Overview

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

We have a history of providing devices that enable information technology (“IT”) equipment to network using standard protocols for connectivity, including Ethernet and wireless. Our first device was a terminal server that allowed “dumb” terminals to connect to a network. Building on the success of our terminal servers, in 1991 we introduced a complete line of print servers that enabled users to inexpensively share printers over a network. Since then, we have continually refined our core technology and have developed additional innovative networking solutions that expand upon the business of providing our customers network connectivity. With the expansion of networking and the Internet, our technology focus has been increasingly expanded beyond IT equipment, so that our device solutions provide a product manufacturer with the ability to network its products within the industrial, service and commercial markets referred to as machine-to-machine (“M2M”) networking.

 

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The following describes our M2M device networking product lines:

·

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

·

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

The following describes our non-core product line:

·

Non-core – Over the years, we have innovated or acquired various product lines that are no longer part of our primary, core markets described above. In general, these non-core businesses represent decreasing markets and we minimize research and development in these product lines. Included in this category are terminal servers, visualization solutions, legacy print servers, software and other miscellaneous products. We have announced the end-of-life for almost all of our non-core products and expect a steep decline in non-core revenues in fiscal 2009 while we complete the exit of this product category.

 

Financial Highlights and Other Information for the Fiscal Quarter Ended September 30, 2008

The following is a summary of the key factors and significant events that impacted our financial performance during the fiscal quarter ended September 30, 2008:

·

Net revenue was $14.2 million for the fiscal quarter ended September 30, 2008, an increase of $1.2 million or 8.9%, compared to $13.1 million for the fiscal quarter ended September 30, 2007.  The increase was primarily the result of a $1.8 million, or 14.9%, increase in our device networking product lines offset by a $593,000, or 46.5%, decrease in our non-core product lines.

·

Gross profit margin was 52.9% for the fiscal quarter ended September 30, 2008 compared to 49.3% for the fiscal quarter ended September 30, 2007.  The increase in gross profit margin percent was primarily attributable to increased absorption of manufacturing overhead costs as a result of higher net revenue and lower manufacturing costs, lower inventory reserve costs, and an increase in license revenue.

·

Income from operations was $202,000, or 1.4% of net revenue, for the fiscal quarter ended September 30, 2008 compared to a loss from operations of $1.6 million, or 12.4% of net revenue, for the fiscal quarter ended September 30, 2007.  Income from operations for the fiscal quarter ended September 30, 2008 included a restructuring charge of $593,000. Loss from operations for the fiscal quarter ended September 30, 2007 included expenses totaling approximately $1.0 million related to the departure of our former president and chief executive officer and other former employees, expenses associated with the executive search for a permanent chief executive officer and $121,000 for a value added tax (“VAT”) liability in connection with an audit of a foreign subsidiary.

·	Net income was $184,000, or $0.00 per basic and diluted share, for the fiscal quarter ended September 30, 2008 compared to a net loss of $1.7 million, or $0.03 per basic and diluted share, for the fiscal quarter ended September 30, 2007.

·	Cash and cash equivalents were $8.2 million as of September 30, 2008, an increase of $783,000, compared to $7.4 million as of June 30, 2008.

·

Net accounts receivable were $2.9 million as of September 30, 2008, a decrease of $1.3 million, compared to $4.2 million as of June 30, 2008. Annualized days sales outstanding (“DSO”) in receivables were 22 days for the fiscal quarter ended September 30, 2008 compared 24 days for the fiscal quarter ended June 30, 2008. Our accounts receivable and DSO are primarily affected by the timing of shipments within a quarter, our collections performance and the fact that a significant portion of our revenues are recognized on a sell-through basis (upon shipment from distributor inventories rather than as goods are shipped to distributors).

 

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·	Net inventories were $8.1 million as of September 30, 2008 compared to $8.0 million as of June 30, 2008. Annualized inventory turns were 3.3 annualized turns for the fiscal quarter ended September 30, 2008 compared to 3.0 annualized turns for the fiscal quarter ended June 30, 2008.

