Digi International 8K Other Events | DGII 16 Oct 06

Exhibit 99.4

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

DIGI INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)


	Three months ended June 30,				Nine months ended June 30,
	2006		2005		2006		2005
	(in thousands, except per common share data)
Net sales	$	35,860	$	30,208	$	103,616	$	88,989
Cost of sales (exclusive of amortization of purchased and core technology shown separately below)		15,222		12,003		44,126		34,489
Amortization of purchased and core technology (1)		1,171		947		3,507		3,027


Gross profit		19,467		17,258		55,983		51,473

Operating expenses:
Sales and marketing		7,277		6,446		20,830		19,300
Research and development		5,402		3,778		15,227		11,850
General and administrative (1)		3,037		3,051		10,084		8,043
Acquired in-process research and development		—		300		—		300

Total operating expenses		15,716		13,575		46,141		39,493


Operating income		3,751		3,683		9,842		11,980

Interest income and other, net		575		306		1,461		809

Income before income taxes		4,326		3,989		11,303		12,789
Income tax provision (benefit)		978		1,505		3,205		(1,455	)

Net income	$	3,348	$	2,484	$	8,098	$	14,244


Net income per common share:
Basic	$	0.14	$	0.11	$	0.35	$	0.64

Diluted	$	0.14	$	0.11	$	0.34	$	0.61


Weighted average common shares, basic		23,124		22,588		22,968		22,381


Weighted average common shares, diluted		23,904		23,296		23,695		23,420


(1)		Amortization of purchased and core technology has been reclassified from general and administrative expenses to a separate line item within cost of sales for all periods presented.

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

DIGI INTERNATIONAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)


	June 30, 2006			September 30, 2005
	(in thousands, except share data)
ASSETS
Current assets:
Cash and cash equivalents	$	14,422		$	12,990
Marketable securities		51,442			37,184
Accounts receivable, net		19,232			16,897
Inventories		19,090			18,527
Other		5,419			5,115

Total current assets		109,605			90,713

Property, equipment and improvements, net		19,904			20,808
Identifiable intangible assets, net		21,152			26,342
Goodwill		38,612			38,675
Other		1,041			1,093

Total assets	$	190,314		$	177,631


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Capital lease obligations, current portion	$	406		$	414
Accounts payable		5,235			6,272
Income taxes payable		6,944			3,306
Accrued expenses:
Compensation		4,223			5,308
Other		5,172			5,048
Deferred revenue		293			370

Total current liabilities		22,273			20,718

Capital lease obligations, net of current portion		817			1,181
Net deferred tax liabilities		255			2,195

Total liabilities		23,345			24,094


Commitments and contingencies
Stockholders’ equity:
Preferred stock, $.01 par value; 2,000,000 shares authorized; none issued and outstanding		—			—
Common stock, $.01 par value; 60,000,000 shares authorized; 25,873,164 and 25,456,755 shares issued		259			255
Additional paid-in capital		141,649			136,513
Retained earnings		43,994			35,896
Accumulated other comprehensive income		396			639
Treasury stock, at cost, 2,732,834 and 2,794,562 shares		(19,329	)		(19,766	)

Total stockholders’ equity		166,969			153,537

Total liabilities and stockholders’ equity	$	190,314		$	177,631

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

DIGI INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)


	Nine months ended June 30,
	2006			2005
	(in thousands)
Operating activities:
Net income	$	8,098		$	14,244
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation of property, equipment and improvements		1,949			1,710
Amortization of identifiable intangible assets and other assets		5,744			4,667
Acquired in-process research and development		—			300
Deferred income taxes		(1,987	)		(3,602	)
Tax benefit related to the exercise of stock options		—			2,045
Stock-based compensation		1,742			—
Other		(436	)		(479	)
Changes in operating assets and liabilities:
Accounts receivable		(696	)		(1,949	)
Inventories		(1,068	)		169
Other assets		(293	)		(709	)
Accounts payable and accrued expenses		(2,838	)		(1,879	)
Income taxes payable		3,636			(3,276	)


Net cash provided by operating activities		13,851			11,241


Investing activities:
(Purchase) settlement of held-to-maturity marketable securities, net		(14,258	)		19,836
Purchase of property, equipment, improvements and certain other identifiable intangible assets		(1,055	)		(772	)
Acquisitions, net of cash acquired		—			(53,665	)


Net cash used in investing activities		(15,313	)		(34,601	)


Financing activities:
Borrowing from short-term loans, net of payments		—			5,000
Payments on line of credit		—			(1,250	)
Payments on capital lease obligations		(372	)		(38	)
Proceeds from exercise of stock options		2,931			5,415
Tax benefit related to the exercise of stock options		485			—
Proceeds from employee stock purchase plan transactions		555			576


Net cash provided by financing activities		3,599			9,703

Effect of exchange rate changes on cash and cash equivalents		(705	)		474

Net increase (decrease) in cash and cash equivalents		1,432			(13,183	)
Cash and cash equivalents, beginning of period		12,990			19,528

Cash and cash equivalents, end of period	$	14,422		$	6,345

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

DIGI INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

BASIS OF PRESENTATION OF UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AND SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The interim unaudited condensed consolidated financial statements included in this Form 10-Q have been prepared by Digi International Inc. (the Company or Digi) pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures, normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted, pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto, including the summary of significant accounting policies, presented in the Company’s 2005 Annual Report on Form 10-K as filed with the SEC.

The condensed consolidated financial statements presented herein reflect, in the opinion of management, all adjustments which consist only of normal, recurring adjustments (except for the reversal of certain income tax reserves described in Note 9) necessary for a fair statement of the condensed consolidated financial position and the condensed consolidated results of operations and cash flows for the periods presented. The condensed consolidated results of operations for any interim period are not necessarily indicative of results for the full year.

Recently Issued Accounting Pronouncements

In July, 2006 the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FIN 48”) “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109.” FIN 48 prescribes a recognition threshold and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for the Company beginning October 1, 2007. The Company is in the process of determining the effect, if any, that the adoption of FIN 48 will have on its consolidated financial statements.

2. RECLASSIFICATION OF CERTAIN IDENTIFIABLE INTANGIBLE ASSET AMORTIZATION

The Company has reclassified the amortization of identifiable intangible assets related to purchased and core technology (see Note 8) from general and administrative expenses to a separate line item within cost of sales in the accompanying Condensed Consolidated Statement of Operations for all periods presented.

