Isilon Systems 10-Q 2009 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the quarterly period ended September 30, 2009

OR

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

For the transition period from                    to

Commission File Number 001-33196

Isilon Systems, Inc.

(Exact name of registrant as specified in its charter)

Delaware	91-2101027
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
3101 Western Ave
Seattle, WA	98121
(Address of principal executive offices)	(Zip code)

Registrant’s telephone number, including area code:

206-315-7500

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

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

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

Large accelerated filer o Accelerated filer x Non-accelerated filero Smaller reporting company o

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

As of October 15, 2009, 64,890,958 shares of the registrant’s Common Stock were outstanding.

1

TABLE OF CONTENTS

Part I – Financial Information
Item 1. Financial Statements (Unaudited)	3
Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2009 and2008	3
Condensed Consolidated Balance Sheets as of September 30, 2009 and December 31, 2008	4
Condensed Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2009 and 2008	5
Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3. Quantitative and Qualitative Disclosures About Market Risk	25
Item 4. Controls and Procedures	25
Part II – Other Information
Item 1. Legal Proceedings	26
Item 1A. Risk Factors	27
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	40
Item 3. Defaults Upon Senior Securities	40
Item 4. Submission of Matters to a Vote of Security Holders	40
Item 5. Other Information	40
Item 6. Exhibits	41
Signatures	42
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

2

PART I – FINANCIAL INFORMATION

ITEM 1. Financial Statements

Isilon Systems, Inc.

Condensed Consolidated Statements of Operations

(unaudited)

(in thousands, except per share data)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Revenue:
Product	$	22,835		$	24,418		$	64,531		$	66,827
Services		7,669			5,914			21,849			15,811
Total revenue		30,504			30,332			86,380			82,638
Cost of revenue:
Product		9,631			9,176			29,691			26,740
Services (1)		3,510			3,810			11,972			9,623
Total cost of revenue		13,141			12,986			41,663			36,363
Gross profit		17,363			17,346			44,717			46,275
Operating expenses:
Research and development  (1)		5,902			6,318			18,148			17,788
Sales and marketing  (1)		10,843			11,341			32,443			35,546
General and administrative (1)		3,563			4,843			11,181			15,303
Restructuring charges		—			—			357			—
Legal settlement		2,000			—			2,000			—
Total operating expenses		22,308			22,502			64,129			68,637
Loss from operations		(4,945	)		(5,156	)		(19,412	)		(22,362	)
Interest income and other		164			398			702			1,860
Loss before income tax expense		(4,781	)		(4,758	)		(18,710	)		(20,502	)
Income tax expense		(86	)		(70	)		(304	)		(243	)
Net loss	$	(4,867	)	$	(4,828	)	$	(19,014	)	$	(20,745	)
Net loss per share, basic and diluted	$	(0.08	)	$	(0.08	)	$	(0.30	)	$	(0.33	)
Shares used in computing basic and diluted net loss per common share		64,550			63,615			64,184			63,171
(1) Includes stock-based compensation as follows:
Cost of revenue	$	60		$	46		$	202		$	124
Research and development		402			376			1,256			788
Sales and marketing		418			470			1,339			1,655
General and administrative		545			681			1,536			1,799

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

Isilon Systems, Inc.

Condensed Consolidated Balance Sheets

(unaudited)

(in thousands, except per share data)

	As of
	September 30, 2009			December 31, 2008
ASSETS
Current assets:
Cash and cash equivalents	$	30,266		$	34,342
Marketable securities		46,751			43,441
Trade receivables, net of allowances of $348 and $250, respectively		17,949			14,436
Inventories		5,966			12,433
Other current assets		4,523			4,243
Total current assets		105,455			108,895
Property and equipment, net		7,528			11,295
Total assets	$	112,983		$	120,190
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	8,395		$	9,779
Accrued liabilities		5,966			4,188
Accrued compensation and related benefits		6,374			5,879
Deferred revenue		22,013			18,209
Total current liabilities		42,748			38,055
Deferred revenue, net of current portion		10,543			8,954
Deferred rent, net of current portion		2,840			3,158
Total liabilities		56,131			50,167
Commitments and contingencies
Stockholders' equity:
Common stock, par value $0.00001: 250,000 authorized; 64,876 and 63,885 shares issued and outstanding		1			1
Additional paid-in capital		203,583			197,685
Accumulated other comprehensive income (loss)		(50	)		5
Accumulated deficit		(146,682	)		(127,668	)
Total stockholders' equity		56,852			70,023
Total liabilities and stockholders' equity	$	112,983		$	120,190

The accompanying notes are an integral part of these condensed consolidated financial statements.

4

Isilon Systems, Inc.

Condensed Consolidated Statements of Cash Flows

(unaudited)

(in thousands)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Cash flows from operating activities
Net loss	$	(4,867	)	$	(4,828	)	$	(19,014	)	$	(20,745	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		1,445			1,599			4,629			4,690
Amortization (accretion) of discount (premium) on marketable securities		187			(19	)		327			(141	)
Stock-based compensation expense		1,425			1,573			4,333			4,366
Changes in operating assets and liabilities:
Accounts receivable, net		(2,361	)		3,705			(3,519	)		4,993
Inventories, net		62			967			6,467			(1,197	)
Other current assets		(37	)		1,129			(6	)		(144	)
Accounts payable		1,164			(976	)		(840	)		(1,694	)
Accrued liabilities, compensation payable and deferred rent		1,404			(284	)		1,877			(530	)
Deferred revenue		2,457			423			5,394			5,503
Net cash provided by (used in) operating activities		879			3,289			(352	)		(4,899	)
Cash flows from investing activities
Purchases of property and equipment		(212	)		(1,605	)		(1,483	)		(4,594	)
Purchases of marketable securities		(9,110	)		(7,597	)		(35,092	)		(31,665	)
Proceeds from maturities of marketable securities		6,850			8,807			31,175			48,677
Net cash provided by (used in) investing activities		(2,472	)		(395	)		(5,400	)		12,418
Cash flows from financing activities
Proceeds from issuance of common stock		1,139			91			1,566			453
Repurchases of unvested common stock		—			—			—			(13	)
Net cash provided by financing activities		1,139			91			1,566			440
Effect of exchange rate changes on cash and cash equivalents		9			(44	)		110			(47	)
Net increase (decrease) in cash and cash equivalents		(445	)		2,941			(4,076	)		7,912
Cash and cash equivalents at beginning of period		30,711			43,970			34,342			38,999
Cash and cash equivalents at end of period	$	30,266		$	46,911		$	30,266		$	46,911

The accompanying notes are an integral part of these condensed consolidated financial statements.

5

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Organization and Significant Accounting Policies

Organization

Isilon Systems, Inc. (the “Company” or “Isilon”) was incorporated in the State of Delaware on January 24, 2001 and designs, develops and markets scale-out network-attached storage (NAS) systems for storing and managing file-based data. We began selling our products and services in January 2003. We sell systems that generally include a software license, hardware, post-contract customer support and, in some cases, additional elements.

Significant Accounting Policies

Accounting Principles

The consolidated financial statements and accompanying notes were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2008 filed with the Securities and Exchange Commission (“SEC”) on February 20, 2009. Certain information and disclosures normally included in financial statements prepared in conformity with GAAP have been condensed or omitted pursuant to the rules and regulations of the SEC.

These financial statements reflect all adjustments, which in the opinion of management, are necessary for a fair statement of the financial position, results of operations and cash flows for the periods presented. Operating results for the three and nine months ended September 30, 2009, are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2009.

We have performed an evaluation of subsequent events through October 23, 2009, which is the date the financial statements were issued.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates are inherent in the preparation of the consolidated financial statements and include accounting for revenue, the allowance for doubtful accounts, obsolete and excess inventory, the valuation allowance for deferred tax assets, and the calculation of stock-based compensation expense. Some of these estimates require difficult, subjective or complex judgments about matters that are uncertain. Actual results could differ from those estimates.

Concentration of Risks

Our cash and cash equivalents are invested with financial institutions in deposits that may exceed federally insured limits. We have not experienced any losses on our deposits of cash and cash equivalents.

We do not require collateral to support credit sales. Allowances are maintained for potential credit losses. During the three and nine months ended September 30, 2009 and 2008, no single customer represented more than 10% of total revenue.  As of September 30, 2009 and December 31, 2008, no one customer represented more than 10% of total net accounts receivable.

We are dependent on two contract manufacturers for our products, and certain key components in our products come from single or limited sources of supply.

6

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

Revenue Recognition

We derive revenue from sales of our products and services. Product revenue consists of revenue from sales of systems and software. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.

Our software is integrated with industry standard hardware and is essential to the functionality of the integrated system product. We provide unspecified software updates and enhancements related to our products through service contracts.  We recognize product revenue when we have entered into an arrangement with a customer, delivery has occurred based on freight terms, the fee is deemed fixed or determinable and free of contingencies and significant uncertainties, and collection is reasonably assured.

On sales to channel partners, we evaluate whether fees are fixed and determinable by considering a number of factors, including our ability to estimate returns, the geography in which a sales transaction originates, payment terms and our relationship and past history with the particular channel partner. Our policy requires that we obtain and review specific evidence indicating that fees are fixed and determinable. Such evidence may include reports from channel partners documenting the sale of the products and services to an end-user customer, copies of end-user purchase orders, data indicating an order has shipped to an end-user customer, cash payments or letters of credit guaranteeing cash payments or other similar information.

At the time of shipment, we record revenue reserves for estimated sales returns and stock rotation arrangements.  Sales returns and stock rotation reserves are estimated based on historical activity and expectations of future experience.  We monitor and analyze actual experience and adjust these reserves on a quarterly basis.

From time to time, we enter into arrangements with customers that include acceptance criteria or other contingencies. In such instances, we defer all revenue on the arrangement until customer acceptance is obtained or the acceptance clause or contingency lapses.

Substantially all of our products are sold in combination with services, which primarily consist of hardware and software support. Software support provides customers with rights to unspecified software updates and to maintenance releases and patches released during the term of the support period. Hardware support includes Internet access to technical content through Isilon Insight, our knowledge database, repair or replacement of hardware in the event of breakage or failure, and telephone and Internet access to technical support personnel during the term of the support period. Installation services, when provided, are also included in services revenue.

Sales generally consist solely of hardware and software products and support services. We have established vendor specific objective evidence, or VSOE, for the fair value of our support services as measured by the renewal prices paid by our customers when the services are sold separately on a standalone basis. Sales may also include installation services. We have established VSOE of fair value for our installation services based on the price separately charged to our customers for the same or similar services. We use the residual method to determine the amount of product revenue to be recognized. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the sales amount is recognized as product revenue. This product revenue is recognized upon delivery, based on freight terms, assuming all other criteria for recognition discussed above have been met. The fair value of support services is recognized as services revenue on the straight-line method over the term of the related support period, which is typically one to three years. The fair value of installation services is recognized upon completion of the installation.

7

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

Accounting for Stock-Based Compensation

We use the straight-line method of allocating the fair value of stock-based compensation expense over the requisite service period of the related award.  For options granted in the three and nine months ended September 30, 2009, we calculated  an expected term of approximately four years. We estimated our expected volatility based on reported market value data for a group of publicly traded companies, which were selected from certain market indices that we believe are relatively comparable after consideration of their size, industry, stage of lifecycle, profitability, growth, and risk and return on investment. We estimated expected forfeitures and recognize only the compensation cost for those stock options expected to vest.

During the three and nine months ended September 30, 2009 and 2008, we recorded non-cash stock-based compensation expense of $1.4 million and $4.3 million, and $1.6 million and $4.4 million, respectively. As of September 30, 2009, our total unrecognized compensation cost related to stock-based awards granted since January 2, 2006 was $13.5 million, which will be recognized over the weighted-average remaining requisite service period of approximately 2.8 years. We recorded no tax benefit related to these options during the three and nine months ended September 30, 2009 since we currently maintain a full valuation allowance on our net deferred tax assets. In future periods, stock-based compensation expense is expected to increase as we record expense related to previously issued stock-based compensation awards and issue additional equity-based awards to continue to attract and retain key employees.

Recent Accounting Pronouncements

In April 2009, the Financial Accounting Standards Board (FASB) issued guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset/liability has significantly decreased and on identifying circumstances that indicate a transaction is not orderly. In addition, the guidance requires disclosure in interim and annual periods of the inputs and valuation techniques used to measure fair value and a discussion of changes in valuation techniques. The adoption of the guidance did not have a material impact on our consolidated financial statements.

In May 2009, the FASB issued guidance establishing general standards for accounting and disclosure of events that occur after the balance sheet date but before financial statements are available to be issued. More specifically, the guidance sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition in the financial statements, identifies the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that should be made about events or transactions that occur after the balance sheet date. The adoption of the guidance did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued guidance to establish a single source of authoritative nongovernmental Generally Accepted Accounting Principles (“GAAP”) in the United States. The guidance is effective for interim and annual periods ending after September 15, 2009, or as of July 1, 2009 for the Company.  Adoption of the guidance did not have an impact on our consolidated financial statements.

In September 2009, FASB’s Emerging Issues Task Force (“EITF”) issued authoritative guidance addressing certain revenue arrangements with multiple deliverables. This guidance states that tangible products with hardware and software components that work together to deliver the product functionality are considered non-software products, and the accounting guidance under the revenue arrangements with multiple deliverables is to be followed. This guidance is effective for the Company’s interim reporting period ending on September 30, 2010. The Company is currently evaluating the impact of the implementation of this guidance on its financial position, results of operations and cash flows.

8

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

2. Restructuring Charges

In April 2009, we initiated a restructuring plan to reduce our operating expenses in response to the uncertainties associated with the recent deterioration in the global economy. The restructuring plan consisted entirely of a reduction in workforce. As a result, during second quarter of 2009, we recorded a restructuring charge of $357,000.  This charge consisted of employee severance, benefits, and related costs and was recorded as a separate component of operating expenses within our condensed consolidated statement of operations for the nine month period ended September 30, 2009.  Of the total restructuring charges recorded, substantially all amounts were paid out during the quarter ended June 30, 2009.