Critical Accounting Policies and Estimates

                The accounting policies that have the greatest impact on our financial condition and results of operations and that require the most judgment are those relating to revenue recognition, warranty reserves, allowance for doubtful accounts, inventory valuation, valuation of deferred income taxes, goodwill and purchased intangible assets, restructuring reserves and legal settlement costs. These policies are described in further detail in our Annual Report on Form 10-K for the fiscal year ended June 30, 2008. There have been no significant changes in our critical accounting policies and estimates during the fiscal quarter ended September 30, 2008 as compared to what was previously disclosed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2008.

Recent Accounting Pronouncements

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

Consolidated Results of Operations

The following table presents the percentage of net revenues represented by each item in our condensed consolidated statement of operations:

		Three Months Ended
		September 30,
		2008				2007
Net revenues			100.0%				100.0%
Cost of revenues			47.1%				50.7%
Gross profit			52.9%				49.3%
Operating expenses:
Selling, general and administrative			36.6%				48.1%
Research and development			10.6%				13.5%
Restructuring charge			4.2%				0.0%
Amortization of purchased intangible assets			0.1%				0.1%
Total operating expenses			51.5%				61.8%
Income (loss) from operations			1.4%				(12.4%	)
Interest expense, net			(0.2%	)			(0.1%	)
Other income, net			0.2%				0.1%
Income (loss) before income taxes			1.4%				(12.5%	)
Provision for income taxes			0.1%				0.2%
Net income (loss)			1.3%				(12.7%	)

Comparison of the Fiscal Quarters Ended September 30, 2008 and 2007

Net Revenue by Product Line

The following table presents net revenue by product line:

 

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		Three Months Ended September 30,
						% of Net								% of Net				Change
		2008				Revenue				2007				Revenue				$					%
		(In thousands, except percentages)
Device enablement		$	11,553				81.3%			$	9,829				75.3%			$	1,724				17.5%
Device management			1,978				13.9%				1,951				14.9%				27				1.4%
Device networking			13,531				95.2%				11,780				90.2%				1,751				14.9%
Non-core			681				4.8%				1,274				9.8%				(593	)			(46.5%	)
Net revenues		$	14,212				100.0%			$	13,054				100.0%			$	1,158				8.9%

 

The increase in net revenue for the fiscal quarter ended September 30, 2008 compared to the fiscal quarter ended September 30, 2007 was primarily a result of an increase in net revenues from our device enablement product line, offset by a decrease in our non-core product lines.  The increase in our device enablement product lines was primarily due to an increase in our embedded device enablement products, and more specifically, our XPort, WiPort and MatchPort product lines.  We are no longer investing in the development of our non-core product lines and expect net revenues related to these products to continue to decline in the future as we focus our investment on our device networking product lines.

Net Revenue by Geographic Region

The following table presents net revenue by geographic region:

 

		Three Months Ended September 30,
						% of Net								% of Net				Change
		2008				Revenue				2007				Revenue				$					%
		(In thousands, except percentages)
Americas		$	8,428				59.3%			$	7,935				60.8%			$	493				6.2%
EMEA			3,812				26.8%				3,385				25.9%				427				12.6%
Asia Pacific			1,972				13.9%				1,734				13.3%				238				13.7%
Net revenues		$	14,212				100.0%			$	13,054				100.0%			$	1,158				8.9%

 

All regions contributed to the increase in net revenue for the fiscal quarter ended September 30, 2008 compared to the fiscal quarter ended September 30, 2007.  Increases in our device enablement product lines and more specifically the XPort, WiPort and MatchPort product lines were the primary drivers for the increase in the Americas, EMEA (“Europe, Middle East and Africa”) and Asia Pacific regions.

Gross Profit

The following table presents gross profit:

		Three Months Ended September 30,
						% of Net								% of Net				Change
		2008				Revenue				2007				Revenue				$					%
		(In thousands, except percentages)
Gross profit		$	7,524				52.9%			$	6,441				49.3%			$	1,083				16.8%

 

Gross profit represents net revenue less cost of revenue. Cost of revenue consisted primarily of the cost of raw material components, subcontract labor assembly from contract manufacturers, manufacturing overhead, amortization of purchased intangible assets, establishing or relieving inventory reserves for excess and obsolete products or raw materials, warranty costs, royalties and share-based compensation.

