-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RldAhCC+hIDZvsz+kCxmPnftnsnbYGGgPfVH2/9fzTYGm6QZZjoX5McKBHb9okLe u2h5qaIbzHZPaVVLNuJCmg== 0001019687-06-001081.txt : 20060508 0001019687-06-001081.hdr.sgml : 20060508 20060508170950 ACCESSION NUMBER: 0001019687-06-001081 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20060331 FILED AS OF DATE: 20060508 DATE AS OF CHANGE: 20060508 FILER: COMPANY DATA: COMPANY CONFORMED NAME: LANTRONIX INC CENTRAL INDEX KEY: 0001114925 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER COMMUNICATIONS EQUIPMENT [3576] IRS NUMBER: 330362767 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-16027 FILM NUMBER: 06817576 BUSINESS ADDRESS: STREET 1: 15353 BARRANCA PARKWAY CITY: IRVINE STATE: CA ZIP: 92618 BUSINESS PHONE: 9494533990 MAIL ADDRESS: STREET 1: 15353 BARRANCA PARKWAY CITY: IRVINE STATE: CA ZIP: 92618 10-Q 1 lantronix_10q-033106.htm LANTRONIX, INC. 10Q 03/31/2006 Lantronix, Inc. 10Q 03/31/2006

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q

x QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2006

OR

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

For the transition period from _________ to ___________.

Commission file number: 1-16027
 
 
LANTRONIX, INC.
(Exact name of registrant as specified in its charter)

Delaware
33-0362767
(State or other jurisdiction
(I.R.S. Employer
of incorporation or organization)
Identification No.)

15353 Barranca Parkway, Irvine, California
(Address of principal executive offices)

92618
(Zip Code)
 

(949) 453-3990
(Registrant’s telephone number, including area code)

Former name, former address and former fiscal year, if changed since last report: N/A

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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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

As of May 4, 2006, 59,197,336 shares of the Registrant’s common stock were outstanding.
 
 
LANTRONIX, INC.

FORM 10-Q
FOR THE FISCAL QUARTER ENDED
March 31, 2006

INDEX

     
Page
       
PART I.
FINANCIAL INFORMATION
  
3
       
Item 1.
Financial Statements.
  
3
       
 
Unaudited Condensed Consolidated Balance Sheets at March 31, 2006 and June 30, 2005
  
3
       
 
Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended
  
 
 
March 31, 2006 and 2005
  
4
       
 
Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended
    
 
March 31, 2006 and 2005
  
5
       
 
Notes to Unaudited Condensed Consolidated Financial Statements.
  
6
       
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
  
14
       
Item 3.
Quantitative and Qualitative Disclosures About Market Risk.
  
25
       
Item 4.
Controls and Procedures.
  
25
       
PART II.
OTHER INFORMATION
  
26
       
Item 1.
Legal Proceedings
  
26
       
Item 1A.
Risk Factors
  
26
       
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.
  
34
       
Item 3.
Defaults Upon Senior Securities
  
34
       
Item 4.
Submission of Matters to a Vote of Security Holders
  
34
       
Item 5.
Other Information
  
34
       
Item 6.
Exhibits
 
34
 

2
 
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements
LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share and share data)
 
   
March 31,
 
June 30,
  
 
2006
 
2005
  
ASSETS
          
Current assets:
          
Cash and cash equivalents
  
$
7,355
  
$
6,690
  
Marketable securities
    
94
   
85
 
Accounts receivable (net of allowance for doubtful accounts of
             
$66 and $158 at March 31, 2006 and June 30, 2005, respectively)
    
1,799
   
2,582
 
Inventories, net
    
6,877
   
6,828
 
Contract manufacturers' receivable (net of allowance of
              
$46 and $22 at March 31, 2006 and June 30, 2005, respectively)
    
1,504
   
711
 
Settlements recovery
    
16,075
   
1,200
 
Prepaid expenses and other current assets
    
1,429
   
1,055
 
 Total current assets
    
35,133
   
19,151
 
               
Property and equipment, net
    
1,094
   
674
 
Goodwill
    
9,488
   
9,488
 
Purchased intangible assets, net
    
649
   
559
 
Officer loans (net of allowance of $4,470
             
at March 31, 2006 and June 30, 2005, respectively)
    
121
   
116
 
Other assets
    
73
   
65
 
 Total assets
  
$
46,558
  
$
30,053
  
               
 LIABILITIES AND STOCKHOLDERS' EQUITY
              
Current liabilities:
              
Accounts payable
  
$
8,145
  
$
4,702
  
Accrued payroll and related expenses
    
1,291
   
1,296
 
Warranty reserve
    
765
   
1,248
 
Restructuring reserve
    
119
   
264
 
Accrued settlements
    
17,725
   
1,200
 
Other current liabilities
    
3,183
   
2,748
 
 Total current liabilities
    
31,228
   
11,458
 
Long-term liabilities
    
102
   
76
 
Long-term capital lease obligations
    
196
   
51
 
               
Commitments and contingencies
              
               
Stockholders' equity:
              
Preferred stock, $0.0001 par value; 5,000,000 shares authorized;
             
none issued and outstanding
    
-
   
-
 
Common stock, $0.0001 par value; 200,000,000 shares authorized;
              
59,191,211 and 58,790,413 shares issued and outstanding at
              
March 31, 2006 and June 30, 2005, respectively
    
6
   
6
 
Additional paid-in capital
    
182,319
   
181,264
 
Deferred compensation
    
-
   
(17
)
Accumulated deficit
    
(167,595
)
  
(163,082
)
Accumulated other comprehensive income
    
302
   
297
 
 Total stockholders' equity
    
15,032
   
18,468
 
 Total liabilities and stockholders' equity
  
$
46,558
  
$
30,053
  
               
See accompanying notes
 
3
 
LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share data)

 
  
Three Months Ended 
  
Nine Months Ended
  
 
  
March 31,
  
March 31,
  
   
2006
  
2005
  
2006
  
2005
  
Net revenues (1)
   $ 13,063  
$
12,303
   $ 38,258  
$
36,256
  
Cost of revenues (2) (3)
    
6,467
   
6,614
   
18,903
   
18,754
 
Cost of revenues - share-based compensation
    24    
-
    65    
-
 
Gross profit
    
6,572
   
5,689
    19,290    
17,502
 
Operating expenses:
                          
Selling, general and administrative (3)
    
5,875
    5,477    
17,837
    18,905  
Selling, general and administrative -
share-based compensation
    
171
   
1
   
499
   
154
 
Research and development (3)
    
1,517
    1,292    
4,125
    5,008  
Research and development -
share-based compensation
    
55
   
5
   
160
   
10
 
Amortization of purchased intangible assets
    
-
    15    
2
    63  
Restructuring recovery
    
-
    -    
(29
)
   -  
Litigation settlement (recovery) costs
    
(1,385
)
   -    
1,215
    -  
Total operating expenses
     6,233    
6,790
    23,809    
24,140
 
Income (loss) from operations
     339    
(1,101
)
   (4,519 )  
(6,638
)
Interest income, net
     16    
3
    37    
19
 
Other income (expense), net
     57    
(194
)
   (2 )  
348
 
Income (loss) before income taxes
     412    
(1,292
)
   (4,484 )  
(6,271
)
Provision for income taxes
     13    
70
    29    
240
 
Income (loss) from continuing operations
     399    
(1,362
)
   (4,513 )  
(6,511
)
Income from discontinued operations
     -    
-
    -    
56
 
Net income (loss)
   $ 399  
$
(1,362
)
 $ (4,513 )
$
(6,455
)
                           
Basic income (loss) per share:
                          
Income (loss) from continuing operations
  
$
0.01
   $ (0.02 )
$
(0.08
)
 $ (0.11 )
Income from discontinued operations
    
-
    -    
-
    -  
Basic net income (loss) per share
   $ 0.01  
$
(0.02
)
 $ (0.08 )
$
(0.11
)
                           
Diluted income (loss) per share:
                          
Income (loss) from continuing operations
  
$
0.01
   $ (0.02 )
$
(0.08
)
 $ (0.11 )
Income from discontinued operations
    
-
   
-
    
-
    -  
Diluted net income (loss) per share
   $ 0.01  
$
(0.02
)
 $ (0.08 )
$
(0.11
)
                           
Basic weighted-average shares
     58,758    
58,642
    58,643    
58,381
 
Diluted weighted-average shares
     60,289    
58,642
    58,643    
58,381
 
                           
(1) Includes net revenues from related party
   $ 430  
$
280
   $ 1,036  
$
896
  
                           
(2) ncludes amortization of purchased intangible assets
 
$
31
   $ 363  
$
551
   $ 1,092  
                           
(3) Excludes share-based compensation expense, which is presented separately by respective expense category.
 
See accompanying notes
 
4

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

 
 
Nine Months Ended 
 
 
 
March 31, 
  
   
2006
  
2005
  
Cash flows from operating activities:
          
Net loss
  
$
(4,513
)
$
(6,455
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
              
Depreciation
    
321
   
504
 
Amortization of purchased intangible assets
    
551
   
1,155
 
Share-based compensation
    
724
   
164
 
Provision for doubtful accounts
    
(19
)
  
59
 
Provision for inventories
    
68
   
206
 
Litigation settlement costs
    
1,215
   
-
 
Restructuring recovery
    
(29
)
  
(56
)
Gain (loss) on disposal of fixed assets
    
(2
)
  
20
 
Foreign currency transaction loss (gain)
    
24
   
(191
)
Changes in operating assets and liabilities:
              
Accounts receivable
   
802
   
534
 
Inventories
   
(117
)
  
(25
)
Contract manufacturers' receivable
   
(793
)
  
399
 
Prepaid expenses and other current assets
   
(265
)
  
698
 
Other assets
   
(12
)
  
16
 
Accounts payable
   
3,441
   
(360
)
Accrued payroll and related expenses
   
(11
)
  
(469
)
Warranty reserve
   
(483
)
  
40
 
Restructuring reserve
   
(116
)
  
(385
)
Other liabilities
   
135
   
(792
)
 Net cash provided by (used in) operating activities
    
921
   
(4,938
)
Cash flows from investing activities:
              
Purchases of property and equipment, net
    
(463
)
  
(87
)
Proceeds from sale of property and equipment
    
8
   
-
 
Purchases of marketable securities
    
-
   
(1,000
)
Proceeds from sale of marketable securities
    
-
   
4,050
 
Net cash (used in) provided by investing activities
    
(455
)
  
2,963
 
Cash flows from financing activities:
              
Net proceeds from issuances of common stock
    
348
   
422
 
Payment of line of credit
    
-
   
(375
)
Payment of convertible note payable
    
-
   
(867
)
Payment of capital lease obligations
    
(120
)
  
-
 
Net cash provided by (used in) financing activities
    
228
   
(820
)
Effect of foreign exchange rate changes on cash
    
(29
)
  
277
 
Increase (decrease) in cash and cash equivalents
    
665
   
(2,518
)
Cash and cash equivalents at beginning of period
    
6,690
   
9,128
 
Cash and cash equivalents at end of period
  
$
7,355
  
$
6,610
  
 
See accompanying notes

5
 
LANTRONIX, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2006

1. Basis of Presentation

The condensed consolidated financial statements included herein are unaudited. They contain all normal recurring accruals and adjustments which, in the opinion of management, are necessary to present fairly the consolidated financial position of Lantronix, Inc. and its subsidiaries (collectively, the “Company”) at March 31, 2006, the consolidated results of its operations for the three and nine months ended March 31, 2006 and 2005, and its cash flows for the nine months ended March 31, 2006 and 2005. All intercompany accounts and transactions have been eliminated. It should be understood that accounting measurements at interim dates inherently involve greater reliance on estimates than at year-end. The results of operations for the three and nine months ended March 31, 2006 are not necessarily indicative of the results to be expected for the full year or any future interim periods.

Certain amounts in the three and nine months ended March 31, 2005 condensed consolidated financial statements have been reclassified to conform with the current three and nine month fiscal presentation. In addition, during the fourth quarter of fiscal 2005, adjustments were identified that resulted in a restatement of certain amounts in the Company’s unaudited first, second and third quarters of fiscal 2005. Additional information on the adjustments is included in the Company’s Annual Report on Form 10-K.

These financial statements do not include certain footnotes and financial presentations normally required under generally accepted accounting principles. Therefore, they should be read in conjunction with the audited consolidated financial statements and notes thereto for the fiscal year ended June 30, 2005, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on September 28, 2005.
 
2. Net Income (Loss) per Share

Basic and diluted net income (loss) per share is calculated by dividing net income (loss) by the weighted-average number of common shares outstanding during the year.

