NETLIST INC (Form: 10-Q, Received: 11/15/2011 16:58:06)

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 October 1, 2011

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

25,458,622 shares outstanding at November 1, 2011

NETLIST, INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE AND NINE MONTHS ENDED OCTOBER 1, 2011

TABLE OF CONTENTS

		Page
PART I.	FINANCIAL INFORMATION	3
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets at October 1, 2011 (unaudited) and January 1, 2011 (audited)	3
	Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended October 1, 2011 and October 2, 2010	4
	Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended October 1, 2011 and October 2, 2010	5
	Notes to Unaudited Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23
Item 4.	Controls and Procedures	34

PART II.	OTHER INFORMATION	35
Item 1.	Legal Proceedings	35
Item 1A.	Risk Factors	35
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	51
Item 6.	Exhibits	52

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NETLIST, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands, except par value)

	(unaudited)			(audited)
	October 1,			January 1,
	2011			2011

ASSETS
Current assets:
Cash and cash equivalents	$	10,102		$	14,210
Investments in marketable securities	—			824
Accounts receivable, net	6,792			6,451
Inventories	8,877			4,509
Prepaid expenses and other current assets	1,337			1,396
Total current assets	27,108			27,390

Property and equipment, net	2,950			4,077
Long-term investments in marketable securities	450			890
Other assets	200			337
Total assets	$	30,708		$	32,694

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	6,290		$	6,256
Accrued payroll and related liabilities	1,747			1,762
Accrued expenses and other current liabilities	431			369
Accrued engineering charges	736			638
Current portion of long-term debt	2,079			674
Total current liabilities	11,283			9,699
Long-term debt, net of current portion	1,591			1,063
Other liabilities	88			85
Total liabilities	12,962			10,847
Commitments and contingencies
Stockholders’ equity:
Common stock, $0.001 par value - 90,000 shares authorized; 25,459 (2011) and 25,284 (2010) shares issued and outstanding	25			25
Additional paid-in capital	90,286			89,074
Accumulated deficit	(72,513		)	(67,141		)
Accumulated other comprehensive loss	(52		)	(111		)
Total stockholders’ equity	17,746			21,847
Total liabilities and stockholders’ equity	$	30,708		$	32,694

See accompanying notes.

NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

	Three Months Ended						Nine Months Ended
	October 1,			October 2,			October 1,			October 2,
	2011			2010			2011			2010

Net sales	$	16,347		$	10,565		$	44,348		$	27,759
Cost of sales(1)	10,819			7,545			30,079			21,103
Gross profit	5,528			3,020			14,269			6,656
Operating expenses:
Research and development(1)	3,983			4,958			11,422			11,156
Selling, general and administrative(1)	2,511			2,986			8,011			8,163
Total operating expenses	6,494			7,944			19,433			19,319
Operating loss	(966		)	(4,924		)	(5,164		)	(12,663		)
Other (expense) income:
Interest (expense) income, net	(72		)	(3		)	(147		)	1
Other (expense) income, net	1			—			(58		)	71
Total other (expense) income, net	(71		)	(3		)	(205		)	72
Loss before provision (benefit) for income taxes	(1,037		)	(4,927		)	(5,369		)	(12,591		)
Provision (benefit) for income taxes	2			12			3			(713		)
Net loss	$	(1,039	)	$	(4,939	)	$	(5,372	)	$	(11,878	)
Net loss per common share:
Basic and diluted	$	(0.04	)	$	(0.20	)	$	(0.22	)	$	(0.51	)

Weighted-average common shares outstanding:
Basic and diluted	25,029			24,799			24,966			23,422

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

Cost of sales	$	21	$	11	$	51	$	33
Research and development	178		134		466		297
Selling, general and administrative	265		268		706		891

See accompanying notes.