The increase in gross profit margin percent was primarily attributable to increased absorption of manufacturing overhead costs as a result of higher net revenue and lower manufacturing costs, lower inventory reserve costs, and an increase in license revenues.

Selling, General and Administrative

 

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

The following table presents selling, general and administrative expenses:

		Three Months Ended September 30,
					% of Net					% of Net		Change
		2008			Revenue		2007			Revenue		$					%
		(In thousands, except percentages)
Personnel-related expenses		$	2,806				$	3,669				$	(863	)			(23.5%	)
Professional fees & outside services			799					708					91				12.9%
Advertising and marketing			556					659					(103	)			(15.6%	)
Facilities			379					381					(2	)			(0.5%	)
Share-based compensation			229					270					(41	)			(15.2%	)
Depreciation			130					83					47				56.6%
Other			309					509					(200	)			(39.3%	)
Selling, general and administrative		$	5,208		36.6%		$	6,279		48.1%		$	(1,071	)			(17.1%	)

 

In order of significance, the decrease in selling, general and administrative expenses for the fiscal quarter ended September 30, 2008 compared to the fiscal quarter ended September 30, 2007 was primarily due to: (i) decreased personnel-related expenses as a result of severance charges related to the departure of the former president and chief executive officer and other former employees, (ii) decreased expenses due to a $121,000 VAT tax liability in connection with a tax audit of a foreign subsidiary during the fiscal quarter ended September 30,2007 and (iii) a decrease in marketing expenses as a result of more focused spending.

Research and Development

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

The following table presents research and development expenses:

		Three Months Ended September 30,
					% of Net					% of Net		Change
		2008			Revenue		2007			Revenue		$					%
		(In thousands, except percentages)
Personnel-related expenses		$	1,055				$	1,254				$	(199	)			(15.9%	)
Facilities			248					213					35				16.4%
Professional fees & outside services			48					81					(33	)			(40.7%	)
Share-based compensation			82					112					(30	)			(26.8%	)
Depreciation			18					12					6				50.0%
Other			52					96					(44	)			(45.8%	)
Research and development		$	1,503		10.6%		$	1,768		13.5%		$	(265	)			(15.0%	)

 

Total research and development expenses for the fiscal quarter ended September 30, 2008 decreased compared to the fiscal quarter ended September 30, 2007 mainly due to a charge recorded in the prior year quarter related to the departure of a former employee.

Restructuring Charges

During the first fiscal quarter ended September 30, 2008, we implemented a second restructuring. As part of the second restructuring, an additional 29 employees from all ranks and across all functional groups of the Company were terminated.

The following table presents restructuring charges:

 

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Three Months Ended September 30,

						% of Net								% of Net				Change
		2008				Revenue				2007				Revenue				$					%
		(In thousands, except percentages)
Restructuring charge		$	593				4.2%			$	-				0.0%			$	593				0.0%

 

Provision for Income Taxes

 

At July 1, 2008, our fiscal 2001 through fiscal 2008 tax years remain open to examination by the Federal and state taxing authorities.  We have net operating losses (“NOLs”) beginning in fiscal 2001 which would cause the statute of limitations to remain open for the year in which the NOL was incurred.

 

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

		Three Months Ended
		September 30,

		2008				2007
Effective tax rate			7%				1%

 

We utilize the liability method of accounting for income taxes as set forth in Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.”  The federal statutory rate was 34% for all periods.  The difference between our effective tax rate and the federal statutory rate resulted primarily from the effect of our domestic losses recorded with a fully reserved tax benefit, as well as the effect of foreign earnings taxed at rates differing from the federal statutory rate. We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. As a result of our cumulative losses, we provided a full valuation allowance against our domestic net deferred tax assets for the fiscal quarters ended September 30, 2008 and 2007.

Liquidity and Capital Resources

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

		September 30,				June 30,				Increase
		2008				2008				(Decrease)
						(In thousands)
Working capital		$	7,372			$	5,686			$	1,686
Cash and cash equivalents		$	8,217			$	7,434			$	783

 

In order of significance, our working capital as of September 30, 2008 increased compared to June 30, 2008 primarily due to: (i) an increase in cash and decrease in accounts payable as a result of the proceeds from the term loan and (ii) a decrease in accrued payroll as a result of the timing of pay periods compared to the prior year, offset by (iii) a decrease in accounts receivable as a result of lower shipments compared to the quarter ended June 30, 2008 and (iv) an increase in short term debt as a result of the new term loan. Our cash balance increased compared to the quarter ended June 30, 2008 as a result of our cash management activities, which included the timing of cash payments to our vendors and the timing of cash receipts from our customers.