3. COMPREHENSIVE INCOME

For the Company, comprehensive income is comprised of net income and foreign currency translation adjustments. Foreign currency translation adjustments are charged or credited to accumulated other comprehensive income within stockholders’ equity.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

3. COMPREHENSIVE INCOME (CONTINUED)

Comprehensive income was as follows (in thousands):


	Three months ended					Nine months ended
	June 30,					June 30,
	2006		2005			2006			2005
Net income	$	3,348	$	2,484		$	8,098		$	14,244
Foreign currency translation gain (loss), net of income tax		85		(496	)		(243	)		384

Comprehensive income	$	3,433	$	1,988		$	7,855		$	14,628
							~~~~~~~~ ~

4. NET INCOME PER COMMON SHARE

Basic net income per common share is calculated based on the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of common and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares of the Company’s stock result from dilutive common stock options and shares purchased through the employee stock purchase plan.

The following table is a reconciliation of the numerators and denominators in the net income per common share calculations (in thousands, except per common share data):


	Three months ended June 30,				Nine months ended June 30,
	2006		2005		2006		2005
Numerator:
Net income	$	3,348	$	2,484	$	8,098	$	14,244


Denominator:
Denominator for basic net income per common share — weighted average shares outstanding		23,124		22,588		22,968		22,381

Effect of dilutive securities:
Employee stock options and employee stock purchase plan		780		708		727		1,039


Denominator for diluted net income per common share — adjusted weighted average shares		23,904		23,296		23,695		23,420


Net income per common share, basic	$	0.14	$	0.11	$	0.35	$	0.64


Net income per common share, diluted	$	0.14	$	0.11	$	0.34	$	0.61

Potentially dilutive shares related to stock options to purchase 1,084,850 and 1,324,850 common shares for the three and nine month periods ended June 30, 2006, respectively, and 990,800 and 615,650 common shares for the three and nine month periods ended June 30, 2005, respectively, were not included in the computation of diluted earnings per common share because the options’ exercise prices were greater than the average market price of common shares and, therefore, their effect would be anti-dilutive.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5. STOCK-BASED COMPENSATION

Stock-based awards are granted under the terms of the Company’s Stock Option Plan (the Stock Option Plan), Non-Officer Stock Option Plan (the Non-Officer Plan) and the 2000 Omnibus Stock Plan (the Omnibus Plan) (collectively, the Plans). The Plans provide for the issuance of stock-based incentives, including incentive stock options (ISOs) and nonstatutory stock options (NSOs), to employees and others who provide services to the Company, including consultants, advisers and directors. Options granted under the Plans generally vest over a four year service period and will expire if unexercised after ten years from the date of grant.

The exercise price for ISOs and non-employee director options granted under the Stock Option Plan or the Omnibus Plan is set at the fair market value of the Company’s common stock based on the closing price on the date of grant. The exercise price for nonstatutory options granted under the Plans is set by the Compensation Committee of the Board of Directors. While the Plans expressly permit grants at less than fair market value, the Company’s practice is to only award grants at fair market value. The authority to grant options under the Plans and set other terms and conditions rests with the Compensation Committee. The Stock Option Plan and Non-Officer Plan terminate in 2006 and the Omnibus Plan terminates in 2010.

Additionally, the Company has outstanding stock options for shares of the Company’s stock under various plans assumed in connection with its prior acquisition of NetSilicon, Inc. (the Assumed Plans). Additional awards cannot be made by the Company under the Assumed Plans.

Also, the Company sponsors an Employee Stock Purchase Plan covering all domestic employees with at least 90 days of service. The Purchase Plan allows eligible participants the right to purchase common stock on a quarterly basis at the lower of 85% of the market price at the beginning or end of each three-month offering period.

Prior to October 1, 2005, the Company accounted for its stock-based awards using the intrinsic-value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25) and related interpretations, in accordance with Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (FAS No. 123). Accordingly, compensation costs for stock options granted were measured as the excess, if any, of the fair value of the Company’s common stock at the date of grant over the exercise price to acquire the common stock. Such compensation expense, if any, was amortized on a straight-line basis over the option vesting period.

Effective October 1, 2005, the Company adopted Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment” (FAS No. 123R), as amended by FASB Staff Position No. FAS 123(R)-4 (FSP FAS 123(R)-4), using the modified prospective method of application. Under this method, compensation expense is recognized both for (i) awards granted, modified or settled subsequent to September 30, 2005 and (ii) the nonvested portion of awards granted prior to October 1, 2005. Compensation expense recorded during the three and nine month periods ended June 30, 2006 includes approximately $0.2 million and $0.5 million, respectively, related to awards issued subsequent to September 30, 2005. In addition, compensation expense recorded during the three and nine month periods ended June 30, 2006 includes approximately $0.3 million and $1.2 million, respectively, related to the current vesting portion of awards issued prior to September 30, 2005.

The impact of adopting FAS No. 123R for the Company’s three and nine month period ended June 30, 2006 was an increase in compensation expense of $0.5 million ($0.3 million after tax) and $1.7 million ($1.1 million after tax), respectively, and a reduction of $0.02 and $0.05, respectively, for both basic and diluted earnings per share. The adoption of FAS No. 123R, effective October 1, 2005, is expected to incrementally increase pre-tax compensation expense by approximately $2.3 million during fiscal 2006.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5. STOCK-BASED COMPENSATION (CONTINUED)

FAS No. 123R also requires that the windfall tax benefit resulting from the tax deductibility of the increase in the value of share-based arrangements be presented as a component of cash flows from financing activities in the Condensed Consolidated Statement of Cash Flows. In periods prior to October 1, 2005, such amounts were presented as a component of cash flows from operating activities.

A summary of option activity under the Plans as of June 30, 2006 and changes during the nine months then ended is presented below (in thousands, except per common share amounts):


							Weighted Average		Weighted Average		Aggregate
	Available			Options			Exercise Price per		Contractual Term		Intrinsic
	for Grant			Outstanding			Common Share		(in years)		Value
Balances, September 30, 2005		950			4,511		$	9.98

Granted		(468	)		468			12.33
Exercised		—			(417	)		7.04
Forfeited		92			(92	)		10.15
Expired		25			(25	)		22.73


Balances, June 30, 2006		599			4,445		$	10.43		5.55	$	13,899


Exercisable at June 30, 2006					3,420		$	9.96		4.56	$	12,771

The intrinsic value of an option is the amount by which the fair value of the underlying stock exceeds its exercise price. The total intrinsic value of all options exercised during the nine month period was $1.9 million. The weighted average fair value of options granted during the nine months ended June 30, 2006 was $5.79. The weighted average fair value was determined based upon the fair value of each option on the grant date, utilizing the Black-Scholes option-pricing model and the following assumptions:


Risk free interest rate		4.28% – 4.97%
Expected option holding period		3 – 5 years
Expected volatility		50% – 60%
Weighted average volatility		55%
Expected dividend yield		0

