| OVERLAND STORAGE INC ITEM 1A Risk Factors An investment in our company involves a high degree of risk |
| In addition to the other information included in this report, you should carefully consider each of the following risk factors in evaluating our business and prospects as well as an investment in our company |
| The risks and uncertainties described below are not the only ones we face |
| Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations |
| If any of the following risks actually occur, our business and financial results could be harmed |
| In that case the trading price of our common stock could decline |
| You should also refer to the other information included or incorporated by reference in this report |
| Our business has been highly dependent on sales to large OEM customers and we are currently experiencing a customer transition |
| Hewlett-Packard Company (HP), including the former Compaq which HP acquired in May 2002, has been our largest customer, accounting for approximately 49dtta7prca of net revenue in fiscal 2006, 54dtta3prca of net revenue in fiscal 2005 and 58dtta8prca of net revenue in fiscal 2004 |
| Neither HP nor any other customer is obligated to purchase a specific amount of our products or provide binding forecasts of purchases for any period |
| 7 ______________________________________________________________________ In August 2005, we announced that HP had selected an alternate supplier for its next-generation mid-range tape automation product |
| HP began purchasing the first product of this new line from the alternate supplier during the first quarter of calendar year 2006 |
| We expect HP to continue to purchase the tape automation products currently supplied by us for some time, but the new product will eventually replace the majority of those purchases |
| We cannot predict how quickly this transition will occur, but we believe the effect on our revenue during fiscal 2007 will be significant |
| In addition, in November 2005, we announced that Overland had been selected by a new tier one OEM customer to supply it with Overland’s next generation tape library |
| Although we expect shipments to this OEM customer to commence in the first half of fiscal 2007, the actual launch date is at the discretion of the customer and we cannot accurately predict the pace at which sales to this customer will accelerate |
| Once these sales occur, we believe our business will become dependent on sales to this customer |
| This customer will not be obligated to purchse a specific amount of our products or provide binding forecasts of purchases for any period |
| We outsourced all of our manufacturing to Sanmina-SCI Corporation (Sanmina), but now are in the process of returning manufacturing to our San Diego facility |
| If we are unable to complete the transition efficiently, or obtain our products from Sanmina in a cost effective and timely manner that meets our customers’ expectations our business, financial condition and results of operations could be materially and adversely affected |
| In August 2005, we completed the outsourcing of all our manufacturing to Sanmina |
| During fiscal 2006, we failed to achieve the customer service levels, product quality and cost reductions expected from the outsourcing |
| We also incurred a significant amount of redundant costs to support the outsourcing which eroded our gross margins during the year |
| As a consequence, we have decided to bring manufacturing back to our San Diego facility |
| We face a number of risks during this transition |
| We may continue to experience product quality issues and shortages from Sanmina |
| We may experience difficulties in re-establishing our production lines in San Diego that could also result in shortages and product quality issues |
| Additionally, our agreement with Sanmina commits us to purchase products and materials based upon the forecast of customer demand that we provide |
| As a consequence of the termination of this agreement, we will be obligated to purchase finished goods and component parts based on such forecasts |
| If such forecasts prove to be higher than current customer demand, we may experience higher than normal inventory carrying costs and some of the inventory may become obsolete either of which could reduce our gross margins |
| Our internal controls and procedures related to accounts payable cut-off need to be improved |
| Management is responsible for establishing and maintaining adequate internal control over financial reporting |
| Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles |
| In making this assessment, management used the criteria set forth in the framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) entitled Internal Control–Integrated Framework |
| As of July 2, 2006, the Company did not maintain effective controls over the completeness and accuracy of accounts payable and accrued expenses |
| Specifically, controls over cut-off and completeness of accounts payable and accrued expenses were insufficient to ensure that invoices from certain vendors were properly evaluated at period end |
| We believe the deficiency resulted primarily from the departures of our controller and accounting manager in April and May 2006, and the resulting reassignment of tasks until the positions were filled in June and July 2006 |
| This control deficiency resulted in audit adjustments to the Company’s 2006 annual consolidated financial statements and the interim consolidated financial statements for the quarter ended July 2, 2006 |
| Additionally, this control deficiency could result in a misstatement of the Company’s accrued liabilities, cost of revenue, and operating expenses that would not be prevented or detected |
| Accordingly, management has determined that this control deficiency constitutes a material weakness |
| If we are unable to improve our internal controls related to accounts payable and accrued expenses, our ability to report our financial results on a timely and accurate basis will be adversely affected, which could in turn have a material adverse effect on our ability to operate our business and remain listed on the Nasdaq Global Market, and could result in legal sanctions or private lawsuits filed against us or our management |
| Our stock price could decline as a result of any of these occurrences |
| Even if the remedial measures discussed in “Controls and Procedures” below are effective at remediating the material weakness, our internal control over financial reporting may not prevent future errors or fraud, since any control system, no matter how well designed, can provide only reasonable and not absolute assurance that the objectives of the control system will be achieved |