We believe that our existing cash and cash equivalents and funds available from our line of credit will be adequate to meet our anticipated cash needs through at least the next 12 months. Our future capital requirements will depend on many factors, including the timing and amount of our net revenues, research and development, expenses associated with any strategic partnerships or acquisitions and infrastructure investments, and expenses related to government investigations and litigation, which could affect our ability to generate additional cash. If cash generated from operations and financing activities is insufficient to satisfy our working capital requirements, we may need to raise capital by borrowing additional funds through bank loans, the selling of securities or other means. There can be no assurance that we will be able to raise any such capital on terms acceptable to us, if at all. If we are unable to secure additional financing, we may not be able to develop or enhance our products, take advantage of future opportunities, respond to competition or continue to operate our business.

 

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In August 2008, we entered into an amendment to our Line of Credit, which provides for a three-year $2.0 million Term Loan and a two-year $3.0 million Revolving Credit Facility. The Term Loan was funded on August 26, 2008 and is payable in 36 equal installments of principal and monthly accrued interest.

Borrowings under the Term Loan and Revolving Credit Facility bear interest at the greater of 6.25% or prime rate plus 1.25% per annum. If we achieve two consecutive quarters of positive EBITDAS (as defined in the Loan Agreement) greater than $1.00, and only for so long as we maintain EBITDAS greater than $1.00 at the end of each subsequent fiscal quarter, then the borrowings under the Term Loan and Revolving Credit Facility will bear interest at the greater of 5.75% or prime rate plus 0.75% per annum. We paid a fully earned, non-refundable commitment fee of $35,000 and are required to pay an additional $35,000 on the first anniversary of the Effective Date.

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

		September 30,				June 30,
		2008				2008
		(In thousands)
Available borrowing capacity		$	1,439			$	3,163
Outstanding letters of credit		$	732			$	732

 

As of September 30, 2008 and June 30, 2008, approximately $723,000 and $801,000, respectively, of our cash was held in foreign subsidiary bank accounts.  Such cash is unrestricted with regard to foreign liquidity needs; however, our ability to utilize a portion of this cash to satisfy liquidity needs outside of such foreign locations is subject to approval by the foreign subsidiary’s board of directors.

Cash Flows

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

					Three Months Ended
					September 30,

		2008				2007
		(In thousands)
Net cash provided by (used in):
Net income (loss)		$	184			$	(1,653	)
Non-cash operating expenses, net			1,088				732
Changes in operating assets and liabilities:
Accounts receivable			1,273				1,434
Inventories			(67	)			376
Contract manufacturers' receivable			(69	)			19
Prepaid expenses and other current assets			(111	)			76
Other assets			(20	)			(1	)
Accounts payable			(1,320	)			(2,380	)
Accrued payroll and related expenses			(808	)			203
Warranty reserve			7				(73	)
Restructuring reserve			(682	)			-
Other liabilities			(276	)			677
Net cash used in operating activities			(801	)			(590	)
Net cash used in investing activities			(214	)			(126	)
Net cash provided by financing activities			1,936				149
Effect of foreign exchange rate changes on cash			(138	)			74
Increase (decrease) in cash and cash equivalents		$	783			$	(493	)

 

Operating activities used cash during the fiscal quarter ended September 30, 2008. This was the result of cash used by operating assets and liabilities, offset by net income and non-cash operating expenses. Significant non-cash items included a restructuring charge, share-based compensation and depreciation. In order of significance, the changes in operating assets and liabilities that had a significant impact on the cash used in operating activities included (i) a decrease in accounts payable due to the pay down of vendors with the proceeds from the term loan, (ii) a decrease in accrued payroll as a result of the timing of payroll cycles at quarter end, and (iii) payments made against the restructuring reserve. This was offset by a decrease in net accounts receivable due to the timing of collections and linearity of sales.

