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DOT HILL SYSTEMS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[November 09, 2012]

DOT HILL SYSTEMS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement for Forward-Looking Information Certain statements contained in this quarterly report on Form 10-Q, including, statements regarding the development, growth and expansion of our business, our intent, belief or current expectations, primarily with respect to our future operating performance and the products we expect to offer, and other statements regarding matters that are not historical facts, are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and are subject to the "safe harbor" created by these sections. Because such forward-looking statements are subject to risks and uncertainties, many of which are beyond our control, actual results may differ materially from those expressed or implied by such forward-looking statements.

Some of the factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements can be found in Part II, Item 1A, "Risk Factors" and in our reports filed with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K for the year ended December 31, 2011. Readers are cautioned not to place undue reliance on forward-looking statements. The forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update such statements to reflect events that occur or circumstances that exist after the date on which they are made.

The following discussion of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included in the preceding pages in this quarterly report on Form 10-Q and our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011.


Overview We design, manufacture and market a range of software and hardware storage systems for the entry and midrange storage markets. Beginning in the second half of 2009, we began placing more emphasis on selling higher gross margin products which includes appliance products and hardware products through indirect sales channels.

Typical customers for our storage systems products, which includes our AssuredSAN line of storage array products, include organizations requiring high reliability, high performance networked storage and data management solutions in an open systems architecture. Our storage solutions consist of integrated hardware, firmware and software products employing a modular system that allows end-users to add various protocol, performance, capacity or data protection schemes as needed. Our broad range of products, from small capacity direct attached to complete multi-hundred terabyte, or TB, storage area networks, or SANs, provide end-users with a cost-effective means of addressing increasing storage demands at compelling price-performance points. Our current product family based on our AssuredSAN architecture provides high performance and large disk array capacities for a broad variety of environments, employing Fibre Channel, Internet Small Computer Systems Interface, or iSCSI or Serial Attached SCSI, or SAS, interconnects to switches and/or hosts. In addition, our Assured family of data protection software products provides additional layers of data protection options to complement our line of storage disk 17-------------------------------------------------------------------------------- Table of Contents arrays. Our current mainstream 2000 and 3000 series of entry-level storage products and Just a Bunch of Disks, or JBOD, arrays are targeted primarily at mainstream enterprise and small-to-medium business, or SMB, applications. Some of our AssuredSAN products have been distinguished by certification as Network Equipment Building System, or NEBS, Level 3 (a telecommunications standard for equipment used in central offices) and are MIL-STD-810F (a military standard created by the U.S. government) compliant based on their ruggedness and reliability. In February 2010, we launched the latest AssuredSAN 3000 series of storage arrays that provide high speed interface options including 8 gigabyte, or GB, Fibre Channel, 1GB and 10GB iSCSI over Ethernet and 6GB SAS connectivity.

On August 22, 2012, we introduced AssuredSANTM Pro 5000 Series with RealStorTM software that incorporates real-time data tiering. With RealStor, businesses gain the advantage of very high performance SSDs, using them to their maximum benefit, while storing less frequently accessed data on slower, but much less expensive hard disk drives. On that same day, we also introduced our AssuredSAN(TM) 4000 Series next-generation, high performance storage solution designed to deliver best-in-class price performance, 99.999 percent availability, and exceptional streaming throughput. The Series 4000 shares the same architecture as the Series 5000. Our Series 2000 and 3000 products are characterized by IDC as Band 2 and Band 3 products. With the announcement of our Series 4000 and 5000 products, we now have products characterized as Bands 4 and 5 products and we have thus increased our total available market as measured by end-user sales price from $4.0 billion to $10.6 billion.

In September 2008, we acquired certain assets, namely RAIDCore from Ciprico Inc., or Ciprico. These products are marketed to OEM accounts as the AssuredVRA product line. This acquisition opened up new markets for us in the enterprise server and workstation markets for data protection internal to the servers and workstations. In particular, the RAIDCore acquisition allows us to broaden our product portfolio in the redundant array of independent disks, or RAID, market while allowing us to sell into the Band 1 market, and to pursue opportunities at current and target OEM customers. We signed our first customer agreement relating to RAIDCore products in May 2009 and began selling to this customer during the third quarter of 2009. Sales of AssuredVRA products were not significant in 2011 or in 2012. Although sales of our AssuredVRA products increased in 2011, such sales do not represent a significant percentage of our total net revenue for the three and nine months ended September 30, 2012.

We have decided to expand our routes to market beyond our focus on OEMs, and in October of 2009, we launched a Dot Hill channel program targeted at selling through distributors and open storage partners, or OSPs. We continued to expand our channel program in 2011 and we believe this will provide Dot Hill with additional sales channels for all of our products. The majority of sales to our channel partners were represented by our AssuredSAN line of products in 2011 and in the first nine months of 2012.

Our agreements with our customers do not contain any minimum purchase commitments and may be terminated at any time upon notice from the applicable customer. Our ability to achieve and maintain profitability will depend on, among other things, the level and mix of orders we actually receive from such customers, the actual amounts we spend on marketing support, the actual amounts we spend for inventory support and incremental internal investment, our ability to reduce product cost, our product lead time, our ability to meet delivery schedules required by our customers and the economic environment.

Our products and services are sold worldwide to facilitate server and SAN storage implementations, primarily through OEMs, and supplemented by system integrators, or SIs, distributors and value added resellers, or VARs. Our storage system products' OEM partners currently include, among others, Hewlett-Packard, or HP, Sony Ericsson, or Ericsson, Motorola, Inc., or Motorola, General Dynamics Government Systems Corporation, or General Dynamics, Lockheed Martin Corporation, or Lockheed Martin, NEC Corporation, or NEC, Tektronix Inc., or Tektronix, Samsung Electronics, or Samsung, Stratus Technologies, or Stratus, and Fujitsu Technology Solutions GmbH, or FTS, and Concurrent Computer Corporation, or Concurrent. Our standalone storage software products' OEM partners currently include, among others, Dell Inc., or Dell. Although our products and services are sold worldwide, the majority of our net revenue is derived from our U.S. operations.