| 8 ______________________________________________________________________ We plan to replace our ERP System in several years, and this may be disruptive to our business |
| Our ERP system is approximately 10 years old, and we anticipate the need to replace it in several years |
| Transition to a new ERP system will be expensive and time consuming and, if problems occur in the transition, our business and results of operations may be materially and adversely affected |
| In addition, we have modified this system significantly during its term of use and it is possible that we would experience a significant system failure before we replace the system |
| Any such failure also may materially and adversely affect our business and results of operations |
| Our financial results may fluctuate substantially for many reasons, and past results should not be relied on as indications of future performance |
| A slowdown in the demand for workstations, mid-range computer systems, networks and servers could have a significant adverse effect on the demand for our products in any given period |
| We have experienced delays in receipt of purchase orders and, on occasion, anticipated purchase orders have been rescheduled or have not materialized due to changes in customer requirements |
| Our customers may cancel or delay purchase orders for a variety of reasons, including the rescheduling of new product introductions, changes in their inventory practices or forecasted demand, general economic conditions affecting our customers’ markets, changes in our pricing or the pricing of our competitors, new product announcements by us or others, quality or reliability problems related to our products or selection of competitive products as alternate sources of supply |
| In particular, our ability to forecast sales to distributors, integrators and value-added resellers is especially limited as these customers typically provide us with relatively short order lead times or are permitted to change orders on short notice |
| Given that a large portion of our sales are generated by our European channel, our first fiscal quarter (July through September) is commonly impacted by seasonally slow European orders, reflecting the summer holiday period in Europe |
| In addition, none of our customers is obligated to purchase a specific amount of our products |
| Our financial results have fluctuated and will continue to fluctuate quarterly and annually based on many other factors such as: · changes in customer mix (eg, OEM vs |
| branded); · changes in product mix; · fluctuations in average selling prices; · currency exchange fluctuations; · increases in costs and expenses associated with the introduction of new products; and · increases in the cost of or limitations on availability of materials |
| Based on all of the foregoing, we believe that our revenue and operating results will continue to fluctuate, and period-to-period comparisons are not necessarily meaningful and should not be relied on as indications of future performance |
| Furthermore, in some future quarters, our revenue and operating results could be below the expectations of public market analysts or investors, which could result in a material adverse effect on the price of our common stock |
| In addition, portions of our expenses are fixed and difficult to reduce if revenue does not meet our expectations |
| These fixed expenses magnify the adverse effect of any revenue shortfall |
| The market price of our common stock may be volatile |
| The market price of our common stock has experienced significant fluctuations since it commenced trading in February 1997 |
| The market price of our common stock may continue to fluctuate significantly in the future |
| Many factors could cause the market price of our common stock to fluctuate, including: · announcements concerning us, our competitors, our customers or our industry; · changes in earnings estimates by analysts; · purchasing decisions of HP and other significant customers; 9 ______________________________________________________________________ · quarterly variations in operating results; · the introduction of new technologies or products; · changes in product pricing policies by us or our competitors; and · changes in general economic conditions |
| In addition, stock markets have experienced extreme price and volume volatility in recent years |
| This volatility has had a substantial effect on the market prices of securities of many smaller public companies for reasons frequently unrelated or disproportionate to the operating performance of the specific companies |
| These market fluctuations may adversely affect the market price of our common stock |
| We face intense competition and price pressure, and many of our competitors have substantially greater resources than we do |
| The worldwide storage market is intensely competitive as a number of manufacturers of tape automation solutions and storage management software products compete for a limited number of customers |
| In addition, barriers to entry are relatively low in these markets |
| We currently participate in the mid-range of the tape backup market |
| In this segment, some of our competitors have substantially greater financial and other resources, larger research and development staffs, and more experience and capabilities in manufacturing, marketing and distributing products |
| The markets for our products are characterized by significant price competition, and we anticipate that our products will face increasing price pressure |
| This pressure could result in significant price erosion, reduced profit margins and loss of market share, any of which could have a material adverse effect on our business, liquidity, results of operation and financial position |
| Our business is highly dependent on the continued market acceptance and usage of tape-based systems for data backup and recovery |
| We have historically derived a majority of our revenue from products based on the use of magnetic tape drives for backup and recovery of digital data |
| Our tape-based storage solutions now compete directly with other storage technologies, such as hard disk drives, and may face competition in the future from other emerging technologies |
| The prices of hard disk drives continue to decrease while capacity and performance have increased |
| We expect that our tape-based products will face increased competition from these alternative technologies and come under increasing price pressure |
