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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

ý

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


For the fiscal year ended December 29, 2007

or

o

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


For the transition period from                                    to                                     

(Mark One)

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

For the fiscal year ended December 30, 2006

or

oTRANSITION 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

(I.R.S. employer


incorporation or organization

95-4812784
(I.R.S. employer
Identification No.)


51 Discovery, Irvine, CA 92618
(Address of principal executive offices) (Zip Code)

(949) 435-0025
(Registrant's telephone number, including area code)

475 Goddard, Irvine, CA 92618

(Address of principal executive offices) (Zip Code)

(949) 435-0025

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class


Name of each exchange on which registered


Common Stock, par value $0.001 per share

The NASDAQ Global Market

          

Securities registered pursuant to Section 12(g) of the Act:

None


(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o    No ýx

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ox    No ýo

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 ý    No o    No x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’sregistrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

Large Accelerated Filer     accelerated filer o

Accelerated Filer     filer o

Non-accelerated filer o
x(Do not check if a
smaller reporting company)

Smaller reporting company ý

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

The initial public offering of the registrant’s shares of common stock, par value $0.001 per share, took place on November 30, 2006, and its common stock began trading on The NASDAQ Global Market on that same date. As such, the registrant’s common equity was not publicly traded as of July 1, 2006, the last day of the registrant’s most recently completed second fiscal quarter.           The aggregate market value of the registrant’sregistrant's common stock held by non-affiliates, based on the closing price of the registrant’sregistrant's common stock as reported on The NASDAQ Global Market on February 15,June 29, 2007, the last business day of the registrant's most recently completed second fiscal quarter, was approximately $79.0$35.2 million. For purposes of this calculation, it has been assumed that all shares of the registrant’sregistrant's common stock held by directors, executive officers and shareholders beneficially owning five percent or more of the registrant’sregistrant's common stock are held by affiliates. The treatment of these persons as affiliates for purposes of this calculation is not conclusive as to whether such persons are, in fact, affiliates of the registrant.

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

Common Stock, par value $0.001 per share

19,616,98719,855,411 shares outstanding at February 15, 20072008

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement for the registrant’sregistrant's Annual Meeting of Stockholders for 20072008 have been incorporated by reference into Part III of this Annual Report on Form 10-K.










PART I

Item 1.    Business of Netlist, Inc.

Overview

We design, manufacture and manufacturesell high performance memory subsystems. We sell our subsystems to original equipment manufacturers, or OEMs, infor the server, high performance computing and communications markets. We target applications within these markets in which memory plays a key role in enabling overall system performance requirements. Our memory subsystems are incorporated into multiple platforms at IBM, Dell, Gateway and Hewlett-Packardconsist of dynamic random access memory integrated circuits, or DRAM ICs, NAND and other OEMs. Our subsystems are designed and manufactured to specifically address the high-performance needs of these customers’ systems.

components assembled on a printed circuit board, or PCB. We collaborateengage with our original equipment manufacturer, or OEM, customers infrom the earliest stages of their new product design cycles. This collaborationdefinition, which provides us with unique insight into the OEM’stheir full range of system architecture and performance requirements and expands our existingrequirements. This close collaboration has also allowed us to develop a significant level of systems expertise. In addition, we have developedWe leverage a portfolio of proprietary technologies and design techniques, to meet OEM needs, including efficient planar design, alternative packaging techniques and custom semiconductor logic. As a result, we are ablelogic, to design application-specificdeliver memory subsystems with optimal combinations of high memory density, small form factor, high signal integrity, effective heat dissipationattractive thermal characteristics and low cost per bit. We also offer our OEM customers flexible order fulfillment and rapid turnaround times.

We were incorporated in Delaware in June 2000 and commenced operations in September 2000.

Our SolutionMemory Products

DRAM Modules

We provideoffer a comprehensive lineup of DRAM ICs, memory modules utilizing a wide range of DRAM technologies from legacy Fast Page/Extended-Data-Out, or FP/EDO, and Synchronous DRAM, or SDRAM, to double-data-rate, or DDR, and DDR2 SDRAM and leading-edge high performance DDR3 SDRAM devices. These modules encompass a broad range of form factors and functions and more current dual in-line memory subsystemsmodules, or DIMMs, fully-buffered DIMMS, or FBDIMMS, small outline dual in-line memory modules, or SO-DIMMs, very low profile, or VLP, DIMMs and mini-DIMMs for space-constrained blade servers, or 1.75 inch thin computing servers, and networking applications. These memory modules come in configurations of up to the server,244 pins and densities of up to 8GB. We utilize advanced device and module-level packaging/stacking technologies to achieve cost-effective high-density solutions. We also accommodate custom module designs based on specific OEM requirements. Our advanced DDR, DDR2 and DDR3 memory modules are designed to operate with high performance computingdevices available through the extensive use of electrical and communications markets. We utilizethermal simulation and modeling. Our DDR, DDR 2 and DDR3 DIMMs are tested at-speed on high-end functional testers utilizing comprehensive test suites, enabling these modules to meet the stringent quality requirements of enterprise class systems.

Flash Modules

        In 2007, we introduced our innovativeIndustrial Flash products, which are based on state of the art single and proprietary technology, as well as our extensive systems expertise, to bridge the gap between industry standard approaches anddual channel 32 bit RISC microcontrollers that meet the requirements of complex OEM systems. Our application-specific solutions provide customers with the following key benefits:

Highly Differentiated Memory Solutions Through Deep Customer Engagement.   We work closely with our OEM customers, fromIndustrial OEM's within the earliest stages of newnetworking, telecom and storage applications. With product definition through the ramp up to mass production, to developperformance and deliver application-specific memory subsystems which address the full range of system architecture and performance requirements. Our close, collaborative relationship with our OEM customers give us early insight both into their current needs and into future technology trends. In addition, our in-depth systems expertise, coupled with our ability to customize solutions, enables our OEM customers to offer differentiated products that feature high levels of performance while improving reliability and, in some cases, reducing cost.

High Performance Through Proprietary Technologies and Design Techniques.We have developed a portfolio of proprietary technologies and design techniques to achieve optimal electronic signal strength and integrity, high memory density and improved heat dissipation. For example, our innovative printed circuit board, or PCB, designs enhance electronic signal integrity, allowing our customers to design and market products that operate at the highest commercially available speeds,sustained read across multiple form factors such as the DDR2 specification, whichCompact Flash, our product line is designed to operatemeet individualized customer requirements and complements our suite of DRAM products.

Selective 2007 Product Focus

4 Rank FBDIMM

        FBDIMM technology poses a significant thermal challenge, especially in higher density DIMM due to the Advanced Memory Buffer, or AMB, and the number of DRAM on the module. We have effectively addressed the above challenges by leveraging many of our core-competencies. The low-power FBDIMM is designed by using a combination of efficient board design, component selection and a



cutting-edge thermal engineering. Our FBDIMM design uses the lowest power AMB and a 4-Rank x8 configuration. A high efficiency heat-sink effectively dissipates the heat even at higher memory system utilization, resulting in high performance and reliable memory operation.

        We offer power efficient FBDIMM solutions in 2GB, 4GB and 8GB capacities at speeds up to 800 MHz. Another techniquePC2-6400 or 800MT/s. In addition to the thermal engineering, we utilize isuse a set of sophisticated design techniques such as impedance matching, reduced capacitive loading and built-in air gaps (to eliminate cross talk and electro-magnetic coupling) to embed passive devices withinenable a high performance registered DIMM that delivers up to PC2-6400 performance.

Very Low Profile Registered DIMM

        We pioneered the PCB, thereby freeing valuable board space to reducevery low profile, or VLP, design using proprietary board-stacking technology. These modules find their applications in the thin form-factor systems like the Blade Servers and Telecom equipment. The VLP designs are available as 1GB, 2GB, 4GB, DDR1 and 2GB, 4GB, and 8GB DDR2 RDIMM.

Small Form Factor DIMM

        1GB, 2GB and 4GB SO-DIMM are available as non-ECC modules in 200-pin connector form-factor. The 1GB and 2GB VLP and LP Mini-RDIMM are also available as ECC modules in 244-pin connector form-factor. Our small DIMM options help increase the capacities of the mobile clients, workstation, and communication systems at optimal cost.

Flash Memory Cards and Modules

        We design and manufacture industrial flash memory products in a variety of form factors and improve signal integrity.capacities. Our solutions also address the system-level thermal issues encountered at high operating speeds via such innovations as planar designswide range of flash memory products come in Compact-Flash, PC Card, Secure Digital with plans to support other form factors with a USB interface. Our flash modules are predominantly used in telecom equipment, printers, embedded controller applications, servers, switches and proprietary heat dissipation technologies thatrouters. Our relationships with numerous suppliers of flash and controller application specific integrated circuits allow us to minimize heat concentrations within the system.

High Quality and Reliability.   We performoffer a fullwide range of product reliability testing and share the results with our customers on an on-going basis. We use advanced design tools to accurately simulate the


system performance targets of our customers and to ensure that ourcost-effective products comply with our customers’ specifications. All of our memory subsystems undergo both functional and system burn-in testing prior to delivery to our customers. We complement our test capabilities with advanced imaging technology to inspect the quality of our micro ball grid array, or microBGA, assemblies. We believe that our testing procedures significantly enhance the quality and reliability of our products.

Rapid Order Fulfillment Capability.TechnologyWe operate our manufacturing facility in a manner that maximizes our ability to meet changing customer demand. Our turn-around times are typically one week or less, and in some cases as few as two days, which allows us to match unforeseen customer demand and to provide our OEM customers with timely access to products.

Cost-Effective Memory Solutions.   We provide high performance memory subsystems at what we believe to be the lowest cost per bit for many applications. Our portfolio of proprietary technologies and design techniques allow us to use cost-effective, current generation dynamic random access memory integrated circuits, or DRAM ICs, and in some cases avoid additional costs from chip-stacking to significantly lower the cost of our memory subsystems. Additionally, the superior thermal characteristics and electronic signal integrity of our subsystems helps OEMs reduce costs through simplified system design.

Our Products

We are currently designing, manufacturing and selling memory subsystems with speeds up to 667 MHz, densities up to 8 gigabytes, and form factors as small as 0.72 inches, or 18.3 millimeters, in height. Our products for the server market address a broad variety of memory capacity and configuration requirements, as well as a broad range of server types, including tower, rack-mounted, and blade servers. Our current products primarily support double data rate, or DDR, and DDR2, DRAM technologies.

The following table lists representative products from our major families of high performance memory subsystems:

DDR2 Registered Dual In-line Memory Module

Density

Height

Speed (MHz)

Applications

256MB

30mm

400/533

RAID Memory

512MB

30mm

400/533/667

Blade Servers

512MB

18.3mm

400/533/667

Blade Servers

1GB

18.3mm

400/533/667

Blade Servers

1GB

30mm

400/533/667

1U, 2U+ Servers, Networking

2GB

30mm

400/533/667

1U, 2U+ Servers, Networking

2GB

18.3mm

400/533/667

Blade Servers, Networking

4GB

30mm

400/533/667

1U, 2U+ Servers, Workstations

4GB

18.3mm

400/533

Blade Servers

DDR2 Fully Buffered Dual In-line Memory Module

Density

Height

Speed (MHz)

Applications

1GB

30mm

400/533/667

1U, 2U+ Servers, Workstations

2GB

30mm

400/533/667

1U, 2U+ Servers, Workstations

4GB

30mm

400/533

1U, 2U+ Servers, Workstations


DDR2 Unbuffered Dual In-line Memory Module

Density

Height

Speed (MHz)

Applications

256MB

30mm

400/533/667

Workstations

512MB

30mm

400/533/667

Workstations

1GB

30mm

400/533/667

Workstations

2GB

30mm

400/533

Workstations

DDR2 Small Outline Dual In-line Memory Module

Density

Height

Speed (MHz)

Applications

1GB

30mm

400/533/667

Notebooks, Networking

2GB

30mm

400/533

Notebooks, Networking

DDR Registered Dual In-line Memory Module

Density

Height

Speed (MHz)

Applications

1GB

30mm

400

1U, 2U+ Servers

1GB

18.3mm

400

Blade Servers, Networking

2GB

30mm

400

1U, 2U+ Servers

2GB

18.3mm

400

Blade Servers, Networking

2GB

18.3mm

400

Blade Servers, Networking

4GB

51mm

400

1U, 2U+ Servers

4GB

30mm

400

1U, 2U+ Servers

8GB

30mm

400

1U, 2U+ Servers

DDR Unbuffered Dual In-line Memory Module

Density

Height

Speed (MHz)

Applications

1GB

30mm

400

1U, 2U+ Servers, Workstations

2GB

30mm

400

1U, 2U+ Servers, Workstations

DDR Small Outline Dual In-line Memory Module

Density

Height

Speed (MHz)

Applications

1GB

1.2”

400

Notebooks, Networking

Technology

We have a portfolio of proprietary technologies and design techniques and have assembled an engineering team with expertise in semiconductor, printed circuit boards, memory subsystem and system design. Our technology competencies include:

Very Low Profile Designs.    We were the first company to create a 1 gigabyte memory subsystem in a form factor of less than one inch in height. We believe our proprietary board design technology is particularly useful in the rapidly growing blade server market, where efficient use of motherboard space is critical. Our technology has allowed us to decrease the system board space required for memory, and improve thermal performance and operating speeds, by enabling our customers to use alternative methods of component layout.

Proprietary PCB Designs.    We utilize advanced, proprietary techniques to optimize electronic signal strength and integrity within a PCB. These techniques include the use of 8- or 10-layer boards, matching conductive trace lengths, a minimized number of conductive connectors, or vias, and precise load balancing


to, among other things, help reduce noise and crosstalk between adjacent traces. In addition, our proprietary designs for the precise placement of intra-substrate components allow us to assemble memory subsystems with significantly smaller physical size, enabling OEMs to develop products with smaller footprints for their customers.


Planar Design.    Our planar solutions are designed to provide high density solutions in a more cost-effective manner than traditional chip-stacking. We believe traditional chip-stacking can represent up to 30% or morea significant portion of the total cost of a memory subsystem. Our planar solutions achieve the same densities as chip-stacked modules but do so by leveraging our PCB design expertise to place ICs in two rows in the same plane rather than on top of each other. Our planar memory subsystem designs feature high memory capacity with improved thermal characteristics by dissipating heat uniformly throughout the PCB.

Advanced Planar Designs.    We plan to extend our planar design capabilities to develop very high density memory subsystems. These advanced planar designs may allow us to build modular solutions at lower costs compared to other packaging technologies. Additionally, these advanced planar solutions may remove heat generated by memory components in a more effective manner and can be used to build memory subsystems in a number of densities and form factors.

IC Design Expertise.    We have designed blocks of custom logic that can be implemented in a stand-alone IC or integrated with other functional blocks in other ICs. We use these custom logic blocks to effectively increase density and reduce costs by allowing the use of two current-generation, lower density DRAM ICs in lieu of a single next-generation higher density IC.

Innovative Design Verification Tools.    We use our innovative and proprietary DRAM load simulators during the product development stage to carefully assess DRAM IC load balancing requirements in our memory subsystems. Our DRAM load simulators are mounted in a memory subsystem in place of DRAM ICs to test the electronic signal strength and integrity of the memory design without disrupting signal quality. This provides us with more accurate feedback than that provided by conventional means because we are able to measure the signals at the precise point of origination.

Thermal Management Designs.We design our memory subsystems to ensure effective heat dissipation. We use thermal cameras to obtain thermal profiles of the memory subsystem during the design phase, allowing us to rearrange components to enhance thermal characteristics and, if necessary, replace components that do not meet specifications. We use thermal simulation and modeling software to create comprehensive heat transfer models of our memory subsystems, which enables our engineers to quickly develop accurate solutions to potential thermal issues. We also develop and use proprietary heat spreaders to enhance the thermal management characteristics of our memory subsystems.

Customers

We primarily market and sell our products to leading OEMs in the server, high performance computing and communications markets. Our memory subsystems are incorporated into multiple platforms at IBM, Dell, Gateway, Lenovo, Hewlett-Packard and other OEMs. Sales to IBM, Dell and Lenovo generated approximately 33%, 38% and 2%, respectively,Consistent with the concentrated nature of the OEM customer base in our target markets, a small number of large customers have historically accounted for a significant portion of our net sales. Net sales in 2006to our three largest customers represented approximately 85%, 75% and 20%, 35% and 13%, respectively,68% of our total net sales in 2005.


The following chart summarizes2007, 2006 and 2005, respectively. See Note 16 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this Report. Net sales to some of our representativeOEM customers in our principal end marketsinclude memory modules that are qualified by us directly with the OEM customer and sold to electronic manufacturing services providers, or EMSs, for 2006:*incorporation into products manufactured exclusively for the OEM customer. These net sales to EMSs have historically fluctuated period by period as a portion of the total net sales to these OEM customers.

Servers

Workstations

Mobile Computing

Dell, Gateway, Google, IBM

        

Dell, Hewlett-Packard

Hewlett-Packard, Lenovo

High Performance Computing

Networking/Telecom

PSSC Labs, Verari,
Western Scientific

Force10, Foundry Networks,
Stoke, Tekelec


*                    Listing does not include all representative markets or customers due to contractual confidentiality provisions.

Our sales are made primarily pursuant to standard purchase orders that may be rescheduled or canceled on relatively short notice. Thus, we do not have a significant backlog.


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

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

Sales and Marketing

We market and sell our products through a direct sales force and a network of independent sales representatives. Our sales activities focus primarily on developing strong relationships at the technical, marketing and executive management levels within market-leading OEMs. These OEMs design systems for a variety of applications that require a significant number of high performance memory subsystems, representing substantial opportunities for us. We have been successful in developing OEM relationships through our ability to provide high performance memory subsystems. Our direct sales group and field application engineers work closely with our OEM customers at an early stage of their design cycles to solve their design challenges and to design our products into their systems.

We believe in the timely communication and exchange of information with our customers. We utilize well-trained, highly technical program management teams to successfully drive new product development and quickly respond to our customers’customers' needs and expectations. Our program management teams provide quick response times and act as a single point-of-contact for routine issues during the sales process. Additionally, they address the long-term business and technology goals of our customers. We employ a team approach to business development whereby our sales team and independent representatives identify, qualify and prioritize customer prospects through offices in a number of locations worldwide.

Our marketing efforts are twofold: creating awareness of the benefits of our proprietary technologies and design techniques in the development of application-specific memory subsystems, and building our brand awareness with our current and potential customers.

Manufacturing

We currently manufacture all of our products at our facilityfacilities in Irvine, California.California and Suzhou in the People's Republic of China, or the PRC. Our advanced engineering and design capabilities, combined with our in-house manufacturing processes, allow us to assemble our memory subsystems reliably and in high volume. Our advanced, customized manufacturing facility isfacilities are capable of surface mount assembly, subsystem testing, system-level burn-in testing, programming, marking, labeling and packaging. At each stage of the production cycle, including product prototyping, qualification sample production and high-volume manufacturing and delivery, we focus on providing our customers with rapid response and short manufacturing turn-around times. Manufacturing cycle times for our products are typically one week or less, and in some cases as few as two days, from receipt of order.


We are expanding        During 2007, we expanded our manufacturing capabilities by opening aour new facility near Shanghai in the People’s Republic of China, or the PRC, which we expect will begin production in the second half of 2007.PRC. This facility will behas been configured in the same manner as our Irvine facility and once operating, will


has significantly increaseincreased our manufacturing capacity. We believe that this facility will enableenables us to achieve better operating leverage through lower material and labor costs. This facility will also putputs our products in closer proximity to a number of our end customers, allowing us to fulfill customer orders more quickly. During February

        As of December 29, 2007, we entered into various agreements for this facility including constructionapproximately $3.6 million of leasehold improvements and purchase of manufacturing equipment.our net long-lived assets were located outside the United States in the PRC.

We acquire components and materials such as DRAM ICs directly from third party suppliersIC manufacturers and assemble them into finished subsystems. We believe that one of our key strengths is the efficient procurement and management of components for our subsystems, which benefits our customers in the form of lower costs and increased product availability. We have a limited number of suppliers, but we have developed strong supplier relationships with key DRAM IC manufacturers, which we believe gives us direct and ready access to the critical components that we need for our production activities. We typically qualify our products with our customers using multiple manufacturers of DRAM ICs. The flexibility to choose from several DRAM IC providers allows us to minimize product cost and maximize product availability.

We schedule production based on purchase order commitments and anticipated orders. In addition, we use advanced inventory management and material resource planning techniques to manage our supply chain. Using electronic data interchange with our suppliers, we are able to react quickly to changes in raw material availability. We release raw materials to the manufacturing floor by means of an on-line computerizedshop floor control system, which allows for internal quality analysis, direct access to inventory information and production floor material tracking. We have a flexible manufacturing system, andworkforce which allows us to manage unforecasted demand. In addition we have the capability to sell excess quantities of DRAM ICs to mitigate inventory risks. Our sales of excess inventory generated approximately $1.9 million, or 2%, of our net sales for 2007 and approximately $11.4 million, or 8%, of our net sales for 2006 and $19.1 million, or 24%, of our net sales for 2005.2006.

Our quality assuranceQuality Assurance engineers work with our suppliers to ensure that the raw materials we receive meet our high quality standards. These engineers also perform onsite quality controlsupplier factory audits and use our internal test and inspection systems to verify that purchased components and materials meet our specifications. Our supplier quality program and incoming material quality control program are important aspects of our overall manufacturing process.

We strive to reduce product failures to the lowest possible rate. To achieve this goal, we perform ongoing reliability testing on our memory subsystems and share the results of that testing with our customers. We believe that this improves the system design process and allows for the elimination of potential problems at the earliest possible stage. In addition, we have implemented procedures which require that all of our memory subsystems undergo functional and system burn-in testing prior to delivery to the customer. We complement our test capabilities with advanced imaging technology to inspect the quality of our microBGA assemblies.

We are certified in ISO 9001:2000 Quality Management Systems, ISO 14001:1996 Environmental Management Standards, and OSHAS 18001:1999 Occupational Health and Safety Management Systems.

Competition

Our products are primarily targeted for the server, high performance computing and communications markets. These markets are intensely competitive, as numerous companies vie for business opportunities at a limited number of large OEMs. Our primary competitors are memory module providers such as SimpleTech, Inc.,STEC, SMART Modular Technologies, Inc., and Viking Interworks, a division of Sanmina-SCI Corporation. We also face competition from DRAM manufacturerssemiconductor suppliers, including Qimonda, Samsung and Micron in a limited range of applications. As we enter new markets and pursue additional applications for our products, we may face competition from a larger number of competitors.


Many        Certain of our competitors have substantially greater financial, technical, marketing, distribution and other resources, broader product lines, lower cost structures, greater brand recognition and longer


standing relationships with customers and suppliers. Some of our competitors may also have a greater ability to influence industry standards than we do, as well as more extensive patent portfolios.

Some of our customers and suppliers may have proprietary products or technologies which are competitive with our products, or could develop internal solutions or enter into strategic relationships with, or acquire, existing high-density memory module providers. Any of these actions could reduce our customers’customers' demand for our products. Some of our significant suppliers of memory ICs may be able to manufacture competitive products at lower costs by leveraging internal efficiencies, or could choose to reduce our supply of memory ICs, adversely affecting our ability to manufacture our memory subsystems on a timely basis, if at all.

Our ability to compete in our current target markets and in future markets will depend in large part on our ability to successfully develop, introduce and sell new and enhanced products on a timely and cost-effective basis, and to respond to changing market requirements. We believe that the principal competitive factors in the selection of high performance memory subsystems by potential customers are:

·

    understanding of OEM system and business requirements;

    ·

    timeliness of new product introductions;

    ·

    design characteristics and performance;

    ·

    quality and reliability;

    ·

    track record of volume delivery;

    ·

    credibility with the customer;

    ·

    fulfillment capability and flexibility; and



    price.

·       price.

We believe that we compete favorably with respect to these factors. We expect, however, that our current and future competitors could develop competing products that could cause a decline in sales or loss of market acceptance of our products.

Research and Development

The market for high performance memory subsystems is characterized by rapidconstantly changing and therefore continuous development of new technology, developmentprocesses and product innovation.innovation is mandatory to be successful as a leading supplier. We believe that the continued and timely development of new products and the enhancementimprovement of existing products are critical to maintaining our competitive position. Our research and developmentteam of engineers focus on developing new product designproducts with innovative thermal solutions, packaging solutions and development, the development of thermal and electronicimproved electrical signal integrity solutions,that enhances reliability over the life of the system. Also, our engineers incorporate various new product testing techniques and methodologies and improvements tofor testing as well as new processes for manufacturing our manufacturing processes.products.

Our engineering staff continually explores practical applications of new technologies, worksclosely engages with our OEM customerspartners and provides support services throughouttheir engineering teams at early stages in their system development. This collaboration allows our engineers to understand the product life cycle, includingcustomer's system architecture, definition, component selection, schematic design, layout, manufacturingpower budget, operating environment such as air flow and test engineering.operating temperature and any mechanical constraints. Our engineers use this information to provide guidance and solutions to implement optimum memory subsystems to our OEM partners. An important aspect of our research and development effort is to understand the challenges presentedfaced by our OEM customers’partners and provide cost effective solutions that satisfy their requirements and satisfy them by utilizing our industry knowledge, proprietary technologies and technical expertise.


        We use advanced design tools in development of our products that allow us to model behavior of a signal trace on our memory modules as well as airflow and thermal profiles of all components in the system. These design tools enable real-time simulation for signal integrity and behavioral modeling of our designs using the Input/Output Buffer Information Specification (IBIS) of our suppliers' components. These simulation tools help us reduce or eliminate electronic signal reflections, clock skews, signal jitter and noise which can reduce system performance and reliability. Also, our engineers use thermal simulation tools to identify potential thermal problems arising from inadequate airflow necessary to cool the components in the system. These efforts allow our engineers to develop optimum thermal solutions for our customer base.

We believe that to remain competitive we must continue to focus on developing advanced memory subsystem technologies to address our customers’customers' increasingly complex memory subsystem requirements. Our total expenditures for research and development were approximately $4.8 million, $3.3 million and $3.0 million for 2007, 2006 and $3.8 million for 2006, 2005, and 2004, respectively.


We use advanced design tools to develop products that operate at high frequencies. These design tools enable real-time simulation and behavioral modeling of our designs using the input/output buffer information specification of our suppliers’ components. These simulation tools help us reduce or eliminate electronic signal reflections, clock skews, signal jitter and noise, all of which can reduce system performance and reliability.

Intellectual Property

Our high performance memory subsystems are developed in part using our proprietary intellectual property, and we believe that the strength of our intellectual property rights will be important to the success of our business. We utilize patent and trade secret protection, confidentiality agreements with customers and partners, disclosure and invention assignment agreements with employees and consultants and other contractual provisions to protect our intellectual property and other proprietary information.

As of December 30, 2006,29, 2007, we had four7 patents issued and eleven9 patent applications pending. Assuming that they are properly maintained, one of our issued patents will expire in 2022, three will expire in 2024 and the other three will expire in 2024.2025. Our issued patents and patent applications relate to PCB design and layout techniques, packaging techniques, and the use of custom logic in high performance memory subsystems. We intend to actively pursue the filing of additional patent applications related to our technology advancements. While we believe that our patent and other intellectual property rights are important to our success, our technical expertise and ability to introduce new products in a timely manner also will continue to be important factors in maintaining our competitive position. Accordingly, we believe that our business is not materially dependent upon any one claim in any of our pending patent applications.

Despite our precautions, a third party may reverse engineer, copy or otherwise obtain and use our products, services or technology without authorization, develop similar technology independently or design around any patents issued to us. There can be no assurance that our efforts taken to prevent misappropriation or infringement of our intellectual property by third parties have been or will be successful.

Employees

As of January 31, 2007,        At February 1, 2008, we had 146 full-timeapproximately 190 employees including 98(including 119 regular employees and 71 temporary employees). Approximately 75 of the regular employees were located in the U.S., and approximately 44 were located in other countries (mainly in China). We had 135 employees in operations, 1518 employees in research and development, 21 employees in sales and marketing, and 1216 employees engaged in other administrative functions. Our operations department performs manufacturing, procurement and planning activities. We use contract employees in our operations department from time to time to effectively manage our manufacturing workflow. As of January 31, 2007,February 1, 2008, our domestic operations department had 335 contract employees engaged full-time in manufacturing and our general and administrative departments had 46 contract employees. We are not party to any collective bargaining agreements with any of our employees. We have never experienced a work stoppage, and we believe our employee relations are good.


General Information

We maintain a website atwww.netlist.com (this uniform resource locator, or URL, is an inactive textual reference only and is not intended to incorporate our website into this Form 10-K). We file reports with the Securities and Exchange Commission and make available, free of charge, on or through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy and information statements and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Our website also contains copies of our corporate governance policy, code of business conduct and ethics, insider trading policy and whistleblower policy, as well as copies of the charters for our audit committee, compensation committee and nominating and corporate governance committee.

8




Item1A. Item 1A.    Risk Factors

This Annual Report on Form 10-K includes forward-looking statements. These forward-looking statements generally are identified by words such as “believe”"believe", “expect”"expect", “anticipate”"anticipate", “estimate”"estimate", “intend”"intend", “strategy”"strategy", “may”"may", “will likely”"will likely" and similar words or phrases. A forward-looking statement is neither a prediction nor a guarantee of future events or circumstances, and those future events or circumstances may not occur. Investors should not place undue reliance on the forward-looking statements, which speak only as of the date of this Report. We are under no obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. These forward-looking statements are all based on currently available market, operating, financial and competitive information and are subject to various risks and uncertainties, including but not limited to the rapidly-changingrapidly- changing nature of technology; evolving industry standards; 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; fluctuations in the market price of critical components; and the political and regulatory environment in the PRC. Our actual future results and trends may differ materially depending on a variety of factors including, but not limited to, the risks and uncertainties discussed below. The risks below are not the only ones we face. Additional risks and risks that management currently considers immaterial may also have an adverse effect on us.

We have a limited operating history, and 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 limited operating history makes 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:Report:

·

    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 inability to develop new or enhanced products that achieve market acceptance in a timely manner;

    ·       the timing of introductions of competing products or technologies;

    ·       our ability to adequately support future growth;

    ·       our ability to procure an adequate supply of key components;

    ·

    changes in the prices of our products or in the cost of the materials that we use to build our products;

    ·products, including fluctuations in the market price of DRAM ICs and NAND;

    our inability to develop new or enhanced products that achieve customer or market acceptance in a timely manner;

      the timing of introductions of competing products or technologies;

      our ability to adequately finance future growth;

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

      our failure to maintain the qualification of our products with our current customers or to qualify future products with our current or prospective customers;

      ·

      our establishment and ongoing operationfailure to produce products that meet the quality requirements of our customers;

      our ability to effectively operate a new manufacturing facility in the PRC;

      ·

      the loss of any of our key personnel;

      ·

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

      ·

      disputes regarding intellectual property rights;

      ·

      litigation involving our products;


      ·

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

      ·and;

      changes in accounting principles or policies.

    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.

    Our two largestSales to a limited number of customers comprised approximately 71%represent a significant portion of our net sales for 2006 and our three largest customers comprised approximately 68% of our net sales for 2005 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 such as Dell, IBM and IBMHewlett Packard have historically represented 38% and 33%, respectively,a significant portion of our net sales in 2006. Sales to Dell, IBM and Lenovo represented 35%, 20% and 13%, respectively, of our net sales in 2005.sales. We currently expect that sales to Dell and IBMHewlett Packard will continue to represent a significant percentage of our net sales for at least the next 12 months. We do not have long-term agreements with these customers, or with any other customer. Any one of these two customers could decide at any time to discontinue, decrease or delay their purchase of our products. In addition, the prices that these two customers pay for our products could change at any time. The loss of either of Dell or IBMHewlett Packard as a customer, or a significant reduction in sales to eitherany of them, would 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’customers' continued sales of servers and other computing systems that incorporate our memory subsystems and our customers’customers' continued incorporation of our products into their systems.

    Because of these and other factors, we cannot assure you that net sales to these customers will continue or that the amount of such net sales will 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.

    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’customers' sales and business results.

    The markets in which we compete are cyclical in nature, and any future downturn could adversely affect our business.

    The        Sales of our products are dependent upon demand in the computing, networking, communications, printer, storage and industrial markets. These markets in which we compete and in which our customers operate have been cyclical and are characterized by wide fluctuations in product supply and demand. These markets have experienced significant downturns, often connected with, or in anticipation of, maturing product cycles, reductions in technology spending and declines in general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity,, high inventory levels and the erosion of average selling prices.

            We may experience substantial period-to-period fluctuations in future operating results due to factors affecting the computing, networking, communications, printers, storage and industrial markets. A decline or significant shortfall in demand in any one of these markets could have a material adverse effect on the demand for our products. As a result, our sales will likely decline during these periods. During an industry downturn, there is also a higher risk that our trade receivables would be uncollectible. In addition, because many of our costs and operating expenses are relatively fixed, if we are unable to control our expenses adequately in response to reduced net sales, our results of operationsgross margins, operating income and cash flow would be negatively impacted.


            A decline in the worldwide semiconductor market or a future decline in economic conditions or consumer confidence in any significant geographic area would also likely decrease the overall demand for our products, which could have a material adverse effect on us. More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility to the United States economy and worldwide financial markets. Any of these occurrences could have a material adverse effect on our business, financial condition and results of operations.

    We are subject to risks relating to product concentration and lack of market diversification.

    In 20062007 and 2005,2006, we derived 79%approximately 68% and 51%79%, respectively, 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 mosta 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. 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.

    Our investments in auction rate securities are subject to risks which may cause losses and affect the liquidity of these investments.

            We hold certain investments in auction rate securities which have failed, or may in the future fail, their respective auctions. An auction failure means that the parties wishing to sell their securities could not do so. As a result of failed auctions, our ability to liquidate and fully recover the carrying value of our investments in the near term may be limited or not exist. If the issuers of these investments are unable to close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments. We may be required to wait until market stability is restored for these investments or until the final maturity of the underlying notes (up to 30 years) to realize our investments' recorded value.


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

    We incurred net losses each year from the inception of our business through fiscal 2005.2005, as well as for the year ended December 29, 2007. Our cumulative net losses were $16.3$23.9 million and $21.4$16.3 million as of December 30, 200629, 2007 and December 31, 2005,30, 2006, respectively. We may not be able to achieve or maintain profitability on a quarterly or annual basis in the future.

    The prices of DRAM ICs and NAND is volatile, and changes in their prices could adversely affect our gross margin.

            The prices of our products are adjusted periodically based in part on the market price of DRAM ICs and NAND, which have historically constituted approximately 70% - 90% of the total cost of our memory subsystems. Once our prices with a customer are negotiated, we are generally unable to revise pricing with that customer until our next regularly scheduled price adjustment. Consequently, we are exposed to the risks associated with the volatility of the price of DRAM ICs and NAND during that period. If the market price for DRAM ICs and NAND increases, we generally cannot pass this price increase on to our customers for products purchased under an existing purchase order. As a result, our cost of sales could increase and our gross margins could decrease. Alternatively, if there is a decline in the price of DRAM ICs and NAND, we may need to reduce our selling prices for subsequent purchase orders, which may result in a decline in our expected net sales.