We began shipping products to HP in the fourth quarter of 2007. In January 2008, we amended our agreement with HP to allow for sales of additional products to additional divisions within HP. Our products are primarily sold as HP's MSA 2000/P2000 product family. Sales to HP increased significantly during 2008 and increased again in 2009 primarily as a result of the successful launch and market acceptance of the HP MSA 2000 products. HP launched its third generation product line, now called the P2000 product line, in February 2010. Sales to HP increased again in 2010 as we began selling our next generation host interfaces across the HP P2000 product line. The agreement with HP does not contain any minimum purchase commitments. In October 2011, we extended our supply agreement with HP by five years to expire in October 2016 and also extended the expiration of 1.6 million warrants granted to HP in March 2008 to expire concurrently with the supply agreement in October 2016. Net revenue from HP approximated 74% of our total net revenue in 2011 and 67% of our total net revenue for the nine months ended September 30, 2012. We expect sales to HP to continue to represent a substantial percentage of our total 18-------------------------------------------------------------------------------- Table of Contents net revenue in 2012. We expect to generate additional revenue from our indirect channel as well as new and potential new OEM customers.

In addition, the demand for our products has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following: • our ability to maintain and enhance relationships with our customers, in particular our OEM customers, as well as our ability to win new business; • our ability to source critical components such as integrated circuits, hard disk drives, memory and other components on a timely basis; • the amount of field failures resulting in product replacements or recalls; • our ability to launch new products in accordance with OEM specifications, schedules and milestones; • our ability to sell Dot Hill branded products through Resellers; • our ability to win new OEM customers; • general economic and political conditions and specific conditions in the markets we address, including the continuing volatility in the technology sector, current general economic volatility and trends in the data storage markets in various geographic regions; • the timing, rescheduling or cancellation of significant customer orders and our ability, as well as the ability of our customers, to manage inventory; and • the inability of certain of our customers who depend on credit to have access to their traditional sources of credit to finance the purchase of products from us, particularly in the current global economic environment, which may lead them to reduce their level of purchases or to seek credit or other accommodations from us.

For these and other reasons, our net revenue and results of operations for the three and nine months ended September 30, 2012 and prior periods may not necessarily be indicative of future net revenue and results of operations.

Our manufacturing strategy includes outsourcing substantially all of our manufacturing to third-party manufacturers in order to reduce sales cycle times and manufacturing infrastructure, enhance working capital and improve margins by taking advantage of the third parties' manufacturing and procurement economies of scale. In September 2008, we entered into a manufacturing agreement with Foxconn Technology Group, or Foxconn. Under the terms of the agreement, Foxconn supplies us with manufacturing, assembly and test services from its facilities in China and final integration services including final assembly, testing and configure-to-order services, through its worldwide facilities. In November 2011, we amended our agreement with Foxconn to extend the manufacturing agreement for a period of three years. In addition, Foxconn agreed to waive the requirement for a letter of credit and improved our payment terms. Foxconn began manufacturing products for us in July 2009 and we began shipping products for general availability under the Foxconn agreement during the second half of 2009.

The majority of our products sold in 2011 and in the three and nine months ended September 30, 2012 were manufactured by Foxconn. We expect Foxconn to manufacture substantially all of our products for the remainder of 2012.

We derive the majority of our net revenue primarily from sales of our Series 2000 and 3000 family of products, which are included in our AssuredSAN product line.

Cost of goods sold includes costs of materials, subcontractor costs, salary and related benefits for the production and service departments, depreciation and amortization of equipment and intangible assets used in the production and service departments, production facility rent and allocation of overhead as well as manufacturing variances and freight.

Research and development expenses consist primarily of project-related expenses, consulting charges and salaries for employees directly engaged in research and development.

Sales and marketing expenses consist primarily of salaries and commissions, marketing related costs, advertising, customer-related evaluation unit expenses, promotional costs and travel expenses.

General and administrative expenses consist primarily of compensation to officers and employees performing administrative functions, as well as expenditures for legal, accounting and other administrative services and fluctuations in currency valuations.

19-------------------------------------------------------------------------------- Table of Contents Other income (expense), net is comprised primarily of interest income earned on our cash and cash equivalents and other miscellaneous income and expense items.

In the first quarter of 2012, our management approved, committed to, and initiated a restructuring and cost reduction plan or the 2012 Plan that is associated with the closure of our Israel Technology Development Center. The 2012 Plan is designed to re-align our software investments to focus on accelerating the development of embedded software features, in order to launch a competitive set of mid-range storage array products in 2012, and to provide more differentiated entry-level products for both OEM and channel customers.

Substantially all of our 2012 Plan workforce reductions were completed by July 31, 2012. The closure of our Israel Technology Development Center is now recorded in discontinued operations, since we have ceased all ongoing operational activities as of September 30, 2012.

Critical Accounting Policies and Estimates An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably likely to occur could materially impact the unaudited condensed consolidated financial statements. Except as noted below, management believes that there have been no significant changes during the three and nine months ended September 30, 2012, to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

Warranty and Related Obligations Our standard warranty provides that if our systems do not function to published specifications, we will repair or replace the defective component or system without charge generally for a period of approximately three years. We generally extend to our customers the warranties provided to us by our suppliers, and accordingly, the majority of our warranty obligations to customers are typically intended to be covered by corresponding supplier warranties. For warranty costs not covered by our suppliers, we provide for estimated warranty costs in the period the revenue is recognized. There can be no assurance that our suppliers will continue to provide such warranties to us in the future or that our warranty obligations to our customers will be covered by corresponding warranties from our suppliers, the absence of which could have a material effect on our financial statements. Estimated liabilities for product warranties are included in accrued expenses.

In October 2009, we discovered a quality issue associated with certain power supply devices provided by a long-term component supplier, which resulted in a higher than expected level of power supply failures to us and our customers.

While we were able to promptly identify and resolve the cause of the failures, we are required to provide replacement products or make repairs to the affected power supply units that had been sold between March and October 2009. Through June 30, 2011, our component supplier had repaired all of the faulty power supplies at no cost to us and reimbursed us for our out-of-pocket costs which has constituted a reimbursement to customers for certain out-of-pocket costs they incurred in connection with these power supply failures. The total amount reimbursed to us by our component supplier approximated $1.0 million through June 30, 2011.

In the second and third quarters of 2011, a material customer provided us with a framework estimating the potential claims precipitated by the power supply failures. As previously disclosed, the customer's preliminary framework of potential claims provided to us included additional costs related to the customer's internal overhead for other internal indirect costs, in addition to third-party direct costs. Based on preliminary discussions for settlement and our analysis of the framework provided by the customer, including future potential claims through the warranty period, we estimated that we had incurred a probable loss of approximately $2.8 million. Consequently, in addition to the $1.3 million previously recognized as of June 30, 2011, we recorded an estimated liability of $1.5 million as of September 30, 2011 within "Accrued expenses" on our condensed consolidated balance sheet.