The following table presents the computation of net income (loss) per share (in thousands, except per share data):
 
 
 
Three Months Ended 
 
Nine Months Ended 
  
   
March 31, 
  
 March 31,
  
Numerator:
  
2006
  
2005
  
2006
  
2005
  
Income (loss) from continuing operations
  
$
399
  
$
(1,362
)
$
(4,513
)
$
(6,511
)
Income from discontinued operations
    
-
   
-
   
-
   
56
 
Net income (loss)
  
$
399
  
$
(1,362
)
$
(4,513
)
$
(6,455
)
Denominator:
                          
Weighted-average shares outstanding
    
59,090
   
58,974
   
58,975
   
58,713
 
Less: Unvested common shares outstanding
    
(332
)
  
(332
)
  
(332
)
  
(332
)
Basic weighted-average shares
    
58,758
   
58,642
   
58,643
   
58,381
 
Effect of dilutive shares:
                          
Stock options
    
1,531
   
-
   
-
   
-
 
Diluted weighted-average shares
    
60,289
   
58,642
   
58,643
   
58,381
 
                           
Basic income (loss) per share from continuing operations
  
$
0.01
  
$
(0.02
)
$
(0.08
)
$
(0.11
)
Basic income from discontinued operations
    
-
   
-
   
-
   
-
 
Basic net income (loss) per share
  
$
0.01
  
$
(0.02
)
$
(0.08
)
$
(0.11
)
                           
Diluted income (loss) per share from continuing operations
  
$
0.01
  
$
(0.02
)
$
(0.08
)
$
(0.11
)
Diluted income from discontinued operations
    
-
   
-
   
-
   
-
 
Diluted net income (loss) per share
  
$
0.01
  
$
(0.02
)
$
(0.08
)
$
(0.11
)
 
 
6
 
The following table presents the common stock equivalents excluded from the diluted net income (loss) per share calculation, because they were anti-dilutive as of such dates. These excluded common stock equivalents could be dilutive in the future.

   
 Three Months Ended
  
 Nine Months Ended
  
   
 March 31,
  
 March 31,
  
   
2006
  
2005
  
2006
  
2005
  
Common stock equivalents
   
1,281,093
   
2,832,163
   
1,856,725
   
3,641,583
 
 
3. Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following (in thousands):
 
   
March 31,
  
June 30,
  
 
  
2006
  
2005
  
           
Raw materials
  
$
3,892
  
$
3,973
  
Finished goods
    
6,994
   
7,277
 
Inventory at distributors
    
1,418
   
1,181
 
     
12,304
   
12,431
 
Reserve for excess and obsolete inventories
    
(5,427
)
  
(5,603
)
   
$
6,877
  
$
6,828
  
4. Purchased Intangible Assets

The composition of purchased intangible assets is as follows (in thousands):
 
       
March 31, 2006
  
June 30, 2005
  
   
Useful
                          
   
Lives
  
 
  
Accumulated
  
 
  
 
  
Accumulated
  
 
  
 
  
in Years
  
Gross
  
Amortization
  
Net
  
Gross
  
Amortization
  
Net
  
                               
Existing technology
    
1 - 5
  
$
7,297
  
$
(7,082
)
$
215
  
$
7,090
  
$
(6,533
)
$
557
  
Patent technology
    
6
    
434
   
-
   
434
   
-
   
-
   
-
 
Tradename/trademark
    
5
    
32
   
(32
)
  
-
   
32
   
(30
)
  
2
 
Total
        
$
7,763
  
$
(7,114
)
$
649
  
$
7,122
  
$
(6,563
)
$
559
  
 
The unamortized balance of purchased intangible assets will be amortized to cost of revenues as follows (in thousands):
 
   
2006
  
2007
  
2008
  
2009
  
Thereafter
  
Total
  
                           
Amount remaining to be amortized
  
$
124
  
$
175
  
$
73
  
$
73
  
$
204
  
$
649
  
 
5. Restructuring Reserve

From the fiscal quarter ended March 31, 2002 through the fiscal quarter ended March 31, 2003, the Company implemented plans to restructure its operations to prioritize its initiatives around the growth area of its business, focus on profit contribution, reduce expenses and improve operating efficiency. These restructuring plans included a worldwide workforce reduction, consolidation of excess facilities and other charges. During the fiscal years ended June 30, 2004 and 2003, approximately 58 and 50 employees, respectively, were terminated across all of the Company’s business functions and geographic regions in connection with the restructuring plans.

We expect to pay the remaining balance of the restructuring reserve within the next twelve months. A summary of the activity in the restructuring reserve account, which relates to the consolidation of excess facilities is as follows (in thousands):
 
 
7
 
   
Nine Months Ended
  
   
March 31, 2006
  
       
Beginning balance
  
$
264
  
Restructuring recovery
    
(29
)
Cash payments
    
(116
)
Ending balance
  
$
119
  
 
6. Warranty

Upon shipment to its customers, the Company provides for the estimated cost to repair or replace products to be returned under warranty. The Company’s products typically carry a one- to two-year warranty. In addition, certain products that were sold prior to August 2003 carry a five-year warranty. Although the Company engages in extensive product quality programs and processes, its warranty obligation is affected by product failure rates, use of materials or service delivery costs that differ from our estimates. As a result, additional warranty reserves could be required, which could reduce gross margins.

The following table is a reconciliation of the changes to the product warranty liability for the periods presented (in thousands):

 
 
Nine Months Ended
 
Year Ended
 
 
 
March 31,
 
June 30,
 
 
 
2006
 
2005
 
           
Beginning balance
  
$
1,248
  
$
1,770
  
Charged to cost of revenues
    
(50
)
  
(88
)
Deductions
    
(433
)
  
(434
)
Ending balance
  
$
765
  
$
1,248
  
 
7. Income Taxes

The Company utilizes the liability method of accounting for income taxes. The following table presents the Company’s effective tax rates based upon the income tax provision for the periods shown:
 
   
 Three Months Ended
  
 Nine Months Ended
  
   
 March 31,
  
 March 31,
  
   
2006
  
2005
  
2006
  
2005
  
                   
Effective tax rate
    
3
%
  
5
%
  
1
%
  
4
%
 
        The federal statutory rate was 34% for all periods. The difference between our effective tax rate and the federal statutory rate resulted primarily from the effect of our domestic losses recorded without a tax benefit, as well as the effect of foreign earnings taxed at rates differing from the federal statutory rate.

8. Bank Line of Credit and Debt

Our revolving credit line at June 30, 2005 was $3.0 million. As of June 30, 2005, we had no borrowings against this line of credit. The line of credit expired on July 22, 2005. However, we had issued letters of credit available under the line of credit totaling approximately $480,000 in place of cash to fund deposits on leases, tax account deposits and security deposits. As a result, our available line of credit at June 30, 2005 was $2.5 million. Pursuant to the line of credit, we were restricted from paying any dividends. As of June 30, 2005, we were not in compliance with the quick ratio covenant as defined in the agreement. A waiver was granted by the bank during August 2005.

The Company issued a two-year note during August 2002 in the principal amount of $867,000 in connection with its acquisition of Stallion Technologies PTY, LTD, accruing interest at a rate of 2.5% per annum. The notes were convertible into the Company’s common stock at any time, at the election of the holders, at a $5.00 conversion price. The notes were due and paid in August 2004, as the holders elected not to convert the notes into the Company’s common stock.
 
8

9. Share-Based Compensation

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”). This Statement requires companies to expense the estimated fair value of stock options and similar equity instruments issued to employees over the requisite service period. SFAS 123R eliminates the alternative to use the intrinsic method of accounting provided for in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), which generally resulted in no compensation expense recorded in the financial statements related to the grant of stock options to employees if certain conditions were met. However, under APB 25 and related accounting guidance, the Company recognized compensation expense for in-the-money option grants to employees and employee stock options assumed by the Company in connection with its acquisitions of the businesses that previously employed those individuals. Additionally, the pro forma impact from recognition of the estimated fair value of stock options granted to employees has been disclosed in our footnotes as required under previous accounting rules.

Effective for the first quarter of fiscal 2006, we adopted SFAS 123R using the modified prospective method, which requires us to record compensation expense for all awards granted after the date of adoption, and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Accordingly, prior period amounts presented herein have not been restated to reflect the adoption of SFAS 123R.

The fair value concepts were not changed significantly in SFAS 123R; however, in adopting SFAS 123R, companies must choose among alternative valuation models and amortization assumptions. After assessing alternative valuation models and amortization assumptions, we are continuing to use both the Black-Scholes-Merton (“BSM”) option-pricing formula and straight-line amortization of compensation expense over the requisite service period of the grant. We will reconsider use of this model if additional information becomes available in the future that indicates another model would be more appropriate for us, or if grants issued in future periods have characteristics that cannot be reasonably estimated using this model. Under SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”), we were not required to estimate forfeitures in our expense calculation for the stock compensation pro forma footnote disclosure; however, SFAS 123R requires an estimate of forfeitures and upon adoption we changed our methodology to include an estimate of forfeitures. The adoption of SFAS 123R had no effect on cash flows from financing activities.

The following table illustrates (i) the impact of adopting SFAS 123R on income (loss) before income taxes, net income (loss) and basic and diluted loss per share and (ii) as if the Company had continued to account for share-based compensation under APB 25 (in thousands, except per share data):
 
   
 Three Months Ended
  
 Nine Months Ended
  
 
 
 March 31, 2006
 
 March 31, 2006
  
   
SFAS 123R
  
APB 25
  
SFAS 123R
  
APB 25
  
Income (loss) before income taxes
  
$
412
  
$
658
  
$
(4,484
)
$
(3,775
)
Net income (loss)
  
$
399
  
$
645
  
$
(4,513
)
$
(3,804
)
Basic net income (loss) per share
  
$
0.01
  
$
0.01
  
$
(0.08
)
$
(0.06
)
Diluted net income (loss) per share
  
$
0.01
  
$
0.01
  
$
(0.08
)
$
(0.06
)
 
The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS 123 to options granted under the Company’s stock option plans. For purposes of this pro forma disclosure, the fair value of the options is estimated using a BSM option-pricing formula and amortized on a straight-line basis to expense over the options’ vesting period (in thousands, except per share data):
 
9


   
Three
Months
Ended
  
Nine
 Months
Ended
  
 
  
March 31,
  
March 31,
  
 
  
2005
  
2005
  
           
Net loss - as reported
  
$
(1,362
)
$
(6,455
)
Add: Share-based employee compensation expense included
    
   
 
in net loss, net of related tax effects - as reported
    
6
   
164
 
Deduct: Share-based employee compensation expense determined
    
   
 
under fair value method, net of related tax effects - pro forma
    
(150
)
  
(966
)
Net loss - pro forma
  
$
(1,506
)
$
(7,257
)
Basic and diluted net loss per share - as reported
  
$
(0.02
)
$
(0.11
)
Basic and diluted net loss per share - pro forma
  
$
(0.03
)
$
(0.12
)
               
 
Share Option Plans
 
The Company has in effect several share-based plans under which non-qualified and incentive stock options have been granted to employees, non-employees and board members. The Company also has an employee stock purchase plan for all eligible employees. The Compensation Committee of the Board of Directors determines eligibility, vesting schedules and exercise prices for options granted under the plans. We issue new shares to satisfy stock option exercises and stock purchases under our share-based plans. No income tax benefit was realized from activity in our share-based plans during the three and nine months ended fiscal 2006 and 2005.
 
A summary of the shares reserved for grant and options available for grant under each plan is as follows:
 
   
 March 31, 2006
  
   
Shares
  
Options
  
 
  
Reserved
 
Available
  
 
  
for Grant
  
for Grant
  
1993 Incentive Stock Option Plan
   
4,000,000
   
-
 
1994 Non-statutory Stock Option Plan
   
10,000,000
   
-
 
2000 Stock Plan (“2000 Plan”)
    
12,000,000
   
5,643,570
 
2000 Employee Stock Purchase Plan (“ESPP”)
    
2,250,000
   
388,318
 
     
28,250,000
   
6,031,888
 
 
Under the 2000 Plan, the number of shares available for issuance may be increased annually on the first day of the calendar year by an amount of shares equal to the lesser of (i) 2,000,000 shares, (ii) 5% of the outstanding shares on such date or (iii) a lesser amount as determined by the Board of the Directors. Each board member is automatically granted an option to purchase 25,000 shares of common stock following each annual meeting of stockholders, subject to certain eligibility requirements. As a result of the Company’s acquisitions, the Company assumed stock options granted under stock option plans established by each acquired company; no additional options will be granted under those plans. Option awards are generally granted with an exercise price equal to the market price of the Company’s stock at the date of grant. Option awards generally have a term of 10 years and vest and become exercisable over a three- to four-year service period.
 