| If our strategy to compete in disk-based markets does not succeed, our business, liquidity, results of operations and financial condition will be materially and adversely affected |
| Our disk-based products involve many significant risks |
| In August 2003, we began shipping our REO SERIES of secondary disk-based backup and recovery products based on technology acquired from Okapi Software |
| In July 2006, we launched ULTAMUS Pro 500, a disk-based protected primary storage solution, with embedded Protection OS software based on the technology obtained in August 2005 from Zetta Systems |
| The success of these disk-based products is uncertain and subject to significant risks, any of which could have a material adverse effect on our business, liquidity, results of operation and financial position |
| We must commit significant resources to these new products before determining whether they will succeed |
| If these new products are not adopted by customers or do not achieve anticipated sales levels, any related intangible assets we have recorded may be impaired |
| Such impairment would result in a charge against earnings in the period for which impairment is determined to exist, and reduce our assets and shareholders’ equity |
| Before our acquisition of Okapi Software, we were not involved in the development, marketing and sale of disk-based products, and before our acquisition of Zetta Systems, we were not involved in the protected primary storage market |
| The protected primary storage area is still new to many of our personnel |
| We will need to continuously update and upgrade these products to stay competitive |
| Any delay in the commercial release of new or enhanced disk-based products could result in a significant loss of potential revenue and may adversely impact the market price of our common stock |
| If our disk-based products do not achieve market acceptance or success, then the association of our brand name with these products may adversely affect our reputation and our sales of other products, as well as dilute the value of our brand name |
| Our success depends on our ability to anticipate rapid technological changes and develop new and enhanced products |
| As an advanced technology company, we are subject to numerous risks and uncertainties, generally characterized by rapid 10 ______________________________________________________________________ technological change and intense competition |
| In this environment, our future success will depend on our ability to anticipate changes in technology, to develop new and enhanced products on a timely and cost-effective basis and to introduce, manufacture and achieve market acceptance of these new and enhanced products |
| Development schedules for high technology products are inherently subject to uncertainty |
| We may not meet our product development schedules, including those for products based on our disk-based technologies, and development costs could exceed budgeted amounts |
| Our business, liquidity, results of operations and financial position may be materially and adversely affected if the products or product enhancements that we develop are delayed or not delivered due to developmental problems, quality issues or component shortage problems, or if our products or product enhancements do not achieve market acceptance or are unreliable |
| The introduction, whether by us or our competitors, of new products embodying new technologies, such as new sequential or random access mass storage devices, and the emergence of new industry standards could render existing products obsolete or not marketable, which may have a material adverse effect on our business, liquidity, results of operations and financial position |
| Our international operations are important to our business and involve unique risks |
| Historically, sales to customers outside of the United States have represented a significant portion of our sales and we expect them to continue representing a significant portion of sales |
| Sales to customers outside the United States are subject to various risks, including: · the imposition of governmental controls mandating compliance with various foreign and US export laws; · currency exchange fluctuations and weak economic conditions in foreign markets; · political and economic instability; · trade restrictions; · changes in tariffs and taxes; · longer payment cycles (typically associated with international sales); and · difficulties in staffing and managing international operations |
| Furthermore, we may not be able to comply with changes in foreign standards in the future |
| Our inability to design products that comply with foreign standards could have a material adverse effect on our business, liquidity, results of operations and financial position |
| We are subject to exchange rate risk in connection with our international operations |
| We do not currently engage in foreign currency hedging activities and therefore we are exposed to some level of currency risk |
| Our wholly-owned subsidiaries in the United Kingdom, France and Germany incur costs which are denominated in local currencies |
| As exchange rates vary, these results when translated into US dollars may vary from expectations and adversely impact overall expected results |
| A weaker US dollar would result in an increase to revenue and expenses upon consolidation, and a stronger US dollar would result in a decrease to revenue and expenses upon consolidation |
| Our ability to compete effectively depends in part on our ability to protect our intellectual property rights effectively |
| We rely on a combination of patent, copyright, trademark, trade secret and other intellectual property laws to protect our intellectual property rights |
| These rights may not however prevent competitors from developing products that are substantially equivalent or superior to our products |
| To the extent we have or obtain patents, such patents may not afford meaningful protection for our technology and products |
| Others may challenge our patents and, as a result, our patents could be narrowed, invalidated or declared unenforceable |
| In addition, current or future patent applications may not result in the issuance of patents in the United States or foreign countries |
| The laws of certain foreign countries may not protect our intellectual property to the same extent as US laws |
| Furthermore, competitors may independently develop similar products, duplicate our products or, if patents are issued to us, design around these patents |