    Customer demand is difficult to accurately forecast and any failure to optimally calibrate our production capacity and inventory levels to meet customer demand could adversely affect our revenues, gross margins and earnings.

            We make significant decisions regarding the levels of business that we will seek and accept, production schedules, component procurement commitments, personnel needs and other resource requirements, based on our estimates of customer requirements. The short-term nature of commitments by many of our customers, the fact that our customers may cancel or defer purchase orders for any reason, and the possibility of unexpected changes in demand for our customers' products each reduce our ability to accurately estimate future customer requirements for our products.

            If we underestimate customer demand, we may not have sufficient inventory of DRAM ICs and NAND on hand to manufacture enough product to meet that demand. We also may not have sufficient capacity at any given time to meet our customers' demands for rapid increases in production. These shortages of inventory and capacity will lead to delays in the delivery of our products, which could cause order cancellations, the loss of customers and a decrease in our net sales.

            Conversely, if we overestimate customer demand, we may have excess raw material inventory of DRAM ICs and NAND. If there is a subsequent decline in the price of DRAM ICs and NAND, the value of our inventory will fall. As a result, we may need to write-down the value of our DRAM IC and NAND inventory, which may result in a significant decrease in our gross margin and financial condition. Also, to the extent that we manufacture products in anticipation of future demand that does not materialize, or in the event a customer cancels or reduces outstanding orders, we could experience an unanticipated increase in our finished goods inventory. In the past, we have had to write-down inventory due to obsolescence, excess quantities and declines in market value below our costs.

    We use a small number of DRAM IC and NAND suppliers and are subject to risks of disruption in the supply of DRAM ICs.ICs and NAND.

    Our ability to fulfill customer orders is dependent on a sufficient supply of DRAM ICs and NAND, which are an essential component of our memory subsystems. There is a relatively small number of suppliers of DRAM ICs and NAND, and we purchase from only a subset of these suppliers. We have no long-term DRAM or NAND supply contracts. Our dependence on a small number of



    suppliers and the lack of any guaranteed sources of DRAM and NAND supply expose us to several risks, including the inability to obtain an adequate supply of DRAM ICs and NAND, price increases, delivery delays and poor quality.

            The recent declines in customer demand and revenues has caused us to reduce our purchases of DRAM ICs and NAND. Should we not maintain sufficient purchase levels with some suppliers, our ability to obtain future supplies of raw materials may be impaired due to the practice of some suppliers to allocate their products to customers with the highest regular demand.

    From time to time, shortages in DRAM ICs and NAND have required some suppliers to limit the supply of their DRAM ICs.ICs and NAND. As a result, we may be unable to obtain the DRAM ICs and NAND necessary to fill customers’customers' orders for our products in a timely manner. If we are unable to obtain a sufficient supply of DRAM ICs and NAND to meet our customers’customers' requirements, these customers may reduce future orders for our products or not purchase our products at all, which would cause our net sales to decline and harm our operating results. In addition, our reputation could be harmed, we may not be able to replace any lost business with new customers, and we may lose market share to our competitors.

    Our customers qualify the DRAM ICs and NAND of our suppliers for use in their systems. If one of our suppliers should experience quality control problems, it may be disqualified by one or more of our customers. This would disrupt our supplies of DRAM ICs and NAND and reduce the number of suppliers available to us, and may require that we qualify a new supplier.

    The priceflash memory market is constantly evolving and competitive, and we may not have rights to manufacture and sell certain types of DRAM ICsproducts utilizing emerging flash formats, or we may be required to pay a royalty to sell products utilizing these formats.

            The flash-based storage market is volatile,constantly undergoing rapid technological change and excess inventory of DRAM ICs, other components,evolving industry standards. Many consumer devices, such as digital cameras, PDAs and finished productssmartphones, are transitioning to emerging flash memory formats, such as the Memory Stick, and xD Picture Card formats, which we do not currently manufacture and do not have rights to manufacture. Although we do not currently serve the consumer flash market, it is possible that certain OEMs may choose to adopt these higher-volume, lower-cost formats. This could adversely affect our gross margin.

    The prices of our products are adjusted periodically based largely on the market price of DRAM ICs, which constituted more than 77% and 82% of the total cost of our memory subsystems sold during 2006 and 2005, respectively. Once our prices with a customer are negotiated, we are generally unable to revise pricing with that customer until our next regularly scheduled price adjustment. Consequently, we are exposed to the risks associated with the volatility of the price of DRAM ICs during that period. If the market price for DRAM ICs increases, we generally cannot pass this price increase on to our customers for products purchased under an existing purchase order. As a result, our cost of sales could increase and our gross margins could decrease. Alternatively, if there is a decline in the price of DRAM ICs, we will need to reduce our selling prices for subsequent purchase orders, which may result in a decline in demand, on a relative basis, for other products that we manufacture such as CompactFlash and embedded USB drives. If we decide to manufacture flash memory products utilizing emerging formats such as those mentioned, we will be required to secure licenses to give us the right to manufacture such products which may not be available at reasonable rates or at all. If we are not able to supply flash card formats at competitive prices or if we were to have product shortages, our expected net sales.


    Customer demand for our products, and thus DRAM ICs, cansales could be difficult to estimate because we do not have long-term commitments from our customers,adversely impacted and our customers maywould likely cancel orders or defer purchase orders for any reason. If we overestimate customer demand, we will have excess inventory of DRAM ICs. If there is a subsequent decline in the price of DRAM ICs, the value of our inventory will fall. As a result, we may needseek other suppliers to write-down the value of our DRAM IC inventory, which may result in a significant decrease in our gross margin and financial condition. If we underestimate customer demand, we will not have sufficient inventory of DRAM ICs to manufacture our products. This will lead to delays in the delivery of our products, which could cause order cancellations, the loss of customers and a decrease in our net sales.replace us.

    If the supply of other component materials used to manufacture our products is interrupted, or if our inventory becomes obsolete, our results of operations and financial condition could be adversely affected.

    We use consumables and other components, including PCBs, to manufacture our memory subsystems. We sometimes procure PCBs and other components from single or limited sources to take advantage of volume pricing discounts. Material shortages or transportation problems could interrupt the manufacture of our products from time to time in the future. These delays in manufacturing could adversely affect our results of operations.

    Frequent technology changes and the introduction of next-generation products also may result in the obsolescence of other items of inventory, such as our custom-built PCBs, which could reduce our gross margin and adversely affect our operating performance and financial condition. We may not be able to sell some products developed for one customer to another customer because our products are



    often designed to address specific customer requirements, and even if we are able to sell these products to another customer, our margin on such products may be reduced.

    We may lose our competitive position if we are unable to timely and cost-effectively develop new or enhanced products that meet our customers’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 a 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’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, develop the product and identify and eliminate design flaws. 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’customers' requirements or gain market acceptance. Accordingly, we cannot assure you that our future product development efforts will result in the development of new or enhanced products or that such products will achieve market acceptance.

    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 DDRDDR1 DRAM architectures to current generation DDR2 DRAM architectures, we must design and qualify new products for use by those customers. In the past, this 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. We must devote substantial resources, including design, engineering, sales, marketing and management efforts, to qualify our products with prospective customers in anticipation of sales. If we delay or do not succeed in qualifying a product with a prospective customer, we will not be able to sell that product to that prospect, which would harm our operating results and business.

    We may not be able to maintain our competitive position because of the intense competition in our targeted markets.

    We participate in a highly competitive market, and we expect competition to intensify. Many of these competitors have longer operating histories, significantly greater resources and name recognition, a larger base of customers and longer-standing relationships with customers and suppliers than we have. As a result, some of these competitors are able to devote greater resources to the development, promotion and sale of products and are better positioned than we are to influence customer acceptance of their products over our products. These competitors also may be able to respond better to new or emerging technologies or standards and may be able to deliver products with comparable or superior performance at a lower price. For these reasons, we may not be able to compete successfully against these competitors.

    In addition to the competitors described above, some of our OEM customers have their own internal design groups that may develop solutions that compete with ours. These design groups have some advantages over us, including direct access to their respective companies’companies' technical information and technology roadmaps. Our OEM customers also have substantially greater resources, financial or otherwise, than we do, and may have lower cost structures than ours. As a result, they may be able to design and manufacture competitive products more efficiently or inexpensively. If any of these OEM customers are successful in competing against us, our sales could decline, our margins could be negatively


    impacted and we could lose market share, any or all of which could harm our business and results of operations.

    We expect our competitors to continue to improve the performance of their current products, reduce their prices and introduce new or enhanced technologies that may offer greater performance and improved pricing. If we are unable to match or exceed the improvements made by our competitors, our market position would deteriorate and our net sales would decline. In addition, our competitors may develop future generations and enhancements of competitive products that may render our technologies obsolete or uncompetitive.

    We also expect to face competition from new and emerging companies that may enter our existing or future markets. These potential competitors may have similar or alternative products which may be less costly or provide additional features.

    The establishment and ongoing operation of our planned manufacturing facility in the People’sPeople's Republic of China, or the PRC, could expose us to new and significant risks.

    We are        During fiscal 2007 we invested significant time and effort in the process of establishing a new manufacturing facility in the PRC. To prepare thisPRC and preparing it for full-scale operations. Our new manufacturing facility for operation, we will need to purchase new equipment, replicate our current manufacturing processesbecame operational in July 2007 and hire additional technical personnel.was successfully qualified by certain key customers. The difficulties normally associated with this complicated process will beare compounded by language and cultural



    differences, as well as the geographic distance from our current facility.domestic facility in Irvine. Our management has limited experience in creating or overseeing foreign operations, and this new facility may divert substantial amounts of their time. Further, this new facility will be subject to factory audits by our customers. We may not be able to begin operations at this new facility on a timely basis, or at all. Even if this facility becomes operational and is qualified by our customers, we cannot assure you that we will be able to maintain control over product quality, delivery schedules, manufacturing yields and costs as we increase our output. We will also have to manage a local workforce that may subject us to uncertainties or regulatory policies. Any difficulties in operating this new facility could cause product delivery delayspolicies and reducewe remain subject to risks related to managing the increased production capacity provided by the facility. Should anticipated demand not materialize, the costs related to having excess capacity would have an adverse impact on our gross margins and operating results.

    We currently anticipate that        As we continue to increase our new manufacturing facilityoperations in the PRC, will become operational in the second half of 2007. Once this facility is established and becomes operational, some of our net sales willin future periods may be denominated in Chinese Renminbi, or Yuan. The Chinese government controls the procedures by which Yuan is converted into other currencies, and conversion of Yuan generally requires government consent. As a result, Yuan may not be freely convertible into other currencies at all times. If the Chinese government institutes changes in currency conversion procedures, or imposes restrictions on currency conversion, those actions may negatively impact our operations and could reduce our operating results. In addition, fluctuations in the exchange rate between Yuan and U.S. dollars may adversely affect our expenses and results of operations as well as the value of our assets and liabilities. These fluctuations may also adversely affect the comparability of our period-to-period results. If we decide to declare dividends and repatriate funds from our Chinese operations, we will be required to comply with the procedures and regulations of applicable Chinese law. Any changes to these procedures and regulations, or our failure to comply with those procedures and regulations, could prevent us from making dividends and repatriating funds from our Chinese operations, which could adversely affect our financial condition. If we are able to make dividends and repatriate funds from our Chinese operations, these dividends would be subject to U.S. corporate income tax.

    The PRC currently provides for favorable tax rates for certain foreign-owned enterprises operating in specified locations in the PRC. We are establishinghave established our ChinaPRC facility in such a tax-favored location. Should the PRC government enact a revised income tax structure, it is possible that we would not realize the tax benefits that we currently anticipate and this could adversely impact our operating results.


    We depend on a few key employees, and if we lose the services of any of those employees or are unable to hire additional personnel, our business could be harmed.

    Our success to        To date haswe have been highly dependent on the experience, relationships and technical knowledge of Chun K. Hong, our President, Chief Executive Officer and Chairman of the Board, Jayesh Bhakta, our Chief Technology Officer, and Christopher Lopes, our Vice President of Sales.certain key employees. We believe that our future success will be dependent on our ability to retain the services of these key employees, develop their successors, reduce our reliance on them, and properly manage the transition of their roles should departures occur.

    The loss of these key employees could delay the development and introduction of, and negatively impact our ability to sell, our products and otherwise harm our business. We do not have employment agreements with any of these key employees other than Mr. Hong.Chun K. Hong, our President, Chief Executive Officer and Chairman of the Board. We do not carry “Key Man”"Key Man" life insurance on any of our key employees.

    Our future success also depends on our ability to attract, retain and motivate highly skilled engineering, manufacturing, other technical and sales personnel. Competition for experienced personnel is intense. We may not be successful in attracting new engineers or other technical personnel, or in retaining or motivating our existing personnel. If we are unable to hire and retain engineers with the skills necessary to keep pace with the evolving technologies in our markets, our ability to continue to provide our current products and to develop new or enhanced products will be negatively impacted, which would harm our business. In addition, the shortage of experienced engineers, and other factors, may lead to increased recruiting, relocation and compensation costs for such engineers, which may



    exceed our expectations and resources. These increased costs may make hiring new engineers difficult, or may reduce our margins.

    As of January 31,December 29, 2007, 20%approximately 36% of our workforce consisted of contract personnel. We invest considerable time and expense in training these contract employees. We may experience high turnover rates in our contract employee workforce, which may require us to expend additional resources in the future. If we convert any of these contract employees into permanent employees, we may have to pay finder’sfinder's fees to the contract agency.

    Our lack of a significant backlog of unfilled orders, and the difficulty inherent in forecasting customer demand, makes it difficult to forecast our short-term production requirements to meet that demand.

    We do not have long-term purchase agreements with our customers. Instead, our customers generally place purchase orders no more than two weeks in advance of their desired delivery date, and these purchase orders generally have no cancellation or rescheduling penalty provisions. This fact, combined with the quick turn-around times that apply to each order, makes it difficult to forecast our production needs and allocate production capacity efficiently. Our production expense levels are based in part on our forecasts of our customers’customers' future product requirements and to a large extent are fixed in the short term. As a result, we likely will be unable to adjust spending on a timely basis to compensate for any unexpected shortfall in those orders. Any significant shortfall of customer orders in relation to our expectations could hurt our operating results, cash flows and financial condition. Also, any rapid increases in production required by our customers could strain our resources and reduce our margins. If such a rapid increase were to occur at any given time, we may not have sufficient short-term manufacturing capacity to meet our customers’customers' immediate demands.

    We attempt to forecast the demand for the DRAM ICs and other components needed to manufacture our products. Lead times for components vary significantly and depend on various factors, such as the specific supplier and the demand and supply for a component at a given time. If we underestimate customer demand or if we have not provided for sufficient manufacturing capacity, we would not be able to manufacture a sufficient quantity of our products and could forego sales opportunities, lose market share and damage our customer relationships.


    If we are unable to manufacture our products efficiently, our operating results could suffer.

    We must continuously review and improve our manufacturing processes in an effort to maintain satisfactory manufacturing yields and product performance, lower our costs and otherwise remain competitive. For example, we began implementing lead-free soldering technologies in our manufacturing processes in the second quarter of 2005, and “Reduction of Hazardous Substances” manufacturing processes in the fourth quarter of 2005, both of which have been fully implemented. Implementing process improvements in the future could negatively impact our manufacturing yields, which would in turn adversely affect our results of operations.

    As we manufacture more complex products, the risk of encountering delays or difficulties increases. The start-up costs associated with implementing new manufacturing technologies, methods and processes, including the purchase of new equipment, and any resulting manufacturing delays and inefficiencies, could negatively impact our results of operations.

    If we need to add manufacturing capacity, an expansion of our existing manufacturing facility or establishment of a new facility could be subject to factory audits by our customers. For example, our new manufacturing facility in the PRC will need to be audited and approved by our key customers. Any delays or unexpected costs resulting from this audit process could adversely affect our net sales and results of operations. In addition, we cannot be certain that we will be able to increase our manufacturing capacity on a timely basis or meet the standards of any applicable factory audits.

    If we fail to protect our proprietary rights, our customers or our competitors might gain access to our proprietary designs, processes and technologies, which could adversely affect our operating results.

    We rely on a combination of patent protection, trade secret laws and restrictions on disclosure to protect our intellectual property rights. We have submitted a number of patent applications regarding our proprietary processes and technology. It is not certain when or if any of the claims in the remaining applications will be allowed. To date we have had only fourseven patents issued. We intend to continue



    filing patent applications with respect to most of the new processes and technologies that we develop. However, patent protection may not be available for some of these processes or technologies.

    It is possible that our efforts to protect our intellectual property rights may not:

    ·

      prevent challenges to, or the invalidation or circumvention of, our existing intellectual property rights;

      ·

      prevent our competitors from independently developing similar products, duplicating our products or designing around any patents that may be issued to us;

      ·

      prevent disputes with third parties regarding ownership of our intellectual property rights;

      ·

      prevent disclosure of our trade secrets and know-how to third parties or into the public domain;

      ·

      result in valid patents, including international patents, from any of our pending or future applications; or

      ·

      otherwise adequately protect our intellectual property rights.

    Others may attempt to reverse engineer, copy or otherwise obtain and use our proprietary technologies without our consent. Monitoring the unauthorized use of our technologies is difficult. We cannot be certain that the steps we have taken will prevent the unauthorized use of our technologies. This is particularly true in foreign countries, such as the PRC, where we are in the process of establishinghave established a new manufacturing facility and where the laws may not protect our proprietary rights to the same extent as applicable U.S. laws.


    If some or all of the claims in our patent applications are not allowed, or if any of our intellectual property protections are limited in scope by a court or circumvented by others, we could face increased competition with regard to our products. Increased competition could significantly harm our business and our operating results.

    We may be involved in costly legal proceedings to defend against claims that we infringe the intellectual property rights of others or to enforce or protect our intellectual property rights.

    Lawsuits claiming that we are infringing others’others' intellectual property rights may be brought against us, and we may have to defend against claims of infringement or invalidity. We currently plan to explore new technologies such as flash memory and to develop new products for our existing markets, such as communications, and for new markets, such as networking. By making use of these new technologies and entering these new markets there is an increased likelihood that others might allege that our products infringe on their intellectual property rights. Litigation is inherently uncertain, and an adverse outcome could subject us to significant liability for damages or invalidate our proprietary rights. An adverse outcome also could force us to take specific actions, including causing us to:

    ·

      cease selling products that are claimed to be infringing a third party’sparty's intellectual property;

      ·

      pay royalties on past or future sales;

      ·

      seek a license from the third party intellectual property owner to use their technology in our products, which license may not be available on reasonable terms, or at all; or

      ·

      redesign those products that are claimed to be infringing a third party’sparty's intellectual property.

    There is a limited pool of experienced technical personnel that we can draw upon to meet our hiring needs. As a result, a number of our existing employees have worked for our existing or potential competitors at some point during their careers, and we anticipate that a number of our future employees will have similar work histories. In the past, some of these competitors have claimed that our employees misappropriated their trade secrets or violated non-competition or non-solicitation agreements. Some of our competitors may threaten or bring legal action involving similar claims against us or our existing employees or make such claims in the future to prevent us from hiring qualified candidates. Lawsuits of this type may be brought, even if there is no merit to the claim, simply as a strategy to drain our financial resources and divert management’smanagement's attention away from our business.


    We also may find it necessary to litigate against others, including our competitors, customers and former employees, to enforce our intellectual property and contractual and commercial rights including, in particular, our trade secrets, as well as to challenge the validity and scope of the proprietary rights of others. We could become subject to counterclaims or countersuits against us as a result of this litigation. Moreover, any legal disputes with customers could cause them to cease buying or using our products or delay their purchase of our products and could substantially damage our relationship with them.

    Any litigation, regardless of its outcome, would be time consuming and costly to resolve, divert our management’smanagement's time and attention and negatively impact our results of operations.

    If we are required to obtain licenses to use third party intellectual property and we fail to do so, our business could be harmed.

    Although some of the components used in our final products contain the intellectual property of third parties, we believe that our suppliers bear the sole responsibility to obtain any rights and licenses to such third party intellectual property. While we have no knowledge that any third party licensor disputes our belief, we cannot assure you that disputes will not arise in the future. The operation of our business and our ability to compete successfully depends significantly on our continued operation without claims of


    infringement or demands resulting from such claims, including demands for payments of money in the form of, for example, ongoing licensing fees.

            We are also developing products to enter new markets, such as the industrial flash market. Similar to our current products, we may use components in these new products that contain the intellectual property of third parties. While we plan to exercise precautions to avoid infringing on the intellectual property rights of third parties, we cannot assure you that disputes will not arise.

    If it is determined that we are required to obtain inbound licenses and we fail to obtain licenses, or if such licenses are not available on economically feasible terms, our business, operating results and financial condition could be significantly harmed.

    If our products do not meet the quality standards of our customers, we may be forced to stop shipments of products until the quality issues are resolved.

            Our customers require our products to meet strict quality standards. Should our products not meet such standards, our customers may discontinue purchases from us until we are able to resolve the quality issues that are causing us to not meet the standards, Such "quality holds" could have a significant adverse impact on our revenues and operating results.

    If our products are defective or are used in defective systems, we may be subject to product recalls or product liability claims.

    If our products are defectively manufactured, contain defective components or are used in defective or malfunctioning systems, we could be subject to product liability claims and product recalls, safety alerts or advisory notices. While we have product liability insurance coverage, it may not be adequate to satisfy claims made against us. We also may be unable to obtain insurance in the future at satisfactory rates or in adequate amounts. Product liability claims or product recalls, regardless of their ultimate outcome, could have an adverse effect on our business, financial condition and reputation, and on our ability to attract and retain customers. In addition, we may determine that it is in our best interest to accept product returns in circumstances where we are not contractually obligated to do so in order to maintain good relations with our customers. Accepting product returns may negatively impact our operating results.


    If we acquire other businesses or technologies in the future, these acquisitions could disrupt our business and harm our operating results and financial condition.

    We will evaluate opportunities to acquire businesses or technologies that might complement our current product offerings or enhance our technical capabilities. We have no experience in acquiring other businesses or technologies. Acquisitions entail a number of risks that could adversely affect our business and operating results, including:

    ·

      difficulties in integrating the operations, technologies or products of the acquired companies;

      ·

      the diversion of management’smanagement's time and attention from the normal daily operations of the business;

      ·

      insufficient increases in net sales to offset increased expenses associated with acquisitions or acquired companies;

      ·

      difficulties in retaining business relationships with suppliers and customers of the acquired companies;

      ·

      the overestimation of potential synergies or a delay in realizing those synergies;

      ·

      entering markets in which we have no or limited experience and in which competitors have stronger market positions; and

      ·

      the potential loss of key employees of the acquired companies.

    Future acquisitions also could cause us to incur debt or be subject to contingent liabilities. In addition, acquisitions could cause us to issue equity securities that could dilute the ownership percentages of our existing stockholders. Furthermore, acquisitions may result in material charges or adverse tax consequences, substantial depreciation, deferred compensation charges, in-process research and development charges, the amortization of amounts related to deferred stock-based compensation expense and identifiable purchased intangible assets or impairment of goodwill, any or all of which could negatively affect our results of operations.


    If we do not effectively manage our growth, our resources, systems and controls may be strained and our results of operations may suffer.

    We have expanded, and plan to continue to expand, our operations, both domestically and internationally. Any future growth may strain our resources, management information and telecommunication systems, and operational and financial controls. To manage our growth effectively, including the development of our new manufacturing facility in the PRC, we must continue to improve and expand our systems and controls. We may not be able to do this in a timely or cost-effective manner, and our current systems and controls may not be adequate to support our future operations. In addition, our officers have relatively limited experience in managing a rapidly growing business or a public company. As a result, they may not be able to provide the guidance necessary to continue our growth or maintain our market position. Any failure to manage our growth or improve or expand our existing systems and controls, or unexpected difficulties in doing so, could harm our business.

    Our internal controls over financial reporting may not be effective, and our independent auditors may not be able to certify as to their effectiveness, which could have a significant and adverse effect on our business.

    We plan to evaluate our internal controls over financial reporting to allow management to report on, and our registered public accounting firm to attest to, those internal controls as will be required by        Section 404 of the Sarbanes-Oxley Act of 2002 and the rules and regulations of the Securities and Exchange Commission, which we collectively refer to as Section 404. This404, require us to evaluate our internal controls over financial reporting to allow management to report on those internal controls as of the end of each year beginning in fiscal 2007. Section 404 will involve system and process evaluations and testing to comply with the management assessment andalso require our independent registered public accounting firm attestation requirementsto attest to the effectiveness of Section 404, which will initially have to be madeour internal controls over financial reporting in our annual report on Form 10-K for our 2007 fiscal year.



    future periods. Effective internal controls are necessary for us to produce reliable financial reports and are important in our effort to prevent financial fraud. In the course of our Section 404 evaluations, we may identify conditions that may result in significant deficiencies or material weaknesses and we may conclude that enhancements, modifications or changes to our internal controls are necessary or desirable. Implementing any such matters would divert the attention of our management, could involve significant costs, and may negatively impact our results of operations.

    We note that there are inherent limitations on the effectiveness of internal controls, as they cannot prevent collusion, management override or failure of human judgment. If we fail to maintain an effective system of internal controls or if management or our independent registered public accounting firm were to discover material weaknesses in our internal controls, we may be unable to produce reliable financial reports or prevent fraud, and it could harm our financial condition and results of operations, result in a loss of investor confidence and negatively impact our share price.

    If a standardized memory solution which addresses the demands of our customers is developed, our net sales and market share may decline.

    Many of our memory subsystems are specifically designed for our OEM customers’customers' high performance systems. Our business would be harmed if these high performance systems were to become standardized so that DRAM IC manufacturers or other companies could develop and manufacture a commodity memory module addressing the demands of some or all of these high performance applications. If DRAM IC manufacturers or other companies are able to develop a standardized solution, our future business may be limited to identifying the next generation of high performance memory demands of OEM customers and developing a solution that addresses such demands. Until fully implemented, this next generation of products may constitute a much smaller market, which may reduce our net sales and market share.


    Our failure to comply with environmental laws and regulations could subject us to significant fines and liabilities or cause us to incur significant costs.

    We are subject to various and frequently changing U.S. federal, state and local and foreign governmental laws and regulations relating to the protection of the environment, including those governing the discharge of pollutants into the air and water, the management and disposal of hazardous substances and wastes, the cleanup of contaminated sites and the maintenance of a safe workplace. In particular, some of our manufacturing processes may require us to handle and dispose of hazardous materials from time to time. For example, in the past our manufacturing operations have used lead-based solder in the assembly of our products. Today, we use lead-free soldering technologies in our manufacturing processes, as this is required for products entering the European Union. We could incur substantial costs, including clean-up costs, civil or criminal fines or sanctions and third-party claims for property damage or personal injury, as a result of violations of, or noncompliance with, environmental laws and regulations. These laws and regulations also could require us to incur significant costs to remain in compliance.

    Economic, political and other risks associated with international sales and operations could adversely affect our net sales.

    Part of our growth strategy involves making sales to foreign corporations and delivering our products to facilities located in foreign countries. To facilitate this process and to meet the long-term projected demand for our products, we are planning tohave set up a new manufacturing facility in the PRC. Selling and manufacturing in foreign countries subjects us to additional risks not present with our domestic operations. We will beginhave begun operating in business and regulatory environments in which we have little or no previous experience. We will need to overcome language and cultural barriers to effectively conduct our operations in these new environments. In addition, the economies of the PRC and other



    countries have been highly volatile in the past, resulting in significant fluctuations in local currencies and other instabilities. These instabilities affect a number of our customers and suppliers in addition to our foreign operations and continue to exist or may occur again in the future. International turmoil and the threat of future terrorist attacks, both domestically and internationally, have contributed to an uncertain political and economic climate, both in the U.S. and globally, and have negatively impacted the worldwide economy. The occurrence of one or more of these instabilities could adversely affect our foreign operations and some of our customers or suppliers, each of which could adversely affect our net sales. In addition, our failure to meet applicable regulatory requirements or overcome cultural barriers could result in production delays and increased turn-around times, which would adversely affect our business.

    Our operations could be disrupted by power outages, natural disasters or other factors.

    Our current manufacturing facility isfacilities are located in Irvine, California.California and Suzhou, PRC. Due to this geographic concentration, a disruption of our manufacturing operations, resulting from equipment failure, power failures, quality control issues, human error, government intervention or natural disasters, including earthquakes, fires or floods, could interrupt or interfere with our manufacturing operations and consequently harm our business, financial condition and results of operations. Such disruptions would cause significant delays in shipments of our products and adversely affect our operating results.

    Our principal stockholders have significant voting power and may take actions that may not be in the best interest of our other stockholders.

    Our        As of December 29, 2007, our executive officers, directors and 5% stockholders beneficially own, in total, approximately 50% of our outstanding common stock. As a result, these stockholders, acting together, have the ability to exert substantial influence over all matters requiring approval by our stockholders, including the election and removal of directors and any proposed merger, consolidation or sale of all or substantially all of our assets


    and other corporate transactions. This concentration of control could be disadvantageous to other stockholders with interests different from those of our executive officers, directors and principal stockholders. For example, our executive officers, directors and principal stockholders could delay or prevent an acquisition or merger even if the transaction would benefit other stockholders. In addition, this significant concentration of share ownership may adversely affect the trading price for our common stock because investors may perceive disadvantages in owning stock in companies with stockholders that have the ability to exercise significant control.

    Anti-takeover provisions under our charter documents and Delaware law could delay or prevent a change of control and could also limit the market price of our stock.

    Our certificate of incorporation and bylaws contain provisions that could delay or prevent a change of control of our company or changes in our board of directors that our stockholders might consider favorable. In addition, these provisions could limit the price that investors would be willing to pay in the future for shares of our common stock. The following are examples of provisions which are included in our certificate of incorporation and bylaws, each as amended:

    ·

      our board of directors is authorized, without prior stockholder approval, to designate and issue preferred stock, commonly referred to as “blank check”"blank check" preferred stock, with rights senior to those of our common stock;

      ·

      stockholder action by written consent is prohibited;

      ·

      nominations for election to our board of directors and the submission of matters to be acted upon by stockholders at a meeting are subject to advance notice requirements; and

      ·

      our board of directors is expressly authorized to make, alter or repeal our bylaws.

      In addition, we are governed by the provisions of Section 203 of the Delaware General Corporate Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our certificate of incorporation and bylaws, and of Delaware law could make it more difficult for stockholders or potential acquirors to obtain control of our board of directors or initiate actions that are opposed by the then-current board of directors, including delaying or impeding a merger, tender offer, or proxy contest or other change of control transaction involving our company. Any delay or prevention of a change of control transaction or changes in our board of directors could prevent the consummation of a transaction in which our stockholders could receive a substantial premium over the then-current market price for their shares.

      Item 1B.    Unresolved Staff Comments

      Not Applicable.

      Item 2.    Properties
                              Properties

      Our corporate headquarters and domestic manufacturing facility are located in approximately 7,00028,700 square feet of space in Irvine, California, under a lease that expires in June 2007.2011. We also continue to lease approximately 8,500 square feet of space forin Irvine, California that previously housed our manufacturing facility, located in Irvine, California.and which we are currently subleasing to another tenant. This lease expires in November 2010. We are presently negotiatingalso currently lease approximately 43,600 square feet of space for larger space,a manufacturing facility in Irvine, to consolidate our headquarters and manufacturing buildings.the PRC. In addition, we lease offices on a monthly basis in corporate office centers located in Austin, Texas, Raleigh, North Carolina and Dublin, Ireland. We are in the process of establishing a manufacturing facility in the PRC. To date we have entered into a letter of intent to lease a facility and have commenced recruiting local personnel. We expect this facility to be operational in the second half of 2007. We believe that our current and planned facilities are adequate for our current and expected operations for the next twelve months and that additional space can be obtained if needed.

      21




      Item 3.    Legal Proceedings

        From timeFederal Securities Class Action

              Beginning in May 2007, we, along with certain of our officers and directors, and our underwriters were named as defendants in four purported class action shareholder complaints, two of which were filed in the U.S. District Court for the Southern District of New York, and two of which were filed in the U.S. District Court for the Central District of California. These purported class action lawsuits were filed on behalf of persons and entities who purchased or otherwise acquired our common stock pursuant or traceable to our November 30, 2006 Initial Public Offering, or IPO. The lawsuits have been consolidated into a single action—Belodoff v. Netlist, Inc., Lead Case No. SACV07-677 DOC (MLGx)—which is pending in the Central District of California. Lead Plaintiff filed the Consolidated Complaint on November 5, 2007. Generally, the complaint alleged that the Registration Statement issued by us in connection with the IPO contained untrue statements of material fact or omissions of material fact in violation of Sections 11 and 15 of Securities Act of 1933. Defendants filed their motions to dismiss the complaint on January 9, 2008. The hearing on defendants' motions to dismiss is set for April 28, 2008. At this time, we may be involved in litigation relatingare unable to claims arising out of our operations in the normal course of business. To date, no legal proceeding has hadform a material effect on us andprofessional judgment that an unfavorable outcome is either probable or remote. Moreover, if an unfavorable outcome should eventually occur, we are not partyat this time able to any material legal proceeding.estimate the amount or range of possible loss.

        California Derivative Action

              In August 2007, a derivative lawsuit was filed in California Superior Court for County of Orange—Smith v. Hong, Case No. 07CC01359—against certain of our officers and directors. This action contains factual allegations similar to those of the federal class action lawsuit described above, but the plaintiff in this case asserts claims for violations of California's insider trading laws, breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment. The plaintiff


      seeks unspecified damages, equitable and/or injunctive relief and disgorgement of all profits, benefits and other compensation obtained by the defendants. The defendants to this action have not responded to the complaint. Pursuant to a stipulation, the parties agreed to temporarily stay the action pending a decision on the defendants' motions to dismiss in the federal securities class action. The parties also agreed that twenty days after the court in the federal securities class action issues a final ruling as to the motions to dismiss brought in that action, the parties will meet and confer regarding the time for defendants to respond to the complaint in this derivative action. At this time, we are unable to form a professional judgment that an unfavorable outcome is either probable or remote. Moreover, if an unfavorable outcome should eventually occur, we are not at this time able to estimate the amount or range of possible loss. In addition, we have received correspondence from counsel for a purported shareholder requesting that we take actions to investigate and remedy alleged wrongdoing by unidentified former and current officers and/or directors based on allegations similar to those in theSmith v. Hong case. We are currently evaluating our response to this request.

      Item 4.    Submission of Matters to a Vote of Security Holders

      Our annual meeting        No matters were submitted to a vote of our stockholders was held on October 23, 2006, at our corporate officessecurity holders in Irvine, for the election of directors and approval of Corbin & Company LLP as our independent registered public accounting firm for our fiscal yearthree months ended December 30, 2006. We did not solicit proxies pursuant to Regulation 14A under the Act, and our board of directors, as described in our registration statement on Form S-1, No. 333-136735, was re-elected in its entirety. 10,897,000 votes were cast for, and none were cast against, the approval of Corbin & Company LLP as our independent registered public accounting firm. There were no abstentions or broker non-votes.29, 2007.