The fair value of each share-based award is estimated on the grant date using the BSM option-pricing formula. Expected volatilities are based on the historical volatility of the Company’s stock price. The expected term of options granted subsequent to the adoption of SFAS 123R is derived using the simplified method as defined in the SEC’s Staff Accounting Bulletin 107, “Implementation of FASB 123R.” The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury interest rates in effect at the time of grant. The fair value of options granted was estimated using the following weighted-average assumptions:
 
10
 

   
 Three Months Ended
  
 Nine Months Ended
  
   
 March 31,
  
 March 31,
  
   
2006
  
2005
  
2006
  
2005
  
Expected term (in years)
    
6.25
    
4.00
    
6.23
    
4.00
  
Expected volatility
    
92.87
    
98.63
    
93.13
    
98.71
  
Risk-free interest rate
    
4.58
%
  
4.04
%
  
4.55
%
  
3.97
%
Dividend yield
    
0.00
%
  
0.00
%
  
0.00
%
  
0.00
%
 
A summary of option activity under the stock option plans and changes during the fiscal year is presented below (in thousands, except share and per share data):


   
  March 31, 2006
  
       
 Weighted-Average
      
   
 
  
 
  
Remaining
  
Aggregate
  
 
  
 
  
Exercise
  
Contractual
  
Intrinsic
  
 
  
Shares
  
Price
  
Term
  
Value
  
Outstanding at beginning of period
    
5,084,110
 
$
1.49
    
 
    
 
  
Granted
    
1,249,476
   
2.06
   
 
    
 
  
Cancelled
    
(363,404
)
  
1.75
   
 
    
 
  
Expired
    
(4,000
)
  
0.23
   
 
    
 
  
Exercised
    
(134,978
)
  
0.79
   
 
    
 
  
Outstanding at end of period
    
5,831,204
 
$
1.61
    
7.6
 
$
5,670
  
Vested or expected to vest
    
5,677,571
 
$
1.61
    
7.6
 
$
5,555
  
Options exercisable at end of period
    
3,270,656
 
$
1.63
    
6.5
 
$
3,748
  
 
A summary of the grant-date fair value and intrinsic value information is as follows (in thousands, except per share data):
 
   
 Three Months Ended
  
 Nine Months Ended
  
   
 March 31,
  
 March 31,
  
   
2006
  
2005
  
2006
  
2005
  
Weighted-average grant-date fair value per share
  
$
1.70
  
$
0.81
  
$
1.62
  
$
0.80
  
Intrinsic value of options exercised
  
$
21
  
$
76
  
$
101
  
$
117
  
Intrinsic value of ESPP shares on purchase date
  
$
177
  
$
49
  
$
237
  
$
139
  
 
A summary of the option activity of the Company’s nonvested shares and changes during the fiscal year is presented below (in thousands, except share and per share data):
 
 
  
 March 31, 2006
  
 
  
 
  
 Weighted-Average
  
Remaining
  
   
 
  
 
  
Remaining
  
Unrecognized
  
 
  
 
  
Grant-Date
  
Years
  
Compensation
 
 
  
Shares
  
Fair Value
  
To Vest
  
Cost
  
Nonvested outstanding at beginning of period
    
2,296,938
 
$
0.81
              
Granted
    
1,249,476
   
1.62
           
Vested
   
(815,911
)
  
0.77
           
Forfeited
    
(169,955
)
  
0.93
             
Nonvested outstanding at end of period
    
2,560,548
 
$
1.21
    
2.9
 
$
2,988
  
 
 
11
 
Employee Stock Purchase Plan

The number of shares available for issuance may be increased annually on the first day of the Company’s fiscal year in an amount equal to the lesser of (i) 150,000 shares, (ii) 2% of the outstanding shares on such date or (iii) a lesser amount as determined by the Board of Directors. Under the ESPP plan, each eligible employee may purchase common stock at each semi-annual purchase date (the last business day of February and August each year), but not more than 15% of the participant’s compensation, as defined. The purchase payable per share will be equal to eighty-five percent (85%) of the lower of (i) the closing selling price per share of common stock on the employee’s entry date into the two-year offering period in which that semi-annual purchase date occurs and (ii) the closing selling price per share of common stock on the semi-annual purchase date. Participants may discontinue their participation in the ESPP or may increase or decrease the rate of their payroll deductions during the ESPP offering period. The fair value of ESPP shares granted during the three and nine months ended March 31, 2006 was estimated using the BSM option-pricing formula with an expected term (in years) of 0.5 to 2.0, expected volatility of 0.95, risk-free interest rate of 3.9% and dividend yield of zero. For ESPP shares granted during the three and nine months ended March 31, 2005, we measured share-based compensation expense in our pro forma disclosure using the intrinsic value method as described in SFAS 123.

10. Comprehensive Income (Loss)

The components of comprehensive income (loss) are as follows (in thousands):
 
   
 Three Months Ended
  
 Nine Months Ended
  
 
  
 March 31,
  
 March 31,
  
   
2006
  
2005
  
2006
  
2005
  
                   
Net income (loss)
  
$
399
  
$
(1,362
)
$
(4,513
)
$
(6,455
)
Other comprehensive income (loss):
                          
  Change in net unrealized (loss) gain on investment,
net of taxes of $0
    
(3
)
  
-
   
9
   
-
 
  Change in translation adjustments, net of taxes of $0    
31
   
(85
)
  
(4
)
  
49
 
Total comprehensive income (loss)
  
$
427
  
$
(1,447
)
$
(4,508
)
$
(6,406
)
 
11.  Litigation

Government Investigation

The SEC is conducting a formal investigation of the events leading up to the Company’s restatement of its financial statements on June 25, 2002. The Department of Justice is also conducting an investigation concerning events related to the restatement.

Class Action Lawsuits

Beginning on May 15, 2002, a number of securities class actions were filed against the Company and certain of its current and former directors and former officers alleging violations of the federal securities laws.  These actions were consolidated into a single action pending in the United States District Court for the Central District of California and entitled: In re Lantronix, Inc. Securities Litigation, Case No. CV 02-3899 GPS (JTLx).  After the Court appointed a lead plaintiff, amended complaints were filed by the plaintiff, and the defendants filed various motions to dismiss directed at particular allegations.  Through that process, certain of the allegations were dismissed by the Court.

On October 18, 2004, the plaintiff filed the third amended complaint, which is now the operative complaint in the action. The complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933, as amended (the “Securities Act”) and violations of Sections 10(b) and 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Securities Act claims are brought on behalf of all persons who purchased common stock of Lantronix pursuant or traceable to the Company’s August 4, 2000 initial public offering (“IPO”). The Exchange Act claims are based on alleged misstatements related to the Company’s financial results that were contained in the Registration Statement and Prospectus for the IPO. The claims brought under the Exchange Act are brought on behalf of all persons and entities that purchased or acquired Lantronix securities from November 1, 2000 through May 30, 2002 (the “Class Period”). The complaint alleges that defendants issued false and misleading statements concerning the business and financial condition in order to allegedly inflate the value of the Company’s securities during the Class Period. The complaint alleges that during the Class Period, Lantronix overstated financial results through improper revenue recognition and failure to comply with Generally Accepted Accounting Principles (“GAAP”). Defendants have filed an answer to the complaint and the case is now in discovery.  The Court has set a trial date in September 2006.  While the complaint does not specify the damages plaintiff may seek on behalf of the purported classes of stockholders, a recovery by the plaintiff and the plaintiff classes could have a material adverse impact on the Company. The proceeds from certain insurance policies have funded and continue to fund much of the Company’s defense to the class action lawsuit.
 
12

The Company has reached agreements in principle to the class action and Synergetic action (described below). The Company has also reached agreements in principle with its relevant insurance carriers with respect to the funding of the cash portions of the settlements with plaintiffs. Under the terms of these agreements in principle, the Company will not be required to contribute any cash to the settlements, as all cash contributed would be from the Company’s insurance carriers. However, as part of the agreements in principle with the plaintiffs in these lawsuits, the Company has agreed to issue certain Lantronix securities to the respective plaintiffs in both lawsuits. As a result of the anticipated issuance of such securities, the Company has taken a charge of $1.1 million in the unaudited consolidated statement of operations for the nine months ended March 31, 2006. In addition, the Company has recorded an accrued settlement of $15.9 million of which the Company anticipates its insurance carriers will fund $14.9 million. The agreements in principle with the plaintiffs in the lawsuits are subject to court approval. There is no guarantee that either of these settlements will be finalized or approved by the courts. The Company recorded a litigation settlement recovery of $1.6 million during the three months ended March 31, 2006 as a result of a reduction in the Company’s portion of the estimated accrued settlements due to one of the Company’s insurance carriers increasing the cash portion they are willing to fund.

Derivative Lawsuit

On June 9, 2005, the Superior Court of the State of California, County of Orange, approved the settlement of a stockholder derivative action (entitled Drake v. Bruscha, et al.) pending against the Company and certain of its current and former directors and former officers. The settlement involves the adoption of certain corporate governance measures and payment of attorneys’ fees and expenses to the derivative plaintiff’s counsel in the amount of $1.2 million. The action was dismissed with prejudice as to all parties, including Mr. Steven Cotton, who was not a party to the settlement agreement and who had objected to the settlement. As part of the settlement, the Company’s insurance carrier has agreed to pay the $1.2 million after the settlement becomes final, and the settlement will have no impact on the Company’s financial statements or results of operations. On August 12, 2005, Mr. Cotton appealed the Superior Court’s approval of the settlement, specifically challenging the amount of the $1.2 million fee award. This settlement does not impact the securities class action or Synergetic Micro Systems securities case.

Employment Suit Brought by Former Chief Financial Officer and Chief Operating Officer Steve Cotton

On September 6, 2002, Steve Cotton, the Company’s former CFO and COO, filed a complaint entitled Cotton v. Lantronix, Inc., et al., No. 02CC14308, in the Superior Court of the State of California, County of Orange. The complaint alleges claims for breach of contract, breach of the covenant of good faith and fair dealing, wrongful termination, misrepresentation, defamation and declaratory relief. The complaint seeks compensatory damages, emotional distress damages, punitive damages, declaratory relief, attorneys' fees, interest and costs.

The Company filed a motion to dismiss on October 16, 2002, on the grounds that Mr. Cotton’s complaints are subject to the binding arbitration provisions in Mr. Cotton’s employment agreement. On January 13, 2003, the Court ruled that five of the six counts in Mr. Cotton’s complaint are subject to binding arbitration. The court has set the sixth cause of action for declaratory relief for trial on August 14, 2006.  The arbitration date on the other five causes of action is not currently set.

Securities Claims Brought by Former Stockholders of Synergetic Micro Systems, Inc. (“Synergetic”)

On October 17, 2002, Richard Goldstein and several other former stockholders of Synergetic filed a complaint entitled Goldstein, et al. v. Lantronix, Inc., et al. in the Superior Court of the State of California, County of Orange, against the Company and certain of its former officers and directors. Plaintiffs filed an amended complaint on January 7, 2003. The amended complaint alleges fraud, negligent misrepresentation, breach of warranties and covenants, breach of contract and negligence, all stemming from its acquisition of Synergetic. The complaint seeks an unspecified amount of damages, interest, attorneys’ fees, costs, expenses, and an unspecified amount of punitive damages. On May 5, 2003, the Company answered the complaint and generally denied the allegations in the complaint. Discovery has commenced, and the court has scheduled a trial date set in May 2006.

The Company has reached agreements in principle to settle the class action and Synergetic action. The Company has also reached agreements in principle with its relevant insurance carriers to fund the cash portions of the settlements with plaintiffs. Under the terms of these agreements in principle, the Company will not be required to contribute any cash to the settlements, as all cash contributed would be from the Company’s insurance carriers. However, as part of the agreements in principle with the plaintiffs in these lawsuits, the Company has agreed to issue certain Lantronix securities to the respective plaintiffs in both lawsuits. As a result of the anticipated issuance of such securities, the Company has taken a charge of $1.1 million in the unaudited consolidated statement of operations for the nine months ended March 31, 2006. In addition, the Company has recorded an accrued settlement of $15.9 million of which the Company anticipates its insurance carriers will fund $14.9 million. The agreements in principle with the plaintiffs in the lawsuits are subject to court approval. There is no guarantee that either of these settlements will be finalized or approved by the courts. The Company recorded a litigation settlement recovery of $1.6 million during the three months ended March 31, 2006 as a result of a reduction in the Company’s portion of the estimated accrued settlements due to one of the Company’s insurance carriers increasing the cash portion they are willing to fund.
 
13

Patent Infringement Litigation

On May 2, 2006, the Company entered into a six-year patent cross-license and litigation dismissal agreement with Digi International, Inc. (“Digi”). In connection with the agreement, the Company agreed to pay Digi $600,000 of which $200,000 was paid on May 2, 2006 with the remaining balance to be paid on or before July 10, 2006. In connection with the agreement, the Company capitalized $435,000, which represents the estimated value of the six-year patent cross-license, as a purchased intangible asset in its unaudited condensed consolidated balance sheets. The remaining balance of the payment, which represents the estimated value of the dismissal of the ongoing litigation between the Company and Digi, was recorded as a settlement charge in the unaudited consolidated statements of operations. The $600,000 payment was recorded as an accrued settlement in the unaudited condensed consolidated balance sheets as of March 31, 2006.

Other

From time to time, the Company is subject to other legal proceedings and claims in the ordinary course of business. The Company is currently not aware of any such legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse effect on its business, prospects, financial position, operating results or cash flows.

The pending lawsuits involve complex questions of fact and law and likely will continue to require the expenditure of significant funds and the diversion of other resources to defend. Management is unable to determine the outcome of its outstanding legal proceedings, claims and litigation involving the Company, its subsidiaries, directors and officers and cannot determine the extent to which these results may have a material adverse effect on the Company’s business, results of operations and financial condition taken as a whole. The results of litigation are inherently uncertain, and adverse outcomes are possible. The Company is unable to estimate the range of possible loss from outstanding litigation, and no amounts have been provided for such matters, except as disclosed above.