3. Legal Settlement

In September 2009, we entered into a memorandum of understanding with the other parties to settle and resolve a shareholder class action lawsuit that was initially filed in November 2007 against Isilon and certain current and former officers and directors. The settlement provides for a payment to the plaintiff class of $15.0 million, of which Isilon will contribute $2.0 million and the balance of which will be paid by our insurers. The $2.0 million for which the Company is responsible was included in our results of operations for the three and nine months ended September 30, 2009. The class action settlement is subject to preliminary and, following notice to class members, final approval by the United States District Court for the Western District of Washington.

4. Net Loss Per Common Share

Basic net loss per share is calculated by dividing net loss by the weighted-average shares of common stock outstanding during the period that are not subject to vesting provisions. The following table presents the potentially dilutive securities outstanding that were excluded from the computation of diluted net loss per common share for the periods presented because their inclusion would have had an anti-dilutive effect:

	As of September 30,
	2009	2008
Options to purchase common stock	9,561,390	9,644,109
Common stock subject to vesting provisions	35,290	106,643
Common stock purchasable under Employee Stock Purchase Plan	32,916	33,225
Warrants to purchase common stock	—	129,992
	9,629,596	9,913,969

5. Comprehensive Loss

Comprehensive loss is as follows:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009				2008		2009			2008
	(in thousands)						(in thousands)
Net loss	$	(4,867	)	$	(4,828	)	$	(19,014	)	$	(20,745	)
Unrealized loss on marketable securities		(77	)		(97	)		(281	)		(183	)
Foreign currency translation adjustment		210			(87	)		226			(121	)
Total comprehensive loss	$	(4,734	)	$	(5,012	)	$	(19,069	)	$	(21,049	)

9

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

6. Marketable Securities

The appropriate classification of marketable securities is determined at the time of acquisition and reevaluated as of each balance sheet date.  At their date of acquisition, our marketable securities were classified as available-for-sale, which were reported at fair value with the related unrealized gains and losses included as a separate component in stockholders’ equity. Realized gains and losses and the credit component of declines in value of securities judged to be other than temporary are included in the results of operations. Realized and unrealized gains and losses are based on the specific identification method. Our investments in marketable securities are diversified among high-credit quality securities in accordance with our investment policy.

Marketable securities totaled $46.8 million as of September 30, 2009 and consisted of investments in U.S. government securities, commercial paper and corporate bonds and notes. Other than those judged to be temporary, there were no realized gains, losses or declines in value on the sale of marketable securities for the three and nine months ended September 30, 2009 and 2008.

The fair value of our marketable securities fluctuates based on changes in market conditions and interest rates; however, given the short-term maturities, we believe these instruments are not subject to significant market or interest rate risk.  Investments in fixed rate, interest-earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to rising interest rates. In a declining interest rate environment, as short term investments mature, reinvestment occurs at less favorable market rates. Given the short term nature of our investments, declining interest rates could negatively impact our investment income.

Marketable securities consisted of the following:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(In thousands)
As of September 30, 2009
Commercial paper	$	2,498	$	—	$	—	$	2,498
Government agencies		44,153		104		(4)		44,253
	$	46,651	$	104	$	(4)	$	46,751
As of December 31, 2008
Commercial paper	$	497	$	—	$	—	$	497
Corporate bonds and notes		2,403		—		(3)		2,400
Government agencies		40,160		385		(1)		40,544
	$	43,060	$	385	$	(4)	$	43,441

Fair Value Measurements

Fair value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the authoritative guidance establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require us to develop our own assumptions. This hierarchy requires companies to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, we measure certain financial assets and liabilities at fair value, including our marketable securities.

10

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

Our cash equivalents and marketable securities instruments are classified within Level 1and Level 2 of the fair value hierarchy because they are valued using quoted market prices or broker-dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued based on quoted market prices in active markets include most U.S. government and agency securities, and money market securities. Such instruments are generally classified within Level 1 of the fair value hierarchy. The types of instruments valued based on other observable inputs include investment-grade corporate bonds, mortgage-backed and asset-backed products, commercial paper, and state, municipal and provincial obligations. Such instruments are generally classified within Level 2 of the fair value hierarchy.

As of September 30, 2009, the fair value hierarchy of our cash equivalents and marketable securities (in thousands) is as follows:

	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs
	(Level 1)		(Level 2)
Cash Equivalents:
Money market fund	$	20,866	$	—
Corporate debt securities		—		502
	$	20,866	$	502
Marketable securities:
U.S. government agencies	$	—	$	44,253
Commercial paper		—		2,498
	$	—	$	46,751

7. Inventories

We outsource the manufacturing of our products to contract manufacturers that assemble each product to our specifications. As protection against component shortages and to provide replacement parts for our service teams, we stock limited supplies of certain key product components. At September 30, 2009 and December 31, 2008, component inventory, included in service inventory and finished goods, totaled $1.5 million and $952,000, respectively.  Our service inventory is also comprised of finished goods to support our field services organization. We reduce inventory to its estimated net realizable value by reserving for excess and obsolete inventories determined primarily based on historical usage, forecasted demand and evaluation unit conversion rate and age. In addition to our normal reserving practices in the first nine months of 2009, inventories decreased by $3.8 million due to a non-cash inventory write down. This write down was the result of softening economic conditions as well as lower forecasted demand for some of our existing products due to the anticipated migration to a new suite of products announced in March 2009.

Inventories consist of the following:

	As of
	September 30, 2009		December 31, 2008
	(in thousands)
Service inventory	$	3,064	$	4,702
Finished goods		1,278		3,306
Evaluation units		1,624		4,425
	$	5,966	$	12,433

11

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

8. Stockholders’ Equity

Stock Option Exchange

On April 24, 2009, we commenced a tender offer pursuant to which non-officer and director holders of certain options with exercise prices greater than $5.15 per share could tender their options in exchange for a reduced number of new options to be granted under the 2006 Equity Incentive Plan based upon the following ratios:

Per Share Exercise Price of Eligible Options	New Options for Exchanged Options
$5.16 – $6.12	1 for 1.25
$6.13 – $12.20	1 for 1.50
$12.21 and higher	1 for 2.0

The new options granted in connection with the Tender Offer are subject to the following terms and vesting schedules:

Year of Grant of Eligible Option	New Term (from New Grant Date)	Vesting Schedule for New Option (from New Grant Date)
2006	6 year term	1 year vesting schedule
2007	7 year term	2 year vesting schedule
2008	8 year term	3 year vesting schedule

We completed the tender offer on May 22, 2009. As a result, we accepted for exchange options totaling 1,673,294. Subject to the terms and conditions of the tender offer, we granted a total of 1,122,407 options in exchange for the options surrendered. The fair value of the new options granted was measured as the total of the unrecognized compensation cost of the original options tendered and the incremental compensation cost of the new options granted. The incremental compensation cost of the new options granted was measured as the excess of the fair value of the new options granted over the fair value of the old options immediately before cancellation. The incremental cost of the 1,122,407 options granted was $10,000.

For new option awards with vesting schedules shorter than the requisite service period of the options tendered, the total fair value of the awards will be amortized over the modified requisite service period. For new option awards with vesting schedules longer than the requisite service period of the options tendered, the total remaining unrecognized compensation expense related to the original option awards will be amortized over the remaining requisite service period of the original awards while the incremental cost of the new options granted will be amortized over the modified requisite service period.

12

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

Stock Options

Detail related to stock option activity is as follows:

	Number of Shares Outstanding			Weighted-Average Exercise Price
Balance as of December 31, 2008		10,056,218		$	5.76
Options granted (1)		3,739,864		$	2.86
Options exercised		(623,150	)	$	1.07
Options cancelled/forfeited (1)		(3,611,542	)	$	8.18
Balance as of September 30, 2009		9,561,390		$	4.02

 ___________

(1) The number of options granted and cancelled/forfeited includes options granted and cancelled/forfeited in connection with the tender offer discussed above.

The total intrinsic value for options exercised during the nine months ended September 30, 2009 and 2008, was $2.1 million and $4.0 million, respectively, representing the difference between the estimated market value of our common stock underlying these options at the dates of exercise and the exercise prices paid.

The fair value of each stock option on the date of grant was estimated using the Black-Scholes option pricing model and the following assumptions were used for the valuations of options granted to employees during the three and nine months ended September 30, 2009 and 2008:

	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2009	2008	2009	2008
Risk-free interest rate	1.2% - 2.0%	2.2% - 3.1%	1.0% - 2.3%	1.9% - 3.5%
Expected term	2.5-4 years	4 years	2.5-4 years	4 years
Dividend yield	None	None	None	None
Volatility	52% - 54%	47% - 49%	51% - 56%	44% - 49%

The estimated weighted-average grant date fair value of options granted during the nine months ended September 30, 2009 and 2008 was $2.01 and $1.89, respectively.

We adopted an Employee Stock Purchase Plan (the “2006 ESPP”) in the fourth quarter of 2006. Under the 2006 ESPP, employees may purchase shares of common stock through payroll deductions at a price per share that is 85% of the fair market value of our common stock on the applicable purchase date, with purchases generally every six months. A total of 1,682,701 shares of our common stock have been reserved for sale under the 2006 ESPP. The total liability for the 2006 ESPP, for the purchase period commencing in August 2009, including the related 15% discount, is $201,000 as of September 30, 2009 and is included in accrued compensation and related benefits in the our condensed consolidated balance sheet.

Warrants

In September 2009, all outstanding common stock warrants were exercised.  The warrant holder elected to complete a net exercise of the warrants whereby no cash was received by the Company and the warrant holder received 77,800 shares of common stock.

13

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

8. Income Taxes

As of September 30, 2009, we had total net operating loss carryforwards for federal and state income tax purposes of $134 million. The benefits of net operating losses and other deferred tax assets are dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, our net deferred tax assets have been fully offset by a valuation allowance. If not utilized, these net operating loss carryforwards will expire for federal purposes between 2021 and 2029. Utilization of these net operating loss carryforwards is subject to an annual limitation due to provisions of the Internal Revenue Code of 1986, as amended. Events that cause limitations in the amount of net operating losses that we may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three-year period.

For the three and nine months ended, September 30, 2009 and 2008, we recorded income tax expense of $86,000 and $304,000, and $70,000 and $243,000, respectively, comprised primarily of foreign taxes. The actual expense recorded for each of these respective periods differs from the federal tax benefit at 34% primarily due to current tax expense in foreign jurisdictions and the valuation allowance applied to the deferred tax benefit of U.S. losses.

9. Segment Information

Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance. We are organized as, and operate in, one reportable segment: the development and sale of network-attached storage (NAS) systems. Our chief operating decision-maker is our chief executive officer. Our chief executive officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region, for purposes of evaluating financial performance and allocating resources. We, and our chief executive officer, evaluate performance based primarily on revenue in the geographic locations in which we operate. Revenue is attributed by geographic region based on the location of the end customer. Our assets are primarily located in the United States of America and not allocated to any specific region; therefore, geographic information is presented only for total revenue.

The following presents total revenue by geographic region:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2009		2008		2009		2008
	(in thousands)				(in thousands)
United States of America	$	23,359	$	20,283	$	64,786	$	57,023
Asia		4,081		7,021		13,577		15,807
Europe, Middle East, and Africa		3,064		3,028		8,017		9,808
Total	$	30,504	$	30,332	$	86,380	$	82,638

14

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

10. Commitments and Contingencies

Purchase Obligations

We typically maintain with our contract manufacturers, a rolling 90-day firm order for products they manufacture for us.  These orders may only be rescheduled, modified, or cancelled by our contract manufacturers under certain circumstances. The remaining amount on the open purchase order with our contract manufacturers and other partners and suppliers at September 30, 2009 was approximately $1.9 million.

Legal Proceedings

On November 1, 2007, a putative class action complaint was filed in the U.S. District Court for the Western District of Washington against Isilon and certain of its current and former directors and officers. The complaint asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder, as well as under Sections 11, 12 and 15 of the Securities Act of 1933.  Substantially similar complaints were filed later in the same court and all of these cases were subsequently consolidated.  On April 18, 2008, lead plaintiffs filed a consolidated amended complaint against Isilon, certain of our current and former directors and officers, underwriters, and venture capital firms.  The consolidated complaint purports to be brought on behalf of a class of persons who purchased or otherwise acquired our stock during the period December 16, 2006 to October 3, 2007.  Plaintiffs allege that defendants violated the federal securities laws by issuing a false and misleading registration statement and prospectus in connection with our December 16, 2006 initial public offering and by thereafter misrepresenting our current and prospective business and financial results, thereby causing our stock price to be artificially inflated during the purported class period.  Plaintiffs seek unspecified compensatory damages, interest, attorneys’ fees and costs, and injunctive relief.

On September 30, 2008, Isilon and the other defendants moved to dismiss the consolidated amended complaint.  Oral argument on the defendants’ motions was heard on December 16, 2008, and a decision was issued on December 29, 2008 granting in part and denying in part the motions.  All claims against defendants Sequoia Capital (and related entities), Atlas Venture (and related entities) and Madrona Venture Group LLC were dismissed.  The Section 12 claims were dismissed as against defendants Isilon, our former CEO Steven Goldman, and our former CFO Stuart Fuhlendorf, as were the Section 10(b) claims against Isilon directors William Ruckelshaus and Matthew McIlwain.  The Court denied the remainder of the defendants’ motions.  All remaining defendants filed answers to the complaint on January 30, 2009.