      PART II

      Item 5.    Market for Registrant’sRegistrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

      Our common stock began trading on The NASDAQ Global Market under the trading symbol “NLST”"NLST" on November 30, 2006. Our common stock was not publicly traded prior to November 30, 2006. The following table sets forth the high and low sale prices for our common stock on the NASDAQ Global Market for the year ended December 29, 2007:

       
       High
       Low
      Fourth Quarter $3.40 $2.11
      Third Quarter  3.60  1.67
      Second Quarter  7.00  2.92
      First Quarter  12.40  6.84

              The high and low sale prices for our common stock from the inception of trading on November 30, 2006 through December 30, 2006 were $11.04 and $7.45, and $11.04, respectively. Our common stock was not publicly traded prior to November 30, 2006.

              The approximate number of holders of our common stock as of February 9, 200715, 2008 was 47. We did not make any purchases of our common stock.21.

      Dividend Policy

      We have never declared or paid cash dividends on our capital stock. Our current credit facility prohibits the payment of cash dividends. Accordingly, we do not anticipate declaring or paying cash dividends on our capital stock in the foreseeable future. Any payments of cash dividends will be at the discretion of our board of directors, and will depend upon our results of operations, earnings, capital requirements, legal and contractual restrictions, and other factors deemed relevant by our board of directors.

      Issuer Purchases of Equity Securities

              During the three months ended December 29, 2007, we did not make any purchases of our common stock.

      Securities Authorized for Issuance under Equity Compensation Plans

      Our board of directors and stockholders have previously approved our Amended and Restated 2000 Equity Incentive Plan and our 2006 Equity Incentive Plan. Except as listed in the table below, we do not have any equity based plans, including individual compensation arrangements, that have not been approved by our stockholders. The following table provides information as of December 29, 2007 with respect to shares of our common stock:

      Equity Compensation Plan Information

      Plan Category

       

       

       

      Number of securities
      to be issued upon exercise
      of outstanding options,
      warrants and rights

       

      Weighted-average
      exercise price of
      outstanding options,
      warrants and rights

       

      Number of securities
      remaining available for
      future issuance under
      equity compensation plans
      (excluding securities
      reflected in column (a))

       

       Number of securities
      to be issued upon exercise
      of outstanding options,
      warrants and rights

       Weighted-average
      exercise price of
      outstanding options,
      warrants and rights

       Number of securities
      remaining available for
      future issuance under
      equity compensation plans
      (excluding securities
      reflected in column (a))

       

       

      (a)

       

      (b)

       

      (c)

       

       (a)

       (b)

       (c)

       

      Equity compensation plans approved by security holders

      Equity compensation plans approved by security holders

       

       

      3,318,250

       

       

       

      $

      3.34

       

       

       

      985,000

      (1)

       

       3,546,500 $3.14 124,500(1)

      Equity compensation plans not approved by security holders

      Equity compensation plans not approved by security holders

       

       

      397,500

      (2)

       

       

      $

      1.35

       

       

       

       

       


       

      518,000

      (2)

      $

      1.27

       


       
       
       
       
       

      Total

      Total

       

       

      3,715,750

       

       

       

      $

      3.13

       

       

       

      985,000

       

       

       4,064,500 $2.90 124,500 

      (1)
      Subject to certain adjustments, beginning January 1, 2008, we currently are able to issue a maximum of 1,000,0001,500,000 shares of common stock pursuant to awards granted under our 2006 Equity

        Incentive Plan. That maximum number will automatically increase on the first day of each calendar year by the lesser of (i) 500,000 shares and (ii) such smaller number of shares as may be determined by our board of directors prior to that date.

      (2)
      Consists entirely ofof:

      (i)
      318,000 warrants for theto purchase of shares of our common stock issued to non-employees. See Note 13non-employees for services rendered. As of December 29, 2007, all warrants were fully vested and exercisable.

      (ii)
      200,000 options to our consolidated financial statements for additional information.

      Performance Graph

      The following Performance Graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing.


      The following graph compares our cumulative total stockholder return since the inception of trading of our common stock on November 30, 2006 with the NASDAQ Stock Market (U.S.) Index and Standard & Poor’s (S&P) Semiconductors Index. The graph assumes that the value of the investment in our common stock and each index (including reinvestment of dividends) was $100 on November 30, 2006.

      Comparison of Historical Cumulative Total Return

      among Netlist, Inc., NASDAQ Stock Market (U.S.) and Standard & Poor’s (S&P) Semiconductors Index

       

      November 30, 2006

       

      December 30, 2006

       

      Netlist, Inc.

       

       

      $

      100.00

       

       

       

      $

      120.00

       

       

      S&P Semiconductors Index

       

       

      $

      100.00

       

       

       

      $

      95.83

       

       

      NASDAQ Stock Market (U.S.) Index

       

       

      $

      100.00

       

       

       

      $

      99.77

       

       


      Use of Proceeds

      Our initial offer and sale to the public ofpurchase shares of our common stock par value $0.001issued to our former chief financial officer in connection with her hiring. The options were to vest over a period of 4 years at an exercise price of $1.67 per share, pursuantand are exercisable up to a registration statement on Form S-1, No. 333-136735, was declared effective by the Securities and Exchange Commission on November 29, 2006. We refer90 days subsequent to this offering as our “IPO”. Thomas Weisel Partners LLC was the managing underwriter for our IPO. We registeredher termination of employment.

        See Note 14 of Notes to Consolidated Financial Statements, included in the IPO an aggregate of 7,187,500 shares of our common stock, of which 6,250,000 shares were registered and offered to the public for our account, and 937,500 shares were registered and offered to the public for the accountPart IV, Item 15 of the selling stockholders uponReport, for additional information on equity compensation plans.

      Recent Sales of Unregistered Securities

              During the exercise of an option granted to the underwriters to cover over-allotments. All of the securities registered in the IPO were sold, and the offering has been terminated. The following chart sets forth, for us and the selling stockholders, the aggregate price of the offering amount registered, the aggregate offering price of the amount sold, the aggregate amount of the underwriting discount, the aggregate amount of fees and expenses incurred for our account, and the net offering proceeds to us and to the selling stockholders.

       

      Aggregate
      Offering Price of
      the Offering
      Amount
      Registered

       

      Aggregate
      Offering Price of
      Amount Sold

       

      Underwriting
      Discount

       

      Fees and
      Expenses Incurred
      for Netlist’s
      Account

       

      Net Offering
      Proceeds

       

      Netlist, Inc.

       

       

      $

      43,750,000

       

       

       

      $

      43,750,000

       

       

       

      $

      3,062,000

       

       

       

      $

      1,147,000

       

       

      $

      39,541,000

       

      Selling Stockholders

       

       

      $

      6,562,500

       

       

       

      $

      6,562,500

       

       

       

      $

      459,375

       

       

       

       

       

      $

      6,103,125

       

      Total

       

       

      $

      50,312,500

       

       

       

      $

      50,312,500

       

       

       

      $

      3,521,375

       

       

       

      $

      1,147,000

       

       

       

       

      The following chart sets forth the manner in whichthree months ended December 29, 2007, we have used the net proceeds from the IPO of approximately $39.5 million as of February 15, 2007, includingdid not sell any purposes for which five (5) percent of the total offering proceeds or $100,000 (whichever is less) has been used (in thousands):

      Use of Net Proceeds:

       

       

       

       

       

      Repayment of indebtedness and accrued interest

       

       

      $

      1,809

       

       

      Reduce outstanding borrowings under our revolving line of credit

       

       

      5,500

       

       

      Payment to directors, officers or to persons owning ten (10) percent or more of our capital stock

       

       

      500

       

       

      Purchase of leaseholds and equipment for manufacturing facility in the People’s Republic of China

       

       

      293

       

       

      Investments in marketable securities

       

       

      5,267

       

       

      Long term investments in marketable securities

       

       

      1,502

       

       

      Temporary investments(1)

       

       

      24,670

       

       

      Total

       

       

      $

      39,541

       

       


      (1)   Consists of investments in money market funds and in highly liquid debt instruments of U.S. municipalities, corporations and the U.S. government and its agencies.unregistered securities.


      Item 6.    Selected Consolidated Financial Data

      The selected consolidated financial data set forth below should be read in conjunction with “Management’s"Management's Discussion and Analysis of Financial Condition and Results of Operations”Operations" and our audited consolidated financial statements and the related notes appearing elsewhere in this report.Report.

      The selected consolidated financial data set forth below are derived from our consolidated financial statements. The consolidated statement of operations data for the years ended January 1, 2005,December 29, 2007, December 30, 2006 and December 31, 2005, and December 30, 2006, and the consolidated balance sheet data as of December 31, 200529, 2007 and December 30, 2006, are derived from our audited consolidated financial statements included elsewhere in this report.Report. The consolidated statement of operations data for the years ended December 31, 2002,January 1, 2005 and December 27, 2003 and the consolidated balance sheet data as of December 31, 2002,2005, January 1, 2005 and December 27, 2003 and January 1, 2005 are derived from our audited consolidated financial statements not included in this report.Report. The historical results are not necessarily indicative of results to be expected for future periods.

       

      Year Ended

       

       

       

      December 31,
      2002

       

      December 27,
      2003

       

      January 1,
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

       

       

      (in thousands, except per share data)

       

      Consolidated Statement of Operations Data:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Net sales

       

       

      $

      13,994

       

       

       

      $

      100,375

       

       

      $

      143,659

       

       

      $

      79,856

       

       

       

      $

      151,448

       

       

      Cost of sales(1)

       

       

      12,147

       

       

       

      86,107

       

       

      133,503

       

       

      73,892

       

       

       

      129,181

       

       

      Gross profit

       

       

      1,847

       

       

       

      14,268

       

       

      10,156

       

       

      5,964

       

       

       

      22,267

       

       

      Operating expenses:  

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Research and development(1)

       

       

      491

       

       

       

      11,759

       

       

      3,770

       

       

      2,961

       

       

       

      3,315

       

       

      Selling, general and administrative(1)

       

       

      1,652

       

       

       

      15,218

       

       

      6,314

       

       

      5,062

       

       

       

      9,191

       

       

      Total operating expenses

       

       

      2,143

       

       

       

      26,977

       

       

      10,084

       

       

      8,023

       

       

       

      12,506

       

       

      Operating income (loss)

       

       

      (296

      )

       

       

      (12,709

      )

       

      72

       

       

      (2,059

      )

       

       

      9,761

       

       

      Other expense, net

       

       

      (290

      )

       

       

      (879

      )

       

      (1,386

      )

       

      (1,200

      )

       

       

      (1,849

      )

       

      Income (loss) before provision (benefit) for income taxes

       

       

      (586

      )

       

       

      (13,588

      )

       

      (1,314

      )

       

      (3,259

      )

       

       

      7,912

       

       

      Provision (benefit) for income taxes

       

       

      46

       

       

       

      2,317

       

       

      (340

      )

       

      (912

      )

       

       

      2,844

       

       

      Net income (loss)

       

       

      $

      (632

      )

       

       

      $

      (15,905

      )

       

      $

      (974

      )

       

      $

      (2,347

      )

       

       

      $

      5,068

       

       

      Net income (loss) per common share:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Basic

       

       

      $

      (0.07

      )

       

       

      $

      (1.62

      )

       

      $

      (0.09

      )

       

      $

      (0.22

      )

       

       

      $

      0.43

       

       

      Diluted

       

       

      $

      (0.07

      )

       

       

      $

      (1.62

      )

       

      $

      (0.09

      )

       

      $

      (0.22

      )

       

       

      $

      0.34

       

       

      Weighted-average common shares outstanding:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Basic

       

       

      9,200

       

       

       

      9,831

       

       

      10,671

       

       

      10,673

       

       

       

      11,705

       

       

      Diluted

       

       

      9,200

       

       

       

      9,831

       

       

      10,671

       

       

      10,673

       

       

       

      15,331

       

       

       
       Year Ended
       
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       January 1,
      2005

       December 27,
      2003

       
       
       (in thousands, except per share data)

       
      Consolidated Statement of Operations Data:                
       Net sales $100,060 $151,448 $79,856 $143,659 $100,375 
       Cost of sales(1)  91,261  129,181  73,892  133,503  86,107 
        
       
       
       
       
       
       Gross profit  8,799  22,267  5,964  10,156  14,268 
        
       
       
       
       
       
       Operating expenses:                
        Research and development(1)  4,748  3,315  2,961  3,770  11,759 
        Selling, general and administrative(1)  15,900  9,191  5,062  6,314  15,218 
        
       
       
       
       
       
         Total operating expenses  20,648  12,506  8,023  10,084  26,977 
        
       
       
       
       
       
       Operating income (loss)  (11,849) 9,761  (2,059) 72  (12,709)
       Other income (expense), net  411  (1,849) (1,200) (1,386) (879)
        
       
       
       
       
       
       Income (loss) before provision (benefit) for income taxes  (11,438) 7,912  (3,259) (1,314) (13,588)
       Provision (benefit) for income taxes  (4,025) 2,844  (912) (340) 2,317 
        
       
       
       
       
       
       Net income (loss) $(7,413)$5,068 $(2,347)$(974)$(15,905)
        
       
       
       
       
       
       Net income (loss) per common share:                
        Basic $(0.38)$0.43 $(0.22)$(0.09)$(1.62)
        Diluted $(0.38)$0.34 $(0.22)$(0.09)$(1.62)
       
      Weighted-average common shares outstanding:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      ��

       
        Basic  19,674  11,705  10,673  10,671  9,831 
        Diluted  19,674  15,331  10,673  10,671  9,831 

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

       

      Year Ended

       

       

       

      December 31,
      2002

       

      December 27,
      2003

       

      January 1,
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

       

       

      (in thousands)

       

      Cost of sales

       

       

      $

       

       

       

      $

      69

       

       

       

      $

      29

       

       

       

      $

      56

       

       

       

      $

      104

       

       

      Research and development

       

       

      371

       

       

       

      9,733

       

       

       

      80

       

       

       

      (52

      )

       

       

      125

       

       

      Selling, general and administrative

       

       

      424

       

       

       

      10,872

       

       

       

      141

       

       

       

      (65

      )

       

       

      363

       

       

      26


       
       Year Ended
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       January 1,
      2005

       December 27,
      2003

       
       (in thousands)

      Cost of sales $171 $104 $56 $29 $69
      Research and development  149  125  (52) 80  9,733
      Selling, general and administrative  861  363  (65) 141  10,872


       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       January 1,
      2005

       December 27,
      2003

       
       (in thousands)

      Consolidated Balance Sheet Data:               
       Cash and cash equivalents $7,182 $30,975 $953 $759 $1,907
       Investments in marketable securities  23,387  6,769      
       Total assets  60,356  87,694  25,842  22,110  22,404
       Total debt(1)  6,250  21,501  13,921  9,379  3,464
       Stockholders' equity  44,193  50,244  2,855  5,261  5,981


       

       

      December 31,
      2002

       

      December 27,
      2003

       

      January 1,
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

       

       

      (in thousands)

       

      Consolidated Balance Sheet Data:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Cash, cash equivalents and short term investments

       

       

      $

      91

       

       

       

      $

      1,907

       

       

       

      $

      759

       

       

       

      $

      953

       

       

       

      $

      36,242

       

       

      Total assets

       

       

      9,129

       

       

       

      22,404

       

       

       

      22,110

       

       

       

      25,842

       

       

       

      87,694

       

       

      Total debt(1)

       

       

      3,778

       

       

       

      3,464

       

       

       

      9,379

       

       

       

      13,921

       

       

       

      21,501

       

       

      Stockholders’ equity

       

       

      754

       

       

       

      5,981

       

       

       

      5,261

       

       

       

      2,855

       

       

       

      50,244

       

       


      (1)
      Amounts include outstanding revolving line of credit balance as of each respective date.

      Effective January 1, 2003, we changed our fiscal year from a calendar year to a 52/53-week fiscal year ending on the Saturday closest to December 31.

      Item 7.                        Management’s    Management's Discussion and Analysis of Financial Condition and Results of Operations

      The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected"Selected Consolidated Financial Data”Data" and our audited consolidated financial statements and the related notes included elsewhere in this report.Report. In addition to historical consolidated financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties, estimates and assumptions. Our actual results could differ materially from those anticipated by these forward-looking statements as a result of many factors, including those discussed in this reportReport under “Risk Factors”"Risk Factors".

      Overview

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

      Due to their importance to overall system architecture and performance, our products must undergo lengthy qualification reviews by our OEM customers, which may last up to six months. In addition, in order to penetrate large OEMs, we have typically been required to demonstrate our ability to meet strict standards for quality, customer service and turnaround time by first supplying less complex products into a limited range of high volume applications. For example, the initial products we sold to IBM were used in mobile computing applications. The majority of our sales of subsequent products to IBM have been for high-end server applications, our primary market focus. 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. Dell, Hewlett Packard and IBM represented approximately 55%, 23% and Lenovo represented 38%, 33% and 2%7%, respectively, of our net sales in fiscal 2006,2007, and 35%approximately 38%, 20%4% and 13%33%, respectively, of our net sales in fiscal 2005. The decline in2006. Net sales to Lenovo was due to our sales emphasis on high-end server applications. We expect that Dell and IBM will continue to represent a significant percentagesome of our OEM customers include memory modules that are qualified by us directly with the OEM customer and sold to electronic manufacturing services providers, or EMSs, for incorporation into products manufactured exclusively for the OEM customer. These net sales to EMSs have historically fluctuated period by period as a portion of the total net sales to these OEM customers. Net sales to Hon Hai Precision Industry Co. Ltd., an EMS that purchases memory modules from us for at least the next 12 months.

      We commenced operations in September 2000 and initially focused on memory subsystems for the telecommunications markets. Beginning in the second quarter of 2001, we shifted our focus to the server and high performance computing markets, due in large part to the telecommunications market downturn.incorporation into



      In 2002, we became a qualified supplierproducts manufactured exclusively for RLX Technologies, Inc., a blade server manufacturer. OneDell, represented approximately 57% of the products we initially developed for RLX, our proprietary 2-inch form factor, 1-gigabyte memory subsystem, led to the development of a range of additional memory subsystems.

      We began qualifying our 2-inch form factor, 1-gigabyte memory subsystem with Dell in the second quarter of 2002 and started shipping it to Dell in the fourth quarter of 2002. Ournet sales to Dell continued to increase throughoutfor fiscal 20032007 and the first three quartersapproximately 40% of fiscal 2004, as we began to ship more of our memory subsystems to a larger number of Dell facilities in the U.S., Europe and Asia. During this time, we also qualified new products with other leading server and high performance computing OEMs. Beginning in the fourth quarter of fiscal 2004, issues associated with the transition from DDR to DDR2 DRAM architectures, including the requirement for new IC packaging, assembly and handling techniques, resulted in a significant decrease in our sales to Dell. In response to this revenue decline, we carried out two workforce reductions in fiscal 2005 to reduce expenses and preserve cash. Ournet sales to Dell beganfor fiscal 2006. Net sales to recover in the fourth quarterKingston Technology Company, Inc., and to International Systems Technology Co. Ltd., both EMSs that purchase memory modules from us for incorporation into products manufactured exclusively for IBM, represented approximately 43% and 21%, respectively, of fiscal 2005. Also during fiscal 2005, ournet sales to IBM for fiscal 2007 and Lenovo began to increase significantly.

      Ourapproximately 57% and 22%, respectively, of net sales to IBM continuedfor fiscal 2006.

              For the year ended December 29, 2007, the market price for mainstream DRAM ICs decreased by approximately 85%. This decline has adversely affected the selling prices of many of our products and generally contributed to grow significantlylower revenues, lower gross margin and reduced inventory value during fiscal 2006, driven by high demand for IBM’s line of blade servers that incorporates our proprietary very low profile memory subsystem. Sales to Dell also grew significantly as our DDR2 products began to shipthis period. Should the decline in volume. In addition, we began shipments to other leading OEMs, including Gatewaythe DRAM IC market continue, it would result in lower net sales, lower gross margin and Hewlett-Packard. We have several new productsreduced inventory value in various stages of qualification that we anticipate will be incorporated into additional platforms currently in development at our customers.subsequent periods.

      Key Business Metrics

      The following describes certain line items in our statements of operations that are important to management’smanagement'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 purchase orders with us approximately two weeks in advance of scheduled delivery. Selling prices are typically negotiated monthly, based on competitive market conditions and the current price of DRAM ICs. Purchase orders generally have no cancellation or rescheduling penalty provisions. We often ship our products to our customers’customers' international manufacturing sites. All of our sales to date, however, are denominated in U.S. dollars. We also sell excess component inventory of DRAM ICs to distributors and other users of memory ICs. These sales accounted for 8%approximately 2% and 24%8% of our net sales infor fiscal 20062007 and 2005,2006, respectively. We expect that component inventory sales will continue to decrease as a percentage of net sales in future periods as we diversify our customer base and therefore are able to use components in a wider range of memory subsystems.

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

      Research and Development.Research and development expense consists primarily of employee and independent contractor compensation and related costs, stock-based compensation, computer-aided design software licenses, reference design development costs, patent-related fees, depreciation or rental of evaluation equipment, and occupancy and other allocated overhead costs. Also included in research



      and development expense are the costs of material and overhead related to the production of engineering samples of new products under development or products used solely in the research and development process. Our customers typically do not separately compensate us for design and engineering work involved in developing application-specific products for them. All research and development costs are expensed as incurred. AsTo the extent that we continue efforts to develop additional proprietary technologies, we anticipate that research and development expenditures will increase.

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

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

      Critical Accounting Policies

      The preparation of our 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 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 consolidated financial statements:

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

      For all sales, we        We generally use a bindingcustomer purchase orderorders and/or contracts as evidence of an arrangement. Delivery occurs when goods are shipped for customers with FOB Shipping Point terms and upon receipt for customers with FOB


      Destination terms, at which time title and risk of loss transfer to the customer. Shipping documents are used to verify delivery and customer acceptance. We assess whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund.

              Customers are generally allowed limited rights of return for up to 30 days, except for sales of excess inventories, which contain no right-of-return privileges. Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. Returns from customers have not been material in any period as our principal customers have adopted build-to-order manufacturing models or just-in-time management processes.



      We offer a standard product warranty to our customers and have no other post-shipment obligations. While these returns have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience similar return rates in the future. Any significant increase in product failure rates and the resulting product returns could have a material adverse effect on our operating results for the period or periods in which such returns materialize.

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

      Customers are generally allowed limited rights of return for up to 30 days. Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. While these returns We have historically beenhad good visibility into our customers' requirements within each reporting period. However, if a customer does not pull our expectationsinventory from its hub in accordance with the schedule it originally provided to us, our predicted future revenues could vary from our forecasts and the provisions established,our results of operations could be materially and adversely affected. Additionally, since we cannot guaranteeown inventories that we will continueare physically located in hubs, our ability to experience similar return rates in the future. Any significanteffectively manage inventory levels may be impaired, causing our inventory turns to decrease, which would increase in product failure ratesexpenses associated with excess and the resulting product returns could have a material adverse effect onobsolete inventories and negatively impact our operating results for the period or periods in which such returns materialize.cash flow.

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

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

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

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

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



      material inventory. Once established, any write-downs are considered permanent adjustments to the cost basis of the excess or obsolete


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

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

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

      Prior to January 1, 2006, we accounted for stock-based compensation issued to employees and directors using the intrinsic value method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25,Accounting for Stock Issued to Employeesand related pronouncements. Under this method, compensation expense was recognized over the respective vesting period based on the excess, on the date of grant, of the fair value of our common stock over the grant price, net of forfeitures. Deferred stock-based compensation was amortized on a straight-line basis over the vesting period of each grant. During the years ended December 31, 2005 and January 1, 2005, stock-based compensation expense, net of forfeitures was $(61,000) and $250,000, respectively.

      On January 1, 2006, we adopted SFAS No. 123(R),Share-Based Payment, or SFAS No. 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors related to our Amended and Restated 2000 Equity Incentive Plan based on estimated fair values. We adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal year 2006. Our consolidated financial statements as of and for the year ended December 30, 2006 reflect the impact of adopting SFAS No. 123(R). In accordance with the modified prospective transition method, our consolidated



      financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R).

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

              The value of the portion of the awardstock-based awards that isare ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statement of operations.financial statements in fiscal 2006 and thereafter. As stock-based compensation expense recognized in the consolidated statement of operations for the year ended December 30, 2006our financial statements is based on awards ultimately expected to vest, it has been reduced


      for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimated average forfeiture rate forIf there are any modifications or cancellations of the year ended December 30, 2006 of 8% was based on historical forfeiture experience and estimated future employee forfeitures. In our pro forma informationunderlying unvested stock-based awards, we may be required under SFAS No. 123 for the periods prior to fiscal 2006, we accounted for forfeitures as they occurred.

      Employeeaccelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense recognized under SFAS No. 123(R) forand unearned stock-based compensation will increase to the year ended December 30, 2006 was $592,000, determined by the Black-Scholes valuation model. As of December 30, 2006, total unrecognized compensation cost, adjusted for estimated forfeitures, related to unvested stock options was $3,687,000, which is expected to be recognized as an expense over a weighted-average period of approximately 4 years. See Note 2 to our consolidated financial statements forextent that we grant additional information.stock-based awards.

      Income Taxes.We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying values and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance, when determined necessary, based on historical taxable income, projected future taxable income, and the expected timing of the reversals of existing temporary differences. If we operate at a loss for an extended period of time or are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to record a valuation allowance against all or a significant portion of our deferred tax assets which could substantially increase our effective tax rate for such period. Any significant changes in statutory tax rates or the amount of our valuation allowance could have a material effect on the value of our deferred tax assets and liabilities, and our reported financial results.

      Our current effective tax rate is approximately 36%. We expect this rate to decrease if Additionally, we generate profits from our planned manufacturing facilityadopted Financial Accounting Standards Board, or FASB, Interpretation No. 48,Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109, or FIN 48, on December 31, 2006, the PRC infirst day of fiscal 2007. This decreaseFIN 48 seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. FIN 48 prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be attributabletaken on a tax return and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under FIN 48 we may only recognize or continue to recognize tax positions that meet a "more likely than not" threshold.


              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 favorable tax treatment availableevolution 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 region in which we intendneed to establish our operation. The magnitude of the decrease is not known, as we have not finalized ourrecord additional tax strategy as it relates to the planned PRC operation.liabilities or potentially reverse previously recorded tax liabilities.


      Results of Operations

      The following table sets forth our consolidated statements of operations for the periods indicated:

       

      Year Ended

       

       

       

      January 1, 
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

      Consolidated Statement of Operations Data:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Net sales

       

       

      $

      143,659

       

       

       

      $

      79,856

       

       

       

      $

      151,448

       

       

      Cost of sales(1)

       

       

      133,503

       

       

       

      73,892

       

       

       

      129,181

       

       

      Gross profit

       

       

      10,156

       

       

       

      5,964

       

       

       

      22,267

       

       

      Operating expenses:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Research and development(1)

       

       

      3,770

       

       

       

      2,961

       

       

       

      3,315

       

       

      Selling, general and administrative(1)

       

       

      6,314

       

       

       

      5,062

       

       

       

      9,191

       

       

      Total operating expenses

       

       

      10,084

       

       

       

      8,023

       

       

       

      12,506

       

       

      Operating income (loss)

       

       

      72

       

       

       

      (2,059

      )

       

       

      9,761

       

       

      Other expense, net

       

       

      (1,386

      )

       

       

      (1,200

      )

       

       

      (1,849

      )

       

      Income (loss) before provision (benefit) for income taxes

       

       

      (1,314

      )

       

       

      (3,259

      )

       

       

      7,912

       

       

      Provision (benefit) for income taxes

       

       

      (340

      )

       

       

      (912

      )

       

       

      2,844

       

       

      Net income (loss)

       

       

      (974

      )

       

       

      $

      (2,347

      )

       

       

      $

      5,068

       

       


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

       

      Year Ended

       

       

       

      January 1, 
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

      Cost of sales

       

       

      $

      29

       

       

       

      $

      56

       

       

       

      $

      104

       

       

      Research and development

       

       

      80

       

       

       

      (52

      )

       

       

      125

       

       

      Selling, general and administrative

       

       

      141

       

       

       

      (65

      )

       

       

      363

       

       


      The following table sets forth our consolidated statements of operations as a percentage of net sales for the periodsyears indicated:

       

      Year Ended

       


       Year Ended
       

       

      January 1, 
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       


       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       

      Consolidated Statement of Operations Data:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Net sales

       

       

      100.0

      %

       

       

      100.0

      %

       

       

      100.0

      %

       

      Net sales 100%100%100%

      Cost of sales

       

       

      92.9

       

       

       

      92.5

       

       

       

      85.3

       

       

      Cost of sales 91 85 93 
       
       
       
       

      Gross profit

       

       

      7.1

       

       

       

      7.5

       

       

       

      14.7

       

       

      Gross profit 9 15 7 
       
       
       
       

      Operating expenses:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Operating expenses:       

      Research and development

       

       

      2.6

       

       

       

      3.7

       

       

       

      2.2

       

       

      Selling, general and administrative

       

       

      4.4

       

       

       

      6.4

       

       

       

      6.1

       

       

      Total operating expenses

       

       

      7.0

       

       

       

      10.1

       

       

       

      8.3

       

       

      Research and development 5 2 4 
      Selling, general and administrative 16 6 6 
       
       
       
       
       Total operating expenses 21 8 10 
       
       
       
       

      Operating income (loss)

       

       

      0.1

       

       

       

      (2.6

      )

       

       

      6.4

       

       

      Operating income (loss) (12)6 (3)

      Other expense, net

       

       

      (1.0

      )

       

       

      (1.5

      )

       

       

      (1.2

      )

       

       
       
       
       
      Other income (expense):Other income (expense):       
      Interest income (expense), net  (1)(2)
      Other income (expense), net    
       
       
       
       
       Total other income (expense), net  (1)(2)

      Income (loss) before provision (benefit) for income taxes

       

       

      (0.9

      )

       

       

      (4.1

      )

       

       

      5.2

       

       

      Income (loss) before provision (benefit) for income taxes (11)5 (4)

      Provision (benefit) for income taxes

       

       

      (0.2

      )

       

       

      (1.1

      )

       

       

      1.9

       

       

      Provision (benefit) for income taxes (4)2 (1)
       
       
       
       

      Net income (loss)

       

       

      (0.7

      )%

       

       

      (3.0

      )%

       

       

      3.3

      %

       

      Net income (loss) (7)%3%(3)%
       
       
       
       

      Year Ended December 29, 2007 Compared to the Year Ended December 30, 2006

        Net Sales, Cost of Sales and Gross Profit

              The following table presents net sales, cost of sales and gross profit for the years ended December 29, 2007 and December 30, 2006 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 29,
      2007

       December 30,
      2006

       Decrease
       %
      Change

       
      Net sales $100,060 $151,448 $(51,388)(34)%
      Cost of sales  91,261  129,181  (37,920)(29)%
        
       
       
         
      Gross profit $8,799 $22,267 $(13,468)(60)%
        
       
       
         
      Gross margin  8.8% 14.7% (5.9)%  
        
       
       
         

              Net Sales.    Net sales for the year ended December 29, 2007 were adversely impacted by two primary factors. First, the significant decreases in DRAM IC market prices during the period, which was primarily driven by continued oversupply in the DRAM market, forced us to significantly reduce



      our selling prices on many of our products. Additionally, we experienced decreases in demand as falling market prices generally led to expectations of further price reductions, which caused certain customers to delay purchases from us.

              The decrease in net sales for the year ended December 29, 2007 as compared to the year ended December 30, 2006 resulted primarily from decreases of (i) $42.1 million in sales of our very low profile memory subsystems, (ii) $21.6 million in sales of Double Data Rate, or DDR and DDR2 memory subsystems and (iii) $23.0 million in sales of other memory products, primarily with respect to certain of our upgrade and distribution business customers that were affected by the the overall downward market in 2007. These decreases were partially offset by increases in net sales for 2007 as compared to 2006 of (i) $27.2 million in sales of laptop personal computer memory subsystems and (ii) $9.6 million in sales of memory subsystems used to control Redundant Arrays of Independent Disks, or RAIDs. The overall decreases in net sales are primarily attributable to the market-driven reductions in selling prices of our products and lower customer demand as described above, particularly on our high volume products with lower average selling prices as well as overall lower than expected demand from OEM products in which our products are incorporated, such as blade servers that use our very low profile memory subsystems.

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

              Sales of our component inventory to distributors and other users of memory ICs represented approximately 2% and 8% of net sales for the years ended December 29, 2007 and December 30, 2006, respectively. We expect that component inventory sales will decrease as a percentage of net sales in future periods as we diversify our customer base and therefore are able to use components in a wider range of memory subsystems.

              Gross Profit and Gross Margin.    Gross profit for the year ended December 29, 2007 as compared to the year ended December 30, 2006 decreased primarily due to the 34% decrease in net sales between the two years. The decrease in gross profit and gross margin for 2007 is also attributable to the significant decrease in the market price of DRAM ICs during 2007. This market decline significantly impacted the valuation of our inventories, whereby we incurred a loss in the year ended December 29, 2007 of approximately $5.3 million as a result of slow moving and lower-of-cost-or-market value inventory adjustments. Additionally, as a result of the overall decrease in demand that we experienced in 2007, along with the start-up costs to establish our new manufacturing facility in the People's Republic of China, or PRC, we incurred excess manufacturing capacity costs in 2007 of approximately $4.7 million. The declines in both gross profit and gross margin in 2007 were partially offset by certain shifts in product mix that provide for higher margins. To the extent that DRAM IC market prices continue to decline, or should our product sales mix move toward lower margin products such as laptop memory, our gross profit, gross margin and overall operating results could be adversely affected in future periods.

        Research and Development

              The following table presents research and development expenses for the years ended December 29, 2007 and December 30, 2006 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 29,
      2007

       December 30,
      2006

       Increase
       %
      Change

       
      Research and development $4,748 $3,315 $1,433 43%

              The increase in research and development expense for the year ended December 29, 2007 as compared to the year ended December 30, 2006 resulted primarily from increases of (i) $0.5 million in



      personnel-related expenses as a result of an increase in the number of employees engaged in research and development activities since December 30, 2006, along with increased expenses related to changes to our employee insurance plan coverage premiums and matching contributions to our employee 401(k) plan, (ii) $0.2 million for certain engineering and design tools, product qualification and other related expenses along with $0.1 million in legal and professional services fees as we increased activities related to new and emerging markets during 2007, (iii) $0.3 million for impairment write-downs of certain long-lived assets used in the product development process as further discussed in Note 11 of Notes to Consolidated Financial Statements and (iv) $0.3 million in various allocated overhead expenses.

