Edgar Filing: LANTRONIX INC

Quarterly Report

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 December 31, 2006

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 February 6, 2007, 59,605,957 shares of the Registrant’s common stock were outstanding.

LANTRONIX, INC.

FORM 10-Q

FOR THE FISCAL QUARTER ENDED

December 31, 2006

INDEX

		Page

PART I.	FINANCIAL INFORMATION	1

Item 1.	Financial Statements.	1

	Unaudited Condensed Consolidated Balance Sheets at December 31, 2006 and June 30, 2006	1

	Unaudited Condensed Consolidated Statements of Operations for the Three and Six Months Ended
	December 31, 2006 and 2005	2

	Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended
	December 31, 2006 and 2005	3

	Notes to Unaudited Condensed Consolidated Financial Statements.	4

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9

Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	19

Item 4.	Controls and Procedures.	19

PART II.	OTHER INFORMATION	19

Item 1.	Legal Proceedings	19

Item 1A.	Risk Factors	19

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds.	28

Item 3.	Defaults Upon Senior Securities	28

Item 4.	Submission of Matters to a Vote of Security Holders	28

Item 5.	Other Information	29

Item 6.	Exhibits	29

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

	December 31,			June 30,
	2006			2006
	(In thousands)
ASSETS
Current Assets:
Cash and cash equivalents	$	7,744		$	7,729
Marketable securities		96			88
Accounts receivable, net		3,468			3,087
Inventories, net		8,528			8,113
Contract manufacturers' receivable		1,033			1,049
Settlements recovery		13,943			15,325
Prepaid expenses and other current assets		606			577
Total current assets		35,418			35,968

Property and equipment, net		1,787			1,589
Goodwill		9,488			9,488
Purchased intangible assets, net		568			610
Officer loans		126			122
Other assets		40			38
Total assets	$	47,427		$	47,815

LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable	$	9,136		$	7,865
Accrued payroll and related expenses		1,905			1,596
Warranty reserve		474			693
Accrued settlements		15,075			16,767
Other current liabilities		3,130			3,675
Total current liabilities		29,720			30,596
Long-term liabilities		270			230
Long-term capital lease obligations		146			211

Commitments and contingencies

Stockholders' equity:
Common stock		6			6
Additional paid-in capital		183,887			182,857
Accumulated deficit		(167,014	)		(166,450	)
Accumulated other comprehensive income		412			365
Total stockholders' equity		17,291			16,778
Total liabilities and stockholders' equity	$	47,427		$	47,815

See accompanying notes.

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2006			2005			2006			2005
	(In thousands, except per share data)

Net revenues (1)	$	14,829		$	12,955		$	27,343		$	25,195
Cost of revenues (2)		7,429			6,357			13,336			12,477
Gross profit		7,400			6,598			14,007			12,718
Operating expenses:
Selling, general and administrative		6,057			6,218			11,555			12,290
Research and development		1,882			1,310			3,600			2,713
Litigation settlement costs		75			2,600			90			2,600
Amortization of purchased intangible assets		18			-			36			2
Restructuring recovery		-			-			-			(29	)
Total operating expenses		8,032			10,128			15,281			17,576
Loss from operations		(632	)		(3,530	)		(1,274	)		(4,858	)
Interest income, net		1			18			7			21
Other income (expense), net		730			(49	)		727			(59	)
Income (loss) before income taxes		99			(3,561	)		(540	)		(4,896	)
Provision for income taxes		12			10			24			16
Net income (loss)	$	87		$	(3,571	)	$	(564	)	$	(4,912	)

Basic - net income (loss) per share	$	0.00		$	(0.06	)	$	(0.01	)	$	(0.08	)

Diluted - net income (loss) per share	$	0.00		$	(0.06	)	$	(0.01	)	$	(0.08	)

Basic - weighted average shares		59,562			58,670			59,413			58,582

Diluted - weighted average shares		60,196			58,670			59,413			58,582

(1) Includes net revenues from related party	$	302		$	306		$	581		$	606

(2) Includes amortization of purchased intangible assets	$	4		$	223		$	6		$	520

See accompanying notes.

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

	Six Months Ended
	December 31,
	2006			2005
	(In thousands)
Cash flows from operating activities:
Net loss	$	(564	)	$	(4,912	)
Adjustments to reconcile net loss to net cash (used in)
provided by operating activities:
Share-based compensation		635			474
Depreciation		194			220
Amortization of purchased intangible assets		42			520
Provision (recovery) for doubtful accounts		20			(35	)
Litigation settlement costs		90			2,600
Provision for inventories		(70	)		(109	)
Gain on disposal of fixed assets		-			(2	)
Restructuring recovery		-			(29	)
Foreign currency transaction loss		-			77
Changes in operating assets and liabilities:
Accounts receivable		(401	)		153
Inventories		(345	)		313
Contract manufacturers' receivable		16			(188	)
Prepaid expenses and other current assets		(25	)		(287	)
Other assets		(6	)		28
Accounts payable		1,272			1,099
Accrued payroll and related expenses		304			163
Accrued settlements		(400	)		-
Warranty reserve		(219	)		(276	)
Other liabilities		(617	)		819
Net cash (used in) provided by operating activities		(74	)		628
Cash flows from investing activities:
Purchases of property and equipment, net		(271	)		(132	)
Net cash used in investing activities		(271	)		(132	)
Cash flows from financing activities:
Net proceeds from issuances of common stock		395			200
Payment of capital lease obligations		(78	)		(79	)
Net cash provided by financing activities		317			121
Effect of foreign exchange rate changes on cash		43			(113	)
Increase in cash and cash equivalents		15			504
Cash and cash equivalents at beginning of period		7,729			6,690
Cash and cash equivalents at end of period	$	7,744		$	7,194

See accompanying notes.