 

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Operating activities used cash during the fiscal quarter ended September 30, 2007. This was the result of a net loss, offset by non-cash operating expenses and cash provided by operating assets and liabilities. The non-cash items that had a significant impact on net loss included share-based compensation and depreciation. In order of significance, the changes in operating assets and liabilities that had a significant impact on the cash used in operating activities included (i) a decrease in net accounts receivable due to the timing of collections and linearity of sales, (ii) an increase in other liabilities as a result of increase in customer prepayments, and (iii) a decrease in finished good inventories. This was offset by a decrease in accounts payable as a result of the timing of inventory receipts and cash payments to vendors.

Investing activities used cash during the fiscal quarter ended September 30, 2008 and 2007. This was due to the purchase of property and equipment.

Financing activities provided cash during the fiscal quarter ended September 30, 2008. This was due to proceeds from the new term loan and sale of common shares through the 2000 Employee Stock Purchase Plan (the “ESPP”) offset by repayments on capital lease obligations and the term loan.

Financing activities provided cash during the fiscal quarter ended September 30, 2007. This was due to proceeds from the sale of common shares through employee stock option exercises and the 2000 Employee Stock Purchase Plan (the “ESPP”) offset by repayments on capital lease obligations.

Off-Balance Sheet Arrangements

We did not have any off balance sheet arrangements as of September 30, 2008.

 

Item 3.  Controls and Procedures

(a) Evaluation of disclosure controls and procedures

 

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of our fiscal year. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer to allow timely decisions regarding required disclosure.

 

(b) Changes in internal controls over financial reporting

 

There have been no changes in our internal controls over financial reporting identified during the fiscal quarter that ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings

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

Item 1A. Risk Factors

We operate in a rapidly changing environment that involves numerous risks and uncertainties. Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described in this section. This section should be read in conjunction with the consolidated financial statements and accompanying notes thereto, and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Annual Report on Form 10-K. If any of these risks or uncertainties actually occurs with material adverse effects on Lantronix, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

 

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

 

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

·

changes in business and economic conditions, including a downturn in the overall economy;

·

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

·

customers’ decisions to defer or accelerate orders;

·

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

·

changes in demand for our products;

·

fluctuations in exchange rates;

·

defects and other product quality problems;

·

loss or gain of significant customers;

·

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

·

announcements or introductions of new products by our competitors;

·

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

·

changes in demand for devices that incorporate our products.

Our common stock may be delisted, which could significantly harm our business.

Our common stock is currently listed on The Nasdaq Capital Market under the symbol “LTRX.” We currently are not in compliance with the $1.00 minimum bid price requirement for inclusion in The Nasdaq Capital Market; however, we have until March 26, 2009, to regain compliance. If our common stock is delisted from The Nasdaq Capital Market, some or all of the following might be impacted, harming our investors:

·

the liquidity of our common stock;

·

the number of institutional investors that will consider investing in our common stock;

·

the number of investors in general that will consider investing in our common stock;

·

the number of market makers in our common stock;

·

the number of analysts following our stock;

·

the availability of information concerning the trading prices;

 

·

the number of broker-dealers willing to execute trades in shares of our common stock; and

·

our ability to obtain financing for the continuation of our operations.

 

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In addition, if our common stock were to be delisted from The Nasdaq Capital Market, the price of our common stock and the ability of stockholders to sell such stock may be adversely affected. A return to the Nasdaq would require full compliance with the initial listing requirements of the exchange.

 

If a major distributor or customer cancels, reduces or delays purchases, our net revenues might decline and our business could be adversely affected.

The number and timing of sales to our distributors have been difficult for us to predict. While our distributors are customers in the sense they buy our products, they are also part of our product distribution system. Some of our distributors could be acquired by a competitor and stop buying product from us.

The following table presents sales to our significant customers as a percentage of net revenues:

			Three Months Ended
			September 30,

		2008				2007
Top five customers (1)			34.7%				40.0%
Ingram Micro			12.0%				9.7%
Tech Data			7.4%				15.0%
(1) Includes Ingram Micro and Tech Data.