NETLIST, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

	Nine Months Ended
	October 1,			October 2,
	2011			2010

Cash flows from operating activities:
Net loss	$	(5,372	)	$	(11,878	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	1,717			1,691
Stock-based compensation	1,223			1,221
Amortization of deferred gain on sale and leaseback transaction	—			(88		)
Realized loss on sale of investments in marketable securities	59			—
Changes in operating assets and liabilities:
Accounts receivable	(341		)	(2,678		)
Inventories	(4,368		)	(1,629		)
Prepaid expenses and other current assets	228			(668		)
Other assets	137			49
Accounts payable	31			1,907
Accrued payroll and related liabilities	(15		)	(448		)
Accrued expenses and other current liabilities	65			(39		)
Accrued engineering charges	98			(88		)
Net cash used in operating activities	(6,538		)	(12,648		)
Cash flows from investing activities:
Acquisition of property and equipment	(570		)	(718		)
Purchase of investments in marketable securities	—			(2,395		)
Proceeds from maturities and sales of investments in marketable securities	1,264			2,917
Net cash provided by (used in) investing activities	694			(196		)
Cash flows from financing activities:
Borrowings on line of credit	500			3,000
Payments on line of credit	(500		)	(3,000		)
Proceeds of bank term loan, net of issuance costs	2,934			1,500
Payments on debt	(1,187		)	(140		)
Proceeds from public offering, net	—			16,210
Proceeds from exercise of equity awards, net of taxes remitted for restricted stock	(11		)	54
Net cash provided by financing activities	1,736			17,624
(Decrease) increase in cash and cash equivalents	(4,108		)	4,780
Cash and cash equivalents at beginning of period	14,210			9,942
Cash and cash equivalents at end of period	$	10,102		$	14,722

See accompanying notes.

NETLIST, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

OCTOBER 1, 2011

Note 1—Description of Business

Netlist, Inc. (the “Company” or “Netlist”) 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 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 January 1, 2011, included in the Company’s Annual Report on Form 10-K filed with the SEC on March 3, 2011.

The condensed consolidated financial statements included herein as of October 1, 2011 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 October 1, 2011, the condensed consolidated results of its operations for the three and nine months ended October 1, 2011 and October 2, 2010, and the condensed consolidated cash flows for the nine months ended October 1, 2011 and October 2, 2010. The results of operations for the nine months ended October 1, 2011 are not necessarily indicative of the results to be expected for the full year or any future interim periods.

Reclassifications

Certain amounts in the 2010 condensed consolidated financial statements have been reclassified to conform to the current year presentation.

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 2011, the Company’s fiscal year is scheduled to end on December 31, 2011 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

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 nine month periods ended October 1, 2011 and October 2, 2010.

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.

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 and short-term corporate bonds (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. Because of their short-term nature, short-term corporate bonds are not frequently traded. Although there are observable quotes for these securities, the markets are not considered active. Accordingly, the fair values of these investments are based on Level 2 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 $0.4 million of Federal Deposit Insurance Corporation insured cash and cash equivalents at October 1, 2011. 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 risk losses related to these investments.

The Company’s trade accounts receivable are primarily derived from sales to OEMs in the computer industry. The Company performs credit evaluations of its customers’ financial condition and limits the amount of credit extended when deemed necessary, but generally requires no collateral. The 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. Provisions are made to reduce excess or obsolete inventories to their estimated net realizable values. Once established, write-downs are considered permanent adjustments to the cost basis of the excess or obsolete inventories.

Property and Equipment

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

Impairment of Long-Lived Assets

The Company evaluates 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 October 1, 2011. 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.

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

The Company has entered into a collaborative arrangement with a partner in order to develop products using certain of the Company’s proprietary technology. Under the arrangement, the development partner was granted a non-exclusive license to specified intellectual property for exclusive use in the development and production of ASIC chipsets for the Company. Both the Company and the development partner provided and continue to provide engineering project management resources at their own expense. The development partner is entitled to non-recurring engineering fees based upon the achievement of development milestones, and to a minimum portion of the Company’s purchasing allocations for the component. Expenses incurred and paid to the development partner are included in research and development expense in the accompanying condensed consolidated statements of operations.

Comprehensive Loss

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

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 October 1, 2011 the product has not generated significant revenue relative to the Company’s investment in the product. The Company has entered into collaborative agreements with both Hewlett-Packard Company (“ HP”) and International Business Machines (“IBM”) pursuant to which these OEMs have agreed to cooperate with the Company in efforts to qualify HyperCloud™ for use in their respective products. If qualification is achieved by one or both of these OEMs, the qualifying OEM will 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 placing or qualifying 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 and $2.0 million at October 1, 2011 and January 1, 2011, respectively.