LANTRONIX, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

December 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 December 31, 2006, and the consolidated results of its operations for the three and six months ended December 31, 2006 and 2005, and its cash flows for the six months ended December 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 six months ended December 31, 2006 are not necessarily indicative of the results to be expected for the full year or any future interim periods.

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, 2006, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on September 12, 2006.

2.	Computation of 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:

	Three Months Ended					Six Months Ended
	December 31,					December 31,
	2006		2005			2006			2005
	(In thousands, except per share data)
Numerator:
Net income (loss)	$	87	$	(3,571	)	$	(564	)	$	(4,912	)
Denominator:
Weighted-average shares outstanding		59,562		59,002			59,413			58,914
Less: Unvested common shares outstanding		-		(332	)		-			(332	)
Basic - weighted average shares		59,562		58,670			59,413			58,582
Effect of dilutive shares:
Stock options		634		-			-			-
Diluted - weighted average shares		60,196		58,670			59,413			58,582

Basic - net income (loss) per share	$	0.00	$	(0.06	)	$	(0.01	)	$	(0.08	)

Diluted - net income (loss) per share	$	0.00	$	(0.06	)	$	(0.01	)	$	(0.08	)

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

Six Months Ended

December 31,

2006

2005

2006

2005

Common stock equivalents

1,682,991

1,403,127

2,500,146

1,255,727

3.	Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:

	December 31,			June 30,
	2006			2006
	(In thousands)
Raw materials	$	3,266		$	3,863
Finished goods		6,136			6,518
Inventory at distributors		1,552			1,690
Large scale integration chips *		964			731
		11,918			12,802
Reserve for excess and obsolete inventories		(3,390	)		(4,689	)
	$	8,528		$	8,113

* This item is both sold individually and embedded into the Company's products.

4.	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. Additionally, the Company sells extended warranty services, which extend the warranty period for an additional one- to three-years depending upon the product.

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

	Six Months Ended			Year Ended
	December 31,			June 30,
	2006			2006
	(In thousands)
Beginning balance	$	693		$	1,248
Recovered to cost of revenues		(49	)		(35	)
Usage		(170	)		(520	)
Ending balance	$	474		$	693

5.	Bank Line of Credit and Debt

In May 2006, the Company entered into a two-year secured revolving Loan and Security Agreement (“Line of Credit”) with a bank, which provides for borrowings up to $5.0 million. The borrowing capacity is limited to eligible accounts receivable as defined under the Line of Credit. Borrowings under the Line of Credit bear interest at the prime rate plus 1.75% per annum. The Company is required to pay an unused line fee of 0.50% on the unused portion of the Line of Credit. In addition, the Company paid a fully earned, non-refundable commitment fee of $54,000 and is required to pay an additional $54,000 on the first anniversary of the Effective Date.

The Company's obligations under the Line of Credit are secured by substantially all of the Company’s assets, including its intellectual property.

The Company is subject to a number of covenants under the Line of Credit, pursuant to which, among other things, the Company has agreed that it will not, without the Bank's prior written consent: (a) sell, lease, transfer or otherwise dispose, any of the Company's business or property, provided, however, that the Company may sell inventory in the ordinary course of business consistent with the provisions of the Line of Credit; (b) change the Company's business structure, liquidate or dissolve, or permit a change in beneficial ownership of more than 20% of the outstanding shares; (c) acquire, merge or consolidate with or into any other business organization; (d) incur any debts outside the ordinary course of the Company's business, except for permitted indebtedness, or grant any security interests in or permit a lien, claim or encumbrance upon all or any portion of the Company's assets, except in favor of or agreed to by the bank; (f) make any investments other than permitted investments; (g) make or permit any payments on any subordinated debt, except under the terms of existing subordinated debt or on terms acceptable to the bank, or amend any provision in any document related to the subordinated debt that would increase the amount thereof, or (h) become an "investment company" as such term is defined under the Investment Company Act of 1940. The Line of Credit also contains a number of affirmative covenants, including, among other things, covenants regarding the delivery of financial statements and notice requirements, accounts receivable, payment of taxes, access to collateral and books and records, maintenance of properties and insurance policies, and litigation by third parties.

The Line of Credit includes events of default that include, among other things, non-payment of principal, interest or fees, violation of affirmative and negative covenants, cross default to certain other indebtedness, material adverse change, material judgments, bankruptcy and insolvency events.

As of December 31, 2006, the Company had no borrowings against the Line of Credit.