        Selling, General and Administrative

              The following table presents selling, general and administrative expenses for the years ended December 29, 2007 and December 30, 2006 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 29,
      2007

       December 30,
      2006

       Increase
       %
      Change

       
      Selling, general and administrative $15,900 $9,191 $6,709 73%

              The increase in selling, general and administrative expenses for the year ended December 29, 2007 as compared to the year ended December 30, 2006 resulted primarily from increases of (i) $2.8 million in personnel-related expenses as a result of an increase in the number of employees engaged in selling, general and administrative activities since December 30, 2006, including recruitment and related expenses, along with increased expenses related to changes to our employee insurance plan coverage premiums and matching contributions to our employee 401(k) plan, (ii) $0.5 million in stock-based compensation expenses due to our increased headcount and additional stock-based awards granted during 2007, (iii) $1.2 million in various selling and promotion expenses primarily as a result of additional product qualification activities, travel and other costs incurred in connection with our efforts to begin operations at our facility in the PRC, (iv) $0.9 million in legal and professional services as a result of additional legal and other professional services primarily related to certain reporting and other obligations due to becoming a public company, along with costs for litigation-related matters as further discussed in Note 9 of Notes to Consolidated Financial Statements, (v) $0.4 million related primarily to certain facility lease relocation costs and a write-down of the carrying value of certain of our long-lived assets and (vi) $1.1 million in various allocated overhead expenses which include, but are not limited to, expenses for insurance, depreciation and rent. The increases in selling, general and administrative expenses are partially offset by decreases of (i) $0.3 million in bad debt expense and (ii) $0.1 million in commission-related expenses due to our lower overall net sales in 2007 as compared to 2006.

        Other Income (Expense), Net

              The following table presents other income (expense) for the years ended December 29, 2007 and December 30, 2006 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 29,
      2007

       December 30,
      2006

       Increase
       %
      Change

       
      Interest income (expense), net $395 $(1,825)$2,220 122%
      Other income (expense), net  16  (24) 40 167%
        
       
       
         
      Total other income (expense), net $411 $(1,849)$2,260 122%

              Net interest income for the year ended December 29, 2007 was comprised of interest income of approximately $1.7 million, partially offset by interest expense of approximately $1.3 million. The increase in net interest income during 2007 as compared to 2006 resulted primarily from (i) interest



      income earned on our cash equivalents and marketable securities balances, which is attributable to the proceeds from our IPO in December 2006 and (ii) a decrease in interest expense due to our lower outstanding line of credit and debt balances in 2007 as compared to 2006.

              Other income (expense), net, primarily includes gains and losses on foreign currency transactions in 2007 and losses on dispositions of property and equipment.

        Provision (Benefit) for Income Taxes

              The following table presents the provision (benefit) for income taxes for the years ended December 29, 2007 and December 30, 2006 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 29,
      2007

       December 30,
      2006

       Decrease
       %
      Change

       
      Provision (benefit) for income taxes $(4,025)$2,844 $(6,869)(242)%

              The federal statutory rate was 35% for fiscal 2007 and 2006. We recorded a benefit for income taxes due to a pre-tax loss for the year ended December 29, 2007 as compared to a provision for income taxes for the year ended December 30, 2006. The differences between our effective tax rates and the federal statutory rate primarily relates to the benefit of lower federal tax brackets, state taxes and foreign losses recorded without tax benefits in fiscal 2007 and the benefit of lower federal tax brackets and state taxes in fiscal 2006.

              We use the liability method of accounting for income taxes as set forth in SFAS No. 109,Accounting for Income Taxes. We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future income, tax planning strategies, and recent financial performance including carryback opportunities to the extent available. As a result of recent cumulative taxable income, a federal carryback opportunity, and projections of income in the near future, we have concluded that no valuation allowance should be recorded as of the end of 2007.

              As a result of our adoption of FIN 48 in fiscal 2007, we recorded an increase in the net liability for unrecognized tax positions of approximately $0.2 million, which was recorded as an adjustment to the beginning balance of accumulated deficit as of December 31, 2006.

              Included in the unrecognized tax benefits at December 29, 2007 was approximately $0.6 million of tax positions that, if recognized, would affect our annual effective tax rate. Our continuing practice is to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. This policy did not change as a result of the adoption of FIN 48. At December 29, 2007, we had approximately $75,000 accrued for interest and $0 accrued for penalties. We do not expect our unrecognized tax benefits to change significantly over the next 12 months.

              In future periods, we will begin to operate under tax holidays in the PRC, which are effective from January 2008 through December 2012.


      Year Ended December 30, 2006 Compared to the Year Ended December 31, 2005

        Net Sales, Cost of Sales and Gross Profit

              The following table presents net sales, cost of sales and gross profit for the years ended December 30, 2006 and December 31, 2005 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 30,
      2006

       December 31,
      2005

       Increase
       %
      Change

       
      Net sales $151,448 $79,856 $71,592 90%
      Cost of sales  129,181  73,892  55,289 75%
        
       
       
         
      Gross profit $22,267 $5,964 $16,303 273%
        
       
       
         
      Gross margin  14.7% 7.5% 7.2%  
        
       
       
         

      Net Sales.Net    Approximately $32.7 million of the increase in net sales for the year ended December 30, 2006 were $151.4 million, an increase of $71.5 million, or 90%, overas compared to the year ended December 31, 2005. Approximately $32.7 million of the increase2005 was attributable to higher unit sales of our very low profile memory subsystems. In addition, DDR2 server memory subsystem sales increased by $28.0 million and DDR subsystem sales decreased by $8.1 million due to customers transitioning to DDR2 architectures. Sales of memory subsystems used to control redundant arrays of independent disks (RAIDs)RAIDs commenced late in the second quarter of fiscal 2006 and contributed $22.4 million to the increase in revenues. Finally, sales of laptop and desktop personal computer, or PC, memory subsystems decreased $3.5 million as we focused on sales of higher margin server memory subsystems.

      Sales of our component inventory to distributors and other users of memory ICs represented 8% and 24% of net sales for the years ended December 30, 2006 and December December��31, 2005, respectively. We expect that component inventorySuch sales will decreasedecreased primarily as a percentageresult of net sales in future periods as weour efforts to diversify our customer base and therefore are ablewhich has resulted in our ability to use components in a wider range of memory subsystems.

      Gross Profit and Gross Margin.Gross profit for the year ended December 30, 2006 was $22.3 million, an increase of $16.3 million, or 273%, over the year ended December 31, 2005. Gross margin increased to 14.7% from 7.5% for the same period.    The increase in both gross profit and gross margin for the year ended December 30, 2006 as compared to the year ended December 31, 2005 is primarily attributable to increased sales of our very low profile memory subsystems and memory subsystems to control RAIDs, which generate higher margins due to their innovative design, as well as lower margin products becoming a smaller portion of our overall product sales mix.

        Research and Development.DevelopmentResearch

              The following table presents research and development expenses for the years ended December 30, 2006 and December 31, 2005 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 30,
      2006

       December 31,
      2005

       Increase
       %
      Change

       
      Research and development $3,315 $2,961 $354 12%

              The increase in research and development expense for the year ended December 30, 2006 were $3.3 million, an increase of $0.3 millionas compared to the year ended December 31, 2005. The increase2005 is related primarily to increases of (i) $0.4 million in part to increasedpersonnel-related expenses as a result of an increase in personnel, salaries and bonuses in fiscal 2006 and (ii) $0.2 million in stock-based compensation.compensation expense. These increases were partially offset by a decreasedecreases of (i) $0.1 million in depreciation expense and (ii) $0.1 million in outside services and professional fees.


        Selling, General and Administrative.AdministrativeSelling,

              The following table presents selling, general and administrative expenses for the years ended December 30, 2006 and December 31, 2005 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 30,
      2006

       December 31,
      2005

       Increase
       %
      Change

       
      Selling, general and administrative $9,191 $5,062 $4,129 82%

              The increase in selling, general and administrative expense for the year ended December 30, 2006 were $9.2 million, an increase of $4.1 millionas compared to the year ended December 31, 2005. The increase2005 is primarily attributable to increases of (i) $2.8 million as a result of higher sales commissions related to increased net sales, increased salaries and bonuses and related costs due to an increase in personnel and higher costs related to qualification of new products at customers, (ii) $0.4 million due to increased stock-based compensation expense and (iii) $0.4 million for a provision for bad debt of approximately $0.4 million related to a single distribution customer.

        Other Expense, Net.Net

              The following table presents other income (expense) for the years ended December 30, 2006 and December 31, 2005 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 30,
      2006

       December 31,
      2005

       Increase
      (Decrease)

       %
      Change

       
      Interest expense, net $(1,825)$(1,221)$604 49%
      Other income (expense), net $(24)$21  (45)(214)%
        
       
       
         
      Total other expense, net $(1,849)$(1,200)$559 47%

      Other expense, net, increased for the year ended December 30, 2006 was $1.8 million, an increase of $0.6 millionas compared to the year ended December 31, 2005 primarily due to higher interest expense related to increased borrowings under our revolving line of credit and convertible notes payable.

        Provision (Benefit) for Income Taxes.Taxes

      The following table presents the provision (benefit) for income taxes for the years ended December 30, 2006 and December 31, 2005 (in thousands, except percentages):

       
       Year Ended
        
        
       
       
       December 30,
      2006

       December 31,
      2005

       Increase
       %
      Change

       
      Provision (benefit) for income taxes $2,844 $(912)$3,756 412%

              We recorded a provision for income taxes for the year ended December 30, 2006 was $2.8 millionas compared to an income tax benefit of $0.9 million in the year ended December 31, 2005. The change was2005 due to our attaining profitability in fiscal 2006.

      Year Ended December 31, 2005 Compared to the Year Ended January 1, 2005

      Net Sales.Net sales for the year ended December 31, 2005 were $79.9 million, a decrease of $63.8 million, or 44%, from the year ended January 1, 2005. This decrease was due to a $72.6 million decrease in net sales to one key customer, partially offset by the commencement of shipments of our very low profile subsystem during the year ended December 31, 2005. The decrease in net sales to the key customer was attributable to its shift in memory technology from DDR to DDR2. Our net sales decreased significantly as the key customer delayed qualifying new suppliers during this transition.

      Sales of our component inventory to distributors and other users of memory ICs represented 24% and 20% of net sales for the years ended December 31, 2005 and January 1, 2005, respectively. The increase in the proportion of component sales was due to the overall decrease in net sales, as sales of component inventory decreased $8.9 million from the year ended January 1, 2005.

      Gross Profit and Gross Margin.Gross profit for the year ended December 31, 2005 was $6.0 million, a decrease of $4.2 million, or 41%, from the year ended January 1, 2005. Gross margin increased to 7.5% for the year ended December 31, 2005 from 7.1% for the year ended January 1, 2005. The decrease in gross profit was attributable to the overall decrease in net sales. The increase in gross margin was attributable to the higher margins realized on sales of our very low profile memory subsystems compared to our other products.

      Research and Development.Research and development expenses in the year ended December 31, 2005 were $3.0 million, a decrease of $0.8 million from the year ended January 1, 2005. This decrease was attributable to reductions in personnel, a decrease in stock-based compensation expense due to forfeitures of equity awards related to personnel reductions, as well as a recovery of costs through the liquidation of engineering samples.

      Selling, General and Administrative.Selling, general and administrative costs in the year ended December 31, 2005 were $5.1 million, a decrease of $1.2 million compared to the year ended January 1, 2005. This decrease was primarily related to the absence in 2005 of costs incurred in 2004 related to our proposed equity financing through an initial public offering. These offering-related costs totaled $1.0 million during the year ended January 1, 2005.

      Other Expense, Net.Other expense, net, during the year ended December 31, 2005 was $1.2 million, a decrease of $0.2 million compared to the year ended January 1, 2005. The decrease was related to a reduction in interest expense due to decreased usage of accounts receivable financing related to a key customer.


      Provision (Benefit) for Income Taxes.The benefit for income taxes during the year ended December 31, 2005 increased $0.6 million compared to the year ended January 1, 2005 due to the increased pre-tax losses in the year ended December 31, 2005.

      Selected Quarterly Financial Information

      The following table presents our unaudited quarterly statements of operations for each of the eight quarters in the two-year period ended December 30, 2006.29, 2007. You should read the following table in conjunction with our audited consolidated financial statements and related notes contained elsewhere in this report.Report. We have prepared the underlying unaudited financial statements on the same basis as our audited consolidated financial statements included in this report,Report, which include all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the quarters presented. Operating results for any quarter are not necessarily indicative of results for any future periods.

       

      Three Months Ended

       


       Three Months Ended
       

       

      April 2,
      2005

       

      July 2,
      2005

       

      October 1,
      2005

       

      December 
      31, 2005

       

      April 1, 
      2006

       

      July 1, 
      2006

       

      September 
      30, 2006

       

      December 
      30, 2006

       


       December 29,
      2007

       September 29,
      2007

       June 30,
      2007

       March 31,
      2007

       December 30,
      2006

       September 30,
      2006

       July 1,
      2006

       April 1,
      2006

       

       

      (in thousands, except share and per share data)

       


       (in thousands, except shares and per share data)

       

      Net sales

       

      $

      20,956

       

      $

      15,539

       

       

      $

      20,057

       

       

       

      $

      23,304

       

       

       

      $

      26,020

       

       

      $

      39,914

       

       

      $

      43,505

       

       

       

      $

      42,009

       

       

      Net sales $22,517 $27,194 $12,811 $37,538 $42,009 $43,505 $39,914 $26,020 

      Cost of sales

       

      20,087

       

      14,232

       

       

      18,163

       

       

       

      21,410

       

       

       

      23,466

       

       

      33,981

       

       

      36,524

       

       

       

      35,210

       

       

      Cost of sales  17,411  23,027  18,734  32,089  35,210  36,524  33,981  23,466 

      Gross profit

       

      869

       

      1,307

       

       

      1,894

       

       

       

      1,894

       

       

       

      2,554

       

       

      5,933

       

       

      6,981

       

       

       

      6,799

       

       

       
       
       
       
       
       
       
       
       
      Gross profit (loss)Gross profit (loss)  5,106  4,167  (5,923) 5,449  6,799  6,981  5,933  2,554 
       
       
       
       
       
       
       
       
       

      Operating expenses:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Operating expenses:                         

      Research and development

       

      916

       

      960

       

       

      617

       

       

       

      468

       

       

       

      666

       

       

      848

       

       

      874

       

       

       

      927

       

       

      Selling, general & administrative

       

      1,194

       

      1,106

       

       

      1,394

       

       

       

      1,368

       

       

       

      1,803

       

       

      2,108

       

       

      2,583

       

       

       

      2,697

       

       

      Total operating expenses

       

      2,110

       

      2,066

       

       

      2,011

       

       

       

      1,836

       

       

       

      2,469

       

       

      2,956

       

       

      3,457

       

       

       

      3,624

       

       

      Research and development  947  1,256  1,478  1,067  927  874  848  666 
      Selling, general and administrative  4,311  4,040  3,845  3,704  2,697  2,583  2,108  1,803 
       
       
       
       
       
       
       
       
       
       Total operating expenses  5,258  5,296  5,323  4,771  3,624  3,457  2,956  2,469 
       
       
       
       
       
       
       
       
       

      Operating income (loss)

       

      (1,241

      )

      (759

      )

       

      (117

      )

       

       

      58

       

       

       

      85

       

       

      2,977

       

       

      3,524

       

       

       

      3,175

       

       

      Operating income (loss)  (152) (1,129) (11,246) 678  3,175  3,524  2,977  85 

      Other expense, net

       

      248

       

      235

       

       

      254

       

       

       

      463

       

       

       

      410

       

       

      534

       

       

      652

       

       

       

      253

       

       

      Other income (expense), net:Other income (expense), net:  183  109  166  (47) (253) (652) (534) (410)
       
       
       
       
       
       
       
       
       

      Income (loss) before provision (benefit) for income taxes

       

      (1,489

      )

      (994

      )

       

      (371

      )

       

       

      (405

      )

       

       

      (325

      )

       

      2,443

       

       

      2,872

       

       

       

      2,922

       

       

      Income (loss) before provision (benefit) for income taxes  31  (1,020) (11,080) 631  2,922  2,872  2,443  (325)

      Provision (benefit) for income taxes

       

      (399

      )

      (296

      )

       

      (116

      )

       

       

      (101

      )

       

       

      (83

      )

       

      895

       

       

      1,084

       

       

       

      948

       

       

      Provision (benefit) for income taxes  202  (363) (3,864)   948  1,084  895  (83)
       
       
       
       
       
       
       
       
       

      Net income (loss)

       

      $

      (1,090

      )

      $

      (698

      )

       

      $

      (255

      )

       

       

      $

      (304

      )

       

       

      $

      (242

      )

       

      $

      1,548

       

       

      $

      1,788

       

       

       

      $

      1,974

       

       

      Net income (loss) $(171)$(657)$(7,216)$631 $1,974 $1,788 $1,548 $(242)
       
       
       
       
       
       
       
       
       

      Net income (loss) per common share:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Net income (loss) per common share:                         

      Basic

       

      $

      (0.10

      )

      $

      (0.07

      )

       

      $

      (0.03

      )

       

       

      $

      (0.02

      )

       

       

      $

      (0.02

      )

       

      $

      0.14

       

       

      $

      0.16

       

       

       

      $

      0.14

       

       

      Diluted

       

      $

      (0.10

      )

      $

      (0.07

      )

       

      $

      (0.03

      )

       

       

      $

      (0.02

      )

       

       

      $

      (0.02

      )

       

      $

      0.11

       

       

      $

      0.12

       

       

       

      $

      0.12

       

       

      Basic $(0.01)$(0.03)$(0.37)$0.03 $0.14 $0.16 $0.14 $(0.02)
      Diluted $(0.01)$(0.03)$(0.37)$0.03 $0.12 $0.12 $0.10 $(0.02)

      Weighted-average common shares outstanding:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       


      Weighted-average common shares outstanding:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Basic

       

      10,672

       

      10,672

       

       

      10,673

       

       

       

      10,673

       

       

       

      10,753

       

       

      11,223

       

       

      11,235

       

       

       

      13,616

       

       

      Diluted

       

      10,672

       

      10,672

       

       

      10,673

       

       

       

      10,673

       

       

       

      10,753

       

       

      15,681

       

       

      15,401

       

       

       

      16,793

       

       

      Basic  19,730  19,689  19,653  19,624  13,616  11,235  11,223  10,753 
      Diluted  19,730  19,689  19,653  21,425  16,793  15,401  15,681  10,753 

              

      Historically, our quarterly operating results have fluctuated significantly. These fluctuations are primarily attributable to the cyclical nature of the industry in which we operate, including changes in revenue related to additions of new customers, the ramp up of new products, products reaching the end of their life cycles, customers’customers' technology transitions, and other similar reasons. As a result, we believe that the period-to-period comparisons of our net sales and operating results are not necessarily meaningful measures of future operating performance and should not be relied upon as indications of that future performance. We expect that our future operating results will fluctuate from quarter-to-quarter and year-to-year, which may make it difficult to predict our future performance and could cause our stock price to fluctuate and decline.


      Liquidity and Capital Resources

      Cash Flows

      The following table summarizes our cash flows for the periods indicated:

       

      Year Ended

       

       

       

      January 1, 
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

      Net cash provided by (used in):

       

       

       

       

       

       

       

       

       

       

       

       

       

      Operating activities

       

       

      $

      (6,567

      )

       

       

      (4,608

      )

       

       

      $

      (9,785

      )

       

      Investing activities

       

       

      (496

      )

       

       

      1,332

       

       

       

      (9,028

      )

       

      Financing activities

       

       

      5,915

       

       

       

      3,470

       

       

       

      48,835

       

       

      Net increase (decrease) in cash and cash equivalents

       

       

      (1,148

      )

       

       

      $

      194

       

       

       

      $

      30,022

       

       

      Since our inception, in 2000, we have financed our operations primarily through issuances of equity and debt securities and cash generated from operations. We received gross proceeds of $2.0 million from the sale of shares of our capital stock in 2000. During 2001 and 2003, we received total proceeds of approximately $1.8 million from the sale of convertible notes. During 2005, we received total proceeds of $1.0 million from the sale of convertible notes. During 2006, we received proceeds of $2.0 million under a new term loan facility. We have also funded our operations with a revolving line of credit under our bank credit facility, from capitalized lease obligations, financing of receivables and from the sale and leaseback of our domestic manufacturing facility. Availability under our revolving line of credit

        Working Capital and Cash and Marketable Securities

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

       
       December 29,
      2007

       December 30,
      2006

      Working Capital $27,387 $45,584
        
       
      Cash and cash equivalents(1) $7,182 $30,975
      Short-term marketable securities(1)  15,573  5,267
      Long-term marketable securities  7,814  1,502
        
       
        $30,569 $37,744
        
       

          (1)
          Included in working capital

              Our working capital decreased to $800,000 atin the end of the second quarter of fiscal 2005 due to a reduction in our borrowing base caused by the decrease in revenue from Dell. Availability has increased to $4.9 million as ofyear ended December 30, 2006 due to an increase in our borrowing base29, 2007 primarily as a result of revenue growth(i) additional net purchases of long-term investments in marketable securities of approximately $6.3 million, (ii) purchases of equipment and leasehold improvements of approximately $6.3 million and (iii) decreases in certain current operating assets and liabilities, primarily due to the overall decline in net sales during the year.

        Cash Provided and Used in the Years Ended December 29, 2007 and December 30, 2006

              The following table summarizes our cash flows for the periods indicated:

       
       Year Ended
       
       
       December 29, 2007
       December 30, 2006
       
      Net cash provided by (used in):       
      Operating activities $14,076 $(9,785)
      Investing activities  (22,922) (9,028)
      Financing activities  (14,947) 48,835 
        
       
       
      Net increase (decrease) in cash and cash equivalents $(23,793)$30,022 
        
       
       

              Operating Activities.    Net cash provided by operating activities for the year ended December 29, 2007 was primarily the result of (i) approximately $5.7 million in net non-cash operating expenses, mainly comprised of inventory adjustments, depreciation and amortization, stock-based compensation, impairment of long-lived assets and deferred income taxes and (ii) approximately $15.8 million in net cash provided by changes in operating assets and liabilities, partially offset by a net loss of approximately $7.4 million.

              Accounts receivable decreased approximately $11.7 million during fiscal 2006.

      In December 2006,2007 primarily as a result of the Company sold 6,250,000 sharesoverall decline in our net sales during the year. During 2007, we were successful in collecting cash from sales to our customers substantially in accordance with our standard payment terms to those customers.


              Inventories decreased approximately $16.1 million during fiscal 2007 primarily as a result of its common stock(i) the overall decline in its initial public offering at an offering priceour net sales during the year, (ii) sales of $7.00 per share, resulting in totalinventories on hand during the current year to our customers, which generated net cash proceeds of $39.5approximately $10.8 million net of underwriters’ discountsin 2007 and offering expenses(iii) a loss of approximately $4.2 million.$5.3 million due to slow moving and lower-of-cost-or-market value inventory adjustments. In the future, our inventory levels will continue to be determined based on, among other factors, the level of customer orders received and overall demand as well as the stage at which our products are in their respective life cycles and competitive situations in the marketplace. We make efforts to balance such considerations against the risk of obsolescence or potentially excess inventory levels.

      Operating Activities.        Accounts payable decreased approximately $5.0 million during fiscal 2007 primarily as a result of an overall decline in materials purchasing levels during the year given our decline in net sales. Cash payments primarily for the purchase of manufacturing materials and related goods for resale to our customers used net operating cash of approximately $5.1 million during 2007.

              Net cash used in operating activities for the year ended December 30, 2006 was $9.8primarily the result of approximately $16.4 million in net cash used by changes in operating assets and liabilities, partially offset by net income of approximately $5.1 million and net non-cash operating expenses of approximately $1.6 million, primarily comprising depreciation and amortization and stock-based compensation. As compared to $4.6 million forfiscal 2005, the year ended December 31, 2005. Thisoverall change in cash used in operating activities in 2006 was primarily due to an increase in cash flow related to net income of $7.4$5.1 million offset by (i) a decrease in cash flow related to accounts receivable of $6.3$6.2 million due to a higher proportion of net sales being generated by customers with longer payment terms;terms, (ii) a decrease in cash flow related to net inventories of $13.2 million as we increased inventory levels to support higher sales volumes and (iii) an increase in cash flow related to accounts payable of $4.1 million as we trade financed our inventory increase and other operating expenses. In addition, cash flow related to income taxes payable increased $0.6 million as we attained profitability in the first half of 2006 and started to accumulate an income tax liability that was paid later in 2006.

      Cash        Investing Activities.    Net cash used in operatinginvesting activities for the year ended December 31, 200529, 2007 was $4.6primarily the result of purchases of additional investments in marketable securities of approximately $63.3 million, as compared to $6.6 million for the year ended January 1, 2005. This change was attributable to a decrease in cash flow related to net loss of $1.4 million, a decrease in cash flow related to accounts receivable of $0.8 million due to a higher proportion of sales being generated by customers with longer payment terms; and a decrease in cash flow related to inventories of $2.2 million. These declines werepartially offset by an increaseproceeds received from maturities and sales of certain investments in cash flow related to accounts payablemarketable securities of $4.0 million and an increase in cash flow related to income taxes of $2.9 million asapproximately $46.6 million. In 2007 we continued to incur losses, did not haveinvest the majority of the proceeds from our initial public offering, or IPO, in various marketable securities investments in connection with our efforts to pay income taxesboth preserve capital as well as achieve competitive returns on our investments. We also used approximately $6.3 million in cash primarily to purchase equipment and received a tax refundleasehold improvements related to our new facilities in 2005 as a result of carrying back net operating losses to prior years.the PRC and in Irvine, California.

      Investing Activities.        Net cash used in investing activities for the year ended December 30, 2006 was $9.0primarily the result of (i) purchases of investments in marketable securities of approximately $6.8 million as compared to cash generated bya result of investing activities of $1.3 million for the year ended December 31, 2005. This change is attributable to a decrease in proceeds of $1.8 million received from the sale of the building housing our manufacturing operation in 2005 to raise capital to fund our operations; an increase in manufacturing equipment purchases of $2.0 million required to support increased sales


      volumes and long term and short term investments of a portion of the proceeds from theour IPO and (ii) purchases of $6.8 million.

      Net cash provided from investing activities was $1.3 millionmanufacturing equipment of approximately $2.5 in 2005order to support increased sales in fiscal 2006 as compared to netfiscal 2005.

              Financing Activities.    Net cash used in investingfinancing activities for the year ended December 29, 2007 was primarily the result of $0.5net repayments on our outstanding revolving line of credit of approximately $14.4 million, along with net repayments on our long term debt of approximately $1.0 million. These repayments were slightly offset by approximately $0.3 million in 2004. This change is attributable tocash provided through the proceedsexercise of $1.8 million from the sale of the building housing our manufacturing operation in 2005 to raise capital to fund our operations. We currently lease back the building, and there was no disruption of manufacturing due to this transaction.stock options during 2007.

      Financing Activities.        Net cash provided by financing activities for the year ended December 30, 2006 was $48.8primarily the result of (i) approximately $39.5 million received as compared to net cash provided by financing activitiesa result of $3.5 million for the year ended December 31, 2005. This change was primarily due the Company’s sale of its common stock in its initial public offering resulting in total proceeds of $39.5 million,our IPO, net of underwriters’underwriters' discounts and offering expenses of approximately $4.2 million and increased usage



      (ii) approximately $9.8 million in net borrowings of our revolving line of credit used to financeassist in financing our working capital needs as a result of our accelerating growth.

      Net cash provided from financing activitiessignificant growth in 2005 was $3.5 million2006 as compared to $5.9 million in 2004. This change is attributable to approximately $1.4 million less in net borrowings against our revolving line of credit and an increase in net payments on capital leases and other debt of $1.0 million.2005.

        Capital Resources

      In August 2006, we amended our credit agreement with our bank. The credit agreement, as amended, provides for a revolving line of credit with maximum borrowings of $25 million, a term loan of $2 million, and an equipment financing line of credit with maximum borrowings of $2 million. Prior to August 2006, the credit agreement provided for a revolving line of credit of $15 million and no term loan or equipment line of credit. In August 2006, we used approximately $1 million of the proceeds from the term loan to repay convertible debt of $950,000 plus accrued interest that had become due and payable. Thedue.The interest rate under the term loan was less than that of the convertible debt repaid.

      Under        In April 2007, we executed a seventh amendment to our credit agreement with our bank, which was effective March 21, 2007. This amendment allows us, at our election, to increase our maximum borrowings on the revolving line of credit we may borrowfrom $25 million, in $2.5 million increments, up to a total of $40 million. In addition, among other terms, the greater of 85% of eligible accounts receivable plus the least ofamendment (i) a percentage of eligible inventory determined from time to time by the Company’s bank, (ii) 80% of the orderly liquidation value, as defined, of eligible inventories, and (iii) $7 million. Interest is payable monthly at the prime rate of 8.25% as of December 2006. Outstanding borrowings under the revolving line of credit were $19.2 million as of December 30, 2006 and $9.5 million as of December 31, 2005. Borrowing availability as of December 30, 2006 was $4.9 million.

      Under the new equipment financing line of credit, we may borrow up to 80% of the cost of equipment purchases up to the maximum of $2 million. Interest on equipment line of credit advances was payable at the prime rate plus 0.5% prior to the Company’s initial public offering in December 2006 and was reduced to the prime rate thereafter. Principal is due monthly throughextends the maturity date of the credit agreement in July 2008, when all unpaid principal and interest is due. Outstanding borrowings under the new equipment line of credit were $1.1to July 31, 2009, (ii) establishes an equipment advance line of $3 million, as(iii) increases the sublimit for letters of December 30, 2006.credit to $5 million, (iv) sets an inventory sublimit of $7 million, subject to increase to $10 million if certain targets are met and (v) provides for the reduction in interest rates on borrowings if certain borrowing amounts and financial performance targets are met.

      The $2 million term loan was fully repaid in December 2006 in connection with the closing of        In July 2007, we executed an eighth amendment to our initial public offering.

      Under the terms of the credit agreement, as amended,which was effective June 29, 2007, and which revised the various financial and other covenants of which we are required to comply with certain financial and other covenants.comply. The financial covenants requireamendment requires us to (i) achieve minimum book net worth on a monthly basis, minimum net income on a quarterly basis, and(ii) limit annual capital expenditures under a defined annual cap. Also, we are required tocap, (iii) achieve certain minimum monthly profitability thresholds and (iv) maintain a minimum debt service coverage ratio in relation toliquidity threshold as of the term loan and equipment lineend of credit.each month. While we are currently in compliance with all financial covenants and expect to maintain compliance for the foreseeable future, we have in the past been in violation of one or more covenants. As of December 31, 2005, January 28, 2006 and February 25, 2006, we were not in compliance with covenants related to minimum book net worth, maximum year to date and monthly net loss as a result of the unanticipated decline in our revenues in fiscal 2005 and early fiscal 2006


      as compared to the forecasts that were utilized to establish the covenants. A delay in the delivery of audited financial statements for fiscal 2004 and fiscal 2005 due to turnover in staffing within our finance department caused us to violate another covenant. Our finance staffing has been stabilized since the beginning of fiscal 2006. In April 2006, we received a waiver from our lender for all of these covenant violations. We cannot assure you that we will not violate one or more covenants in the future. If we were to be in violation of covenants under our credit agreement, our lender could choose to accelerate payment on all outstanding loan balances. There can be no assurance that we would be able to quickly obtain equivalent or suitable replacement financing in this event. If we were not able to secure alternative sources of funding, such acceleration would have a material adverse impact on our financial condition.

              Under the revolving line of credit, we may borrow up to the greater of 85% of eligible accounts receivable plus the least of (i) a percentage of eligible inventory determined from time to time by our bank, (ii) 80% of the orderly liquidation value, as defined, of eligible inventories, and (iii) $7 million. Interest is payable monthly at the prime rate of 7.25% as of December 29, 2007. Outstanding borrowings under the revolving line of credit were approximately $4.9 million and $19.2 million as of December 29, 2007 and December 30, 2006, respectively. Borrowing availability as of December 29, 2007 was approximately $6.4 million.

              Under the equipment financing line of credit, we may borrow up to 80% of the cost of equipment purchases up to a maximum of $3 million. Interest on equipment line of credit advances was payable at the prime rate plus 0.5% prior to our initial public offering in December 2006 and was reduced to the prime rate thereafter. Principal is due monthly through the maturity date of the credit agreement in July 2009, when all unpaid principal and interest is due. Outstanding borrowings under the equipment line of credit were approximately $0.9 million and $1.1 million at December 29, 2007 and December 30, 2006, respectively.

              Any borrowings under the revolving and equipment lines of credit are collateralized by a general first priority lien against all of our assets, both tangible and intangible.


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

      We believe our existing cash balances, our borrowing availability under our bank credit facility, 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.

        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 any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

      Contractual Obligations

      The following table outlinessummarizes our principal obligations and commitments, excluding periodic interest payments, as of December 30, 2006:29, 2007 (in thousands):

       
       Within
      One Year

       1-3 Years
       4-5 Years
       After
      5 Years

       Total
      Scheduled payments under contractual obligations:               
      Long-term debt $454  492     $946
      Capital lease obligations  287  145      432
      Operating leases  743  1,949  20    2,712
      Purchase commitments  524  354      878
        
       
       
       
       
       Total  2,008  2,940  20    4,968
      Potential cash requirements under existing commitments:               
      Letters of credit  500        500
        
       
       
       
       
       Total $2,508 $2,940 $20 $ $5,468
        
       
       
       
       

              For purposes of the table above, obligations for purchase commitments are defined as agreements that represent a firm commitment and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current manufacturing needs and are typically fulfilled by our vendors within a relatively short time horizon. We have additional purchase orders (not included in the table above) that represent authorizations to purchase for which we generally have a contractual right to increase or decrease quantities as needed. We do not have significant agreements for the purchase of inventories or other goods specifying minimum quantities or set prices that exceed our expected requirements.

       

       

      Within 
      One Year

       

      1-3 Years

       

      4-5 Years

       

      After 5
      Years

       

      Total

       

       

       

      (in thousands)

       

      Scheduled payments under contractual obligations:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Long-term debt

       

       

      $

      595

       

       

       

      $

      687

       

       

       

      $

      179

       

       

       

      $

       

       

      $

      1,461

       

      Capital lease obligations

       

       

      438

       

       

       

      318

       

       

       

      46

       

       

       

       

       

      802

       

      Operating leases

       

       

      173

       

       

       

      260

       

       

       

      124

       

       

       

       

       

      557

       

      Purchase commitments

       

       

      690

       

       

       

       

       

       

       

       

       

       

       

      690

       

      Total

       

       

      1,896

       

       

       

      1,265

       

       

       

      349

       

       

       

       

       

      3,510

       

      Potential cash requirements under existing commitments:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Letters of credit

       

       

      500

       

       

       

       

       

       

       

       

       

       

       

      500

       

      Total

       

       

      $

      2,396

       

       

       

      $

      1,265

       

       

       

      $

      349

       

       

       

      $

       

       

      $

      4,010

       


              

      We believe that funds expected to be generated from future operations will be sufficient to satisfy these contractual obligations and commercial commitments and that the ultimate payments associated with these commitments will not have a material adverse impact on our liquidity position.

