UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2012

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

For the transition period from to

Commission file number 001-33170

NETLIST, INC.

(Exact name of registrant as specified in its charter)

Delaware		95-4812784
State or other jurisdiction of incorporation or organization		(I.R.S. Employer Identification No.)

51 Discovery, Suite 150

Irvine, CA 92618

(Address of principal executive offices) (Zip Code)

(949) 435-0025

(Registrant’s telephone number, including area code)

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

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

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

Large accelerated filer o		Accelerated filer o

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

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

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

Common Stock, par value $0.001 per share

28,417,974 shares outstanding at July 30, 2012

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NETLIST, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands, except par value)

	(unaudited)			(audited)
	June 30,			December 31,
	2012			2011

ASSETS
Current assets:
Cash and cash equivalents	$	11,299		$	10,535
Accounts receivable, net	8,094			11,399
Inventories	9,643			6,057
Prepaid expenses and other current assets	1,432			806
Total current assets	30,468			28,797

Property and equipment, net	3,306			2,771
Long-term investments in marketable securities	445			444
Other assets	130			161
Total assets	$	34,349		$	32,173

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	7,317		$	6,155
Accrued payroll and related liabilities	1,305			1,813
Accrued expenses and other current liabilities	1,285			460
Accrued engineering charges	490			450
Current portion of long-term debt	908			2,144
Total current liabilities	11,305			11,022
Long-term debt, net of current portion	2,825			1,118
Other liabilities	88			94
Total liabilities	14,218			12,234
Commitments and contingencies
Stockholders’ equity:
Common stock, $0.001 par value - 90,000 shares authorized; 28,411 (2012) and 26,390 (2011) shares issued and outstanding	28			26
Additional paid-in capital	97,959			92,709
Accumulated deficit	(77,801		)	(72,740		)
Accumulated other comprehensive loss	(55		)	(56		)
Total stockholders’ equity	20,131			19,939
Total liabilities and stockholders’ equity	$	34,349		$	32,173

See accompanying notes.

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NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

	Three Months Ended						Six Months Ended
	June 30,			July 2,			June 30,			July 2,
	2012			2011			2012			2011

Net sales	$	10,552		$	16,001		$	24,519		$	28,001
Cost of sales(1)	7,814			11,064			16,345			19,260
Gross profit	2,738			4,937			8,174			8,741
Operating expenses:
Research and development(1)	3,770			3,755			7,612			7,439
Selling, general and administrative(1)	2,871			2,583			5,480			5,500
Total operating expenses	6,641			6,338			13,092			12,939
Operating loss	(3,903		)	(1,401		)	(4,918		)	(4,198		)
Other income (expense):
Interest expense, net	(79		)	(50		)	(150		)	(75		)
Other income (expense), net	3			(59		)	8			(59		)
Total other expense, net	(76		)	(109		)	(142		)	(134		)
Loss before provision for income taxes	(3,979		)	(1,510		)	(5,060		)	(4,332		)
Provision for income taxes	1			1			1			1
Net loss	$	(3,980	)	$	(1,511	)	$	(5,061	)	$	(4,333	)
Net loss per common share:
Basic and diluted	$	(0.14	)	$	(0.06	)	$	(0.18	)	$	(0.17	)

Weighted-average common shares outstanding:
Basic and diluted	28,111			24,988			27,420			24,935

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

Cost of sales	$	42	$	18	$	77	$	31
Research and development	153		146		345		288
Selling, general and administrative	287		242		583		440

See accompanying notes.

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NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Comprehensive Loss

(in thousands)

	Three Months Ended						Six Months Ended
	June 30,			July 2,			June 30,			July 2,
	2012			2011			2012			2011

Net loss	$	(3,980	)	$	(1,511	)	$	(5,061	)	$	(4,333	)
Other comprehensive loss:
Unrealized loss transferred from other comprehensive loss to earnings	—			59			—			59
Net unrealized gain (loss) on investments in marketable securities, net of tax	(6		)	(1		)	1			7
Total comprehensive loss	$	(3,986	)	$	(1,453	)	$	(5,060	)	$	(4,267	)

See accompanying notes.

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NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

	Six Months Ended
	June 30,			July 2,
	2012			2011

Cash flows from operating activities:
Net loss	$	(5,061	)	$	(4,333	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	1,070			1,183
Stock-based compensation	1,005			759
Realized loss on sale of investments in marketable securities	—			59
Changes in operating assets and liabilities:
Accounts receivable	3,305			(2,885		)
Inventories	(3,586		)	(6,861		)
Prepaid expenses and other current assets	354			1,046
Other assets	31			104
Accounts payable	662			5,165
Accrued payroll and related liabilities	(508		)	(279		)
Accrued expenses and other current liabilities	19			46
Accrued engineering charges	40			293
Net cash used in operating activities	(2,669		)	(5,703		)
Cash flows from investing activities:
Acquisition of property and equipment	(1,089		)	(244		)
Proceeds from maturities and sales of investments in marketable securities	—			1,266
Net cash (used in) provided by investing activities	(1,089		)	1,022
Cash flows from financing activities:
Borrowings on line of credit	—			500
Payments on line of credit	—			(500		)
Proceeds of bank term loan, net of issuance costs	1,320			2,934
Payments on debt	(1,045		)	(767		)
Proceeds from public offering, net	3,618			—
Proceeds from exercise of equity awards, net of taxes remitted for restricted stock	629			(6		)
Net cash provided by financing activities	4,522			2,161
Increase (decrease) in cash and cash equivalents	764			(2,520		)
Cash and cash equivalents at beginning of period	10,535			14,210
Cash and cash equivalents at end of period	$	11,299		$	11,690

See accompanying notes.

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NETLIST, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

Note 1—Description of Business

Netlist, Inc. (the “Company”, “Netlist”or “our”) designs and manufactures a wide variety of high performance, logic-based memory subsystems for the global datacenter and high-performance computing and communications markets. The Company’s memory subsystems consist of combinations of dynamic random access memory integrated circuits (“DRAM ICs” or “DRAM”), NAND flash memory (“NAND”), application-specific integrated circuits (“ASICs”) and other components assembled on printed circuit boards (“PCBs”). Netlist primarily markets and sells its products to leading original equipment manufacturer (“OEM”) customers. The Company’s solutions are targeted at applications where memory plays a key role in meeting system performance requirements. The Company leverages a portfolio of proprietary technologies and design techniques, including efficient planar design, alternative packaging techniques and custom semiconductor logic, to deliver memory subsystems with high memory density, small form factor, high signal integrity, attractive thermal characteristics, reduced power consumption and low cost per bit.

Note 2—Summary of Significant Accounting Policies

Basis of Presentation

The interim unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (the “U.S.”) for interim financial information and with the instructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 8 of SEC Regulation S-X. These condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the U.S. for complete financial statements. Therefore, these unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto for the year ended December 31, 2011, included in the Company’s Annual Report on Form 10-K filed with the SEC on February 28, 2012.