On September 21, 2009, we entered into a memorandum of understanding with the other parties to settle and resolve the class action.  The settlement provides for a payment to the plaintiff class of $15.0 million, of which Isilon will contribute $2.0 million and the balance will be paid by our insurers.  The class action settlement is subject to preliminary and, following notice to class members, final approval by the United States District Court for the Western District of Washington.

On March 18 and 24, 2008, shareholder derivative actions were filed in the Superior Court of the State of Washington (King County), allegedly on behalf of and for the benefit of Isilon, against certain of our current and former directors and officers.  Isilon was named as a nominal defendant.  On April 17, 2008, the court consolidated these actions and appointed lead counsel.  The derivative complaints arise out of many of the factual allegations at issue in the securities class action, and generally allege that the individual defendants breached fiduciary duties owed to Isilon by publicly misrepresenting our business prospects and by failing to properly account for certain revenues recognized in our fiscal year ended December 31, 2006, and first and second quarters in fiscal 2007.  The complaints seek unspecified damages and equitable relief, disgorgement of compensation, attorneys’ fees, costs, and expenses.  Because the complaints are derivative in nature, they do not seek monetary damages from Isilon.  However, we may be required to advance the legal fees and costs incurred by the individual defendants.

On August 27, 2008, at the request of the parties, the court stayed the consolidated derivative action pending resolution of the motions to dismiss in the securities class action. As noted above, the motions in the securities case were resolved on December 29, 2008.  On February 6, 2009, the derivative plaintiff filed an amended complaint.  The parties thereafter stipulated, and the court ordered, that the stay in the derivative case be lifted, and that defendants’ motion(s) to dismiss the amended consolidated derivative complaint be filed by November 11, 2009.

We are unable to predict the final outcome of these cases. If the court does not approve the settlement of the class action and the matter proceeds to trial and ultimately results in a court determination against us, it could have a material adverse effect on our consolidated financial position, results of operations or cash flows. Our potential indemnity obligations to current and former officers and directors in the class action, the derivative action and in the SEC’s lawsuit against our former CFO could also result in significant liability (at least as to the advancement of fees and costs) and could have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

15

Isilon Systems, Inc

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

(unaudited)

We have cooperated on a voluntary basis with an SEC investigation concerning our prior financial restatement.  The SEC issued a formal order of nonpublic investigation and subpoenas to certain of our former officers.  The SEC’s investigation is a nonpublic, fact-finding inquiry to determine if there have been violations of the federal securities laws. On September 14, 2009, the SEC announced it had authorized the final settlement with Isilon of its investigation of our restatement. Without admitting or denying the allegations in the SEC’s complaint, we consented to a permanent injunction against any future violations of certain provisions of the federal securities laws and related regulations concerning the filing of periodic reports and the maintenance of accurate books and records and adequate internal controls. No monetary penalties were assessed against Isilon as part of the settlement.  The settlement concludes the SEC’s formal investigation of Isilon in connection with our prior financial restatement.

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

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Act”) and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to them. In some cases you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential,” and similar expressions intended to identify forward-looking statements. Examples of these statements include, but are not limited to, statements regarding our competitive environment and the health of the overall storage sector and impact of U.S. and global macro-economic conditions; the anticipated growth of file-based data; the expected demand for and benefits of our storage products; our future business plans and growth strategy; pricing pressures and fluctuations; our ability to improve existing products and to develop new and future products; our ability to attract new customers; our anticipated revenue and expenses; our ability to add value-added resellers and distributors and to sell our products domestically and internationally; our ability to realize operating leverage and realize efficiencies in our sales model by leveraging partners and distributors to sell to new and existing customers; seasonality in our business; anticipated results of potential or actual litigation or regulatory proceedings; statements relating to our financial restatement and the remediation of our internal controls; our ability to manage our supply chain and improve operational efficiency; anticipated development or acquisition of intellectual property and resulting benefits; expected impacts of changes in accounting rules, including the impact on deferred tax benefits; the impact of governmental regulation; employee hiring and retention, including reductions in force and headcount; the future payment of dividends, use of cash, cash needs and ability to raise capital; and potential liability from contractual relationships. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Part II, Item 1A of this Quarterly Report on Form 10-Q and our other filings with the SEC. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. Except as required by law, we assume no obligation to update these forward-looking statements, whether as a result of new information, future events, or otherwise.

The following discussion and analysis should be read in conjunction with the unaudited financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Overview

We were founded in January 2001 specifically to create a solution that addressed the unique challenges associated with the storage and management of file-based data. From January 2001 to January 2003, we were focused on designing and developing our OneFS® operating system software used in all of our storage systems. We began commercial shipments of our first systems in January 2003, and since then we have been focused on optimizing our solution to meet our customers’ needs and establishing development, manufacturing and marketing partnerships. Today, our solution includes a suite of systems, software and services.

We sell scale-out network-attached storage (“NAS”) systems that consist of three or more storage nodes. Each node is comprised of our proprietary OneFS operating system software and industry standard hardware components integrated into a self-contained, 7-inch, 3.5-inch, and 1.75-inch high, rack-mountable chassis. Customers can scale our storage systems incrementally as their needs grow by purchasing additional nodes or clusters of nodes from us to enhance storage capacity, performance or both. Our future revenue growth will depend upon further penetration of our existing customers as well as expansion of our customer base in existing and other industries that depend upon file-based data. We consider the development of direct and indirect sales channels in domestic and international markets a key to our future revenue growth and the global acceptance of our products. We also are dependent on the development, adoption and acceptance of new software and systems to increase our overall margins and achieve profitability.

Our product revenue growth rate will depend significantly on continued growth in our target industries and our ability to continue to attract new customers in those industries. Our growth in services revenue will depend upon increasing the number of systems under service contracts. Any such increases will depend on a growing customer base and our customers renewing existing service contracts.

Key Business Metrics

We monitor a number of key metrics to help forecast growth, establish budgets, measure the effectiveness of our sales and marketing efforts, and measure operational effectiveness.

17

New Customers and Repeat Sales Orders.  Our goal is to attract a significant number of new customers and to encourage existing customers to purchase additional products, specifically our higher margin software applications, SyncIQ® , SnapshotIQ™, SmartConnect™, and SmartQuotas™. A majority of our customers buy our storage systems and later add additional nodes or software applications as the need arises under our ‘pay-as-you-grow’ model.

Channel and Indirect Distribution Leverage. We are actively growing our relationships with channel and distribution partners to further penetrate our targeted markets domestically and internationally. We track our sales orders by direct or indirect customers with the goal of increasing revenue from channel partners.

Gross Margin. Our goal is to grow our gross margin to increase the profitability of our business. Some of the key factors affecting our gross margin are average sales prices of our systems, the revenue attributable to software applications as a percentage of total revenue, the rate at which our customers adopt our higher margin products, the timing of component cost reductions through product redesign, the timing of supplier cost reductions, the ability to manage inventory levels, the ability to control costs associated with servicing our customers and overall market conditions. We consider our ability to monitor and manage these factors to be a key aspect of attaining and expanding our profitability.

Operating Cash Flow. We closely monitor operating cash flow as a measure of our business performance. Some of the key factors affecting operating cash flows are our ability to generate net income and manage working capital. Increasing inventory turns and reducing days sales outstanding in accounts receivable are both contributors to improving working capital. Our goal is to maximize cash flows while continuing to invest in our business. Our close tracking of operating cash flow allows us to better manage the cash needs of our business.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with United States generally accepted accounting principles, or GAAP. These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the dates of the consolidated financial statements, the disclosure of contingencies as of the dates of the consolidated financial statements, and the reported amounts of revenue and expenses during the periods presented. We believe the following to be our critical accounting policies because they are important to the portrayal of our financial condition and results of operations and they require critical management estimates and judgments about matters that are uncertain: revenue recognition, allowance for doubtful accounts, stock-based compensation, inventory valuation, and accounting for income taxes. See “Risk Factors” for certain matters that may affect our future financial condition or results of operations. Although we believe that our estimates and judgments are reasonable under the circumstances, actual results may differ from those estimates. These critical accounting policies are consistent with those disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Results of Operations

The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements, related notes and risk factors included elsewhere in this Quarterly Report on Form 10-Q.

The first nine months of 2009 were characterized by overall global economic uncertainty, unpredictable financial markets and the resulting impact to business conditions. These overall economic circumstances led many of our existing and potential customers to delay or reduce previously planned capital expenditures. Our results of operations, including total revenues, gross margin, net loss, and cash flows, were impacted by these global economic conditions.

Revenue. We derive our revenue from sales of our products and services. Our customers typically purchase a cluster of our storage devices comprised of three or more nodes and related support services. Each node includes our OneFS operating system software and industry standard hardware. We offer various systems to meet the customer-specific storage capacity and performance requirements. In addition, customers may purchase separate additional software applications for enhanced functionality. Pricing of our products depends, in part, on our cost of goods sold at the time we determine the overall pricing of our products and the size of the cluster and software modules purchased.  We may periodically change the list prices of our storage system products.

18

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
	(dollars in thousands)
Revenue by type:
Product	$	22,835		$	24,418		$	64,531		$	66,827
Services		7,669			5,914			21,849			15,811
Total revenue	$	30,504		$	30,332		$	86,380		$	82,638
% revenue by type:
Product		75	%		81	%		75	%		81	%
Services		25			19			25			19
Total		100	%		100	%		100	%		100	%
Revenue by geography:
Domestic	$	23,359		$	20,283		$	64,786		$	57,023
International		7,145			10,049			21,594			25,615
Total revenue	$	30,504		$	30,332		$	86,380		$	82,638
% revenue by geography:
Domestic		77	%		67	%		75	%		69	%
International		23			33			25			31
Total		100	%		100	%		100	%		100	%
Revenue by sales channel:
Direct	$	12,654		$	13,711		$	38,294		$	38,597
Indirect		17,850			16,621			48,086			44,041
Total revenue	$	30,504		$	30,332		$	86,380		$	82,638
% revenue by sales channel:
Direct		41	%		45	%		44	%		47	%
Indirect		59			55			56			53
Total		100	%		100	%		100	%		100	%

Total revenue increased 1% and 5% for the three and nine months ended September 30, 2009, from the comparable period in the prior year. This increase is primarily attributable to increased service revenues as a result of an increase in our installed customer base, offset by decreases in our product revenue due to a slowdown in capital expenditures by our customers.  The revenue growth in the three and nine month periods ended September 30, 2009 as compared to the same periods in the prior year has been driven by domestic sales resulting from improving macroeconomic conditions and business execution.  The domestic revenue growth is substantially offset by the decline in international revenues, primarily comprised of Asia and EMEA, due to lagging economic condition improvements and challenges in business execution.

Product revenue decreased 6% and 3% for the three and nine months ended September 30, 2009 compared to the same periods in the prior year. We believe typical seasonality as well as continued cautious spending by customers in response to the current economic conditions impacted our ability to acquire new customers during the three and nine months ended September 30, 2009. A majority of our customers that buy our storage systems later add to their storage cluster. For the three and nine months ended September 30, 2009, reorders from existing customers represented approximately 76% and 79%, respectively, of total revenue, compared to 86% and 80% for the comparable periods in the prior year.  Our total customer base increased 27% from September 30, 2008 to September 30, 2009. The number of new customers added during the three and nine months ended September 30, 2009 was 69 and 174, respectively.  The number of new customers represented an increase of 23% and a decrease of 3% for the three and nine months ended September 30, 2009, respectively, as compared to the number of new customers added in the comparable periods in the prior year.

19

Services revenue includes support services for both our software and our hardware products. Services revenue increased 30% and 38% for the three and nine months ended September 30, 2009 compared to the same periods in the prior year. The percentage of our total revenue derived from support services was 25% for both the three and nine months ended September 30, 2009 compared to 19% for both the three and nine months ended September 30, 2008. The increase in services revenue was a result of an increase in our customer base currently on service and maintenance contracts. As our installed customer base grows and since a majority of our customers continue to renew their service contracts, we expect services revenue to continue to grow.

The increase in indirect channel revenue was due to our focus on enhancing our relationships with our channel and distribution partners.  No channel or distribution partner accounted for more than 10% of our revenue during the three and nine months ended September 30, 2009 and 2008. We plan to continue to expand our relationships with channel and distribution partners and over time expect the percent of revenue generated through the channel to grow.

Cost of Revenue and Gross Margin. Cost of product revenue consists primarily of amounts paid to our contract manufacturers in connection with the procurement of hardware components and assembly of those components into our systems, costs of shipping and logistics, and valuation reserves taken for excess and obsolete inventory. Cost of services revenue is primarily comprised of salaries and related employee benefits, third-party costs in providing technical support, and the cost of inventory used to service hardware maintenance contracts. Our gross margin has been, and will continue to be, affected by a variety of factors, including charges related to excess and obsolete inventory maintained for use in supporting our field services organization, average sales prices of our systems, the revenue attributable to sales of software applications as a percentage of total revenue, the rate at which our customers adopt our higher margin products and software applications, the timing of component cost reductions, the timing of supplier cost reductions, and overall market conditions.

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
	(dollars in thousands)
Cost of revenue:
Product	$	9,631		$	9,176		$	29,691		$	26,740
Services		3,510			3,810			11,972			9,623
Total cost of revenue	$	13,141		$	12,986		$	41,663			36,363
Gross margin:
Product		58	%		62	%		54	%		60	%
Services		54			36			45			39
Total gross margin		57			57			52			56

Total gross margin remained flat for the three months ended September 30, 2009 compared to the comparable period of the prior year.

Gross margin for product revenue decreased 4 percentage points for the three months ended September 30, 2009 from the comparable period in the prior year.  This decrease was primarily driven by a higher proportion of lower margin product sales in the current period as compared to the same period in the prior year, partially offset by increased cost efficiencies.  This trend was primarily the result of a change in the mix between domestic and international sales.