Negotiations continued with our customer throughout the fourth quarter of 2011 into the first half of 2012. Based on the results of ongoing negotiations with the material customer, we increased our estimated liability at December 31, 2011 to $5.5 million, resulting in a charge of $2.7 million during the fourth quarter of 2011 within "Accrued expenses" on our condensed consolidated balance sheet, gross of any third-party recoveries.

A final settlement with this material customer was reached during the second quarter of 2012. The terms of the agreement required an immediate payment of $2.0 million and an estimated remaining liability of approximately $2.7 million as of September 30, 2012 related to a combination of future price concessions and rebates to be paid quarterly based on sales 20-------------------------------------------------------------------------------- Table of Contents volumes through December 31, 2012. While our estimated liability relating to failed power supply units is subject to some uncertainty until final settlement, based on our current expectation of sales volumes with this material customer, we do not believe the incurrence of an additional loss is either probable or reasonably possible at this time.

During the second quarter of 2011, based on the advice of legal counsel, we established that our component supplier is contractually obligated to reimburse us for fair and reasonable costs we incur with our customers associated with these power supply failures. Our component supplier had continued to re-work and distribute to our customer the affected population of power supplies at no cost to us. In addition, at the time, our collection experience with similar amounts already reimbursed to us by our supplier and our belief that our component supplier and its parent companies had the financial ability to continue to reimburse us for any additional costs we may incur, we recorded a current asset within "Prepaid expenses and other assets" on our consolidated balance sheet of $1.3 million as of June 30, 2011.

During the third quarter of 2011, as the claims from our customer became clearer, we commenced negotiations with our component supplier for fair and reasonable costs that we have and are likely to incur through the warranty period associated with this component failure. Originally we determined that the supplier was unlikely to make an up-front cash payment for the original settlement amount of $1.3 million, but it indicated a willingness to provide some form of reimbursement for costs incurred, in the form of cash and/or note receivable of $0.5 million plus future product rebates. Based on our judgment at the time, we reduced the previously recorded current asset of $1.3 million within "Prepaid expenses and other assets" to $0.5 million as of September 30, 2011. We continued to negotiate this settlement with our supplier and during the second quarter of 2012, the supplier signed a final settlement agreement providing for additional reimbursements above what was recognized as of September 30, 2011. Pursuant to the settlement, the supplier agreed to cash consideration of $1.2 million, of which we received $0.7 million subsequent to the signing of the settlement agreement, with the remaining $0.5 million to be received in installments over the next three quarters. Additionally, our supplier committed to product rebates and/or price concessions on product orders for a period of 39 months from the execution of the settlement agreement, in return for our agreement to release our supplier from all obligations relating to the power supply failures known by us to date. This agreement is not subject to any required future purchases.

In addition, we have commenced discussions with our General Liability and Errors and Omissions Insurance and underwriters and will continue to pursue our rights to cover any damages we incur and that are not reimbursed by our supplier. The insurance company has issued a reservation of rights letter to us and at this time, it is not possible to estimate to what extent the residual amounts, if any, we will be covered by our carrier. As of September 30, 2012 we have not assumed or recorded any insurance reimbursement.

To the extent our settlement agreements with our customer and our component supplier are not on mutually beneficial terms, or our component supplier does not continue to reimburse us for the expenses incurred by us or our customers, and we are unsuccessful in recovering such expenses from our insurance provider, we could incur additional expenses which could potentially have a material effect on our financial statements and liquidity.

Long-lived Asset Impairment We periodically review the recoverability of the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. An impairment in the carrying value of an asset group is recognized whenever anticipated future undiscounted cash flows from an asset group are estimated to be less than its carrying value. The amount of impairment recognized is the difference between the carrying value of the asset group and its fair value. Fair value estimates are based on assumptions concerning the amount and timing of estimated future cash flows and assumed discount rates, reflecting varying degrees of perceived risk.

As of September 30, 2011, we identified a change in circumstances that indicated the carrying amount of our long-lived assets may not be recoverable, as our primary AssuredUVS customer informed us that the AssuredUVS software would no longer be a component of its business strategy, which would result in a significant decline in revenues for the Company. Our long-lived assets consisted of the intangible assets associated with our acquisition of certain identified Cloverleaf Communications, Inc., or Cloverleaf, assets acquired in January 2010 with an original carrying value of $5.0 million and property and equipment of $1.2 million.

Since we did not have an immediate replacement for our AssuredUVS customer, management's forecasted undiscounted cash flows indicated that the assets were potentially not recoverable, and proceeded to estimate the fair value of each long-lived asset. Property and equipment consisted of mostly machinery and equipment used for testing and development of our AssuredUVS technology.

Management determined that carrying value approximated fair value, as property was either acquired 21-------------------------------------------------------------------------------- Table of Contents in the 2010 acquisition of Cloverleaf, had been purchased subsequently, or could be re-deployed, establishing recent evidence of fair value. It was depreciated over a 3 - 5 year estimated useful life.

Intangible assets consisted primarily of acquired software of $4.9 million and a trade name of $0.1 million. We determined the fair value of the acquired software by estimating the replacement cost of the software, taking into account both the software as acquired and subsequent development work, as well as the business alternatives we were considering and the corresponding value of the software in these alternative approaches. We estimated the value of the software based on the probabilities of each of the business alternatives. We determined the fair value of the trade name using an income approach and considered the fact that the software's trade name at the time of acquisition was no longer being used. All estimates were based on management using appropriate assumptions and projections.

Our impairment analysis at September 30, 2011 identified $2.9 million of impaired long-lived assets, consisting entirely of intangible assets recognized as part of the Cloverleaf acquisition in 2010. Long-lived asset impairment charges are recorded consistent with our treatment of related amortization expense specific to each acquired intangible assets. We recorded $2.8 million of impaired acquired software and $0.1 million of impaired acquired trade name as a component of cost of goods sold for the year ended December 31, 2011.

In February 2012, our Board of Directors approved a plan to exit our AssuredUVS business and close down our Israel Technology Development Center (see Note 7), at which time it was determined that the valuations at that date were appropriate. During the second quarter of 2012, we explored the potential sale of the AssuredUVS business, but were unsuccessful in locating a buyer and ended efforts to sell the business or its component assets as of June 30, 2012.

Accordingly, we recognized an impairment of $0.2 million of property, plant and equipment and $1.6 million for the remaining value of acquired software as a component of cost of goods sold as of June 30, 2012. The AssuredUVS business is now recorded in discontinued operations, since we have ceased all ongoing operational activities as of September 30, 2012.