12. Revision of Statements of Cash Flows

During the third quarter of fiscal 2006, adjustments were identified relating to the presentation of discontinued operations in the Company’s consolidated statements of cash flows as reported in the Company’s Annual Report on Form 10-K. As set forth in the table below, the Company has separately disclosed the operating and investing portions of the cash flows attributable to its discontinued operations, which in prior periods were reported on a combined basis as a single amount. These changes had no impact on the consolidated balance sheets, statements of operations or financial condition of the Company. The following table presents the revised line items in the consolidated statements of cash flows (in thousands):
 
   
 Years Ended June 30,
  
   
 2005
  
 2004
  
 2003
  
   
As
Reported
  
As
Revised
  
As
Reported
  
As
Revised
  
As
Reported
  
As
 Revised
  
                           
Net loss from continuing operations
  
$
(7,060
)
$
-
  
$
(10,607
)
$
-
  
$
(37,434
)
$
-
  
Net income (loss) from discontinued
operations
    
56
   
-
   
(5,047
)
  
-
   
(10,115
)
  
-
 
Net loss
    
-
   
(7,004
)
  
-
   
(15,654
)
  
-
   
(47,549
)
Loss on disposal of fixed assets
    
22
   
22
   
25
   
-
   
-
   
-
 
Changes in operating assets and liabilities of
discontinued operations
    
-
   
-
   
3,351
   
2,759
   
7,108
   
7,169
 
Net cash used in operating activities
    
(4,370
)
  
(4,370
)
  
(2,937
)
  
(3,554
)
  
(17,570
)
  
(17,509
)
Investing cash flows of
discontinued operations
    
-
   
-
   
-
   
617
   
-
   
(61
)
Net cash provided by (used in)
investing activities
    
2,926
   
2,926
   
3,459
   
4,076
   
(2,086
)
  
(2,147
)
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement

You should read the following discussion and analysis in conjunction with our Unaudited Condensed Consolidated Financial Statements and the related notes thereto contained elsewhere in this Quarterly Report on Form 10-Q. 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 (“SEC”), including our Annual Report on Form 10-K for the fiscal year ended June 30, 2005 and subsequent reports on our Current Reports on Form 8-K, which discuss our business in greater detail.
 
14

       The section entitled “Risk Factors” set forth in Part II, Item 1A, and similar discussions in our other SEC filings, describe some of the important risk factors that may affect our business, results of operations and financial condition. You should carefully consider those risks, in addition to the other information in this Quarterly Report on Form 10-Q and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.
 
       This report contains forward-looking statements which include, but are not limited to, statements concerning projected net revenues, expenses, gross profit and net income (loss), the need for additional capital, market acceptance of our products, our ability to achieve further product integration, the status of evolving technologies and their growth potential and our production capacity. Among these forward-looking statements are statements regarding a potential decline in net revenue from non-core product lines, potential variances in quarterly operating expenses, the adequacy of existing resources to meet cash needs, some reduction in the average selling prices and gross margins of products, need to incorporate software from third-party vendors and open source software in our future products and the potential impact of an increase in interest rates or fluctuations in foreign exchange rates on our financial condition or results of operations. These forward-looking statements are based on our current expectations, estimates and projections about our industry, our beliefs and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, including but not limited to those identified under the heading “Risk Factors” set forth in Part II, Item 1A. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Overview

Lantronix, Inc. (“Lantronix” or “the Company”) designs, develops and markets devices that make it possible to access, manage, control and configure electronic products over the Internet or other networks. We are a leader in providing innovative networking solutions. We were initially formed as “Lantronix,” a California corporation, in June 1989. We reincorporated as “Lantronix, Inc.,” a Delaware corporation, in May 2000.

We have a history of providing devices that enable information technology (“IT”) equipment to network using standard protocols for connectivity, including Ethernet and wireless. Our first device was a terminal server that allowed “dumb” terminals to connect to a network. Building on the success of our terminal servers, in 1991 we introduced a complete line of print servers that enabled users to inexpensively share printers over a network. Since then, we have continually refined our core technology and have developed additional innovative networking solutions that expand upon the business of providing our customers network connectivity. With the expansion of networking and the Internet, our technology focus has been increasingly broader and has expanded beyond IT equipment, so that our device solutions provide a product manufacturer with the ability to network its products within the industrial, service and commercial markets.

We provide three broad categories of products: “device networking solutions” that enable electronic products to be connected to a network; “IT management solutions” that enable multiple pieces of equipment, usually IT-related network hardware such as servers, routers, switches and similar pieces of equipment to be managed over a network; and “non-core” products and services that include visualization solutions, legacy print servers and other miscellaneous products. The expansion of our business in the future is directed at the first two of these categories, which comprise our “core” businesses of device networking and IT management solutions.

  Today, our solutions include fully integrated hardware and software devices, as well as software tools, to develop related customer applications. Because we deal with network connectivity, we provide solutions to extremely broad market segments, including industrial, retail, medical, commercial, financial, governmental, building automation and many more. Our technology is used to provide networking capabilities to products such as medical equipment, manufacturing equipment, bar code scanners, building heating, ventilation and air conditioning systems, elevators, process control equipment, vending machines, thermostats, security cameras, temperature sensors, card readers, point of sale terminals, time clocks and virtually any product that has some form of standard data control capability.
 
15

  We sell our products through a global network of distributors, systems integrators, value-added resellers (“VARs”), manufacturers’ representatives and original equipment manufacturers (“OEMs”). In addition, we sell directly to selected accounts.

Financial Highlights and Other Information for the Fiscal Quarter Ended March 31, 2006

The following is a summary of the key factors and significant events that impacted our financial performance during the fiscal quarter ended March 31, 2006:

·  
Net revenues of $13.1 million for the fiscal quarter ended March 31, 2006 increased by $760,000 or 6.2% as compared to $12.3 million reported during the fiscal quarter ended March 31, 2005. The increase in net revenues is primarily due to an increase in our device networking product line of $876,000, which was offset by decreases in our IT management and non-core product lines of $77,000 and $39,000, respectively. Net revenues of $13.1 million for the fiscal quarter ended March 31, 2006 increased by $108,000 or 0.8% as compared to $13.0 million reported during the fiscal quarter ended December 31, 2005. The increase in net revenues is primarily due to increases in our non-core and IT management product lines of $354,000 and $39,000, respectively, which were offset by a decrease in our device networking product line of $285,000.

·  
Gross profit as a percentage of net revenues was 50.3% for the fiscal quarter ended March 31, 2006, increasing 4.1 percentage points from the 46.2% reported in the fiscal quarter ended March 31, 2005. As a percentage of net revenues, the increase in gross profit is primarily due to a reduction in product warranty reserves to reflect a decrease in our product return rates, a decrease in the amortization of purchased intangible assets, a reduction in manufacturing overhead costs, which were offset by an increase in standard product costs as a result of a shift in the product mix in device networking sales towards lower margin product sales.

·  
Income from operations as a percentage of net revenues was 2.6% for the fiscal quarter ended March 31, 2006 compared to a 9.0% loss from operations in the fiscal quarter ended March 31, 2005. The income from operations is primarily due to a recovery of accrued litigation settlements and a higher gross profit offset by an increase in legal fees, share-based compensation expense recorded in connection with our adoption of SFAS 123R in the first quarter of fiscal 2006 as further described below, and an increase in research and development expenses.
 
·  
Net income of $399,000 or $0.01 per diluted share, in the fiscal quarter ended March 31, 2006, increased from a net loss of $1.4 million, or $0.02 per diluted share, in the fiscal quarter ended March 31, 2005.

·  
Cash, cash equivalents and marketable securities increased from $7.3 million as of December 31, 2005 to $7.4 million as of March 31, 2006.

·  
Accounts receivable, net were $1.8 million as of March 31, 2006 as compared to $2.6 million at June 30, 2005. Days sales outstanding (“DSO”) in receivables as of March 31, 2006 improved to 15.4 days from 22.2 days as of June 30, 2005. Our accounts receivable and DSO are primarily affected by the linearity of shipments within the year, our collections performance and the fact that a significant portion of our revenues are recognized on a sell-through basis (upon shipment from distributor inventories rather than as goods are shipped to distributors).

·  
Inventories, net were $6.9 million as of March 31, 2006 as compared to $6.8 million as of June 30, 2005. Our annualized inventory turns remained consistent with 3.8 turns as of March 31, 2006 compared to 3.8 turns as of June 30, 2005.

Critical Accounting Policies and Estimates

        The accounting policies that have the greatest impact on our financial condition and results of operations and that require the most judgment are those relating to revenue recognition, allowance for doubtful accounts, inventory valuation, valuation of deferred income taxes, goodwill and purchased intangible assets and legal settlement costs. These policies are described in further detail in our Annual Report on Form 10-K for the fiscal year ended June 30, 2005. Except for share-based compensation treatment described below, there have been no significant changes in our critical accounting policies and estimates during the fiscal quarter ended March 31, 2006 as compared to what was previously disclosed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2005.

Adoption of SFAS 123R

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”).Effective for the first quarter of fiscal 2006, we adopted SFAS 123R using the modified prospective method, which requires us to record compensation expense for all awards granted after the date of adoption, and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Accordingly, prior period amounts presented herein have not been restated to reflect the adoption of SFAS 123R.
 
16

The following table illustrates (i) the impact of adopting SFAS 123R on income (loss) before income taxes, net income (loss) and basic and diluted income (loss) per share and (ii) as if we had continued to account for share-based compensation under APB 25 (in thousands, except per share data):
 
   
 Three Months Ended
  
 Nine Months Ended
  
   
 March 31, 2006
  
 March 31, 2006
  
   
SFAS 123R
 
APB 25
 
SFAS 123R
 
APB 25
  
Income (loss) before income taxes
  
$
412
  
$
658
  
$
(4,484
)
$
(3,775
)
Net income (loss)
  
$
399
  
$
645
  
$
(4,513
)
$
(3,804
)
Basic net income (loss) per share
  
$
0.01
  
$
0.01
  
$
(0.08
)
$
(0.06
)
Diluted net income (loss) per share
  
$
0.01
  
$
0.01
  
$
(0.08
)
$
(0.06
)
 
The following table illustrates the effect on net loss and loss per share if we had applied the fair value recognition provisions of SFAS 123 to options granted under our stock option plans in the first fiscal quarter of 2005. (in thousands, except per share data):
 
   
Three
Months
Ended
  
Nine
Months
Ended
  
 
  
March 31,
  
March 31,
  
 
  
2005
  
2005
  
           
Net loss - as reported
  
$
(1,362
)
$
(6,455
)
Add: Share-based employee compensation expense included
              
in net loss, net of related tax effects - as reported
    
6
   
164
 
Deduct: Share-based employee compensation expense determined
              
under fair value method, net of related tax effects - pro forma
    
(150
)
  
(966
)
Net loss - pro forma
  
$
(1,506
)
$
(7,257
)
Basic and diluted net loss per share - as reported
  
$
(0.02
)
$
(0.11
)
Basic and diluted net loss per share - pro forma
  
$
(0.03
)
$
(0.12
)
 
Total compensation cost related to nonvested awards not yet recognized and the weighted-average period over which it is expected to be recognized is as follows (in thousands):
 
   
March 31,
2006
  
Cost of revenues
  
$
250
  
Sales, general and administrative
    
2,088
 
Research and development
    
650
 
Total
  
$
2,988
  
         
Weighted-average remaining years
    
2.9
 
 
Recent Accounting Pronouncements

Recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the American Institute of Certified Public Accountants and the SEC did not or are not believed by management to have a material impact on our present or future consolidated financial statements.