      New Accounting Pronouncements

      In June 2006,2007 the FASB issued Interpretationratified EITF No. 48, 07-3,Accounting for UncertaintyNonrefundable Advance Payments for Goods or Services to Be Used in Income Taxes—an interpretation of FASB StatementFuture Research and Development Activities, or EITF No. 109 (“FIN 48”), which clarifies the accounting07-3. EITF No. 07-3 requires non-refundable advance payments for uncertainty in income taxes. FIN 48 prescribes a recognition thresholdgoods and measurement attribute for the financial statement recognition and measurement of a tax position taken or expectedservices to be takenused in a tax return. The Interpretation requires thatfuture research and development activities to be recorded as an asset and the Company recognize inpayments to be expensed when the financial statements the impact of tax position, if that positionresearch and development activities are performed. EITF No. 07-3 is more likely than not of being sustained on audit, based on the technical merits


      of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006 with the cumulative effect of the change in accounting principle recorded as an adjustment to beginning retained earnings. The Company is currently in the process of assessing the impact the adoption of FIN 48 will have on its consolidated financial statements.

      In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. Specifically, SFAS No. 157 sets forth a definition of fair value, and establishes a hierarchy prioritizing the inputs to valuation techniques, giving the highest priority to quoted prices in active markets for identical assets and liabilities and the lowest priority to unobservable inputs. The provisions of SFAS No. 157 are generally required to be applied on a prospective basis, except to certain financial instruments accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, for which the provisions of SFAS No. 157 should be applied retrospectively. The Company will adopt SFAS No. 157 in the first quarter of 2008 and is still evaluating the effect, if any, on its financial position or results of operations.

      In September 2006, the SEC staff issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB No. 108 was issued in order to eliminate the diversity in practice surrounding how public companies quantify financial statement misstatements. SAB No. 108 requires that registrants quantify errors using both a balance sheet and income statement approach and evaluate whether either approach results in a misstated amount that, when all relevant quantitative and qualitative factors are considered, is material. The adoption of this statement2007. This standard is not expected to have a material impact on the Company’sour future consolidated financial condition or results of operations.statements.

      Item 7A.    Quantitative and Qualitative Disclosures About Market Risk

        Interest Rate Risk

      Our exposure to market risk for changes in interest rates relates primarily to our bank credit facility because borrowings under all lines under the facility are variable rate borrowings, generally at prime. Assuming that all lines under the facility are fully available and drawn and holding other variables constant, each 1.0% increase in interest rates on our variable rate borrowings will result in an increase in annual interest expense and a decrease in our cash flows and income before taxes of approximately $0.2$0.4 million per year. We doTo date, we have not useused derivative instruments to hedge the interest rate risk related to our credit facility.

      We have invested most of the proceeds of our initial public offering in securities which may be subject to market risk for changes in interest rates. To mitigate this risk, we maintain a portfolio of cash equivalents and short-term investments in a variety of marketable securities, which meet high quality credit standards, as specified in our investment policy, and include commercial paper, money market funds, government and non-government debt securities and auction rate securities. Currently, we are exposedOur investment policy guidelines generally limit the amount of credit exposure to minimal market risks.

      Off-Balance Sheet Arrangements

      any one issue, issuer or type of instrument. We currently do not have any relationshipsuse derivative financial instruments.

              Our cash equivalents and investments in marketable securities are classified as available-for-sale in accordance with unconsolidated entitiesSFAS No. 115,Accounting for Certain Investments in Debt and Equity Securities, or financial partnerships, suchSFAS No. 115, and are therefore stated at fair value. Differences between fair value and amortized cost are recorded as entities often referred tounrealized gains and losses and are reported, net of taxes, as structured finance or special purpose entities, which would have been established fora component of accumulated other comprehensive income (loss). The fair value of our investments in marketable securities fluctuates based on changes in market conditions and interest rates; however, given the purposegeneral short-term maturities of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition,our investments, we do not believe these instruments are subject to significant market or interest rate risk.

              Due to disruptions of, and the resulting reduced liquidity in certain financial markets in 2007, two of our AAA rated auction rate securities with a total purchased cost of approximately $2.0 million experienced failed auctions during the fourth quarter of 2007. Due to the failed auctions, we were unable to sell the securities at their respective costs, resulting in a decrease in fair value which has been recorded as a component of accumulated other comprehensive loss in accordance with SFAS No. 115. These investments have been classified as long-term investments in marketable securities in our consolidated balance sheet as of December 29, 2007. As of February 23, 2008, the unrealized loss on these two investments was approximately $141,000. We have concluded that the unrealized losses on these two investments are temporary because (i) we believe that the decline in market value that has occurred is due to general market conditions, (ii) the auction rate securities continue to be of a high credit quality and interest is paid as due and (iii) we have the intent and ability to hold these



      investments until a recovery in market value occurs. The fair value of these securities could change significantly in the future and we may be required to record other-than-temporay impairment charges or additional unrealized losses in future periods.

              Unrealized losses on certain of our other investments as of the end of 2007 were due primarily to changes in interest rates. We have determined that the unrealized losses on all of our investments in marketable securities at December 29, 2007 are temporary in nature. We review our investments to evaluate indications of possible impairment. Factors considered in determining whether impairments are other than temporary include the length of time and extent to which fair value has been less than the amortized cost basis, the financial condition and near-term prospects of the investee and our intent and ability to hold an investment for a period of time sufficient to allow for any undisclosed borrowings or debt,anticipated recovery in market value.

              Fixed rate securities may have their market value adversely impacted due to rising interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates.

              The carrying value, maturity and estimated fair value of our cash equivalents and investments in marketable securities as of December 29, 2007 were as follows (in thousands, except interest rates):

       
        
       Maturity
        
       
       Carrying Value December 29, 2007
       Within One Year after December 29, 2007
       Greater Than One Year After December 29, 2007
       Fair Value December 29, 2007
      Investments            
      Cash equivalents $6,895 $6,895 $ $6,895
       Weighted average interest rate  4.91% 4.91% %  
      Marketable securities $23,387 $15,573 $7,814 $23,387
       Weighted average interest rate  5.68% 5.88% 5.13%  

        Exchange Rate Risk

              We consider our direct exposure to foreign exchange rate fluctuations to be minimal. Currently, sales to our customers provide for pricing and payment in U.S. dollars, and, therefore, are not subject to exchange rate fluctuations. Increases in the value of the U.S. dollar relative to other currencies could make our products more expensive, which could negatively impact our ability to compete. As a result of our foreign operations, we have certain costs, assets and liabilities that are denominated in foreign currencies, and therefore, decreases in the value of the U.S. dollar could result in increases in our manufacturing costs that could have a material adverse effect on our business, financial condition and results of operations. To date, we have not entered into any synthetic leases. We are, therefore, not materially exposedused derivative instruments to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.manage risks related to foreign currency exchange rate fluctuations.

      Item 8.    Financial Statements and Supplementary Data

      See Index to Consolidated Financial Statements.        The financial statements and supplementary data required by this item are included in Part IV, Item 15 of this Report.

      40





      Item 9.    Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

      Not Applicable.        In 2006 we appointed KMJ Corbin & Company LLP as our new independent registered public accounting firm to conduct the audit of our financial statements beginning as of and for the year ended December 31, 2005, with quarterly reviews of our financial statements beginning as of and for the quarter ended April 1, 2006. The decision to engage KMJ Corbin & Company LLP was recommended by management and approved by the Audit Committee of the Board of Directors.

      Item 9A.    Controls and Procedures

      Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

      Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as of December 30, 2006.appropriate to allow timely decisions regarding required disclosures.

      Management’sManagement's Report on Internal Control Over Financial Reporting

      This annual report does not include a report of management’s assessment regarding        Our management is responsible for establishing and maintaining adequate internal control over financial reporting, oras such term is defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 29, 2007 based on the criteria set forth inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the criteria set forth inInternal Control—Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 29, 2007.

              This Annual Report does not include an attestation report of our independent registered public accounting firm dueregarding internal control over financial reporting. We were not required to a transition period established byhave, nor have we engaged our independent registered public accounting firm to perform, an audit on our internal control over financial reporting pursuant to the rules of the Securities and Exchange Commission for newly public companies.that permit us to provide only management's report in this Annual Report.

      Changes in Internal Control Over Financial Reporting

      There were no changes in our internal control over financial reporting during the fourth quarter of fiscal 20062007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

      Inherent Limitations on Internal Control

              A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision



      making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

      Item 9B.    Other Information

              None.

      Not Applicable.


      PART III

      Certain information required by this Part III is omitted from this Annual Report as we will file our definitive Proxy Statement for our Annual Meeting of Stockholders pursuant to Regulation 14A of the Exchange Act not later than 120 days after the end of the fiscal year covered by this Annual Report, and certain information included in the Proxy Statement is incorporated herein by reference.

      Item 10.    Directors, Executive Officers and Corporate Governance

      We incorporate by reference herein the sections entitled Election"Election Of Directors,” “Board" "Board Of Directors; Audit Committee Financial Expert”Expert" And “Other"Other Information—Section 16(a) Beneficial Ownership Reporting Compliance”Compliance" in our Proxy Statement.

      We have adopted a “Code"Code of Business Conduct and Ethics”Ethics" that applies to all employees, including our executive officers. A copy of the Code of Business Conduct and Ethics is posted on our Internet site at www.netlist.com.www.netlist.com. In the event that we make any amendment to, or grant any waivers of, a provision of the Code of Business Conduct and Ethics that applies to the principal executive officer, principal financial officer, or principal accounting officer that requires disclosure under applicable Securities and Exchange Act rules, we intend to disclose such amendment or waiver and the reasons therefor on our Internet site.


      Item 11.    Executive Compensation

      The information required by this Item is incorporated herein by reference to the section entitled “Executive Compensation” "Executive Compensation" and “Directors’ Compensation” "Directors' Compensation" in our Proxy Statement.

      Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

      The information required by this Item is incorporated herein by reference to the section entitled “Security"Security Ownership of Certain Beneficial Owners and Management”Management" and “Equity"Equity Compensation Plan Information”Information" in our Proxy Statement.

      Item 13.    Certain Relationships and Related Transactions, and Director Independence

      The information required by this Item is incorporated herein by reference to the section entitled “Certain"Certain Relationships and Related Transactions” Transactions" in our Proxy Statement.

      Item 14.    Principal Accounting Fees and Services

      The information required by this Item is incorporated herein by reference to the section entitled “Auditors,"Auditors, Audit Fees and Auditor Independence”Independence" in our Proxy Statement.



      PART IV

      Item 15.    Exhibits, Financial Statement Schedules

      (a)(1)     All financial statements filed as part of this report.

      Reports(a)(1)

      All financial statements filed as part of this report.



      Report of Independent Registered Public Accounting Firms

      Firm



      F-2




      Consolidated Balance Sheets


      F-4


      F-3




      Consolidated Statements of Operations


      F-5


      F-4




      Consolidated Statements of Stockholders’Stockholders' Equity


      F-6


      F-5




      Consolidated Statements of Cash Flows


      F-7


      F-6

      (a)(2)     All financial statement schedules filed as part of this report.

      Reports
      (a)(2)



      All financial statement schedules filed as part of this report.





      Report of Independent Registered Public Accounting FirmsFirm on Financial Statement Schedule


      F-29


      S-1




      Schedule II—Consolidated Valuation and Qualifying Accounts


      F-30


      S-2

              All other schedules for which provision is made in the applicable accounting regulations of the Commission are not required under the related instructions, are inapplicable or not material, or the information called for thereby is otherwise included in the consolidated financial statements, and therefore have been omitted.

      (a)(3)


      Exhibits


      All other schedules for which provision is made in the applicable accounting regulations of the Commission are not required under the related instructions, are inapplicable or not material, or the information called for thereby is otherwise included in the consolidated financial statements, and therefore have been omitted.

      (a)(3)     Exhibits

      3.1(1)

      Restated Certificate of Incorporation of Netlist, Inc.


      3.2(1)



      Amended and Restated Bylaws of Netlist, Inc.



      10.1(2)



      Amended and Restated Credit and Security Agreement, dated as of December 27, 2003, among Netlist, Inc., Netlist Technology Texas, L.P. (“("Netlist Texas”Texas"), and Wells Fargo Business Credit, Inc. (“("Wells Fargo”Fargo").

      10.2(2)


      10.2(2)



      First Amendment to Amended and Restated Credit and Security Agreement, dated as of June 30, 2004, among Netlist, Inc., Netlist Texas and Wells Fargo.

      10.3(2)


      10.3(2)



      Second Amendment to Credit and Security Agreement and Waiver of Defaults, dated as of December 20, 2005, among Netlist, Inc., Netlist Texas and Wells Fargo.

      10.4(2)


      10.4(2)



      Third Amendment to Amended and Restated Credit and Security Agreement, dated as of February 14, 2006, among Netlist, Inc., Netlist Texas and Wells Fargo.

      10.5(2)


      10.5(2)



      Fourth Amendment to Amended and Restated Credit and Security Agreement and Waiver of Defaults, dated as of April 18, 2006, among Netlist, Inc., Netlist Texas and Wells Fargo.

      10.6(2)


      10.6(2)



      Fifth Amendment to Amended and Restated Credit and Security Agreement, dated as of July 28, 2006, among Netlist, Inc., Netlist Texas and Wells Fargo.


      10.7(1)#



      Amended and Restated 2000 Equity Incentive Plan of Netlist, Inc.


      10.8(2)#



      Letter agreement regarding employment, dated January 11, 2006, between Netlist, Inc. and Lee Kim.

      10.9(2)


      10.9(2)



      Full-time Permanent Engagement Resources Agreement, dated as of January 10, 2006, between Netlist, Inc. and Tatum, LLC.


      10.10(3)


      10.10(3)



      Master Sales and Supply Agreement, dated as of January 1, 2004, between Netlist, Inc. and Netlist Texas.

      10.11(2)


      10.11(2)



      Management Fee Agreement, dated as of January 1, 2004, between Netlist, Inc. and Netlist Texas.

      10.12(2)


      10.12(2)



      Form of Indemnity Agreement for officers and directors.

      10.13(3)
      10.13(3)#



      Employment Agreement, dated September 5, 2006, between Netlist, Inc. and Chun K. Hong.

      10.14(3)
      10.14(3)#



      Form of Performance Incentive Agreement entered into by Netlist, Inc. with each of Christopher Lopes, Jayesh Bhakta and Paik Ki Hong in August 2006.

      10.15(3)
      10.15(3)#



      Form of Amendment to Performance Incentive Agreement entered into by Netlist, Inc. with each of Christopher Lopes, Jayesh Bhakta and Paik Ki Hong in September 2006.

      10.16(1)
      10.16(1)#



      2006 Equity Incentive Plan of Netlist, Inc.

      10.17(1)


      10.17(1)



      Note Purchase Agreement, dated October 3, 2005, between Netlist, Inc. and Serim Paper Manufacturing Co., Ltd. (“("Serim Paper”Paper").

      10.18(1)


      10.18(1)



      7.5% Promissory Note, dated October 3, 2005, issued by Netlist, Inc. to Serim Paper.

      10.19(1)


      10.19(1)



      Note Purchase Agreement, dated February 12, 2006, between Netlist, Inc. and Serim Paper.

      10.20(1)


      10.20(1)



      6.5% Promissory Note, dated February 12, 2006, issued by Netlist, Inc. to Serim Paper.

      10.21


      10.21(4)



      Sixth Amendment to Amended and Restated Credit and Security Agreement, dated as of December 29, 2006.

      14.1(1)


      10.22(5)



      Lease (Multi-Tenant; Net), dated April 2, 2007, by and between The Irvine Company LLC, a Delaware limited liability company, and Netlist, Inc., a Delaware corporation.


      10.23(5)


      Seventh Amendment to Amended and Restated Credit and Security Agreement, dated effective as of March 21, 2007, by and among Netlist, Inc., a Delaware corporation, Netlist Technology Texas, L.P., a Texas limited partnership, and Wells Fargo Bank, National Association.

      10.24(6)


      Eighth Amendment to Amended and Restated Credit and Security Agreement, dated effective as of June 29, 2007, by and among Netlist, Inc., a Delaware corporation, Netlist Technology Texas, L.P., a Texas limited partnership, and Wells Fargo Bank, National Association.

      10.25(7)


      Offer Letter to Nita Moritz dated August 16, 2007

      10.26(8)#


      Stock Option Agreement dated September 17, 2007 for options to purchase 200,000 shares of the Registrant's common stock awarded to Nita J. Moritz

      14.1(1)


      Code of Business Conduct and Ethics.

      21.1(2)


      21.1(9)



      Subsidiaries of Netlist, Inc.

      23.1


      23.1(9)



      Consent of KMJ Corbin & Company LLP.


      24.1



      23.2

      Consent of Deloitte & Touche LLP.

      24.1

      Power of Attorney (included on the signature page in this Part IV of this report).

      31.1


      31.1(9)



      Certification of Chief Executive Officer of Periodic Report Pursuant to Rule 13a-15(e) or Rule 15d-15(e).



      31.2


      31.2(9)



      Certification of Chief Financial Officer of Periodic Report Pursuant to Rule 13a-15(e) or Rule 15d-15(e).

      32


      32(9)



      Certification by Chief Executive Officer and Chief Financial Officer of Periodic Report Pursuant to 18 U.S.C. Section 1350.


        (1)
        Incorporated by reference to the corresponding exhibit number of the registration statement on Form S-1 of the registrant (No. 333-136735) filed with the Securities and Exchange Commission on October 23, 2006.



        (2)
        Incorporated by reference to the corresponding exhibit number of the registration statement on Form S-1 of the registrant (No. 333-136735) filed with the Securities and Exchange Commission on August 18, 2006.



        (3)
        Incorporated by reference to the corresponding exhibit number of the registration statement on Form S-1 of the registrant (No. 333-136735) filed with the Securities and Exchange Commission on September 27, 2006.



        (4)
        Incorporated by reference to the corresponding exhibit number of the annual report on Form 10-K of the registrant filed with the Securities and Exchange Commission on February 28, 2007.

        (5)
        Incorporated by reference to exhibit numbers 10.1 and 10.2 of the current report on Form 8-K of the registrant filed with the Securities and Exchange Commission on April 6, 2007.

        (6)
        Incorporated by reference to exhibit numbers 10.1 of the quarterly report on Form 10-Q of the registrant filed with the Securities and Exchange Commission on August 14, 2007.

        (7)
        Incorporated by reference to the corresponding exhibit number of the current report on Form 8-K of the registrant filed with the Securities and Exchange Commission on September 18, 2007.

        (8)
        Incorporated by reference to exhibit number 4.3 of the registration statement on Form S-8 of the registrant (No. 333-146192) filed with the Securities and Exchange Commission on September 20, 2007.

        (9)
        Filed herewith


        #
        Management contract or compensatory plan or arrangement.

        (b)


      (b)Exhibits

              See subsection (a)(3) above.



      (c)


      Financial Statement Schedules



              See subsections (a)(1) and (2) above.




      SIGNATURES

      See subsection (a)(3) above.

      (c)Financial Statement Schedules

      See subsections (a)(1) and (2) above.

      44




      SIGNATURES

      Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Irvine, State of California, on this 2729th day of February, 2007.2008.

      NETLIST, INC.


      By:



      By:


      /s/ Chun K. Hong


      Chun K. Hong


      President, Chief Executive Officer and


      Chairman of the Board


      POWER OF ATTORNEY

      Each person whose signature appears below constitutes and appoints Chun K. Hong and Lee Kim,Gail Itow, jointly and severally, each in his or her own capacity, hishis/her true and lawful attorneys-in-fact, with full power of substitution, for himhim/her and hishis/her name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this report, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such said attorneys-in-fact and agents with full power and authority to do so and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

      Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated:

      Signature


      Title


      Date







      /s/ Chun K. Hong


      Chun K. Hong

      President, Chief Executive Officer and

      Chun K. Hong

      Chairman of the Board

      February 27, 2007


      (Principal Executive Officer)

      February 29, 2008


      /s/ Lee Kim

      Gail Itow
      Gail Itow



      Vice President and Chief Financial Officer

      February 27, 2007

      Lee Kim


      (Principal Financial Officer and Principal

      Accounting Officer)



      February 29, 2008

      Accounting Officer)


      /s/ Nam Ki Hong

      Director

      February 27, 2007


      Nam Ki Hong



      Director



      February 29, 2008

      Director


      /s/ Thomas F. Lagatta


      Thomas F. Lagatta



      Director



      February 29, 2008


      /s/ Alan H. Portnoy

      Director

      February 27, 2007


      Alan H. Portnoy



      Director



      February 29, 2008


      /s/ David M. Rickey

      Director

      February 27, 2007


      David M. Rickey



      Director



      February 29, 2008


      /s/ Preston Romm

      Director

      February 27, 2007


      Preston Romm



      Director



      February 29, 2008

      45




      INDEX TO CONSOLIDATED FINANCIAL STATEMENTS




      REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

      Board of Directors and Stockholders
      Netlist, Inc.

      We have audited the accompanying consolidated balance sheets of Netlist, Inc. and subsidiaries (the “Company”"Company") as of December 30, 200629, 2007 and December 31, 2005,30, 2006, and the related consolidated statements of operations, stockholders’stockholders' equity and cash flows for each of the twothree years in the period ended December 30, 2006.29, 2007. These consolidated financial statements are the responsibility of the Company’sCompany's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

      We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit on its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’sCompany's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide for a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Netlist, Inc. and subsidiaries as of December 30, 200629, 2007 and December 31, 2005,30, 2006, and the consolidated results of their operations and their cash flows for each of the twothree years in the period ended December 30, 200629, 2007 in conformity with accounting principles generally accepted in the United States of America.

      As described in Note 2 to the consolidated financial statements, on December 31, 2006, the Company changed its method of accounting for income tax uncertainties in accordance with guidance provided in FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement 109, and effective January 1, 2006, the Company changed its method of accounting for share-based compensation to adopt Statement of Financial Accounting Standards No. 123(R),Share-Based Payment.

      /s/  KMJ CORBIN & COMPANY LLP
      Irvine, California
      February 27, 20072008


      F-
      2




      REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

      Board of Directors and Stockholders
      Netlist, Inc.

      We have audited the consolidated statements of operations, stockholders’ equity and cash flows of Netlist, Inc. and subsidiaries (the “Company’’) for the year ended January 1, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

      We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of the Company’s operations and its cash flows for the year ended January 1, 2005, in conformity with accounting principles generally accepted in the United States of America.

      /s/ DELOITTE & TOUCHE LLP
      Costa Mesa, California
      March 1, 2006

      F-3




      NETLIST, INC. AND SUBSIDIARIES

      Consolidated Balance Sheets

      (in thousands, except per share amounts)par value)

       

       

      December 31,
      2005

       

      December 30,
      2006

       

      ASSETS

       

       

       

       

       

       

       

       

       

      Current assets:

       

       

       

       

       

       

       

       

       

      Cash and cash equivalents

       

       

      $

      953

       

       

       

      $

      30,975

       

       

      Investments in marketable securities

       

       

       

       

       

      5,267

       

       

      Accounts receivable, net of allowance for sales returns and doubtful accounts of $109 (2005) and $88 (2006), respectively

       

       

      13,140

       

       

       

      23,703

       

       

      Inventories

       

       

      6,816

       

       

       

      19,473

       

       

      Income taxes receivable

       

       

      259

       

       

       

       

       

      Deferred taxes

       

       

      902

       

       

       

      1,054

       

       

      Prepaid expenses and other current assets

       

       

      434

       

       

       

      988

       

       

      Total current assets

       

       

      22,504

       

       

       

      81,460

       

       

      Property and equipment, net

       

       

      2,437

       

       

       

      3,830

       

       

      Deferred taxes

       

       

      759

       

       

       

      576

       

       

      Long-term investments in marketable securities

       

       

       

       

       

      1,502

       

       

      Other assets

       

       

      142

       

       

       

      326

       

       

      Total assets

       

       

      $

      25,842

       

       

       

      $

      87,694

       

       

      LIABILITIES AND STOCKHOLDERS’ EQUITY

       

       

       

       

       

       

       

       

       

      Current liabilities:

       

       

       

       

       

       

       

       

       

      Accounts payable

       

       

      $

      6,645

       

       

       

      $

      11,680

       

       

      Revolving line of credit

       

       

      9,463

       

       

       

      19,238

       

       

      Current portion of long-term debt

       

       

      720

       

       

       

      1,033

       

       

      Current portion of deferred gain on sale and leaseback transaction

       

       

      116

       

       

       

      118

       

       

      Current portion of convertible notes payable

       

       

      1,000

       

       

       

       

       

      Income taxes payable

       

       

       

       

       

      552

       

       

      Accrued expenses and other current liabilities

       

       

      1,841

       

       

       

      3,255

       

       

      Total current liabilities

       

       

      19,785

       

       

       

      35,876

       

       

      Long-term debt, net of current portion

       

       

      988

       

       

       

      1,230

       

       

      Deferred gain on sale and leaseback transaction, net of current portion

       

       

      464

       

       

       

      344

       

       

      Convertible notes payable, net of current portion

       

       

      1,750

       

       

       

       

       

      Total liabilities

       

       

      22,987

       

       

       

      37,450

       

       

      Commitments and contingencies (Note 10)

       

       

       

       

       

       

       

      Stockholders’ equity:

       

       

       

       

       

       

       

       

       

      Series A convertible preferred stock, $2.00 par value—1,000 shares authorized; 1,000 shares issued and outstanding (liquidation preference of $2,000) (2005); no shares issued and outstanding (2006)

       

       

      2,000

       

       

       

       

       

      Preferred stock, $0.001 par value—10,000 shares authorized; no shares issued and outstanding

       

       

       

       

       

       

       

      Common stock, $0.001 par value—90,000 shares authorized; 10,673 (2005) and 19,544 (2006) shares issued and outstanding

       

       

      11

       

       

       

      20

       

       

      Additional paid-in capital

       

       

      22,604

       

       

       

      66,557

       

       

      Note receivable from stockholder

       

       

      (23

      )

       

       

      (1

      )

       

      Deferred stock-based compensation

       

       

      (337

      )

       

       

       

       

      Accumulated deficit

       

       

      (21,400

      )

       

       

      (16,332

      )

       

      Total stockholders’ equity

       

       

      2,855

       

       

       

      50,244

       

       

      Total liabilities and stockholders’ equity

       

       

      $

      25,842

       

       

       

      $

      87,694

       

       

       
       December 29, 2007
       December 30, 2006
       
      ASSETS       
      Current assets:       
       Cash and cash equivalents $7,182 $30,975 
       Investments in marketable securities  15,573  5,267 
       Accounts receivable, net of allowance for doubtful accounts of $89 (2007) and $62 (2006)  12,034  23,703 
       Inventories  3,333  19,473 
       Income taxes receivable  708   
       Deferred taxes  3,464  1,054 
       Prepaid expenses and other current assets  392  988 
        
       
       
        Total current assets  42,686  81,460 
      Property and equipment, net  8,191  3,830 
      Deferred taxes  1,065  576 
      Long-term investments in marketable securities  7,814  1,502 
      Other assets  600  326 
        
       
       
        Total assets $60,356 $87,694 
        
       
       
      LIABILITIES AND STOCKHOLDERS' EQUITY       
      Current liabilities:       
       Accounts payable $6,697 $11,680 
       Revolving line of credit  4,872  19,238 
       Current portion of long-term debt  740  1,033 
       Current portion of deferred gain on sale and leaseback transaction  118  118 
       Income taxes payable    552 
       Accrued expenses and other current liabilities  2,872  3,255 
        
       
       
        Total current liabilities  15,299  35,876 
      Long-term debt, net of current portion  638  1,230 
      Deferred gain on sale and leaseback transaction, net of current portion  226  344 
        
       
       
        Total liabilities  16,163  37,450 
      Commitments and contingencies       
      Stockholders' equity:       
       Preferred stock, $0.001 par value—10,000 shares authorized; no shares issued and outstanding     
       Common stock, $0.001 par value—90,000 shares authorized; 19,758 (2007) and 19,544 (2006) shares issued and outstanding  20  20 
       Additional paid-in capital  68,109  66,557 
       Note receivable from stockholder    (1)
       Accumulated deficit  (23,899) (16,332)
       Accumulated other comprehensive income (loss)  (37)  
        
       
       
        Total stockholders' equity  44,193  50,244 
        
       
       
        Total liabilities and stockholders' equity $60,356 $87,694 
        
       
       

      See accompanying notes to consolidated financial statements.


      F-4




      NETLIST, INC. AND SUBSIDIARIES

      Consolidated Balance Sheets

      (in thousands, except par value)


      NETLIST, INC. AND SUBSIDIARIES

      Consolidated Statements of Operations

      (in thousands, except per share amounts)

       

      Year Ended

       


       Year Ended
       

       

      January 1, 
      2005

       

      December 31,
       2005

       

      December 30,
       2006

       


       December 29, 2007
       December 30, 2006
       December 31, 2005
       

      Net sales

       

       

      $

      143,659

       

       

       

      $

      79,856

       

       

       

      $

      151,448

       

       

      Net sales $100,060 $151,448 $79,856 

      Cost of sales(1)

       

       

      133,503

       

       

       

      73,892

       

       

       

      129,181

       

       

      Cost of sales(1) 91,261 129,181 73,892 
       
       
       
       

      Gross profit

       

       

      10,156

       

       

       

      5,964

       

       

       

      22,267

       

       

      Gross profit 8,799 22,267 5,964 
       
       
       
       

      Operating expenses:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Operating expenses:       

      Research and development(1)

       

       

      3,770

       

       

       

      2,961

       

       

       

      3,315

       

       

      Selling, general and administrative(1)

       

       

      6,314

       

       

       

      5,062

       

       

       

      9,191

       

       

      Total operating expenses

       

       

      10,084

       

       

       

      8,023

       

       

       

      12,506

       

       

      Research and development(1) 4,748 3,315 2,961 
      Selling, general and administrative(1) 15,900 9,191 5,062 
       
       
       
       
       Total operating expenses 20,648 12,506 8,023 
       
       
       
       

      Operating income (loss)

       

       

      72

       

       

       

      (2,059

      )

       

       

      9,761

       

       

      Operating income (loss) (11,849) 9,761 (2,059)
       
       
       
       

      Other income (expense):

       

       

       

       

       

       

       

       

       

       

       

       

       

      Other income (expense):       

      Interest expense, net of interest income

       

       

      (1,071

      )

       

       

      (1,221

      )

       

       

      (1,825

      )

       

      Other income (expense), net

       

       

      (315

      )

       

       

      21

       

       

       

      (24

      )

       

      Total other expense, net

       

       

      (1,386

      )

       

       

      (1,200

      )

       

       

      (1,849

      )

       

      Interest income (expense), net 395 (1,825) (1,221)
      Other income (expense), net 16 (24) 21 
       
       
       
       
       Total other income (expense), net 411 (1,849) (1,200)
       
       
       
       

      Income (loss) before provision (benefit) for income taxes

       

       

      (1,314

      )

       

       

      (3,259

      )

       

       

      7,912

       

       

      Income (loss) before provision (benefit) for income taxes (11,438) 7,912 (3,259)

      Provision (benefit) for income taxes

       

       

      (340

      )

       

       

      (912

      )

       

       

      2,844

       

       

      Provision (benefit) for income taxes (4,025) 2,844 (912)
       
       
       
       

      Net income (loss)

       

       

      $

      (974

      )

       

       

      $

      (2,347

      )

       

       

      $

      5,068

       

       

      Net income (loss) $(7,413)$5,068 $(2,347)
       
       
       
       

      Net income (loss) per common share:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Net income (loss) per common share:       

      Basic

       

       

      $

      (0.09

      )

       

       

      $

      (0.22

      )

       

       

      $

      0.43

       

       

      Diluted

       

       

      $

      (0.09

      )

       

       

      $

      (0.22

      )

       

       

      $

      0.34

       

       

      Basic $(0.38)$0.43 $(0.22)
      Diluted (0.38) 0.34 (0.22)

      Weighted-average common shares outstanding:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Weighted-average common shares outstanding:       

      Basic

       

       

      10,671

       

       

       

      10,673

       

       

       

      11,705

       

       

      Diluted

       

       

      10,671

       

       

       

      10,673

       

       

       

      15,331

       

      Basic 19,674 11,705 10,673 
      Diluted 19,674 15,331 10,673 

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

      Cost of sales

       

       

      $

      29

       

       

       

      $

      56

       

       

       

      $

      104

       

       

      Research and development

       

       

      80

       

       

       

      (52

      )

       

       

      125

       

       

      Selling, general and administrative

       

       

      141

       

       

       

      (65

      )

       

       

      363

       

       


       Cost of sales $171 $104 $56 
       Research and development  149  125  (52)
       Selling, general and administrative  861  363  (65)

      See accompanying notes to consolidated financial statements.