Valuation of Goodwill We review goodwill for impairment on an annual basis at November 30 and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable.

Current accounting standards require that a two-step impairment test be performed on goodwill. In the first step, we compare the fair value of our reporting unit to its carrying value. We determine the fair value of our reporting unit using a combination of the income approach and market capitalization approach. If the fair value of the reporting unit exceeds the carrying value of the net assets, goodwill is not impaired, and we are not required to perform further testing. If the carrying value of the net assets exceeds the fair value of the reporting unit, then we must perform the second step in order to determine the implied fair value of the reporting unit's goodwill and compare it to the carrying value of the reporting unit's goodwill.

If the carrying value of the reporting unit's goodwill exceeds its implied fair value, then we must record an impairment charge equal to the difference.

Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future discounted cash flows. Under the market capitalization approach, valuation multiples are calculated based on operating data from publicly traded companies within our industry. Multiples derived from companies within our industry provide an indication of how much a knowledgeable investor in the marketplace would be willing to pay for a company. These multiples are applied to the operating data for the reporting unit to arrive at an indicated fair value. Significant management judgment is required in the forecasts of future operating results that are used in the estimated future discounted cash flow method of valuation. The estimates we have used are consistent with the plans and estimates that we use to manage our business. We base our fair value estimates on forecasted revenue and operating costs along with business plans. Our forecasts consider the effect of a number of factors including, but not limited to, the current future projected competitiveness and market acceptance of the product, technological risk, the ease of use and ease of implementation of the product, the likely outcome of sales and marketing efforts and projected costs associated with product development, customer support and selling, general and administrative costs. It is possible, however, that the plans may change and that actual results may differ significantly from our estimates.

During September 2011, our primary AssuredUVS customer became delinquent on the settlement of its payables to us and upon our investigation it became evident that its financial resources were limited. It also informed us that they were changing their strategy which would result in a significant decline in revenue for the Company, and we determined it was "more-likely-than-not" that the reporting unit was less than its carrying value. The impairment of the goodwill related to the reporting unit is now reported in discontinued operations (see Note 3), since we have ceased all ongoing operational activities as of September 30, 2012.

22-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth certain items from our statements of operations as a percentage of net revenue for the periods indicated (percentages may not aggregate due to rounding): Three Months Ended Nine Months Ended September 30, September 30, 2011 2012 2011 2012 Net revenue 100.0 % 100.0 % 100.0 % 100.0 % Cost of goods sold 76.1 74.6 75.5 73.1 Gross profit 23.9 25.4 24.5 26.9 Operating expenses: Research and development 17.5 19.4 15.5 18.8 Sales and marketing 7.6 7.4 6.6 6.9 General and administrative 4.0 4.4 4.2 4.7 Restructuring charge 1.4 (0.4 ) 0.4 (0.2 ) Total operating expenses 30.5 30.8 26.7 30.2 Operating loss (6.6 ) (5.4 ) (2.2 ) (3.3 ) Other income (expense), net - - - - Loss before income taxes and discontinued operations (6.6 ) (5.4 ) (2.2 ) (3.3 ) Income tax (benefit) expense 0.2 0.3 0.1 0.3 Loss from continuing operations (6.8 ) (5.7 ) (2.3 ) (3.6 ) Loss from discontinued operations (18.7 ) (0.6 ) (7.9 ) (2.9 ) Net loss (25.5 )% (6.3 )% (10.2 )% (6.5 )% Three and Nine Months Ended September 30, 2011 Compared to the Three and Nine Months Ended September 30, 2012 Net Revenue Three Months Ended September 30, 2011 2012 Increase % Change (in thousands, except percentages) Net Revenue $ 47,805 $ 48,223 $ 418 0.9 % Nine Months Ended September 30, 2011 2012 Increase % Change (in thousands, except percentages) Net Revenue $ 148,806 $ 150,529 $ 1,723 1.2 % Net revenues increased approximately $0.4 million from $47.8 million for the three months ended September 30, 2011 to $48.2 million for the three months ended September 30, 2012. The increase in net revenue was primarily due to a $2.5 million increase in sales to other OEM customers, offset by a $2.1 million decrease in revenue from HP from $35.0 million for the three months ended September 30, 2011 to $32.9 million for the three months ended September 30, 2012. However, we expect sales to HP to continue to represent a substantial portion of our net revenue during 2012. Sales to HP approximated 73% of our net revenue for the three months ended September 30, 2011 compared to 68% of our net revenue for the three months ended September 30, 2012.

Net revenues for the nine months ended September 30, 2011 to September 30, 2012 increased approximately $1.7 million from $148.8 million to $150.5 million, respectively. However, there were significant customer fluctuations within this period. Revenues from HP decreased from $113.3 million for the nine months ended September 30, 2011 compared to $100.4 million 23-------------------------------------------------------------------------------- Table of Contents for the nine months ended September 30, 2012, a decline of $12.9 million. There were additional revenue changes which contributed to the fluctuation in the nine months ended September 30, 2012. Sales of our AssuredVRA products decreased from $2.1 million to $1.7 million for the nine months ended September 30, 2011 and September 30, 2012. Other OEM revenue increased $13.3 million for the nine months ended September 30, 2012 and was a result of adding new OEM partners and increased sales as our OEM customers responded to the global hard drive supply constraints earlier in 2012. Sales to our channel partners increased from $4.8 million for the nine months ended September 30, 2011 to $6.5 million for the nine months ended September 30, 2012. This was due to an increase in resellers that were better qualified to resell our products.

Cost of Goods Sold and Gross Profit Three Months Ended Three Months Ended Increase % September 30, 2011 September 30, 2012 (Decrease) Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Cost of Goods Sold $ 36,364 76.1 % $ 35,955 74.6 % $ (409 ) (1.1 )% Gross Profit $ 11,441 23.9 % $ 12,268 25.4 % $ 827 7.2 % Nine Months Ended Nine Months Ended Increase % September 30, 2011 September 30, 2012 (Decrease) Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Cost of Goods Sold $ 112,322 75.5 % $ 110,035 73.1 % $ (2,287 ) (2.0 )% Gross Profit $ 36,484 24.5 % $ 40,494 26.9 % $ 4,010 11.0 % Cost of goods sold decreased for the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011 primarily as a result of a more favorable mix of sales revenue and cost reductions, which were partially offset by increased warranty related costs.

