments and SMBs, to anticipate and respond to change. Whether an organization’s data is distributed around the corner or across continents, our solutions tie it all together for easy and cost-effective management of different tiers of information over time. We enable companies to expend fewer resources on IT allowing them to focus on being more responsive to the needs of their customers.

We develop and deliver a comprehensive solution set of award-winning products and services for moving and storing data throughout the organization and during the entire data lifecycle. Our Snap Server ^® product is a complete line of network attached storage and storage area network solutions designed to ensure primary and secondary data is accessible and protected regardless of its location. Our Snap Server ^® solutions are available with backup, replication and mirroring software in fixed capacity or highly scalable configurations. These solutions provide simplified disk-based data protection and maximum flexibility to protect mission critical data for both continuous local backup and remote disaster recovery. Our NEO SERIES ^® and REO SERIES ^® of virtual tape libraries, tape backup and archive systems are designed to meet the need for cost-effective, reliable data storage for long-term archiving and compliance requirements.

Our approach emphasizes long term investment protection for our customers and reduces the complexities and ongoing costs associated with storage management. Moreover, most of our products are designed with a scalable architecture which enables companies to purchase additional storage as needed, on a just-in-time basis, and make it available instantly without downtime.

End users of our products include SMEs, SMBs, distributed enterprise companies such as divisions and operating units of large multi-national corporations, governmental organizations, and educational institutions. Our products are used in a broad range of industries including financial services, video surveillance, healthcare, retail, manufacturing, telecommunications, broadcasting, research and development and many others. See “Business” in Part I, Item 1 of this report for more information about our business, products and operations.

Overview

This overview discusses matters on which our management primarily focuses in evaluating our financial position and operating performance.

Generation of revenue . We generate the majority of our revenue from sales of our data protection products. The balance of our revenue is provided by selling maintenance contracts and rendering related services, selling spare parts, and earning royalties on our licensed technology. The majority of our sales are generated through our branded channel which includes systems integrators and VARs, with the remainder from our private label arrangements with OEMs.

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Business Transition. In August 2005, we announced that our largest OEM customer, HP, had selected an alternate supplier for its next-generation mid-range tape automation products. HP began purchasing the alternate supplier’s new product line during the first quarter of calendar year 2006, which decreased our sales to HP. However, in mid-2007 HP re-launched its tape automation products containing our product with support for HP’s new LTO-4 tape drives, causing a slowdown in the rate of replacement of our products by the alternate supplier’s product. Although we believe that our sales to HP will continue to decline, in the fourth quarter of fiscal 2009 we extended our supply agreement with HP until July 2012 with automatic renewals for three successive one-year periods unless earlier terminated by either party. Revenue from HP in fiscal 2010 decreased 44.2% compared with fiscal 2009, and decreased 30.2% in fiscal 2009 compared with fiscal 2008.

During fiscal 2010, we continued to experience decreased revenues. We believe customers have delayed purchases or chose not to purchase for a number of reasons, including, among others, (i) the uncertainty of the world economy and a general decrease in IT spending and (ii) a reluctance by some customers to purchase our products due to weakness in our financial condition.

Due in large part to the overall decline in HP revenue, we reported net revenue of $77.7 million for fiscal 2010, compared with $105.6 million for fiscal 2009. The decline in net revenue resulted in a net loss of $13.0 million, or $2.04 per share, for fiscal 2010 compared with a net loss of $18.0 million, or $4.23 per share, for fiscal 2009.