      F-


      5




      NETLIST, INC. AND SUBSIDIARIES

      Consolidated Statements of Stockholders’Stockholders' Equity

      (in thousands)

       

       

      Series A
      Preferred
      Stock

       

      Common Stock

       

      Additional
      Paid-in

       

      Notes
      Receivable
      From

       

      Deferred
      Stock-Based

       

      Accumulated

       

      Net
      Stockholders’

       

       

       

      Shares

       

      Amount

       

      Shares

       

      Amount

       

      Capital

       

      Stockholders

       

      Compensation

       

      Deficit

       

      Equity

       

      Balance, December 27, 2003

       

       

      1,000

       

       

       

      $

      2,000

       

       

       

      10,650

       

       

       

      $

      11

       

       

       

      $

      24,656

       

       

       

      $

      (22

      )

       

       

      $

      (2,585

      )

       

       

      $

      (18,079

      )

       

       

      $

      5,981

       

       

      Forfeiture of stock options and warrants

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      (1,335

      )

       

       

       

       

       

      943

       

       

       

       

       

       

      (392

      )

       

      Amortization of deferred stock-based compensation

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      642

       

       

       

       

       

       

      642

       

       

      Exercise of stock options

       

       

       

       

       

       

       

       

      22

       

       

       

       

       

       

      4

       

       

       

       

       

       

       

       

       

       

       

       

      4

       

       

      Interest from stockholder notes receivable

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      (1

      )

       

       

       

       

       

       

       

       

      (1

      )

       

      Payment of interest on stockholder note receivable

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      1

       

       

       

       

       

       

       

       

       

      1

       

       

      Net loss

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      (974

      )

       

       

      (974

      )

       

      Balance, January 1, 2005

       

       

      1,000

       

       

       

      2,000

       

       

       

      10,672

       

       

       

      11

       

       

       

      23,325

       

       

       

      (22

      )

       

       

      (1,000

      )

       

       

      (19,053

      )

       

       

      5,261

       

       

      Issuance of stock options to nonemployees

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      6

       

       

       

       

       

       

      (6

      )

       

       

       

       

       

       

       

      Forfeiture of stock options and warrants

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      (730

      )

       

       

       

       

       

      454

       

       

       

       

       

       

      (276

      )

       

      Amortization of deferred stock-based compensation

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      215

       

       

       

       

       

       

      215

       

       

      Exercise of stock options

       

       

       

       

       

       

       

       

      1

       

       

       

       

       

       

      3

       

       

       

       

       

       

       

       

       

       

       

       

      3

       

       

      Interest from stockholder note receivable

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      (1

      )

       

       

       

       

       

       

       

       

      (1

      )

       

      Net loss

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      (2,347

      )

       

       

      (2,347

      )

       

      Balance, December 31, 2005

       

       

      1,000

       

       

       

      2,000

       

       

       

      10,673

       

       

       

      11

       

       

       

      22,604

       

       

       

      (23

      )

       

       

      (337

      )

       

       

      (21,400

      )

       

       

      2,855

       

       

      Reclassification of deferred stock-based compensation upon adoption of SFAS No. 123(R)

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      (337

      )

       

       

       

       

       

      337

       

       

       

       

       

       

       

       

      Estimated relative fair value of beneficial conversion feature on convertible note payable

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      50

       

       

       

       

       

       

       

       

       

       

       

       

      50

       

       

      Stock-based compensation

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      592

       

       

       

       

       

       

       

       

       

       

       

       

      592

       

       

      Interest from stockholder notes receivable

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      (1

      )

       

       

       

       

       

       

       

       

      (1

      )

       

      Payment on stockholders notes receivable

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      23

       

       

       

       

       

       

       

       

       

       

       

      23

       

       

      Exercise of warrants

       

       

       

       

       

       

       

       

      550

       

       

       

       

       

       

      110

       

       

       

       

       

       

       

       

       

       

       

       

      110

       

       

      Issuance of common stock in connection with conversion of note payable and accrued interest

       

       

       

       

       

       

       

       

      21

       

       

       

       

       

       

      53

       

       

       

       

       

       

       

       

       

       

       

       

      53

       

       

      Tax benefit from exercise of warrants

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      203

       

       

       

       

       

       

       

       

       

       

       

       

      203

       

       

      Issuance of common stock in an initial public offering (net of underwriters’ discounts and offering expenses)

       

       

       

       

       

       

       

       

      6,250

       

       

       

      6

       

       

       

      39,535

       

       

       

       

       

       

       

       

       

       

       

       

      39,541

       

       

      Conversion of preferred stock

       

       

      (1,000

      )

       

       

      (2,000

      )

       

       

      1,000

       

       

       

      1

       

       

       

      1,999

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Conversion of debt at initial public offering

       

       

       

       

       

       

       

       

       

       

      1,050

       

       

       

      2

       

       

       

      1,748

       

       

       

       

       

       

       

       

       

       

       

       

      1,750

       

       

      Net income

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      5,068

       

       

       

      5,068

       

       

      Balance, December  30, 2006

       

       

      –—

       

       

       

      $

       

       

       

      19,544

       

       

       

      $

      20

       

       

       

      $

      66,557

       

       

       

      $

      (1

      )

       

       

      $

       

       

       

      ($16,332

      )

       

       

      $

      50,244

       

       

       
       Series A Preferred Stock
        
        
        
        
        
        
        
        
       
       
       Common Stock
        
       Notes
      Receivable
      From
      Stockholders

        
        
       Accumulated
      Other
      Comprehensive
      Income (Loss)

        
       
       
       Additional
      Paid-in
      Capital

       Deferred
      Stock-Based
      Compensation

       Accumulated
      Deficit

       Total
      Stockholders'
      Equity

       
       
       Shares
       Amount
       Shares
       Amount
       
      Balance, January 1, 2005 1,000 $2,000 10,672 $11 $23,325 $(22)$(1,000)$(19,053)$ $5,261 
       Issuance of stock options to nonemployees        6    (6)      
        Forfeiture of stock options and warrants        (730)   454      (276)
        Amortization of deferred stock-based compensation            215      215 
       Exercise of stock options    1    3          3 
       Interest from stockholder note receivable          (1)       (1)
       Net loss and comprehensive loss              (2,347)   (2,347)
        
       
       
       
       
       
       
       
       
       
       
      Balance, December 31, 2005 1,000  2,000 10,673  11  22,604  (23) (337) (21,400)   2,855 
       Reclassification of deferred stock-based compensation upon adoption of SFAS No. 123R        (337)   337       
       Estimated relative fair value of beneficial conversion feature on convertible note payable        50          50 
       Stock-based compensation        592          592 
       Interest from stockholder notes receivable          (1)       (1)
       Payment on stockholder notes receivable          23        23 
       Exercise of warrants    550    110          110 
       Issuance of common stock in connection with conversion of note payable and accrued interest    21    53          53 
       Tax benefit from exercise of warrants        203          203 
       Issuance of common stock in an intial public offering (net of underwirters' discounts and offering expenses)    6,250  6  39,535          39,541 
       Coversion of preferred stock (1,000) (2,000)1,000  1  1,999           
       Coversion of debt at intial public offering    1,050  2  1,748          1,750 
       Net income and comprenhensive income              5,068    5,068 
        
       
       
       
       
       
       
       
       
       
       
      Balance, December 30, 2006    19,544  20  66,557  (1)   (16,332)   50,244 
       Cumulative effect to prior year accumulated deficit related to the adoption of FIN 48              (154)   (154)
       Stock-based compensation        1,181          1,181 
       Payment on stockholder notes receivable          1        1 
       Exercise of stock options    191    310          310 
       Exercise of warrants    23               
       Tax benefit from stock option exercises        61          61 
       Components of comprehensive loss:                             
         Change in net unrealized loss on investments                (37) (37)
       Net loss              (7,413)   (7,413)
                                 
       
       Comprehensive loss                  (7,450)
        
       
       
       
       
       
       
       
       
       
       
      Balance, December 29, 2007  $ 19,758 $20 $68,109 $ $ $(23,899)$(37)$44,193 
        
       
       
       
       
       
       
       
       
       
       

      See accompanying notes to consolidated financial statements.


      F-
      6




      NETLIST, INC. AND SUBSIDIARIES

      Consolidated Statements of Cash Flows

      (in thousands)

       
       Year Ended
       
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       
      Cash flows from operating activities:          
       Net income (loss) $(7,413)$5,068 $(2,347)
       Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:          
        Depreciation and amortization  1,510  972  1,031 
        Amortization of deferred gain on sale and leaseback transaction  (118) (118)  
        Deferred income taxes  (2,899) 31  (682)
        Impairment of long-lived assets  502     
        Loss (gain) on disposal of assets  68  30  (11)
        Loss on inventory adjustments  5,328     
        Facility relocation charge  134     
        Stock-based compensation  1,181  592  (61)
        Interest on notes receivable from stockholders    (1) (1)
        Amortization of debt discount    50   
        Changes in operating assets and liabilities:          
         Accounts receivable  11,669  (10,563) (4,327)
         Inventories  10,812  (12,657) 526 
         Income taxes receivable  (708) 259  234 
         Prepaid expenses and other current assets  596  (268) 99 
         Other assets  (274) (184) (85)
         Accounts payable  (5,089) 5,035  921 
         Income taxes payable  (706) 552   
         Accrued expenses and other current liabilities  (517) 1,417  95 
        
       
       
       
        Net cash provided by (used in) operating activities  14,076  (9,785) (4,608)
        
       
       
       
      Cash flows from investing activities:          
        Acquisition of property and equipment  (6,268) (2,500) (484)
        Proceeds from sale of equipment    218  19 
        Repayment of note receivable from stockholder  1  23   
        Purchase of investments in marketable securities  (63,253) (6,769)  
        Proceeds from maturities of marketable securities  44,299     
        Proceeds from sales of marketable securities  2,299     
        Proceeds from sale and leaseback of facility      1,797 
        
       
       
       
        Net cash provided by (used in) investing activities  (22,922) (9,028) 1,332 
        
       
       
       
      Cash flows from financing activities:          
        Borrowings on lines of credit  114,195  159,680  82,015 
        Payments on lines of credit  (128,561) (149,905) (77,995)
        Borrowings from debt  290  3,073   
        Payments on debt  (1,242) (2,917) (1,553)
        Proceeds from convertible notes payable      1,000 
        Repayment of convertible notes payable    (950)  
        Proceeds from exercise of stock options and warrants  310  110  3 
        Excess tax benefit from exercise of stock options and warrants  61  203   
        Proceeds from initial public offering, net of offering costs    39,541   
        
       
       
       
        Net cash provided by (used in) financing activities  (14,947) 48,835  3,470 
        
       
       
       
      Net increase (decrease) in cash and cash equivalents  (23,793) 30,022  194 
      Cash and cash equivalents, beginning of year  30,975  953  759 
        
       
       
       
      Cash and cash equivalents, end of year $7,182 $30,975 $953 
        
       
       
       
      Supplemental disclosure of cash flow information:          
        Cash paid during the year for:          
         Interest $1,359 $2,010 $1,169 
        
       
       
       
         Income taxes $227 $1,804 $2 
        
       
       
       

       

       

      Year Ended

       

       

       

      January 1,
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

      Cash flows from operating activities:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Net income (loss)

       

       

      $

      (974

      )

       

       

      $

      (2,347

      )

       

       

      $

      5,068

       

       

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

       

       

       

       

       

       

       

       

       

       

       

       

       

      Depreciation and amortization

       

       

      867

       

       

       

      1,031

       

       

       

      972

       

       

      Amortization of deferred gain on sale and leaseback transaction

       

       

       

       

       

       

       

       

      (118

      )

       

      Deferred income taxes

       

       

      218

       

       

       

      (682

      )

       

       

      31

       

       

      Loss (gain) on disposal of assets

       

       

      43

       

       

       

      (11

      )

       

       

      30

       

       

      Stock-based compensation

       

       

      250

       

       

       

      (61

      )

       

       

      592

       

       

      Interest on notes receivable from stockholders

       

       

       

       

       

      (1

      )

       

       

      (1

      )

       

      Amortization of debt discount

       

       

       

       

       

       

       

       

      50

       

       

      Changes in operating assets and liabilities:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Accounts receivable

       

       

      (3,570

      )

       

       

      (4,327

      )

       

       

      (10,563

      )

       

      Inventories

       

       

      2,704

       

       

       

      526

       

       

       

      (12,657

      )

       

      Income taxes receivable

       

       

      (493

      )

       

       

      234

       

       

       

      259

       

       

      Prepaid expenses and other current assets

       

       

      (116

      )

       

       

      99

       

       

       

      (268

      )

       

      Other assets

       

       

      (7

      )

       

       

      (85

      )

       

       

      (184

      )

       

      Accounts payable

       

       

      (3,032

      )

       

       

      921

       

       

       

      5,035

       

       

      Income taxes payable

       

       

      (2,634

      )

       

       

       

       

       

      552

       

       

      Accrued expenses and other current liabilities

       

       

      177

       

       

       

      95

       

       

       

      1,417

       

       

      Net cash used in operating activities

       

       

      (6,567

      )

       

       

      (4,608

      )

       

       

      (9,785

      )

       

      Cash flows from investing activities:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Acquisition of property and equipment

       

       

      (557

      )

       

       

      (484

      )

       

       

      (2,500

      )

       

      Proceeds from sale of equipment

       

       

      61

       

       

       

      19

       

       

       

      218

       

       

      Repayment of note receivable shareholder

       

       

       

       

       

       

       

       

      23

       

       

      Purchase of investments in marketable securities

       

       

       

       

       

       

       

       

      (5,267

      )

       

      Purchase of investments in long term marketable securities

       

       

       

       

       

       

       

       

      (1,502

      )

       

      Proceeds from sale and leaseback of facility

       

       

       

       

       

      1,797

       

       

       

       

       

      Net cash provided by (used in) investing activities

       

       

      (496

      )

       

       

      1,332

       

       

       

      (9,028

      )

       

      Cash flows from financing activities:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Borrowings on lines of credit

       

       

      146,488

       

       

       

      82,015

       

       

       

      159,680

       

       

      Payments on lines of credit

       

       

      (141,045

      )

       

       

      (77,995

      )

       

       

      (149,905

      )

       

      Borrowings from debt

       

       

      820

       

       

       

       

       

       

      3,073

       

       

      Payments on debt

       

       

      (348

      )

       

       

      (1,553

      )

       

       

      (2,917

      )

       

      Proceeds from convertible notes payable

       

       

       

       

       

      1,000

       

       

       

       

       

      Repayment of convertible notes payable

       

       

       

       

       

       

       

       

      (950

      )

       

      Proceeds from exercise of stock options and warrants

       

       

       

       

       

      3

       

       

       

      110

       

       

      Tax benefit from exercise of warrants

       

       

       

       

       

       

       

       

      203

       

       

      Proceeds from initial public offering, net of offering costs

       

       

       

       

       

       

       

       

      39,541

       

       

      Net cash provided by financing activities

       

       

      5,915

       

       

       

      3,470

       

       

       

      48,835

       

       

      Net increase (decrease) in cash and cash equivalents

       

       

      (1,148

      )

       

       

      194

       

       

       

      30,022

       

       

      Cash and cash equivalents, beginning of period

       

       

      1,907

       

       

       

      759

       

       

       

      953

       

       

      Cash and cash equivalents, end of period

       

       

      $

      759

       

       

       

      $

      953

       

       

       

      $

      30,975

       

       

      Supplemental disclosure of cash flow information:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Cash paid during the period for:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Interest

       

       

      $

      1,061

       

       

       

      $

      1,169

       

       

       

      $

      2,010

       

       

      Income taxes

       

       

      $

      3,400

       

       

       

      $

      2

       

       

       

      $

      1,804

       

       

      Supplemental disclosure of non-cash investing and financing activities:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Purchase of equipment through capitalized lease obligations

       

       

      $

      184

       

       

       

      $

      837

       

       

       

      $

      113

       

       

      Purchase of insurance policies through notes payable

       

       

      $

       

       

       

      $

      238

       

       

       

      $

      286

       

       

      Deferred gain on sale and leaseback of facility

       

       

      $

       

       

       

      $

      580

       

       

       

      $

       

       

      Estimated relative fair value of beneficial conversion feature on convertible note payable

       

       

      $

       

       

       

      $

       

       

       

      $

      50

       

       

      Issuance of common stock in connection with conversion of note payable and accrued interest

       

       

      $

       

       

       

      $

       

       

       

      $

      53

       

       

      Preferred stock conversion

       

       

      $

       

       

       

      $

       

       

       

      $

      2,000

       

       

      Conversion of notes payable into common stock

       

       

      $

       

       

       

      $

       

       

       

      $

      1,750

       

       


      NETLIST, INC. AND SUBSIDIARIES

      Consolidated Statements of Cash Flows (Continued)

      (in thousands)

      Supplemental disclosure of non-cash investing and financing activities:          
        Purchase of equipment through capitalized lease obligations $67 $113 $837 
        
       
       
       
        Purchase of equipment not paid for at the end of the year $123 $ $ 
        
       
       
       
        Cumulative effect to prior year accumulated deficit related to the adoption of FIN 48 $154 $ $ 
        
       
       
       
        Purchase of insurance policies through notes payable $ $286 $238 
        
       
       
       
        Deferred gain on sale and leaseback of facility $ $ $580 
        
       
       
       
        Estimated relative fair value of beneficial conversion feature on convertible note payable $ $50 $ 
        
       
       
       
        Issuance of common stock in connection with conversion of note payable and accrued interest $ $53 $ 
        
       
       
       
        Preferred stock conversion $ $2,000 $ 
        
       
       
       
        Conversion of notes payable into common stock $ $1,750 $ 
        
       
       
       

      See accompanying notes to consolidated financial statements.


      F-7




      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      December 29, 2007

      NOTE 1—DESCRIPTION OF BUSINESS

      Description of Business

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

      In December 2006, the Company sold 6,250,000 of its common shares in its initial public offering ("IPO") at an offering price of $7.00 per share, resulting in proceeds of $39.5 million, net of underwriters’underwriters' discounts and offering expenses of approximately $4.2 million.

              In 2007, the Company established a new manufacturing facility in the People's Republic of China ("PRC"). This facility became operational in July 2007 upon the successful qualification of certain key customers.

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

        Basis of Presentation

      The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.

        Principles of Consolidation

      The consolidated financial statements include the accounts of Netlist, Inc. and its wholly owned subsidiaries, Netlist Holdings GP, Inc., Netlist Holdings LP, Inc., Netlist Technology Texas LP, and Netlist International.subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

        Fiscal Year

      Effective January 1, 2003, the        The Company changed its fiscal year fromhas a calendar year to a 52/53-week52/53-week fiscal year ending on the Saturday closest to December 31. The 2004,2007, 2006 and 2005 and 2006 fiscal years ended on January 1, 2005,December 29, 2007, December 30, 2006 and December 31, 2005, and December 30, 2006, respectively, and consisted of 52 weeks.

        Use of Estimates

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

      Cash and Cash Equivalents and Investments in Marketable Securities

      The Company investsbases its excess cash in money market fundsestimates and in highly liquid debt instrumentsassumptions on current facts, historical experience and various other factors that it believes to be reasonable under the circumstances, the results of U.S. municipalities, corporationswhich form the basis for making judgments about the carrying values of assets and liabilities and the U.S. governmentaccrual of costs and its agencies. All highly liquid investments with stated maturities of three months or lessexpenses that are not readily apparent from date of purchase are classified as cash equivalents; all highly liquid investments with stated maturities of greater than three months are classified as investments in marketable securities.

      other sources. The Company determines that appropriate classification of its investments in marketable debt securities at the time of purchase and reevaluates such designation at each balance sheet date. The

      F-8




      Company’s marketable debt 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 market value based on market quotes. Unrealized gains and losses, net of deferred taxes, have not been significant and will be recorded as a component of other comprehensive income.

      Fair Value of Financial Instruments

      The fair values of the Company’s cash and cash equivalents, accounts receivable, marketable securities, accounts payable and accrued expenses approximate carrying values due to their short maturities. The fair value of the Company’s debt instruments approximates their carrying values based on rates currently available to the Company.

      Concentration of Credit Risk

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

      The Company invests primarily in money market funds and high quality commercial paper and other debt instruments. Cash equivalents are maintained with high quality institutions, the composition and maturities of which are regularly monitored by management. Investments in marketable securities are in high-credit quality debt instruments with an active resale market. Such investments are made only in instruments issued or enhanced by high-quality institutions. The Company has not incurred any credit risk losses related to these investments.

      The Company’s trade accounts receivable are primarily derived from sales to original equipment manufacturers (“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 the Company’s credit evaluation process, relatively short collection terms and the high level of credit worthiness of its customers.

      Inventories

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

      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.

      F-9




      Impairment of Long-Lived Assets

      The Company evaluates long-lived assets held and usedactual results experienced by the Company for impairment on an annual basis or whenever events or changes in circumstances indicate that their net book value may notdiffer materially and adversely from the Company's estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be recoverable. When such factors and circumstances exist, the Company compares the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. Impairment, if any, is based on the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the determination is made. At affected.


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 31, 2005 and December 30, 2006, the Company’s management believes there is no impairment of its long-lived assets. 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.29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

        Revenue Recognition

      The Company’sCompany's revenues primarily consist of product sales of high performance memory subsystems to OEMs.original equipment manufacturers ("OEMs"). Revenues also include sales of excess inventories to distributors and other users of memory ICsintegrated circuits ("ICs") totaling approximately $28,016,000, $19,127,000, $11,424,000$1.9 million, $11.4 million and $19.1 million during the years ended January 1, 2005,December 29, 2007, December 30, 2006 and December 31, 2005, and December 30, 2006, respectively.

      The Company recognizes revenues in accordance with the Securities and Exchange Commission’sCommission's Staff Accounting Bulletin (“SAB”("SAB") No. 104,Revenue Recognition ("SAB No. 104"). Under the provisions of SAB No. 104, 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 collectibility of the resulting receivable is reasonably assured.

      For all sales, the        The Company generally uses a bindingcustomer purchase orderorders 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 inventories, which contain no right-of-return privileges. Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. Returns from customers have not been material in any period as the Company’s principal customers have adopted build-to-order manufacturing models or just-in-time management processes. The Company offers a standard product warranty to its customers and has no other post-shipment obligations. The Company assesses collectibility based on the creditworthiness of the customer as determined by credit checks and evaluations, as well as the customer’scustomer's payment history.

      Most        A portion of the Company’sCompany's international shipments are made to third-party inventory warehouses, or hubs, and the Company recognizes revenue when the inventory is pulled from the hub for use in production by the customer. The Company receives a report from the customer on a daily basis indicating the inventories pulled from a hub for use by the customer, and performs a daily reconciliation of inventories shipped to and pulled by the customer to those inventories reflected on the customer’scustomer's reports to ensure that sales are recognized in the appropriate periods.

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

        F-Cash and Cash Equivalents

              Cash and cash equivalents consist of cash and short-term investments with original maturities of 90 days or less.

        Investments in Marketable Securities

              In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115,10Accounting for Certain Investments in Debt and Equity Securities ("SFAS No. 115"), the Company determines the appropriate classification of its investments in marketable debt securities at the time of purchase and


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

      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 market value based on market quotes. Unrealized gains and losses, net of deferred taxes, are recorded as a component of other comprehensive income (loss).

              The Company generally invests its excess cash in money market funds and in highly liquid debt instruments of United States ("U.S.") municipalities, corporations, the U.S. government and its agencies and auction rate securities. 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 fair values of the Company's cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate carrying values due to their short maturities. Investments in marketable securities are comprised of available-for-sale securities that are reported at fair value with the related unrealized gains and losses included in accumulated other comprehensive income (loss), a component of stockholders' equity, net of tax. The fair value of marketable securities is determined based on quoted market prices. The fair value of the Company's debt instruments approximates their carrying values based on rates currently available to the Company.

        Allowance for Doubtful Accounts

              The Company evaluates the collectibility 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 recognizes allowances for doubtful accounts based primarily on the length of time the receivables are past due, the current business environment and the Company's historical experience.

        Concentration of Credit Risk

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

              The Company invests primarily in money market funds and high quality commercial paper and other debt instruments. Cash equivalents are maintained with high quality institutions, the composition and maturities of which are regularly monitored by management. Investments in marketable securities are in high-credit quality debt instruments with an active resale market. Such investments are made only in instruments issued or enhanced by high-quality institutions. The Company has not incurred any credit risk 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


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)




      Company believes that the concentration of credit risk in its trade receivables is moderated by the Company's credit evaluation process, relatively short collection terms and the high level of credit worthiness of its customers. 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 cost or net realizable value. Cost is determined on an average cost basis which approximates actual cost on a first-in, first-out basis and includes raw materials, labor and manufacturing overhead. At each balance sheet date, the Company evaluates its ending inventories for excess quantities and obsolescence. This evaluation includes an analysis of sales levels by product type. Among other factors, the Company considers historical demand and forecasted demand in relation to the inventory on hand, competitiveness of product offerings, market conditions and product life cycles when determining obsolescence and net realizable value. Provisions are made to reduce excess or obsolete inventories to their estimated net realizable values. Once established, write-downs are considered permanent adjustments to the cost basis of the excess or obsolete inventories.

        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 long-lived assets held and used by the Company for impairment on an annual basis or whenever events or changes in circumstances indicate that their net book value may not be recoverable. When such factors and circumstances exist, the Company compares the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. Impairment, if any, is based on the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the determination is made. Other than those matters discussed at Note 11, the Company's management believes there is no further impairment of its long-lived assets recorded on the accompanying consolidated balance sheets as of December 29, 2007 and December 30, 2006. 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 to its customers, other than on sales of excess inventory, depending on the product and negotiated terms of purchase agreements. Such warranties require the Company to repair or replace defective product returned to the Company during such warranty period at no cost to the customer. An estimate by the Company for warranty relatedwarranty-related costs is recorded by the Company at the time of sale based on its historical and


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

      estimated product return rates and expected repair or replacement costs. Such costs have historically been consistent between periods and in-line with management's expectations. The Company's warranty liability is included as a component of accrued expenses and other current liabilities in the accompanying consolidated balance sheets.

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

      Beginning balance, December 30, 2006 $298 
      Charged to costs and expenses  256 
      Usage  (201)
        
       
      Ending balance, December 29, 2007 $353 
        
       

              Prior to fiscal 2007, activity related to warranty costs was insignificant.

        Beneficial Conversion Feature

      The convertible feature of one of the Company’sCompany's convertible notes provided for a rate of conversion that was below market value (see Note 8)7). Such feature is normally characterized as a “beneficial"beneficial conversion feature” (“BCF”feature" ("BCF"). Pursuant to Emerging Issues Task Force (“EITF”("EITF") Issue No. 98-5,Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratio and EITF No. 00-27,Application of EITF Issue No. 98-5 to Certain Convertible Instruments, the estimated relative fair value of the BCF was recorded as a discount from the face amount of the convertible note. The Company amortized the discount using the effective interest method through the conversion of such instrument.

        Stock-Based Compensation

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

      Prior to January 1, 2006, the Company accounted for stock-based compensation issued to employees and directors using the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion (“APB”("APB") No. 25,Accounting for Stock Issued to Employees ("APB No. 25"), and related pronouncements (see Note 13).pronouncements. Under this method, compensation expense was recognized over the respective vesting period based on the excess, on the date of grant, of the estimated fair value of the Company’sCompany's common stock over the grant price, net of forfeitures. Deferred stock-based compensation expense was amortized on a straight-line basis over the vesting period of each grant. During the years ended January 1, 2005 and December 31, 2005, stock-based compensation expense, net of forfeitures, was approximately $250,000 and $(61,000), respectively.


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

      Under SFAS No. 123, entities were required to recognize as expense over the vesting period the fair value of all stock-based awards on the date of the grant. Alternatively, SFAS No. 123 allowed entities to continue to apply the provisions of APB No. 25 and provide pro forma net income (loss) disclosures for employee stock option grants as if the fair value based method defined in SFAS No. 123 had been applied. The Company has elected to apply the provisions of APB No. 25 and provide pro forma disclosures required by SFAS No. 123 and SFAS No. 148,Accounting for Stock-Based Compensation—Transition and Disclosure.

      Had compensation cost for the Company’sCompany's stock-based awards to employees been determined based on the estimated fair value at the grant dates consistent with the fair value method of SFAS No. 123, the

      F-11




      Company’s Company's net loss and loss per share for the yearsyear ended January 1, 2005 and December 31, 2005 would have approximated the pro forma amounts indicated below (in thousands, except per share amounts):

       

      Year Ended

       

       

      January 1,
      2005

       

      December 31,
      2005

       


       Year Ended
      December 31,
      2005

       

      Net loss, as reported

       

       

      $

      (974

      )

       

       

      $

      (2,347

      )

       

      Net loss, as reported $(2,347)

      Plus: stock-based employee compensation expense included in reported net loss, net of tax

       

       

      185

       

       

       

      (44

      )

       

      Plus: stock-based employee compensation expense included in reported net loss, net of tax (44)

      Less: stock-based employee compensation expense determined under fair value based method, net of tax

       

       

      (470

      )

       

       

      354

       

       

      Less: stock-based employee compensation expense determined under fair value based method, net of tax 354 
       
       

      Pro forma net loss

       

       

      $

      (1,259

      )

       

       

      $

      (2,037

      )

       

      Pro forma net loss $(2,037)
       
       

      Net loss per common share as reported:

       

       

       

       

       

       

       

       

       

      Net loss per common share as reported:   

      Basic

       

       

      $

      (0.09

      )

       

       

      $

      (0.22

      )

       

      Diluted

       

       

      $

      (0.09

      )

       

       

      $

      (0.22

      )

       

      Basic $(0.22)
       
       
      Diluted $(0.22)
       
       

      Pro forma:

       

       

       

       

       

       

       

       

       

      Pro forma:   

      Basic

       

       

      $

      (0.12

      )

       

       

      $

      (0.19

      )

       

      Diluted

       

       

      $

      (0.12

      )

       

       

      $

      (0.19

      )

       

      Basic $(0.19)
       
       
      Diluted $(0.19)
       
       

              

      The fair value of options granted under the Company’sCompany's equity incentive plan during the yearsyear ended January 1, 2005 and December 31, 2005 was estimated on the date of grant using the Black-Scholes option-pricing model utilizing the single option approach using the following weighted-average assumptions:


      January 1,Year Ended
      2005

      December 31,
      2005


      Risk-free interest rate

      4.13%

      Weighted-average risk-free rate

      Expected term (in years)

      10

      n/a

      4.13

      %

      Expected term

      volatility

      24

      n/a

      10 years

      %

      Expected stock volatility

      dividends

      n/a

      24

      %

      Dividend yield

      n/a

      There were no options granted during fiscal 2004.

      Effective January 1, 2006, the Company adopted SFAS No. 123(R),Share-Based Payment ("SFAS No. 123(R)"), which establishes standards for the accounting of transactions in which an entity exchanges its equity instruments for goods or services, primarily focusing on accounting for transactions


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)


      where an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires a publican entity to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant-date fair value of the award and to recognize it as compensation expense over the period the employee is required to provide service in exchange for the award, usually the vesting period. SFAS No. 123(R) supersedes the Company’sCompany's previous accounting under APB No. 25 for periods beginning in fiscal 2006. SFAS No. 123(R) also amends SFAS No. 95,Statement of Cash Flows, and requires the benefits of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under previous literature. In March 2005, the Securities and Exchange Commission issued SAB No. 107,Share-Based Payment ("SAB No. 107"), relating to SFAS No. 123(R). The Company has applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R).

      The Company adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’sCompany's fiscal year 2006. The Company’sCompany's consolidated financial statements as of and for the yearyears ended December 29, 2007 and December 30, 2006 reflect the impact of adopting SFAS No. 123(R). In accordance with the modified prospective transition method, the Company’sCompany's consolidated financial statements for periods prior periodsto fiscal 2006 have not been restated to reflect, and do not include, the impact of SFAS No. 123(R).

      F-12




      SFAS No. 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’sCompany's consolidated statement of operations. Prior to the adoption of SFAS No. 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB No. 25 as allowed under SFAS No. 123. Under this method, stock-based compensation expense had been recognized in the Company’sCompany's consolidated statements of operations for option grants to employees and consultantsdirectors below the fair market value of the underlying stock at the date of grant.

      Stock-based        In accordance with SFAS No. 123(R), employee and director stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’sCompany's consolidated statementstatements of operations for the yearyears ended Decebmer 29, 2007 and December 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). AsGiven that stock-based compensation expense recognized in the consolidated statementstatements of operations for the yearyears ended December 29, 2007 and December 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimated average forfeiture rate forrates used by the year ended December 30, 2006 of approximately 8% wasCompany are based on historical forfeiture experience and estimated future


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)


      employee forfeitures. The estimated term of option grants for the year ended December 30, 2006 was six years. In the Company’sCompany's pro forma information required under SFAS No. 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.

      Pursuant to SFAS No. 123(R), deferred stock-based compensation expense with a balance of $337,000 at December 31, 2005 was eliminated against additional paid-in capital upon the adoption of SFAS No. 123(R) on January 1, 2006. The deferred stock-based compensation expense was primarily related to stock awards granted to various employees and directors prior to the adoption of SFAS No. 123(R).

      The fair value of stock-based awards to employees and directors is calculated using the Black-Scholes option pricing model. The Black-Scholes model requires subjective assumptions regarding future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The expected volatility for the years ended December 29, 2007 and December 30, 2006 is based on the historical volatilities of the common stock of comparable publicly traded companies based on the the Company's belief that it currently has limited historical data regarding the volatility of its stock price on which to base a meaningful estimate of expected volatility. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the pricingexpected term of the grant effective as of the date of the grant. The expected volatility for the year ended December 30, 2006dividends assumption is based on the historical volatilitiesCompany's history and expectation of the common stock of comparable publicly traded companies.dividend payouts. These factors could change in the future, affecting the determination of stock-based compensation expense in future periods.

      Year
      December 30,
      2006

      Expected term

      6 years

      Expected volatility

      43%

      Risk-free interest rate

      4.55%-4.97%

      Expected dividends

        F-13




      A summary of option activity as of December 30, 2006 and changes during the year then ended, is presented below (dollars and shares in thousands, except per share data):

       

       

      Shares

       

      Weighted-
      Average
      Exercise
      Price

       

      Weighted-
      Average
      Remaining
      Contractual
      Term
      (Years)

       

      Aggregate
      Intrinsic
      Value

       

      Options outstanding at January 1, 2006

       

       

      2,190

       

       

       

      $1.26

       

       

       

       

       

       

       

       

       

       

       

      Options granted

       

       

      1,478

       

       

       

      $ 6.16

       

       

       

       

       

       

       

       

       

       

       

      Options exercised

       

       

       

       

       

      $  —

       

       

       

       

       

       

       

       

       

       

       

      Options forfeited

       

       

      (350

      )

       

       

      $ 2.18

       

       

       

       

       

       

       

       

       

       

       

      Options outstanding at December 30, 2006

       

       

      3,318

       

       

       

      $ 3.34

       

       

       

      7.62

       

       

       

      $ 15,458

       

       

       

      Options exercisable at December 30, 2006

       

       

      1,424

       

       

       

      $0.74

       

       

       

      5.48

       

       

       

      $10,338

       

       

       

      Options vested and expected to vest at December 30, 2006

       

       

      3,167

       

       

       

      $3.25

       

       

       

      7.67

       

       

       

      $15,052

       

       

       

      The weighted-average grant date fair value of options granted during the year ended December 30, 2006 was $2.98 per option. The total intrinsic value of options exercised during the year ended December 30, 2006 was zero as no options were exercised during the period. Upon the exercise of options, the Company issues new shares from its authorized shares.

      As of December 30, 2006, there was approximately $3,687,000 of total unrecognized compensation cost, net of estimated expected forfeitures, related to employee and director stock option compensation arrangements. That cost is expected to be recognized on a straight-line basis over the next 4 years. The total fair value of shares vested less estimated forfeitures during the year ended December 30, 2006 was approximately $592,000.

      As a result of adopting SFAS No. 123(R) on January 1, 2006, the Company’s income before provision for income taxes and net income for the year ended December 30, 2006 were approximately $481,000 and $308,000 lower, respectively, than if it had continued to account for share-based compensation under APB No. 25. Basic net income per share for the year ended December 30, 2006 was approximately $0.03 lower than if the Company had continued to account for share-based compensation under APB No. 25. Diluted net income per share for the year ended December 30, 2006 was approximately $0.02 lower due to the adoption of SFAS No. 123(R).

      The following table summarizes stock-based compensation expense related to employee and director stock options under SFAS No. 123(R) for the year ended December 30, 2006, which was allocated as follows (in thousands):

      Year Ended
      December 30,
      2006

      Stock-based compensation expense included in:

      Cost of sales

      $ 104

      Research and development

      125

      Selling, general and administrative

      363

      Income Taxes

      The Company accounts for income taxes in accordance with SFAS No. 109,Accounting for Income Taxes ("SFAS No. 109"). Under SFAS No. 109, 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

      F-14




      attributable to events that have been recognized on a cumulative basis in the consolidated financial statements. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion of the deferred tax asset will not be realized.