The condensed consolidated financial statements included herein as of June 30, 2012 are unaudited; however, they contain all normal recurring accruals and adjustments that, in the opinion of the Company’s management, are necessary to present fairly the condensed consolidated financial position of the Company and its wholly-owned subsidiaries as of June 30, 2012, the condensed consolidated results of its operations and comprehensive loss for the three and six months ended June 30, 2012 and July 2, 2011, and the condensed consolidated cash flows for the six months ended June 30, 2012 and July 2, 2011. The results of operations for the six months ended June 30, 2012 are not necessarily indicative of the results to be expected for the full year or any future interim periods.

Principles of Consolidation

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

Fiscal Year

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

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of net sales and expenses during the reporting period. By their nature, these estimates and assumptions are subject to an inherent degree of uncertainty. Significant estimates made by management include, among others, provisions for uncollectible receivables and sales returns, warranty liabilities, valuation of inventories, fair value of financial instruments, impairment of

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long-lived assets, stock-based compensation expense and realization of deferred tax assets. The Company bases its estimates on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. The Company reviews its estimates on an on-going basis. The actual results experienced by the Company may differ materially and adversely from its estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected.

Revenue Recognition

The Company’s revenues primarily consist of product sales of high-performance memory subsystems to OEMs. Revenues also include sales of excess component inventories to distributors and other users of memory integrated circuits (“ICs”). Such sales amounted to less than $0.1 million for each of the three and six month periods ended June 30, 2012 and July 2, 2011.

The Company recognizes revenues in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 605. Accordingly, the Company recognizes revenues when there is persuasive evidence of an arrangement, product delivery and acceptance have occurred, the sales price is fixed or determinable, and collectability of the resulting receivable is reasonably assured.

The Company generally uses customer purchase orders and/or contracts as evidence of an arrangement. Delivery occurs when goods are shipped for customers with FOB Shipping Point terms and upon receipt for customers with FOB Destination terms, at which time title and risk of loss transfer to the customer. Shipping documents are used to verify delivery and customer acceptance. The Company assesses whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund. Customers are generally allowed limited rights of return for up to 30 days, except for sales of excess component inventories, which contain no right-of-return privileges. Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. The Company offers a standard product warranty to its customers and has no other post-shipment obligations. The Company assesses collectibility based on the creditworthiness of the customer as determined by credit checks and evaluations, as well as the customer’s payment history.

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

Cash and Cash Equivalents

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

Investments in Marketable Securities

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

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

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Fair Value of Financial Instruments

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

Allowance for Doubtful Accounts

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

Concentration of Credit Risk

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

The Company invests its cash equivalents primarily in money market mutual funds. Cash equivalents are maintained with high quality institutions, the composition and maturities of which are regularly monitored by management. The Company had $4.8 million of Federal Deposit Insurance Corporation and Securities Investor Protection Corporation insured cash and cash equivalents at June 30, 2012. Investments in marketable securities are generally in high-credit quality debt instruments. Such investments are made only in instruments issued or enhanced by high-quality institutions. The Company has not incurred any credit losses related to these investments.

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

Inventories

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

Property and Equipment

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

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Impairment of Long-Lived Assets

The Company evaluates the recoverability of the carrying value of long-lived assets held and used by the Company for impairment on at least an annual basis or whenever events or changes in circumstances indicate that their carrying value may not be recoverable. When such factors and circumstances exist, the Company compares the projected undiscounted future net cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. If the carrying value is determined not to be recoverable from future operating cash flows, the asset is deemed impaired and an impairment loss is recognized to the extent the carrying value exceeds the estimated fair value of the asset. The fair value of the asset or asset group is based on market value when available, or when unavailable, on discounted expected cash flows. The Company’s management believes there is no impairment of long-lived assets as of June 30, 2012. There can be no assurance, however, that market conditions will not change or demand for the Company’s products will continue, which could result in future impairment of long-lived assets.

Warranties

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

Stock-Based Compensation

The Company accounts for equity issuances to non-employees in accordance with ASC Topic 505. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date used to determine the fair value of the equity instrument issued is the earlier of the date on which the third-party performance is complete or the date on which it is probable that performance will occur.

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

The fair value of common stock option awards to employees and directors is calculated using the Black-Scholes option pricing model. The Black-Scholes model requires subjective assumptions regarding future stock price volatility and expected time to exercise, along with assumptions about the risk-free interest rate and expected dividends, all of which affect the estimated fair values of the Company’s common stock option awards. The expected term of options granted is calculated as the average of the weighted vesting period and the contractual expiration date of the option. This calculation is based on the safe harbor method permitted by the SEC in instances where the vesting and exercise terms of options granted meet certain conditions and where limited historical exercise data is available. The expected volatility is based on the historical volatility of the Company’s common stock. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the expected term of the grant effective as of the date of the grant. The expected dividend assumption is based on the Company’s history and management’s expectation regarding dividend payouts. Compensation expense for common stock option awards with graded vesting schedules is recognized on a straight-line basis over the requisite service period for the last separately vesting portion of the award, provided that the accumulated cost recognized as of any date at least equals the value of the vested portion of the award.

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

Income Taxes

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

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

ASC Topic 740 prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under ASC Topic 740 the Company may only recognize or continue to recognize tax positions that meet a “more likely than not” threshold.

Research and Development Expenses

Research and development expenditures are expensed in the period incurred.

Collaborative Arrangement

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

The second agreement is a Collaboration Agreement (the “HP Agreement”) with Hewlett-Packard Company (“HP”). Under the HP Agreement, HP and the Company agreed to cooperate with respect to the qualification of HyperCloud™ technology for use with HP servers and to engage in certain joint marketing efforts when qualification is achieved. HP and the Company agreed to commit resources and funds in support of these activities. The HP Agreement is exclusive for a period of time. HP and the Company agreed to collaborate on the future use of HyperCloud™ load reduction and rank multiplication technologies for next generation server memory for HP.

In the fourth quarter of 2011, the Company reimbursed HP and IBM $0.1 million and $0.2 million, respectively, for the cost of certain qualification activities. The Company reimbursed HP an additional $0.5 million and $0.9 million in the quarter and six month period ended June 30, 2012, respectively. The payments are included in research and development expense in the condensed consolidated statements of operations. The Company expects to make additional payments of $0.8 million to IBM for joint HyperCloud™ marketing activities. The $0.8 million payment to IBM is included in prepaid expenses and other accrued liabilities in the June 30, 2012 unaudited condensed consolidated balance sheet, as milestones that trigger the payment were achieved in March 2012. The Company is amortizing the $0.8 million payment to be made to IBM based on actual unit shipments compared with estimated total shipments over the term of the Collaboration Agreement. The Company’s net sales will be determined after deduction of the amortization of customer allowances for marketing activities, in accordance with ASC Topic 605-50.

There can be no assurance that the efforts undertaken under either of the IBM or HP collaboration agreements will result in revenues for the Company that are sufficient to cover the cost of the qualification activities, including the payments made to HP and IBM under the collaboration agreements.