Positive trends. During fiscal 2010, we have achieved a number of financial and operational objectives designed to further our efforts to regain profitability:

Liquidity and capital resources. At June 30, 2010, we had a cash balance of $8.9 million, compared to $5.5 million at June 30, 2009. In fiscal 2010, we incurred a net loss of $13.0 million. During the third quarter of fiscal 2010, we sold an aggregate of 794,659 shares of Series A Convertible Preferred Stock and warrants to purchase up to 6,373,266 shares of common stock in a private placement for a total issuance price of $11.9 million (net proceeds of approximately $10.9 million). During the second quarter of fiscal 2010, we sold 2.1 million shares of our common stock in a public offering at $2.10 per share for gross proceeds of $4.3 million (net proceeds of approximately $3.7 million) and we received $2.0 million from the liquidation of our auction rate securities (ARS). Historically, our primary source of liquidity has been cash generated from operations. We currently have financing agreements in place with a borrowing base that is determined by the amount of qualifying non-OEM accounts receivable sales during a period. Our practice has been to borrow the full amount of non-OEM accounts receivable sales we transact. We have no unused source of liquidity at this time and cash management and preservation continues to be a top priority. We expect to incur negative operating cash flows during the remainder of calendar 2010 as we continue to reshape our business model and further improve operational efficiencies.

Management has projected that cash on hand, including cash received from our private placement of shares of Series A Convertible Preferred Stock in February 2010, and funding available under the our non-OEM accounts receivable financing agreements will be sufficient to allow us to continue operations at current levels through the end of calendar 2010. Significant changes from our current forecast, including, but not limited to:

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(i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs and/or (iv) changes to the historical timing of collecting accounts receivable or to the borrowing terms on our non-OEM account receivable financing arrangements, could have a material adverse affect on our ability to access the level of funding necessary to continue operations at current levels. If any of these events occur, management may be forced to make further reductions in spending, further extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.

As of June 30, 2010, we had working capital of $2.4 million, reflecting a $0.6 million increase in current assets compared to June 30, 2009, and a $4.5 million decrease in current liabilities during fiscal 2010. The increase in current assets is primarily attributable our private placement of shares of Series A Convertible Preferred Stock in February 2010, offset by cash used in operating activities and reduced sales, resulting in lower inventory balances. The decrease in current liabilities is primarily attributable to a $1.9 million reduction in debt primarily related to payments made on outstanding notes payable to Anacomp, Inc. (Anacomp) and Adaptec, Inc. (Adaptec), a $1.7 million reduction in the product warranty liability and a $0.9 million reduction in accrued liabilities. Current liabilities associated with our non-OEM accounts receivable financing arrangements, including accrued interest, were $4.5 million and $4.2 million as of June 30, 2010 and 2009, respectively. See “Liquidity and Capital Resources” below for a description of these arrangements.

Industry trends. We estimate that the cost of data management is four times the cost of storage devices. Furthermore, many SMEs and SMBs are seeking to implement tiered storage for primary and secondary data utilizing a combination of low cost SATA (Serial ATA) drives and high performance SAS (Serial Attached SCSI) drives. IDC estimates that the total networked attached storage (NAS) market will grow at approximately 7.6% through 2014, and the growth rate for NAS storage systems in price bands up to $15,000, where most of our Snap Server ^® solutions lie, is estimated at 10.8%. According to IDC, tape storage still constitutes approximately 8.1% of the total storage revenue in the global storage market. Sales of tape automation appliances represented 46.6% and 50.1% of our revenue during fiscal 2010 and 2009, respectively.

Recent Developments

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial position and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of consolidated financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates, including, but not limited to, those related to revenue recognition, available-for-sale securities, share-based compensation, bad debts, inventories, intangible and other long-lived assets, warranty obligations, income taxes and restructuring charges. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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Critical accounting policies are those policies that, in management’s view, are most important in the portrayal of our financial condition and results of operations. The footnotes to our consolidated financial statements also include disclosure of significant accounting policies. The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our financial statements. These critical accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Our critical accounting policies and estimates that require the most significant judgment are discussed further below.