6.	Share-Based Compensation

The following table presents a summary of option activity under the Company’s stock option plans:

	Number of
	Shares
Balance at June 30, 2006		5,467,753
Options granted		685,000
Options forfeited		(328,490	)
Options expired		(28,638	)
Options exercised		(227,597	)
Balance at December 31, 2006		5,568,028

The following table presents information related to stock option grants:

	Three Months Ended				Six Months Ended
	December 31,				December 31,
	2006		2005		2006		2005
Weighted-average grant date fair value	$	1.18	$	1.17	$	1.22	$	1.16
Weighted-average grant date exercise price	$	1.54	$	1.49	$	1.57	$	1.47

The following table presents a summary of share-based compensation by functional line item:

	Three Months Ended				Six Months Ended
	December 31,				December 31,
	2006		2005		2006		2005
	(In thousands)				(In thousands)
Cost of revenues	$	24	$	21	$	36	$	41
Selling, general and administrative		202		161		411		328
Research and development		96		53		188		105
	$	322	$	235	$	635	$	474

7.	Other Income (Expense), net

In June 2006, the Company entered into an agreement to sell its ownership interest in Xanboo for aggregate cash consideration of $2.0 million. On June 13, 2006, the Company sold 65% of its interest in Xanboo for cash consideration of $1.3 million. The Company recorded the $1.3 million cash payment received during June 2006 as other income in the consolidated statements of operations for the fiscal year ended June 30, 2006. On October 19, 2006, the Company sold its remaining interest in Xanboo for cash consideration of $700,000. The Company recorded the $700,000 cash payment as other income in the consolidated statements of operations for the fiscal quarter ended December 31, 2006.

8.	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						Six Months Ended
	December 31,						December 31,
	2006			2005			2006			2005
Effective tax rate		12	%		0	%		4	%		0	%

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.

9.	Comprehensive Loss

The components of comprehensive loss are as follows:

	Three Months Ended					Six Months Ended
	December 31,					December 31,
	2006		2005			2006			2005
	(In thousands)					(In thousands)
Net income (loss)	$	87	$	(3,571	)	$	(564	)	$	(4,912	)
Other comprehensive income (loss):
Change in net unrealized gain on investment, net of taxes of $0		2		5			8			12
Change in translation adjustments, net of taxes of $0		53		(30	)		39			(35	)
Total comprehensive loss	$	142	$	(3,596	)	$	(517	)	$	(4,935	)

10.

Litigation Settlements

Securities Litigation Settlements

Securities Class Action Lawsuits (“Class Action”)

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. 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.

The Company reached an agreement with plaintiffs to settle the Class Action lawsuit. The Company also reached agreements with its relevant insurance carriers with respect to the funding of the cash portions of the settlement with plaintiffs, and the cash funding of the settlement has been completed. Under the terms of the agreement with the Class Action plaintiffs, the Company will not be required to contribute any cash to the Class Action settlement, as all cash contributed would be from the Company’s insurance carriers. However, as part of the agreement with the plaintiffs in the Class Action lawsuit, the Company has agreed to issue certain Lantronix securities to the plaintiffs. As a result of the anticipated issuance of such securities, and in connection with the issuance of securities for the settlement of the Synergetic action described below, the Company recorded a charge of $1.2 million in the consolidated statement of operations for the fiscal year ended June 30, 2006. As of December 31, 2006, the Company had an accrued settlement of $15.1 million of which the Company’s insurance carriers agreed to fund $13.9 million. On December 11, 2006, the United States District Court for the Central District of California gave its final approval to the settlement and issued a final order and judgment in the matter. The Company expects to issue the Lantronix securities with a fair value of $1.1 million to the class plaintiffs as final consideration for the settlement by February 9, 2007.

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.

In May 2006, the Company entered into a definitive settlement agreement with the plaintiffs in the Synergetic action. Pursuant to the settlement agreement, in June 2006, the Company issued 84,053 common shares with a fair value of $175,000 as partial consideration for its settlement of the Synergetic claims, and the Company’s insurance carriers paid $750,000 to the plaintiffs. In connection with the settlement, the plaintiffs filed a request for dismissal with prejudice of all claims against all parties with the Court on July 7, 2006, and this litigation is now concluded.

Government Investigation

During June 2006, the Company reached an agreement in principle with the regional staff of the SEC regarding the terms of a settlement that the regional staff has agreed to recommend to the SEC. On September 27, 2006, the Commission formally approved of the proposed settlement. The settlement, under which the Company has not admitted or denied any wrongdoing, fully resolves all claims against the Company relating to the formal investigation that the SEC commenced in July 2002 relating to the Company’s restatement of its financial results announced in May and June 2002. The settlement includes the following principal terms:

The Company agreed to a cease and desist order from future violations of securities laws;

The Company was not required to pay any monetary penalties; and

The Company has agreed to cooperate with the Commission on any further proceedings in connection with its investigation.

Accrued Settlements and Settlements Recovery

The following table presents details of the Company’s accrued settlements and settlements recovery:

	December 31,		June 30,
	2006		2006
	(In thousands)
Accrued settlements:
Class Action and Synergetic	$	15,075	$	15,167
Derivative		-		1,200
Patent infringement		-		400
		15,075		16,767
Settlements recovery:
Class Action and Synergetic		13,943		14,125
Derivative		-		1,200
		13,943		15,325
Direct settlement obligations of the Company	$	1,132	$	1,442

11.