Gross margin for services revenue increased 18 percentage points for the three months ended September 30, 2009 compared to the comparable periods of the prior year.  This increase was the result of economies of scale in the service organization as the overall customer base and resulting number of service contracts continues to grow.

For the nine months ended September 30, 2009, total gross margin decreased 4 percentage points compared to the comparable period of the prior year. This decrease was primarily due to a non-cash inventory write down of $3.8 million recorded during the first quarter of 2009. This write down was the result of softening economic conditions as well as lower forecasted demand for some of our existing products due to the anticipated migration to a new suite of products announced in March 2009.  The write down of inventory impacted both our gross margin from product revenue as well as our gross margin for services revenue.

Gross margin for product revenue decreased 6 percentage points for the nine months ended September 30, 2009 from the comparable period in the prior year.  The decrease in product revenue gross margin was primarily the result of the inventory write down previously discussed. Excluding the inventory write down, gross margin for product revenue decreased 2 percentage points during the nine months ended September 30, 2009 compared to the comparable period of the prior year.  This remaining decrease was the effect of a higher proportion of lower margin product sales in the current nine month period as compared to the same period in the prior year.  This trend was primarily the result of a change in the mix between domestic and international sales.

20

Gross margin for services revenue increased 6 percentage points for the nine months ended September 30, 2009, compared to the comparable periods of the prior year. Excluding the effect of the inventory write-down, gross margin for services revenue increased 11 percentage points for the nine months ended September 30, 2009 compared to the comparable period in the prior year. This increase was primarily driven by the increasing customer base and the economies of scale in the service organization as the overall customer base, and resulting number of service contracts, continues to grow.

As our customer base continues to grow, it will be necessary for us to continue to make significant upfront investments in our customer service and support structure to support this growth. The rate at which we add new customers as well as the added complexity of managing spares inventory located in various geographic regions will affect the amount of these upfront investments. The timing of these additional expenditures could materially affect our cost of revenue, both in absolute dollars and as a percentage of total revenue, in any particular period.

Research and Development Expenses. Research and development expenses primarily include personnel costs, prototype expenses, facilities expenses and depreciation of equipment used in research and development. Research and development expenses are recorded when incurred. We continue to devote substantial resources to the development of additional functionality for existing products and the development of new systems and software products.

	Three Months Ended											Nine Months Ended
	September 30,											September 30,
	2009			2008			$ change		% change			2009			2008			$ change		% change
	(dollars in thousands)											(dollars in thousands)
Research and development expenses	$	5,902		$	6,318		$	(416)		(7	)%	$	18,148		$	17,788		$	360		2	%
Percent of total revenue		19	%		21	%							21	%		22	%

Research and development expenses for the three months ended September 30, 2009 decreased from the same period in the prior year primarily due to a decrease in salaries and benefits. Although salaries and benefits decreased for the three months ended September 30, 2009 as compared to the same period in the prior year, salaries and benefits actually increased for the nine months ended September 30, 2009 compared to the same period of the prior year attributable to the fact that headcount continued to increase during 2008 through the initiation and implementation of our restructuring plan in the second quarter of 2009.  Research and development headcount was 122 at September 30, 2009 compared to 130 at September 30, 2008.  In addition to the increase in salaries and benefits for the nine month period ended September 30, 2009 as compared to the same period in the prior year, stock based compensation increased, offset by a decrease in professional services.  Stock-based compensation expense related to research and development increased to $1.3 million in the first nine months of 2009 from $788,000 in the first nine months of 2008.

Sales and Marketing Expenses. Sales and marketing expenses primarily include personnel costs, sales commissions, professional services fees, trade shows, marketing programs, facilities and depreciation expenses. Over the long term, we plan to invest in expanding our domestic and international sales and marketing activities and building brand awareness. Generally, sales personnel are not immediately productive and thus sales and marketing expenses do not immediately result in revenue. Hiring additional sales personnel reduces short-term operating margins until the sales personnel become fully productive. Accordingly, the timing of sales personnel hiring and the rate at which they become productive will affect our future performance.

	Three Months Ended											Nine Months Ended
	September 30,											September 30,
	2009			2008			$ change		% change			2009			2008			$ change		% change
	(dollars in thousands)											(dollars in thousands)
Sales and marketing Expenses	$	10,843		$	11,341		$	(498)		(4)	%	$	32,443		$	35,546		$	(3,103)		(9)	%
Percent of total revenue		36	%		37	%							38	%		43	%

21

Sales and marketing expenses decreased during the three and nine month periods ended September 30, 2009 as compared to the same periods in the prior year primarily as a result of our execution on cost savings programs implemented in response to the challenges presented by the current economic environment. In addition, stock-based compensation decreased during the nine months ended September 30, 2009 compared to the comparable periods of the prior year.  Stock-based compensation expense related to sales and marketing decreased to $1.3 million in the first nine months of 2009 from $1.7 million in the first nine months of 2008.  The decreases during the three months ended September 30, 2009 were partially offset by an increase in commissions when compared to the same period in the prior year.

General and Administrative Expenses. General and administrative expenses primarily include personnel costs; facilities expenses related to our executive, finance, human resources, information technology and legal organizations; bad debt expense; public company related  expenses and fees for professional services such as legal, accounting, compliance and information systems. Also included in general and administrative expenses are attorneys’ fees and costs for legal proceedings described in more detail in Part 1, Note 10 in the Notes to Condensed Consolidated Financial Statements, as well as costs associated with our Audit Committee investigation, which was completed during 2008.

	Three Months Ended											Nine Months Ended
	September 30,											September 30,
	2009			2008			$ change		% change			2009			2008			$ change		% change
	(dollars in thousands)											(dollars in thousands)
General and administrative expenses	$	3,563		$	4,843		$	(1,280)		(26)	%	$	11,181		$	15,303		$	(4,122)		(27)	%
Percent of total revenue		12	%		16	%							13	%		19	%

General and administrative expenses decreased primarily due to decreases in professional services fees, depreciation expense and stock based compensation expenses during the three and nine months ended September 30, 2009 compared to the comparable periods of the prior year. During the nine months ended September 30, 2008, general and administrative expenses included $2.8 million in professional service fees associated with our Audit Committee investigation and restatement of financial statements, which concluded in April of 2008. The decrease in depreciation expense resulted from a lower level of capital expenditures during the three and nine months ended September 30, 2009 as compared to the prior year.  Stock-based compensation expense decreased to $545,000 in the third quarter of 2009 from $681,000 in the third quarter of 2008 and to $1.5 million in the first nine months of 2009 from $1.8 million in the first nine months of 2008. The remaining expenses included in general and administrative expenses remained relatively flat for the three and nine months ended September 30, 2009 compared to the comparable period in the prior year.

Restructuring Charges.  In April 2009, we initiated a restructuring plan to reduce our operating expenses in response to the uncertainties associated with the deteriorating global economic business conditions. Under this plan, we reduced our workforce by approximately 10%. We recorded restructuring charges of $357,000. These charges consisted of employee severance, benefits, and related costs. Of the total restructuring charges recorded, substantially all amounts were paid out prior to June 30, 2009.

Legal Settlement. In September 2009, we entered into a memorandum of understanding with the other parties to settle and resolve a shareholder class action lawsuit.  The memorandum of understanding provides for a payment to the plaintiff class of $15.0 million, of which Isilon will contribute $2.0 million and the balance will be paid by insurers.  We have recorded legal settlement expenses totaling $2.0 million during third quarter of 2009.  The settlement is subject to preliminary and, following notice to class members, final approval by the United States District Court for the Western District of Washington.

Interest income and other. Interest income and other primarily includes interest income on cash, cash equivalents and marketable securities balances.

	Three Months Ended								Nine Months Ended
	September 30,								September 30,
		2009		2008			$ change		2009			2008		$ change
	(in thousands)								(in thousands)
Interest income and other		$	164	$	398	$	(234	)		$	702	$	1,860	$	(1,158	)

Interest income and other decreased by $234,000 and $1.2 million for the three and nine months ended September 30, 2009, respectively, compared to the comparable periods in the prior year due to a decrease in our interest income resulting from a decline in market interest rates on our investments.

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Liquidity and Capital Resources

As of September 30, 2009, our principal sources of liquidity consisted of cash, cash equivalents and marketable securities of $77.0 million.

The following table shows our working capital and cash and cash equivalents as of the stated dates:

	As of
	September 30, 2009			December 31, 2008
	(in thousands)
Working capital		$	62,707		$	70,840
Cash, cash equivalents and marketable securities			77,017			77,783

The following table shows our cash flows from operating activities, investing activities and financing activities for the stated periods:

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2009			2008		2009			2008
	(dollars in thousands)
Net cash provided by (used in) operating activities	$	879		$	3,289	$	(352	)	$	(4,899	)
Net cash provided by (used in) investing activities		(2,472	)		(395)		(5,400	)		12,418
Net cash provided by financing activities		1,139			91		1,566			440

Cash Flows from Operating Activities

Net cash provided by operating activities was $879,000 for the three months ended September 30, 2009 and consisted of our net loss of $4.9 million, offset by non-cash items such as depreciation and amortization expense of $1.4 million, stock-based compensation expense of $1.4 million and net changes in operating assets and liabilities of $2.7 million.  Net cash provided by operating activities during the three months ended September 30, 2008 was $3.3 million and was comprised of our net loss of $4.8 million offset by non-cash items such as $1.6 million of depreciation and amortization expense, $1.6 million of stock-based compensation expense, and $5.0 million of net changes in operating assets and liabilities.

Net cash used in operating activities was $352,000 for the nine months ended September 30, 2009 and primarily consisted of our net loss of $19.0 million offset by non-cash items such as $4.6 million in depreciation and amortization expense, $4.3 million of stock-based compensation expense, and $9.4 million of net changes in operating assets and liabilities, which includes a $3.8 million non-cash inventory write down.  Net cash used in operating activities was $4.9 million during the nine months ended September 30, 2008 and primarily consisted of our net loss of $20.7 million, offset by non-cash items such as depreciation and amortization expense of $4.7 million, stock-based compensation expense of $4.4 million, and net changes in operating assets and liabilities of $6.9 million.  Included in operating cash out flows for the first nine months of 2008 was $3.8 million in professional service fees related to our Audit Committee investigation and restatement of financial statements.

Cash Flows from Investing Activities

Cash flows from investing activities primarily relate to capital expenditures to support our growth and net maturities and purchases of marketable securities. Net cash used in investing activities during the three months ended September 30, 2009 was $2.5 million, comprised primarily of $2.3 million of net purchases of marketable securities.  Net cash used in investing activities for the three months ended September 30, 2008 was $0.4 million, comprised of $1.2 million of net proceeds from the maturities of marketable securities, offset by $1.6 million of capital expenditures, primarily related to increased research and development lab equipment and purchases of computer and office equipment to support continued growth.

Net cash used in investing activities for the nine months ended September 30, 2009 was $5.4 million, comprised of $3.9 million in net purchases of marketable securities and $1.5 million of capital expenditures. Net cash provided by investing activities during the nine months ended September 30, 2008 was $12.4 million and was comprised of net proceeds from maturities of marketable securities of $17.0 million offset by capital expenditures of $4.6 million.

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Cash Flows from Financing Activities

Net cash provided by financing activities for the three and nine months ended September 30, 2009 was $1.1 million and $1.6 million, respectively, and was entirely due to proceeds from the issuance of common stock in connection with the exercise of stock options as well as purchases under our Employees Stock Purchase Plan.  Net cash provided by financing activities during the three and nine months ended September 30, 2008 was $91,000 and $440,000, respectively, and was primarily related to the proceeds from the issuance of common stock during the respective periods.

We believe that our $77 million of cash, cash equivalents and marketable securities at September 30, 2009, will be sufficient to fund our projected operating requirements for at least twelve months. However, we may need to raise additional capital or incur additional indebtedness to continue to fund our operations in the future. Our future capital requirements will depend on many factors, including our rate of revenue growth, our ability to achieve sustainable profitability, the expansion of our sales and marketing activities, the timing and extent of our expansion into new territories, the timing of introductions of new products and enhancements to existing products, and the continuing market acceptance of our products. Although we currently are not a party to any agreement or letter of intent with respect to potential material investments in, or acquisitions of, complementary businesses, services or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all.

Contractual Obligations

As of September 30, 2009, our principal commitments consisted of obligations outstanding under operating leases. We lease our facilities under operating leases that expire at various dates through 2014. There have been no material changes in our principal lease commitments compared to those discussed in our Annual Report on Form 10-K for the year ended December 31, 2008.

We outsource the manufacturing of our products to contract manufacturers in which we typically maintain a rolling 90-day firm order based on production forecast. These orders may only be rescheduled, modified, or cancelled by our contract manufacturers under certain circumstances. The remaining amount on the open purchase order with our contract manufacturers and other partners and suppliers at September 30, 2009 was approximately $1.9 million.

Off-Balance Sheet Arrangements

During the periods presented, we did 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.

Recent Accounting Pronouncements

In April 2009, the Financial Accounting Standards Board (“FASB”) issued guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset/liability has significantly decreased and on identifying circumstances that indicate a transaction is not orderly. In addition, the guidance requires disclosure in interim and annual periods of the inputs and valuation techniques used to measure fair value and a discussion of changes in valuation techniques. The adoption of the guidance did not have a material impact on our consolidated financial statements.

In May 2009, the FASB issued guidance establishing general standards for accounting for and disclosure of events that occur after the balance sheet date but before financial statements are available to be issued. More specifically, the guidance sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition in the financial statements, identifies the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that should be made about events or transactions that occur after the balance sheet date. The adoption of the guidance did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued guidance to establish a single source of authoritative nongovernmental Generally Accepted Accounting Principles (“GAAP”) in the United States. The guidance is effective for interim and annual periods ending after September 15, 2009, or as of July 1, 2009 for the Company.  Adoption of the guidance did not have an impact on our consolidated financial statements.