 

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

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

 

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

Our future success depends in large part on our ability to continue to enhance existing products, lower product cost and develop new products that maintain technological competitiveness and meet government and industry standards. The demand for network-enabled products is relatively new and can change as a result of innovations, new technologies or new government and industry standards. For example, a recent directive in the European Union bans the use of lead and other heavy metals in electrical and electronic equipment after July 1, 2006. As a result, in advance of this deadline, some of our customers selling products in Europe had begun demanding product from component manufacturers that did not contain these banned substances. Any failure by us to develop and introduce new products or enhancements in response to new government and industry standards could harm our business, financial condition or results of operations. These requirements might or might not be compatible with our current or future product offerings. We might not be successful in modifying our products and services to address these requirements and standards. For example, our competitors might develop competing technologies based on Internet Protocols, Ethernet Protocols or other protocols that might have advantages over our products. If this were to happen, our net revenues might not grow at the rate we anticipate, or could decline.

 

Delays in deliveries or quality problems with our component suppliers could damage our reputation and could cause our net revenues to decline and harm our results of operations.

 

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

 

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

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

 

Environmental regulations such as the Waste Electrical and Electronic Equipment (“WEEE”)  and RoHS directives may require us to redesign our products and to develop compliance administration systems.

 

Various countries have begun to require companies selling a broad range of electrical equipment to conform to regulations such as the WEEE and RoHS directives and we expect additional countries and locations to adopt similar regulations in the future. New environmental standards such as these could require us to redesign our products in order to comply with the standards, and require the development of compliance administration systems. We have already invested significant resources into developing compliance tracking systems, and further investments may be required. Additionally, we may incur significant costs to redesign our products and to develop compliance administration systems; however alternative designs may have an adverse effect on our gross profit margin. If we cannot develop compliant products timely or properly administer our compliance programs, our revenues may also decline due to lower sales, which would adversely affect our operating results.

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

If we are unable to develop new products as a result of our research and development efforts, or if the products we develop are not successful, our business could be harmed. Even if we do develop new products that are accepted by our target markets, we do not know whether the net revenues from these products will be sufficient to justify our investment in research and development. In addition, if we do not invest sufficiently in research and development, we may be unable to maintain our competitive position. Our investment in research and development may decrease, which may put us at a competitive disadvantage compared to our competitors and adversely affect our market position.

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

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

 

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Current or future litigation could adversely affect us.

We are subject to a wide range of claims and lawsuits in the course of our business.  For example, we recently concluded multiple securities lawsuits with our stockholders and litigation with a former executive officer.  We may have an obligation to continue to indemnify the former executive officer and defend him in the litigation regarding the securities violation with which he has been charged.  There is a risk that our insurance carriers may not reimburse us for such costs. Any lawsuit may involve complex questions of fact and law and may require the expenditure of significant funds and the diversion of other resources. The results of litigation are inherently uncertain, and adverse outcomes are possible.

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

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

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

Certain of our products contain components developed and maintained by third-party software vendors or are available through the “open source” software community. We also expect that we may incorporate software from third-party vendors and open source software in our future products. Our business would be disrupted if this software, or functional equivalents of this software, were either no longer available to us or no longer offered to us on commercially reasonable terms. In either case, we would be required to either redesign our products to function with alternate third-party software or open source software, or develop these components ourselves, which would result in increased costs and could result in delays in our product shipments. Furthermore, we might be forced to limit the features available in our current or future product offerings.

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

We outsource substantially all of our manufacturing to four manufacturers in Asia: Venture Electronics Services, Uni Precision Industrial Ltd., Universal Scientific Industrial Company, LTD and Hana Microelectronics, Inc. In addition, two independent third party foundries located in Asia manufacture substantially all of our large scale integration chips. Our reliance on these third-party manufacturers exposes us to a number of significant risks, including:

·

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

·

lack of guaranteed production capacity or product supply; and

·

reliance on these manufacturers to maintain competitive manufacturing technologies.

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

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

 

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Our international activities are subject to uncertainties, which include international economic, regulatory, political and other risks that could harm our business, financial condition or results of operations.