Foreign Currency Re-measurement

The functional currency of the Company’s foreign subsidiary is the U.S. dollar. Local currency financial statements are re-measured 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 re-measured using the average exchange rate for the period, except items related to nonmonetary assets and liabilities, which are re-measured using historical exchange rates. All re-measurement gains and losses are included in determining net loss.

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 our 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.

New Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-4, Fair Value Measurement (“ASU 11-4”). ASU 11-4 amends existing guidance to achieve convergence in measurement and disclosure between U.S. Generally Accepted Accounting Standards (“GAAP”) and International Financial Reporting Standards (“IFRS”). ASU 11-4 is effective for fiscal year 2012. The Company is currently evaluating the impact that ASU 11-4 will have on its consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-5, Comprehensive Income (“ASU 11-5”). ASU 11-5 amends existing guidance to increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS. ASU 11-5 is effective for fiscal year 2012. The Company is currently evaluating the impact that ASU 11-4 will have on its consolidated financial statements.

Note 3—Supplemental Financial Information

Inventories

Inventories consist of the following (in thousands):

	October 1,		January 1,
	2011		2011

Raw materials	$	5,817	$	2,631
Work in process	857		171
Finished goods	2,203		1,707
	$	8,877	$	4,509

Warranty Liabilities

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

	Nine Months Ended
	October 1,			October 2,
	2011			2010

Beginning balance	$	194		$	240
Charged to costs and expenses	281			176
Cost of warranty claims	(300		)	(214		)
Ending balance	175			202
Less current portion	(87		)	(117		)
Long-term warranty obligations	$	88		$	85

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.

Facility Relocation Costs

The following table summarizes the activity related to the Company’s accrual for facility relocation costs during the period indicated (in thousands):

	Nine Months Ended
	October 1,		October 2,
	2011		2010

Beginning balance	$	—	$	84
Reduction in expected costs	—		(28		)
Net payments	—		(10		)
Ending balance	$	—	$	46

As a result of the relocation of the Company’s domestic headquarters and manufacturing facility during the third quarter of 2007, the Company vacated its previous manufacturing facility. The Company subleased this facility, but remained obligated under a non-cancellable operating lease through November 2010. In accordance with ASC Topic 420, the Company recorded a net charge and related liability of approximately $134,000 in 2007, which approximated the estimated fair value of the net remaining lease payments. At the conclusion of the master lease and sublease terms, the Company determined that its original estimates regarding the net remaining lease payments exceeded its actual liability by approximately $33,000. Accordingly, the excess accrual was reversed, and the liability for facility relocation was reduced to zero at January 1, 2011.

In May 2009, the Company entered into an agreement to sublease a portion of its new domestic headquarters facility to another tenant at a discount from the rent required under its lease commitment. As a result, the Company recorded an additional charge of approximately $61,000. In February 2010, the sublessor vacated the space that it had subleased. The Company determined that the space could be used in its operations. As a result, the Company reversed approximately $28,000 of its accrual for facility relocation costs, and the liability was reduced to zero at January 1, 2011.

The expenses and reversal of accruals described above are included as a component of selling, general and administrative expense in the accompanying condensed consolidated statements of operations.

Comprehensive Loss

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

	Three Months Ended						Nine Months Ended
	October 1,			October 2,			October 1,			October 2,
	2011			2010			2011			2010

Net loss	$	(1,039	)	$	(4,939	)	$	(5,372	)	$	(11,878	)
Other comprehensive loss:
Unrealized loss transferred from other comprehensive loss to earnings	—			—			59			—
Net unrealized loss on investments, net of tax	(7		)	(1		)	—			(48		)
Total comprehensive loss	$	(1,046	)	$	(4,940	)	$	(5,313	)	$	(11,926	)

Accumulated other comprehensive loss reflected on the condensed consolidated balance sheets at October 1, 2011 and January 1, 2011, represents accumulated net unrealized losses on investments.