Revenue Recognition

We recognize revenue from sales of products when persuasive evidence of an arrangement exists, the price is fixed or determinable, collectability is reasonably assured and delivery has occurred. Under this policy, revenue on direct product sales (excluding sales to distributors) is recognized upon shipment of products to our customers. These customers are not entitled to any specific right of return or price protection, except for any defective product that may be returned under our warranty policy. Generally, title and risk of loss transfer to the customer when the product leaves our dock. Product sales to distribution customers are subject to certain rights of return, stock rotation privileges and price protection. Because we are unable to estimate our exposure for returned product or price adjustments, revenue from shipments to these customers is not recognized until the related products are in turn sold to the ultimate customer by the distributor. For products in which software is more than an incidental component, we recognize revenue in accordance with current authoritative guidance for software revenue recognition.

When there are multiple elements in an arrangement, we allocate revenue to the separate elements based on relative fair value, provided we have fair value for all elements of the arrangement. If in an arrangement we have fair value for undelivered elements but not the delivered element, we defer the fair value of the undelivered element(s) and the residual revenue is allocated to the delivered element(s). Undelivered elements typically include services. Revenue from extended warranty and product service contracts is initially deferred and recognized ratably over the contract period.

We have various royalty arrangements with independent service providers that sell our product and also sell and provide service on our product. These independent service providers pay a royalty fee for service contracts in place on our product. The royalty fee is calculated by us for the units covered in the quarter, and agreed to by the service provider, based upon the monthly fee for each unit covered by the independent service provider.

We have various licensing agreements relating to our Variable Rate Randomizer (VR ^{2 ®} ) technology with third parties. The licensees pay us a royalty fee for sales of their products that incorporate our VR ^{2 ®}  technology. The licensees provide us with periodic reports that include the quantity of units, subject to royalty, sold to their end users. We record the royalty when reported to us by the licensee, generally in the period during which the licensee ships the products containing VR ^{2 ®}  technology.

Allowance for Doubtful Accounts

We estimate our allowance for doubtful accounts based on an assessment of the collectability of specific accounts and the overall condition of the accounts receivable portfolio. When evaluating the adequacy of the allowance for doubtful accounts, we analyze specific trade and other receivables, historical bad debts, customer credits, customer concentrations, customer credit-worthiness, current economic trends and changes in customers’ payment terms and/or patterns. If the financial condition of our customers were to deteriorate, impairing their ability to make additional payments, then we may need to make additional allowances. Likewise, if we determine that we could realize more of our receivables in the future than previously estimated, we would adjust the allowance to increase income in the period we made the determination. We review the allowance for doubtful accounts on a quarterly basis and record adjustments as considered necessary. Generally, our allowance for doubtful accounts is based on specific identification. If we fail to identify an account as doubtful, or if we identify an account as uncollectible that is later collected, our results could vary.

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Share-Based Compensation

Share-based compensation expense can be significant to our results of operations, even though no cash is used for such expense. In determining period expense associated with unvested options, we estimate the fair value of each option at the date of grant. We use the Black-Scholes option pricing model to determine the fair value of the award. This model requires the input of highly subjective assumptions, including the expected volatility of our stock and the expected term the average employee will hold the option prior to the date of exercise. In addition, we estimate pre-vesting forfeitures for share-based awards that are not expected to vest. We primarily use historical data to determine the inputs and assumptions to be used in the Black-Scholes pricing model. Changes in these inputs and assumptions could occur and could materially affect the measure of estimated fair value and make it difficult to compare the results in future periods to our current results.

A 10.0% change in our share-based compensation for the year ended June 30, 2010 would have affected our net loss by $170,000.

Inventory Valuation

We record inventories at the lower of cost or market. We assess the value of our inventories periodically based upon numerous factors including, among others, expected product or material demand, current market conditions, technological obsolescence, current cost and net realizable value. If necessary, we adjust our inventory for obsolete or unmarketable inventory by an amount equal to the difference between the cost of the inventory and the estimated market value. If actual market conditions are less favorable than we project, we may need to record additional inventory adjustments and adverse purchase commitments.