Comprehensive Loss

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

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Risks and Uncertainties

The Company has invested and expects to continue to invest a significant portion of its research and development budget into the design of ASIC devices, including the HyperCloud™ memory subsystem. This new design and the products it is incorporated into are subject to increased risks as compared to the Company’s existing products. The Company may be unable to achieve customer or market acceptance of the HyperCloud™ memory subsystem or other new products, or achieve such acceptance in a timely manner. The Company has experienced a longer qualification cycle than anticipated with its HyperCloud™ memory subsystems, and as of June 30, 2012 the product has not generated significant product margins relative to the Company’s investment in the product. The Company has entered into collaborative agreements with both HP and IBM pursuant to which these OEMs have cooperated with the Company to qualify HyperCloud™ for use in their respective products. The qualifying OEMs have engaged and continue to engage with the Company in joint marketing and further product development efforts. The Company and each of the OEMs have committed financial and other resources toward the collaboration. There can be no assurance that the efforts undertaken pursuant to either of the collaborative agreements will result in any new revenues for the Company. Further delays or any failure in marketing this product with HP, IBM or other potential customers would adversely impact the Company’s results of operations.

The Company’s operations in the People’s Republic of China (“PRC”) are subject to various political, geographical and economic risks and uncertainties inherent to conducting business in China. These include, but are not limited to, (i) potential changes in economic conditions in the region, (ii) managing a local workforce that may subject the Company to uncertainties or certain regulatory policies, (iii) changes in other policies of the Chinese governmental and regulatory agencies, and (iv) changes in the laws and policies of the U.S. government regarding the conduct of business in foreign countries, generally, or in China, in particular. Additionally, the Chinese government controls the procedures by which its local currency, the Chinese Renminbi (“RMB”), is converted into other currencies and by which dividends may be declared or capital distributed for the purpose of repatriation of earnings and investments. If restrictions in the conversion of RMB or in the repatriation of earnings and investments through dividend and capital distribution restrictions are instituted, the Company’s operations and operating results may be negatively impacted. Restricted net assets of the Company’s subsidiary in the PRC totaled $0.6 million at December 31, 2011. The liabilities of the Company’s subsidiary in the PRC exceeded its assets as of June 30, 2012.

Foreign Currency Remeasurement

The functional currency of the Company’s foreign subsidiary is the U.S. dollar. Local currency financial statements are remeasured into U.S. dollars at the exchange rate in effect as of the balance sheet date for monetary assets and liabilities and the historical exchange rate for nonmonetary assets and liabilities. Expenses are remeasured using the average exchange rate for the period, except items related to nonmonetary assets and liabilities, which are remeasured using historical exchange rates. All remeasurement gains and losses are included in determining net loss. Transaction gains and losses were not significant in the three and six months ended June 30, 2012 or July 2, 2011.

Net Loss Per Share

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

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Note 3—Supplemental Financial Information

Inventories

Inventories consist of the following (in thousands):

	June 30,		December 31,
	2012		2011

Raw materials	$	4,534	$	4,312
Work in process	1,747		237
Finished goods	3,362		1,508
	$	9,643	$	6,057

Warranty Liabilities

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

	Six Months Ended
	June 30,			July 2,
	2012			2011

Beginning balance	$	189		$	194
Estimated cost of warranty claims charged to cost of sales	100			214
Cost of actual warranty claims	(68		)	(207		)
Ending balance	221			201
Less current portion	(133		)	(100		)
Long-term warranty obligations	$	88		$	101

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

Computation of Net Loss Per Share

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

	Three Months Ended						Six Months Ended
	June 30,			July 2,			June 30,			July 2,
	2012			2011			2012			2011

Basic and diluted net loss per share:
Numerator: Net loss	$	(3,980	)	$	(1,511	)	$	(5,061	)	$	(4,333	)
Denominator: Weighted-average common shares outstanding, basic and diluted	28,111			24,988			27,420			24,935
Basic and diluted net loss per share	$	(0.14	)	$	(0.06	)	$	(0.18	)	$	(0.17	)

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

	Three Months Ended		Six Months Ended
	June 30,	July 2,	June 30,	July 2,
	2012	2011	2012	2011
Common share equivalents	694	1,530	973	1,572

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

Major Customers

The Company’s product sales have historically been concentrated in a small number of customers. The following table sets forth sales to customers comprising 10% or more of the Company’s net sales as follows:

	Three Months Ended				Six Months Ended
	June 30,		July 2,		June 30,		June 30,
	2012		2011		2012		2011
Customer:
Customer A	60	%	64	%	74	%	67	%
Customer B	18	%	*	%	*	%	*	%

The Company’s accounts receivable are concentrated with two customers at June 30, 2012 representing approximately 71% and 13% of aggregate gross receivables. At December 31, 2011, one customer represented approximately 80% of aggregate gross receivables. A significant reduction in sales to, or the inability to collect receivables from, a significant customer could have a material adverse impact on the Company. The Company mitigates risk associated with foreign receivables by purchasing comprehensive foreign credit insurance.

Cash Flow Information

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

	Six Months Ended
	June 30,			July 2,
	2012			2011

Supplemental disclosure of non-cash investing and financing activities:
Purchase of equipment not paid for at the end of the period	$	500		$	(6	)
Debt financed acquisition of assets	$	180		$	169
Change in unrealized gain (loss) from investments in marketable securities	$	(1	)	$	(66	)
Contractual marketing funds due to collaboration partners	$	800		$	—

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Note 4—Fair Value Measurements

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

			Fair Value Measurements at June 30, 2012 Using
			Quoted Prices		Significant
			in Active		Other		Significant
	Fair Value at		Markets for		Observable		Unobservable
	June 30,		Identical Assets		Inputs		Inputs
	2012		(Level 1)		(Level 2)		(Level 3)

Money market mutual funds	$	5,603	$	5,603	$	—	$	—
Auction and variable floating rate notes	445		—		—		445
Total	$	6,048	$	5,603	$	—	$	445

			Fair Value Measurements at December 31, 2011 Using
			Quoted Prices		Significant
			in Active		Other		Significant
	Fair Value at		Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2011		(Level 1)		(Level 2)		(Level 3)

Money market mutual funds	$	5,600	$	5,600	$	—	$	—
Auction and variable floating rate notes	444		—		—		444
Total	$	6,044	$	5,600	$	—	$	444

The following tables summarize the Company’s assets measured at fair value on a recurring basis as presented in the Company’s condensed consolidated balance sheets at June 30, 2012 and December 31, 2011:

			Fair Value Measurements at June 30, 2012 Using
			Quoted Prices in		Significant Other		Significant
	Fair Value at		Active Markets for		Observable		Unobservable
	June 30,		Identical Assets		Inputs		Inputs
	2012		(Level 1)		(Level 2)		(Level 3)

Cash equivalents	$	5,603	$	5,603	$	—	$	—
Long-term marketable securities	445		—		—		445
Total assets measured at fair value	$	6,048	$	5,603	$	—	$	445

			Fair Value Measurements at December 31, 2011 Using
			Quoted Prices in		Significant Other		Significant
	Fair Value at		Active Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2011		(Level 1)		(Level 2)		(Level 3)

Cash equivalents	$	5,600	$	5,600	$	—	$	—
Long-term marketable securities	444		—		—		444
Total assets measured at fair value	$	6,044	$	5,600	$	—	$	444

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

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

	Six Months Ended
	June 30,		July 2,
	2012		2011

Beginning balance	$	444	$	890
Proceeds from sales of available-for-sale marketable securities	—		(441		)
Realized loss included in other income (expense), net	—		(59		)
Unrealized loss transferred from other comprehensive loss to earnings	—		59
Unrealized income included in other comprehensive loss	1		7
Ending balance	$	445	$	456

