OVERLAND STORAGE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions that are difficult to predict.

Words and expressions reflecting optimism, satisfaction or disappointment with current prospects, as well as words such as "believes," "hopes," "intends," "estimates," "expects," "projects," "plans," "anticipates" and variations thereof, or the use of future tense, identify forward-looking statements, but their absence does not mean that a statement is not forward-looking. Such forward-looking statements are not guarantees of performance and our actual results could differ materially from those contained in such statements. Factors that could cause or contribute to such differences include, but are not limited to: our ability to maintain and increase sales volumes of our products; our ability to continue to aggressively control costs and operating expenses; our ability to achieve the intended cost savings and maintain quality with our manufacturing partner; our ability to generate cash from operations; the ability of our suppliers to provide an adequate supply of components for our products at prices consistent with historical prices; our ability to raise outside capital and to repay our debt as it comes due; our ability to introduce new competitive products and the degree of market acceptance of such new products; the timing and market acceptance of new products introduced by our competitors; our ability to maintain strong relationships with branded channel partners; our ability to maintain the listing of our common stock on the NASDAQ Capital Market; customers', suppliers' and creditors' perceptions of our continued viability; rescheduling or cancellation of customer orders; loss of a major customer; our ability to enforce our intellectual property rights and protect our intellectual property; general competition and price measures in the market place; unexpected shortages of critical components; worldwide information technology spending levels; and general economic conditions. In evaluating such statements we urge you to specifically consider various factors identified in this report, including the matters set forth under the heading "Risk Factors" in Item 1A of Part II of this report, and set forth in our annual report on Form 10-K for the fiscal year ended June 30, 2012 filed with the Securities and Exchange Commission ("SEC") on September 13, 2012 under the caption "Risk Factors" in Item 1A of Part I, any of which could cause actual results to differ materially from those indicated by such forward-looking statements.

We are a trusted global provider of unified data management and data protection solutions designed to enable small and medium enterprises ("SMEs"), distributed enterprises, and small and medium businesses ("SMBs") to anticipate and respond to data storage requirements. Whether an organization's data is locally or globally based, our solutions consolidate and protect data for easy and cost-effective management of different tiers of information. We enable companies to expend fewer resources on information technology ("IT") allowing them to focus on being more responsive to the needs of their customers.

We develop and deliver a comprehensive solution set of award-winning products and services for storing data throughout the organization and during the entire data lifecycle. Our SnapServer® product is a complete line of network attached storage ("NAS") products, and our SnapSAN® products are storage area network ("SAN") solutions designed to ensure primary and secondary data is accessible and protected regardless of its location. Our SnapServer® and SnapSAN® solutions are available with backup, replication and mirroring software in highly scalable configurations. These solutions provide simplified disk-based data protection and maximum flexibility to protect mission critical data for both continuous local backup and remote disaster recovery. Our NEO SERIES® and REO SERIES® libraries are tape and virtual tape solutions designed to meet the need for cost-effective, reliable data storage for long-term archiving and compliance requirements.

Our approach emphasizes long-term investment protection for our customers and reduces the complexities and ongoing costs associated with storage management.

Moreover, most of our products are designed with a scalable architecture which enables companies to purchase additional storage as needed, on a just-in-time basis, and make it available instantly without downtime.

End users of our products include SMEs, SMBs, distributed enterprise companies such as divisions and operating units of large multi-national corporations, governmental organizations, and educational institutions. Our products are used in a broad range of industries including financial services, video surveillance, healthcare, retail, manufacturing, telecommunications, broadcasting, research and development and many others.

11 -------------------------------------------------------------------------------- Table of Contents Overview This overview discusses matters on which our management primarily focuses in evaluating our financial position and operating performance.

Generation of revenue. We generate the majority of our revenue from sales of our data protection products. The balance of our revenue is provided by selling maintenance contracts and rendering related services, and earning royalties on our licensed technology. The majority of our sales are generated from sales of our branded products through a worldwide channel, which includes systems integrators and VARs.

We reported net revenue of $11.7 million for the first quarter of fiscal 2013, compared with $14.1 million for the first quarter of fiscal 2012. The decline in net revenue resulted in a net loss of $4.9 million, or $0.17 per share, for the first quarter of fiscal 2013 compared with a net loss of $5.4 million, or $0.23 per share, for the first quarter of fiscal 2012.

Intellectual property rights. In August and October 2010, we filed patent infringement lawsuits in the United States District Court for the Southern District of California and United States International Trade Commission ("ITC"), respectively, against various parties. Both lawsuits claim infringement of two of our United States patents, Nos. 6,328,766 and 6,353,581.