In September 2009, FASB’s Emerging Issues Task Force (“EITF”) issued authoritative guidance addressing certain revenue arrangements with multiple deliverables. This guidance states that tangible products with hardware and software components that work together to deliver the product functionality are considered non-software products, and the accounting guidance under the revenue arrangements with multiple deliverables is to be followed. This guidance is effective for the Company’s interim reporting period ending on September 30, 2010. The Company is currently evaluating the impact of the implementation of this guidance on its financial position, results of operations and cash flows.

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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

A description of our quantitative and qualitative disclosures about market risks is set forth in Part II, Item 7A, of our Annual Report on Form 10-K for the year ended December 31, 2008 filed with the SEC on February 20, 2009.

ITEM 4. Controls and Procedures

a) Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including our chief executive officer and chief financial officer (together, our “certifying officers”), of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act.  Disclosure controls and procedures are controls and other procedures designed to ensure that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms, and that the information is accumulated and communicated to our management, including our certifying officers, to allow timely decisions regarding required disclosure. Based upon this evaluation, our certifying officers concluded that our disclosure controls and procedures were effective as of September 30, 2009.

b) Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended September 30, 2009, that our certifying officers concluded materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

ITEM 1. Legal Proceedings

On November 1, 2007, a putative class action complaint was filed in the U.S. District Court for the Western District of Washington against Isilon and certain of its current and former directors and officers. The complaint asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder, as well as under Sections 11, 12 and 15 of the Securities Act of 1933.  Substantially similar complaints were filed later in the same court and all of these cases were subsequently consolidated.  On April 18, 2008, lead plaintiffs filed a consolidated amended complaint against Isilon, certain of our current and former directors and officers, underwriters, and venture capital firms.  The consolidated complaint purports to be brought on behalf of a class of persons who purchased or otherwise acquired our stock during the period December 16, 2006 to October 3, 2007.  Plaintiffs allege that defendants violated the federal securities laws by issuing a false and misleading registration statement and prospectus in connection with our December 16, 2006 initial public offering and by thereafter misrepresenting our current and prospective business and financial results, thereby causing our stock price to be artificially inflated during the purported class period.  Plaintiffs seek unspecified compensatory damages, interest, attorneys’ fees and costs, and injunctive relief.

On September 30, 2008, Isilon and the other defendants moved to dismiss the consolidated amended complaint.  Oral argument on the defendants’ motions was heard on December 16, 2008, and a decision was issued on December 29, 2008 granting in part and denying in part the motions.  All claims against defendants Sequoia Capital (and related entities), Atlas Venture (and related entities) and Madrona Venture Group LLC were dismissed.  The Section 12 claims were dismissed as against defendants Isilon, our former CEO Steven Goldman, and our former CFO Stuart Fuhlendorf, as were the Section 10(b) claims against Isilon directors William Ruckelshaus and Matthew McIlwain.  The Court denied the remainder of the defendants’ motions.  All remaining defendants filed answers to the complaint on January 30, 2009.

On September 21, 2009, we entered into a memorandum of understanding with the other parties to settle and resolve the class action.  The settlement provides for a payment to the plaintiff class of $15.0 million, of which Isilon will contribute $2.0 million and the balance will be paid by our insurers.  The class action settlement is subject to preliminary and, following notice to class members, final approval by the United States District Court for the Western District of Washington.

On March 18 and 24, 2008, shareholder derivative actions were filed in the Superior Court of the State of Washington (King County), allegedly on behalf of and for the benefit of Isilon, against certain of our current and former directors and officers.  Isilon was named as a nominal defendant.  On April 17, 2008, the court consolidated these actions and appointed lead counsel.  The derivative complaints arise out of many of the factual allegations at issue in the securities class action, and generally allege that the individual defendants breached fiduciary duties owed to Isilon by publicly misrepresenting our business prospects and by failing to properly account for certain revenues recognized in our fiscal year ended December 31, 2006, and first and second quarters in fiscal 2007.  The complaints seek unspecified damages and equitable relief, disgorgement of compensation, attorneys’ fees, costs, and expenses.  Because the complaints are derivative in nature, they do not seek monetary damages from Isilon.  However, we may be required to advance the legal fees and costs incurred by the individual defendants.

On August 27, 2008, at the request of the parties, the court stayed the consolidated derivative action pending resolution of the motions to dismiss in the securities class action.  As noted above, the motions in the securities case were resolved on December 29, 2008.  On February 6, 2009, the derivative plaintiff filed an amended complaint.  The parties thereafter stipulated, and the court ordered, that the stay in the derivative case be lifted, and that defendants’ motion(s) to dismiss the amended consolidated derivative complaint be filed by November 11, 2009.

We are unable to predict the final outcome of these cases. If the court does not approve the settlement of the class action and the matter proceeds to trial and ultimately results in a court determination against us, it could have a material adverse effect on our consolidated financial position, results of operations or cash flows. Our potential indemnity obligations to current and former officers and directors in the class action, the derivative action and in the SEC’s lawsuit against our former CFO could also result in significant liability (at least as to the advancement of fees and costs) and could have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

We have cooperated on a voluntary basis with an SEC investigation concerning our prior financial restatement.  The SEC issued a formal order of nonpublic investigation and issued subpoenas to certain of our former officers.  The SEC’s investigation was a nonpublic, fact-finding inquiry to determine if there have been violations of the federal securities laws. On September 14, 2009, the SEC announced that it had authorized the final settlement with Isilon of its investigation of our restatement. Without admitting or denying the allegations in the SEC’s complaint, we consented to a permanent injunction against any future violations of certain provisions of the federal securities laws and related regulations concerning the filing of periodic reports and the maintenance of accurate books and records and adequate internal controls. No monetary penalties were assessed against Isilon as part of the settlement.  The settlement concludes the SEC’s formal investigation of Isilon in connection with our prior financial restatement.

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ITEM 1A. Risk Factors

Risks Related to Our Restatement

Matters relating to or arising from our financial  restatement and prior weaknesses in our internal controls, including regulatory and litigation matters, could have a material adverse effect on our business, revenues, operating results, or financial condition.

As more fully described in the Explanatory Note in Part 1 of our Annual Report on Form 10-K for the year ended December 30, 2007, in November 2007, our Audit Committee initiated an independent investigation of certain of our sales to resellers and other customers to determine whether commitments were made that have an impact on the timing and treatment of revenue recognition, and whether our internal controls relating to revenue recognition were sufficient.  Our Audit Committee conducted its investigation and review with the assistance of independent counsel and an independent forensic accounting advisor.

On April 2, 2008, we announced the completion of the investigation and filed our Annual Report on Form 10-K for the year ended December 30, 2007, which included our restated financial statements for the fiscal year ended December 31, 2006, and our restated financial information for the first and second quarters of fiscal 2007, ended April 1, 2007 and July 1, 2007, respectively.   The circumstances and findings of our Audit Committee’s investigation are more fully described in the Explanatory Note in Part 1 of our Annual Report on Form 10-K for 2007.

The investigation and resulting restatement could have a material adverse effect on our relationships with customers and customer prospects as it resulted in the initiation of securities class action litigation, derivative litigation, and an SEC investigation, any of which if not finally resolved could have a material adverse effect on our business, revenues, operating results, or financial condition.  Under Delaware law, our bylaws, and certain indemnification agreements, we may have an obligation to indemnify certain current and former officers and directors in relation to these matters.  Such indemnification may have a material adverse effect on our business, results of operations, and financial condition to the extent insurance does not cover our costs.  The insurance carriers that provide our directors’ and officers’ liability policies may seek to rescind or deny coverage with respect to those pending investigations or actions in whole or in part, or we may not have sufficient coverage under such policies, in which case our business, results of operations, and financial condition may be materially and adversely affected.

Litigation and Regulatory Matters

As further described in Part II, Item 1, of this Form 10-Q, we and certain of our executive officers, directors, underwriters and venture capital firms were named as defendants in a consolidated federal securities class action.  The amended consolidated complaint filed April 18, 2008, asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder, as well as under Section 11, 12 and 15 of the Securities Act of 1933.  On September 30, 2008, the Company and the other defendants moved to dismiss the consolidated amended complaint.  In a decision issued on December 29, 2008, the court granted in part and denied in part the motions to dismiss.  All claims against defendants Sequoia Capital (and related entities), Atlas Venture (and related entities) and Madrona Venture Group LLC were dismissed.  The Section 12 claims were dismissed as against the Company, its former CEO Steven Goldman, and its former CFO Stuart Fuhlendorf, as were the Section 10(b) claims against Isilon directors William Ruckelshaus and Matthew McIlwain.  The Court denied the remainder of the defendants’ motions.  All remaining defendants filed answers to the complaint on January 30, 2009.

In September 2009, we entered into a memorandum of understanding with the other parties to settle and resolve the class action.  The settlement provides for a payment to the plaintiff class of $15.0 million, of which Isilon will contribute $2.0 million and the balance will be paid by our insurers.  The class action settlement is subject to preliminary and, following notice to class members, final approval by the United States District Court for the Western District of Washington.

In addition, on March 18 and 24, 2008, shareholder derivative actions were filed in the Superior Court of the State of Washington (King County), allegedly on behalf of and for the benefit of the Company, against certain of our current and former directors and officers.  The Company was also named as a nominal defendant.  The derivative complaints arise out of many of the factual allegations at issue in the class action, and generally allege that the individual defendants breached fiduciary duties owed to the Company by publicly misrepresenting Isilon’s business prospects, and by failing to properly account for certain revenues recognized in our fiscal year ended December 31, 2006, and first and second quarters in fiscal 2007.

On August 27, 2008, at the request of the parties, the court stayed the consolidated derivative action pending resolution of the motions to dismiss in the securities class action.  As noted above, the motions in the securities case were resolved on December 29, 2008.   On February 6, 2009, the derivative plaintiff filed an amended complaint.  The parties thereafter stipulated, and the Court ordered, that the stay in the derivative case be lifted, and that defendants’ motion(s) to dismiss the amended consolidated derivative complaint be filed by November 11, 2009.

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We are unable to predict the final outcome of these cases. If the court does not approve the settlement of the class action and the matter proceeds to trial and ultimately results in a court determination against us, it could have a material adverse effect on our consolidated financial position, results of operations or cash flows. Our potential indemnity obligations to current and former officers and directors in the class action, the derivative action and in the SEC’s lawsuit against our former CFO could also result in significant liability (at least as to the advancement of fees and costs) and could have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

We have cooperated on a voluntary basis with an SEC investigation concerning our prior financial restatement.  The SEC issued a formal order of nonpublic investigation and issued subpoenas to certain of our former officers. The SEC’s investigation was a nonpublic, fact-finding inquiry to determine if there have been violations of the federal securities laws. On September 14, 2009,  the SEC announced that it had authorized the final settlement with us of its investigation of our restatement. Without admitting or denying the allegations in the SEC’s complaint, we consented to a permanent injunction against any future violations of certain provisions of the federal securities laws and related regulations concerning the filing of periodic reports and the maintenance of accurate books and records and adequate internal controls. No monetary penalties were assessed against Isilon as part of the settlement.  The settlement concludes the SEC’s formal investigation of Isilon in connection with our prior financial restatement.

As all of these matters are not finalized and complete at this time, we cannot provide any assurances that the final outcome of these matters will not have a material adverse effect on our business, results of operations, or financial condition.  We could become subject to additional litigation or regulatory proceedings or actions arising out of our Audit Committee’s investigation and the related restatement of our historic financial statements.   Litigation and regulatory proceedings can be time-consuming and expensive and could divert management time and attention from our business, which could have a material adverse effect on our revenues and results of operations.  The adverse resolution of any specific lawsuit or regulatory action or proceeding could have a material adverse effect on our business, results of operations, financial condition, and cash flows.

If we fail to establish and maintain proper and effective internal controls, our ability to produce accurate financial statements on a timely basis could be impaired, which would adversely affect our consolidated operating results, our ability to operate our business and investors’ views of us.

Ensuring that we have adequate internal financial and accounting controls and procedures in place to produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. Failure on our part to have effective internal financial and accounting controls would cause our financial reporting to be unreliable, could have a material adverse effect on our business, operating results, and financial condition and could cause the trading price of our common stock to fall dramatically. In our Quarterly Report on Form 10-Q for the period ended September 30, 2007, our Chief Executive Officer and Chief Financial Officer determined that our internal control over financial reporting was not effective.

Our Audit Committee's investigation of revenue recognition issues identified internal control weaknesses relating primarily to the failure to communicate complete information regarding certain sales transactions containing non-standard terms among finance, accounting, legal, sales and senior management personnel and an ineffective risk assessment process. This material weakness was remediated as of December 30, 2007. Remedying our material weakness has required substantial management time and attention and incremental expenses.  Any failure to maintain the remediation of our identified control deficiencies or any additional errors or delays in our financial reporting, whether or not resulting from a failure to remedy the deficiencies that resulted in the restatement, would have a material adverse effect on our business and results of operations and could have a substantial adverse impact on the trading price of our common stock and our relationships with customers.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting to ensure that information regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States. Our management does not expect that our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company will have been detected.

We are required to comply with Section 404 of the Sarbanes-Oxley Act of 2002.  We have expended significant resources in developing and maintaining the necessary documentation and testing procedures required by Section 404 of the Sarbanes-Oxley Act and expect to continue to expend significant resources in maintaining this compliance.  We cannot be certain that the actions we have taken to continue to improve our internal control over financial reporting will be sufficient or that we will be able to maintain and continue to implement and improve our processes and procedures in the future, which could cause us to be unable to produce accurate financial statements on a timely basis. Any of the foregoing could cause investors to lose confidence in the reliability of our consolidated financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance our operations and growth.

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Risks Related to Our Business and Industry

Economic conditions in the United States and globally could adversely affect our business.