Gross profit margin increased from 23.9% for the three months ended September 30, 2011 to 25.4% for the three months ended September 30, 2012. Gross profit margin benefited from manufacturing cost reductions, component cost reductions and a more favorable product and customer mix, which were partially offset by increased warranty related costs. Gross profit and gross margins for the three months ended September 30, 2012 were also positively impacted by decreased manufacturing overhead costs which decreased from $6.0 million for the three months ended September 30, 2011 to $4.5 million for the three months ended September 30, 2012.

Gross profit margin increased from 24.5% for the nine months ended September 30, 2011 to 26.9% for the nine months ended September 30, 2012. Gross profit margins benefited from manufacturing cost reductions, component cost reductions and a more favorable product and customer mix, which were partially offset by increased warranty related costs. Furthermore, gross profit and gross margins for the nine months ended September 30, 2012 were positively impacted by decreased manufacturing support costs which decreased from $13.9 million for the nine months ended September 30, 2011 to $9.8 million for the nine months ended September 30, 2012.

Research and Development Expenses Three Months Ended Three Months Ended % September 30, 2011 September 30, 2012 Increase Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Research and Development Expenses $ 8,384 17.5 % $ 9,368 19.4 % $ 984 11.7 % 24-------------------------------------------------------------------------------- Table of Contents Nine Months Ended Nine Months Ended % September 30, 2011 September 30, 2012 Increase Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Research and Development Expenses $ 23,125 15.5 % $ 28,226 18.8 % $ 5,101 22.1 % Research and development expense increased $1.0 million to $9.4 million for the three months ended September 30, 2012 compared to $8.4 million for the three months ended September 30, 2011. The increase was primarily due to a $0.7 million increase in salaries and payroll expense and a $0.6 million increase in project materials expense. These increases were partially offset by a $0.2 million decrease in depreciation expense and a $0.1 million decrease in other miscellaneous expenses. The increase in salaries and payroll expense and project materials expense is the result of the acquisition of materials and additions to staff to support customizations for newer OEM customers, the launch of the company's Series 4000 and 5000 mid-range products and next generation product development. The net decrease in depreciation expense is due to $0.4 million of depreciation expense on certain software licenses in 2011, versus an increase in 2012 of $0.2 million in depreciation expense resulting from the acquisition of materials to support strategic development projects.

Research and development expense increased $5.1 million to $28.2 million for the nine months ended September 30, 2012 compared to $23.1 million for the nine months ended September 30, 2011. This increase was due to an increase in salaries and payroll related expenses for research and development personnel of $2.7 million, an increase in project materials and depreciation expense of $1.4 million, an increase in allocated costs of $0.6 million, and an increase in consulting expense of $0.4 million. The increase in salaries and payroll related expense is the result of the 2012 reinstatement of salary reductions which were in effect throughout 2011. The increase in salaries expense is also the result of increased headcount focused on customizations for newer OEM customers, the launch of the company's Series 4000 and 5000 mid-range products and next generation product development. The increase in project materials expense and depreciation expense is the result of an increase in capital assets and project supplies required to support new customer wins, the launch of our mid-range products, and the development of our next generation storage products due to be released in 2013.

The increase in allocated costs is due to increased headcount and equipment necessary to support the research and development function. The increase in consulting expense is primarily the result of an increased reliance on domestic and foreign engineering consultants to assist certain engineering functions with strategic development projects.

We expect that the timing of our engineering material purchases and additional headcount requirements to support new product releases will affect the amount of research and development expenses in future periods.

Sales and Marketing Expenses Three Months Ended Three Months Ended % September 30, 2011 September 30, 2012 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Sales and Marketing Expenses $ 3,623 7.6 % $ 3,558 7.4 % $ (65 ) (1.8 )% Nine Months Ended Nine Months Ended % September 30, 2011 September 30, 2012 Increase Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Sales and Marketing Expenses $ 9,889 6.6 % $ 10,415 6.9 % $ 526 5.3 % Sales and marketing expense decreased approximately $0.1 million to $3.6 million for the three months ended September 30, 2012 compared to $3.6 million for the three months ended September 30, 2011. This decrease was primarily due to a decrease in salaries and payroll related expenses of $0.1 million due to the timing of replacing an employee.

Sales and marketing expense increased approximately $0.5 million to $10.4 million for the nine months ended September 30, 2012 compared to $9.9 million for the nine months ended September 30, 2011. This increase was primarily due to an increase in evaluation unit expenses of $0.4 million and an increase in trade show expenses of $0.1 million. The increase 25-------------------------------------------------------------------------------- Table of Contents in evaluation unit expenses was due to an increase in customer interest in new products. The increase in trade show expenses is primarily due to promoting our new product offerings.

General and Administrative Expenses Three Months Ended Three Months Ended % September 30, 2011 September 30, 2012 Increase Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) General and Administrative Expenses $ 1,922 4.0 % $ 2,101 4.4 % $ 179 9.3 % Nine Months Ended Nine Months Ended % September 30, 2011 September 30, 2012 Increase Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) General and Administrative Expenses $ 6,267 4.2 % $ 7,146 4.7 % $ 879 14.0 % General and administrative expenses increased approximately $0.2 million to $2.1 million for the three months ended September 30, 2012 compared to $1.9 million for the three months ended September 30, 2011. The increase was primarily due to a $0.2 million increase in salaries and payroll related expenses for the hiring of key administrative personnel.

General and administrative expenses increased approximately $0.9 million to $7.1 million for the nine months ended September 30, 2012 compared to $6.3 million for the nine months ended September 30, 2011. This increase was due to $0.6 million realized and unrealized foreign currency net losses, a $0.4 million increase in salaries and payroll related expenses, and a $0.3 million increase in recruiting and consultant fees. These increases were partially offset by a $0.3 million decrease in stock-based compensation. The realized and unrealized foreign currency net losses resulted from an unfavorable change in unrealized foreign currency losses of $1.1 million, partially offset by realized foreign currency gains of $0.5 million related to transactions reflecting changes in the value of the Euro, British Pound, and Japanese Yen in relation to the United States Dollar. The increase in salaries and payroll related expense is the result of the 2012 reinstatement of salary reductions which were in effect throughout 2011 combined with the hiring of key administrative personnel. The decline in stock-based compensation was due to an increased emphasis on the use of stock options versus restricted stock awards, reducing the overall value of more recent grants.