| In order to protect or enforce our patent rights, we may initiate interference proceedings, oppositions, or patent litigation 11 ______________________________________________________________________ against third parties, such as infringement suits |
| These lawsuits could be expensive, take significant time and divert management’s attention from other business concerns |
| The patent position of information technology firms generally is highly uncertain, involves complex legal and factual questions, and has recently been the subject of much litigation |
| No consistent policy has emerged from the US Patent and Trademark Office or the courts regarding the breadth of claims allowed or the degree of protection afforded under information technology patents |
| Our success will depend partly on our ability to operate without infringing on or misappropriating the proprietary rights of others |
| Our business is such that we may at any time be sued for infringing the patent rights or misappropriating the proprietary rights of others |
| For example, during fiscal 2004 we settled a case alleging patent infringement |
| Intellectual property litigation is costly and, even if we prevail, the cost of such litigation could adversely affect our business, liquidity, results of operations and financial condition |
| In addition, litigation is time consuming and diverts management attention and resources away from our business |
| If we do not prevail in any litigation, we could be required to stop the infringing activity and/or pay substantial damages |
| Under some circumstances in the United States, these damages could be triple the actual damages the patent holder incurs |
| If we have supplied infringing products to third parties for marketing or licensed third parties to manufacture, use or market infringing products, we may be obligated to indemnify these third parties for any damages they may be required to pay to the patent holder and for any losses the third parties may sustain themselves as the result of lost sales or damages paid to the patent holder |
| If a third party holding rights under a patent successfully asserts an infringement claim with respect to any of our products, we may be prevented from manufacturing or marketing our infringing product in the country or countries covered by the patent we infringe, unless we can obtain a license from the patent holder |
| Any required license may not be available to us on acceptable terms, or at all |
| Some licenses may be non-exclusive, and therefore, our competitors may have access to the same technology licensed to us |
| If we fail to obtain a required license or are unable to design around a patent, we may be unable to market some of our products, which could have a material adverse effect on our business, liquidity, financial condition and results of operations |
| We have made a number of acquisitions in the past and may make acquisitions in the future |
| The failure to successfully integrate acquisitions, could harm our business, financial condition and operating results |
| We have in the past and expect in the future to make acquisitions of complementary businesses, products or technologies as we implement our business strategy |
| Mergers and acquisitions involve numerous risks, including liabilities that we may assume from the acquired company, difficulties in the assimilation of the operations and personnel of the acquired business, the diversion of management’s attention from other business concerns, risks of entering markets in which we have no direct prior experience, and the potential loss of key employees of the acquired business |
| Future mergers and acquisitions by us also may result in dilutive issuances of our equity securities and the incurrence of debt, amortization expenses and potential impairment charges related to intangible assets |
| Any of these factors could adversely affect our business, liquidity, results of operations and financial position |
| Our warranty reserves may not adequately cover our warranty obligations |
| We have established reserves for the estimated liability associated with our product warranties |
| However, we could experience unforeseen circumstances where these or future reserves may not adequately cover our warranty obligations |
| For example, the failure or inadequate performance of product components that we purchase could increase our warranty obligations beyond these reserves |
| Our success depends on our ability to attract, retain and motivate our executives and other key personnel |
| Our future success depends in large part on our ability to attract, retain and motivate our executives and other key personnel, many of whom have been instrumental in developing new technologies and setting strategic plans |
| Our growth also depends in large part on our continuing ability to hire, motivate and retain highly qualified management, technical, sales and marketing team members |
| Competition for qualified personnel is intense and there can be no assurance that we will retain existing personnel or attract additional qualified personnel in the future |
| The WEEE and RoHS directives in Europe may impact the cost of our products and/or our ability to sell products in Europe |
| The European Union (EU) enacted Directive 2002/96/EC on Waste Electrical and Electronic Equipment (WEEE), which regulates the collection, recovery and recycling of waste from electrical and electronic products, and Directive 2002/95/EC on the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (RoHS), which bans the use of certain 12 ______________________________________________________________________ hazardous materials including lead, mercury, cadmium, chromium and halogenated flame-retardants |
| Detailed regulations on practices and procedures related to WEEE and RoHS continue to evolve in member states and we have yet to assess fully the ramifications to our products |
| In order to comply with the WEEE directive, we intend to join a consortium and contribute to the cost of collection, treatment, disposal and recycling of past and future covered products |
| We believe the costs to comply with WEEE will not be material |
| Compliance with the RoHS directive is a very significant effort that is currently underway |
| It requires us to source new compliant components for virtually all of our hardware products either from existing or alternate suppliers so that no electrical products failing to meet RoHS standards are put on the EU market |
| At this time we cannot provide assurance that compliance with RoHS will not have a material adverse effect on our business, liquidity, results of operations and financial condition |