Computation of Net Loss Per Share

Basic and diluted net loss per share is calculated by dividing net loss by the weighted-average common shares outstanding during the period. The following table sets forth the computation of net loss per share (in thousands, except per share data):

	Three Months Ended						Nine Months Ended
	October 1,			October 2,			October 1,			October 2,
	2011			2010			2011			2010

Numerator: Net loss	$	(1,039	)	$	(4,939	)	$	(5,372	)	$	(11,878	)
Denominator: Weighted-average common shares outstanding, basic and diluted	25,029			24,799			24,966			23,422
Net loss per share, basic and diluted	$	(0.04	)	$	(0.20	)	$	(0.22	)	$	(0.51	)

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, and the exercise of warrants, 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		Nine Months Ended
	October 1,	October 2,	October 1,	October 2,
	2011	2010	2011	2010
Common share equivalents	1,336	1,779	1,485	1,978

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				Nine Months Ended
	October 1,		October 2,		October 1,		October 2,
	2011		2010		2011		2010
Customer:
Customer A	67	%	69	%	67	%	53	%
Customer B	*	%	13	%	*	%	25	%

* less than 10% of net sales

The Company’s accounts receivable are concentrated with two customers at October 1, 2011 and January 1, 2011, representing approximately 73% and 12% and 75% and 13%, respectively, 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):

	Nine Months Ended
	October 1,		October 2,
	2011		2010

Supplemental disclosure of non-cash investing and financing activities:
Purchase of equipment not paid for at the end of the period	$	3	$	270
Debt financed acquisition of assets	$	169	$	199
Change in unrealized (gain) loss from investments in marketable securities	$	59	$	48

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

Money market mutual funds	$	5,524	$	5,524	$	—	$	—
Auction and variable floating rate notes	450		—		—		450
Total	$	5,974	$	5,524	$	—	$	450

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

Money market mutual funds	$	12,654	$	12,654	$	—	$	—
Corporate notes and bonds	824		—		824		—
Auction and variable floating rate notes	890		—		—		890
Total	$	14,368	$	12,654	$	824	$	890

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 October 1, 2011 and January 1, 2011:

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

Cash equivalents	$	5,524	$	5,524	$	—	$	—
Long-term marketable securities	450		—		—		450
Total assets measured at fair value	$	5,974	$	5,524	$	—	$	450

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

Cash equivalents	$	12,654	$	12,654	$	—	$	—
Short-term marketable securities	824		—		824		—
Long-term marketable securities	890		—		—		890
Total assets measured at fair value	$	14,368	$	12,654	$	824	$	890

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.

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):

	Nine Months Ended
	October 1,			October 2,
	2011			2010

Beginning balance	$	890		$	941
Sales of available-for-sale marketable securities	(440		)	—
Realized loss included in other income (expense), net	(59		)	—
Unrealized loss transferred from other comprehensive loss to earnings	59			—
Unrealized loss included in other comprehensive loss	—			(47		)
Ending balance	$	450		$	894

Note 5—Investments in Marketable Securities

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

	October 1, 2011
			Net
	Amortized		Unrealized			Fair
	Cost		Gain (Loss)			Value

Auction and variable floating rate notes	$	502	$	(52	)	$	450

	January 1, 2011
			Net
	Amortized		Unrealized			Fair
	Cost		Gain (Loss)			Value

Corporate notes and bonds	$	824	$	—		$	824
Auction and variable floating rate notes	1,001		(111		)	890
	$	1,825	$	(111	)	$	1,714

Realized gains and losses on the sale of investments in marketable securities are determined using the specific identification method. 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):

	October 1, 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	$	—	$	—	$	450	$	(52	)

	January 1, 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	$	—	$	—	$	890	$	(111	)

As of October 1, 2011, the Company held one investment that was in an unrealized loss position. As of January 1, 2011, the Company held two investments that were 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 October 1, 2011, the Company held one investment in a Baa1 rated auction rate debt securities 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 was owned at January 1, 2011, and disposed of in June 2011 for a realized loss of $59,000.

The Company does not believe that the current illiquidity of its remaining investment in auction rate securities 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 investments in auction rate securities have been classified as long-term investments in marketable securities in the accompanying unaudited condensed consolidated balance sheets. The Company has concluded that the estimated gross unrealized losses on these investments, which totaled approximately $50,000 and $111,000 at October 1, 2011 and January 1, 2011, respectively, are temporary because (i) the Company believes that the liquidity limitations that have occurred are due to general market conditions, (ii) the remaining 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.