Restructuring Charge (Recovery) Three Months Ended Three Months Ended % September 30, 2011 September 30, 2012 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Restructuring Charge (Recovery) $ 659 1.4 % $ (183 ) (0.4 )% $ (842 ) (127.8 )% Nine Months Ended Nine Months Ended % September 30, 2011 September 30, 2012 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Restructuring Charge (Recovery) $ 655 0.4 % $ (228 ) (0.2 )% $ (883 ) (134.8 )% Restructuring expenses decreased to a recovery of $0.2 million for the three and nine months ended September 30, 2012 compared to an expense of $0.7 million for the three and nine months ended September 30, 2011. These expenses relate to our 2008 and 2010 Restructuring Plans, for which there are no significant expenses remaining to be incurred in 2012. See Note 7 of Notes to Unaudited Condensed Consolidated Financial Statements for more details regarding our restructuring activities.

26-------------------------------------------------------------------------------- Table of Contents Other Income (Expense), net Three Months Ended Three Months Ended % September 30, 2011 September 30, 2012 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Other Income (Expense), net $ (15 ) - % $ (5 ) - % $ (10 ) (66.7 )% Nine Months Ended Nine Months Ended % September 30, 2011 September 30, 2012 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Other Income (Expense), net $ (22 ) - % $ 8 - % $ (30 ) (136.4 )% Other income (expense), net consists of interest income on our cash and cash equivalents, interest expense related to our note payable and other miscellaneous items. Other income (expense), was slightly lower for the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011.

Income Taxes We recorded an income tax provision of $0.2 million and $0.5 million for the three and nine months ended September 30, 2012 and an income tax provision of $0.1 million and $0.2 million for the three and nine months ended September 30, 2011. Our provision primarily relates to estimated liabilities relating to certain tax positions involving our foreign subsidiaries that have not been concluded on with the relevant taxing authority.

Loss From Discontinued Operations Three Months Ended Three Months Ended % September 30, 2011 September 30, 2012 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Loss From Discontinued Operations $ (8,945 ) (18.7 )% $ (280 ) (0.6 )% $ (8,665 ) (96.9 )% Nine Months Ended Nine Months Ended % September 30, 2011 September 30, 2012 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Loss From Discontinued Operations $ (11,734 ) (7.9 )% $ (4,411 ) (2.9 )% $ (7,323 ) (62.4 )% Loss from discontinued operations decreased $8.7 million to $0.3 million for the three months ended September 30, 2012 compared to $8.9 million for the three months ended September 30, 2011. The decline in losses was primarily driven by the Company's decision in the first quarter of 2012 to close down our Israel Technology Center and exit out of our AssuredUVS business. This decrease was due to an increase in gross profit of $3.4 million, primarily driven by a decrease of $0.2 million in revenue and a decrease of $3.6 million cost of goods sold.

Additionally, there was a decline in operating expenses from discontinued operations of $5.3 million. The decrease in cost of goods sold was primarily a result of a $2.9 million intangible impairment charge in 2011. The decrease in operating expenses primarily consisted of a decrease in research and development expense of $1.1 million, a decrease in sales and marketing expense of $0.2 million, an impairment of goodwill of $4.1 million recorded in 2011, partially offset by an increase in general and administrative expense of $0.1 million.

Operating expenses from discontinued operations decreased primarily due to a $0.9 million decrease in salaries and payroll related expenses, a $0.2 million decrease in depreciation expense, a $0.1 million decrease in stock-based compensation expense, a $0.1 million decrease in facility expense and an impairment of goodwill of $4.1 million recorded in 2011 and a $0.2 million decrease in other operating expenses. These decreases were partially offset by an increase in professional service fees of $0.3 million.

27-------------------------------------------------------------------------------- Table of Contents Loss from discontinued operations decreased $7.3 million to $4.4 million for the nine months ended September 30, 2012 compared to $11.7 million for the nine months ended September 30, 2011. The decline in losses was primarily driven by the Company's decision in the first quarter of 2012 to close down our Israel Technology Center and exit out of our AssuredUVS business. This decrease was due to an increase in gross profit of $1.0 million, primarily driven by a decrease of $1.4 million in revenue and a decrease of $2.4 million cost of goods sold.

Additionally, there was a decline in operating expenses from discontinued operations of $6.3 million. The decrease in cost of goods sold was primarily a result of a $2.9 million intangible impairment charge in 2011. The decrease in operating expenses from discontinued operations consisted of a decrease in research and development expense of $2.6 million, a decrease in sales and marketing expense of $0.5 million, and an impairment of goodwill of $4.1 million recorded in 2011, partially offset by an increase in general and administrative expense of $0.1 million, in addition to restructuring charges of $0.8 million recorded in 2012. Operating expenses from discontinued operations decreased primarily due to a $2.3 million decrease in salaries and payroll related expenses, a $0.3 million decrease in depreciation expense, a $0.3 million decrease in stock-based compensation expense, a $0.2 million decrease in facility expense, an impairment of goodwill of $4.1 million recorded in 2011 and a $0.2 million decrease in insignificant other operating expenses, offset by an increase in restructuring charges of $0.8 million. These decreases were offset by an increase in professional service fees of $0.3 million.

All of the above are a result of activity related to our plan to exit our AssuredUVS business and close down our Israel Technology Development Center. See Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements for more details regarding our discontinued operations.

Liquidity and Capital Resources The primary drivers affecting cash and liquidity are net losses, working capital requirements and capital expenditures. Historically, the payment terms we have had to offer our customers have been relatively similar to the terms received from our creditors and suppliers. We typically bill customers on an open account basis subject to our standard credit quality and payment terms ranging between net 30 and net 45 days. If our net revenue increases, it is likely that our accounts receivable balance will also increase. Conversely, if our net revenue decreases, it is likely that our accounts receivable will also decrease. Our accounts receivable could increase if customers, such as large OEM customers, delay their payments or if we grant them extended payment terms. Our accounts payable also increase or decrease in connection with changes in volumes as well as our cash conservation strategies.

As of September 30, 2012, we had $40.5 million of cash and cash equivalents and $37.9 million of working capital compared to $46.2 million of cash and cash equivalents and $41.4 million of working capital as of December 31, 2011. The decrease in cash and cash equivalents is further described below.

Cash equivalents include highly liquid investments purchased with an original maturity of 90 days or less and consist principally of money market funds.

Operating Activities Net cash used by operating activities for the nine months ended September 30, 2012 was $4.7 million compared to $1.1 million of cash provided by operations for the nine months ended September 30, 2011. The operating activities that affected cash consisted primarily of a net loss, which totaled $9.9 million for the nine months ended September 30, 2012 compared to a net loss of $15.4 million for the nine months ended September 30, 2011. The decrease in our net loss for the nine months ended September 30, 2012 was primarily attributable to our exit from our AssuredUVS business, including the closing of our Israel Technology Center and we improved margins due to changes in product mix. These savings were offset by increased operating costs, the majority of which were due to increased engineering costs as we continue to invest in our next generation technologies and in our mid-range storage array products launched in 2012, and to provide more differentiated entry-level products for both OEM and channel customers.