              In July 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109 ("FIN 48"). FIN 48 and seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. FIN 48 prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under FIN 48 the Company may only recognize or continue to recognize tax positions that meet a "more likely than not" threshold. The Company adopted FIN 48 on December 31, 2006, the first day of fiscal 2007.

        Research and Development Expense

              Research and development expenditures are expensed in the period incurred.


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

        Advertising Expense

              Advertising costs are expensed in the period incurred. Advertising expenses for fiscal years 2007, 2006 and 2005 were not significant.

        Comprehensive Income (Loss)

              SFAS No. 130,Reporting Comprehensive Income

      Comprehensive, establishes standards for reporting and displaying comprehensive income and its components in the consolidated financial statements. Accumulated other comprehensive income (loss) includes allunrealized gains or losses on investments.

        Risks and Uncertainties

              The Company's operations in the 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 stockholders’ equity duringeconomic conditions in the region, (ii) managing a local workforce that may subject the Company to uncertainties or certain regulatory policies and (iii) changes in other policies of the Chinese governmental and regulatory agencies. Additionally, the Chinese government controls the procedures by which its local currency, the Chinese Renminbi ("RMB"), is converted into other currencies. If changes or restrictions in the conversion of RMB are instituted, the Company's operations and operarting results may be negatively impacted.

        Foreign Currency Remeasurement

              The functional currency of the Company's foreign subsidiary in the PRC is the U.S. dollar. The local currency financial statements of this subsidiary are remeasured into U.S. dollars using the current exchange rate 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, from non-owner sources. For the years January 1, 2005, December 30, 2005except items related to nonmonetary assets and December 30, 2006 there were no differences between the Company’sliabilities, which are remeasured using historical exchange rates. All remeasurement gains and losses are included in determining net income (loss) and its comprehensive income (loss).

        Net Income (Loss) Per Share

      Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted-average shares outstanding during the period.year. Diluted net income (loss) per share is calculated by dividing the net income (loss) by the weighted-average shares and dilutive potential common shares outstanding during the period.year. Dilutive potential shares consist of dilutive shares issuable upon the exercise of outstanding stock options and warrants computed using the treasury stock methodmethod. Prior to fiscal 2007, in addition to outstanding stock options and warrants, dilituive potential common shares also consisted of shares issuable upon the conversion of convertible notes payable and convertible preferred stock using the “if converted”"if converted" method. All potentially dilutive shares of approximately 4,001,000

        New Accounting Pronouncements

              In June 2007, the FASB ratified EITF No. 07-3,Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and 3,632,000 duringDevelopment Activities ("EITF No. 07-3"). EITF No. 07-3 requires non-refundable advance payments for goods and services to be used in future


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

      research and development activities to be recorded as an asset and the payments to be expensed when the research and development activities are performed. EITF No. 07-3 is effective for fiscal years ended January 1,beginning after December 15, 2007. This standard is not expected to have a material impact on the Company's future consolidated financial statements.

        Reclassifications

              Certain amounts in the 2006 and 2005 and December 30, 2005, respectively,consolidated financial statements have been excluded from diluted loss per share as their effect would be anti-dilutive forreclassified to conform with the periods then ended. Potentially dilutive sharescurrent year presentation.

      NOTE 3—SUPPLEMENTAL FINANCIAL INFORMATION

        Inventories

              Inventories consist of approximately 3,626,000 forthe following (in thousands):

       
       December 29, 2007
       December 30, 2006
      Raw materials $1,878 $10,513
      Work in process  425  3,343
      Finished goods  1,030  5,617
        
       
        $3,333 $19,473
        
       

              During the year ended December 29, 2007, the Company incurred a loss of approximately $5.3 million due to slow moving and lower-of-cost-or-market value inventory adjustments, which is included as a component of cost of sales in the accompanying consolidated statement of operations.


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 3—SUPPLEMENTAL FINANCIAL INFORMATION (Continued)

        Property and Equipment

              Property and equipment consist of the following (dollars in thousands):

       
       Estimated
      Useful
      Lives

       December 29, 2007
       December 30, 2006
       
      Machinery and equipment 3-7 yrs. $8,055 $5,153 
      Leasehold improvements *  1,484  44 
      Furniture and fixtures 5 yrs.  457  205 
      Computer equipment and software 3-7 yrs.  2,278  1,731 
          
       
       
           12,274  7,133 
      Less accumulated depreciation and amortization    (4,083) (3,303)
          
       
       
          $8,191 $3,830 
          
       
       

          *
          Estimated useful life is generally 7 years, or the remaining lease term, whichever is shorter

              Included in property and equipment are assets under capital leases with a cost of approximately $1.9 million and $2.3 million and accumulated amortization of approximately $1.2 million and $1.2 million at December 29, 2007 and December 30, 2006, have been includedrespectively.

        Comprehensive Income (Loss)

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

       
       Year Ended
       
       
       December 29, 2007
       December 30, 2006
       December 31, 2005
       
      Net income (loss) $(7,413)$5,068 $(2,347)
      Other comprehensive loss:          
       Change in net unrealized loss on investments  (37)    
        
       
       
       
      Total comprehensive income (loss) $(7,450)$5,068 $(2,347)
        
       
       
       

              Accumulated other comprehensive loss reflected on the consolidated balance sheet at December 29, 2007 represents accumulated net unrealized losses on investments in the diluted net income per share computation for the period then ended.marketable securites.


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 3—SUPPLEMENTAL FINANCIAL INFORMATION (Continued)

        Computation of Net Income (Loss) Per Share

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

       

       

      Year Ended

       

       

       

      January 1,
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

      Basic income (loss) per share:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Net income (loss)

       

       

      $  (974

      )

       

       

      $ (2,347

      )

       

       

      $ 5,068

       

       

      Weighted-average common shares outstanding, basic

       

       

      10,671

       

       

       

      10,673

       

       

       

      11,705

       

       

      Basic income (loss) per share

       

       

      $ (0.09

      )

       

       

      $ (0.22

      )

       

       

      $   0.43

       

       

      Diluted income (loss) per share:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Net income (loss)

       

       

      $  (974

      )

       

       

      $ (2,347

      )

       

       

      $ 5,068

       

       

      Convertible notes interest expense (net of tax)

       

       

       

       

       

       

       

       

      74

       

       

      Adjusted net income (loss) available to common stockholders

       

       

      $  (974

      )

       

       

      $ (2,347

      )

       

       

      $ 5,142

       

       

      Weighted-average common shares outstanding, basic

       

       

      10,671

       

       

       

      10,673

       

       

       

      11,705

       

       

      Effect of dilutive securities:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Stock options and warrants

       

       

       

       

       

       

       

       

      1,722

       

       

      Convertible preferred stock

       

       

       

       

       

       

       

       

      929

       

       

      Convertible notes payable

       

       

       

       

       

       

       

       

      975

       

       

      Weighted-average common shares outstanding, diluted

       

       

      10,671

       

       

       

      10,673

       

       

       

      15,331

       

       

      Diluted net income (loss) per share

       

       

      $ (0.09

      )

       

       

      $ (0.22

      )

       

       

      $   0.34

       

       

       
       Year Ended
       
       
       December 29, 2007
       December 30, 2006
       December 31, 2005
       
      Basic net income (loss) per share:          
       Numerator: Net income (loss) $(7,413)$5,068 $(2,347)
        
       
       
       
       Denominator: Weighted-average common shares outstanding, basic  19,674  11,705  10,673 
        
       
       
       
       Basic net income (loss) per share $(0.38)$0.43 $(0.22)
        
       
       
       
      Diltued net income (loss) per share:          
       Net income (loss) $(7,413)$5,068 $(2,347)
       Convertible notes interest expense (net of tax)    74   
        
       
       
       
       Numerator: Adjusted net income (loss) available to common stockholders $(7,413)$5,142 $(2,347)
       Weighted-average common shares outstanding, basic  19,674  11,705  10,673 
       Effect of dilutive securities:          
        Stock options and warrants    1,722   
        Convertible preferred stock    929   
        Convertible notes payable    975   
        
       
       
       
       Denominator: Weighted-average common shares outstanding, diluted  19,674  15,331  10,673 
        
       
       
       
       Diluted net income (loss) per share $(0.38)$0.34 $(0.22)
        
       
       
       

              All potentially dilutive common share equivalents of approximately 1.5 million and 3.6 million shares have been excluded from the diluted net loss per share calculations for the years ended December 29, 2007 and December 31, 2005 as their effect would be anti-dilutive for the years then ended.

      New Accounting Pronouncements


      In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty inNETLIST, INC. AND SUBSIDIARIES

      F-15




      income taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation requires that the Company recognize in the financial statements the impact of tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006 with the cumulative effect of the change in accounting principle recorded as an adjustment to beginning retained earnings. The Company is currently in the process of assessing the impact the adoption of FIN 48 will have on its consolidated financial statements.

      In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. Specifically, SFAS No. 157 sets forth a definition of fair value, and establishes a hierarchy prioritizing the inputs to valuation techniques, giving the highest priority to quoted prices in active markets for identical assets and liabilities and the lowest priority to unobservable inputs. The provisions of SFAS No. 157 are generally required to be applied on a prospective basis, except to certain financial instruments accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, for which the provisions of SFAS No. 157 should be applied retrospectively. The Company will adopt SFAS No. 157 in the first quarter of 2008 and is still evaluating the effect, if any, on its financial position or results of operations.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      In September 2006, the SEC staff issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB No. 108 was issued in order to eliminate the diversity in practice surrounding how public companies quantify financial statement misstatements. SAB No. 108 requires that registrants quantify errors using both a balance sheet and income statement approach and evaluate whether either approach results in a misstated amount that, when all relevant quantitative and qualitative factors are considered, is material. The adoption of this statement is not expected to have a material impact on the Company’s consolidated financial condition or results of operations.December 29, 2007

      NOTE 3—4—INVESTMENTS IN MARKETABLE SECURITIES

      Investments in marketable securities consist of the following at December 29, 2007 and December 30, 2006 (in thousands):

       
       December 29, 2007
       
       Amortized
      Cost

       Net
      Unrealized
      Gain (Loss)

       Fair
      Value

      Cash and money markets $6,148 $ $6,148
      Commercial paper  1,734    1,734
      Corporate notes and bonds  11,892  (9) 11,883
      Federal agency notes and bonds  4,382  13  4,395
      Auction and variable floating rate notes  6,163  (41) 6,122
        
       
       
        $30,319 $(37)$30,282
        
       
       
      Classified as:         
      Cash equivalents       $6,895
      Marketable securities        23,387
              
              $30,282
              

      U.S. corporate bonds

      $ 6,275

      U.S. treasury/agency debt securities

      494

      $ 6,769

       
       December 30, 2006
       
       Amortized
      Cost

       Net
      Unrealized
      Gain (Loss)

       Fair
      Value

      Cash and money markets $29,952 $ $29,952
      Corporate notes and bonds  6,275    6,275
      Federal agency notes and bonds  494    494
        
       
       
        $36,721 $ $36,721
        
       
       
      Classified as:         
      Cash equivalents       $29,952
      Marketable securities        6,769
              
              $36,721
              

              Realized gains and losses on the sale of investments in marketable securities are determined using the specific identification method. Net realized gains recorded during the year ended December 29, 2007 were not significant.


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 4—INVESTMENTS IN MARKETABLE SECURITIES (Continued)

      The contractual maturitiesfollowing table provides the breakdown of debtinvestments in marketable securities with unrealized losses at December 29, 2007 (in thousands):

       
       Continuous Unrealized Loss
       
       Less than 12 months
       12 months or greater
       
       Fair
      Value

       Unrealized
      Loss

       Fair
      Value

       Unrealized
      Loss

      Corporate notes and bonds $6,830 $(12)$ $
      Federal agency notes and bonds  998  (3)   
      Auction and variable floating rate notes  1,965  (41)   
        
       
       
       
        $9,793 $(56)$ $
        
       
       
       

              As of December 29, 2007, the Company held 11 investments that were in an unrealized loss position.

              Due to disruptions of, and the resulting reduced liquidity in certain financial markets in 2007, two of the Company's AAA rated auction rate securities with a total purchased cost of approximately $2.0 million experienced failed auctions during the fourth quarter of 2007. Due to the failed auctions, the Company was unable to sell the securities at their respective costs, resulting in a decrease in fair value, which has been recorded as a component of accumulated other comprehensive loss in accordance with SFAS No. 115. These investments have been classified as long-term investments in marketable securities in the Company's consolidated balance sheet as of December 29, 2007. As of February 23, 2008, the unrealized loss on these two investments was approximately $141,000. The Company has concluded that the unrealized losses on these investments are temporary because (i) the Company believes that the decline in market value that has occurred is due to general market conditions, (ii) the auction rate securities continue to be of a high credit quality and interest is paid as due and (iii) the Company has the intent and ability to hold these investments until a recovery in market value occurs. The fair value of these securities could change significantly in the future and the Company may be required to record other-than-temporay impairment charges or additional unrealized losses in future periods.

              The unrealized losses on the Company's other investments were due primarily to changes in interest rates. The Company has determined that the unrealized losses on all of its investments in marketable securities at December 29, 2007 are temporary in nature. The Company reviews its investments to evaluate indications of possible impairment. Factors considered in determining whether impairments are other than temporary include the length of time and extent to which fair value has been less than the amortized cost basis, the financial condition and near-term prospects of the investee and the Company's intent and ability to hold an investment for a period of time sufficient to allow for any anticipated recovery in market value. 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.


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 4—INVESTMENTS IN MARKETABLE SECURITIES (Continued)

              The following table presents the amortized cost and fair value of the Company's cash equivalents and investments in marketable securities classified as held to maturityavailable-for-sale at December 30, 2006 is as follows (in thousands): $5,267 due in one year or less and $1,502 due in one year through two years. Unrealized gains and losses, net of deferred taxes, have not been significant.

      F-16




      NOTE 4—INVENTORIES

      Inventories consist of the following29, 2007 by contractual maturity (in thousands):

       

       

      December 31,
      2005

       

      December 30,
      2006

       

      Raw materials

       

       

      $ 2,551

       

       

       

      $ 10,513

       

       

      Work in process

       

       

      1,027

       

       

       

      3,343

       

       

      Finished goods

       

       

      3,238

       

       

       

      5,617

       

       

       

       

       

      $ 6,816

       

       

       

      $ 19,473

       

       

       
       Amortized
      Cost

       Fair
      Value

      Maturity      
      Less than one year $18,306 $18,305
      One to two years  5,850  5,855
      Greater than two years*  6,163  6,122
        
       
        $30,319 $30,282
        
       

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

      NOTE 5—PROPERTY AND EQUIPMENT

      Property and equipment consist of the following (dollars in thousands):

       

       

      Estimated
      Useful
      Lives

       

      December 31,
      2005

       

      December 30,
      2006

       

      Machinery and equipment

       

       

      3-7 yrs.

       

       

       

      $ 3,595

       

       

       

      $ 5,153

       

       

      Leasehold improvements

       

       

      3 yrs.

       

       

       

       

       

       

      44

       

       

      Furniture and fixtures

       

       

      5 yrs.

       

       

       

      205

       

       

       

      205

       

       

      Computer equipment and software

       

       

      3-7 yrs.

       

       

       

      1,241

       

       

       

      1,731

       

       

       

       

       

       

       

       

       

      5,041

       

       

       

      7,133

       

       

      Less accumulated depreciation and amortization

       

       

       

       

       

       

      (2,604

      )

       

       

      (3,303

      )

       

       

       

       

       

       

       

       

      $ 2,437

       

       

       

      $ 3,830

       

       

      Included in property and equipment are assets under capital leases with a cost of $2,618,000 and $2,326,000 and accumulated amortization of $896,000 and $1,176,000 at December 31, 2005 and December 30, 2006, respectively.

      NOTE 6—CREDIT AGREEMENT

      The Company has entered into an agreement (the “Credit Agreement”) with a bank which, as amended through November 2006, provides for a line of credit facility up to $25 million ($3 million of which may be in the form of letters of credit),for borrowings limited to 85% of eligible accounts receivable, plus the least of (i) a percentage of eligible inventory determined from time to time by the Company’sCompany's bank, (ii) 80% of the orderly liquidation value, as defined, of eligible inventories, and (iii) $7 million. Interest is payable monthly, at the Company’sCompany's option, either at prime rate plus 0.50% or LIBOR plus 3%. The interest rate was reduced to the prime rate or LIBOR plus 2.50% in December 2006 concurrent with the Company’sCompany's raise of capital through an initial public offering (see Note 1)offering.

              In April 2007, the Company executed the Seventh Amendment to the Amended and Restated Credit and Security Agreement (the "Seventh Amendment"). The Seventh Amendment, which was effective as of March 21, 2007, allows the Company to, at its election, increase its line of credit facility, as amended, matures on July 31, 2008.

      The Credit Agreement also provided forfrom $25 million, in $2.5 million increments, up to a $2total of $40 million term loan to be funded in two advances. The first advance of $1 million was made in August 2006, and the second advance of $1 million was made in September 2006. The term loan principal was payable in equal monthly installments of $83,350 commencing on September 1, 2006. Interest was payable monthly, at the Company’s option, either at the prime rate plus 0.50% or LIBOR plus 3%. The term loan, including all accruedof interest, which was 7.25% at December 29, 2007 and unpaid interest was repaid in8.25% at December 2006 concurrent30, 2006. In addition, the Seventh Amendment (i) extends the maturity date of the line of credit to July 31, 2009, (ii) establishes an equipment advance line of $3 million, (iii) increases the sublimit for letters of credit to $5 million, (iv) sets an inventory sublimit of $7 million, with the Company’s raise of capital through an initial public offering (see Note 1).

      The Credit Agreement alsoability to increase to $10 million if certain financial targets are met, (v) provides for equipment advances upthe reduction in interest rates on borrowings if certain borrowing amounts and financial performance targets are met and (vi) revised certain financial covenants.

              In July 2007, the Company executed the Eighth Amendment to $2 million.the Amended and Restated Credit and Security Agreement (the "Eighth Amendment"), which was effective as of June 29, 2007. Among other things, the Eighth Amendment added certain minimum profitability financial covenant requirements. As of December 29, 2007, the Company was in compliance with all financial covenants.

              Interest on the equipment advances is payable monthly, at the Company’sCompany's option, either at the prime rate plus 0.50% or LIBOR plus 3%. The interest rate was reduced to the prime rate or LIBOR plus 2.50% in December 2006 concurrent with the Company’s initial public offering.. Interest only payments were required on the

      F-17




      equipment advances through January 31, 2007. Commencing February 1, 2007, the Company is required to repay the


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 5—CREDIT AGREEMENT (Continued)


      equipment advances in 42 equal monthly installments. The outstanding balance on this loan was $1,072,000approximately $0.9 million and $1.1 million at December 29, 2007 and December 30, 2006, respectively (see Note 7) 6). The

              Any borrowings under the revolving and equipment advances, including all accrued and unpaid interest, are due on July 31, 2008.

      Any borrowingslines of credit, are collateralized by a general first priority lien against all Companyof the Company's assets, both tangible and intangible.

      Prior        The following table presents details of interest expense related to July 2006, the credit agreement provided for a revolving line of credit of $15 million and no term loan or equipment line of credit.

      Interest was payable monthly at the prime rate plus 0.50% in fiscal 2004 (5.75% at January 1, 2005) and in fiscal 2005 at the prime rate plus 4.75% for eligible foreign accounts (12.00% at December 31, 2005) and at December 30, 2006 at the prime rate (8.25%) and for all other advances at the prime rate plus 3.50% and prime rate plus 0.50% (10.75% at December 31, 2005 and 8.25% at December 30, 2006, respectively). Outstanding borrowings on this line of credit at December 31, 2005 and December 30, 2006 were $9,463,000 and $19,238,000, respectively. Borrowing availability under the line of credit, was approximately $2,400,000 and $4,872,000 at December 31, 2005 and December 30, 2006, respectively.

      The Credit Agreement, as amended, contains certain restrictions and covenants. Under these restrictions and covenants, the Company must maintain certain levels of tangible net worth, achieve minimum monthly and quarterly profitability, and limit capital expenditures. The Company was not in compliancealong with certain covenants at December 31, 2005. Effective April 18, 2006, the Company executed the Fourth Amendment to Amended and Restated Credit and Security Agreement and Waiver of Defaults (the “Fourth Amendment”). The Fourth Amendment provides for, among other things, a waiver of noncompliance as of the dates above and added an additional requirement for the Company to consummate a private equity offering not later than March 31, 2007, with minimum net proceeds of $4,000,000.applicable information (in thousands):

       
       Year Ended
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

      Interest expense $862 $1,195 $553
        
       
       
       
       December 29, 2007
       December 30, 2006
      Outstanding borrowings on the line of credit $4,872 $19,238
        
       
      Borrowing availability under the line of credit $6,366 $4,872
        
       

      Effective July 28, 2006, the Company executed the Fifth Amendment to Amended and Restated Credit and Security Agreement (the “Fifth Amendment”). The Fifth Amendment eliminated the prior covenant that required the Company to raise a minimum of $4 million in a private equity offering prior to March 31, 2007.

      Effective December 29, 2006, the Company executed the Sixth Amendment to the Amended and Restated Credit and Security Agreement (the “Sixth Amendment”). The Sixth Amendment increased the allowable capital expenditures to $2,500,000 for the six-month period ended December 30, 2006 and any fiscal year thereafter. As of December 30, 2006, the Company was in compliance with all covenants.

      NOTE 7—6—LONG-TERM DEBT

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

       

      December 31,
      2005

       

      December 30,
      2006

       

       December 29, 2007
       December 30, 2006
       

      Obligations under capital leases (see Note 10)

       

       

      $ 1,285

       

       

       

      $    802

       

       

      Term note payable to bank (see Note 6)

       

       

       

       

       

      1,072

       

       

      Obligations under capital leases $432 $802 
      Equipment note payable to bank (see Note 5) 872 1,072 

      Notes payable to others

       

       

      423

       

       

       

      389

       

       

       74 389 
       
       
       

       

       

      1,708

       

       

       

      2,263

       

       

       1,378 2,263 

      Less current portion

       

       

      (720

      )

       

       

      (1,033

      )

       

       (740) (1,033)

       

       

      $  988

       

       

       

      $ 1,230

       

       

       
       
       
       $638 $1,230 
       
       
       

        F-18




        Mortgage Note Payable

      In November 2000, the Company obtained an SBA-backed 25-year mortgage note payable collateralized by its manufacturing facility in Irvine, California. This note bore interest at the prime rate plus 1.0% (6.25% at January 1, 2005), with principal and interest payments due monthly through 2025. In December 2005, the mortgage was paid in full in connection with the sale and leaseback transaction of the manufacturing facility (see Note 10)9).

        Notes Payable to Others

      In November 2002, the Company entered into a $100,000 unsecured loan agreement with an individual, bearing interest at 7% payable annually, principal due, as amended, in June 2006. In


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 6—LONG-TERM DEBT (Continued)

      January 2004, $4,000 of the principal amount was used to exercise certain stock options. The balance of this note was $96,000 at January 1, 2005, December 31, 2005 and December 30, 2006. The note is currently due on demand. The balance of this note and accrued interest was repaid in full in January 2007.

      In January 2003, the Company entered into a $300,000 loan agreement with a financing company, collateralized by assets owned by an employee related to the majority stockholder. This note bears interest at 14% per annum and matures in January 2009. Principal and interest payments of approximately $6,000 are due and payable monthly. The balance of this note was $185,000approximately $74,000 and $133,000 at December 31, 200529, 2007 and December 30, 2006, respectively.

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

        Capital Leases

      The Company has purchased manufacturing and computer equipment through the use of various capital leases. TheseAs of December 29, 2007, these leases require aggregate monthly payments of $44,450approximately $44,000 and mature at various dates through May 2011. The interest rates on these leases vary between 4.3% and 10.4% (see Note 10)9).

      As of December 30, 2006,29, 2007, maturities of long-term debt were as follows (in thousands):

      Fiscal Year

       

       

       

       

       

        

      2007

       

      $ 1,033

       

      2008

      2008

       

      633

       

       $740

      2009

      2009

       

      373

       

       474

      2010

      2010

       

      214

       

       149

      2011

      2011

       

      10

       

       15

       

      $ 2,263

       

       
       $1,378
       

              

      Interest expense related to long-term debt was $177,000, $250,000 and $238,000 foris presented in the years ended January 1, 2005 and December 31, 2005 and December 30, 2006, respectively.following table (in thousands):

       
       Year Ended
       
       December 29, 2007
       December 30, 2006
       December 31, 2005
      Interest expense $213 $238 $250
        
       
       

      NETLIST, INC. AND SUBSIDIARIES

      F-19NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)




      December 29, 2007

      NOTE 8—7—CONVERTIBLE NOTES PAYABLE

      In April 2001, the Company issued two convertible promissory notes, each in the original principal amount of $625,000, to Serim Paper Manufacturing Co., Ltd. (“("Serim Paper”Paper") and HeungHwa Industries Co., Ltd. (“HeungHwa”("HeungHwa"), bearing interest at 7.50% per annum (collectively, the “$"$625,000 Notes”Notes"). In February 2003, the Company issued an additional $500,000 convertible note to Serim Paper, bearing interest at 6.50% per annum (the “$"$500,000 Note”Note"). The $625,000 Notes and the $500,000 Note were guaranteed by the Company’sCompany's majority stockholder and were originally convertible, at the option of the holder, into shares of a new series of preferred stock at a price equal to the lower of $2.50 per share or the per share fair market value of the new preferred stock. In the event of a public offering of the Company’sCompany's common stock at a price in excess of the conversion price, the notes would automatically convert into shares of the Company’sCompany's common stock at the conversion price.

      In October 2002 and April 2004, the Company exchanged the $625,000 Notes (or the applicable successor notes) for new notes with the same terms and new maturity dates. In August 2004, the Company exchanged the $500,000 Note for a new note with the same terms and a new maturity date. Effective October 2005, the Company exchanged the then outstanding $625,000 Notes for new notes which provided for a conversion price of $1.667 per share (estimated fair value of the preferred stock at the effective date of exchange) with new maturity dates of April 3, 2007. Effective February 2006, the Company exchanged the then outstanding $500,000 Note for a new note which provided for a conversion price of $1.667 per share (estimated fair value of the preferred stock at the effective date of exchange) with a new maturity date of August 12, 2007. In December 2006, concurrent with the Company’sCompany's raise of capital through an initial public offeringIPO these notes (totaling $1,750,000)$1.75 million) automatically converted to approximately 1,050,000 million shares of common stock.

      In December 2005, the Company issued $1,000,000$1.0 million in secured convertible promissory notes (the “2005 Notes”"2005 Notes"), bearing interest at 9.96% per annum. The 2005 Notes were secured (subordinated to the Credit Agreement) by substantially all the Company’sCompany's assets. The 2005 Notes were convertible, at the option of the holder, at any time after the earlier of (i) the maturity date or (ii) the consummation of a private placement offering of common stock of the Company with gross aggregate proceeds to the Company of at least $1,000,000.$1.0 million. The 2005 Notes were convertible into shares of the Company’sCompany's common stock at either the offering price in a private placement offering of the Company’sCompany's common stock, or if no offering, at the fair value of a share of common stock as determined by the Company’sCompany's Board of Directors. In the event of a merger transaction with a public company concurrent with a private placement offering with gross aggregate proceeds of at least $5,000,000,$5.0 million, the outstanding principal and accrued but unpaid interest would automatically be converted into shares of the Company’sCompany's common stock at a rate of 67.5% of the price per share at which such shares were sold in the private placement offering. In accordance with EITF No. 00-27, since the terms of the contingent conversion option dodid not permit the Company to compute the additional number of shares that it would need to issue upon conversion of the notes if the contingent event occured and the conversion price was adjusted, the Company determined the value of the beneficial conversion feature as of the commitment date and would record the beneficial conversion amount as additional interest expense only if the contingent event occured. The estimated value of the beneficial conversion feature at the commitment date was approximately $500,000.

      The 2005 Notes had an original maturity date of February 28, 2006. In March 2006, the note holders agreed to extend the maturity date to May 31, 2006. In June 2006, a note holder of $50,000 in


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 7—CONVERTIBLE NOTES PAYABLE (Continued)


      principal agreed to extend the maturity date of its convertible note until August 31, 2006 and fix the conversion price of the note at $2.55 per share. In connection with the amendment of the $50,000 convertible note in June 2006, the Company recorded a BCF of $50,000 as a result of fixing the conversion price at a per share amount that was below the estimated fair value of the Company’sCompany's common stock at the date of amendment. The BCF was recorded as a discount from the face amount of the convertible note and was amortized using the effective interest method through maturity of such instrument. In August 2006, the

      F-20




      note holder converted the principal balance of $50,000 and accrued interest of $3,000 into 20,863 shares of the Company’sCompany's common stock. As a result, the Company recorded interest expense of $50,000 during the year ended December 30, 2006 related to the amortization of the debt discount.

      On August 4, 2006, the Company repaid the remaining $950,000 of outstanding principal on the 2005 Notes, including accrued and unpaid interest of $59,010. As a result of the repayment, the Company willwas not be required to record any further beneficial conversion charge.

      NOTE 9—8—INCOME TAXES

              For financial reporting purposes, income (loss) before provision (benefit) for income taxes includes the following components (in thousands):

       
       Year Ended
       
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       
      United States $(10,816)$7,912 $(3,259)
      Foreign  (622)    
        
       
       
       
        $(11,438)$7,912 $(3,259)
        
       
       
       

      The Company’sCompany's income tax provision (benefit) consists of the following (in thousands):

       

       

      Year Ended

       

       

       

      January 1,
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

      Current:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Federal

       

       

      $ (499

      )

       

       

      $ (232

      )

       

       

      $ 2,772

       

       

      State

       

       

      (59

      )

       

       

      2

       

       

       

      41

       

       

      Total current

       

       

      (558

      )

       

       

      (230

      )

       

       

      2,813

       

       

      Deferred:

       

       

       

       

       

       

       

       

       

       

       

       

       

      Federal

       

       

      225

       

       

       

      (319

      )

       

       

      (273

      )

       

      State

       

       

      (7

      )

       

       

      (363

      )

       

       

      304

       

       

      Total deferred

       

       

      218

       

       

       

      (682

      )

       

       

      31

       

       

      Income tax provision (benefit)

       

       

      $ (340

      )

       

       

      $ (912

      )

       

       

      $ 2,844

       

       

       
       Year Ended
       
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       
      Current:          
       Federal $(1,127)$2,772 $(232)
       State  1  41  2 
        
       
       
       
        Total current  (1,126) 2,813  (230)
        
       
       
       
      Deferred:          
       Federal  (2,171) (273) (319)
       State  (728) 304  (363)
        
       
       
       
        Total deferred  (2,899) 31  (682)
        
       
       
       
      Income tax provision (benefit) $(4,025)$2,844 $(912)
        
       
       
       

              

      Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities are classified as current or noncurrent according tofor financial reporting purposes and the classification of the related asset or liability.amounts used for income tax


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 8—INCOME TAXES (Continued)


      purposes. Significant components of the Company’sCompany's deferred tax assets and liabilities are as follows at December 31, 2005 and December 30, 2006 (in thousands):

       

       

      December 31,
      2005

       

      December 30,
      2006

       

      Deferred tax assets:

       

       

       

       

       

       

       

       

       

      Reserves and allowances

       

       

      $ 1,046

       

       

       

      $  914

       

       

      Other accruals

       

       

      73

       

       

       

      357

       

       

      Compensatory stock options and rights

       

       

      503

       

       

       

      546

       

       

      Tax credit carryforwards

       

       

      249

       

       

       

      193

       

       

      Deferred gain

       

       

      241

       

       

       

      194

       

       

      NOL carryforward

       

       

      289

       

       

       

       

       

      Total deferred tax assets

       

       

      2,401

       

       

       

      2,204

       

       

      Deferred tax liabilities:

       

       

       

       

       

       

       

       

       

      State taxes, net of federal income tax benefit

       

       

      (278

      )

       

       

      (176

      )

       

      Depreciation and amortization

       

       

      (304

      )

       

       

      (254

      )

       

      Prepaid expenses

       

       

      (158

      )

       

       

      (144

      )

       

      Total deferred tax liabilities

       

       

      (740

      )

       

       

      (574

      )

       

       

       

       

      $ 1,661

       

       

       

      $ 1,630

       

       

       
       December 29,
      2007

       December 30,
      2006

       
      Deferred tax assets:       
       Reserves and allowances $3,384 $914 
       Others accruals  347  357 
       Compensatory stock options and rights  905  546 
       Tax credit carryforwards  241  193 
       Deferred gain  144  194 
       Contribution carryforwards  2   
       NOL carryforward  125   
        
       
       
        Total deferred tax assets  5,148  2,204 
        
       
       
      Deferred tax liabilities:       
       State taxes, net of federal income tax benefit  (422) (176)
       Depreciation and amortization  (167) (254)
       Prepaid expenses  (30) (144)
        
       
       
        Total deferred tax liabilities  (619) (574)
        
       
       
        $4,529 $1,630 
        
       
       

      F-21




      The Company generated federal net operating losses (“NOL”) of approximately $1,669,000 and $1,071,000 for the years ended December 31, 2005 and January 1, 2005, respectively. The federal NOL generated for December 31, 2005 and for January 1, 2005 were carried back, to December 27, 2003, and fully utilized. In addition, the Company carried back approximately $125,000 of federal credits generated for the year ended January 1, 2005 to the year ended December 27, 2003. At December 30, 2006, the Company’s state credit carryforward is approximately $193,000.        A reconciliation of income taxes computed by applying the statutory U.S. income tax rate to the Company’sCompany's income before income taxes to the income tax provision (benefit) is as follows:

       

      Year Ended

       

       Year Ended
       

       

      January 1,
      2005

       

      December 31,
      2005

       

      December 30,
      2006

       

       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       

      U.S. federal statutory tax

       

       

      (35

      )%

       

       

      (35

      )%

       

       

      35

      %

       

       (35)%35%(35)%

      State taxes, net of federal effect

       

       

      (4

      )

       

       

      (7

      )

       

       

      3

       

       

       (4)3 (7)

      Research and development credits

       

       

      (10

      )

       

       

       

       

       

      (2

      )

       

        (2) 

      Benefit of lower tax rate

       

       

      1

       

       

       

      1

       

       

       

      (1

      )

       

       1 (1)1 

      Stock-based compensation

       

       

      7

       

       

       

       

       

       

      1

       

       

       1 1  

      Loss from foreign subsidiary

       

       

      14

       

       

       

      11

       

       

       

       

       

       2  11 

      Domestic production

       

       

       

       

       

       

       

       

      (1

      )

       

        (1) 

      Other

       

       

      1

       

       

       

      3

       

       

       

      1

       

       

        1 3 

      Income tax provision (benefit)

       

       

      (26

      )%

       

       

      (27

      )%

       

       

      36

      %

       

       
       
       
       
      Effective income tax provision (benefit) rate (35)%36%(27)%
       
       
       
       

              The Company generated a federal net operating loss ("NOL") of approximately $3.4 million for the year ended December 29, 2007 which will be carried back to the fiscal year ended December 30, 2006. The NOL of approximately $1.7 million generated for the year ended December 31, 2005 was carried back to December 27, 2003 and fully utilized. In addition, federal credits of approximately $43,000 will be carried back to the year ended December 30, 2006. At December 29, 2007, the


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 10—8—INCOME TAXES (Continued)


      Company has approximately $1.6 million of state NOLs which begin to expire in fiscal year 2017, and approximately $0.2 million of state credits which carry forward indefinitely.