Impairment of Long-Lived Assets

We test for recoverability of long-lived assets whenever events or changes in circumstances indicate the carrying value may not be recoverable. When the carrying value is not considered recoverable, an impairment loss is recognized for the amount by which the carrying value of a long-lived asset exceeds its fair value, with a corresponding reduction in the carrying value of the related assets. Such impairment charges may be material. Fair value is generally determined based on the estimated future discounted cash flows over the remaining useful life of the asset or asset group using a discount rate determined by management to be commensurate with the risk inherent in our current business model.

The assumptions supporting the cash flow analysis, including the discount rates, are determined using management’s best estimates as of the date of the impairment review. If these estimates or their related assumptions change in the future, or if our future results are significantly different than forecasted, we may be required to further evaluate our long-lived assets for recoverability and record impairment charges for these assets that could adversely affect our results of operations.

During the fourth quarter of fiscal 2008, we recorded a $7.4 million impairment related to our property and equipment. See “Fiscal 2009 Compared with Fiscal 2008—Impairment of Long-Lived Assets” under the heading “Results of Operations” below. The estimated fair value of these assets was determined using the income approach, which is based on a discounted cash flow analysis, as well as consideration of the estimated value that could be realized upon sale. The assumptions used by us included estimates of (i) projected cash flows for a period approximating the remaining estimated useful life of the asset group, (ii) a discount rate commensurate with the implied risk in an investment in us and the risk of the underlying cash flows, and (iii) enterprise value.

Warranty Obligations

We provide for estimated future costs of warranty obligations in accordance with current accounting rules. For return-to-factory and on-site warranties, we accrue for warranty costs at the time revenue is recognized based on contractual rights and on the historical rate of claims and costs to provide warranty services. If we experience

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an increase in warranty claims above historical experience or our costs to provide warranty services increase, we may be required to increase our warranty accrual. Any such unforeseen increases may have an adverse impact on our gross margins in the periods in which they occur. Similarly, if we experience a decrease in warranty claims or our costs to provide services decline, we may be required to decrease our warranty accrual, which may have a favorable impact on our gross margins in the periods in which they occur.

Results of Operations

The following table sets forth certain financial data as a percentage of net revenue:

A summary of the sales mix by product follows:

Fiscal 2010 Compared with Fiscal 2009

Net Revenue. Net revenue decreased to $77.7 million during fiscal 2010 from $105.6 million during fiscal 2009, a decrease of $27.9 million, or 26.4%. The decline was primarily the result of anticipated lower OEM

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revenue, specifically from HP, reflecting the previously announced transition by HP to an alternate supplier. In our branded channel, the decrease in net revenue was attributable to decreased volumes across all channels.

Product Revenue

Net product revenue decreased to $53.6 million during fiscal 2010 from $80.7 million during fiscal 2009, a decrease of $27.1 million, or 33.6%.

Net product revenue from OEM customers decreased to $14.9 million during fiscal 2010 from $28.7 million during fiscal 2009. The decrease of $13.8 million, or 48.1%, was primarily associated with declining sales to HP. Net revenue from HP represented 22.5% of total net revenue during fiscal 2010, compared with 29.7% during fiscal 2009.

Net product revenue from Overland branded products, excluding service revenue, decreased to $38.7 million during fiscal 2010 from $52.0 million during fiscal 2009. The decrease of $13.3 million, or 25.6%, was primarily associated with decreases of $6.0 million from ARCvault ^® products, $3.6 million from REO ^® products, $1.6 million from Ultamus ^® products and $1.0 million from Snap Sever ^® products. These decreases were partially offset by an increase of $0.4 million from NEO ^® products, which we began selling the NEO ^® S product in the second quarter of fiscal 2010. We believe that the overall decrease in sales of Overland branded products is primarily a result of (i) the uncertainty in the world economy, (ii) a general decrease in IT spending worldwide, and (iii) a reluctance to purchase our products due to uncertainty regarding our financial condition.

Service Revenue

Net service revenue was relatively constant at $23.6 million during fiscal 2010 compared to $24.1 million during fiscal 2009.