Litigation

From time to time, the Company is subject to other legal proceedings and claims in the ordinary course of business. Except as discussed in Note 10, 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.

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, 2006 and subsequent reports on our Current Reports on Form 8-K, which discuss our business in greater detail.

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.

During the fiscal quarter ended September 30, 2006, we renamed our product lines to reflect our single focus on device networking and our broadening product portfolio and entry into new adjacent applications. The Company will report its two core product lines as “device enablement” (formerly “device networking”), and “device management” (formerly “IT management”). The non-core category, representing older legacy products, will include terminal servers formerly categorized as a part of “IT management”.

The following describes our core product lines:

Device Enablement - We offer an array of embedded and external device enablement solutions that enable integrators and manufacturers of electronic and electro-mechanical products to add network connectivity, manageability and control. Our customers’ products originate from a wide variety of applications within the machine-to-machine (“M2M”) market, from blood analyzers that relay critical patient information directly to a hospital’s information system, to simple devices such as time clocks, allowing the user to obtain information from these devices and to improve how they are managed and controlled. We also offer products such as multi-port servers that enable devices outside the data center to cost effectively share the network connection and convert various protocols to industry-standard interfaces such as Ethernet and the Internet.

Device Management -We offer off-the-shelf appliances such as console servers, remote KVM servers, and power control products that enable IT professionals to remotely connect, monitor and control network infrastructure equipment and large groups of servers using highly secure out-of-band management technology. In addition, we offer off-the-shelf appliances that enable IT professionals to reliably, remotely and simply monitor, configure and manage multiple devices from a single point of control.

The following describes our non-core product line:

Non-core Products - Over the years, we have innovated or acquired various product lines that are no longer part of our primary, core markets described above. In general, these non-core businesses represent decreasing markets and we minimize research and development in these product lines. Included in this category are terminal servers, visualization solutions, legacy print servers, software and other miscellaneous products.

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

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

Net revenues of $14.8 million for the fiscal quarter ended December 31, 2006 increased by $1.9 million or 14.5% as compared to $13.0 million reported during the fiscal quarter ended December 31, 2005. The increase in net revenues is due to an increase of $2.4 million in our core product lines as a result of a $1.9 million increase in our device enablement product line and a $588,000 increase in our device management product line. Our non-core product line decreased by $572,000.

Gross profit as a percentage of net revenues was 49.9% for the fiscal quarter ended December 31, 2006, decreasing 1.0 percentage point from the 50.9% reported in the fiscal quarter ended December 31, 2005. The decrease in gross margin percent is primarily attributable to a combination of sale incentive discounts and a change in product mix from higher margin non-care legacy products towards lower-margin device enablement products, offset by a decrease in the amortization of purchased intangible assets.

Loss from operations as a percentage of net revenues was 4.3% for the fiscal quarter ended December 31, 2006 compared to a 27.2% loss from operations in the fiscal quarter ended December 31, 2005.

Net income of $87,000 or $0.00 per basic and diluted share, in the fiscal quarter ended December 31, 2006, increased from a net loss of $3.6 million, or $0.06 per basic and diluted share, in the fiscal quarter ended December 31, 2005. Net income for the quarter ended December 31, 2006 was significantly impacted by the $700,000 of income recognized on the sale of our investment in Xanboo. Net loss for the quarter ended December 31, 2005 was significantly impacted by $2.6 million of litigation settlement costs.

Cash, cash equivalents and marketable securities remained consistent at $7.8 million as of December 31, 2006 and June 30, 2006, respectively.

Accounts receivable, net were $3.5 million as of December 31, 2006 as compared to $3.1 million at June 30, 2006. Annualized days sales outstanding (“DSO”) in receivables as of December 31, 2006 increased to 20 days from 16 days as of June 30, 2006. Our accounts receivable and DSO are primarily affected by the timing of shipments within a quarter, 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 $8.5 million as of December 31, 2006 as compared to $8.1 million as of June 30, 2006. Our annualized inventory turns increased with 3.6 annualized turns during the fiscal quarter ended December 31, 2006 compared to 3.4 annualized turns during the fiscal quarter ended June 30, 2006.

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, warranty reserves, 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, 2006. There have been no significant changes in our critical accounting policies and estimates during the fiscal quarter ended December 31, 2006 as compared to what was previously disclosed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2006.

Recent Accounting Pronouncements

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Qualifying Misstatements in Current Year Financial Statements (“SAB 108”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 was issued to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that we quantify misstatements based on their impact on each of our financial statements and related disclosures. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company is currently assessing the impact, if any, from the adoption of SAB 108.

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently assessing the impact, if any, from the adoption of SFAS 157.