The following table presents our sales within geographic regions:

Three Months Ended September 30,

						% of Net								% of Net				Change
		2008				Revenue				2007				Revenue				$					%
		(In thousands, except percentages)
Americas		$	8,428				59.3%			$	7,935				60.8%			$	493				6.2%
EMEA			3,812				26.8%				3,385				25.9%				427				12.6%
Asia Pacific			1,972				13.9%				1,734				13.3%				238				13.7%
Net revenues		$	14,212				100.0%			$	13,054				100.0%			$	1,158				8.9%

 

We expect that international revenues will continue to represent a significant portion of our net revenues in the foreseeable future. Doing business internationally involves greater expense and many risks. For example, because the products we sell abroad and the products and services we buy abroad may be priced in foreign currencies, we could be affected by fluctuating exchange rates. In the past, we have lost money because of these fluctuations. We might not successfully protect ourselves against currency rate fluctuations, and our financial performance could be harmed as a result. In addition, we use contract manufacturers based in Asia to manufacture substantially all of our products. International revenues and operations are subject to numerous risks, including:

·

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

·

reduced protection for intellectual property rights in some countries;

·

differing labor regulations;

·

compliance with a wide variety of complex regulatory requirements;

·

fluctuations in currency exchange rates;

·

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

·

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

·

greater difficulty in staffing and managing foreign operations; and

·

increased financial accounting and reporting burdens and complexities.

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

We are exposed to foreign currency exchange risks, which could harm our business and operating results.

We hold a significant portion of our cash balance in foreign currencies (particularly euros), and as such are exposed to adverse changes in exchange rates associated with foreign currency fluctuations. However, we do not currently engage in any hedging transactions to mitigate these risks. Although from time to time we review our foreign currency exposure and evaluate whether we should enter into hedging transactions, we may not adequately hedge against any future volatility in currency exchange rates and, if we engage in hedging transactions, the transactions will be based on forecasts which later may prove to be inaccurate. Any failure to hedge successfully or anticipate currency risks properly could adversely affect our operating results.

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

 

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At any time, competitive products may be introduced with more attractive features or at lower prices than ours. There is a risk that we may be unable to sell our inventory in a timely manner to avoid it becoming obsolete.

The following table presents our reserve for excess and obsolete inventory:

		September 30,				June 30,
		2008				2008
		(In thousands)
Finished goods		$	5,834			$	5,707
Raw materials			1,768				1,836
Inventory at distributors			1,645				2,008
Large scale integration chips *			1,180				809
Inventories, gross			10,427				10,360
Reserve for excess and obsolete inventory			(2,326	)			(2,322	)
Inventories, net		$	8,101			$	8,038
* This item is sold individually and embedded into the Company's products.

 

In the event we are required to substantially discount our inventory or are unable to sell our inventory in a timely manner, we would be required to increase our reserves and our operating results could be substantially harmed.

We are subject to export control regulations that could restrict our ability to increase our international revenue and may adversely affect our business.

Our products and technologies are subject to U.S. export control laws, including the Export Administration Regulations, administered by the Department of Commerce and the Bureau of Industry Security, and their foreign counterpart laws and regulations, which may require that we obtain an export license before we can export certain products or technology to specified countries. These export control laws, and possible changes to current laws, regulations and policies, could restrict our ability to sell products to customers in certain countries or give rise to delays or expenses in obtaining appropriate export licenses. Failure to comply with these laws and regulations could result in government sanctions, including substantial monetary penalties, denial of export privileges, and debarment from government contracts. Any of these could adversely affect our operations and, as a result, our financial results could suffer.

 

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

Our financial performance depends substantially on the performance of our executive officers, key technical, marketing and sales employees. We are also dependent upon our technical personnel, due to the specialized technical nature of our business.  If we were to lose the services of our executive officers or any of our key personnel and were not able to find replacements in a timely manner, our business could be disrupted, other key personnel might decide to leave, and we might incur increased operating expenses associated with finding and compensating replacements.

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

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

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

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

 

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

Substantial litigation regarding intellectual property rights exists in our industry.  For example, in May 2006 we settled a patent infringement lawsuit with Digi in which we signed an agreement with Digi to cross-license each other’s patents.  In addition, we paid Digi $600,000 as part of the settlement.  The results of litigation are inherently uncertain, and adverse outcomes are possible.  Adverse outcomes may have a material adverse effect on our business, financial condition or results of operations.