Since at least mid-2007, global credit, financial and other markets in the U.S. and globally have suffered substantial stress, volatility, illiquidity and disruption. This global economic uncertainty has continued, resulting in, among other things, the bankruptcy or acquisition of, or government assistance to, many major domestic and international financial institutions.  This ongoing macroeconomic uncertainty poses a continuing risk to the overall economy as businesses and consumers may defer, delay or forgo purchases in response to continuing negative financial or economic news and events which could affect demand for our products and services.  There could be a number of negative follow-on effects from the ongoing economic uncertainty on our business, including insolvency of key suppliers resulting in product delays and inability of customers to obtain credit to finance purchases of our products and/or customer insolvencies.

Moreover, as noted above, the current uncertainty in global economic conditions poses a risk to the overall global economy as consumers and businesses may defer purchases in response to negative financial or economic news and events, which could negatively affect product demand and other related matters.  Consequently, demand could be different from our current expectations due to factors including negative changes in general business and economic conditions and/or further tightening or deterioration in global credit markets, either of which could affect consumer confidence, customer acceptance of our and our competitors’ products and changes in customer order patterns including order cancellations.

In early April 2009, we announced a company-wide reduction in force of approximately 10%. While this and other cost-saving initiatives are intended to improve our cost structure and path to profitability, the reduction in workforce may negatively impact our research and development efforts, our sales capacity and our relationships with customers and vendors.  Moreover, should the economic slowdown continue or worsen, we will need to evaluate whether further cost and workforce reductions are warranted.  Accordingly, we cannot be assured that recent and potential future cost-saving initiatives will not negatively impact our operations, growth and competitive position in the marketplace.

We have a history of losses, and we may not achieve profitability in the future.

We have not been profitable in any fiscal period since we were formed. We experienced a net loss of $4.9 million and $19.0 million for the three and nine months ended September 30, 2009 and $4.8 million and $20.7 million for the three and nine months ended September 30, 2008. As of September 30, 2009, our accumulated deficit was $147.0 million. We expect to make significant expenditures related to the development of our products and expansion of our business, including expenditures for additional sales and marketing and research and development personnel. We may encounter unforeseen difficulties, complications and delays and other unknown factors that require additional expenditures. As a result of these increased expenditures, we will have to generate and sustain substantially increased revenue to achieve profitability. Our revenue growth trends in prior periods are not likely to be sustainable. Accordingly, we may not be able to achieve or maintain profitability and we may continue to incur significant losses in the future.

We face intense competition and expect competition to increase in the future, which could reduce our revenue, margins and customer base.

The storage market is highly competitive and we expect competition to intensify in the future. This competition could make it more difficult for us to sell our products, and result in increased pricing pressure, reduced profit margins, increased sales and marketing expenses and failure to increase, or the loss of, market share, any of which would likely seriously harm our business, operating results and financial condition. For instance, the decrease in the price of disk drives and other industry standard hardware components has resulted in increased pricing pressure and a reduction in the price per megabyte of storage.

Currently, we face competition from a number of established companies, including EMC Corporation, Hewlett-Packard Company, Hitachi Data Systems Corporation, International Business Machines Corporation, NetApp, Inc. and Sun Microsystems, Inc. We also face competition from a large number of private companies and recent market entrants. Many of our current competitors have, and some of our potential competitors could have, longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we have. Potential customers may prefer to purchase from their existing suppliers rather than a new supplier regardless of product performance or features.

We expect increased competition from other established and emerging companies, including companies such as networking infrastructure and storage management companies that provide complementary technology and functionality. In addition, third parties currently selling our products could market products and services that compete with ours. Some of our competitors, including EMC, Hewlett-Packard and NetApp, have made acquisitions of businesses that allow them to offer more directly competitive and comprehensive solutions than they had previously offered. Our current and potential competitors may also establish cooperative relationships among themselves or with third parties. If so, new competitors or alliances that include our competitors may emerge that could acquire significant market share. We expect these trends to continue and potentially accelerate as companies attempt to strengthen or maintain their market positions in this evolving industry and in the midst of a difficult and challenging macroeconomic environment. In addition, we compete against internally developed storage solutions as well as combined third-party software and hardware solutions. Any of these competitive threats, alone or in combination with others, could seriously harm our business, operating results and financial condition.

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Our operating results may fluctuate significantly, which makes our future results difficult to predict and could cause our operating results to fall below expectations.

Our operating results may fluctuate due to a variety of factors, many of which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our past results as an indication of our future performance. In addition, a significant portion of our quarterly sales typically occurs near the end of the quarter. As a result, small delays can make our operating results difficult to predict. If our revenue or operating results fall below the expectations of investors or any securities analysts that follow our company, the price of our common stock would likely decline.

Factors that may affect our operating results include:

· changes and uncertainty in the U.S. and global economies and macroeconomic conditions, and specific economic conditions in the computer and storage industries;

· general or sustained decrease in global corporate spending on information technology and storage related products leading to a decline in demand for our products;

· continued and increased customer uncertainty due to uncertainty and weakness in the U.S. and global economies;

· reductions in customers’ budgets for information technology and storage related purchases, delays in their purchasing cycles or deferments of their product purchases based on market and economic uncertainty or in anticipation of new products or updates from us or our competitors;

· the ability of our customers, channel partners, and suppliers to obtain financing or to fund capital expenditures and their ability to continue as a going concern;

· the timing and magnitude of shipments and timing of installations of our products in each quarter;

· our ability to build, expand and improve our direct sales operations, reseller and other distribution channels;

· our ability to build, expand and improve sales backlogs and improve sales linearity;

· our ability to improve our marketing and demand generation and attract new customers;

· our ability to continually improve and provide high quality customer service and experience;

· our ability to effectively manage our relationships with our third party maintenance providers that provide onsite support, hardware replacement, manage and disburse our spares product inventory and provide other field services in the U.S. and international regions in which we sell our products;

· the rates at which customers purchase additional storage systems from us and renew their service contracts with us;

· the timing of recognizing revenue as a result of revenue recognition rules;

· fluctuations in demand, sales cycles and prices for our products and services;

· our ability to develop, introduce and ship in a timely manner new products and product enhancements that meet customer requirements;

· the timing of product releases, upgrades or announcements by us or our competitors;

· any change in competitive dynamics, including new entrants or discounting of product prices;

· our ability to control costs, including our operating expenses and the costs of the components we use in our products;

· the possibility of seasonality of demand for our products;

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· volatility in our stock price, which may lead to higher stock compensation expenses pursuant to Statement of Financial Accounting Standards No. 123(R),  Share-Based Payment , or SFAS 123(R), which first became effective for us in the first quarter of 2006 and requires that employee stock-based compensation be measured based on its fair value on the grant date and recorded as an expense in our financial statements over the recipient’s service period;

· future accounting pronouncements and changes in accounting policies; and

· geopolitical events such as war or incidents of terrorism.

Our limited operating history in an emerging market sector makes it difficult to evaluate our current business and future prospects, and may increase the risk of your investment.

Our company has only been in existence since January 2001. We first began shipping products in January 2003 and much of our growth has occurred since October 2005. Our limited operating history in an emerging market sector makes it difficult to evaluate our current business and our future prospects. We have encountered and will continue to encounter risks and difficulties frequently experienced by growing companies in rapidly changing industries, such as the risks described in this report. If we do not address these risks successfully, our business will be harmed.

Our future financial performance depends on growth in the storage of file-based data. If growth in the storage of file-based data  does not continue at the rate that we forecast, our operating results would be materially and adversely impacted.

Our products are designed to address the growth in storage of file-based data. Accordingly, our future financial performance will depend in large part on growth in this new category and on our ability to adapt to emerging demands. Changes in technologies could adversely affect the demand for storage systems. For example, advances in file compression technology could result in smaller file sizes and reduce the demand for storage systems. A reduction in demand for storage of file-based data caused by lack of customer acceptance, weakening economic conditions, competing technologies and products, decreases in corporate spending or otherwise, would result in decreased revenue or a lower revenue growth rate. We cannot assure you that growth in the storage of file-based data will continue or that we will be able to respond adequately to changes in the future.  If we are unable to maintain or replace our relationships with customers or to increase the diversification of our customer base, it would be more difficult to maintain or grow our revenue and our growth might be limited.

Historically, a significant portion of our total revenue has come from a limited number of customers in a small number of industries, particularly media and entertainment and Internet companies.  For example, our largest customer for 2007, Eastman Kodak Company, accounted for approximately 10% of our total revenue, and our two largest customers for 2006, Comcast Corporation, which purchased through one of our resellers, and Eastman Kodak Company, together accounted for approximately 25% of our total revenue. While our customer base has grown and diversified, the potential for concentrated purchases by certain new and existing customers remains and our largest customers may continue to vary from quarter to quarter. As a consequence of historical patterns and the potential concentrated nature of our customers’ purchasing patterns, the proportion of our total revenue derived from a small number of customers may be even higher in any future quarter.  If this were to occur, we cannot provide any assurance that we will be able to sustain such revenue. In addition, our customers, including our large customers, generally buy systems on a purchase order basis and as such generally do not enter into long-term contracts or minimum purchase commitments. If we are unable to sustain our revenue from these customers or to replace it with revenue from new or existing customers, our growth may be limited. If economic conditions change for the industries in which our largest customers do business, or if we are unable to attract significant numbers of customers in other targeted industries, including life sciences, government, manufacturing and oil and gas, our ability to maintain or grow our revenue would be adversely affected.

If we are unable to develop and introduce new products and respond to technological changes, if our new products do not achieve market acceptance or if we fail to manage product transitions, we may fail to increase, or may lose, market share.

Our future growth depends on the successful development and introduction of new systems and software products. Due to the complexity of storage systems, these products are subject to significant technical risks that may impact our ability to introduce these products successfully. Our new products also may not achieve market acceptance. In addition, our new products must respond to technological changes and evolving industry standards. If we are unable, for technological or other reasons, to develop and introduce new products in a timely manner in response to changing market conditions or customer requirements, or if these products do not achieve market acceptance, our operating results could be materially and adversely affected.

Product introductions by us in future periods may also reduce demand for our existing products. As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories and ensure that sufficient supplies of new products can be delivered to meet customer demand.

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We rely on value-added resellers and other distribution partners to sell our products, and disruptions to, or our failure to develop and manage, our distribution channels and the processes and procedures that support them could result in these resellers and partners discontinuing the marketing and distribution of our products and services.
 

Our future success is highly dependent upon establishing and maintaining successful relationships with a variety of value-added resellers and other distribution partners, including OEM partners that may bundle or include our products in a broader product set. A substantial portion of our total revenue is currently sold through our resellers and distribution partners. Therefore, our ability to maintain or grow our revenue will likely depend, in part, on our ability to maintain our arrangements with our existing resellers and other distribution partners, and to establish and expand arrangements with new partners in these areas, and any failure to do so could have a material adverse effect on our future revenue. Additionally, by relying on such partners, we may have less contact with the ultimate users of our products, thereby making it more difficult for us to establish brand awareness, ensure proper delivery and installation of our products, service ongoing customer requirements and respond to evolving customer needs.

Recruiting and retaining qualified resellers and distribution partners and training them in our technology and product offerings require significant time and resources. In order to develop and expand our distribution channel, we must continue to scale and improve our processes and procedures that support our such partners, including investments in systems and training. Those processes and procedures may become increasingly complex and difficult to manage.

We typically enter into non-exclusive, written distribution agreements with our resellers and distribution partners that generally have a one-year term, have no minimum sales commitment and do not prohibit them from offering products and services that compete with ours. Accordingly, our distribution partners may choose to discontinue offering our products and services or may not devote sufficient attention and resources toward selling our products and services. Our competitors may provide incentives to our existing and potential distribution partners to use or purchase their products and services or to prevent or reduce sales of our products and services. Some of our distribution partners possess significant resources and advanced technical abilities and may, either independently or jointly with our competitors, develop and market products and related services that compete with our offerings. If this were to occur, these distribution partners might discontinue marketing and distributing our products and services. In addition, these distribution partners would have an advantage over us when marketing their competing products and related services because of their existing customer relationships. The occurrence of any of these events would likely materially adversely affect our business, operating results and financial condition.

Claims by others that we infringe their proprietary technology could cause us to incur substantial costs, distract our management and, if these claims are successful, require us to pay substantial damages or prevent us from offering our products.

Third parties could claim that our products or technologies infringe their proprietary rights. The data storage industry is characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. We expect that infringement claims may further increase as the number of products and competitors in our sector increases. We have not to date been involved in any litigation related to intellectual property.  In the past, on July 31, 2006, we received a letter from counsel to SeaChange International, Inc. suggesting that our products may be infringing certain SeaChange patents.  We exchanged correspondence with SeaChange’s legal counsel, the latest of which was our letter of August 31, 2007, which pointed out that there appears to be no reasonable basis for SeaChange to claim that Isilon infringes any of the SeaChange patents.  We received no further correspondence in the matter.  If this matter or other matters arise, and we are unable to reach an amicable resolution, it is possible that litigation could result. The outcome of any litigation is inherently unpredictable, and accordingly, we cannot assure you that, in the future, a court would not find that our products infringed these patents. We cannot assure you that we do not currently infringe, or that we will not in the future infringe, upon any third-party patents or other proprietary rights.

Any claim of infringement by a third party, even one without merit, could cause us to incur substantial costs defending against the claim, and could distract our management from our business. Further, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages. A judgment could also include an injunction or other court order that could prevent us from offering our products. In addition, we might be required to seek a license for the use of the infringed intellectual property, which might not be available on commercially reasonable terms or at all. Alternatively, we might be required to develop non-infringing technology, which could require significant effort and expense and might ultimately be unsuccessful. Any of these events could seriously harm our business, operating results and financial condition. Third parties may also assert infringement claims against our customers and channel partners. Any of these claims would require us to initiate or defend potentially protracted and costly litigation on their behalf, regardless of the merits of these claims, because we generally indemnify our customers and channel partners from claims of infringement of proprietary rights of third parties. If any of these claims succeeds, we might be forced to pay damages on behalf of our customers or channel partners, which could have a material adverse effect on our business, operating results and financial condition.