Note 5—Investments in Marketable Securities

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

	June 30, 2012
			Net
	Amortized		Unrealized			Fair
	Cost		Loss			Value

Auction and variable floating rate notes	$	500	$	(55	)	$	445

	December 31, 2011
			Net
	Amortized		Unrealized			Fair
	Cost		Loss			Value

Auction and variable floating rate notes	$	500	$	(56	)	$	444

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

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

	June 30, 2012
	Continuous Unrealized Loss
	Less than 12 months				12 months or greater
	Fair		Unrealized		Fair		Unrealized
	Value		Loss		Value		Loss

Auction and variable floating rate notes	$	—	$	—	$	445	$	(55	)

	December 31, 2011
	Continuous Unrealized Loss
	Less than 12 months				12 months or greater
	Fair		Unrealized		Fair		Unrealized
	Value		Loss		Value		Loss

Auction and variable floating rate notes	$	—	$	—	$	444	$	(56	)

As of June 30, 2012 and December 31, 2011, the Company held one investment that was in an unrealized loss position.

Auction Rate Securities

Disruptions in the credit market continue to adversely affect the liquidity and overall market for auction rate securities. As of June 30, 2012 and December 31, 2011, the Company held one investment in a Baa1 rated auction rate debt security of a municipality with a total purchase cost of $0.5 million. An additional A3 rated debt obligation backed by pools of student loans guaranteed by the U.S. Department of Education with a total purchase cost of $0.5 million was disposed of in June 2011 for a realized loss of approximately $59,000.

The Company does not believe that the current illiquidity of its auction rate security investment will materially impact its ability to fund its working capital needs, capital expenditures or other business requirements. The Company, however, remains uncertain as to when full liquidity will return to the auction rate markets, whether other secondary markets will become available or when the underlying security may be called by the issuer. Given these and other uncertainties, the Company’s auction rate security investment has been classified as long-term in the accompanying condensed consolidated balance sheets. To estimate their fair value the Company used a discounted cash flow model based on estimated interest rates, timing and amount of cash flows, the credit quality of the underlying security, and illiquidity consideration. The Company has concluded that the estimated gross unrealized loss on this investments, which totaled approximately $55,000 and $56,000 at June 30, 2012 and December 31, 2011, respectively, is temporary because (i) the Company believes that the liquidity limitations that have occurred are due to general market conditions, (ii) the auction rate security continues to be of a high credit quality and interest is paid as due and (iii) the Company has the intent and ability to hold this investment until a recovery in the market occurs.

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Other Investments in Marketable Securities

The Company maintains an investment portfolio of various holdings, types and maturities. The Company invests in instruments that meet high quality credit standards, as specified in its investment policy guidelines. These guidelines generally limit the amount of credit exposure to any one issue, issuer or type of instrument. Excluding its auction rate security, there were no unrealized gains or losses at June 30, 3012 or December 31, 2011.

The following table presents the amortized cost and fair value of the Company’s investments in marketable securities classified as available-for-sale at June 30, 2012 by contractual maturity (in thousands):

	June 30, 2012
	Amortized		Fair
	Cost		Value

Maturity
Greater than two years*	$	500	$	445

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

Note 6—Credit Agreement

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

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

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

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

	Three Months Ended				Six Months Ended
	June 30,		July 2,		June 30,		July 2,
	2012		2011		2012		2011

Interest expense	$	25	$	—	$	48	$	2

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The following table presents details of the Company’s outstanding borrowings and availability under our line of credit (in thousands):

	June 30,		December 31,
	2012		2011
Availability under the revolving line of credit	$	5,235	$	7,797
Outstanding borrowings on the revolving line of credit	—		—
Amounts reserved under credit sublimits	—		(2,022		)
Unutilized borrowing availability under the revolving line of credit	$	5,235	$	5,775

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

All obligations under the Credit Agreement are secured by a first priority lien on the Company’s tangible and intangible assets. The Credit Agreement subjects the Company to certain affirmative and negative covenants, including financial covenants with respect to the Company’s liquidity and tangible net worth and restrictions on the payment of dividends. As of June 30, 2012, the Company was in compliance with its financial covenants.

Note 7—Long-Term Debt

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

	June 30,			December 31,
	2012			2011

Consolidated Term Loan, net of unamortized issuance cost of $36 (2012)	$	3,464		$	—
Term Loan I	—			875
Term Loan II, net of unamortized issuance cost of $38 (2011)	—			2,087
Obligations under capital leases	208			300
Note payable to others	61			—
	3,733			3,262
Less current portion	(908		)	(2,144		)
	$	2,825		$	1,118

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

	Three Months Ended				Six Months Ended
	June 30,		July 2,		June 30,		July 2,
	2012		2011		2012		2011

Interest expense	$	57	$	54	$	108	$	82

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Note 8—Income Taxes

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

	Three Months Ended						Six Months Ended
	June 30,			July 2,			June 30,			July 2,
	2012			2011			2012			2011

Provision for income taxes	$	1		$	1		$	1		$	1
Effective tax rate	—		%	(0.1		)%	—		%	—		%

The Company evaluates whether a valuation allowance should be established against its deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. Due to uncertainty of future utilization, the Company has provided a full valuation allowance as of June 30, 2012 and December 31, 2011. Accordingly, no benefit has been recognized for net deferred tax assets.

The Company had unrecognized tax benefits at June 30, 2012 and December 31, 2011 of approximately $0.02 million that, if recognized, would affect the Company’s annual effective tax rate.

Note 9—Commitments and Contingencies

Litigation and Patent Reexaminations

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

Google Litigation

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

In December 2009, the Company filed a patent infringement lawsuit against Google in the Northern District Court, seeking damages and injunctive relief based on Google’s infringement of U.S. Patent No. 7,619,912 (“the ‘912 patent”), which is related to the ‘386 patent and relates generally to rank multiplication. In February 2010, Google answered the Company’s complaint and asserted counterclaims against the Company seeking a declaration that the patent is invalid and not infringed, and claiming that the Company committed fraud, negligent misrepresentation and breach of contract based on Netlist’s activities in the JEDEC standard-setting organization. The counterclaim seeks unspecified compensatory damages. Accruals have not been recorded for loss contingencies related to Google’s counterclaim because it is not probable that a loss

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has been incurred and the amount of any such loss cannot be reasonably estimated. In October 2010, Google requested and was later granted an Inter Partes Reexamination of the ‘912 patent by the USPTO. The reexamination proceedings are described below. In connection with the reexamination request, the Northern District Court granted the Company and Google’s joint request to stay the ‘912 patent infringement lawsuit against Google until the completion of the reexamination proceedings.