The adjustments to reconcile net loss to net cash used by operating activities for the nine months ended September 30, 2012 for items that did not affect cash consisted of depreciation and amortization of $2.8 million, loss on the write-off of intangible assets of $1.6 million, loss on the write-off of property and equipment of $0.3 million, stock-based compensation expense of $3.0 million and an insignificant provision for bad debt expense.

Cash flows from operations reflects the positive impact of $3.4 million related to a decrease in accounts receivable, which was primarily due to a decrease in the number of days sales outstanding, which decreased from 62 days at the end of the fourth quarter of 2011 to 54 days at the end of the third quarter of 2012.

Additionally, accounts receivable at December 31, 2011 increased due to seasonal year end demand. Cash flows from operations also reflects the positive impact of $1.1 million 28-------------------------------------------------------------------------------- Table of Contents related to an overall decrease in prepaid expenses and other assets at September 30, 2012, which was primarily due to payments received from a material component supplier in relation to certain failed power supply units. Deferred revenue had a $0.4 million positive impact to cash from operations due to an increase in prepaid maintenance agreements sold through our Channel partners.

Cash flows from operations also reflect the impact of $1.0 million related to an overall increase in other long-term liabilities, primarily due to increased deferred rents on our facility leases in Longmont, CO and Carlsbad, CA.

Cash flows from operations reflect a negative impact of $0.2 million due to a slight increase in inventories from December 31, 2011 to September 30, 2012.

Cash flows from operations also reflect a negative impact of $4.7 million due to the pay down of our accounts payable balance, which is also reflected in our days payable outstanding which decreased from 75 days at the end of the fourth quarter 2011 to 69 days at the end of the third quarter of 2012. Accrued compensation and other expenses negatively impacted the cash from operations by $2.6 million due to settling a large invoice for software licenses and payments on a settlement with a material customer related to failed power supply units.

Cash flows from operations also include a decrease in our restructuring accrual of $0.8 million which is due primarily to expense payments related to shutting down the Israel Technology Development Center and continued reductions in our 2008 Plan and 2010 Plan contractual commitments.

Investing Activities Cash used in investing activities for the nine months ended September 30, 2012 was approximately $2.9 million compared to $2.1 million for the nine months ended September 30, 2011. Cash used in investing activities for the nine months ended September 30, 2012 was due to purchases of property and equipment primarily associated with test and other equipment used by our contract manufacturing partners in the production of our products and for equipment used in our Longmont, Colorado engineering laboratories.

Financing Activities Cash provided by financing activities for the nine months ended September 30, 2012 was approximately $1.9 million compared to $0.9 million for the nine months ended September 30, 2011. Cash provided by financing activities for the nine months ended September 30, 2012 was primarily due to $1.8 million of borrowings under the Silicon Valley Bank line of credit and the sale of stock to employees under our employee stock plans of approximately $0.7 million, which was offset by tax liability payments of $0.5 million made by Dot Hill associated with employee equity awards and $0.1 million for the ongoing pay down of our note payable associated with our 2008 acquisition of certain intangible assets from Ciprico.

Based on current macro-economic conditions and conditions in the state of the data storage systems markets, our own organizational structure and our current outlook, we presently expect our cash and cash equivalents will be sufficient to fund our operations, working capital and capital requirements for at least the next 12 months. However, our capital resources could be negatively impacted by unforeseen future events.

Our standard warranty provides that if our systems do not function to published specifications, we will repair or replace the defective component or system without charge generally for a period of approximately three years. We generally extend to our customers the warranties provided to us by our suppliers, and accordingly, the majority of our warranty obligations to customers are intended to be covered by corresponding supplier warranties. For warranty costs not covered by our suppliers, we provide for estimated warranty costs in the period the revenue is recognized. There can be no assurance that our suppliers will continue to provide such warranties to us in the future or that our warranty obligations to our customers will be covered by corresponding warranties from our suppliers, the absence of which could have a material effect on our financial statements. Estimated liabilities for product warranties are included in accrued expenses.

In October 2009, we discovered a quality issue associated with certain power supply devices provided by a long-term component supplier, which resulted in a higher than expected level of power supply failures to us and our customers.

While we were able to promptly identify and resolve the cause of the failures, we are required to provide replacement products or make repairs to the affected power supply units that had been sold between March and October 2009. Through June 30, 2011, our component supplier had repaired all of the faulty power supplies at no cost to us and reimbursed us for our out-of-pocket costs, which has constituted a reimbursement to customers for certain out-of-pocket costs they incurred in connection with these power supply failures. The total amount reimbursed to us by our component supplier approximated $1.0 million through June 30, 2011.

In the second and third quarters of 2011, a material customer provided us with a framework estimating the potential claims precipitated by the power supply failures. As previously disclosed, the customer's preliminary framework of potential claims provided to us included additional costs related to the customer's internal overhead for other internal indirect costs, in 29-------------------------------------------------------------------------------- Table of Contents addition to third-party direct costs. Based on preliminary discussions for settlement and our analysis of the framework provided by the customer, including future potential claims through the warranty period, we estimated that we had incurred a probable loss of approximately $2.8 million. Consequently, in addition to the $1.3 million previously recognized as of June 30, 2011, we recorded an estimated liability of $1.5 million as of September 30, 2011 within "Accrued expenses" on our condensed consolidated balance sheet.

Negotiations continued with our customer throughout the fourth quarter of 2011 into the first half of 2012. Based on the results of ongoing negotiations with the material customer, we increased our estimated liability at December 31, 2011 to $5.5 million, resulting in a charge of $2.7 million during the fourth quarter of 2011 within "Accrued expenses" on our condensed consolidated balance sheet, gross of any third-party recoveries.

A final settlement with this material customer was reached during the second quarter of 2012. The terms of the agreement required an immediate payment of $2.0 million, and an estimated remaining liability of approximately $2.7 million as of September 30, 2012 related to a combination of future price concessions and rebates to be paid quarterly based on sales volumes through December 31, 2012. While our estimated liability relating to failed power supply units is subject to some uncertainty until final settlement, based on our current expectation of sales volumes with this material customer, we do not believe the incurrence of an additional loss is either probable or reasonably possible at this time.