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 securities, there were no unrealized gains or losses at October 1, 2011 or January 1, 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 October 1, 2011 by contractual maturity (in thousands):

	October 1, 2011
	Amortized		Fair
	Cost		Value

Maturity
Greater than two years*	$	502	$	450

*	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 and August 10, 2011 (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, 2013, subject to the conditions of the Credit Agreement.

The Credit Agreement contains an overall sublimit of $10.0 million to collateralize the Company’s contingent obligations under letters of credit, foreign exchange contracts and cash management services. Amounts outstanding under the overall sublimit reduce the amount available pursuant to the Credit Agreement. At October 1, 2011, letters of credit in the amount of $2.8 million were outstanding. The letters of credit expired in October 2011, and were renewed for $2.0 million through October 31, 2012.

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 payments for 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				Nine Months Ended
	October 1,		October 2,		October 1,		October 2,
	2011		2010		2011		2010

Interest expense	$	10	$	12	$	12	$	36

	October 1,			January 1,
	2011			2011
Availability under the revolving line of credit	$	4,318		$	5,100
Outstanding borrowings on the revolving line of credit	—			—
Amounts reserved under credit sublimits	(2,821		)	(2,900		)
Unutilized borrowing availability under the revolving line of credit	$	1,497		$	2,200

In connection with the September 30, 2010 amendment to the Credit Agreement, Silicon Valley Bank extended a $1.5 million term loan, which bears interest at a rate of prime plus 2.00% effective with the August 10, 2011 amendment (“Term Loan I”). The Company is required to make monthly principal payments of $41,666 of over the 36 month term of the loan, or $0.5 million annually. Term Loan I matures in September 2013. In May 2011, Silicon Valley Bank extended an additional $3.0 million term loan (“Term Loan II”), and extended the term of the existing credit facility through September 2013. The Term Loan II bears interest at a rate of prime plus 2.75%, effective with the August 10, 2011 amendment, and is payable in equal installments of $125,000 over the 24 month term of the loan, or $1.5 million annually. Term Loan II matures in May 2013.

The term loans are classified in long-term debt in the accompanying condensed consolidated balance sheets.

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 October 1, 2011, the Company was in compliance with its financial covenants.

Note 7—Long-Term Debt

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

	October 1,			January 1,
	2011			2011

Term Loan I	$	1,000		$	1,375
Term Loan II, net of unamortized issuance cost of $47	2,453			—
Obligations under capital leases	217			362
	3,670			1,737
Less current portion	(2,079		)	(674		)
	$	1,591		$	1,063

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

	Three Months Ended				Nine Months Ended
	October 1,		October 2,		October 1,		October 2,
	2011		2010		2011		2010

Interest expense	$	62	$	5	$	144	$	11

Note 8—Income Taxes

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

	Three Months Ended						Nine Months Ended
	October 1,			October 2,			October 1,			October 2,
	2011			2010			2011			2010

Provision (benefit) for income taxes	$	2		$	12		$	3		$	(713	)
Effective tax rate	—		%	(0.2		)%	—		%	5.7		%

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 October 1, 2011 and January 1, 2011. Accordingly, no benefit has been recognized for net deferred tax assets, including net operating losses that cannot be realized currently via carryback to periods of taxable income.

During the nine months ended October 2, 2010, the Company carried back approximately $1.7 million of gross net operating losses under the Worker, Homeownership, and Business Act and received a federal income tax refund of approximately $0.7 million.

The Company had unrecognized tax benefits at October 1, 2011 and January 1, 2011 of approximately $0.1 million that, if recognized, would affect the Company’s annual effective tax rate.