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Our sales cycles can be long and unpredictable, and our sales development efforts require considerable time and expense. As a result, our sales are difficult to predict and may vary substantially from quarter to quarter, which may cause our operating results to fluctuate significantly.

The timing of our revenue is difficult to predict. Our sales efforts involve building and expanding our direct sales operations and reseller distribution channels, improving our ability to build sales backlogs and improve sales linearity, and educating our customers about the use and benefits of our products, including their technical capabilities and potential cost savings to an organization. Customers may undertake a significant evaluation process that in the past has resulted in a lengthy sales cycle, in some cases more than 12 months. We spend substantial time and resources on our sales efforts without any assurance that our efforts will produce any sales. In addition, product purchases are frequently subject to budget constraints, multiple approvals and unplanned administrative processing and other delays, which may be further impacted by current macroeconomic concerns and conditions. If we do not realize expected sales from a specific customer for a particular quarter in that quarter or at all, our business, operating results and financial condition could be harmed.

We derive substantially all of our total revenue from sales of our Isilon IQ product family and related services, and a decline in demand for our Isilon IQ product family would cause our revenue to grow more slowly or to decline.

We derive substantially all of our total revenue from sales of our Isilon IQ product family and customer and technical support services associated with this product family. As a result, we are vulnerable to fluctuations in demand for this product family, whether as a result of competition, product obsolescence, technological change, customer budgetary constraints or other factors. If demand for our Isilon IQ product family were to decline, our financial condition would be harmed.

If we are unable to continue to create valuable innovations in software, we may not be able to generate additional high-margin revenue to increase our gross margins.

Our industry has a history of declining storage hardware prices as measured on a cost per gigabyte or terabyte of storage capacity basis. In order to maintain or increase our gross margins, we will need to continue to create valuable software that is included with our scale-out NAS storage systems and/or sold as separate standalone software applications. Any new feature or application that we develop or acquire may not be introduced in a timely or cost-effective manner and may not achieve the broad market acceptance necessary to help increase our overall gross margin. If we are unable to successfully develop or acquire, and then market and sell, additional software functionality, such as our SmartConnect, SnapshotIQ, Migration IQ, SmartQuotas and SyncIQ software applications, our ability to maintain or increase our high-margin revenue and gross margin will be adversely affected.

We currently rely on two contract manufacturers to assemble our products, and our failure to forecast demand for our products accurately or manage our relationships with our contract manufacturers successfully could negatively impact our ability to sell our products.

We currently rely on two contract manufacturers. In an agreement dated August 30, 2007, we established a contract manufacturing relationship with Solectron Corporation, subsequently acquired by Flextronics International Ltd.  This agreement provides current terms and operating conditions while we are continuing to discuss and negotiate the terms of a master services agreement.  Since that time, we have utilized Flextronics to manufacture and assemble our products, procure components for our systems and help manage our supply chain, perform testing and manage delivery of our products.  In an agreement dated September 14, 2009, we entered into a master service agreement with Jabil Circuit, Inc. This agreement provides terms and operating conditions for the manufacture and assembling of products, procuring components, helping manage our supply chain, performing testing and managing delivery of our products.

Our reliance on contract manufacturers reduces our control over the assembly process, exposing us to risks, including reduced control over quality assurance, production costs, product supply and excess inventory. If we fail to manage or maintain our relationships with our contract manufacturers effectively, including failing to finalize master service agreements, or if our contract manufacturers experience delays, disruptions, capacity constraints or quality control problems in their operations, our ability to ship products to our customers could be impaired and our competitive position and reputation could be harmed. If we and our contract manufacturers are unable to negotiate with suppliers for reduced component costs, our operating results would be harmed.  If we are required to change contract manufacturers or assume internal manufacturing operations, we may lose revenue, incur increased costs and damage our customer relationships. Qualifying new contract manufacturers and commencing volume production are expensive and time-consuming. We provide forecasts to our contract manufacturers regarding product demand and production levels. If we inaccurately forecast demand for our products, we may have excess or inadequate inventory or incur cancellation charges, carrying costs or penalties, which could adversely impact our operating results.

We intend to introduce new products and product enhancements, which could require us to achieve volume production rapidly by coordinating with our contract manufacturers and component suppliers. We may need to increase our component purchases, contract manufacturing capacity, and internal test and quality functions if we experience increased demand. The inability of our contract manufacturers to provide us with adequate supplies of high-quality products, or an inability to obtain adequate quantities of components, could cause a delay in our order fulfillment, and our business, operating results and financial condition would be adversely affected.

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We rely on a limited number of suppliers, and in some cases single-source suppliers, and any disruption or termination of these supply arrangements could delay shipments of our products and could materially and adversely affect our relationships with current and prospective customers.

We rely on a limited number of suppliers for several key components utilized in the assembly of our products. We purchase several of our required components, such as disk drives and chassis, from a single supplier. This reliance on a limited number of suppliers involves several risks, including:

· supplier capacity constraints;

· price increases;

· timely delivery; and

· component quality.

Component quality is particularly significant with respect to our suppliers of disk drives. In order to meet product capacity requirements, we must obtain disk drives of extremely high quality and capacity. We cannot assure you that we will be able to obtain enough of these components in the future or that prices of these components will not increase. In addition, problems with respect to supply, yield and quality of these components and timeliness of deliveries could occur. Disruption or termination of the supply of these components could delay shipments of our products and could materially and adversely affect our relationships with current and prospective customers. These delays could also materially and adversely affect our operating results.

If we fail to manage future growth effectively, we may not be able to market and sell our products and services successfully.

We have expanded our operations significantly since inception and anticipate that further significant expansion will be required. Our future operating results depend to a large extent on our management’s ability to manage expansion and growth successfully, including, but not limited to, hiring, training and developing our sales personnel to become productive and generate revenue, forecasting revenue, controlling expenses, implementing and enhancing infrastructure, systems and processes, addressing new markets and expanding international operations. A failure to manage our growth effectively could materially and adversely affect our ability to market and sell our products and services.

Our products incorporate components that are subject to pricing and supply volatility, and, as a result, our cost structure and our ability to respond in a timely manner to customer demand are sensitive to such volatility in the market prices and supply for these components.

A significant portion of our expenses is directly related to the pricing of commoditized components utilized in the manufacture of our products, such as disk drives, memory chips, and CPUs. As part of our procurement model, we do not enter into long-term supply contracts for these components, but instead have our contract manufacturers purchase these components on our behalf. In some cases, our contract manufacturers do so in a competitive-bid purchase order environment with suppliers or on the open market at spot prices. As a result, our cost structure is affected by price volatility in the marketplace for these components, especially for disk drives. This volatility makes it difficult to predict expense levels and operating results and may cause them to fluctuate significantly. Furthermore, such components can be subject to limits on supply or other supply volatility which may negatively impact our ability to obtain quantities necessary to grow our business and respond to customer demand for our products.

We maintain relatively low inventory and acquire components only as needed; as a result, if shortages of these components arise, we may not be able to secure enough components to build new products to meet customer demand.

We attempt to maintain relatively low inventory and acquire components only as needed, and as a result do not enter into long-term supply contracts for these components. As a result, our ability to respond to customer orders efficiently may be constrained by the then-current availability or terms and pricing of these components. Our industry has experienced component shortages and delivery delays in the past, and we may experience shortages or delays of critical components in the future as a result of strong demand in the industry or other factors. For example, disk drives can represent a significant portion of our cost of revenue, and both the price and availability of various kinds of disk drives are subject to substantial volatility.  In the past, we have encountered situations where we paid higher prices than we had anticipated for disk drives or had to use a larger or smaller capacity drives as a replacement. Likewise, in the past, the industry experienced a shortage of selected memory chips, which caused some of our motherboard suppliers to reduce or suspend shipments to us. This delayed our ability to ship selected configurations to some of our customers, and in some cases accelerated a transition by us to other components. In addition, new generations of disk drives are often in short supply and are subject to industry allocations that may limit our ability to procure these disk drives. Many of the other components required to build our systems are occasionally in short supply and subject to industry allocations. If shortages or delays arise, the prices of these components may increase or the components may not be available at all. We may not be able to secure enough components at reasonable prices or of acceptable quality to build new products to meet customer demand, which could adversely affect our business, operating results and financial condition.

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If we lose key personnel, if key personnel are distracted or if we are unable to attract and retain highly-qualified personnel on a cost-effective basis, it would be more difficult for us to manage our existing business operations and to identify and pursue new growth opportunities.

Our future performance depends on the continued service of our key technical, sales, services, and management personnel. We rely on our executive officers and senior management to manage our existing business operations and to identify and pursue new growth opportunities. The loss of key employees could result in significant disruptions to our business, and the integration of replacement personnel could be time-consuming, cause additional disruptions to our business or be unsuccessful.   The loss of the services of key executives for any reason could adversely affect our business, operating results and financial condition.

Our future success also depends on our continued ability to attract and retain highly-qualified technical, sales, services, and management personnel. In particular, our ability to enhance and maintain our technology requires talented software development engineers with specialized skills in areas such as distributed computing, file systems and operating systems. If we are not able to recruit and retain these engineers, the quality and speed with which our products are developed would likely be seriously compromised, and our reputation and business would suffer as a result. Competition for these and the other personnel we require, particularly in the Seattle metropolitan area, is intense, and we may fail to retain our key technical, sales, services and management employees or to attract or retain other highly-qualified technical, sales, services, and management personnel in the future.

Our ability to sell our products is highly dependent on the quality of our customer service offerings, and our failure to offer high-quality customer service offerings would have a material adverse effect on our ability to market and sell our products and services.

After our products are deployed within our customers’ networks, our customers depend on our services organization to resolve issues relating to our products. High-quality customer support services are critical for the successful marketing and sale of our products. If we or our third-party maintenance providers or channel partners do not effectively assist our customers in deploying our products, succeed in helping our customers to resolve post-deployment issues quickly, and provide ongoing support, it would adversely affect our ability to sell our products to existing customers and could harm our prospects with potential customers. In addition, as we expand further into larger enterprise accounts, and expand our operations internationally, our customer services organization will face additional challenges, including those associated with providing more mission-critical services in enterprise accounts, as well as delivering services, training and documentation in languages other than English. As a result, our failure to maintain high-quality customer support services could have a material adverse effect on our business, operating results and financial condition.

Our products are highly technical and may contain undetected software or hardware defects, which could cause data unavailability, loss or corruption that might, in turn, result in liability to our customers and harm to our reputation and business.

Our storage products are highly technical and complex and are often used to store information critical to our customers’ business operations. Our products have contained and may contain undetected errors, defects or security vulnerabilities that could result in data unavailability, loss or corruption or other harm to our customers. Some errors in our products may only be discovered after they have been installed and used by customers. Any errors, defects or security vulnerabilities discovered in our products after commercial release, as well as any computer virus or human error on the part of our customer support or other personnel resulting in a customer’s data unavailability, loss or corruption could result in a loss of revenue or delay in revenue recognition, a loss of customers or increased service and warranty costs, any of which could adversely affect our business, operating results and financial condition. In addition, we could face claims for product liability, tort or breach of warranty, including claims relating to changes to our products made by our channel partners. Our contracts with customers contain provisions relating to warranty disclaimers and liability limitations, which may be difficult to enforce. Defending a lawsuit, regardless of its merit, would be costly and might divert management’s attention and adversely affect the market’s perception of us and our products. In addition, if our business liability insurance coverage proves inadequate with respect to a claim or future coverage is unavailable on acceptable terms or at all, our business, operating results and financial condition could be adversely impacted.

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Our international sales and operations subject us to additional risks that may adversely affect our international operations and reduce our international sales.

We derived approximately 23% and 25% of our total revenue from customers outside the United States during the three and nine months ended September 30, 2009. We have sales and technical support personnel in several countries worldwide. We expect to continue to add personnel in additional countries.  Our various international operations subject us to a variety of risks, including:

· the difficulty of managing and staffing international offices and the increased travel, infrastructure and legal compliance costs associated with multiple international locations;

· difficulties in enforcing contracts and collecting accounts receivable, and longer payment cycles, especially in emerging markets;

· the challenge of managing development teams in geographically disparate locations;

· tariffs and trade barriers and other regulatory or contractual limitations on our ability to sell or develop our products in various foreign markets;

· increased exposure to foreign currency exchange rate risk;

· reduced protection for intellectual property rights in some countries ; and

· political and economic instability, including a global recession.

As we expand our business globally, our success will depend, in large part, on our ability to anticipate and effectively manage these risks. Our failure to manage any of these risks successfully could harm our international operations and reduce our international sales, adversely affecting our business, operating results and financial condition.

If we are unable to protect our intellectual property rights, our competitive position could be harmed or we could be required to incur significant expenses to enforce our rights.

Our success is dependent in part on obtaining, maintaining and enforcing our patent and other proprietary rights. We rely on trade secret, patent, copyright and trademark laws, and confidentiality agreements with employees and third parties, all of which offer only limited protection. The steps we have taken to protect our proprietary rights may not be adequate to prevent misappropriation of our proprietary information or infringement of our intellectual property rights, and our ability to prevent this misappropriation or infringement is uncertain, particularly in countries outside of the United States. Further, with respect to patent rights, we do not know whether any of our pending patent applications will result in the issuance of a patent or whether the examination process will require us to narrow our claims. To date, we have obtained one issued United States patent and this patent, as well as any additional patents that may be issued to us may be contested, circumvented, found unenforceable or invalidated, and we may not be able to prevent third parties from infringing them. Moreover, the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages, and, as a result, our competitors may be able to develop technologies similar or superior to ours.