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes,” by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Under FIN 48, the financial statement effects of a tax position should initially be recognized when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. A tax position that meets the more-likely-than-not recognition threshold should initially and subsequently be measured as the largest amount of tax benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement with a taxing authority. FIN 48 is effective for fiscal years beginning after December 15, 2006. The cumulative effect, if any, of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings in the period adopted. The Company is currently evaluating the impact that the adoption of FIN 48 will have on the results of operations, financial position and liquidity.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the American Institute of Certified Public Accountants, and the Securities and Exchange Commission did not or are not believed by management to have a material impact on the Company’s 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:

	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2006			2005			2006			2005

Net revenues		100.0	%		100.0	%		100.0	%		100.0	%
Cost of revenues		50.1	%		49.1	%		48.8	%		49.5	%
Gross profit		49.9	%		50.9	%		51.2	%		50.5	%
Operating expenses:
Selling, general and administrative		40.8	%		48.0	%		42.3	%		48.8	%
Research and development		12.7	%		10.1	%		13.2	%		10.8	%
Litigation settlement costs		0.5	%		20.1	%		0.3	%		10.3	%
Amortization of purchased intangible assets		0.1	%		0.0	%		0.1	%		0.0	%
Restructuring recovery		0.0	%		0.0	%		0.0	%		(0.1	%)
Total operating expenses		54.2	%		78.2	%		55.9	%		69.8	%
Loss from operations		(4.3	%)		(27.2	%)		(4.7	%)		(19.3	%)
Interest income, net		0.0	%		0.1	%		0.0	%		0.1	%
Other income (expense), net		4.9	%		(0.4	%)		2.7	%		(0.2	%)
Income (loss) before income taxes		0.7	%		(27.5	%)		(2.0	%)		(19.4	%)
Provision for income taxes		0.1	%		0.1	%		0.1	%		0.1	%
Net income (loss)		0.6	%		(27.6	%)		(2.1	%)		(19.5	%)

Comparison of the Three and Six Months Ended December 31, 2006 and 2005

Net Revenues by Product Line

Our revenue is generated primarily by sales of our networking devices. Device enablement and device management represent our core product lines. The non-core product line represents legacy products that we are no longer investing in the development of. Net revenue is revenue less reductions for rebates and provisions for returns and allowances.

The following table presents net revenues by product line:

	Three Months Ended December 31,
			% of Net				% of Net		Change
	2006		Revenues		2005		Revenues		$			%
	(In thousands, except percentages)
Device enablement	$	10,833		73.1%	$	8,975		69.3%	$	1,858			20.7%
Device management		2,560		17.3%		1,972		15.2%		588			29.8%
Core		13,393		90.3%		10,947		84.5%		2,446			22.3%
Non-core		1,436		9.7%		2,008		15.5%		(572	)		(28.5%)
	$	14,829		100.0%	$	12,955		100.0%	$	1,874			14.5%

The increase in net revenues for the three months ended December 31, 2006 as compared to the same period one year ago was a result of an increase in net revenues from our device enablement and device management products, offset by a decrease in our non-core products. The increase in our device enablement product line is primarily due to an increase in volume in our embedded device enablement products, which includes our XPort and WiPort product families, slightly offset by a decline in our external device enablement products. 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 our core product lines.

The following table presents net revenues by product line:

	Six Months Ended December 31,
			% of Net					% of Net			Change
	2006		Revenue			2005		Revenue			$			%
	(In thousands, except percentages)
Device enablement	$	19,836		72.5	%	$	17,232		68.4	%	$	2,604			15.1	%
Device management		4,274		15.6	%		3,838		15.2	%		436			11.4	%
Core		24,110		88.2	%		21,070		83.6	%		3,040			14.4	%
Non-core		3,233		11.8	%		4,125		16.4	%		(892	)		(21.6	%)
	$	27,343		100.0	%	$	25,195		100.0	%	$	2,148			8.5	%

The increase in net revenues for the six months ended December 31, 2006 as compared to the same period one year ago was a result of an increase in net revenues from our device enablement and device management products, offset by a decrease in our non-core products. The increase in our device enablement product line is primarily due to an increase in volume in our embedded device enablement products, which includes our XPort and WiPort product families, slightly offset by a decline in our external device enablement products. 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 our core product lines.

Net Revenues by Region

The following table presents net revenues by geographic region:

	Three Months Ended December 31,
			% of Net					% of Net			Change
	2006		Revenues			2005		Revenues			$		%
	(In thousands, except percentages)
Americas	$	9,573		64.6	%	$	7,893		60.9	%	$	1,680		21.3	%
EMEA		3,720		25.1	%		3,609		27.9	%		111		3.1	%
Asia Pacific		1,536		10.3	%		1,453		11.2	%		83		5.7	%
	$	14,829		100.0	%	$	12,955		100.0	%	$	1,874		14.5	%

The increase for the three months ended December 31, 2006 as compared to the same period one year ago is primarily a result of an increase in net revenues in the Americas. In order of significance, the increase in net revenues in the Americas is the result of increased sales of our embedded device enablement products and to a lesser extent, our device management products, slightly offset by a decrease in our non-core products.

The following table presents net revenues by geographic region:

	Six Months Ended December 31,
			% of Net					% of Net			Change
	2006		Revenue			2005		Revenue			$		%
	(In thousands, except percentages)
Americas	$	17,229		63.0	%	$	16,072		63.8	%	$	1,157		7.2	%
EMEA		6,711		24.5	%		6,568		26.1	%		143		2.2	%
Asia Pacific		3,403		12.5	%		2,555		10.1	%		848		33.2	%
	$	27,343		100.0	%	$	25,195		100.0	%	$	2,148		8.5	%

The increase for the six months ended December 31, 2006 as compared to the same period one year ago is primarily a result of an increase in net revenues in the Americas. In order of significance, the increase in net revenues in the Americas is the result of increased sales of our embedded device enablement products and to a lesser extent, our device management products, slightly offset by a decrease in our non-core products.