Royalty Fees

Net royalty fees decreased to $0.5 million during fiscal 2010 from $0.8 million during fiscal 2009. The decrease of $0.3 million, or 37.5%, is primarily associated with lower VR ^{2 ®}  technology royalties. VR ^{2 ®} technology royalties during fiscal 2010 totaled $0.3 million compared with $0.7 million during fiscal 2009.

Gross Profit. Overall gross profit decreased to $21.4 million during fiscal 2010 from $29.2 million during fiscal 2009, a decrease of $7.8 million, or 26.7%. Gross margin remained relatively constant at 27.5% during fiscal 2010 compared to 27.6% during fiscal 2009.

Product Revenue

Gross profit on product revenue during fiscal 2010 was $8.3 million compared to $15.4 million during fiscal 2009. The decrease of $7.1 million, or 46.1%, was primarily due to the 33.6% decrease in net product revenue. Gross margin on product revenue at 15.5% for fiscal 2010 declined from 19.1% for fiscal 2009 primarily as a result of increased freight costs and warranty repair costs, as well as duplicative costs associated with our transition to an outsourced manufacturer. We expect these duplicative costs to continue until our transition to the outsourced manufacturer is complete.

Service Revenue

Gross profit on service revenue during fiscal 2010 was relatively constant at $12.6 million compared to $13.0 million in fiscal 2009. Gross margin on service revenue remained relatively constant at 53.4% during fiscal 2010 compared to 53.9% during fiscal 2009.

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Share-Based Compensation. During fiscal 2010, we had share-based compensation expense of $1.7 million compared with $0.3 million in fiscal 2009. The increase of approximately $1.4 million is primarily due to a one time grant of stock options to acquire, in the aggregate, 1.8 million shares of our common stock in February 2010 to executive officers as a retention tool.

Share-based compensation was allocated as follows (in thousands):

Fiscal 2010 Cost Reductions and Restructuring of Workforce. During fiscal 2010, we implemented two reductions in force as part of our cost-cutting initiatives.

The following table summarizes the activity associated with the fiscal 2010 restructurings (severance costs in thousands):

The following table summarizes the activity and balances of accrued restructuring charges during fiscal 2009 and 2010 (in thousands):

Sales and Marketing Expense. Sales and marketing expense in fiscal 2010 decreased to $18.0 million from $26.3 million during fiscal 2009. The decrease of $8.3 million, or 31.6%, was primarily a result of a decrease of $5.5 million in employee and related expenses including (i) a $0.8 million reduction in commissions as a result of reduced sales, (ii) a $0.6 million reduction in travel expenses due to cost control efforts and a reduction in the number of trade shows and partner conferences attended or hosted, (iii) the effects of a decrease in the average headcount by 32 employees, primarily due to the reductions in workforce in the first three quarters of fiscal 2009

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and (iv) the effects of a company-wide temporary 10.0% salary reduction implemented in January 2009, which was partially reinstated in fiscal 2010. In addition, the following factors further contributed to the decrease in sales and marketing expenses: (i) a decrease of $1.6 million in public relations and advertising expense, including contractor fees, due to restructuring and reductions in marketing programs and bringing previously outsourced projects in house, (ii) a decrease of $0.5 million in distributor support and incentives, (iii) a decrease of $0.4 million in severance costs associated with the fiscal 2009 restructurings and (iv) a decrease of $0.4 million in demo and promotion costs. These decreases were slightly offset by a $0.3 million increase in share-based compensation expense primarily associated with company wide options granted in July 2009 and options granted to an executive officer in February 2010.

Research and Development Expense. Research and development expense in fiscal 2010 decreased to $5.8 million from $9.3 million during fiscal 2009. The decrease of $3.5 million, or 37.6%, is primarily a result of (i) a decrease of $2.6 million in employee and related expenses, including travel costs, associated with a decrease in average headcount by 13 employees and the effects of a company-wide temporary 10.0% salary reduction implemented in January 2009, which was partially reinstated in fiscal 2010, (ii) a decrease of $0.5 million for contractors expense, (iii) a decrease of $0.3 million in development expense due to the completion of scheduled research and development projects and (iv) a decrease of $0.2 million in severance costs associated with fiscal 2009 restructurings. These decreases were offset by a $0.2 million increase in share-based compensation expense primarily associated with company wide options granted in July 2009 and options granted to an executive officer in March 2010.