Consolidated Results of Operations

The following table sets forth, for the periods indicated, the percentage of net revenues represented by each item in our condensed consolidated statement of operations:
 
17


   
Three Months Ended
  
Nine Months Ended
  
 
  
March 31,
  
March 31,
  
 
  
2006
  
2005
  
2006
  
2005
  
                   
Net revenues
    
100.0
%
  
100.0
%
  
100.0
%
  
100.0
%
Cost of revenues
    
49.5
%
  
53.8
%
  
49.4
%
  
51.7
%
Cost of revenues - share-based compensation
   
0.2
%
  
0.0
%
  
0.2
%
  
0.0
%
Gross profit
    
50.3
%
  
46.2
%
  
50.4
%
  
48.3
%
Operating expenses:
                          
Selling, general and administrative
    
45.0
%
  
44.5
%
  
46.6
%
  
52.2
%
Selling, general and administrative -
share-based compensation
    
1.3
%
  
0.0
%
  
1.3
%
  
0.4
%
Research and development
    
11.6
%
  
10.5
%
  
10.8
%
  
13.8
%
Research and development - share-based compensation
    
0.4
%
  
0.0
%
  
0.4
%
  
0.0
%
Amortization of purchased intangible assets
    
0.0
%
  
0.1
%
  
0.0
%
  
0.2
%
Restructuring recovery
    
0.0
%
  
0.0
%
  
(0.1
%)
  
0.0
%
Litigation settlement costs
    
(10.6
%)
  
0.0
%
  
3.2
%
  
0.0
%
Total operating expenses
    
47.7
%
  
55.2
%
  
62.2
%
  
66.6
%
Income (loss) from operations
    
2.6
%
  
(9.0
%)
  
(11.8
%)
  
(18.3
%)
Interest income, net
    
0.1
%
  
0.0
%
  
0.1
%
  
0.1
%
Other income (expense), net
    
0.5
%
  
(1.5
%)
  
0.0
%
  
0.9
%
Income (loss) before income taxes
    
3.2
%
  
(10.5
%)
  
(11.7
%)
  
(17.3
%)
Provision for income taxes
    
0.1
%
  
0.6
%
  
0.1
%
  
0.7
%
Income (loss) from continuing operations
    
3.1
%
  
(11.1
%)
  
(11.8
%)
  
(18.0
%)
Income from discontinued operations
    
0.0
%
  
0.0
%
  
0.0
%
  
0.2
%
Net income (loss)
    
3.1
%
  
(11.1
%)
  
(11.8
%)
  
(17.8
%)
 
Comparison of the Three and Nine Months Ended March 31, 2006 and 2005

Net Revenues by Product Category (in thousands)
 
   
  Three Months Ended
  
 
  
 March 31,
  
   
 
  
% of Net
  
 
  
% of Net
  
$ 
 
%
  
 
  
2006
  
Revenue
  
2005
  
Revenue
  
Variance
  
Variance
  
                           
Device networking
  
$
8,690
    
66.5%
 
$
7,814
    
63.5%
 
$
876
    
11.2% 
 
IT management
    
2,887
   
22.1%
 
  
2,964
   
24.1%
 
  
(77
)
  
(2.6%)
 
Non-core
    
1,486
   
11.4%
 
  
1,525
   
12.4%
 
  
(39
)
  
(2.6%)
 
Total
  
$
13,063
    
100.0%
 
$
12,303
    
100.0%
 
$
760
    
6.2% 
 
                                       
                                       
 
Nine Months Ended 
 
 March 31, 
 
 
 
 
% of Net 
 
 
 
 
% of Net
 
 
$ 
 
 
%
 
 
 
 
2006
 
 
Revenue
 
 
2005
 
 
Revenue
 
 
Variance
 
 
Variance
 
                                       
Device networking
  
$
25,922
    
67.8%
 
$
22,119
    
61.0%
 
$
3,803
    
17.2% 
 
IT management
    
8,518
   
22.3%
 
  
9,385
   
25.9%
 
  
(867
)
  
(9.2%)
 
Non-core
    
3,818
   
9.9%
 
  
4,752
   
13.1%
 
  
(934
)
  
(19.7%)
 
Total
  
$
38,258
    
100.0%
 
$
36,256
    
100.0%
 
$
2,002
    
5.5% 
 
 
The increase in net revenues for the three months ended March 31, 2006 as compared to the same period one year ago was a result of an increase in net revenues from our device networking products, offset by a decrease in our IT management products, and to a lesser extent, our non-core products. The increase in our device networking product line is primarily due to an increase in volume in our embedded device networking products, which includes our X-port products, offset by a decline in our external device networking products. The decrease in IT management product sales is primarily due to a decrease in terminal server IT management product sales offset by an increase in our SecurLinx IT management product sales. We are no longer investing in the development of our non-core product lines and expect net revenues related to these products to continue to decline in the future as we focus our investment in device networking and certain IT management products.
 
18

The increase in net revenues for the nine months ended March 31, 2006 as compared to the same period one year ago was a result of an increase in net revenues from our device networking products, offset by a decrease in our IT management products, and our non-core products. The increase in our device networking product line is primarily due to an increase in volume in our embedded device networking products, which includes our X-port products. The decrease in IT management product sales is primarily due to a decrease in terminal server IT management product sales and to a lesser extent a decrease in our SecurLinx IT management product sales. We are no longer investing in the development of our non-core product lines and expect net revenues related to these products to continue to decline in the future as we focus our investment in device networking and certain IT management products.

Net Revenues by Region (in thousands)

   
  Three Months Ended
 
   
  March 31,
 
 
 
 
 
% of Net
 
 
 
% of Net
 
$ 
 
%
  
 
  
2006
  
Revenue
 
2005
  
Revenue
 
Variance
 
Variance
 
                           
Americas
  
$
8,005
    
61.3
%
$
7,597
    
61.7
%
$
408
    
5.4
%
EMEA
    
3,601
   
27.6
%
  
3,600
   
29.3
%
  
1
   
0.0
%
Asia Pacific
    
1,457
   
11.1
%
  
1,106
   
9.0
%
  
351
   
31.7
%
Total
  
$
13,063
    
100.0
%
$
12,303
    
100.0
%
$
760
    
6.2
%
 

   
  Nine Months Ended
 
   
  March 31,
 
 
 
 
 
% of Net
 
 
 
% of Net
 
$ 
 
%
  
 
  
2006
  
Revenue
 
2005
  
Revenue
 
Variance
 
Variance
 
                           
Americas
  
$
24,077
    
62.9
%
$
23,141
    
63.8
%
$
936
    
4.0
%
EMEA
    
10,169
   
26.6
%
  
9,805
   
27.0
%
  
364
   
3.7
%
Asia Pacific
    
4,012
   
10.5
%
  
3,310
   
9.2
%
  
702
   
21.2
%
Total
  
$
38,258
    
100.0
%
$
36,256
    
100.0
%
$
2,002
    
5.5
%
 
The increase for the three months ended March 31, 2006 as compared to the same period one year ago is a result of an increase in net revenues in the Americas and Asia Pacific regions. In order of significance, the increase in net revenues in the Americas region is primarily attributable to an increase in sales of our device networking, non-core and IT management products. The increase in net revenues in the Asia Pacific region is primarily due to an increase in sales of our device networking products.

The increase for the nine months ended March 31, 2006 as compared to the same period one year ago is a result of an increase in net revenues across all of our geographic regions. The increase in net revenues in the Americas region is primarily attributable to an increase in sales of device networking products offset by lower sales of IT management and non-core products. The increase in net revenues in the EMEA (“Europe, Middle East and Africa”) and Asia Pacific regions is primarily due to an increase in sales of our device networking products.
 
19

Gross Profit (in thousands)
 
   
Three Months Ended
  
   
March 31,
  
   
 
  
% of Net
  
 
  
% of Net
  
$ 
  
%
  
 
  
2006
  
Revenue
  
2005
  
Revenue
  
Variance
  
Variance
  
                           
Gross profit
  
$
6,572
    
50.3
%
$
5,689
    
46.2
%
$
883
    
15.5
%
 
   
Nine Months Ended
  
   
March 31,
  
   
 
  
% of Net
  
 
  
% of Net
  
$ 
  
%
  
 
  
2006
  
Revenue
  
2005
  
Revenue
  
Variance
  
Variance
  
                           
Gross profit
  
$
19,290
    
50.4
%
$
17,502
    
48.3
%
$
1,788
    
10.2
%
 
Gross profit represents net revenues less cost of revenues. Cost of revenues consists primarily of the cost of raw material components, subcontract labor assembly from contract manufacturers, manufacturing overhead, amortization of purchased intangible assets, establishing or relieving inventory reserves for excess and obsolete products or raw materials, warranty costs, royalties and share-based compensation.

In order of significance, the increase in gross profit as a percentage of net revenues for the three months ended March 31, 2006 as compared to the same period one year ago is primarily due to the following factors: (i) a reduction in product warranty reserves to reflect a decrease in our product return rates; (ii) a decrease in the amortization of purchased intangible assets as a result of a majority of our purchased intangible assets becoming fully amortized; and (iii) a reduction in manufacturing overhead costs; offset by an increase in standard product costs as a result of a shift in the product mix in device networking sales towards lower margin product sales.

In order of significance, the increase in gross profit as a percentage of net revenues for the nine months ended March 31, 2006 as compared to the same period one year ago is primarily due to the following factors: (i) a decrease in the amortization of purchased intangible assets as a result of a majority of our purchased intangible assets becoming fully amortized; (ii) a reduction in product warranty reserves to reflect a decrease in our product return rates; and (iii) a reduction in manufacturing overhead costs; offset by an increase in standard product costs as a result of a shift in the product mix in device networking sales towards lower margin product sales.

Cost of revenues includes amortization of purchased intangible assets as follows (in thousands): 
 
   
Three Months Ended 
  
Nine Months Ended 
  
   
 March 31,
  
 March 31,
  
   
2006
  
2005
  
2006
  
2005
  
Amortization of purchased intangible assets
  
$
31
  
$
363
  
$
551
  
$
1,092
  
  
The unamortized balance of purchased intangible assets will be amortized to cost of revenues as follows (in thousands):
 
   
2006
  
2007
  
2008
  
2009
  
Thereafter
  
Total
  
                           
Amount remaining to be amortized
  
$
124
  
$
175
  
$
73
  
$
73
  
$
204
  
$
649
  
 
20
 
Selling, General and Administrative (in thousands)

   
Three Months Ended
  
   
March 31,
  
   
 
 
% of Net
 
 
 
% of Net
 
 $
 
%
 
 
 
2006
 
Revenue
 
2005
 
Revenue
 
Variance
 
Variance
  
                           
Selling, general and administrative (1)
  
$
5,875
    
45.0
%
$
5,477
    
44.5
%
$
398
    
7.3
%
Selling, general and administrative
                                     
- share-based compensation
  
$
171
    
1.3
%
$
1
    
0.0
%
$
170
    
17000.0
%
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.
 
 
   
Nine Months Ended
  
   
March 31,
  
   
 
  
% of Net
 
 
  
% of Net
   $  
%
  
 
  
2006
  
Revenue
 
2005
  
Revenue
 
Variance
  
Variance
  
                           
Selling, general and administrative (1)
  
$
17,837
    
46.6
%
$
18,905
    
52.1
%
$
(1,068
)
  
(5.6
%)
Selling, general and administrative
                                     
- share-based compensation
  
$
499
    
1.3
%
$
154
    
0.4
%
$
345
    
224.0
%
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.
 
Selling, general and administrative expenses consist primarily of personnel-related expenses including salaries and commissions, facility expenses, information technology, trade show expenses, advertising, purchased patents and professional legal and accounting fees offset by reimbursement of legal fees from insurance proceeds.

In order of significance, the increase in selling, general and administrative expense for the three months ended March 31, 2006 as compared to the same period one year ago is primarily due to the following factors: (i) an increase in legal and professional fees primarily as a result of legal fees related to ongoing litigation; and (ii) an increase in personnel-related and facilities expenses as a result of an increase in headcount in the current fiscal quarter; offset by a decrease in facility and advertising expenses.

In order of significance, the decrease in selling, general and administrative expense for the nine months ended March 31, 2006 as compared to the same period one year ago is primarily due to the following factors: (i) a decrease in personnel-related and facilities expenses as a result of a reduction of average headcount for the period; (ii) a reduction of advertising expenditures; and (iii) a recovery of bad debts; offset by an increase in legal and professional fees primarily as a result of legal fees related to ongoing litigation.

The increase in share-based compensation expense is due to our adoption of SFAS 123R as of July 1, 2005. See above section, Adoption of SFAS 123R, for additional detail.

Research and Development (in thousands)
 
   
Three Months Ended
  
   
March 31,
  
 
 
 
 
% of Net
 
 
 
% of Net
 
$ 
 
%
  
 
  
2006
  
Revenue
 
2005
  
Revenue
 
Variance
 
Variance
 
                           
Research and development (1)
  
$
1,517
    
11.6%
 
$
1,292
    
10.5%
 
$
225
    
17.4%
 
Research and development
                                      
- share-based compensation
  
$
55
    
0.4%
 
$
5
    
0.0%
 
$
50
    
1,000.0%
  
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.
  
 
21

   
Nine Months Ended
  
   
March 31,
  
   
 
 
% of Net
 
 
 
% of Net
 
$
 
%
 
 
 
2006
 
Revenue
 
2005
 
Revenue
 
Variance
 
Variance
 
                           
Research and development (1)
  
$
4,125
    
10.8%
 
$
5,008
    
13.8%
 
$
(883
)
  
(17.6%)
 
Research and development
                                      
- share-based compensation
  
$
160
    
0.4%
 
$
10
    
0.0%
 
$
150
    
1500.0% 
 
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.
  
 
Research and development expenses consist primarily of personnel-related expenses, as well as expenditures to third-party vendors for research and development activities.

In order of significance, the increase in research and development expenses for the three months ended March 31, 2006 as compared to the same period one year ago is primarily due to the following factors: (i) an increase in personnel-related expenses as a result of an increase in headcount in the current fiscal quarter; and (ii) an increase in professional fees and outside services used to supplement our research and development activities.

In order of significance, the decrease in research and development expenses for the nine months ended March 31, 2006 as compared to the same period one year ago is primarily due to the following factors: a decrease in personnel-related expenses as a result of a reduction of average headcount for the period; partially offset by an increase in professional fees and outside services used to supplement our research and development activities.