The fair value of each option award granted during the periods presented was estimated using the Black-Scholes option valuation model that uses the assumptions noted in the table above. Expected volatilities are based on the historical volatility of our stock. We use historical data to estimate option exercise and employee termination information within the valuation model; separate groups of grantees that have similar historical exercise behaviors are considered separately for valuation purposes. The expected term of options granted is derived from the vesting period and historical information and represents the period of time that options granted are expected to be outstanding. The risk-free rate used is the zero-coupon U.S. Treasury bond rate in effect at the time of the grant whose maturity equals the expected term of the option.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5. STOCK-BASED COMPENSATION (CONTINUED)

A summary of the Company’s nonvested options as of June 30, 2006 and changes during the nine months then ended is presented below (in thousands, except per common share amounts):


				Weighted Average
				Grant Date
	Number of			Fair Value per
	Options			Common Share
Nonvested at September 30, 2005		967		$	4.81
Granted		468			5.79
Vested		(318	)		4.08
Forfeited		(92	)		5.55


Nonvested at June 30, 2006		1,025		$	5.42

The Company used historical data to estimate pre-vesting forfeiture rates. As of June 30, 2006 the total unrecognized compensation cost related to nonvested stock-based compensation arrangements net of expected forfeitures was $5.3 million and the related weighted average period over which it is expected to be recognized is approximately 2.8 years.

The Company’s pro forma net income and pro forma earnings per share for the three months and nine months ended June 30, 2005, which include pro forma net income and earning per share amounts as if the fair-value-based method of accounting had been used, are as follows (in thousands, except per common share amounts):


	Three months ended			Nine months ended
	June 30, 2005			June 30, 2005
Net income as reported	$	2,484		$	14,244
Add: Total stock-based compensation expense included in reported net income, net of related tax effects		—			37
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects		(311	)		(1,044	)

Pro forma net income	$	2,173		$	13,237


Net income per common share:
Basic — as reported	$	0.11		$	0.64
Basic — pro forma	$	0.10		$	0.59

Diluted — as reported	$	0.11		$	0.61
Diluted — pro forma	$	0.09		$	0.57

6. ACQUISITIONS

Rabbit Semiconductor Inc.

On May 26, 2005, the Company acquired Rabbit Semiconductor Inc. (Rabbit), formerly Z-World, Inc., a privately held corporation for a purchase price of $49.3 million in cash (excluding cash acquired of $0.4 million and assumption of $1.3 million of debt) in exchange for all outstanding shares of Rabbit’s common stock and outstanding stock options. The Company did not replace Rabbit’s outstanding options with Digi options.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

6. ACQUISITIONS (CONTINUED)

The transaction was accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The purchase price allocation resulted in goodwill of $30.6 million. The Company believes that the acquisition resulted in the recognition of goodwill primarily because the complementary nature of Rabbit microprocessor and microprocessor-based modules and Z-World single board computer product lines are anticipated to extend Digi’s position in the commercial grade device networking module business.

The following unaudited pro forma condensed consolidated results of operations have been prepared as if the acquisition of Rabbit had occurred as of October 1, 2004. Pro forma adjustments primarily include amortization of identifiable intangible assets and the $0.3 million charge related to acquired in-process research and development associated with the Rabbit acquisition. Had the Company acquired Rabbit as of October 1, 2004, net sales, net income and net income per share would have changed to the pro forma amounts below (in thousands, except per common share amounts):


	Three months ended June 30, 2005				Nine months ended June 30, 2005
	Pro forma		As Reported		Pro forma		As Reported
Net sales	$	34,227	$	30,208	$	107,160	$	88,989
Net income	$	1,015	$	2,484	$	11,803	$	14,244
Net income per common share, basic	$	0.04	$	0.11	$	0.53	$	0.64
Net income per common share, diluted	$	0.04	$	0.11	$	0.50	$	0.61

The unaudited pro forma condensed consolidated results of operations are not necessarily indicative of results that would have occurred had the acquisition occurred as of the beginning of fiscal 2005, nor are they necessarily indicative of the results that will be obtained in the future.

FS Forth-Systeme GmbH/Sistemas Embebidos S.A.

Effective April 1, 2005, the Company acquired FS Forth-Systeme GmbH/Sistemas Embebidos S.A. (collectively referred to as FS Forth) from Embedded Solutions AG of Germany. FS Forth is a provider of embedded modules, software and development services. The purchase price included a payment of $4.8 million in cash, with contingent consideration of up to $2.0 million payable in installments of $0.8 million on October 1, 2006 and $1.2 million on October 1, 2007 if FS Forth achieves certain future milestones.

The transaction was accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The purchase price allocation resulted in goodwill of $2.4 million. The Company believes that the FS Forth acquisition resulted in the recognition of goodwill primarily because of the anticipated extension of its commercial grade device networking module business. At the time of the acquisition, FS Forth had modules that immediately added value to the Company’s broader module product line. During the first quarter of fiscal 2006, goodwill attributable to the FS Forth acquisition was reduced by a purchase price adjustment of $0.1 million as the result of a change in certain tax liabilities, as defined in the purchase agreement.

The Company has determined that the FS Forth acquisition was not material to the consolidated results of operations or financial condition of the Company; therefore, pro forma financial information is not presented.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

7. INVENTORIES

Inventories are stated at the lower of cost or market value, with cost determined using the first-in, first-out method. Inventories consisted of the following (in thousands):


	June 30,		September 30,
	2006		2005
Raw materials	$	14,406	$	15,074
Work in process		1,051		569
Finished goods		3,633		2,884

	$	19,090	$	18,527

8. GOODWILL AND OTHER IDENTIFIABLE INTANGIBLE ASSETS

Amortized identifiable intangible assets were comprised of the following (in thousands):


	June 30, 2006							September 30, 2005
	Gross							Gross
	carrying		Accum.					carrying		Accum.
	amount		amort.			Net		amount		amort.			Net
Purchased and core technology	$	41,114	$	(30,159	)	$	10,955	$	41,086	$	(26,517	)	$	14,569
License agreements		2,440		(1,790	)		650		2,440		(1,490	)		950
Patents and trademarks		5,911		(2,597	)		3,314		5,691		(1,956	)		3,735
Customer maintenance contracts		700		(306	)		394		700		(254	)		446
Customer relationships		7,854		(2,015	)		5,839		7,803		(1,161	)		6,642

Total	$	58,019	$	(36,867	)	$	21,152	$	57,720	$	(31,378	)	$	26,342

Amortization expense was $1.9 million and $1.4 million for the three months ended June 30, 2006 and 2005, respectively, and $5.5 million and $4.2 million for the nine months ended June 30, 2006 and 2005, respectively.