In November 2011, we entered into a multi-year settlement and cross-licensing agreement with IBM pursuant to which we released all claims we had against Dell and IBM in the United States District Court for the Southern District of California and at the ITC. However, our infringement case against BDT AG and its affiliates continues.

In July 2012, the ITC released the public version of the Initial Determination, which finds that the six asserted claims of U.S. Patent No. 6,328,766 are valid.

The Initial Determination found no infringement of United States Patent No.

6,353,581, but concluded the asserted claims of the patent were valid. We petitioned the full Commission of the ITC for a review of some of the Initial Determination findings. See "Item 1. Legal Proceedings" for additional information on the patent litigation lawsuits.

In June 2012, we filed five additional patent infringement lawsuits in the United States District Court for the Southern District of California against seven companies. See "Item 1. Legal Proceedings" for additional information on these patent litigation lawsuits.

In August 2012, Quantum Corporation filed counterclaims against us in the United States District Court for the Southern District of California action, alleging trademark infringement and unfair competition claims, and infringement of United States Patent Nos. 5,491,812, 6,542,787, 6,498,771 and 5,925,119 by our products. Quantum is seeking monetary damages from us and injunctive relief.

Liquidity and capital resources. At September 30, 2012, we had a cash balance of $7.2 million, compared to $10.5 million at June 30, 2012. In the first quarter of fiscal 2013, we incurred a net loss of $4.9 million. In August 2011, we entered into a credit facility that provides for an $8.0 million secured revolving loan and may be used to fund our working capital and our general business requirements. Cash management and preservation continue to be a top priority. We expect to incur negative operating cash flows during the remainder of calendar year 2012 as we continue to reshape our business model and further improve operational efficiencies.

Management has projected that cash on hand, combined with available borrowings under our credit facility, will be sufficient to allow us to continue operations for the next 12 months. Significant changes from our current forecasts, including but not limited to: (i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs, and/or (iv) changes in the historical timing of collecting accounts receivable could have a material adverse impact on our liquidity. This could force us to make further reductions in spending, extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.

12 -------------------------------------------------------------------------------- Table of Contents As of September 30, 2012, we had negative working capital of $0.5 million, reflecting a decrease in current assets of $6.1 million and an increase in current liabilities of $1.8 million, during the first quarter of fiscal 2013.

The decrease in current assets is primarily attributable to cash used in operating activities, and a $3.0 million decrease in accounts receivable due to lower sales volumes primarily in our taped-based and disk-based products sold in the Americas and EMEA. These decreases were offset by a $0.4 million increase in inventory. The increase in current liabilities is primarily attributable to a $4.0 million increase in current debt related to the maturity date of our credit facility, offset by a $2.0 million decrease in accounts payable and accrued liabilities related to operating activities.

Industry trends. We estimate that the cost of managing digital assets is four times the cost of acquiring storage devices. Furthermore, many SMEs and SMBs are seeking to implement tiered storage for primary and secondary data utilizing a combination of low cost SATA (Serial ATA) drives, high performance SAS (Serial Attached SCSI) and Solid State Drives ("SSDs") drives. IDC estimates that the total NAS market will grow at approximately 9.1% through 2015, and the growth rate for NAS storage systems in price bands up to $15,000, where our SnapServer® solutions lie, is estimated to be 17.3%. According to IDC, tape storage still constitutes approximately 7.3% of the total storage revenue in the global storage market. Sales of tape automation appliances represented 32.4% and 29.6% of our revenue during fiscal 2013 and 2012, respectively.

Recent Developments In October 2012, we released our SnapScale X2™, a clustered NAS solution that enables organizations with rapid or unpredictable data growth to scale capacity and performance without adding management complexity. This addition to our current product portfolio expands our total addressable market in the growing Scale-Out NAS market.

Critical Accounting Policies and Estimates We describe our significant accounting policies in Note 1, "Operations and Summary of Significant Accounting Policies," of the notes to consolidated financial statements included in our annual report on Form 10-K for the fiscal year ended June 30, 2012; and we discuss our critical accounting policies and estimates in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of that report. Unless otherwise described below, there have been no material changes in our critical accounting policies and estimates.