Inphi Litigation

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

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

‘386 Patent Reexamination

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

‘912 Patent Reexamination

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

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‘627 Patent Reexamination

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

‘537 Patent Reexamination

As noted previously, in April 2010, Inphi requested and was later denied an Inter Partes Reexamination of the ‘537 patent by the USPTO. In June 2010, Inphi submitted a new request and was later granted an Inter Partes Reexamination of the ‘537 patent by the USPTO. In September 2010, the USPTO issued a Non-Final Action confirming the patentability of four claims. In October 2010, the Company responded by amending or canceling some of the claims, adding new claims, and making arguments as to the validity of the rejected claims in view of cited references. Inphi filed its comments on the Company’s response in January 2011. In June 2011, the USPTO issued an Action Closing Prosecution (“ACP”) which reconfirmed the patentability of the four claims. In August 2010, the Company responded by amending some of the claims and making arguments as to the validity of the rejected claims in view of cited references. Inphi filed its comments on the Company’s response in September 2011. The USPTO issued a Right of Appeal Notice (“RAN”) in February 2012, in which the claim rejections were withdrawn, thus confirming the patentability of all sixty (60) claims in view of all the previously submitted comments by both Inphi and the Company. Inphi filed a notice of appeal in March 2012.Inphi filed its appeal brief on May 8, 2012 but received a Notice of Defective Appeal Brief. Inphi filed a corrective appeal brief on May 31, 2012, and Netlist filed its responsive brief to the corrected Inphi appeal brief on July 2, 2012. The Examiner will also have an opportunity to respond to Inphi’s corrected appeal brief as well as Netlist’s responsive brief and, if the Examiner maintains his position, the Company and the USPTO examiner will jointly defend the patent in a hearing with the USPTO, in accordance with established procedures for Inter Partes Reexamination.

‘274 Patent Reexamination

As noted previously, in April 2010, Inphi requested and was later denied an Inter Partes Reexamination of the ‘274 patent by the USPTO. In June 2010, Inphi submitted a new request and was later granted an Inter Partes Reexamination of the ‘274 patent by the USPTO. In September 2011, the USPTO issued a Non-Final Action, confirming the patentability of six claims. The Company has responded by amending or canceling some of the claims, adding new claims, and making arguments as to the validity of the rejected claims in view of cited references. Inphi filed its comments on the Company’s response in November 2011. The USPTO issued an ACP in March 2012, which confirmed the patentability of one hundred and four (104) claims in view of all the previously submitted comments by both Inphi and the Company. The PTO subsequently issued a Right of Appeal Notice on June 22, 2012. This Notice triggered Inphi’s right as the losing party to file a Notice of Appeal by July 23, 2012 and file an appeal brief by September 23, 2012. The Company and the Examiner will then have an opportunity to respond to the appeal brief and, if the Examiner maintains his position, the Company and the USPTO examiner will jointly defend the patent in a hearing with the USPTO, in accordance with established procedures for Inter Partes Reexamination.

Other Contingent Obligations

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

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Note 10—Stockholders’ Equity

Common Stock

In November 2011, the Company entered into a sales agreement with Ascendiant Capital Markets LLC (“Ascendiant”), whereby shares with a total value of up to $10.0 million may be released for sale to the public at the discretion of management at a price equal to the current market price in an “at-the-market” offering as defined in Rule 415 under the Securities Act of 1933. Since November 2011, the Company has received net proceeds of approximately $5.5 million, including approximately $3.6 million raised through the sale of 1,058,336 shares in the six months ended June 30, 2012. In the six months ended June 30, 2012 the Company paid commissions to Ascendiant, in connection with these sales, of 3.5%, or approximately $132,000. The sales agreement with Ascendiant expires in November 2014.

During the six ended June 30, 2012 and July 2, 2011, the Company cancelled 13,433 and 19,730 shares of common stock, respectively, valued at approximately $48,000 and $47,000, respectively, in connection with its obligation to holders of restricted stock to withhold the number of shares required to satisfy the holders’ tax liabilities in connection with the vesting of such shares.

Stock-Based Compensation

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

Subject to certain adjustments, as of June 30, 2012, the Company was authorized to issue a maximum of 5,405,566 shares of common stock pursuant to awards under the 2006 Plan. That maximum number will automatically increase on the first day of each subsequent calendar year by the lesser of (i) 5.0% of the number of shares of common stock that are issued and outstanding as of the first day of the calendar year, and (ii) 1,200,000 shares of common stock, subject to adjustment for certain corporate actions. At June 30, 2012, the Company had 330,154 shares available for grant under the 2006 Plan. At June 30, 2012, an additional 95,000 shares were reserved for issuance upon exercise of inducement grants. Options granted under the 2000 Plan, the 2006 Plan and outside the equity incentive plans primarily vest at a rate of at least 25% per year over four years and expire 10 years from the date of grant. Restricted stock awards vest in eight equal increments at intervals of approximately six months from the date of grant.

A summary of the Company’s common stock option activity for the six months ended June 30, 2012 is presented below (shares in thousands):

	Options Outstanding
			Weighted-
			Average
	Number of		Exercise
	Shares		Price
Options outstanding at December 31, 2011	5,368		$	2.62
Options granted	1,592		3.48
Options exercised	(1,004	)	0.67
Options cancelled	(612	)	3.16
Options outstanding at June 30, 2012	5,344		$	3.21

The intrinsic value of options exercised in the six months ended June 30, 2012 was $2.6 million.

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A summary of the Company’s restricted stock awards as of and for the six months ended June 30, 2012 is presented below (shares in thousands):

	Restricted Stock Outstanding
			Weighted-
			Average
			Grant-Date
	Number of		Fair Value
	Shares		per Share
Balance outstanding at December 31, 2011	319		$	3.32
Restricted stock forfeited	(27	)	3.49
Restricted stock vested	(60	)	3.37
Balance outstanding at June 30, 2012	232		$	3.29

The following table presents details of the assumptions used to calculate the weighted-average grant date fair value of common stock options granted by the Company:

	Six Months Ended
	June 30,			July 2,
	2012			2011
Expected term (in years)	6.1			6.0
Expected volatility	126		%	136		%
Risk-free interest rate	1.12		%	2.20		%
Expected dividends	—			—
Weighted-average grant date fair value per share	$	3.10		$	2.28

The fair value per share of restricted stock grants is calculated based on the fair value of the Company’s common stock on the respective grant dates. The grant date fair value of restricted stock vested was $0.2 million and $0.1 million in the six months ended June 30, 2012 and July 2, 2011, respectively.

At June 30, 2012, the amount of unearned stock-based compensation currently estimated to be expensed from fiscal 2012 through fiscal 2015 related to unvested common stock options and restricted stock awards is approximately $5.2 million, net of estimated forfeitures. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is approximately 3.0 years. If there are any modifications or cancellations of the underlying unvested awards, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense.

Note 11—Segment and Geographic Information

The Company operates in one reportable segment: the design and manufacture of high-performance memory subsystems for the server, high-performance computing and communications markets. The Company evaluates financial performance on a Company-wide basis.

At June 30, 2012 and December 31, 2011, approximately $1.9 million and $1.5 million of the Company’s long-lived assets, net of depreciation and amortization, respectively, were located in the PRC. Substantially all other long-lived assets were located in the U.S.

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

Cautionary Statement

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Unaudited Condensed Consolidated Financial Statements and the related notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 and subsequent reports on Form 10-Q and Form 8-K.