Gross Profit

Gross profit represents net revenues less cost of revenues. Cost of revenues consists 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.

The following table presents gross profit:

	Three Months Ended December 31,
			% of Net					% of Net			Change
	2006		Revenues			2005		Revenues			$		%
	(In thousands, except percentages)
Gross profit	$	7,400		49.9	%	$	6,598		50.9	%	$	802		12.2	%

In order of significance, the decrease in gross profit as a percentage of net revenues for the three months ended December 31, 2006 as compared to the same period one year ago is in part due to the following factors: (i) an increase in discounts and allowances (ii) an increase in manufacturing overhead costs; offset by (iii) a decrease in the amortization of purchased intangible assets as a result of a majority of our purchased intangible assets becoming fully amortized.

The following table presents gross profit:

	Six Months Ended December 31,
			% of Net					% of Net			Change
	2006		Revenue			2005		Revenue			$		%
	(In thousands, except percentages)
Gross profit	$	14,007		51.2	%	$	12,718		50.5	%	$	1,289		10.1	%

The increase in gross profit as a percentage of net revenues for the six months ended December 31, 2006 as compared to the same period one year ago is primarily due to a decrease in the amortization of purchased intangible assets as a result of a majority of our purchased intangible assets becoming fully amortized.

Selling, General and Administrative

Selling, general and administrative expenses consist of personnel-related expenses including salaries and commissions, share-based compensation, facility expenses, information technology, trade show expenses, advertising, and legal and accounting fees offset by reimbursement of legal fees from insurance proceeds.

The following table presents selling, general and administrative expenses:

	Three Months Ended December 31,
			% of Net						% of Net			Change
	2006		Revenues			2005			Revenues			$			%
	(In thousands, except percentages)
Personnel-related expenses	$	3,124				$	2,820					$	304			10.8	%
Professional fees & outside services		845					1,483						(638	)		(43.0	%)
Advertising and marketing		737					705						32			4.5	%
Facilities		477					456						21			4.6	%
Share-based compensation		202					162						40			24.7	%
Depreciation		66					79						(13	)		(16.5	%)
Bad debt expense (recovery)		3					(41	)					44			(107.3	%)
Other		603					554						49			8.8	%
Selling, general and administrative	$	6,057		40.8	%	$	6,218			48.0	%	$	(161	)		(2.6	%)

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

The following table presents selling, general and administrative expenses:

	Six Months Ended December 31,
			% of Net						% of Net			Change
	2006		Revenue			2005			Revenue			$			%
	(In thousands, except percentages)
Personnel-related expenses	$	5,925				$	5,401					$	524			9.7	%
Professional fees & outside services		1,605					2,947						(1,342	)		(45.5	%)
Advertising and marketing		1,352					1,475						(123	)		(8.3	%)
Facilities		1,017					969						48			5.0	%
Share-based compensation		411					330						81			24.5	%
Depreciation		143					170						(27	)		(15.9	%)
Bad debt expense (recovery)		20					(35	)					55			(157.1	%)
Other		1,082					1,033						49			4.7	%
Selling, general and administrative	$	11,555		42.3	%	$	12,290			48.8	%	$	(735	)		(6.0	%)

In order of significance, the decrease in selling, general and administrative expense for the six months ended December 31, 2006 as compared to the same period one year ago is in part due to the following factors: (i) a decrease in legal and professional fees primarily as a result of the settlement of our outstanding litigation and (ii) a decrease in direct advertising and marketing expenses; offset by (iii) an increase in personnel-related expenses as a result of an increase in headcount.

Research and Development

Research and development expenses consist of personnel-related expenses, facility expenses and share-based compensation, as well as expenditures to third-party vendors for research and development activities.

The following table presents research and development expenses:

	Three Months Ended December 31,
			% of Net					% of Net			Change
	2006		Revenues			2005		Revenues			$			%
	(In thousands, except percentages)
Personnel-related expenses	$	1,338				$	1,019				$	319			31.3	%
Facilities		148					125					23			18.4	%
Professional fees & outside services		137					32					105			328.1	%
Share-based compensation		96					52					44			84.6	%
Depreciation		11					12					(1	)		(8.3	%)
Other		152					70					82			117.1	%
Research and development	$	1,882		12.7	%	$	1,310		10.1	%	$	572			43.7	%

The increase in research and development expenses for the three months ended December 31, 2006 as compared to the same period one year ago is primarily due to an increase in personnel-related expenses as a result of an increase in headcount and professional fees for outside consultants.