              The Company will begin to operate under tax holidays in the PRC, which are effective from January 2008 through December 2012.

              In accordance with SFAS No. 123(R), the deferred tax assets at December 29, 2007 do not include approximately $14,000 of excess tax benefits from employee stock option exercises that are a component of the state net operating loss carryover. The Company's stockholders' equity balance will be increased if and when such excess tax benefits are ultimately realized.

              The Company adopted FIN 48 on December 31, 2006, the first day of fiscal 2007. As a result of the adoption of FIN 48, the Company recorded an increase in the net liability for unrecognized tax positions of approximately $0.2 million, which was recorded as an adjustment to the beginning balance of accumulated deficit as of December 31, 2006. The following table summarizes the activity related to the Company's unrecognized tax benefits (in thousands):

      Balance at December 31, 2006 $515
      Accrual of potential interest related to unrecognized tax benefits  45
        
      Balance at December 29, 2007 $560
        

              Included in the unrecognized tax benefits at December 29, 2007 was approximately $0.6 million of tax positions that, if recognized, would affect the Company's annual effective tax rate.

              The Company's continuing practice is to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. This policy did not change as a result of the adoption of FIN 48. The Company had approximately $75,000 accrued for interest and $0 accrued for penalties at December 29, 2007. The Company does not expect its unrecognized tax benefits to change significantly over the next 12 months.

              The Company files tax returns with federal, state and foreign jurisdictions. The Company is no longer subject to IRS or state examinations prior to fiscal 2003, although certain carryforward attributes that were generated prior to fiscal 2003 may still be adjusted by the IRS.

      NOTE 9—COMMITMENTS AND CONTINGENCIES

        Leases

      The Company leases certain of its facilities and equipment under non-cancelable operating leases that expire at various dates through November 2010.October 2012. Rental expense foris presented in the years ended January 1, 2005, following table (in thousands):

       
       Year Ended
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

      Rental expense $953 $409 $343
        
       
       

      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 31, 2005 and December 30, 2006 totaled $207,000, $343,000, and $409,000, respectively.29, 2007

      NOTE 9—COMMITMENTS AND CONTINGENCIES (Continued)

              The Company also has acquired certain equipment through the use of various capital leases for certain equipment.leases.

      In December 2005, the Company sold the building containing its manufacturing facility and the related land in Irvine, California to an unrelated third party for gross proceeds of $1,900,000.approximately $1.9 million. Concurrent with the sale, the Company entered into an agreement to lease the property back at an initial monthly rent of $10,000, subject to annual rent increases of 3% through lease expiration in November 2010. The Company is accounting for the lease as an operating lease. In connection with the sale, the Company recognized a gain of $580,000approximately $0.6 million which was deferred and is being amortized into income ratably over the remaining lease term. During each of the yearyears ended December 29, 2007 and December 30, 2006, the Company amortized approximately $118,000 of the gain which is recorded as a reduction of rent expense in the accompanying statementconsolidated statements of operations. Additionally, in January 2008 the Company entered into an agreement to sublease this facility to another tenant as a result of its facility relocation, as discussed further in Note 12. The Company expects to receive total future minimum rental income from this sublease of approximately $0.3 million.

      A summary of future minimum payments under both capital and operating lease commitments as of December 30, 200629, 2007 is as follows (in thousands):

      Fiscal Year

       

       

       

      Capital
      Leases

       

      Operating 
      Leases

       

       Capital
      Leases

       Operating
      Leases

      2007

       

       

      $

      507

       

       

       

      $

      173

       

       

      2008

      2008

       

       

      282

       

       

       

      128

       

       

       $312 $743

      2009

      2009

       

       

      70

       

       

       

      132

       

       

       94 769

      2010

      2010

       

       

      39

       

       

       

      124

       

       

       63 741

      2011

      2011

       

       

      10

       

       

       

       

       

       14 439
      2012  20
       
       

      Total minimum lease payments

      Total minimum lease payments

       

       

      908

       

       

       

      $

      557

       

       

       483 $2,712
         

      Less amount representing interest

      Less amount representing interest

       

       

      (106

      )

       

       

       

       

       

       (51)  

      Present value of future minimum lease payments (see Note 7)

       

       

      $

      802

       

       

       

       

       

       

       
        
      Present value of future minimum lease payments (see Note 6) $432  
       
        

        Other Commitments

              

      F-22




      Litigation

      The Company is subject to litigation in the ordinary course of business. The Company is not currently party to any pending litigation matters.

      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 negligence or willful misconduct of the Company; (iii) indemnities involving the accuracy of representations and warranties in certain contracts; (iv) indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware; and (v) certain real estate leases, under which the Company may be required to indemnify property owners for environmental and other liabilities, and other claims arising from the Company’s use of the applicable premises. The duration of these indemnities, commitments and guarantees varies and, in certain cases, may be indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential for future payments the Company could be obligated to make. Historically, the Company has not been obligated to make significant payments for these obligations, and no liabilities have been recorded for these indemnities, commitments and guarantees in the accompanying consolidated balance sheets.

      In February 2006, the Company’sCompany's former Vice President of Finance (the “Former Officer”"Former Officer") submitted his resignation. In order to secure the services of the Former Officer through an orderly transition of his responsibilities and in exchange for standard mutual releases of obligations, the Company entered into a severance agreement with the Former Officer. The agreement called for the continuation of the Former Officer’sOfficer's salary through December 31, 2006. The Company also reimbursed the Former Officer for the cost of maintaining his prior medical insurance benefits through the earlier of December 31, 2006 or the date on which he obtains medical coverage through a new employer. The total cost of the salary continuation and medical benefits to be provided under the agreement was approximately $149,000. Under terms of the agreement, the Former Officer was obligated to provide a specified minimum number of hours of service to the Company each month through the end of 2006. During the year ended December 30, 2006, the Company paid approximately $143,000 to the Former Officer in connection with the severance agreement.


      In November 2006,NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 9—COMMITMENTS AND CONTINGENCIES (Continued)

        Federal Securities Class Action

              Beginning in May 2007, the Company, signed a Lettercertain of Intent (“LOI”)its officers and directors, and the Company's underwriters were named as defendants in four purported class action shareholder complaints, two of which were filed in the U.S. District Court for the rentalSouthern District of a facilityNew York, and two of which were filed in the U.S. District Court for the Company’s operationCentral District of California. These purported class action lawsuits were filed on behalf of persons and entities who purchased or otherwise acquired the Company's common stock pursuant or traceable to the Company's November 30, 2006 Initial Public Offering (the "IPO"). The lawsuits have been consolidated into a single action—Belodoff v. Netlist, Inc., Lead Case No. SACV07-677 DOC (MLGx)—which is pending in the People’s RepublicCentral District of China.California. Lead Plaintiff filed the Consolidated Complaint on November 5, 2007. Generally, the complaint alleged that the Registration Statement issued by the Company in connection with the IPO contained untrue statements of material fact or omissions of material fact in violation of Sections 11 and 15 of Securities Act of 1933. Defendants filed their motions to dismiss the complaint on January 9, 2008. The Company paid a deposit of $12,000. This agreement expires Februaryhearing on defendants' motions to dismiss is set for April 28, 2007 at which2008. At this time, the Company is unable to form a professional judgment that an unfavorable outcome is either probable or remote. Moreover, if an unfavorable outcome should eventually occur, the Company is not at this time able to estimate the amount or range of possible loss.

        California Derivative Action

              In August 2007, a derivative lawsuit was filed in California Superior Court for County of Orange—Smith v. Hong, Case No. 07CC01359—against certain of the Company's officers and directors. This action contains factual allegations similar to those of the federal class action lawsuit described above, but the plaintiff in this case asserts claims for violations of California's insider trading laws, breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment. The plaintiff seeks unspecified damages, equitable and/or injunctive relief and disgorgement of all profits, benefits and other compensation obtained by the defendants. The defendants to this action have not responded to the complaint. Pursuant to a stipulation, the parties agreed to temporarily stay the action pending a decision on the defendants' motions to dismiss in the federal securities class action. The parties also agreed that twenty days after the court in the federal securities class action issues a final ruling as to the motions to dismiss brought in that action, the parties will signmeet and confer regarding the time for defendants to respond to the complaint in this derivative action. At this time, the Company is unable to form a leaseprofessional judgment that an unfavorable outcome is either probable or remote. Moreover, if an unfavorable outcome should eventually occur, the offer will expire.Company is not at this time able to estimate the amount or range of possible loss. In addition, the Company has received correspondence from counsel for a purported shareholder requesting that the Company take actions to investigate and remedy alleged wrongdoing by unidentified former and current officers and/or directors based on allegations similar to those in theSmith v. Hong case. The Company is evaluating its response to this request.

        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.


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 11—9—COMMITMENTS AND CONTINGENCIES (Continued)

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

      NOTE 10—RELATED PARTY TRANSACTIONS

      In February 2003, the Company loaned an employee $19,900 to exercise a portion of his then-vested common stock options. This full recourse note bearsbore interest at a rate of 7% payable annually, and iswas due on February 17, 2008. As of December 31, 2005 the amount of outstanding principal and accrued and unpaid interest on this note was approximately $24,000, and has beenwas recorded as a reduction of stockholders’stockholders' equity in the consolidated balance sheets.sheet. In December 2006, the employee repaid a portionapproximately $23,000 of the note, the amount outstanding atand thus as of December 30, 2006, the remaining amount outstanding was approximately $1,000.$1,000, which was recorded as a reduction of stockholders' equity in the consolidated balance sheet. In May 2007, the remaining $1,000 was repaid in full.

      Interest income related to these loans amounted to approximately $1,000, $1,000, and $1,000 during the years ended January 1, 2005,December 30, 2006 and December 31, 2005, andrespectively. Interest income for the year ended December 30, 2006, respectively.29, 2007 was not significant.

      F-NOTE 11—IMPAIRMENT OF LONG-LIVED ASSETS

              During fiscal 2006, the Company acquired certain laser soldering equipment (the "Equipment") primarily intended for use in connection with a new product technology to be developed for a customer. In the first quarter of 2007, management determined that certain alternative equipment and related design processes were a more appropriate complement to the development of this technology. As a result, the Company determined the extent to which it expected to utilize the Equipment in the future had decreased from its original estimates, and thus the Company concluded that the carrying value of the Equipment of approximately $0.3 million was no longer recoverable and was in fact impaired. In accordance with SFAS No. 144,23Accounting for the Impairment or Disposal of Long-Lived Assets, during the first quarter of 2007, the Company estimated the current fair value of the Equipment primarily using market prices for comparable machinery and equipment. As a result of its analysis, the Company recorded an impairment charge of approximately $0.1 million to write down the carrying value of the Equipment to its estimated fair value during the first quarter of 2007. Subsequently, during the second quarter of 2007, management determined that, due primarily to the highly customized nature of the Equipment, the likelihood of alternative uses or disposal through a sale were significantly


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 11—IMPAIRMENT OF LONG-LIVED ASSETS (Continued)




      remote, and therefore recorded an additional charge of approximately $0.2 million to write-off the remaining carrying value of the Equipment. These charges are included as a component of research and development expense in the accompanying consolidated statement of operations for the year ended December 29, 2007.

              Additionally, during the fourth quarter of 2007, the Company recorded a charge of approximately $0.2 million to write-down the carrying value of certain other long-lived assets for which the current carrying value was determined to be impaired. This charge is included as a component of selling, general and administrative expense in the accompanying consolidated statement of operations for the year ended December 29, 2007.

      NOTE 12—STOCKHOLDERS’ EQUITYFACILITY RELOCATION COSTS

      Issuance        As a result of Common Stockthe relocation of its domestic headquarters and manufacturing facility during the third quarter of 2007, the Company vacated its previous manufacturing facility. The Company is currently obligated under a noncancellable operating lease of this facility through November 2010, and therefore recorded a net one-time charge and related liability of approximately $134,000 in fiscal 2007, which approximates the estimated fair value of the net remaining lease payments in accordance with SFAS No. 146,Accounting for OptionCosts Associated with Exit or Disposal Activities. This charge is included as a component of selling, general and Warrant Exercises

      In 2003, options to purchase 100,000 shares of common stock were exercised for cashadministrative expense in the amountaccompanying consolidated statement of $100operations for the year ended December 29, 2007. The related liability is included as a component of accrued expenses and a full recourse note receivableother current liabilities in the amount of $19,900, bearing interest at 7% per annum, with interest payable annually and principal due in 2008 (see Note 11). In December 2006, principal and accrued interest of $23,000 on this note was repaid. The amount outstandingaccompanying consolidated balance sheet at December 30, 2006 was approximately $1,000.29, 2007.

      In January 2004, options        The following table summarizes the activity and liability balance related to purchase 20,000 shares of common stock were exercised by forgiving $4,000 of a $100,000 note due others (see Note 6) in lieu of cash paymentthe facility relocation costs recorded for the exercise price. In addition, 1,667 common stock options were exercised for $333 in cash.year ended December 29, 2007 (in thousands):

      Beginning balance, December 30, 2006 $ 
      Charged to costs and expenses  134 
      Payments  (31)
        
       
      Ending balance, December 29, 2007 $103 
        
       

      NETLIST, INC. AND SUBSIDIARIES

      In May 2005, options to purchase 1,667 shares of common stock were exercised for $3,251 cash.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      In March and April 2006, certain warrant holders exercised warrants to purchase 550,000 shares of common stock for $110,000 cash.December 29, 2007

      NOTE 13—STOCKHOLDERS' EQUITY

        Series A Convertible Preferred Stock (“("Series A”A")

      The Series A Convertible Preferred Stock automatically converted to 1,000,000 shares of Common stock upon completion of the Company’sCompany's IPO on December 5, 2006. Prior to that date the Series A stockholders were entitled to noncumulative dividends at the rate of $0.16 per share per annum, when, as and if declared by the Board of Directors, prior and in preference to the payment of any dividends on common stock. Shares of Series A were convertible, at the option of the holder, into shares of common stock, on a 1:1 basis. The conversion could occur at any time after issuance and was automatically adjusted for stock splits such that the value of the converted shares remains unchanged. Conversion was automatic immediately prior to the closing of a public offering of the Company’sCompany's common stock, or at the election of the holders of a majority of the shares of Series A preferred stock. Holders of Series A were entitled to a liquidation preference, as defined, of $2.00 per share, plus any declared and unpaid dividends, prior to any distribution of assets to holders of common stock. Holders of Series A carried voting rights on an as-converted basis.

        Common Stock

      In October 2006, in connection with the Company’sCompany's IPO, the Board of Directors authorized an increase in the number of common shares from 16,000,000 to 90,000,000, effective as of and contingent upon the closing of the IPO. The closing of the IPO occurred in November 2006.

        Serial Preferred Stock

      At the completion of the Company’s IPO the Company authorized 10,000,000 shares of Serial Preferred Stock, with a par value of $0.001 per share. No shares were outstanding at December 29, 2007 or December 30, 2006.

      NOTE 13—14—STOCK OPTIONS AND WARRANTS

        Common Stock Options

      In November 2000, the Company adopted the 2000 Equity Incentive Plan (the “2000 Plan”"2000 Plan") and in October 2006, the Company adopted the 2006 Equity Incentive Plan (the “2006 Plan”"2006 Plan"), under which direct stock awards or options to acquire shares of the Company’sCompany's common stock may be granted to employees and nonemployees of the Company. The 2000 Plan iswas administered by the Board of Directors or a committee thereof, and the 2006 Plan is administered by the Compensation Committee of the Board of Directors. The 2000 Plan permitted the issuance of up to 5,750,000 shares of the Company’sCompany's common

      F-24




      stock. Effective as of the IPO, no further grants may be made under the 2000 Plan. The 2006 Plan permits the issuance of a maximum of 500,000 shares of common stock, automatically increasing on the first day of each calendar year beginning on or after January 1, 2007 by the lesser of (i) 500,000 shares andor (ii) such smaller number of shares as may be determined by our Board of Directors prior to that date. Options granted under the 2000 Plan and 2006 Plan primarily vest overat a rate of at least 20%25% per year over fivefour years and expire 10 years from the date of grant. As


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 14—STOCK OPTIONS AND WARRANTS (Continued)

              A summary of common stock option activity under the 2000 Plan and 2006 Plan during the period from January 1, 2005 to December 30, 2006,29, 2007 is presented below:

       
       Number of
      Shares

       Weighted-
      Average
      Exercise
      Price

       Weighted-
      Average
      Remaining
      Contractual
      Life

       Aggregate
      Intrinsic
      Value

       
       (in thousands)

        
       (in years)

       (in thousands)

      Options outstanding—January 1, 2005 1,539 $0.61     
      Options granted 866  2.55     
      Options exercised (2) 1.95     
      Options cancelled (213) 1.98     
        
              
      Options outstanding—December 31, 2005 2,190  1.25     
      Options granted 1,478  6.16     
      Options exercised        
      Options cancelled (350) 2.18     
        
              
      Options outstanding—December 30, 2006 3,318  3.34     
      Options granted 1,163  3.15     
      Options exercised (191) 1.62     
      Options cancelled (544) 5.44     
        
              
      Options outstanding—December 29, 2007 3,746  3.06 7.4 $2,343
        
       
       
       
      Options exercisable—December 29, 2007 1,641 $1.58 5.4 $2,078
        
       
       
       
      Options expected to vest—December 29, 2007 1,895 $4.69 8.9 $239
        
       
       
       
      Options available for grant under the 2006 Plan at December 29, 2007 125        
        
              

              The following table summarizes information about stock options outstanding and exercisable at December 29, 2007:

       
       Options Outstanding
       Options Exercisable
      Range of Exercise Prices

       Number of
      shares

       Weighted
      Average
      Remaining
      Contractual
      Life

       Weighted
      Average
      Exercise
      Price

       Number of
      shares

       Weighted
      Average
      Exercise
      Price

       
       (in thousands)

       (in years)

        
       (in thousands)

        
      $0.20 - $  0.30 1,011 4.1 $0.02 1,011 $0.02
      $1.25 - $  1.88 406 9.1 $1.61 52 $1.25
      $1.93 - $  2.90 1,029 8.2 $2.35 383 $2.51
      $3.00 - $  4.50 265 9.5 $3.32  $
      $6.94 - $10.41 1,035 8.7 $7.07 195 $7.00
        
            
         
        3,746 7.4 $3.06 1,641 $1.58
        
            
         

      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 14—STOCK OPTIONS AND WARRANTS (Continued)

              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, along with certain other pertinent information:

       
       Year Ended
       
       
       December 29,
      2007

       December 30,
      2006

       
      Expected term (in years)  5.4  6 
      Expected volatility  80% 43%
      Risk-free interest rate  4.43% 4.91%
      Expected dividends     
        
       
       
      Weighted-average grant date fair value per share $2.18 $2.98 
        
       
       
      Intrinsic value of options exercised (in thousands) $813 $ 
        
       
       
      Fair value of options vested (in thousands) $1,181 $592 
        
       
       

              The intrinsic value of common stock options excerised during the year ended December 29, 2007 represents the difference between the fair market value of the Company's common stock on the date of exercise and the exercise price of each option.

              Upon the exercise of common stock options, the Company issues new shares from its authorized shares.

              At December 29, 2007, the amount of unearned stock-based compensation currently estimated to be expensed from fiscal 2008 through 2011 related to unvested common stock options is approximately $3.4 million, net of estimated forfeitures. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is approximately 2.8 years. If there are any modifications or cancellations of the underlying unvested common stock options, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that the Company grants additional common stock options or other equity awards.

              In January 2008, the Company granted 120,000 and 100,000 common stock options to purchase 985,000its chief executive officer and chief financial officer, respectively. The per share exercise price of these option grants are equal to the fair maket value of the Company's common shares were available for future grant under the 2006 Plan.stock on their respective dates of grant. Both option grants vest over a period of 4 years.

        Warrants

      From time to time, the Company issues warrants to purchase shares of the Company's common stock to non-employees for services rendered or to be rendered in the future. Such warrants are issued


      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 14—STOCK OPTIONS AND WARRANTS (Continued)

      outside of the 2000 Plan and 2006 Plan. AsA summary of the warrant activity during the period from January 1, 2005 to December 30, 2006, there were29, 2007 is presented below:

       
       Number of
      Shares

       Weighted-
      Average
      Exercise
      Price

       Weighted-
      Average
      Remaining
      Contractual
      Life

       Aggregate
      Intrinsic
      Value

       
       (in thousands)

        
       (in years)

       (in thousands)

      Warrants outstanding—January 1, 2005 910 $0.53     
      Warrants granted        
      Warrants exercised        
      Warrants cancelled        
        
              
      Warrants outstanding—December 31, 2005 910  0.53     
      Warrants granted 38  4.33     
      Warrants exercised (550) 0.20     
      Warrants cancelled        
        
              
      Warrants outstanding—December 30, 2006 398  1.35     
      Warrants granted        
      Warrants exercised (23) 1.25     
      Warrants cancelled (57) 3.84     
        
       
           
      Warrants outstanding—December 29, 2007 318 $1.01 0.4 $377
        
       
       
       
      Warrants exercisable—December 29, 2007 318        
        
              

              In July 2007, a warrant holder exercised 42,000 warrants to purchase 397,500shares of the Company's common stock, whereby the Company issued approximately 23,000 shares of common stock pursuant to a net issue election and effectively received approximately 19,000 shares back from the warrant holder as consideration in lieu of which 360,000 are fully vestedcash for the exercised warrants. The 19,000 shares were forfeited on the exercise date.

              In August 2007 and exercisable. The remainingNovember 2007, approximately 27,000 and 11,000 outstanding unexercised warrants, respectively, held by a consulting firm were deemed cancelled pursuant to the terms of their governing agreements as a result of the termination of a resource agreement between the Company and the firm in connection with the resignation of the Company's former chief financial officer.

              In February 2008, certain warrant holders exercised 300,000 warrants to purchase 37,500shares of the Company's common stock, whereby the Company issued approximately 97,000 shares of common stock vest overpursuant to a four year period.net issue election and effectively received approximately 203,000 shares back from the warrant holders as consideration in lieu of cash for the exercised warrants. The weighted-average203,000 shares were forfeited on the exercise pricedate.

              Upon the exercise of these outstanding warrants, was $1.35 per share at December 30, 2006.

      A summary of changes in outstanding common stock options and warrants during the period from December 28, 2003 to December 30, 2006 is presented below (shares in thousands):

       

       

      Total
      Shares

       

      Weighted-
      Average
      Exercise
      Price

       

      Outstanding—December 28, 2003

       

       

      2,750

       

       

       

      $

      0.70

       

       

      Granted

       

       

       

       

       

       

       

      Exercised

       

       

      (22

      )

       

       

      $

      0.20

       

       

      Canceled

       

       

      (279

      )

       

       

      $

      1.72

       

       

      Outstanding—January 1, 2005

       

       

      2,449

       

       

       

      $

      0.58

       

       

      Granted

       

       

      866

       

       

       

      $

      2.55

       

       

      Exercised

       

       

      (2

      )

       

       

      $

      1.95

       

       

      Canceled

       

       

      (213

      )

       

       

      $

      1.98

       

       

      Outstanding—December 31, 2005

       

       

      3,100

       

       

       

      $

      1.04

       

       

      Granted

       

       

      1,515

       

       

       

      $

      3.01

       

       

      Exercised

       

       

      (550

      )

       

       

      $

      0.20

       

       

      Canceled

       

       

      (350

      )

       

       

      $

      2.18

       

       

      Outstanding—December 30, 2006

       

       

      3,715

       

       

       

      $

      1.86

       

       

      The following table summarizes information about stock options and warrants outstanding and exercisable at December 30, 2006 (shares in thousands):

       

       

      Options/Warrants Outstanding

       

      Options/Warrants Exercisable

       

      Exercise
      Price

       

       

       

      Number of
      Shares

       

      Weighted-
      Average
      Remaining
      Life (Years)

       

      Weighted-
      Average
      Price

       

          Number    
      of Shares

       

         Weighted-   
      Average
      Price

       

      $0.20

       

       

      1,045

       

       

       

      5

       

       

       

      $

      0.20

       

       

       

      1,043

       

       

       

      $

      0.20

       

       

      $1.00

       

       

      300

       

       

       

      1

       

       

       

      $

      1.00

       

       

       

      300

       

       

       

      $

      1.00

       

       

      $1.25

       

       

      189

       

       

       

      6

       

       

       

      $

      1.25

       

       

       

      179

       

       

       

      $

      1.25

       

       

      $1.95

       

       

      33

       

       

       

      7

       

       

       

      $

      1.95

       

       

       

      28

       

       

       

      $

      1.95

       

       

      $2.55

       

       

      953

       

       

       

      9

       

       

       

      $

      2.55

       

       

       

      224

       

       

       

      $

      2.55

       

       

      $7.00

       

       

      1,180

       

       

       

      10

       

       

       

      $

      7.00

       

       

       

      10

       

       

       

      $

      7.00

       

       

      $8.00

       

       

      15

       

       

       

      10

       

       

       

      $

      8.00

       

       

       

       

       

       

      $

      8.00

       

       

       

       

       

      3,715

       

       

       

       

       

       

       

       

       

       

       

      1,784

       

       

       

       

       

       

      F-25




      During fiscal 2003, the Company issued options to purchase 696,500issues new shares of common stock to employees. Due to the difference between the exercise price and the estimated fair value of common stock, $2,931,000 of deferred compensation expense was recorded that will be amortized to expense over the vesting period. During fiscal 2004, 2005 and 2006, the Company recognized compensation expense (net of forfeitures) of $250,000, ($64,000) and $580,000, related to these grants.from its authorized shares.


      NETLIST, INC. AND SUBSIDIARIES

      During fiscal 2005, the Company issued options to purchase 831,000 shares of the Company’s common stock to employees and directors. The options were granted at exercise prices which were equal to the estimated fair value of the common stock on the date of grant. Therefore, no stock-based compensation expense was recorded in the accompanying consolidated statement of operations.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      During fiscal 2005 and 2006, the Company issued options to purchase 35,000 shares and 20,000 shares, respectively, of the Company’s common stock to non-employee consultants for services to be perfomed over a four year period. During the years ended December 31, 2005 and December 30, 2006, the Company recognized consulting expense of $3,000 and $3,000, respectively, which is included in selling, general and administrative expenses.29, 2007

      During the year ended December 30, 2006, the Company granted warrants to purchase 37,500 shares of the Company’s common stock to a consulting firm for services. The estimated fair value of the warrants at the date of issuance using the Black-Scholes pricing model was determined to be $60,400 and will be amortized to consulting expense over a four year vesting period. Consulting expense related to these warrants was $8,900 during the year ended December 30, 2006 and is included in selling, general and administrative expenses.

      The weighted-average fair value of common stock options and warrants granted during the year ended December 31, 2005 was $0.17. No common stock options or warrants were granted during fiscal 2004.

      NOTE 14—15—401(k) PLAN

      The Company sponsors a 401(k) defined contribution plan. Employees are eligible to participate in this plan provided they are employed full-time and have reached 21 years of age. Participants may make pre-tax contributions to the plan subject to a statutorily prescribed annual limit. Each participant is fully vested in his or her contributions on the contributions and investment earnings. The Company may make matching contributions on the contributions of a participant on a discretionary basis. In fiscal 2007, the Company adopted a limited matching contribution policy and made approximately $0.1 million in contributions to participants in this plan during the year ended December 29, 2007. There were no Company contributions made during the three years in the period ended December 30, 2006.2006 and December 31, 2005.

      NOTE 15—16—MAJOR CUSTOMERS AND SUPPLIERS

      The Company’sCompany'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’sCompany's total revenues as follows:

       

       

      Year Ended

       

       

       

      January 1,

       

      December 31,

       

      December 30,

       

       

       

      2005

       

      2005

       

      2006

       

      Customer:

       

       

       

       

       

       

       

       

       

       

       

       

       

         A

       

       

      71

      %

       

       

      35

      %

       

       

      38

      %

       

         B

       

       

       

       

       

      13

      %

       

       

      2

      %

       

         C

       

       

      2

      %

       

       

      20

      %

       

       

      33

      %

       

       
       Year Ended
       
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       
      Customer:       
       Dell 55%38%35%
       Lenovo   13%
       IBM  33%20%
       Hewlett Packard 23%  

              

      The Company’sCompany's accounts receivable are concentrated with two customers at December 31, 2005,29, 2007, representing 39%approximately 66% and 17%23%; and four customers at December 30, 2006, representing approximately 32%, 19%, 14% and 13% 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.

      F-26




      The Company’sCompany's purchases have historically been concentrated in a small number of suppliers. The following table sets forth purchases from suppliers comprising 10% or more of the Company’sCompany's total purchases as follows:

       

       

      Year Ended

       

       

       

      January 1,
      2005

       

      December 31, 
      2005

       

      December 30, 
      2006

       

      Supplier:

       

       

       

       

       

       

       

       

       

       

       

       

       

         A

       

       

      33

      %

       

       

      37

      %

       

       

      27

      %

       

         B

       

       

      21

      %

       

       

      19

      %

       

       

      13

      %

       

         C

       

       

      13

      %

       

       

      19

      %

       

       

      5

      %

       

         D

       

       

       

       

       

       

       

       

      18

      %

       

       
       Year Ended
       
       
       December 29,
      2007

       December 30,
      2006

       December 31,
      2005

       
      Supplier:       
       A 14%27%37%
       B  13%19%
       C   19%
       D 28%18% 
       E 11%  

      NETLIST, INC. AND SUBSIDIARIES

      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

      December 29, 2007

      NOTE 16—MAJOR CUSTOMERS AND SUPPLIERS (Continued)

              

      While the Company believes alternative suppliers could be utilized, any inability to obtain components or products in the amounts needed on a timely basis or at commercially reasonable prices could result in delays in product introductions, interruption in product shipments or increases in product costs, which could have a material adverse effect on the Company.

      NOTE 16—17—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. All

              To date, a majority of the Company’sCompany's international sales relate to shipments of products to its U.S. customers’customers' international manufacturing sites or third-party hubshubs. Net sales derived from shipments to international destinations, primarily to Asia, (including foreign subsidiaries of customers that are headquartered in the U.S.) represented approximately 79%, 46%, and are37% of the Company's net sales in 2007, 2006 and 2005, respectively. All of the Company's net sales to date have been denominated in U.S. dollars.

      As of December 31, 2005 and December 30, 2006 all29, 2007, approximately $3.6 million of the Company's net long-lived assets arewere located outside the United States in the United States.PRC.


      NOTE 17—SUBSEQUENT EVENTS

      In January 2007, options to purchase 73,000 common shares were exercised for $89,350.

      In February 2007, the Company entered into various agreements for its PRC facility amounting to approximately $2,600,000. As of February 26, 2007, the Company has paid out $293,000 toward these obligations, which include leasehold improvements and manufacturing equipment. During March 2007, the Company expects to enter into a five year lease commitment on a building in Suzhou, PRC. The monthly rent is anticipated to be approximately $12,000.

      F-27




      REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

      Board of Directors and Stockholders
      Netlist, Inc.:

      We have audited the consolidated financial statements of Netlist, Inc. and subsidiaries (the “Company”"Company") as of December 30, 200629, 2007 and December 31, 2005,30, 2006 and for each of the twothree years in the period ended December 30, 2006,29, 2007, and have issued our report thereon dated February 27, 2007.2008. Our audits also included the consolidated financial statement schedule of the Company for the years ended December 29, 2007, December 30, 2006 and December 31, 2005 listed in the accompanying index at Item 15(a)(2). This consolidated financial statement schedule is the responsibility of the Company’sCompany's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

      /s/ CORBIN & COMPANY, LLP

      Irvine, California

      February  27, 2007

      /s/ KMJCORBIN & COMPANY LLP
      Irvine, California
      February 27, 2008


      F-
      28NETLIST, INC. AND SUBSIDIARIES

      Schedule II—Consolidated Valuation and Qualifying Accounts

      (in thousands)

       
       Balance at Beginning of Year
       Charged to Costs and Expenses
       (Deductions)
       Balance at End of Year
      Year Ended December 29, 2007:            
       Allowance for doubtful accounts $62  51 $(24)$89
       Allowance for sales returns  26  1,614  (1,212) 428
        
       
       
       
        Total $88 $1,665 $(1,236)$517
        
       
       
       
      Year Ended December 30, 2006:            
       Allowance for doubtful accounts $88 $371 $(397)$62
       Allowance for sales returns  21  149  (144) 26
        
       
       
       
        Total $109 $520 $(541)$88
        
       
       
       
      Year Ended December 31, 2005:            
       Allowance for doubtful accounts $100 $ $(12)$88
       Allowance for sales returns  132  19  (130) 21
        
       
       
       
        Total $232 $19 $(142)$109
        
       
       
       




      QuickLinks

      REPORTTABLE OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMCONTENTS

      To the Board of Directors and Stockholders
      PART I

      PART II
      PART III
      PART IV
      SIGNATURES
      POWER OF ATTORNEY
      INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
      NETLIST, INC. AND SUBSIDIARIES Consolidated Balance Sheets (in thousands, except par value)
      NETLIST, INC. AND SUBSIDIARIES Consolidated Statements of the Company’s management. Our responsibility is to express an opinion based on our audit. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements described above, taken as a whole, presents fairly, in all material respects, the information set forth therein.

      /s/ DELOITTE & TOUCHE LLP

      Costa Mesa, California

      March 1, 2006

      F-29




      Netlist, Inc.Operations (in thousands, except per share amounts)


      NETLIST, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity (in thousands)
      NETLIST, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands)
      NETLIST, INC. AND SUBSIDIARIES Schedule II—Consolidated Valuation and Qualifying Accounts (in thousands)

       

       

      Balance At
      Beginning of
      Period

       

      Charged to
      Cost and 
      Expenses

       

      (Deductions)

       

      Balance at
      End of
      Period

       

      Allowance for sales returns and doubtful accounts:

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Year Ended January 1, 2005

       

       

      $

      136

       

       

       

      $

      200

       

       

       

      $

      (104

      )

       

       

      $

      232

       

       

      Year Ended December 31, 2005

       

       

      $

      232

       

       

       

      $

      19

       

       

       

      $

      (142

      )

       

       

      $

      109

       

       

      Year Ended December 30, 2006

       

       

      $

      109

       

       

       

      $

      520

       

       

       

      $

      (541

      )

       

       

      $

      88

       

       

      F-30