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

Overview

We design, manufacture and sell high-performance, intelligent memory subsystems for datacenter server and high-performance computing and communications markets. Our memory subsystems consist of combinations of dynamic random access memory integrated circuits (“DRAM ICs” or “DRAM”), NAND flash memory (“NAND”), application-specific integrated circuits (“ASICs”) and other components assembled on printed circuit boards (“PCBs”). We primarily market and sell our products to leading original equipment manufacturer (“OEM”) customers. Our solutions are targeted at applications where memory plays a key role in meeting system performance requirements. We leverage a portfolio of proprietary technologies and design techniques, including efficient planar design, alternative packaging techniques and custom semiconductor logic, to deliver memory subsystems with high memory density, small form factor, high signal integrity, attractive thermal characteristics and low cost per bit. Unless the context otherwise requires, all references in this Report to “we,” “us,” “our,” “the Company,” or “Netlist” refer to Netlist, Inc. and its subsidiaries.

Our Products

Hypercloud™

In November 2009, we introduced HyperCloud™ DDR3 memory technology. HyperCloud™ utilizes an ASIC chipset that incorporates Netlist patented rank multiplication technology that increases memory capacity and load reduction technology that increases memory bandwidth. We expect that these patented technologies will make possible improved levels of performance for memory intensive datacenter applications and workloads, including enterprise virtualization, cloud computing infrastructure, business intelligence real-time data analytics, and high performance computing. In November 2011, we introduced the world’s first 32GB two-virtual rank RDIMM integrating HyperCloud™ with our proprietary Planar-X technology. The new memory modules enable up to 768GB of DRAM memory in next generation two-processor servers.

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Also in November 2011, we announced collaborative agreements with each of Hewlett-Packard Company (“HP”) and International Business Machines (“IBM”), pursuant to which these OEMs have cooperated with us in efforts to qualify HyperCloud™ memory products for use with their respective products. In February 2012 and May 2012, we achieved memory qualification of HyperCloud™ at IBM and HP, respectively. HP and IBM have engaged and continue to engage with us in joint marketing and further product development efforts. We and each of the OEMs have committed financial and other resources toward the collaboration. However, the efforts undertaken under either of the collaborative agreements may not result in significant product margins for us relative to our investment in developing and marketing this product.

NVvault™

The NVvault™ product line consists primarily of battery-free and battery-powered cache memory subsystem targeting RAID storage applications. NVvault™ battery-free provides server and storage OEMs a solution for enhanced datacenter fault recovery. The NVvault™ products have historically been sold primarily to Dell, most recently for incorporation in its PERC 7 server products. NVvault™ sales to Dell totaled $4.7 million and $15.1 million for the three and six months ended June 30, 2012. Following Intel’s launch of its Romley platform in the first quarter of 2012, we have experienced a decline in NVvault™ sales to Dell. We expect this trend to continue through 2013, after which sales of NVvault™ products for incorporation into PERC 7 servers will be minimal. In order to leverage our NVvault™ technology into a more diverse customer base, we continue to pursue additional qualifications of NVvault™ with other customers. We also introduced EXPRESSvault™in March 2011, and continue to pursue qualifications of next generation DDR3 NVvault™ with customers. However, our efforts may not result in significant revenues from the sale of NVvault™ products. While, nearly all of 2010 sales of NVvault™ were made to Dell, as a result of our diversification efforts, approximately 7% of revenues from NVvault™ for the six month periods ended June 30, 2012 and July 2, 2011, were to other customers.

Specialty Memory Modules and Flash-Based Products

The remainder of our revenues arose primarily from OEM sales of specialty memory modules and flash-based products, the majority of which were utilized in data center and industrial applications. When developing custom modules for an equipment product launch, we engage with our OEM customers from the earliest stages of new product definition, providing us unique insight into their full range of system architecture and performance requirements. This close collaboration has also allowed us to develop a significant level of systems expertise. We leverage a portfolio of proprietary technologies and design techniques, including efficient planar design, alternative packaging techniques and custom semiconductor logic, to deliver memory subsystems with high speed, capacity and signal integrity, small form factor, attractive thermal characteristics and low cost per bit. Revenues from our specialty modules and flash-based products are subject to fluctuation as a result of the life cycles of the products into which our modules are incorporated. Our ability to continue to produce revenues from specialty memory modules and flash-based products is dependent on our ability to qualify our products on new platforms as current platforms reach the end of their lifecycles, and on the state of the global economy.

Consistent with the concentrated nature of the OEM customer base in our target markets, a small number of large customers have historically accounted for a significant portion of our net sales. One customer represented approximately 74% and 67% of our net sales for the six months ended June 30, 2012 and July 2, 2011, respectively.

Key Business Metrics

The following describes certain line items in our condensed consolidated statements of operations that are important to management’s assessment of our financial performance:

Net Sales. Net sales consist primarily of sales of our high performance memory subsystems, net of a provision for estimated returns under our right of return policies, which generally range up to 30 days. We generally do not have long-term sales agreements with our customers. Although OEM customers typically provide us with non-binding forecasts of future product demand over specific periods of time, they generally place orders with us approximately two weeks in advance of scheduled delivery. Selling prices are typically negotiated monthly, based on competitive market conditions and the current price of DRAM ICs and NAND. Purchase orders generally have no cancellation or rescheduling penalty provisions. We often ship our products to our customers’ international manufacturing sites. All of our sales to date, however, are denominated in U.S. dollars. We also sell excess component inventory of DRAM ICs and NAND to distributors and other users of memory ICs. As compared to previous years, component inventory sales remain a relatively small percentage of net sales as a result of our efforts to diversify both our customer and product line bases. This diversification effort has also allowed us to use components in a wider range of memory subsystems. We expect that component inventory sales will continue to represent a minimal portion of our net sales in future periods.

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Cost of Sales. Our cost of sales includes the cost of materials, manufacturing costs, depreciation and amortization of equipment, inventory valuation provisions, stock-based compensation, and occupancy costs and other allocated fixed costs. The DRAM ICs and NAND incorporated into our products constitute a significant portion of our cost of sales, and thus our cost of sales will fluctuate based on the current price of DRAM ICs and NAND. We attempt to pass through such DRAM IC and NAND flash memory cost fluctuations to our customers by frequently renegotiating pricing prior to the placement of their purchase orders. However, the sales prices of our memory subsystems can also fluctuate due to competitive situations unrelated to the pricing of DRAM ICs and NAND, which affects gross margins. The gross margin on our sales of excess component DRAM IC and NAND inventory is much lower than the gross margin on our sales of our memory subsystems. As a result, fluctuations in DRAM IC and NAND inventory sales as a percentage of our overall sales could impact our overall gross margin. We assess the valuation of our inventories on a quarterly basis and record a provision to cost of sales as necessary to reduce inventories to the lower of cost or net realizable value.

Research and Development. Research and development expense consists primarily of employee and independent contractor compensation and related costs, stock-based compensation, non-recurring engineering fees, computer-aided design software licenses, reference design development costs, patent filing and protection legal fees, depreciation or rental of evaluation equipment, and occupancy and other allocated overhead costs. Also included in research and development expense are the costs of material and overhead related to the production of engineering samples of new products under development or products used solely in the research and development process. Our customers typically do not separately compensate us for design and engineering work involved in developing application-specific products for them. All research and development costs are expensed as incurred. We anticipate that research and development expenditures will increase in future periods as we seek to expand new product opportunities, increase our activities related to new and emerging markets and continue to develop additional proprietary technologies.