During the second quarter of 2011, based on the advice of legal counsel, we established that our component supplier is contractually obligated to reimburse us for fair and reasonable costs we incur with our customers associated with these power supply failures. Our component supplier had continued to re-work and distribute to our customer the affected population of power supplies at no cost to us. In addition, at the time, our collection experience with similar amounts already reimbursed to us by our supplier and our belief that our component supplier and its parent companies had the financial ability to continue to reimburse us for any additional costs we may incur, we recorded a current asset within "Prepaid expenses and other assets" on our consolidated balance sheet of $1.3 million as of June 30, 2011.

During the third quarter of 2011, as the claims from our customer became clearer, we commenced negotiations with our component supplier for fair and reasonable costs that we have and are likely to incur through the warranty period associated with this component failure. Originally we determined that the supplier was unlikely to make an up-front cash payment for the original settlement amount of $1.3 million, but it indicated a willingness to provide some form of reimbursement for costs incurred, in the form of cash and/or note receivable of $0.5 million plus future product rebates. Based on our judgment at the time, we reduced the previously recorded current asset of $1.3 million within "Prepaid expenses and other assets" to $0.5 million as of September 30, 2011. We continued to negotiate this settlement with our supplier and during the second quarter of 2012, the supplier signed a final settlement agreement providing for additional reimbursements above what was recognized as of September 30, 2011. Pursuant to the settlement, the supplier agreed to cash consideration of $1.2 million, of which we received $0.7 million subsequent to the signing of the settlement agreement, with the remaining $0.5 million to be received in installments over the next three quarters. Additionally, our supplier committed to product rebates and/or price concessions on product orders for a period of 39 months from the execution of the settlement agreement, in return for our agreement to release our supplier from all obligations relating to the power supply failures known by us to date. This agreement is not subject to any required future purchases.

In addition, we have commenced discussions with our General Liability and Errors and Omissions Insurance and underwriters and will continue to pursue our rights to cover any damages we incur and that are not reimbursed by our supplier. The insurance company has issued a reservation of rights letter to us and at this time, it is not possible to estimate to what extent the residual amounts, if any, we will be covered by our carrier. As of September 30, 2012 we have not assumed or recorded any insurance reimbursement.

To the extent our settlement agreements with our customer and our component supplier are not on mutually beneficial terms, or our component supplier does not continue to reimburse us for the expenses incurred by us or our customers, and we are unsuccessful in recovering such expenses from our insurance provider, we could incur additional expenses which could potentially have a material effect on our financial statements and liquidity.

In July 2012, a technology partner notified us of a dispute regarding royalties paid to it for the right to include their technology in certain products sold by us under an intellectual property licensing agreement. This claim relates to certain sales during the period from June 2006 to August 2011. We are reviewing this claim, but cannot at this stage in the process determine the likelihood of the outcome. Our initial estimate of our potential exposure ranges between $0.0 million and $1.9 million.

During September 2011, our primary AssuredUVS customer became delinquent on the settlement of its payables to us and upon our investigation it became evident that its financial resources were limited. It informed us that the AssuredUVS 30-------------------------------------------------------------------------------- Table of Contents software would no longer be a component of its business strategy, which would result in a significant decline in revenues for the Company, and we determined it was "more-likely-than-not" that the reporting unit was less than its carrying value.

The actual amount and timing of working capital and capital expenditures that we may incur in future periods may vary significantly and will depend upon numerous factors, including the timing and extent of net revenue and expenditures from our core business and strategic investments, the overall level of net profits or losses, our ability to manage our relationships with our contract manufacturers, the potential growth or decline in inventory to support our customers, costs associated with product quality issues and the recovery, if any, of such costs from a supplier, the status of our relationships with key customers, partners and suppliers, the timing and extent of the introduction of new products and services, growth in operations and the economic environment. In addition, the actual amount and timing of working capital will depend on our ability to maintain payment terms with our suppliers consistent with the credit terms of our customers. For example, if Foxconn, our major contract manufacturing partner, were to shorten our payment terms with them, or if HP were to lengthen their payment terms with us, our financial condition could be harmed.

We maintain a credit facility with Silicon Valley Bank for cash advances and letters of credit of up to an aggregate of $30 million based upon an advance rate dependent on certain concentration limits within eligible accounts receivable. These limitations exclude certain eligible customer receivables if an individual customer account balance exceeds 25, 50 or 85 percent of the total eligible accounts receivable, depending on the customer, as defined by our Loan and Security Agreement with Silicon Valley Bank. Borrowings under the credit facility bear interest at the prime rate and are secured by substantially all of our accounts receivable, deposit and securities accounts. The agreement provides for a negative pledge on our inventory and intellectual property, subject to certain exceptions, and contains usual and customary covenants for an arrangement of its type, including an obligation that we maintain at all times a net worth, as defined in the agreement, of $50 million (subject to certain increases). The agreement also includes provisions to increase the financing facility by $20 million subject to our meeting certain requirements, including $40 million in borrowing base for the immediately preceding 90 days, and Silicon Valley Bank locating a lender willing to finance the additional facility. In addition, if our cash and cash equivalents net of the total amount outstanding under the credit facility fall below $20 million (measured on a rolling three-month basis), the interest rate will increase to prime plus 1% and additional restrictions will apply. Our credit facility also provides for a cash management services sublimit under the revolving credit line of up to $300,000.

During the second quarter of 2012, we amended our credit agreement with Silicon Valley Bank. The amendment extends the maturity date to July 21, 2015 and amended certain other terms of the credit agreement, which we do not believe materially impacts our financial position. As of September 30, 2012 we had no outstanding letters of credit and there was $1.8 million outstanding under the Silicon Valley Bank line of credit.

At September 30, 2012, our long-term commitments had not materially changed from those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011.

Off - Balance Sheet Arrangements At September 30, 2012, we did not have any relationship with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance variable interest, or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we did not engage in trading activities involving non-exchange traded contracts. As a result, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. We do not have relationships and transactions with persons and entities that derive benefits from their non-independent relationship with us or our related parties except as disclosed herein.

We enter into indemnification agreements with third parties in the ordinary course of business that generally require us to reimburse losses suffered by the third party due to various events, such as lawsuits arising from patent or copyright infringement. These indemnification obligations are considered off-balance sheet arrangements under accounting guidance. It is not possible to determine the maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these agreements.

Recent Accounting Pronouncements Please see Note 1 of the Notes to Unaudited Condensed Consolidated Financial Statements.

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