The increase in share-based compensation expense is due to our adoption of SFAS 123R as of July 1, 2005. See above section, Adoption of SFAS 123R, for additional detail.

Restructuring Charges

During the nine months ended March 31, 2006, approximately $29,000 of restructuring charges were recovered as a result of a decrease in our expected liability related to the consolidation of excess facilities that occurred during our fiscal 2004 and 2003 restructurings.

Litigation Settlement (Recovery) Costs (in thousands)
 
   
 Three Months Ended
  
 
  
 March 31,
  
 
 
 
 
% of Net
 
 
 
% of Net
 
$ 
 
%
 
 
 
2006
 
Revenue
 
2005
 
Revenue
 
Variance
 
Variance
  
                           
Litigation settlement (recovery) costs
  
$
(1,385
)
  
(10.6
%)
$
-
    
0.0
%
$
(1,385
)
  
N/A
  
                                       
     
 
  
Nine Months Ended 
 
 March 31, 
   
 
 
 
% of Net 
 
 
 
 
 
% of Net
 
 
$ 
 
%
 
 
 
 
2006
 
 
Revenue
 
 
2005
 
 
Revenue
 
 
Variance
 
 
Variance
  
                                       
Litigation settlement costs
  
$
1,215
    
3.2
%
$
-
    
0.0
%
$
1,215
    
N/A
  
 
The increase in litigation settlement recovery for the three months ended March 31, 2006 as compared to the same period one year ago is primarily due to a $1.6 million recovery of class action litigation settlement costs as a result of anticipated payments by one of the Company’s insurance carriers offset by a $165,000 settlement charge recorded in connection with a six-year patent cross-license and litigation dismissal settlement agreement.

The increase in litigation settlement costs for the nine months ended March 31, 2006 as compared to the same period one year ago is due to a $1.1 million settlement charge we recorded in connection with an agreement in principle to settle the outstanding class action lawsuits and a $165,000 settlement charge we recorded in connection with a six-year patent cross-license and litigation dismissal settlement agreement.
 
22

Refer to Note 11 in our notes to the unaudited condensed consolidated financial statements for further discussion of our ongoing litigation matters.

Other Income (Expense), Net (in thousands)
 
   
Three Months Ended
 
   
March 31,
  
 
 
 
 
% of Net
 
 
 
% of Net
 
$ 
 
%
  
 
  
2006
  
Revenue
  
2005
  
Revenue
  
Variance
  
Variance
  
                           
Other income (expense), net
  
$
57
    
0.4
%
$
(194
)
  
-1.6
%
$
251
    
N/A
  
 

   
Nine Months Ended
 
   
March 31,
  
 
 
 
 
% of Net
 
 
 
% of Net
 
$ 
 
%
  
 
  
2006
  
Revenue
  
2005
  
Revenue
  
Variance
  
Variance
  
                           
Other income (expense), net
  
$
(2
)
  
(0.0
%)
$
348
    
1.0
%
$
(350
)
  
N/A
  
 
The increase in other income for the three months ended March 31, 2006 as compared to the same period one year ago is primarily due to foreign transaction gains for the three months ended March 31, 2006 as opposed to foreign exchange losses for the three months ended March 31, 2005.

The difference in other expense for the nine months ended March 31, 2006 as compared to the same period one year ago is primarily due to foreign transaction losses for the nine months ended March 31, 2006 as opposed to foreign exchange gains for the nine months ended March 31, 2005.

Provision for Income Taxes - Effective Tax Rate

The Company utilizes the liability method of accounting for income taxes. The following table presents the Company’s effective tax rates based upon the income tax provision for the periods shown:

   
 Three Months Ended
  
 Nine Months Ended
  
   
 March 31,
  
 March 31,
  
   
2006
  
2005
  
2006
  
2005
  
                   
Effective tax rate
    
3
%
  
5
%
  
1
%
  
4
%
 
The federal statutory rate was 34% for all periods. The difference between our effective tax rate and the federal statutory rate resulted primarily from the effect of our domestic losses recorded without a tax benefit, as well as the effect of foreign earnings taxed at rates differing from the federal statutory rate.

Liquidity and Capital Resources

Since inception, we have financed our operations through the issuance of common stock and through net cash generated from operations. We consider all highly liquid investments purchased with original maturities of 90 days or less to be cash equivalents.

The following table summarizes the major components of the consolidated statement of cash flows (in thousands):
 
23
 
   
 Nine Months Ended
  
   
 March 31,
  
   
2006
  
2005
  
Net cash provided by (used in):
  
 
  
 
  
Net loss
  
$
(4,513
)
$
(6,455
)
Non-cash operating expenses, net
    
2,853
   
1,861
 
Changes in operating assets and liabilities
    
2,581
   
(344
)
Net cash provided by (used in) operating activities
    
921
   
(4,938
)
Net cash (used in) provided by investing activities
    
(455
)
  
2,963
 
Net cash provided by (used in) financing activities
    
228
   
(820
)
Effect of foreign exchange rate changes on cash
    
(29
)
  
277
 
Increase (decrease) in cash and cash equivalents
  
$
665
  
$
(2,518
)
 
 
  
March 31,
  
June 30,
 
 
  
2006
  
2005
  
Cash and cash equivalents
  
$
7,355
  
$
6,690
  
Marketable securities
    
94
   
85
 
 
  
$
7,449
  
$
6,775
  
 
Our cash, cash equivalents and marketable securities balances increased by approximately $170,000, from $6.8 million at June 30, 2005, to $6.9 million at September 30, 2005. During the second fiscal quarter ended December 31, 2005 our cash and cash equivalents and marketable securities increased by an additional $346,000 to $7.3 million. During the third fiscal quarter ended March 31, 2006 our cash and cash equivalents and marketable securities increased by an additional $158,000 to $7.4 million. We refer to the sum of these components as “cash” for the purpose of discussing our cash usage and liquidity.

Operating activities provided cash for the nine months ended March 31, 2006. This was primarily the result of the net loss offset by net cash provided from changes in operating assets and liabilities and non-cash operating expenses.  In order of significance, the non-cash operating expenses that had a significant impact on net loss included litigation settlement costs, share-based compensation, amortization of purchased intangible assets and depreciation. In order of significance, the changes in operating assets and liabilities which had a significant impact on the cash provided by operating activities included accounts payable, accounts receivable, contract manufacturers’ receivable, prepaid expenses and other current assets and warranty reserve.
 
Operating activities used cash for the nine months ended March 31, 2005. This was primarily the result of the net loss offset by non-cash operating expenses.  In order of significance, the non-cash operating expenses that had a significant impact on net loss included amortization of purchased intangible assets, depreciation, provision for inventories, share-based compensation and foreign currency transaction gain. In order of significance, the changes in operating assets and liabilities which had a significant impact on the cash used in operating activities included other liabilities, accrued payroll and related expenses, restructuring reserve and accounts payable offset by prepaid expenses and other current assets, accounts receivable and contract manufacturers’ receivable.
 
Investing activities used cash for the nine months ended March 31, 2006. This was for the purchase of property and equipment offset by proceeds from sale of property and equipment. Investing activities provided cash for the nine months ended March 31, 2005. This was primarily due to net proceeds from the purchase and sale of marketable securities offset by the purchase of property plant and equipment.

Financing activities provided cash for the nine months ended March 31, 2006. This was primarily due to proceeds from the sale of common shares through employee stock option exercises and the Employee Stock Purchase Plan offset by repayments on capital lease obligations. Financing activities used cash for the nine months ended March 31, 2005. This was primarily due to a payment to retire our convertible note payable and payments on our line of credit offset by proceeds from the sale of common shares through employee stock option exercises and the Employee Stock Purchase Plan.

Our revolving credit line at June 30, 2005 was $3.0 million. As of June 30, 2005, we had no borrowings against this line of credit. The line of credit expired July 22, 2005. However, we had issued letters of credit available under the line of credit totaling approximately $480,000 in place of cash to fund deposits on leases, tax account deposits and security deposits. As a result, our available line of credit at June 30, 2005 was $2.5 million. Pursuant to the line of credit, we were restricted from paying any dividends. As of June 30, 2005, we were not in compliance with the quick ratio covenant as defined in the agreement. A waiver was granted by the bank during August 2005.
 
24

As of March 31, 2006, approximately $2.2 million of our tangible assets (primarily cash held in foreign subsidiary bank accounts) were held by subsidiaries outside the U.S. Such assets are unrestricted with regard to foreign liquidity needs, however, our ability to utilize a portion of such assets to satisfy liquidity needs outside of such foreign locations are subject to approval by the foreign locations’ board of directors.

The cumulative effect of the reductions initiated in October 2004 through January 2005 has been that we have lowered our operating costs to streamline operations and lower our cash breakeven point from the earlier revenue range of $14-15 million in quarterly revenues as an operating model, to approximately $13 million per quarter. This target is based upon a financial model, and we expect that actual expenses may vary in any quarter and therefore financial results impacting cash usage or profitability will vary. Further, this model assumes that we will significantly reduce our legal fees as certain cases are settled. Also, uses of cash to fund inventories, receivables and payables will cause results to vary from the financial model.

We believe that our existing cash, cash equivalents and marketable securities will be adequate to meet our anticipated cash needs through at least the next twelve months. Our future capital requirements will depend on many factors, including the timing and amount of our net revenues, research and development, expenses associated with any strategic partnerships or acquisitions and infrastructure investments, and expenses related to ongoing government investigations and pending litigation, which could affect our ability to generate additional cash. If cash generated from operations and financing activities is insufficient to satisfy our working capital requirements, we may need to borrow funds through bank loans, sales of securities or other means. We are in the process of negotiating a new bank line of credit. There can be no assurance that we will be able to raise any such capital on terms acceptable to us, if at all. If we are unable to secure additional financing, we may not be able to develop or enhance our products, take advantage of future opportunities, respond to competition or continue to operate our business.

Off-Balance Sheet Arrangements

We did not have any off balance sheet arrangements as of March 31, 2006.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk
 
Our exposure to interest rate risk is limited to the exposure related to our cash and cash equivalents, which is tied to market interest rates. We had the following cash and cash equivalents and marketable securities consisting of publicly traded equity securities (in thousands) for the periods indicated:

   
March 31,
 
June 30,
 
 
 
2006
 
2005
  
Cash and cash equivalents
  
$
7,355
  
$
6,690
  
Marketable securities
    
94
   
85
 
   
$
7,449
  
$
6,775
  
 
We believe our cash and cash equivalents and marketable securities would not decline in value by a significant amount if interest rates increase, and therefore would not have a material effect on our financial condition or results of operations.

Foreign Currency Risk
 
We sell products internationally. As a result, our financial results could be harmed by factors such as changes in foreign currency exchange rates, particularly the Euro, or weak economic conditions in foreign markets. 
 
Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures
 
We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of our fiscal quarter ended March 31, 2006. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer to allow timely decisions regarding required disclosure.
 
25
 
(b) Changes in internal controls over financial reporting
 
As described in our Form 10-K filed on September 28, 2005, in connection with our fiscal 2005 financial statement close, we determined and concluded that there were significant deficiencies in our financial statement close process. We concluded that those conditions constituted a material weakness in our internal controls over financial reporting. During our fiscal quarter ended September 30, 2005, we implemented certain improvements to our internal control over financial reporting, as described in more detail in our Form 10-Q filed with the SEC on November 14, 2005. Other than as described below, there has not been any other change in our internal control over financial reporting that occurred during our fiscal quarter ended March 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
 
In January 2006, management initiated, with the Audit Committee’s concurrence, a process whereby incoming invoices are recorded by our accounts payable function upon receipt.
 
PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The information set forth in Note 11 to our notes to the unaudited condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q is hereby incorporated by reference.

Item 1A. Risk Factors

Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described below, in addition to the other cautionary statements and risks described elsewhere and the other information contained in this Quarterly Report on Form 10-Q and in our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. This should be read in conjunction with our unaudited condensed consolidated financial statements and the accompanying notes thereto, and other parts of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Quarterly Report on Form 10-Q. If any of these known or unknown risks or uncertainties actually occurs with material adverse effects on Lantronix, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

Our quarterly operating results may fluctuate, which could cause our stock to decline.

We have experienced, and expect to continue to experience, significant fluctuations in revenues, expenses and operating results from quarter to quarter. We, therefore, believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance, and you should not rely on them to predict our future performance or the future performance of our stock. Our short-term expense levels for ongoing operations are relatively fixed and are based on our expectations of future net revenues. If we were to experience a reduction in revenues in a quarter, we would likely be unable to adjust our short-term expenditures. If this were to occur, our operating results for that fiscal quarter would be harmed. If our operating results in future fiscal quarters fall below the expectations of market analysts and investors, the price of our common stock would likely fall. Other factors that might cause our operating results to fluctuate on a quarterly basis include:

·  
changes in the mix of net revenues attributable to higher-margin and lower-margin products;

·  
customers’ decisions to defer or accelerate orders;

·  
variations in the size or timing of orders for our products;

·  
changes in demand for our products;

·  
defects and other product quality problems;

·  
loss or gain of significant customers;

·  
short-term fluctuations in the cost or availability of our critical components;

·  
announcements or introductions of new products by our competitors;

·  
effects of terrorist attacks in the U.S. and abroad; and

·  
changes in demand for devices that incorporate our products.