Estimated amortization expense related to identifiable intangible assets for the remainder of fiscal 2006 and the five succeeding fiscal years is as follows (in thousands):


2006 (three months)	$	1,780
2007		5,870
2008		4,021
2009		2,741
2010		2,605
2011		2,268

The changes in the carrying amount of goodwill were as follows (in thousands):


	Nine months ended June 30,
	2006			2005
Beginning balance, October 1	$	38,675		$	5,816

Acquisition of Rabbit		—			32,517
Acquisition of FS Forth		—			2,365
Purchase price adjustment — FS Forth		(147	)		—
Foreign currency translation adjustment		84			(156	)


Ending balance, June 30	$	38,612		$	40,542

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

8. GOODWILL AND OTHER IDENTIFIABLE INTANGIBLE ASSETS (CONTINUED)

The purchase price of FS Forth, acquired in fiscal year 2005, was reduced as a result of a change in certain tax liabilities, as defined in the purchase agreement. Contingent consideration of up to $2.0 million may be payable to FS Forth based upon the achievement of certain future milestones (see Note 6).

9. INCOME TAXES

In the third quarter of fiscal 2006, the Company received tax refunds of $0.3 million related to final determination of prior year uncertainties and recorded other tax benefits primarily relating to a prior period research and development credit totaling $0.3 million. These items aggregating $0.6 million are accounted for as a discrete event in the third quarter of fiscal 2006.

In the first quarter of fiscal 2005, the Internal Revenue Service (IRS) completed an audit of certain of the Company’s prior fiscal years income tax returns, subject to final approval by the Congressional Joint Committee on Taxation. As a result of a settlement agreement associated with this audit, the Company paid $3.2 million to the IRS in the first quarter of fiscal 2005 resulting in a reduction to its income taxes payable liability. In February 2005, the Congressional Joint Committee on Taxation approved the settlement with the IRS. The Company had tax reserves recorded in excess of the ultimate settlement amount, which resulted in the reversal of $5.7 million of excess income tax reserves during the second quarter of fiscal 2005. This reversal was accounted for as a discrete event in the second quarter of fiscal 2005.

10. FINANCIAL GUARANTEES

The Company, in general, warrants its products to be free from defects in material and workmanship under normal use and service for a period of up to five years from the date of receipt. The Company has the option to repair or replace products it deems defective with regard to material or workmanship. Estimated warranty costs are accrued in the period that the related revenue is recognized based upon an estimated average per unit repair or replacement cost applied to the estimated number of units under warranty. These estimates are based upon historical warranty incidence and are evaluated on an ongoing basis to ensure the adequacy of the warranty reserve. The following table summarizes the activity associated with the product warranty accrual (in thousands):


	Three months ended June 30,
	Balance at		Warranties		Settlements			Balance at
	March 31		issued		made			June 30
2006	$	1,050	$	160	$	(128	)	$	1,082
2005	$	900	$	274	$	(126	)	$	1,048


	Nine months ended June 30,
	Balance at		Warranties			Settlements		Balance at
	October 1		issued			made		June 30
2006	$	1,187	$	268	(1)	$	(373)	$	1,082
2005	$	855	$	610		$	(417)	$	1,048


(1)		Warranties issued includes a decrease in estimate adjustment of $117,000 in the first quarter of fiscal 2006.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

10. FINANCIAL GUARANTEES (CONTINUED)

The Company is not responsible and does not warrant that custom software versions created by original equipment manufacturer (OEM) customers based upon the Company’s software source code will function in a particular way, will conform to any specifications or are fit for any particular purpose and does not indemnify these customers from any third-party liability as it relates to or arises from any customization or modifications made by the OEM customer.

11. SHORT-TERM LOAN

On May 20, 2005, the Company entered into a short-term loan agreement with Wells Fargo in the amount of $21.0 million. This short-term loan was used to finance the Rabbit acquisition. Interest was based on the daily LIBOR rate plus 0.35%. The Company repaid $16.0 million as of June 30, 2005. The remaining $5.0 million was paid in full on July 15, 2005.

At the time the Company acquired Rabbit (see Note 6), Rabbit maintained a $5.0 million revolving line of credit with an outstanding balance of $1.3 million. In June 2005, the Company repaid all but $25,000 of this line of credit which was classified as a current short-term loan.

12. SEGMENT INFORMATION

Prior to the first quarter of fiscal 2006 the Company operated in two reportable segments. Effective October 1, 2005, the Company changed its organizational structure to functional reporting to eliminate redundancies in management and infrastructure. In addition, certain intellectual property that was previously utilized primarily in products that comprised the Device Networking Solutions segment has now been integrated throughout the Company’s products in order to provide more functionality and allow for ease of migration to next generation technologies for the Company’s customers. As a result of these changes in organizational structure and use of the Company’s product technology, the Chief Executive Officer, as the chief operating decision maker, now reviews and assesses financial information, operating results, and performance of the Company’s business in the aggregate. Accordingly, the Company has a single operating and reporting segment effective October 1, 2005 and has restated the previous periods ended June 30, 2005 to conform to the single reportable segment.

The Company’s revenues consist of products that are in non-embedded and embedded product groupings. Non-embedded products provide external connectivity solutions, while embedded products solutions generally incorporate networking modules or microprocessors that are smaller in size than non-embedded products and are internal to the devices being networked. The products included in the non-embedded product grouping include multi-port serial adapters, network connected products including terminal servers and non-embedded device servers, universal serial bus connected products, and cellular products. The products included in the embedded product grouping include microprocessors and development tools, embedded modules, core modules and single-board computers, and network interface cards. The following table provides revenue by product grouping (in thousands):


	Three months ended June 30,				Nine months ended June 30,
	2006		2005		2006		2005
Non-embedded	$	22,176	$	20,362	$	62,804	$	65,255
Embedded		13,684		9,846		40,812		23,734

Total Revenue	$	35,860	$	30,208	$	103,616	$	88,989

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

13. LEGAL PROCEEDINGS

On April 19, 2002, a consolidated amended class action complaint was filed in the United States District Court for the Southern District of New York asserting claims relating to the initial public offering (IPO) of NetSilicon and approximately 300 other public companies. The complaint names as defendants the Company, NetSilicon, certain of its officers and certain underwriters involved in NetSilicon’s IPO, among numerous others, and asserts, among other things, that NetSilicon’s IPO prospectus and registration statement violated federal securities laws because they contained material misrepresentations and/or omissions regarding the conduct of NetSilicon’s IPO underwriters in allocating shares in NetSilicon’s IPO to the underwriters’ customers. The Company believes that the claims against the NetSilicon defendants are without merit and has defended the litigation vigorously. Pursuant to a stipulation between the parties, the two named officers were dismissed from the lawsuit, without prejudice, on October 9, 2002.

In June 2003, the Company elected to participate in a proposed settlement agreement with the plaintiffs in this litigation. If ultimately approved by the Court, this proposed settlement would result in a dismissal, with prejudice, of all claims in the litigation against the Company and against any of the other issuer defendants who elect to participate in the proposed settlement, together with the current or former officers and directors of participating issuers who were named as individual defendants.