Selling, General and Administrative. Selling, general and administrative expenses consist primarily of employee salaries and related costs, stock-based compensation, independent sales representative commissions, professional services, promotional and other selling and marketing expenses, and occupancy and other allocated overhead costs. A significant portion of our selling effort is directed at building relationships with OEMs and other customers and working through the product approval and qualification process with them. Therefore, the cost of material and overhead related to products manufactured for qualification is included in selling expenses. As we continue to service existing and establish new customers, we anticipate that our sales and marketing expenses will increase.

Critical Accounting Policies

The preparation of our condensed consolidated financial statements in conformity with accounting principles generally accepted in the U.S. requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of net sales and expenses during the reporting period. By their nature, these estimates and assumptions are subject to an inherent degree of uncertainty. We base our estimates on our historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. We review our estimates on an on-going basis. Actual results may differ from these estimates, which may result in material adverse effects on our operating results and financial position. We believe the following critical accounting policies involve our more significant assumptions and estimates used in the preparation of our condensed consolidated financial statements:

Revenue Recognition. We recognize revenues in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 605. Accordingly, we recognize revenues when there is persuasive evidence that an arrangement exists, product delivery and acceptance have occurred, the sales price is fixed or determinable, and collectibility of the resulting receivable is reasonably assured.

We generally use customer purchase orders and/or contracts as evidence of an arrangement. Delivery occurs when goods are shipped for customers with FOB Shipping Point terms and upon receipt for customers with FOB Destination terms, at which time title and risk of loss transfer to the customer. Shipping documents are used to verify delivery and customer acceptance. We assess whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund. Customers are generally allowed limited rights of return for up to 30 days, except for sales of excess component inventories, which contain no right-of-return privileges. Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. We offer a standard product warranty to our customers and have no other post-shipment obligations. We assess collectibility based on the creditworthiness of the customer as determined by credit checks and evaluations, as well as the customer’s payment history.

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

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

Allowance for Doubtful Accounts. We perform credit evaluations of our customers’ financial condition and limit the amount of credit extended to our customers as deemed necessary, but generally require no collateral. We evaluate the collectibility of accounts receivable based on a combination of factors. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet its financial obligations subsequent to the original sale, we will record an allowance against amounts due, and thereby reduce the net recognized receivable to the amount that we reasonably believe will be collected. For all other customers, we record allowances for doubtful accounts based primarily on the length of time the receivables are past due based on the terms of the originating transaction, the current business environment and our historical experience. Uncollectible accounts are charged against the allowance for doubtful accounts when all cost effective commercial means of collection have been exhausted. Generally, our credit losses have been within our expectations and the provisions established. However, we cannot guarantee that we will continue to experience credit loss rates similar to those we have experienced in the past.

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

Inventories. We value our inventories at the lower of the actual cost to purchase or manufacture the inventory or the net realizable value of the inventory. Cost is determined on an average cost basis which approximates actual cost on a first-in, first-out basis and includes raw materials, labor and manufacturing overhead. At each balance sheet date, we evaluate ending inventory quantities on hand and record a provision for excess quantities and obsolescence. Among other factors, we consider historical demand and forecasted demand in relation to the inventory on hand, competitiveness of product offerings, market conditions and product life cycles when determining obsolescence and net realizable value. In addition, we consider changes in the market value of DRAM ICs and NAND in determining the net realizable value of our raw material inventory. Once established, any write downs are considered permanent adjustments to the cost basis of our excess or obsolete inventories.

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

Impairment of Long-Lived Assets. We evaluate the recoverability of the carrying value of long-lived assets held and used in our operations for impairment on at least an annual basis or whenever events or changes in circumstances indicate that their carrying value may not be recoverable. When such factors and circumstances exist, we compare the projected undiscounted future net cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. These projected future cash flows may vary significantly over time as a result of increased competition, changes in technology, fluctuations in demand, consolidation of our customers and reductions in average selling prices. If the carrying value is determined not to be recoverable from future operating cash flows, the asset is deemed impaired and an impairment loss is recognized to the extent the carrying value exceeds the estimated fair value of the asset. The fair value of the asset or asset group is based on market value when available, or when unavailable, on discounted expected cash flows.

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Warranty Reserve. We offer product warranties generally ranging from one to three years, depending on the product and negotiated terms of purchase agreements with our customers. Such warranties require us to repair or replace defective product returned to us during the warranty period at no cost to the customer. Warranties are not offered on sales of excess inventory. Our estimates for warranty-related costs are recorded at the time of sale based on historical and estimated future product return rates and expected repair or replacement costs. While such costs have historically been consistent between periods and within our expectations and the provisions established, unexpected changes in failure rates could have a material adverse impact on us, requiring additional warranty reserves, and adversely affecting our gross profit and gross margins.

Stock-Based Compensation. We account for equity issuances to non-employees in accordance with ASC Topic 505. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date used to determine the fair value of the equity instrument issued is the earlier of the date on which the third-party performance is complete or the date on which it is probable that performance will occur.

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

The fair value of common stock option awards to employees and directors is calculated using the Black-Scholes option pricing model. The Black-Scholes model requires subjective assumptions regarding future stock price volatility and expected time to exercise, along with assumptions about the risk-free interest rate and expected dividends, all of which affect the estimated fair values of our common stock option awards. The expected term of options granted is calculated as the average of the weighted vesting period and the contractual expiration date of the option. This calculation is based on the safe harbor method permitted by the SEC in instances where the vesting and exercise terms of options granted meet certain conditions and where limited historical exercise data is available. The expected volatility is based on the historical volatility of our common stock. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the expected term of the grant effective as of the date of the grant. The expected dividends assumption is based on our history and our expectations regarding dividend payouts. We evaluate the assumptions used to value our common stock option awards on a quarterly basis. If factors change and we employ different assumptions, stock- based compensation expense may differ significantly from what we have recorded in prior periods. Compensation expense for common stock option awards with graded vesting schedules is recognized on a straight-line basis over the requisite service period for the last separately vesting portion of the award, provided that the accumulated cost recognized as of any date at least equals the value of the vested portion of the award.

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

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

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

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ASC Topic 740 prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under ASC Topic 740 we may only recognize or continue to recognize tax positions that meet a “more likely than not” threshold.