General and Administrative Expense. General and administrative expense in fiscal 2010 increased to $11.9 million from $10.4 million during fiscal 2009. The increase of $1.5 million, or 14.4%, is primarily a result of (i) an increase of $0.8 million in share-based compensation expense primarily associated with company wide options granted in July 2009 and options granted to executive officers in February 2010, (ii) an increase of $0.3 million in severance cost associated with the termination of an executive officer and (iii) an increase of $0.2 million in legal fees associated with the Crossroads settlement in May 2010.

Interest Expense. We incurred interest expense of $1.5 million and $0.6 million during fiscal 2010 and 2009, respectively. In fiscal 2009, we entered into two non-OEM accounts receivable financing agreements and converted $2.3 million in accounts payable to a note payable. Under the non-OEM accounts receivable financing agreements we recorded interest expense of $1.3 million, including $0.1 million in amortization of debt issuance costs, compared to $0.4 million in fiscal 2009. Interest expense associated with our notes payable to Anacomp and Adaptec totaled $0.2 million during fiscal 2010 compared to $0.1 million during fiscal 2009.

Other Income (expense), net. During fiscal 2010, we incurred other income (expense), net, of $1.0 million of income compared with $0.8 million of expense during fiscal 2009. The increase of $1.8 million, or 225.0%, was primarily the result of the liquidation of our ARS resulting in a recognized gain of $0.5 million during fiscal 2010, compared to a $1.6 million other than temporary impairment loss during fiscal 2009. This increase was partially offset by a decrease of approximately $0.4 million in realized currency exchange gains due to foreign currency fluctuations.

(Benefit from) provision for Income Taxes. During fiscal 2010, we recognized benefit from income taxes of $1.8 million compared to recording a provision for income taxes of $30,000 during fiscal 2009. The net benefit in fiscal 2010 primarily related to our net operating loss carry back recognized pursuant to amended Internal Revenue Code Section 172(b)(1)(H). In fiscal 2009, we recorded nominal income tax expense.

Fiscal 2009 Compared with Fiscal 2008

Net Revenue. Net revenue decreased to $105.6 million during fiscal 2009 from $127.7 million during fiscal 2008, a decrease of $22.1 million, or 17.3%. The decline was primarily the result of anticipated lower OEM revenue, specifically from HP, reflecting the previously announced transition by HP to an alternate supplier. In our branded channel, the decrease in net revenue was attributable to decreased volumes across all channels.

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Product Revenue

Net product revenue decreased to $80.7 million during fiscal 2009 from $106.0 million during fiscal 2008, a decrease of $25.3 million, or 23.9%.

Net product revenue from OEM customers decreased to $28.7 million during fiscal 2009 from $46.4 million during fiscal 2008. The decrease of $17.7 million, or 38.1%, was primarily associated with declining sales to HP. Net revenue from HP represented 29.7% of total net revenue during fiscal 2009, compared with 35.2% during fiscal 2008.

Net product revenue from Overland branded products, excluding service revenue, decreased to $52.0 million during fiscal 2009 from $59.6 million during fiscal 2008. The decrease of $7.6 million, or 12.8%, was primarily associated with decreases of $9.5 million from NEO products, $3.8 million from ARCvault ^® products and $3.2 million from REO ^® products. These decreases were partially offset by $9.3 million of sales of Snap Server ^® products, which we began selling in the first quarter of fiscal 2009. We believe the overall decrease in sales of Overland branded products is primarily a result of (i) the uncertainty in the world economy, (ii) a general decrease in IT spending worldwide, and (iii) a reluctance to purchase our products due to uncertainty regarding our financial condition.