Consummation of the proposed settlement remains conditioned upon obtaining approval by the Court. On September 1, 2005, the Court preliminarily approved the proposed settlement and directed that notice of the terms of the proposed settlement be provided to class members. Thereafter, the Court held a fairness hearing on April 24, 2006, at which objections to the proposed settlement were heard. After the fairness hearing, the Court took under advisement whether to grant final approval to the proposed settlement.

If the proposed settlement is not consummated, the Company intends to continue to defend the litigation vigorously. The litigation process is inherently uncertain and unpredictable, however, and there can be no guarantee as to the ultimate outcome of this pending lawsuit. The Company maintains liability insurance for such matters and expects that the liability insurance will be adequate to cover any potential unfavorable outcome, less the applicable deductible amount of $250,000 per claim.

As of June 30, 2006, the Company has accrued a liability for the deductible amount of $250,000 which the Company believes reflects the amount of loss that is probable. In the event the Company has losses that exceed the limits of the liability insurance, such losses could have a material effect on the business, or consolidated results of operations or financial condition of the Company.

On April 13, 2004, the Company filed a lawsuit against Lantronix Inc. (Lantronix) alleging that certain of Lantronix’s products infringe the Company’s U.S. Patent No. 6,446,192. The Company filed the lawsuit in the U.S. District Court in Minnesota. The lawsuit sought both monetary and non-monetary relief. On May 3, 2004, Lantronix filed a lawsuit against the Company alleging that certain of the Company’s products infringe Lantronix’s U.S. Patent No. 6,571,305, in the U.S. District Court for the Central District of California. The lawsuit sought both monetary and non-monetary relief. On February 7, 2005 Lantronix and Acticon Technologies LLC filed a lawsuit against the Company alleging that certain of the Company’s products infringe U.S. Patent No. 4,972,470. The lawsuit was filed in the U.S. District Court for the Eastern District of Texas. The lawsuit sought both monetary and non-monetary relief. On May 12, 2005 Lantronix filed a lawsuit against the Company alleging that certain of the Company’s products infringe Lantronix’s U.S. Patent No. 6,881,096. The lawsuit was filed in the U.S. District Court for the Eastern District of Texas. The lawsuit sought both monetary and non-monetary relief. On May 2, 2006, Lantronix and the Company settled all pending infringement litigations between the companies. Under and subject to the terms of the agreement, the

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

13. LEGAL PROCEEDINGS (CONTINUED)

companies have cross-licensed each others’ patents, and each company will have the benefit and protection afforded by all of each others’ current and future patents for a period of six years.

In the normal course of business, the Company is subject to various claims and litigation, including patent infringement and intellectual property claims. Management of the Company expects that these various claims and litigation will not have a material adverse effect on the consolidated results of operations or financial condition of the Company.

14. SUBSEQUENT EVENTS

On July 27, 2006, the Company acquired MaxStream, Inc., a privately held corporation for a purchase price of approximately $38.5 million in cash and stock, with $19.25 million paid in cash and 1,650,919 shares paid in the Company’s stock. The transaction is being accounted for using the purchase method of accounting. Accordingly, the purchase price will be allocated to the estimated fair value of the assets acquired and the liabilities assumed. On July 26, 2006, the Company entered into a short-term loan agreement with Wells Fargo in the amount of $5.0 million to finance this acquisition. Interest is based on the daily LIBOR rate plus 0.35% (5.70% at July 31, 2006). Per the terms of the agreement, payment of the outstanding balance is due October 31, 2006; however, the Company has the option to prepay without penalty. The Company intends to repay the loan before the end of the fourth quarter of fiscal 2006.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This Form 10-Q contains certain statements that are “forward-looking statements” as that term is defined under the Private Securities Litigation Reform Act of 1995, and within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.

The words “believe,” “anticipate,” “intend,” “estimate,” “target,” “may,” “will,” “expect,” “plan,” “project,” “should,” or “continue” or the negative thereof or other expressions, which are predictions of or indicate future events and trends and which do not relate to historical matters, identify forward-looking statements. Such statements are based on information available to management as of the time of such statements and relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, perceived opportunities in the market and statements regarding the Company’s mission and vision. Forward-looking statements involve known and unknown risks, uncertainties and other factors, which may cause the actual results, performance or achievements of the Company to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements. The Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

The future operating results and performance trends of the Company may be affected by a number of factors, including, without limitation, those described under “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended September 30, 2005. Those risk factors, and other risks, uncertainties and assumptions identified from time to time in the Company’s filings with the Securities and Exchange

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CRITICAL ACCOUNTING POLICIES

Commission, including without limitation, its Annual Report on Form 10-K, its quarterly reports on Form 10-Q and its registration statements, could cause the Company’s actual future results to differ from those projected in the forward-looking statements as a result of the factors set forth in the Company’s various filings with the Securities and Exchange Commission and of changes in general economic conditions, changes in interest rates and/or exchange rates and changes in the assumptions used in making such forward-looking statements.

A description of the Company’s critical accounting policies was provided in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Company’s Annual Report on Form 10-K for the year ended September 30, 2005. Effective October 1, 2005 the Company adopted Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment” (FAS No. 123R), as amended by FSP FAS 123(R)-4, using the modified prospective method of application (see Note 5 to Condensed Consolidated Financial Statements).

OVERVIEW

Digi operates in the communications technology industry, which is characterized by rapid technological advances and evolving industry standards. The market can be significantly affected by new product introductions and marketing activities of industry participants. Digi places a high priority on development of innovative products that provide differentiated features and functions and allow for ease of integration with customers’ applications that improve customers’ time to market. The Company competes for customers on the basis of product performance, support, quality, product features, company reputation, customer and channel relationships, price and availability.

The Company intends to continue to extend its current product lines with next generation commercial grade device networking products and technologies targeted for selected vertical markets, including but not limited to point of sale, industrial automation, office automation, medical, and building controls. The Company believes that there is a market trend of device networking in vertical commercial applications that will require communications intelligence or connectivity to the network or the internet. These devices will be used for basic data communications, management, monitoring and control, and maintenance. The Company believes that it is well positioned to leverage its current products and technologies to take advantage of this market trend.