Note 9—Commitments and Contingencies

Patent Claims

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. On August 29, 2008, Google filed a declaratory judgment lawsuit against the Company in the U.S. District Court for the Northern District of California, seeking a declaration that Google did not infringe the ’386 patent and that the ’386 patent is invalid. Google is not seeking any monetary damages. On November 18, 2008, the Company filed a counterclaim for infringement of the ’386 patent by Google. Claim construction proceedings were held on November 14, 2009, and the Company prevailed on every disputed claim construction issue. On June 1, 2010, the Company filed a motion for summary judgment of patent infringement and a motion for summary judgment

to dismiss Google’s affirmative defenses based on Netlist’s activities in the JEDEC standard-setting organization. The hearings for these motions have been postponed indefinitely by the Court. On September 1, 2010, the United States Patent and Trademark Office (“USPTO”) granted Google’s request for reexamination of the ’386 patent. On September 14, 2010, the Court granted Google’s request to stay the litigation pending the conclusion of the reexamination by the USPTO. On October 20, 2010, Smart Modular, Inc. (“SMOD”) filed a request for reexamination of the ’386 patent with the USPTO. In January 2011, the USPTO granted SMOD’s request for reexamination. The two reexaminations requested by Google and SMOD were merged by the USPTO into a single proceeding on March 3, 2011 and a Non-Final Action was issued by the USPTO on April 6, 2011. The Company filed its response to the Non-Final Action on July 6, 2011, and SMOD filed its comments on the Company’s response on October 26, 2011. The Company intends to vigorously pursue its infringement claims against Google and to continue to vigorously defend its patent rights in the USPTO.

On September 22, 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 suit alleges that Inphi is contributorily infringing and actively inducing the infringement of a U.S. patent owned by the Company , U.S. Patent No. 7,532,537 (“the ’537 patent”), which relates generally to memory modules with load isolation and memory domain translation capabilities. The Company is seeking damages and injunctive relief based on Inphi’s use of its patented technology. On December 22, 2009, the Company filed an Amended Complaint against Inphi asserting claims of patent infringement based on two additional patents, U.S. Patent No. 7,619,912 (“the ’912 patent”), which is related to the ’386 patent and relates generally to rank multiplication, 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. Inphi has denied infringement and has asserted that the patents-in-suit are invalid. On April 19, 2010, Inphi filed requests for reexamination of the three patents-in-suit, and on April 21, 2010, Inphi filed a paper with the USPTO intended to provoke an interference proceeding on the three patents-in-suit. Inphi then filed a motion to stay the lawsuit, which was granted on May 18, 2010. On September 1, 2010, in the reexamination of the ’912 patent, the USPTO confirmed the patentability of all fifty-one claims of the ’912 patent.

On December 4, 2009, the Company filed a patent infringement lawsuit against Google in the U.S. District Court for the Northern District of California, seeking damages and injunctive relief based on Google’s infringement of the ’912 patent. On February 11, 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. On October 20 and October 21, 2010, respectively, SMOD and Google each filed requests for reexamination of the ’912 patent, which were each granted in January 2011. On January 26, 2011, the Court granted the parties’ joint request to stay the patent infringement lawsuit against Google until the completion of the reexamination proceedings. On February 28, 2011, the USPTO merged the latter two reexaminations and the Inphi reexamination into a single proceeding. A Non-Final Action in the merged reexamination proceeding dated April 4, 2011 stated that the USPTO rejected claims 1-20 and 22-51 and confirmed the patentability of claim 21 of the ’912 patent. The Company filed its response to the Non-Final Action on July 5, 2011, and Inphi, Google, and SMOD filed their comments on the Company’s response on August 29, 2011. The USPTO mailed a second Non-Final Action in the merged reexamination proceeding on October 14, 2011, which confirmed the patentability of twenty claims of the ’912 patent. The Company intends to vigorously pursue its infringement claims against Inphi and Google and to continue to vigorously defend its patent rights in the USPTO.

With regard to the ’537 patent, Inphi’s request for reexamination was granted and a Non-Final Action was issued on September 8, 2010 by the USPTO. The Company filed its response on October 8, 2010, Inphi filed its comments on November 9, 2010, and the USPTO issued an Action Closing Prosecution (“ACP”) on June 21, 2011. The Company filed its response to the ACP on August 22, 2011, and Inphi filed its comments on the Company’s response on September 21, 2011. The Company intends to vigorously pursue its infringement claims against Inphi and to continue to vigorously defend its patent rights in the USPTO.

With regard to the ’274 patent, Inphi’s request for reexamination was granted on August 27, 2010. A Non-Final Action was issued on September 27, 2011 by the USPTO, and the Company filed its response on October 27, 2011.