The following table presents research and development expenses:

	Six Months Ended December 31,
			% of Net					% of Net			Change
	2006		Revenue			2005		Revenue			$			%
	(In thousands, except percentages)
Personnel-related expenses	$	2,609				$	2,021				$	588			29.1	%
Facilities		314					271					43			15.9	%
Professional fees & outside services		218					150					68			45.3	%
Share-based compensation		188					105					83			79.0	%
Depreciation		20					24					(4	)		(16.7	%)
Other		251					142					109			76.8	%
Research and development	$	3,600		13.2	%	$	2,713		10.8	%	$	887			32.7	%

The increase in research and development expenses for the six months ended December 31, 2006 as compared to the same period one year ago is primarily due to an increase in personnel-related expenses as a result of an increase in headcount.

Provision for Income Taxes

The following table presents our effective tax rate based upon our income tax provision:

	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2006			2005			2006			2005
Effective tax rate		12	%		0	%		4	%		0	%

We utilize the liability method of accounting for income taxes as set forth in SFAS No. 109, “Accounting for Income Taxes.” 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. We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. As a result of our cumulative losses, we provided a full valuation allowance against our net deferred tax assets for the three and six months ended December 31, 2006 and 2005.

Other Income (Expense), Net

Other income (expense), net consists of gains (losses) on the sale of investments, foreign currency transactions and the disposal of fixed assets.

The following tables present other income (expense), net:

	Three Months Ended December 31,
			% of Net						% of Net			Change
	2006		Revenues			2005			Revenues			$		%
	(In thousands, except percentages)
Other income (expense), net	$	730		4.9	%	$	(49	)		-0.4	%	$	779		-1589.8	%

	Six Months Ended December 31,
			% of Net						% of Net			Change
	2006		Revenues			2005			Revenues			$		%
	(In thousands, except percentages)
Other income (expense), net	$	727		2.7	%	$	(59	)		-0.2	%	$	786		-1332.2	%

The increase in other income (expense), net for the three and six months ended December 31, 2006 as compared to the same period one year ago is primarily due to $700,000 of income recognized on the sale of our investment in Xanboo.

Liquidity and Capital Resources

Since inception through fiscal 2007, we have financed our operations through the issuance of common stock and operating activities. We refer to the sum of cash and cash equivalents and marketable securities as “cash” for the purposes of discussing our cash balance and liquidity.

The following table presents details of our working capital and cash:

	December 31,		June 30,		Increase
	2006		2006		(Decrease)
			(In thousands)
Working capital	$	5,698	$	5,372	$	326
Cash and cash equivalents	$	7,744	$	7,729	$	15
Marketable securities		96		88		8
	$	7,840	$	7,817	$	23

In order of significance, our working capital increased in part due to (i) a decrease in other current liabilities as a result of the timing of payments, (ii) a buildup of inventories and (iii) an increase in accounts receivable as a result of the increase in sales and timing of receipts; offset by (iv) an increase in accounts payable as a result of the timing of cash payments to vendors and (v) a net loss for the year ended December 31, 2006. Our cash balances increased slightly as a result of our cash management activities which include the timing of cash payments to our vendors and the timing of cash receipts from our customers.

We believe that the cumulative effect of expense reductions initiated in fiscal 2005 and the settlement of our patent litigation during fiscal 2006 will result in reduced operating expenses and will lower our cash breakeven point to approximately $14.0 to $15.0 million per fiscal quarter. This target is based upon a financial model, and we expect that actual expenses may vary in any fiscal quarter and therefore financial results impacting cash usage or profitability will vary. 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, marketable securities and funds available from our line of credit 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 government investigations and 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. 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.

In May 2006, we entered into a two-year secured revolving Loan and Security Agreement ("Line of Credit”) with a bank, which provides for borrowings up to $5.0 million. The borrowing capacity is limited to eligible accounts receivable as defined under the Line of Credit. Borrowings under the Line of Credit bear interest at the prime rate plus 1.75% per annum. We are required to pay an unused line fee of 0.50% on the unused portion of the Line of Credit. As of December 31, 2006, we had no borrowings against the Line of Credit.

The following table presents our available borrowing capacity and outstanding letters of credit, which were used to secure equipment leases, deposits for a building lease, foreign value added tax account deposits and security deposits:

	December 31,		June 30,
	2006		2006
	(In thousands)
Available borrowing capacity	$	2,826	$	2,221
Outstanding letters of credit	$	1,280	$	1,594

During March 2006, we entered into a lease agreement whereby the lessor will advance an amount not to exceed $1.0 million for the implementation of a new ERP information system to manage our business operations. During the ERP implementation period, we will pay interest of 9.0% on the amounts advanced. The lease agreement states that the aggregate amount advanced to us by the lessor will be repaid over a three-year period following the completion of the ERP implementation. As of December 31, 2006, we had incurred costs of $483,000 in connection with the ERP implementation which have or will be advanced by the lessor.

As of December 31, 2006, approximately $2.0 million of our cash is held in foreign subsidiary bank accounts. Such cash is unrestricted with regard to foreign liquidity needs; however, our ability to utilize a portion of this cash to satisfy liquidity needs outside of such foreign locations is subject to approval by the foreign location board of directors.