During the third quarter of fiscal 2006, the Company made good progress with new product releases and telecommunications carrier certifications, and is continuing its growth from cellular products, ConnectPort Display, and acquired product lines. The Cellular products and ConnectPort Display are included in the non-embedded product grouping, and the acquired product lines are included in the embedded product grouping (see Note 12 to Condensed Consolidated Financial Statements). The Company has maturing products, including its network interface cards and multi-port serial adapters, which are expected to decline in future periods. Net sales of network interface cards decreased from 9.8% of total net sales for the three months ended June 30, 2005, to 1.8% of total net sales for the three months ended June 30, 2006. Net sales from network interface cards, included in the embedded products grouping, are expected to decline to approximately 1% or less of total quarterly net sales beginning with the fourth quarter of fiscal 2006. Multi-port serial adapters’ net sales, included in the non-embedded products grouping, are anticipated to continue a general trend of flattening to slow decline over future quarters.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW (CONTINUED)

For the three and nine months ended June 30, 2006:

• Net sales of $35.9 million, for the three months ended June 30, 2006, represented an increase of $5.7 million, or 18.7%, compared to net sales of $30.2 million for the three months ended June 30, 2005. Net sales of $103.6 million, for the nine months ended June 30, 2006, represented an increase of $14.6 million, or 16.4%, compared to net sales of $89.0 million for the nine months ended June 30, 2005.

• Gross profit margin decreased to 54.3% compared to 57.1% for the three months ended June 30, 2006 and 2005, respectively. Gross profit margin decreased to 54.0% compared to 57.8% for the nine months ended June 30, 2006 and 2005, respectively. Amortization of purchased and core technology identifiable intangible assets of $1.2 million and $0.9 million, or 3.3% and 3.2%, for the three months ended June 30, 2006 and 2005, respectively, and $3.5 million and $3.0 million for the nine months ended June 30, 2006 and 2005, respectively, or 3.4% for each of the nine months ended June 30, 2006 and 2005,has been reclassified from general and administrative expenses to a separate line item within cost of sales for all periods presented (see Note 2 to the Condensed Consolidated Financial Statements).

• Total operating expenses for the three months ended June 30, 2006 were $15.7 million compared to $13.6 million for the three months ended June 30, 2005, an increase of $2.1 million. Total operating expenses for the nine months ended June 30, 2006 were $46.1 million compared to $39.5 million for the nine months ended June 30, 2005, an increase of $6.6 million. As a result of adopting FAS No. 123R, stock-based compensation of $0.6 million and $1.7 million was recorded in operating expenses for the three and nine months ended June 30, 2006. Because FAS No. 123R was adopted prospectively, there were no charges for stock-based compensation for the three and nine months ended June 30, 2005.

Net income increased $0.8 million to $3.3 million, or $0.14 per diluted share, for the three months ended June 30, 2006, compared to $2.5 million, or $0.11 per diluted share, for the three months ended June 30, 2005. Net income decreased $6.1 million to $8.1 million, or $0.34 per diluted share, for the nine months ended June 30, 2006, compared to $14.2 million, or $0.61 per diluted share, for the nine months ended June 30, 2005. Stock-based compensation expense reduced earnings per diluted share by $0.02 and $0.05 for the three and nine months ended June 30, 2006, respectively. As a result of a settlement with the IRS in February of 2005, the Company recorded a reversal of $5.7 million of excess income tax reserves during the second quarter of fiscal 2005. This reversal was accounted for as a discrete event and resulted in an income tax benefit of $5.7 million and an increase in diluted earnings per share of $0.24 for the nine months ended June 30, 2005.

• The Company’s net working capital position (total current assets less total current liabilities) increased $17.3 million to $87.3 million during the nine months ended June 30, 2006 and its current ratio was 4.9 to 1 as of that date. Cash and cash equivalents and marketable securities increased $15.7 million to $65.9 million during the period. At June 30, 2006, the Company had no debt other than capital lease obligations.

• FS Forth and Rabbit were acquired on April 1, 2005 and May 26, 2005, respectively for a combined purchase price of $53.7 million (before cash acquired of $0.4 million). For further information on these acquisitions, see Note 6, “Acquisitions” in the accompanying notes to the consolidated financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CONSOLIDATED RESULTS OF OPERATIONS

The following table sets forth selected information derived from the Company’s interim condensed consolidated statements of operations expressed in dollars and as a percentage of net sales for the periods indicated (dollars in thousands):


	Three months ended June 30,								Nine months ended June 30,
	2006 (1)(2)				2005 (2)				2006(1)(2)				2005 (2)
Net sales	$	35,860	100.0	%	$	30,208	100.0	%	$	103,616	100.0	%	$	88,989		100.0	%
Cost of sales (exclusive of amortization of purchased and core technology shown separately below) (1)		15,222	42.4			12,003	39.7			44,126	42.6			34,489		38.8
Amortization of purchased and core technology (2)		1,171	3.3			947	3.2			3,507	3.4			3,027		3.4

Gross profit		19,467	54.3			17,258	57.1			55,983	54.0			51,473		57.8
Operating expenses:
Sales and marketing (1)		7,277	20.3			6,446	21.3			20,830	20.1			19,300		21.6
Research and development (1)		5,402	15.1			3,778	12.5			15,227	14.7			11,850		13.3
General and administrative (1)(2)		3,037	8.4			3,051	10.1			10,084	9.7			8,043		9.1
Acquired in-process research and development		—	0.0			300	1.0			—	0.0			300		0.3

Total operating expenses		15,716	43.8			13,575	44.9			46,141	44.5			39,493		44.3

Operating income		3,751	10.5			3,683	12.2			9,842	9.5			11,980		13.5
Interest income and other, net		575	1.6			306	1.0			1,461	1.4			809		0.9

Income before income taxes		4,326	12.1			3,989	13.2			11,303	10.9			12,789		14.4
Income tax provision (benefit)		978	2.8			1,505	5.0			3,205	3.1			(1,455	)	(1.6	)

Net income	$	3,348	9.3	%	$	2,484	8.2	%	$	8,098	7.8	%	$	14,244		16.0	%


(1)		As a result of adopting FAS No. 123R as of October 1, 2005 on a modified prospective basis, stock-based compensation expense (pre-tax) is included in the consolidated results of operations for the three and nine months ended June 30, 2006 as follows (in thousands):


	Three months ended		Nine months ended
	June 30, 2006		June 30, 2006
Cost of sales	$	22	$	65
Sales and marketing		185		504
Research and development		132		401
General and administrative		240		772

Totals	$	579	$	1,742

(2)

Amortization of purchased and core technology has been reclassified from general and administrative expenses to a separate line item within cost of sales for all periods presented.