On September 14, 2011, SMOD filed a request for reexamination of U.S. Pat. No. 7,864,627, issued to the Company on January 4, 2011, which is related to the ’912 patent. The USPTO has not yet made a decision regarding whether to grant this request.

On November 30, 2009, Inphi filed a patent infringement lawsuit against the Company in the U.S. District Court for the Central District of California alleging infringement of two Inphi patents generally related to memory module output buffers. On April 18, 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.

On March 24, 2010, Ring Technologies Enterprises filed a patent infringement lawsuit in the U.S. District Court for the Eastern District of Texas against Dell, Inc. (“Dell”) and its suppliers. The suit alleged that the Company and forty-two (42) other defendants infringed on its U.S. Patent No. 6,879,526. On July 18, 2011 the Court dismissed all claims in this action against the Company, without prejudice, with each party to bear its own costs, expenses and attorney’s fees. The case against the Company is now closed.

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.

Note 10—Stockholders’ Equity

Common Stock

During the nine months ended October 1, 2011, the Company cancelled 37,422 shares of common stock valued at approximately $77,000 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 October 1, 2011, the Company was authorized to issue a maximum of 4,205,566 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 October 1, 2011, the Company had 181,840 shares available for grant under the 2006 Plan. At October 1, 2011, an additional 180,000 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 nine months ended October 1, 2011 is presented below (shares in thousands):

	Options Outstanding
			Weighted-
			Average
	Number of		Exercise
	Shares		Price
Options outstanding at January 1, 2011	4,634		$	2.57
Options granted	1,396		2.23
Options exercised	(201	)	0.33
Options cancelled	(260	)	2.95
Options outstanding at October 1, 2011	5,569		$	2.54

The intrinsic value of options exercised in the nine months ended October 1, 2011 was $0.4 million.

A summary of the Company’s restricted stock awards as of and for the nine months ended October 1, 2011 is presented below (shares in thousands):

	Restricted Stock Outstanding
			Weighted-
			Average
			Grant-Date
	Number of		Fair Value
	Shares		per Share
Balance outstanding at January 1, 2011	426		$	3.46
Restricted stock granted	24		1.51
Restricted stock forfeited	(13	)	3.31
Restricted stock vested	(118	)	3.47
Balance outstanding at October 1, 2011	319		$	3.32

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:

	Nine Months Ended
	October 1,			October 2,
	2011			2010
Expected term (in years)	6.0			5.5
Expected volatility	136		%	146		%
Risk-free interest rate	2.16		%	2.14		%
Expected dividends	—			—
Weighted-average grant date fair value per share	$	2.03		$	3.07

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 weighted-average fair value per share of the restricted stock granted in the nine months ended October 1, 2011 and October 2, 2010 was $1.51 and $3.46 respectively, calculated based on the fair market value of the Company’s common stock on the respective grant dates.

At October 1, 2011, the amount of unearned stock-based compensation currently estimated to be expensed from fiscal 2011 through fiscal 2014 related to unvested common stock options and restricted stock awards is approximately $3.7 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 October 1, 2011 and January 1, 2011, approximately $1.8 million and $2.3 million, respectively, of the Company’s net long-lived assets were located in the PRC.

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 January 1, 2011 and subsequent reports on Form 8-K, which discuss our business in greater detail.

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 continuing development, qualification and volume production of EXPRESSvault™, NVvault™ and HyperCloud™; 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.

Products

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 functionality that increases memory bandwidth. We expect that this technology 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. HyperCloud™ memory is being evaluated by several of our OEM customers for use in their server products. HyperCloud™ is interoperable with JEDEC standard DDR3 memory modules. Our HyperCloud™ products are designed to allow for installation in servers without the need for a BIOS change. As such, their anticipated sales launch is not dependent on the design plans or product cycle of our OEM customers. However, we have experienced a longer qualification cycle than anticipated.

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. Additionally , we announced collaborative agreements with each of Hewlett-Packard Company (“HP”) and International Business Machines (“IBM”), pursuant to which these OEMs have agreed to cooperate with us in efforts to qualify HyperCloud™ memory products for use with their respective products. If qualification is achieved by one or both of these OEMs, the qualifying OEMs will 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 any new revenues for us.