Protecting against the unauthorized use of our products, trademarks and other proprietary rights is expensive and difficult. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Any such litigation could result in substantial costs and diversion of management resources, either of which could harm our business, operating results and financial condition. Further, many of our current and potential competitors have the ability to dedicate substantially greater resources to enforcing their intellectual property rights than we have. Accordingly, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property.

Our use of open source and third-party software could impose unanticipated conditions or restrictions on our ability to commercialize our products.

We incorporate open source software into our products. Although we monitor our use of open source software to avoid subjecting our products to conditions we do not intend, the terms of many open source licenses have not been interpreted by United States courts, and there is a risk that these licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. In this event, we could be required to seek licenses from third parties in order to continue offering our products, to make generally available, in source code form, proprietary code that links to certain open source modules, to re-engineer our products, or to discontinue the sale of our products if re-engineering could not be accomplished on a timely basis, any of which could adversely affect our business, operating results and financial condition.

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We may also find that we need to incorporate certain proprietary third-party technologies, including software programs, into our products in the future. However, licenses to relevant third-party technology may not be available to us on commercially reasonable terms, or at all. Therefore, we could face delays in product releases until equivalent technology can be identified, licensed or developed, and integrated into our current products. These delays, if they occur, could materially adversely affect our business, operating results and financial condition.

Our products must interoperate with many software applications that are developed by others and if we are unable to devote the necessary resources to ensure that our products interoperate with those applications, we may fail to increase, or we may lose, market share and we may experience a weakening demand for our products.

Our products must interoperate with many software applications that are developed by others. When new or updated versions of these software applications are introduced, we must sometimes develop updated versions of our software so that they interoperate properly with these applications. We may not accomplish these development efforts quickly, cost-effectively or at all. These development efforts require substantial capital investment and the devotion of substantial employee resources. For example, our products currently interoperate with a number of data protection applications marketed by vendors such as Symantec Corporation and EMC. If we fail to maintain compatibility with these applications, our customers may not be able to protect adequately the data resident on our products and we may, among other consequences, fail to increase, or we may lose, market share and experience a weakening in demand for our products, which would adversely affect our business, operating results and financial condition.

Our products must interoperate with various data-access protocols and, if we are unable to ensure that our products interoperate with these protocols, our products might become less competitive.

Our products interoperate with servers and software applications predominantly through the use of protocols, many of which are created and maintained by independent standards organizations. However, some of these protocols that exist today or that may be created in the future are or could be proprietary technology and therefore require licensing the proprietary protocol’s specifications from a third party or implementing the protocol without specifications, which might entail significant effort on our part. If we fail to obtain a license to these specifications from third-party vendors on reasonable terms or at all, and we are not able to implement the protocol in the absence of these specifications, our products might become less competitive, which would harm our business. For example, Microsoft Corporation maintains and enhances the Common Internet File System, or CIFS, a proprietary protocol that our products use to communicate with the Windows operating system, the most popular computer operating system in the world. Although our products are currently compatible with CIFS, at present we do not license the specifications to this proprietary protocol. If we are not able to continue to maintain adequate compatibility with CIFS or if we are not able to license adequate specifications to this protocol on reasonable terms, our products would likely be less competitive in the marketplace, which would adversely affect our business, operating results and financial condition.

If our products do not interoperate with our customers’ networks, servers or software applications, installations would be delayed or cancelled.

Our products must interoperate with our customers’ existing infrastructure, specifically their networks, servers and software applications. This infrastructure often utilizes multiple protocol standards, products from multiple vendors and a wide range of storage features. If we find, as we have in the past, defects in the existing software or hardware used in our customers’ infrastructure or an incompatibility or deficiency in our software, we may have to modify our software so that our products will interoperate with our customers’ infrastructure. This could cause longer sales and implementation cycles for our products and could cause order cancellations, either of which would adversely affect our business, operating results and financial condition.

We may engage in future acquisitions that could disrupt our business, cause dilution to our stockholders, reduce our financial resources and result in increased expenses.

In the future, we may acquire other businesses, products or technologies. We have not made any acquisitions to date. Accordingly, our ability as an organization to make acquisitions is unproven. We may not be able to find suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. If we do complete acquisitions, we may not strengthen our competitive position or achieve our goals, or these acquisitions may be viewed negatively by customers, financial markets or investors. In addition, any acquisitions that we make could lead to difficulties in integrating personnel, technologies and operations from the acquired businesses and in retaining and motivating key personnel from these businesses. Acquisitions may disrupt our ongoing operations, divert management from day-to-day responsibilities, increase our expenses and adversely impact our business, operating results and financial condition. Future acquisitions may reduce our cash available for operations and other uses, and could result in an increase in amortization expense related to identifiable assets acquired, potentially dilutive issuances of equity securities or the incurrence of debt.

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Changes in financial accounting standards or practices may cause adverse, unexpected financial reporting fluctuations and affect our reported results of operations.

A change in accounting standards or practices can have a significant effect on our operating results and may affect our reporting of transactions completed before the change is effective. New accounting pronouncements and varying interpretations of existing accounting pronouncements have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, although not yet currently required, we could be required to adopt International Financial Reporting Standards (“IFRS”) which is different than accounting principles generally accepted in the United States of America for our accounting and reporting standards.

Our business is subject to increasingly complex environmental legislation that has increased both our costs and the risk of noncompliance.

We face increasing complexity in our product design and procurement operations as we adjust to new and upcoming requirements relating to the materials composition of many of our products. The European Union, or EU, has adopted certain directives to facilitate the recycling of electrical and electronic equipment sold in the EU, including the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment, or RoHS, directive. The RoHS directive restricts the use of lead, mercury and certain other substances in electrical and electronic products placed on the market in the EU after July 1, 2006.

In connection with our compliance with these environmental laws and regulations, we could incur substantial costs, including reserves taken for excess component inventory, and be subject to disruptions to our operations and logistics. In addition, we will need to ensure that we can manufacture compliant products and that we can be assured a supply of compliant components from suppliers. Similar laws and regulations have been proposed or may be enacted in other regions, including in the United States, China and Japan. Other environmental regulations may require us to reengineer our products to utilize components that are compatible with these regulations, and this reengineering and component substitution may result in additional costs to us. We cannot assure you that existing laws or future laws will not have a material adverse effect on our business.

We are subject to governmental export and import controls that could impair our ability to compete in international markets.

Because we incorporate encryption technology into our products, our products are subject to United States export controls and may be exported outside the United States only with the required level of export license or through an export license exception. In addition, various countries regulate the importation of certain encryption technology and have enacted laws that could limit our ability to distribute our products or could limit our customers’ ability to implement our products in those countries. Changes in our products or changes in export and import regulations may create delays in the introduction of our products in international markets, prevent our customers with international operations from deploying our products throughout their global systems or, in some cases, prevent the export or import of our products to certain countries altogether. Any change in export or import regulations or related legislation, shift in approach to the enforcement or scope of existing regulations or change in the countries, persons or technologies targeted by these regulations could result in decreased use of our products by, or in our decreased ability to export or sell our products to, existing or potential customers with international operations.

If we need additional capital in the future, it may not be available to us on favorable terms, or at all.

We have historically relied on outside financing and customer payments to fund our operations, capital expenditures and expansion. We may require additional capital from equity or debt financing in the future to fund our operations or respond to competitive pressures or strategic opportunities. Due to the recent tightening of the credit and private equity markets, such financing may not be available, or we may not be able to secure timely additional financing on favorable terms. The terms of any additional financing may place limits on our financial and operating flexibility. If we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. If we are unable to obtain adequate financing or financing on terms satisfactory to us, if and when we require it, our ability to grow or support our business and to respond to business challenges could be significantly limited.

Our business is subject to the risks of earthquakes and other natural catastrophic events, and to interruption by man-made problems such as computer viruses or terrorism.

Our corporate headquarters are located in Seattle, Washington, an area that is at heightened risk of earthquake and volcanic events. We may not have adequate business interruption insurance to compensate us for losses that may occur from any such significant events. A significant natural disaster, such as an earthquake or volcanic eruption, could have a material adverse impact on our business, operating results and financial condition. Also, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems. In addition, acts of terrorism could cause disruptions in our or our customers’ business or the economy as a whole. To the extent that these disruptions result in delays or cancellations of customer orders or the deployment of our products, our business, operating results and financial condition would be adversely affected

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The trading price of our common stock is likely to be volatile.

The trading prices of the securities of technology companies have been highly volatile. Further, our common stock has a limited trading history. Since our initial public offering in December 2006 through October 15, 2009, our stock price has fluctuated from a high of $28.50 to a low of $1.86.  Factors affecting the trading price of our common stock, some of which are outside our control, include:

· variations in our operating results or those of our competitors;

· market conditions in our industry, the industries of our customers and the economy as a whole;

· announcements of technological innovations, new products or product enhancements, strategic alliances or significant agreements by us or by our competitors;

· the gain or loss of significant customers;

· the level of sales in a particular quarter;

· lawsuits threatened or filed against us;

· inquiries or investigations by the SEC, NASDAQ, law enforcement or other regulatory bodies;

· the recruitment or departure of key personnel;

· changes in the estimates of our operating results or changes in recommendations by any securities analysts who elect to follow our common stock; and

· the adoption or modification of regulations, policies, procedures or programs applicable to our business.

In addition, if the market for technology stocks or the stock market in general experiences loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, operating results or financial condition. The trading price of our common stock might also decline in reaction to events that affect other companies in our industry even if these events do not directly affect us. For example, current macroeconomic conditions have caused substantial and continuing volatility in the U.S. stock markets. Although such conditions have not been specific to our company, our stock has experienced similar volatility. Some companies that have had volatile market prices for their securities have had securities class actions filed against them. If a suit were filed against us, regardless of its merits or outcome, it would likely result in substantial costs and divert management’s attention and resources. This could have a material adverse effect on our business, operating results and financial condition.

Future sales of shares by existing stockholders could cause our stock price to decline.

We completed our initial public offering in December 2006, and the contractual lock-up applicable to our equity holders at the time of our initial public offering expired in September 2007. As a result, additional shares of our common stock have become eligible for sale in the public market, including shares held by directors, executive officers and other affiliates. In addition, outstanding warrants and options to purchase shares of our common stock under our 2001 Stock Plan, 2006 Equity Incentive Plan or 2006 Employee Stock Purchase Plan, as well as additional shares reserved for issuance under our 2006 Equity Incentive Plan have become, and will continue to become, eligible for sale in the public market subject to certain legal and contractual limitations. If a significant portion of these shares are sold, or if it is perceived that they will continue to be sold, the trading price of our common stock could decline substantially.

Insiders continue to have substantial control over us and will be able to influence corporate matters.

As of September 30, 2009, our directors and executive officers and their affiliates beneficially own, in the aggregate, approximately 61% of our outstanding common stock. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit other stockholders’ ability to influence corporate matters and may have the effect of delaying or preventing a third party from acquiring control over us.

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Provisions in our certificate of incorporation and bylaws and Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our common stock.

Our certificate of incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:

· establish a classified board of directors so that not all members of our board are elected at one time;

· provide that directors may only be removed “for cause;”

· authorize the issuance of “blank check” preferred stock that our board of directors could issue to increase the number of outstanding shares and to discourage a takeover attempt;

· eliminate the ability of our stockholders to call special meetings of stockholders;

· prohibit stockholder action by written consent, which has the effect of requiring all stockholder actions to be taken at a meeting of stockholders;

· provide that the board of directors is expressly authorized to make, alter or repeal our bylaws; and

· establish advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.

In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control of our company by prohibiting stockholders owning in excess of 15% of our outstanding voting stock from merging or combining with us unless certain approvals are obtained.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

ITEM 3. Defaults Upon Senior Securities

None.

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

 None.

ITEM 5. Other Information

Our insider trading policy allows directors, officers and other employees covered under the policy to establish, under limited circumstances contemplated by Rule 10b5-1 under the Securities Exchange Act of 1934, as amended, written programs that permit automatic trading of our stock or trading of our stock by an independent person (such as a broker or an investment bank) who is not aware of material, nonpublic information at the time of the trade.  On August 5, 2008, Sujal Patel, our CEO, entered into a Rule 10b5-1 trading plan pursuant to which shares of our common stock (will be sold for his account from time to time) in accordance with the provisions of the plan without any further action or involvement by Mr. Patel.  By its terms, this trading plan is scheduled to expire on November 19, 2009.  On August 31, 2009, Mr. Patel entered into a subsequent Rule 10b5-1 trading plan, pursuant to which shares of our common stock will be sold for his account from time to time in accordance with the provisions of the plan without any further action or involvement by Mr. Patel.

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ITEM 6. Exhibits

The following exhibits are incorporated by reference or filed herewith.

Exhibit Number	Description
31.1*	Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer.
31.2 *	Rule 13a-14(a)/15d-14(a) Certification of Principal Accounting and Financial Officer.
32.1 ‡	Section 1350 Certification of Chief Executive Officer.
32.2 ‡	Section 1350 Certification of Chief Financial Officer.

* Filed herewith.

‡ Furnished herewith.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	ISILON SYSTEMS, INC.
Date: October 23, 2009	By:	/s/ Sujal Patel
		Sujal Patel
		President, Chief Executive Officer and Director
		(Principal Executive Officer)
	By:	/s/ William Richter
		William Richter
		Vice President of Finance and Chief Financial Officer
		(Principal Accounting and Financial Officer)

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INDEX TO EXHIBITS

Exhibit Number	Description
31.1*	Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer.
31.2 *	Rule 13a-14(a)/15d-14(a) Certification of Principal Accounting and Financial Officer.
32.1 ‡	Section 1350 Certification of Chief Executive Officer.
32.2 ‡	Section 1350 Certification of Chief Financial Officer.

* Filed herewith.

‡ Furnished herewith.

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