NET SALES

Net sales for the three and nine months ended June 30, 2006 were $35.9 million and $103.6 million compared to net sales of $30.2 million and $89.0 million for the three and nine months ended June 30, 2005, or an increase of 18.7% and 16.4%, respectively.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

NET SALES (CONTINUED)

Net sales of the Company’s device server, core modules and single board computers, terminal server, USB, chips and software, and cellular product lines increased $8.8 million and $27.5 million, or 45.1% and 52.4%, in the three and nine months ended June 30, 2006 compared to the three and nine months ended June 30, 2005. Net sales attributable to the asynchronous, synchronous, remote access server (RAS), and integrated services digital network (ISDN) products decreased $3.1 million and $12.9 million, or 28.6% and 35.2% for the three and nine months ended June 30, 2006, compared to the same periods one year ago. Network interface cards made up 1.8% and 3.1% of total net sales for the three and nine months ended June 30, 2006 compared to 9.8% and 13.0% for the three and nine months ended June 30, 2005. Net sales from network interface cards are expected to decline to approximately 1% or less of total quarterly net sales beginning with the fourth quarter of fiscal 2006. Multi-port serial adapters’ net sales are anticipated to continue a general trend of flattening to slow decline over future quarters.

Embedded products net sales increased $3.8 million and $17.1 million for the three and nine months ended June 30, 2006 compared to the three and nine months ended June 30, 2005, primarily due to increases in embedded device server products, chips and software, and incremental sales attributable to acquired products, partially offset by the continued decline of the network interface cards. Non-embedded products net sales increased $1.8 million compared to the three months ended June 30, 2005 primarily due to increases in the Company’s terminal server and cellular products. Non-embedded products net sales decreased $2.5 million compared to the nine months ended June 30, 2005 primarily due to the continued decline of the multi-port serial adapters, partially offset by the increase in terminal server and cellular products net sales.

Fluctuation in foreign currency rates, included in the product line net sales above, compared to the same periods one year ago had a favorable impact on net sales of $0.1 million in the three month period ended June 30, 2006 and an unfavorable impact on net sales of $0.9 million in the nine month period ended June 30, 2006.

GROSS PROFIT

The Company reclassified amortization expense related to purchased and core technology from general and administrative expense to a separate line item within cost of sales for all periods presented (see Note 2 to Condensed Consolidated Financial Statements). Amortization of intangible assets related to purchased and core technology represented 3.3% and 3.2% of net sales for the three month periods ended June 30, 2006 and 2005, respectively, and 3.4% of net sales for each of the nine month periods ended June 30, 2006 and 2005.

Gross profit margin for the three and nine months ended June 30, 2006 was 54.3% and 54.0% compared to 57.1% and 57.8% for the three and nine months ended June 30, 2005, including the reclassification of amortization of purchased and core technology described above. The decrease in gross profit margin was due primarily to fluctuations in customer and product mix of 1.1% and 1.7%, the impact of Rabbit product sales which carry a lower gross profit margin of 1.1% and 1.7%, and higher manufacturing expenses of 0.5% and 0.4%. Amortization of purchased and core technology had a 0.1% unfavorable impact on gross profit margin for the three months ended June 30, 2006 compared to the three months ended June 30, 2005, and represented the same percentage of net sales for both the nine month periods ended June 30, 2006 and 2005.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)

GROSS PROFIT (CONTINUED)

We expect that our gross profit margin will be approximately 51.5% to 56.5% over the next several years. Gross profit margin includes the amortization of purchased and core technology as a component of cost of sales, which we anticipate to be approximately 3.5%. Since we have certain mature products with higher gross margins that are declining in sales volume, and new products, such as our embedded modules that currently carry lower gross profit margins and are increasing in sales volume, we anticipate that our gross profit margin will be slightly less than our historical gross profit margin as a result of the product mix change and the position within their respective product life cycles.

OPERATING EXPENSES

Sales and marketing expenses for the three months ended June 30, 2006 were $7.3 million, or 20.3% of net sales, compared to $6.4 million, or 21.3% of net sales, for the three months ended June 30, 2005. The net increase of sales and marketing expense for the three months ended June 30, 2006 compared to 2005 is primarily due to $0.5 million in increased ongoing expenses as a result of the Rabbit acquisition in the third quarter of 2005 and $0.2 million in stock-based compensation expense. Sales and marketing expenses for the nine months ended June 30, 2006 were $20.9 million, or 20.1% of net sales, compared to $19.3 million, or 21.6% of net sales, for the nine months ended June 30, 2005. The net increase in sales and marketing expenses for the nine months ended June 30, 2006 compared to 2005 is primarily due to an increase of $2.4 million in ongoing expenses as a result of the acquisitions of Rabbit and FS Forth in the third quarter of fiscal 2005 and stock-based compensation expense of $0.5 million in fiscal 2006, partially offset by a decrease of $1.2 million in sales and marketing compensation related expenses.

Research and development expenses for the three months ended June 30, 2006 were $5.4 million, or 15.1% of net sales, compared to $3.8 million, or 12.5% of net sales, for the three months ended June 30, 2005. The net increase in research and development expenses for the three months ended June 30, 2006 over 2005 is primarily due to $0.8 million of increased ongoing expenses related to the Rabbit acquisition, $0.1 million in stock-based compensation in the third quarter of 2006, and a net increase of $0.5 million in variable compensation related expenses. Research and development expenses for the nine months ended June 30, 2006 were $15.2 million, or 14.7% of net sales, compared to $11.9 million, or 13.3% of net sales, for the nine months ended June 30, 2005. The net increase in research and development expenses is primarily due to $3.7 million of increased ongoing expenses as a result of the acquisitions made by the Company in the third quarter of fiscal 2005 and $0.4 million of stock-based compensation expense in fiscal 2006. The Company realized savings of $1.0 million in research and development expenses compared to the same quarter of the prior year primarily related to the network interface card products and certain chip development projects.

General and administrative expenses were $3.0 million, or 8.4% of net sales, for the three months ended June 30, 2006 compared to $3.1 million, or 10.1% of net sales, for the three months ended June 30, 2005. The net increase in general and administrative expense for the three months ended June 30, 2006 compared to 2005 is primarily due to $0.2 million related to the additional ongoing expenses of the Rabbit acquisition in 2005, $0.2 million in stock-based compensation expense in 2006 offset by a $0.3 million reduction in professional fees. General

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)

OPERATING EXPENSES (CONTINUED)

and administrative expenses were $10.1 million, or 9.7% of net sales, for the nine months ended June 30, 2006 compared to $8.0 million, or 9.1% of net sales, for the nine months ended June 30, 2005. The net increase in general and administrative expenses was due primarily to $0.8 million in increased ongoing expenses as a result of the Rabbit and FS Forth acquisitions in 2005, $0.8 million of stock-based compensation in fiscal 2006 and a $0.7 million increase in professional fees. Intangibles amortization associated with acquisitions resulted in a net increase of $0.7 million (excluding amortization of purchased and core technology, which is shown as a separate line item within cost of sales). This was offset by decreases of $0.4 million of compensation related expenses and $0.5 million of various other general and administrative expenses.