In February 2010, we announced general availability of NVvault TM battery-free, a non-volatile cache memory subsystem targeting RAID storage applications. NVvault TM battery-free provides server and storage OEMs a solution for enhanced datacenter fault recovery. Unlike our traditional battery-powered fault tolerant cache product which relied solely on batteries to power the cache, NVvault TM battery-free utilizes a combination of DRAM for high throughput performance and flash for extended data retention. The introduction of NVvault TM battery-free, as well as the launch of the current version of the battery-powered module in connection with Dell introduction of the PERC 7 line of servers in December 2009, has resulted in RAID controller subsystem revenues of $27.4 million, or 62% of total revenues for the nine months ended October 1, 2011. This compares favorably with $13.7 million in RAID controller subsystem revenues, or 49% of total revenues for the nine months ended October 2, 2010. Although revenues in 2011 and 2010 have been primarily for shipments to Dell, in the fourth quarter of 2010 we qualified NVvault TM battery-free with other OEMs, and we continue to pursue further qualifications. We are also pursuing other OEM and end-user opportunities with the introduction of EXPRESSvault™ in March 2011 and the introduction of the next generation DDR3 NVvault.

The remainder of our revenues arose primarily from OEM sales of custom memory modules, 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 custom modules have declined as a result of certain of our OEM product placements nearing the end of their product life. The reversal of this trend is dependent on our ability to qualify our memory modules on new platforms as current platforms reach the end of their life cycles, 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 67% of our net sales for the nine months ended October 1, 2011. Two customers represented approximately 53% and 25%, respectively, of our net sales for the nine months ended October 2, 2010.

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.

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.

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 and short-term corporate bonds, 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. Because of their short-term nature, short-term corporate bonds are not frequently traded. Although there are

observable quotes for these securities, the markets are not considered active. Accordingly, the fair values of these investments are based on Level 2 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.

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 2011. Benefits recognized in 2010 were limited to those made available as a one-time carry-back through economic recovery legislation. 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.

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				Nine Months Ended
	October 1,		October 2,		October 1,		October 2,
	2011		2010		2011		2010

Net sales	100	%	100	%	100	%	100	%
Cost of sales	66		71		68		76
Gross profit	34		29		32		24
Operating expenses:
Research and development	24		47		26		40

Selling, general and administrative	15		28		18		29

Total operating expenses	40		75		44		70
Operating loss	(6	)	(47	)	(12	)	(46	)
Other (expense) income:
Interest (expense) income, net	—		—		—		—
Other (expense) income, net	—		—		—		—

Total other (expense) income, net	—		—		—		—

Loss before provision (benefit) for income taxes	(6	)	(47	)	(12	)	(46	)

Provision (benefit) for income taxes	—		—		—		(3	)

Net loss	(6	)%	(47	)%	(12	)%	(43	)%

Three and Nine Months Ended October 1, 2011 Compared to Three and Nine months Ended October 2, 2010

Net Sales, Cost of Sales and Gross Profit

The following table presents net sales, cost of sales and gross profit for the three and nine months ended October 1, 2011 and October 2, 2010 (in thousands, except percentages):

	Three Months Ended
	October 1,			October 2,						%
	2011			2010			Change			Change

Net sales	$	16,347		$	10,565		$	5,782		55	%
Cost of sales	10,819			7,545			3,274			43	%
Gross profit	$	5,528		$	3,020		$	2,508		83	%
Gross margin	34		%	29		%	5		%

	Nine Months Ended
	October 1,			October 2,						%
	2011			2010			Change			Change

Net sales	$	44,348		$	27,759		$	16,589		60	%
Cost of sales	30,079			21,103			8,976			43	%
Gross profit	$	14,269		$	6,656		$	7,613		114	%
Gross margin	32		%	24		%	8		%

Net Sales. The increase in net sales for the three months ended October 1, 2011 as compared with the three months ended October 2, 2010 resulted primarily from increases of approximately (i) $3.6 million in sales of NVvault™ non-volatile cache systems used in RAID controller subsystems, including $3.4 million from NVvault™ battery-free, the flash-based cache system that became generally available in 2010, (ii) $1.0 million in sales of flash memory products, resulting from existing and