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

Results of Operations

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

	Three Months Ended				Six Months Ended
	June 30,		July 2,		June 30,		July 2,
	2012		2011		2012		2011

Net sales	100	%	100	%	100	%	100	%
Cost of sales	74		69		67		69
Gross profit	26		31		33		31
Operating expenses:
Research and development	35		23		31		27
Selling, general and administrative	27		16		22		20
Total operating expenses	63		40		53		46
Operating loss	(37	)	(9	)	(20	)	(15	)
Other income (expense):
Interest expense, net	(1	)	—		(1	)	—
Other income (expense), net	—		—		—		—
Total other expense, net	(1	)	—		(1	)	—
Loss before provision for income taxes	(38	)	(9	)	(21	)	(15	)
Provision for income taxes	—		—		—		—
Net loss	(38	)%	(9	)%	(21	)%	(15	)%

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Three and Six Months Ended June 30, 2012 Compared to Three and Six Months Ended July 2, 2011

Net Sales, Cost of Sales and Gross Profit

The following table presents net sales, cost of sales and gross profit for the three and six months ended June 30, 2012 and July 2, 2011 (in thousands, except percentages):

	Three Months Ended
	June 30,			July 2,						%
	2012			2011			Change			Change

Net sales	$	10,552		$	16,001		$	(5,449	)	(34	)%
Cost of sales	7,814			11,064			(3,250		)	(29	)%
Gross profit	$	2,738		$	4,937		$	(2,199	)	(45	)%
Gross margin	26		%	31		%	(5		)%

	Six Months Ended
	June 30,			July 2,						%
	2012			2011			Change			Change

Net sales	$	24,519		$	28,001		$	(3,482	)	(12	)%
Cost of sales	16,345			19,260			(2,915		)	(15	)%
Gross profit	$	8,174		$	8,741		$	(567	)	(6	)%
Gross margin	33		%	31		%	2		%

Net Sales. The decrease in net sales for the three months ended June 30, 2012 as compared with the three months ended July 2, 2011 resulted primarily from decreases of approximately (i) $4.5 million in sales of NVvault™ non-volatile cache systems used in RAID controller subsystems, including $3.3 million from NVvault™ battery-free, the flash-based cache system (ii) $1.9 million of specialty memory module sales primarily used in industrial applications as one customer slowed production as a result of its product nearing the end of its life, and (iii) $0.9 million in flash product sales, offset by an increase of (i) $1.9 million in sales resulting from existing and new customer qualifications.

The decrease in net sales for the six months ended June 30, 2012 as compared with the six months ended July 2, 2011 resulted primarily from decreases of approximately (i) $3.8 million of specialty memory module sales primarily used in industrial applications as one customer slowed production as a result of its product nearing the end of its life, (ii) $1.3 million in sales of NVvault™ non-volatile cache systems used in RAID controller subsystems and (iii) $1.0 million in flash product sales, offset by an increase of (i) $2.6 million in sales resulting from existing and new customer qualifications.

Gross Profit and Gross Margin. The decrease in gross profit for the three months ended June 30, 2012 as compared to the three months ended July 2, 2011 is due to a change in the product mix primarily as a result of the anticipated decrease in sales of Dell NVvault™ which have a higher margin than many of our other product lines. Gross profits for the six months ended June 30, 2012 as compared to the six months ended July 2, 2011 were relatively flat, as the decline in Dell NVvault™ sales began in the second quarter of 2012. As noted previously, the decline in Dell NVvault™ sales could continue to have a significant impact on our revenue and gross profit through 2013.

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Research and Development.

The following table presents research and development expenses for the three and six months ended June 30, 2012 and July 2, 2011 (in thousands, except percentages):

	Three Months Ended
	June 30,		July 2,				%
	2012		2011		Change		Change

Research and development	$	3,770	$	3,755	$	15	—	%

	Six Months Ended
	June 30,		July 2,				%
	2012		2011		Change		Change

Research and development	$	7,612	$	7,439	$	173	2	%

The increase in research and development expense in the three months ended June 30, 2012 as compared to the three months ended July 2, 2011 resulted primarily from increases of (i) $0.2 million in non-recurring engineering charges for supply partners engaged in new product development activities and (ii) $0.2 million in material expenses related to product builds and testing, primarily related to our HyperCloud™ products, offset by decreases of $0.4 million in professional and outside services.

The increase in research and development expense in the six months ended June 30, 2012 as compared to the six months ended July 2, 2011 resulted primarily from increases of (i) $0.2 million in internal engineering headcount costs, and (ii) $0.6 million in material expenses related to product builds and testing, partially offset by a decrease of $0.6 million in non-recurring engineering charges for supply partners engaged in new product development activities.

Selling, General and Administrative.

The following table presents selling, general and administrative expenses for the three and six months ended June 30, 2012 and July 2, 2011 (in thousands, except percentages):

	Three Months Ended
	June 30,		July 2,				%
	2012		2011		Change		Change

Selling, general and administrative	$	2,871	$	2,583	$	288	11	%

	Six Months Ended
	June 30,		July 2,					%
	2012		2011		Change			Change

Selling, general and administrative	$	5,480	$	5,500	$	(20	)	—	%

Selling, general and administrative expense for the three months ended June 30, 2012 as compared to the three months ended July 2, 2011 increased by $0.3 million due to an increase in sample units sent out for evaluation by potential customers

Selling, general and administrative expense decreased by $0.02 million for the six months ended June 30, 2012 as compared to the six months ended July 2, 2011, as we improved operating efficiency.

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Other (Expense) Income.

The following table presents other (expense) income for the three and six months ended June 30, 2012 and July 2, 2011 (in thousands, except percentages):

	Three Months Ended
	June 30,			July 2,						%
	2012			2011			Change			Change

Interest expense, net	$	(79	)	$	(50	)	$	(29	)	58	%
Other (expense) income, net	3			(59		)	62			(105	)%
Total other expense, net	$	(76	)	$	(109	)	$	33		(30	)%

	Six Months Ended
	June 30,			July 2,						%
	2012			2011			Change			Change

Interest expense, net	$	(150	)	$	(75	)	$	(75	)	100	%
Other (expense) income, net	8			(59		)	67			(114	)%
Total other expense, net	$	(142	)	$	(134	)	$	(8	)	6	%

The increase in interest expense for the three months ended June 30, 2012 compared with the three months ended July 2, 2011 was the result of new term loans that originated in May 2011 and May 2012.

The decrease in other (expense) income, net, for the three and six months ended June 30, 2012 as compared to the three and six months ended July 2, 2011 was primarily the result of a realized loss in 2011 of $59,000 from the sale of an auction rate security that was purchased in 2008.

Provision for Income Taxes.

The following table presents the provision for income taxes for the three and six months ended June 30, 2012 and July 2, 2011 (in thousands, except percentages):

	Three Months Ended
	June 30,		July 2,				%
	2012		2011		Change		Change

Provision for income taxes	$	1	$	1	$	—	—	%

	Six Months Ended
	June 30,		July 2,				%
	2012		2011		Change		Change

Provision for income taxes	$	1	$	1	$	—	—	%

We did not record a benefit of income taxes for the three and six months ended June 30, 2012 and July 2, 2011, as tax benefits resulting from operating losses generated were fully reserved.

Liquidity and Capital Resources

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

		Page
PART I.	FINANCIAL INFORMATION	3
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets at June 30, 2012 (unaudited) and December 31, 2011 (audited)	3
	Unaudited Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2012 and July 2, 2011	4
	Unaudited Condensed Consolidated Statements of Comprehensive Loss for the Three and Six Months Ended June 30, 2012 and July 2, 2011	5
	Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and July 2, 2011	6
	Notes to Unaudited Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
Item 4.	Controls and Procedures	37
Item 5.	Other Information	37

PART II.	OTHER INFORMATION	37
Item 1.	Legal Proceedings	37
Item 1A.	Risk Factors	37
Item 6.	Exhibits	55