INTEREST INCOME AND OTHER, NET

Interest income and other, net was $0.6 million for the three months ended June 30, 2006 compared to $0.3 million for the three months ended June 30, 2005. The Company realized interest income on marketable securities and cash equivalents of $0.7 million and $0.5 million for the three months ended June 30, 2006, and 2005, respectively. This increase in interest income is primarily due to the increase in the average interest rates of 4.6% for the three months ended June 30, 2006 from 2.7% for the three months ended June 30, 2005. The average invested balance for the three months ended June 30, 2006 and 2005 was $61.3 million and $60.8 million, respectively.

Interest income and other, net was $1.5 million for the nine months ended June 30, 2006 compared to $0.8 million for the nine months ended June 30, 2005. The Company realized interest income at higher average interest rates of 4.1% for the nine months ended June 30, 2006 from 2.3% for the nine months ended June 30, 2005. In the fiscal 2006 period, the average cash and marketable securities balances decreased to $53.3 million compared to the fiscal 2005 period which was $72.7 million. Other expense remained relatively flat between periods.

INCOME TAXES

Income taxes have been provided for at an effective rate of 22.6% and 28.4% for the three and nine month periods ended June 30, 2006, respectively, compared to an effective rate of 37.7% and (11.4%) for the three and nine month periods ended June 30, 2005, respectively. In the third quarter of fiscal 2006, the Company received tax refunds of $0.3 million related to final determination of prior year uncertainties and recorded other tax benefits primarily relating to a prior period research and development credit totaling $0.3 million. These items aggregating $0.6 million are accounted for as a discrete event in the third quarter of fiscal 2006.

In February 2005, the Congressional Joint Committee on Taxation approved a settlement with the Internal Revenue Service on an audit of certain of the Company’s prior fiscal years income tax returns. The Company had established tax reserves in excess of the ultimate settled amounts. As a result, the Company reversed $5.7 million of excess income tax reserves during the second quarter of fiscal 2005. This reversal was accounted for as a discrete event and resulted in an income tax benefit during the second fiscal quarter of 2005 of $5.7 million.

The effective tax rates for both the first nine months of fiscal 2006 and 2005 are lower than the U.S. statutory rate of 35.0% due to the utilization of income tax credits and exclusion of extraterritorial income in both periods presented. The effective tax rate for the first nine months of fiscal 2005 is also lower than the statutory rate as a result of the tax benefit associated with the favorable tax settlement described above. The effective tax rate of 28.4% for the first nine months of fiscal 2006 is higher than the effective tax rate for the first nine months of

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)

INCOME TAXES (CONTINUED)

fiscal 2005 of (11.4%) primarily due to the $5.7 million tax benefit associated with the favorable tax settlement in the third quarter of fiscal 2005. Tax refunds related to final determination of prior year uncertainties and other tax benefits totaling $0.6 million which were accounted for as a discrete event in the third quarter of fiscal 2006 contributed to the reduction in the effective rate below the statutory rate.

LIQUIDITY AND CAPITAL RESOURCES

The Company has financed its operations principally with funds generated from operations. At June 30, 2006, the Company had cash, cash equivalents and marketable securities totaling $65.9 million compared to $50.2 million at September 30, 2005. The Company’s working capital increased $17.3 million to $87.3 million at June 30, 2006 compared to $70.0 million at September 30, 2005.

Net cash provided by operating activities was $13.8 million for the nine months ended June 30, 2006 compared to $11.2 million for the nine months ended June 30, 2005. The increase in net cash provided by operating activities of $2.6 million between comparable nine month periods ended June 30, 2006 and 2005 is primarily the result of a payment of $3.2 million to the IRS in November of 2004 as part of the settlement agreement related to the review of prior fiscal years.

Net cash used in investing activities was $15.3 million during the nine months ended June 30, 2006 compared to net cash used by investing activities of $34.6 million during the same period in the prior fiscal year. Net purchases of marketable securities were $14.3 million during the nine months ended June 30, 2006 compared to net settlements of marketable securities of $19.8 million during the same period one year ago. Purchases of property, equipment, improvements and certain other intangible assets were $1.0 million and $0.8 million for the nine months ended June 30, 2006 and 2005, respectively. During the nine months ended June 30, 2005, the Company paid $48.9 million for the acquisition of Rabbit and $4.8 million for the acquisition of FS Forth.

The Company anticipates total fiscal 2006 capital expenditures to approximate $1.9 million.

The Company generated $3.6 million from financing activities during the nine months ended June 30, 2006 compared to $9.7 million during the same period a year ago. The source of cash is primarily the result of proceeds from stock option and employee stock purchase plan transactions in both periods, and the reflection of cash provided by the adjustment for tax benefits related to the exercise of stock options as a financing activity in fiscal 2006. In addition, there were capital lease payments during 2006 of $0.4 million and an insignificant amount of payments in 2005. During the third quarter of fiscal 2005, the Company entered into a $21.0 million short-term loan of which $16.0 million was repaid during the same quarter resulting in net borrowings of $5.0 million in the nine months ended June 20, 2005 (see Note 11 to the Company’s Condensed Consolidated Financial Statements). The Company determined that it was more economical to borrow funds to finance the Rabbit acquisition than to liquidate marketable securities prior to their scheduled maturities. The Company acquired $1.3 million of revolving line of credit debt as part of the Rabbit acquisition of which $25,000 was outstanding at June 30, 2005 (see Note 11 to the Company’s Condensed Consolidated Financial Statements).

On July 26, 2006, the Company entered into a short-term loan agreement in the amount of $5.0 million to finance the July 27, 2006 acquisition of MaxStream, Inc. For further information see Note 14, “Subsequent Events” in the accompanying notes to the consolidated financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)

LIQUIDITY AND CAPITAL RESOURCES (CONTINUED)

The Company’s management believes that current financial resources, cash generated from operations and the Company’s potential capacity for additional debt and/or equity financing will be sufficient to fund current and future business operations.

As of June 30, 2006, the Company had contingent purchase price obligations outstanding of $2.0 million related to the acquisition of FS Forth (see Note 6 to the Company’s Condensed Consolidated Financial Statements).

The following summarizes the Company’s contractual obligations at June 30, 2006 (in thousands):


	Payments due by fiscal period
			Less than
	Total		1 year		1-3 years		3-5 years		Thereafter

Operating leases	$	6,505	$	2,151	$	2,178	$	1,085	$	1,091
Capital leases		1,494		526		808		160		—

Total contractual cash obligations	$	7,999	$	2,677	$	2,986	$	1,245	$	1,091

The lease obligations summarized above relate to various operating lease agreements for office space and equipment. The capital leases summarized above are for manufacturing equipment at Rabbit. The table above excludes up to $2.0 million of additional contingent purchase price payments related to the FS Forth acquisition (see Note 6 to the Company’s Condensed Consolidated Financial Statements).

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Digi International (DGII) 8-KOther Events