13 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth certain financial data as a percentage of net revenue: Three Months Ended September 30, 2012 2011 Net revenue 100.0 % 100.0 % Cost of revenue 66.3 67.4 Gross profit 33.7 32.6 Operating expenses: Sales and marketing 35.2 31.7 Research and development 13.6 17.6 General and administrative 24.6 21.9 73.4 71.2 Loss from operations (39.7 ) (38.6 ) Other income (expense), net (1.4 ) 1.4 Loss before income taxes (41.1 ) (37.2 ) Provision for income taxes 0.4 0.8 Net loss (41.5 )% (38.0 )% A summary of the sales mix by product follows: Three Months Ended September 30, 2012 2011 Tape-based products: NEO Series® 32.4 % 29.6 % Disk-based products: REO Series® 0.9 1.4 SnapServer® 17.0 16.8 17.9 18.2 Service 43.3 43.7 Spare parts and other 6.4 8.5 100.0 % 100.0 % 14-------------------------------------------------------------------------------- Table of Contents The First Quarter of Fiscal 2013 compared with the First Quarter of Fiscal 2012 Net Revenue. Net revenue decreased to $11.7 million during the first quarter of fiscal 2013 from $14.1 million during the first quarter of fiscal 2012, a decrease of $2.4 million, or 17.0%. The decline was due to lower revenue from our Overland branded products, primarily as a result of decreased sales volumes in our taped-based and disk-based products sold in the Americas and EMEA, and decreased service revenue primarily from our OEM customer. OEM net revenue, which is primarily made up of service revenue, accounted for 11.6% and 15.6% of net revenues in the first quarter of fiscal 2013 and 2012, respectively.

Product Revenue Net product revenue decreased to $6.6 million during the first quarter of fiscal 2013 from $7.9 million during the first quarter of fiscal 2012. The decrease of approximately $1.3 million, or 16.5%, was primarily associated with a decrease of $0.8 million in disk and tape-based products sold in EMEA, related to our belief of the uncertainty in the European economy, and a decrease of $0.3 million in disk-based products sold in the Americas.

Service Revenue Net service revenue decreased to $5.1 million during the first quarter of fiscal 2013 from $6.2 million during the first quarter of fiscal 2012. The decrease of approximately $1.1 million, or 17.7%, was primarily due to decreased service revenue from our sole OEM customer.

Gross Profit. Overall gross profit decreased to $3.9 million during the first quarter of fiscal 2013 compared to $4.6 million during the first quarter of fiscal 2012. Gross margin at 33.7% for the first quarter of fiscal 2013 increased from 32.6% for the first quarter of fiscal 2012.

Product Revenue Gross profit on product revenue during the first quarter of fiscal 2013 was $0.6 million compared to $1.1 million during the first quarter of fiscal 2012. The decrease of $0.5 million, or 45.5%, was primarily due to the 16.5% decrease in net product revenue and fixed costs associated with product cost. Gross margin on product revenue at 8.8% for the first quarter of fiscal 2013 decreased from 13.9% for the first quarter of fiscal 2012. This decrease was primarily due to lower sales volumes and no significant decrease in the level of recurring fixed costs.

Service Revenue Gross profit on service revenue was constant at $3.4 million during the first quarter of fiscal 2013 and 2012. Gross margin on service revenue at 66.2% for the first quarter of fiscal 2013 increased from 55.3% for the first quarter of fiscal 2012.

15 -------------------------------------------------------------------------------- Table of Contents Share-based Compensation Expense. During the first quarter of fiscal 2013 and 2012, we recorded share-based compensation expense of approximately $1.3 million and $1.4 million, respectively. Share-based compensation expense for the second quarter of fiscal 2013 is expected to be approximately $1.2 million.

The Company recorded the following compensation expense related to its share-based compensation awards (in thousands): Three Months Ended September 30, 2012 2011 Cost of product sales $ 35 $ 16 Sales and marketing 250 207 Research and development 79 184 General and administrative 889 1,015 $ 1,253 $ 1,422 Sales and Marketing Expense. Sales and marketing expense in the first quarter of fiscal 2013 decreased to $4.1 million from $4.5 million during the first quarter of fiscal 2012. The decrease of $0.4 million, or 8.9%, was primarily a result of a decrease of $0.2 million in employee and related expenses, and a decrease of $0.2 million in advertising expense, including contractor fees, due to reductions in marketing programs and transitioning formerly outsourced projects to internal projects.

Research and Development Expense. Research and development expense in the first quarter of fiscal 2013 decreased to $1.6 million from $2.5 million during the first quarter of fiscal 2012. The decrease of $0.9 million, or 36.0%, was primarily a result of a decrease of $0.4 million in development expense as a result of a lower level of new product development expenses from the prior year, and a decrease of $0.4 million in employee and related expenses associated with a decrease in average headcount.

General and Administrative Expense. General and administrative expense was relatively constant at $2.9 million and $3.1 million during the first quarter of fiscal 2013 and 2012, respectively.