Cash Flows

The following table presents the major components of the consolidated statements of cash flows:

	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2006			2005			2006			2005
	(In thousands)						(In thousands)
Net cash provided by (used in):
Net income (loss)	$	87		$	(3,571	)	$	(564	)	$	(4,912	)
Non-cash operating expenses, net		443			3,282			911			3,716
Changes in operating assets and liabilities:
Accounts receivable		(735	)		308			(401	)		153
Inventories		777			(539	)		(345	)		313
Contract manufacturers' receivable		(352	)		(209	)		16			(188	)
Prepaid expenses and other current assets		(50	)		193			(25	)		(287	)
Other assets		(3	)		24			(6	)		28
Accounts payable		(685	)		449			1,272			1,099
Accrued payroll and related expenses		517			448			304			163
Accrued settlements		-			-			(400	)		-
Warranty reserve		(21	)		(222	)		(219	)		(276	)
Other liabilities		124			355			(617	)		819
Net cash provided (used in) by operating activities		102			518			(74	)		628
Net cash used in investing activities		(267	)		(94	)		(271	)		(132	)
Net cash provided by financing activities		166			10			317			121
Effect of foreign exchange rate changes on cash		56			(93	)		43			(113	)
Increase in cash and cash equivalents	$	57		$	341		$	15		$	504

Three months ended

Operating activities provided cash during the three months ended December 31, 2006. This was the result of a net income, cash provided by operating assets and liabilities and non-cash operating expenses. The non-cash items that had a significant impact on the net loss included share-based compensation and depreciation. In order of significance, the changes in operating assets and liabilities which had a significant impact on the cash provided in operating activities included (i) a decrease in inventories as a result of the increase in revenues (ii) an increase in accrued payroll due to the timing of payroll periods; offset by (iii) an increase in accounts receivable as a result of higher sales and the timing of cash collections, (iv) a decrease in accounts payable as a result of the timing of payments to vendors and (v) an increase in the contract manufacturers’ receivables due to the timing of shipments and cash collections.

Operating activities provided cash for the three months ended December 31, 2005. 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. Non-cash items that had a significant impact on net loss included litigation settlement costs, depreciation, amortization of purchased intangible assets and share-based compensation. In order of significance, the changes in operating assets and liabilities which had a significant impact on the cash provided in operating activities included (i) an increase in accounts payable and other liabilities as a result of the timing of cash payments (ii) an increase in accrued payroll related to the timing of payroll periods (iii) a decrease in accounts receivable as a result of the timing of cash collections; offset by (iii) an increase in inventories due to the timing of shipments (iv) a reduction in the warranty reserve to reflect lower expected warranty return rates and (v) an increase in the contract manufacturers’ receivables due to the timing of shipments and cash collections.

Investing activities used cash during the three months ended December 31, 2006 and 2005. This was due to the purchase of property and equipment.

Financing activities provided cash during the three months ended December 31, 2006 and 2005. This was 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.

Six months ended

Operating activities used cash during the six months ended December 31, 2006. This was the result of a net loss, cash used by operating assets and liabilities, offset by non-cash operating expenses. The non-cash items that had a significant impact on the net loss included share-based compensation and depreciation. In order of significance, the changes in operating assets and liabilities which had a significant impact on the cash used in operating activities included (i) an increase in accounts receivable as a result of higher sales and the timing of cash collections, (ii) an increase in inventories, (iii) a decrease in other liabilities as a result of a decrease in customer deposits and the timing of payments to vendors, (iv) a decrease in accrued settlements as a result of the payment of the Digi settlement and (v) a reduction in the warranty reserve to reflect lower expected warranty return rates; offset by (vi) an increase in accounts payable as a result of the timing of cash payments to vendors and an increase in accrued payroll related to the timing of payroll periods.

Operating activities provided cash for the six months ended December 31, 2005. 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. Non-cash items that had a significant impact on net loss included litigation settlement costs, depreciation, amortization of purchased intangible assets and share-based compensation. Changes in operating assets and liabilities which had a significant impact on the cash provided by operating activities included accounts payable and other liabilities.

Investing activities used cash during the six months ended December 31, 2006 and 2005. This was due to the purchase of property and equipment.

Financing activities provided cash during the six months ended December 31, 2006 and 2005. This was 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.

Off-Balance Sheet Arrangements

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We do not use derivative financial instruments for speculative or trading purposes. We place our investments in instruments that meet high credit quality standards, as specified in our investment policy.

Interest Rate Risk

Our exposure to interest rate risk is limited to the exposure related to our cash and cash equivalents and marketable securities. Our cash and cash equivalents are held in cash deposit accounts and, as such, we believe our cash and cash equivalents are not subject to significant interest rate risk. We believe our 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.

The following table presents our cash and cash equivalents and marketable securities:

	December 31,		June 30,
	2006		2006
	(In thousands)
Cash and cash equivalents	$	7,744	$	7,729
Marketable securities		96		88
	$	7,840	$	7,817

Foreign Currency Risk

We hold a significant portion of our cash balance in foreign currencies (particularly the euro) and, as such, we are subject to foreign currency fluctuations. In addition, we sell products internationally. As a result, our financial results could be harmed by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. We do not currently enter into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we feel our foreign currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk.

The following table presents our cash balance held in foreign currencies:

	December 31,		June 30,
	2006		2006
	(In thousands)
Cash held in foreign currencies	$	2,194	$	2,554

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 December 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.