26
 
Current or future litigation could adversely affect us.

We are currently involved in significant litigation, including multiple security class action lawsuits, a state derivative lawsuit, and litigation with a former executive officer. The pending lawsuits involve complex questions of fact and law and will likely continue to require the expenditure of significant funds and the diversion of other resources. Except as described in this Form 10-Q, we do not know what the outcome of outstanding legal proceedings will be and cannot determine the extent to which these resolutions might have a material adverse effect on our business, financial condition or results of operations. The results of litigation are inherently uncertain, and adverse outcomes are possible. For a more detailed description of pending litigation, see Note 11 to our notes to the unaudited condensed consolidated financial statements of Part I, Item 1 of this Form 10-Q.

 From time to time, we are subject to other legal proceedings and claims. Litigation can involve complex factual and legal questions and its outcome is uncertain. Any claim that is successfully asserted against us may cause us to pay substantial damages. Even if we were to prevail, any litigation could be costly and time-consuming and would divert the attention of our management and key personnel from our business operations, which could have a material adverse effect on us.

Current or future litigation over intellectual property rights could adversely affect us.

Substantial litigation regarding intellectual property rights exists in our industry. For example, in May 2006 we settled a patent infringement lawsuit with Digi International, Inc. (“Digi”) in which we signed an agreement with Digi to cross-license each other’s patents. In addition, we agreed to pay Digi $600,000 as part of the settlement of which $200,000 was paid in May 2006 with the remaining balance to be paid in July 2006. The results of litigation are inherently uncertain, and adverse outcomes are possible. Adverse outcomes may have a material adverse effect on our business, financial condition or results of operations. For a more detailed description of pending litigation, see Note 11 to the notes to our unaudited condensed consolidated financial statements of Part I, Item I of this Form 10-Q.

There is a risk that other third parties will claim that our products, or our customers’ products, infringe on their intellectual property rights or that we have misappropriated their intellectual property. In addition, software, business processes and other property rights in our industry might be increasingly subject to third-party infringement claims as the number of competitors grows and the functionality of products in different industry segments overlaps. Other parties might currently have, or might eventually be issued, patents that pertain to the proprietary rights we use. Any of these third parties might make a claim of infringement against us. The results of litigation are inherently uncertain, and adverse outcomes are possible.

        Responding to any infringement claim, regardless of its validity, could:
 
·  
be time-consuming, costly and/or result in litigation;
 
·  
divert management’s time and attention from developing our business;
 
·  
require us to pay monetary damages, including treble damages if we are held to have willfully infringed;
 
·  
require us to enter into royalty and licensing agreements that we would not normally find acceptable;
 
·  
require us to stop selling or to redesign certain of our products; or
 
·  
require us to satisfy indemnification obligations to our customers.
 
        If any of these occur, our business, financial condition or results of operations could be adversely affected.
 
Our use of contract manufacturers in China and Taiwan involves risks that could adversely affect us. 

We use contract manufacturers based in China and Taiwan. There are significant risks of doing business in these locations, including the following:

·  
These locations do not afford the same level of protection to intellectual property as do domestic or many foreign countries. If our products were reverse-engineered or our intellectual property were otherwise pirated (reproduced and duplicated without our knowledge or approval), our revenues would be reduced;

·  
Delivery times are extended due to the distances involved, requiring more lead-time in ordering and increasing the risk of excess inventories;

·  
We could incur ocean freight delays because of labor problems, weather delays or customs problems; and

·  
U.S. foreign relations with these locations have, historically, been subject to change. Political considerations and actions could interrupt our expected supply of products from these locations.
 
27
 
Delays in deliveries or quality problems with our component suppliers could damage our reputation and could cause our net revenues to decline and harm our results of operations. 

We and our contract manufacturers are responsible for procuring raw materials for our products. Our products incorporate components or technologies that are only available from single or limited sources of supply. In particular, some of our integrated circuits are only available from a single source and in some cases are no longer being manufactured. From time to time, integrated circuits used in our products will be phased out of production. When this happens, we attempt to purchase sufficient inventory to meet our needs until a substitute component can be incorporated into our products. Nonetheless, we might be unable to purchase sufficient components to meet our demands, or we might incorrectly forecast our demands, and purchase too many or too few components. In addition, our products use components that have, in the past, been subject to market shortages and substantial price fluctuations. From time to time, we have been unable to meet our orders because we were unable to purchase necessary components for our products. We do not have long-term supply arrangements with many of our vendors to obtain necessary components or technology for our products. If we are unable to purchase components from these suppliers, product shipments could be prevented or delayed, which could result in a loss of sales. If we are unable to meet existing orders or to enter into new orders because of a shortage in components, we will likely lose net revenues and risk losing customers and harming our reputation in the marketplace, which could adversely effect our business, financial condition or results of operations.

If we lose the services of any of our contract manufacturers or suppliers, we may not be able to obtain alternate sources in a timely manner, which could harm our customer relations and adversely affect our net revenues and harm our results of operations.

We do not have long-term agreements with our contract manufacturers or suppliers. If any of these subcontractors or suppliers ceased doing business with us, we may not be able to obtain alternative sources in a timely or cost-effective manner. Due to the amount of time that it usually takes us to qualify contract manufacturers and suppliers, we could experience delays in product shipments if we are required to find alternative subcontractors and suppliers. Some of our suppliers have or provide technology or trade secrets, the loss of which could be disruptive to our procurement and supply processes. If a competitor should acquire one of our contract manufacturers or suppliers, we could be subjected to more difficulties in maintaining or developing alternative sources of supply of some components or products. Any problems that we may encounter with the delivery, quality or cost of our products could damage our customer relationships and materially and adversely affect our business, financial condition or results of operations.

If our research and development efforts are not successful, our net revenues could decline and our business could be harmed.

If we are unable to develop new products as a result of our research and development efforts, or if the products we develop are not successful, our business could be harmed. Even if we do develop new products that are accepted by our target markets, we do not know whether the net revenue from these products will be sufficient to justify our investment in research and development. In addition, if we do not invest sufficiently in research and development, we may be unable to maintain our competitive position. Our research and development spending has decreased, which may put us at a competitive disadvantage compared to our competitors and adversely affect our market position. The following table shows our research and development expenditures and percentages of net revenue for the periods indicated (amounts in thousands, except percentages):
 
   
 Nine Months Ended
  
   
 March 31,
  
   
2006
  
2005
  
Research and development (1)
  
$
4,125
  
$
5,008
  
Research and development - share-based compensation
    
160
   
10
 
   
$
4,285
  
$
5,018
  
Research and development as a percent of net revenue
    
11.2
%
  
13.8
%
(1) Excludes share-based compensation expense, which is presented separately by respective expense category.
  
 
28
 
If a major customer cancels, reduces or delays purchases, our net revenues might decline and our business could be adversely affected.

The number and timing of sales to our distributors have been difficult for us to predict. While our distributors are customers in the sense they buy our products, they are also part of our product distribution system. To some extent, any business lost from a distributor would likely be replaced by sales to other customer/distributors in a reasonable period, rather than a total loss of that business such as from a customer who used our products in their business or products. Some of our distributors could be acquired by a competitor and stop buying product from us. The following table presents our largest customers as a percentage of net revenue for the periods indicated:
 
   
 Nine Months Ended
  
   
 March 31,
  
   
2006
  
2005
  
Top five customers
    
41.0
%
  
42.9
%
Ingram Micro
    
13.0
%
  
16.0
%
Tech Data
    
12.0
%
  
11.2
%
 
Below is a table of our two largest customers as a percentage of accounts receivable, net for the periods indicated:

   
March 31,
  
June 30,
  
   
2006
  
2005
  
Ingram Micro
   
*
    
16.0
%
Tech Data
    
*
    
11.0
%
 
* Less than 10% of accounts receivable, net.

The loss or deferral of one or more significant sales in a quarter could harm our operating results. We have in the past, and might in the future, lose one or more major customers. If we fail to continue to sell to our major customers in the quantities we anticipate, or if any of these customers terminate our relationship, our reputation, the perception of our products and technology in the marketplace, could be harmed. The demand for our products from our OEM, VAR and systems integrator customers depends primarily on their ability to successfully sell their products that incorporate our device networking solutions technology. Our sales are usually completed on a purchase order basis and we have few long-term purchase commitments from our customers.

Our future success also depends on our ability to attract new customers, which often involves an extended selling process. The sale of our products often involves a significant technical evaluation, and we often face delays because of our customers’ internal procedures for evaluating and deploying new technologies. For these and other reasons, the sales cycle associated with our products is typically lengthy, often lasting six to nine months and sometimes longer. Therefore, if we were to lose a major customer, we might not be able to replace the customer in a timely manner, or at all. This would cause our net revenues to decrease and could cause our stock price to decline.

If we fail to develop or enhance our products to respond to changing market conditions and government and industry standards, our competitive position will suffer and our business will be adversely affected. 

Our future success depends in large part on our ability to continue to enhance existing products, lower product cost and develop new products that maintain technological competitiveness and meet government and industry standards. The demand for network-enabled products is relatively new and can change as a result of innovations, changes or new government and industry standards. For example, industry segments might adopt new or different standards, giving rise to new customer requirements. On January 27, 2003, the European Parliament and the Council of the European Union authorized Directive 2002/95/EC on the restriction of the use of certain hazardous substances in electrical and electronic equipment. This new directive, also referred to as RoHS, requires that manufacturers reduce usage of six hazardous substances to minimum acceptable levels by July 2006. Any failure by us to develop and introduce new products or enhancements in response to new government and industry standards could harm our business, financial condition or results of operations. These requirements might or might not be compatible with our current or future product offerings. We might not be successful in modifying our products and services to address these requirements and standards. For example, our competitors might develop competing technologies based on Internet Protocols, Ethernet Protocols or other protocols that might have advantages over our products. If this were to happen, our net revenues might not grow at the rate we anticipate, or could decline.
 
29

We expect the average selling prices of our products to decline, which could reduce our net revenues, gross margins and profitability.

In the past, we have experienced some reduction in the average selling prices and gross margins of products, and we expect that this will continue for our products as they mature. We expect competition to continue to increase, and we anticipate this could result in additional downward pressure on our pricing. Our average selling prices for our products might decline as a result of other reasons, including promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments. We also may not be able to increase the price of our products if the prices of components or our overhead costs increase. In addition, we may be unable to adjust our prices in response to currency exchange rate fluctuations resulting in lower gross margins. If these were to occur, our gross margins would decline and we may not be able to reduce the cost to manufacture our products to keep up with the decline in prices.

If the SEC should levy fines against us, or if we have violated the rules regarding offering securities to the public, it could damage our reputation with customers and vendors and adversely affect our stock price.

The SEC is investigating the events surrounding the restatement of our financial statements filed on June 25, 2002 for the fiscal year ended June 30, 2001 and for the six months ended December 31, 2002. The SEC could conclude that we violated the rules of the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (the “Exchange Act”). In either event, the SEC might levy civil fines against us, or might conclude that we lack sufficient internal controls to warrant our being allowed to continue offering our shares to the public. This investigation involves substantial cost. These costs, and the cost of any fines imposed by the SEC, are not covered by insurance. In addition to sanctions imposed by the SEC, an adverse determination could significantly damage our reputation with customers and vendors, and harm our employees’ morale.

If software that we license or acquire from the open source software community and incorporate into our products were to become unavailable or no longer available on commercially reasonable terms, it could adversely affect sales of our products, which could disrupt our business and harm our financial results.

Certain of our products contain components developed and maintained by third-party software vendors or are available through the “open source” software community. We also expect that we may incorporate software from third-party vendors and open source software in our future products. Our business would be disrupted if this software, or functional equivalents of this software, were either no longer available to us or no longer offered to us on commercially reasonable terms. In either case, we would be required to either redesign our products to function with alternate third-party software or open source software, or develop these components ourselves, which would result in increased costs and could result in delays in our product shipments. Furthermore, we might be forced to limit the features available in our current or future product offerings. We are presently developing products for use on the Linux platform. The SCO Group (“SCO”) has filed and threatened to file lawsuits against companies that operate Linux for commercial purposes, alleging that such use of Linux infringes SCO’s rights. These allegations may adversely affect the demand for the Linux platform and, consequently, the sales of our Linux-based products.

Our products may contain undetected software or hardware errors or defects that could lead to an increase in our costs, reduce our net revenues or damage our reputation. 

We currently offer warranties ranging from one to two years on each of our products. Our products could contain undetected errors or defects. If there is a product failure, we might have to replace all affected products without being able to book revenue for replacement units, or we may have to refund the purchase price for the units. We do not have a long history with which to assess the risks of unexpected product failures or defects for our device server product line. Regardless of the amount of testing we undertake, some errors might be discovered only after a product has been installed and used by customers. Any errors discovered after commercial release could result in loss of net revenues and claims against us. Significant product warranty claims against us could harm our business, reputation and financial results and cause the price of our stock to decline.