Other Income (Expense), net. During the first quarter of fiscal 2013, we incurred other income (expense), net, of $0.1 million of expense compared with $0.2 million of income during the first quarter of fiscal 2012. The change of $0.3 million was primarily due to $0.1 million in realized foreign currency losses in the first quarter of fiscal 2013, compared to $0.2 million in realized foreign currency gains in the first quarter of fiscal 2012.

Liquidity and Capital Resources At September 30, 2012, we had a cash balance of $7.2 million, compared to $10.5 million at June 30, 2012. In the first quarter of fiscal 2013, we incurred a net loss of $4.9 million. Cash management and preservation continue to be a top priority. We expect to incur negative operating cash flows through the fourth quarter of fiscal 2013 as we continue to reshape our business model and further improve operational efficiencies.

As of September 30, 2012, we had negative working capital of $0.5 million, reflecting a decrease in current assets of $6.1 million and an increase in current liabilities of $1.8 million, during the first quarter of fiscal 2013.

The decrease in current assets is primarily attributable to cash used in operating activities, and a $3.0 million decrease in accounts receivable due to lower sales volumes primarily in our taped-based and disk-based products sold in the Americas and EMEA. These decreases were offset by a $0.4 million increase in inventory. The increase in current liabilities is primarily attributable to a $4.0 million increase in current debt related to the maturity date of our credit facility, offset by a $2.0 million decrease in accounts payable and accrued liabilities related to operating activities.

16 -------------------------------------------------------------------------------- Table of Contents Management has projected that cash on hand, combined with available borrowings under our credit facility, will be sufficient to allow us to continue operations for the next 12 months. Significant changes from our current forecasts, including but not limited to: (i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs, and/or (iv) changes in the historical timing of collecting accounts receivable could have a material adverse impact on our liquidity. This could force us to make further reductions in spending, extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.

As a result of our recurring losses from operations and negative cash flows, the report from our independent registered public accounting firm regarding our consolidated financial statements for the year ended June 30, 2012 includes an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern.

During the first quarter of fiscal 2013, we used cash in operating activities of $3.3 million, compared to $2.1 million in the first quarter of fiscal 2012. The use of cash during the first quarter of fiscal 2013 was primarily a result of our net loss of $4.9 million offset by $1.5 million in non-cash items, which were share-based compensation, depreciation and amortization. In addition, we had decreases in accounts receivable, accounts payable, and accrued liabilities due to lower sales, offset by an increase in inventory.

We used cash in investing activities of $0.3 million during the first quarter of fiscal 2013, compared to $0.2 million in the first quarter of fiscal 2012.

During the first quarter of fiscal 2013 and 2012, capital expenditures totaled $0.3 million and $0.2 million, respectively. Such expenditures were associated with machinery and equipment to support new product introductions.

We generated cash from our financing activities of $0.3 million during the first quarter of fiscal 2013, compared to $1.6 million during the first quarter of fiscal 2012. During the first quarter of fiscal 2013, we drew $0.5 million on our credit facility, and received $145,000 from the exercise of stock options and ESPP purchases, offset by $0.4 million paid for taxes for net settlement of restricted stock units. During the first quarter of fiscal 2012, we drew $1.4 million on our credit facility and received $0.2 million from the exercise of warrants and stock options.

Inflation Inflation has not had a significant impact on our operations during the periods presented. Historically, we have been able to pass on to our customers increases in raw material prices caused by inflation. If at any time we cannot pass on such increases, our margins could suffer.

Off-Balance Sheet Arrangements We have no off-balance sheet arrangements or significant guarantees to third parties that are not fully recorded in our consolidated balance sheet or fully disclosed in the notes to our consolidated financial statements.

Recently Issued Accounting Pronouncements See Note 9 to our consolidated condensed financial statements for information about recent accounting pronouncements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk from changes in foreign currency exchange rates as measured against the U.S. dollar. These exposures are directly related to our normal operating and funding activities.

Historically, we have not used derivative instruments or engaged in hedging activities.

17 -------------------------------------------------------------------------------- Table of Contents Foreign Currency Risk. We conduct business on a global basis and essentially all of our products sold in international markets are denominated in U.S. dollars.

Historically, export sales have represented a significant portion of our sales and are expected to continue to represent a significant portion of sales. Our wholly-owned subsidiaries in the United Kingdom, France and Germany incur costs that are denominated in local currencies. As exchange rates vary, these results may vary from expectations when translated into U.S. dollars, which could adversely impact overall expected results. The effect of exchange rate fluctuations on our results of operations during the first quarter of fiscal 2013 and 2012 resulted in a loss of $0.1 million and a gain of $0.2 million, respectively.

Item 4. Controls and Procedures.

Disclosure Controls and Procedures Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) under the Exchange Act of 1934. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by our annual report.

Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting during the fiscal quarter ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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