Service Revenue

Net service revenue increased to $24.1 million during fiscal 2009 from $20.6 million during fiscal 2008. The increase of $3.5 million, or 17.0%, is attributable to a $5.4 million increase in warranty revenue associated with an increase in the number of service contracts sold due to increased sales efforts, partially offset by a $1.9 million decrease in out-of-warranty services provided, primarily to HP.

Royalty Fees

Net royalty fees decreased to $0.8 million during fiscal 2009 from $1.1 million during fiscal 2008. The decrease of $0.3 million, or 27.3%, is primarily associated with lower VR ^{2 ®}  technology royalties and HP software royalties. VR ^{2 ®} technology royalties during fiscal 2009 totaled $0.7 million compared with $0.8 million during fiscal 2008. HP software royalties were $26,000 and $0.2 million during fiscal 2009 and 2008, respectively.

Gross Profit. Overall gross profit increased to $29.2 million during fiscal 2009 from $28.1 million during fiscal 2008, an increase of $1.1 million, or 3.9%. Gross margin increased to 27.6% during fiscal 2009 from 22.0% during fiscal 2008.

Product Revenue

Gross profit on product revenue during fiscal 2009 was $15.4 million compared to $17.7 million during fiscal 2008. The decrease of $2.3 million, or 13.0%, was primarily due to the 23.9% decrease in product revenue. Gross margin on product revenue at 19.1% for fiscal 2009 increased from 16.7% for fiscal 2008 primarily due to Snap Server ^® product revenues, which began in fiscal 2009 and carry higher margins than most of our other products.

Service Revenue

Gross profit on service revenue during fiscal 2009 was $13.0 million compared to $9.2 million during fiscal 2008. The increase of $3.8 million, or 41.3%, was primarily associated with an increase in warranty contracts recognized in fiscal 2009 compared with fiscal 2008. Gross margin on service revenue at 53.9% for fiscal 2009 increased from 44.7% for fiscal 2008 primarily due to new service offerings and the addition of the Snap Server ^® product line, which have more favorable margins.

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Share-Based Compensation. During fiscal 2009, we had share-based compensation expense of $0.3 million compared with $1.0 million in fiscal 2008. The decrease of approximately $0.7 million is primarily due to a one time grant of stock options to acquire, in the aggregate, 1.5 million shares of our common stock in August 2007 to executive officers and key employees as a retention tool. The share-based compensation expense associated with the August 2007 option grants was recognized primarily in fiscal 2008. These options vested monthly for one year and resulted in increased share-based compensation expense through the first quarter of fiscal 2009. Compensation expense associated with option and restricted stock awards with graded vesting is recognized on an accelerated basis.

Share-based compensation was allocated as follows (in thousands):

Fiscal 2009 Cost Reductions and Restructuring of Workforce. During fiscal 2009, we implemented several reductions in force as part of our cost-cutting initiatives. As part of the March 2009 restructuring, we terminated the employment of the sole employee in our Colorado facility. In April 2009, we vacated this facility, the lease for which expires February 2011. In the fourth quarter of fiscal 2009, we recorded a charge of $55,000 to research and development expense for the estimated fair value of the liability associated with vacating this facility.

The following table summarizes the activity associated with the fiscal 2009 restructurings (severance costs in thousands):

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The following table summarizes the activity and balances of accrued restructuring charges during fiscal 2008 and 2009 (in thousands):

Sales and Marketing Expense. Sales and marketing expense in fiscal 2009 decreased to $26.3 million from $31.6 million during fiscal 2008. The decrease of $5.3 million, or 16.8%, is primarily due to a decrease of $3.0 million in employee and related expenses including (i) a $1.0 million reduction in commissions as a result of reduced sales, (ii) a $0.9 million reduction in travel expenses due to cost control efforts and a reduction in the number of trade shows and partner conferences attended or hosted, and (iii) the effects of a company-wide temporary 10.0% salary reduction implemented in January 2009. Other cost reductions included a $1.1 million reduction in public relations and advertising expense due to the reduction in trade shows and partner conferences attended or hosted, and a $0.5 million reduction in outside contractor expenses due to cost control efforts. These decreases were slightly offset by a $0.4 million increase in severance associated with the fiscal 2009 restructurings.