If our contract manufacturers are unable or unwilling to manufacture our products at the quality and quantity we request, our business could be harmed.

We outsource substantially all of our manufacturing to three manufacturers: Venture Electronics Services, Uni Precision Industrial Ltd., and Universal Scientific Industrial Company, LTD. Our reliance on these third-party manufacturers exposes us to a number of significant risks, including:

·  
reduced control over delivery schedules, quality assurance, manufacturing yields and production costs;

·  
lack of guaranteed production capacity or product supply; and

·  
reliance on these manufacturers to maintain competitive manufacturing technologies.
 
30
 
Our agreements with these manufacturers provide for services on a purchase order basis. If our manufacturers were to become unable or unwilling to continue to manufacture our products at requested quality, quantity, yields and costs, or in a timely manner, our business would be seriously harmed. As a result, we would have to attempt to identify and qualify substitute manufacturers, which could be time consuming and difficult, and might result in unforeseen manufacturing and operations problems. For example, Jabil Circuit, Inc. acquired Varian, Inc. in March 2005 and closed the facility that manufactured our products. We transferred this production to another contract manufacturer. Moreover, as we shift products among third-party manufacturers, we may incur substantial expenses, risk material delays or encounter other unexpected issues.

In addition, a natural disaster could disrupt our manufacturers’ facilities and could inhibit our manufacturers’ ability to provide us with manufacturing capacity in a timely manner or at all. If this were to occur, we likely would be unable to fill customers’ existing orders or accept new orders for our products. The resulting decline in net revenues would harm our business. We also are responsible for forecasting the demand for our individual products. These forecasts are used by our contract manufacturers to procure raw materials and manufacture our finished goods. If we forecast demand too high, we may invest too much cash in inventory, and we may be forced to take a write-down of our inventory balance, which would reduce our earnings. If our forecast is too low for one or more products, we may be required to pay charges that would increase our cost of revenues or we may be unable to fulfill customer orders, thus reducing net revenues and therefore earnings.

Because we depend on international sales for a substantial amount of our net revenues, we are subject to international economic, regulatory, political and other risks that could harm our business, financial condition or results of operations. 

The following table presents the amount of revenue derived from international sources (amounts in thousands except percentages) for the periods indicated:
 
 
 Nine Months Ended
 
 
 March 31,
 
 
 
 
% of Net
 
 
 
% of Net
 
$ 
  
%
  
 
2006
  
Revenue
 
2005
  
Revenue
 
Variance
 
Variance
 
                         
Americas
$
24,077
    
62.9
%
$
23,141
    
63.8
%
$
936
    
4.0
%
EMEA
  
10,169
   
26.6
%
  
9,805
   
27.0
%
  
364
   
3.7
%
Asia Pacific
  
4,012
   
10.5
%
  
3,310
   
9.2
%
  
702
   
21.2
%
Total
$
38,258
    
100.0
%
$
36,256
    
100.0
%
$
2,002
    
5.5
%
 
We expect that international revenues will continue to represent a significant portion of our net revenues in the foreseeable future. Doing business internationally involves greater expense and many risks. For example, because the products we sell abroad and the products and services we buy abroad are priced in foreign currencies, we are affected by fluctuating exchange rates. In the past, we have lost money because of these fluctuations. We might not successfully protect ourselves against currency rate fluctuations, and our financial performance could be harmed as a result. In addition, we face other risks of doing business internationally, including:

·  
unexpected changes in regulatory requirements, taxes, trade laws and tariffs;

·  
reduced protection for intellectual property rights in some countries;

·  
differing labor regulations;

·  
compliance with a wide variety of complex regulatory requirements;

·  
changes in a country’s or region’s political or economic conditions;

·  
effects of terrorist attacks in the U.S. and abroad;

·  
greater difficulty in staffing and managing foreign operations; and

·  
increased financial accounting and reporting burdens and complexities.
 
31
 
Our international operations require significant attention from our management and substantial financial resources. We do not know whether our investments in other countries will produce desired levels of net revenues or profitability.

If we are unable to sell our inventory in a timely manner it could become obsolete, which could require us to increase our reserves and harm our operating results. 

At any time, competitive products may be introduced with more attractive features or at lower prices than ours. There is a risk that we may be unable to sell our inventory in a timely manner to avoid it becoming obsolete. The following table shows our inventory and excess and obsolete inventory reserve (in thousands) for the periods indicated:
 
   
March 31,
  
June 30,
  
   
2006
  
2005
  
           
Raw materials
  
$
3,892
  
$
3,973
  
Finished goods
    
6,994
   
7,277
 
Inventory at distributors
    
1,418
   
1,181
 
     
12,304
   
12,431
 
Reserve for excess and obsolete inventories
    
(5,427
)
  
(5,603
)
   
$
6,877
  
$
6,828
  
 
In the event we are required to substantially discount our inventory or are unable to sell our inventory in a timely manner, we would be required to increase our reserves and our operating results could be substantially harmed.

If we are unable to attract, retain or motivate key senior management and technical personnel, it could seriously harm our business. 

Our financial performance depends substantially on the performance of our executive officers and key technical employees. We are dependent in particular on Marc Nussbaum, our President and Chief Executive Officer, and James Kerrigan, our Chief Financial Officer and Secretary. We have no employment contracts with these executives. We are also dependent upon our technical personnel, due to the specialized technical nature of our business. If we lose the services of Mr. Nussbaum, Mr. Kerrigan or any of our key technical personnel and are not able to find replacements in a timely manner, our business could be disrupted, other key personnel might decide to leave, and we might incur increased operating expenses associated with finding and compensating replacements.

If our OEM customers develop their own expertise in network-enabling products, it could result in reduced sales of our products and harm our operating results.

We sell to both resellers and OEMs. Selling products to OEMs involves unique risks, including the risk that OEMs will develop internal expertise in network-enabling products or will otherwise incorporate network functionality in their products without using our device networking solutions. If this were to occur, our sales to OEMs would likely decline, which could reduce our net revenue and harm our operating results.

New product introductions and pricing strategies by our competitors could reduce our market share or cause us to reduce the prices of our products, which would reduce our net revenues and gross margins.

The market for our products is intensely competitive, subject to rapid change and is significantly affected by new product introductions and pricing strategies of our competitors. We face competition primarily from companies that network-enable devices, semiconductor companies, companies in the automation industry and companies with significant networking expertise and research and development resources. Our competitors might offer new products with features or functionality that are equal to or better than our products. In addition, since we work with open standards, our customers could develop products based on our technology that compete with our offerings. We might not have sufficient engineering staff or other required resources to modify our products to match our competitors. Similarly, competitive pressure could force us to reduce the price of our products. In each case, we could lose new and existing customers to our competition. If this were to occur, our net revenues could decline and our business could be harmed.
 
32
 
We may not be able to adequately protect or enforce our intellectual property rights, which could harm our competitive position. 

We have not historically relied on patents to protect our proprietary rights, although we are now building a patent portfolio. In May 2006, we entered into a patent cross-license agreement with Digi in which the parties agreed to cross-license each other’s patents, which could reduce the value of our existing patent portfolio. We rely primarily on a combination of laws, such as copyright, trademark and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. Despite any precautions that we have taken:

·  
laws and contractual restrictions might not be sufficient to prevent misappropriation of our technology or deter others from developing similar technologies;

·  
other companies might claim common law trademark rights based upon use that precedes the registration of our marks;

·  
other companies might assert other rights to market products using our trademarks;

·  
policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we might be unable to determine the extent of this unauthorized use;

·  
courts may determine that our software programs use open source software in such a way that deprives the entire programs of intellectual property protection; and

·  
current federal laws that prohibit software copying provide only limited protection from software pirates.

Also, the laws of some of the countries in which we market and manufacture our products offer little or no effective protection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third-parties to benefit from our technology without paying us for it, which could significantly harm our business.

Business interruptions could adversely affect our business.
 
Our operations and those of our suppliers are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, terrorist attacks and other events beyond our control. A substantial portion of our facilities, including our corporate headquarters and other critical business operations, are located near major earthquake faults and, therefore, may be more susceptible to damage if an earthquake occurs. We do not carry earthquake insurance for direct earthquake-related losses. In addition, we do not carry business interruption insurance for, nor do we carry financial reserves against, business interruptions arising from earthquakes or certain other events. If a business interruption occurs, our business could be materially and adversely affected.

If we fail to maintain an effective system of disclosure controls or internal controls over financial reporting, our business and stock price could be adversely affected. 

Section 404 of the Sarbanes-Oxley Act of 2002 requires companies to evaluate periodically the effectiveness of their internal controls over financial reporting, and to include a management report assessing the effectiveness of their internal controls as of the end of each fiscal year. As we are currently a non-accelerated filer, current SEC rules will require that our first management report on the effectiveness of our internal controls be in our first fiscal year ending on or after July 15, 2007. These rules will also require our independent public accountant to attest to, and report on, management’s assessment of our internal controls over financial reporting.

Our management does not expect that our internal controls over financial reporting will prevent all errors or frauds. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, involving us have been, or will be, detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by individual acts of a person, or by collusion among two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies and procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to errors or frauds may occur and not be detected.
 
33

In connection with our fiscal 2005 audit and described in our Annual Report on Form 10-K filed with the SEC on September 28, 2005, we determined and informed our Audit Committee that we had incorrectly accounted for (i) the accrual of professional fees and other accrued liabilities and (ii) amounts previously recorded as stock-based compensation related to a stock option grant to a terminated employee, which resulted in the adjustment to amounts as originally reported in our first, second and third fiscal quarters of 2005 consolidated financial statements. In addition, we determined and concluded that there were other significant deficiencies in our financial statement close process. We concluded that these conditions were a material weakness in our internal controls over financial reporting. We have taken steps to remediate the material weakness in our internal controls over financial reporting and the ineffectiveness of our disclosure controls. Our failure to adequately remediate our material weakness could have a material adverse effect on our business, results of operations and financial condition.

We cannot assure you that we or our independent registered public accounting firm will not identify a material weakness in our disclosure controls and internal controls over financial reporting in the future. If our internal controls over financial reporting are not considered adequate, we may experience a loss of public confidence, which could have an adverse effect on our business and our stock price.

We may experience difficulties in implementing or enhancing new information systems.
 
We plan to implement a new enterprise resource planning (“ERP”) information system to manage our business operations during calendar 2006. While we do not expect to use the new ERP information system to manage our business during the current fiscal year ending June 30, 2006, the possibility exists that our migration to the new ERP information system could adversely affect our disclosure controls and procedures or our operations in future periods. The process of implementing new information systems could adversely impact our ability to do the following in a timely manner: accept and process customer orders, receive inventory and ship products, invoice and collect receivables, place purchase orders and pay invoices, and all other business transactions related to the finance, order entry, purchasing, supply chain and human resource processes within the new ERP systems. Any such disruption could adversely affect our financial position, results of operations, cash flows and the market price of our common stock.
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

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

None.

Item 5. Other Information

None.

Item 6. Exhibits
 
Exhibit
 
Number
Description of Document
   
31.1
Certification of Principal Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of Principal Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
* Furnished, not filed.
 
 
34
 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
     
 
LANTRONIX, INC.
(Registrant)
 
 		  
 		  
 
Date: May 5, 2006 By:   /s/ Marc H. Nussbaum
 
Marc H. Nussbaum
Chief Executive Officer
(Principal Executive Officer)  
 
     
 
Date: May 5, 2006 By:   /s/ James W. Kerrigan
 
James W. Kerrigan
Chief Financial Officer and Secretary
(Principal Financial Officer)

35
 
 EX-31.1 2 ex_31-1.htm CERTIFICATION OF CEO Certification of CEO
Exhibit 31.1
 

 CERTIFICATIONS

I, Marc H. Nussbaum, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Lantronix, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
 
 
     
 
Date: May 5, 2006 By:   /s/ Marc H. Nussbaum
 
Marc H. Nussbaum
Chief Executive Officer

EX-31.2 3 ex_31-2.htm CERTIFICATION OF CFO AND SECRETARY Certification of CFO and Secretary
Exhibit 31.2
 
 
CERTIFICATIONS

I, James W. Kerrigan, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Lantronix, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

 
     
 
Date: May 5, 2006 By:   /s/ James W. Kerrigan
 
James W. Kerrigan
Chief Financial Officer and Secretary

 
 EX-32.1 4 ex_32-1.htm CERTIFICATION OF CEO AND CFO Certification of CEO and CFO
Exhibit 32.1
 
 
CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER
PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Marc H. Nussbaum, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of Lantronix, Inc. on Form 10-Q for the fiscal quarter ended March 31, 2006 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Quarterly Report on Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of Lantronix, Inc.
 
     
 
Date: May 5, 2006 By:   /s/ Marc H. Nussbaum
 
 
Name:
Title:
Marc H. Nussbaum
Chief Executive Officer  
 
I, James W. Kerrigan, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of Lantronix, Inc. on Form 10-Q for the fiscal quarter ended March 31, 2006 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Quarterly Report on Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of Lantronix, Inc.
 
     
 
Date: May 5, 2006 By:   /s/ James W. Kerrigan
 
James W. Kerrigan
Chief Financial Officer and Secretary


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