Research and Development Expense. Research and development expense in fiscal 2009 remained flat at $9.3 million compared to fiscal 2008. During fiscal 2009 there was a decrease of $1.6 million in material-intensive product development expenses due to the completion of scheduled research and development projects. This decrease was offset by (i) a $0.9 million increase in employee and related expenses related to our acquisition of the Snap Server ^® product line in June 2008, which increased average headcount by eight employees, and (ii) an increase of $0.5 million in outside contractor expenses for tape library development.

General and Administrative Expense. General and administrative expense in fiscal 2009 increased to $10.4 million from $10.1 million during fiscal 2008. The increase of $0.3 million, or 3.0%, is primarily due to (i) an increase of $0.7 million in legal fees, for financing and strategic alternatives, (ii) an increase of $0.6 million in amortization of intangibles associated with the acquisition of the Snap Server ^® product line in June 2008, and (iii) an increase of $0.3 million in outside contractor expenses, principally for financial and accounting services. These increases were offset by (i) a decrease of $0.9 million in depreciation expense due to lower carrying values of fixed assets, and (ii) a $0.5 million decrease in employee and related expenses related to our fiscal 2009 restructurings.

Impairment of Long-Lived Assets. In the fourth quarter of fiscal 2008, we recorded an impairment charge of $7.4 million related to property and equipment. As discussed in Note 2 to the consolidated financial statements, management performed impairment analyses of its long-lived assets as of June 30, 2009 and 2008 due to our continued operating and cash flow losses and our forecasts. The impairment analysis as of June 30, 2008, excluded the long-lived assets from the recently completed Snap Server acquisition (Note 3 to the consolidated financial statements). We concluded that the carrying amount of this asset group was not recoverable as of June 30, 2008, and consequently we recognized an impairment loss of $7.4 million. Management concluded that the carrying amount of the asset group (including the long-lived assets from the Snap Server acquisition which has been fully integrated into our operations) was recoverable as of June 30, 2009, and therefore did not record an impairment loss on our long-lived assets in fiscal 2009.

Interest Income. During fiscal 2009, we generated interest income of $0.2 million, compared with $0.8 million during the prior fiscal year. The decrease of $0.6 million, or 75.0%, is due to the decrease in cash and investment balances in fiscal 2009 compared with fiscal 2008. We liquidated our short-term investments in the first quarter of fiscal 2009.

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Interest Expense. We incurred interest expense of $0.6 million and $5,000 during fiscal 2009 and 2008, respectively. In fiscal 2009, we entered into two non-OEM accounts receivable financing agreements and converted $2.3 million in accounts payable to a note (the Anacomp Note). Under the non-OEM accounts receivable financing agreements we recorded interest expense of $0.4 million, including $0.1 million in amortization of debt issuance costs. Interest expense associated with our notes payable to Anacomp and Adaptec totaled $0.1 million during fiscal 2009. During fiscal 2008, no interest expense was recorded related to the note payable to Adaptec.

Other Expense, net. During fiscal 2009, we incurred other expense, net, of $0.8 million compared with $2.0 million during fiscal 2008. The decrease of $1.2 million in other expense, net, is primarily associated with $0.9 million in realized currency exchange gains in fiscal 2009, compared with $61,000 of realized currency exchange losses in fiscal 2008. Losses on investments related to impairment charges were $1.6 million in fiscal 2009 and $1.9 million in fiscal 2008.

Provision for Income Taxes. We recorded nominal income tax expense during fiscal 2009 compared with $0.4 million during fiscal 2008. The decrease is primarily due to the expiration of statutes of limitations on certain tax positions and the favorable settlement of tax issues with the tax authorities.