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

Responding to any infringement claim, regardless of its validity, could:

 

·

be time-consuming, costly and/or result in litigation;

 

·

divert management’s time and attention from developing our business;

 

·

require us to pay monetary damages, including treble damages if we are held to have willfully infringed;

 

·

require us to enter into royalty and licensing agreements that we would not normally find acceptable;

 

·

require us to stop selling or to redesign certain of our products; or

 

·

require us to satisfy indemnification obligations to our customers.

 

If any of these occur, our business, financial condition or results of operations could be adversely affected.

We may not be able to adequately protect or enforce our intellectual property rights, which could harm our competitive position or require us to incur significant expenses to enforce our rights.

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

·

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

·

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

·

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

·

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

·

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

·

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

Also, the laws of some of the countries in which we market and manufacture our products offer little or no effective protection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third-parties to benefit from our technology without paying us for it.  Consequently, we may be unable to prevent our proprietary technology from being exploited by others in the U.S. or abroad, which could require costly efforts to protect our technology. Policing the unauthorized use of our products, trademarks and other proprietary rights is expensive, difficult and, in some cases, impracticable. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of management resources, either of which could harm our business. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property, which may harm our business, financial condition and results of operations.

 

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Acquisitions, strategic partnerships, joint ventures or investments may impair our capital and equity resources, divert our management’s attention or otherwise negatively impact our operating results.

We may pursue acquisitions, strategic partnerships and joint ventures that we believe would allow us to complement our growth strategy, increase market share in our current markets and expand into adjacent markets, broaden our technology and intellectual property and strengthen our relationships with distributors and OEMs. Any future acquisition, partnership, joint venture or investment may require that we pay significant cash, issue stock or incur substantial debt. Acquisitions, partnerships or joint ventures may also result in the loss of key personnel and the dilution of existing stockholders as a result of issuing equity securities. In addition, acquisitions, partnerships or joint ventures require significant managerial attention, which may be diverted from our other operations. These capital, equity and managerial commitments may impair the operation of our business. Furthermore, acquired businesses may not be effectively integrated, may be unable to maintain key pre-acquisition business relationships, may contribute to increased fixed costs and may expose us to unanticipated liabilities and otherwise harm our operating results.

Business interruptions could adversely affect our business.

 

Our operations and those of our suppliers are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, terrorist attacks and other events beyond our control. A substantial portion of our facilities, including our corporate headquarters and other critical business operations, are located near major earthquake faults and, therefore, may be more susceptible to damage if an earthquake occurs. We do not carry earthquake insurance for direct earthquake-related losses. If a business interruption occurs, our business could be materially and adversely affected.

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

Section 404 of the Sarbanes-Oxley Act of 2002 requires companies to evaluate periodically the effectiveness of their internal controls over financial reporting, and to include a management report assessing the effectiveness of their internal controls as of the end of each fiscal year. Beginning with our annual report on Form 10-K for our fiscal year ended June 30, 2008, we are required to comply with the requirement of Section 404 of the Sarbanes-Oxley Act of 2002 to include in each of our annual reports an assessment by our management of the effectiveness of our internal controls over financial reporting.  Beginning with our annual report on Form 10-K for our fiscal year ending June 30, 2010,  our independent registered public accounting firm will issue a report assessing the effectiveness of our internal controls.

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

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

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

None.

 

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Item 3.   Defaults Upon Senior Securities

None.

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

None.

Item 5.   Other Information

None.

Item 6.   Exhibits

Exhibit
Number	Description of Document
31.1	Certification of Principal Executive Officer and Principal Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Executive Officer and Principal Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

* Furnished, not filed.

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

Date: October 31, 2008

LANTRONIX, INC.

(Registrant)

By:	/s/ Jerry D. Chase
	Jerry D. Chase
	President and Chief Executive Officer
	(Principal Executive and Financial Officer)

 

 

By:	/s/ Reagan Y. Sakai
	Reagan Y. Sakai
	Chief Financial Officer and Secretary
	(Principal Executive and Financial Officer)

 

 

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Exhibit Index

 

Exhibit
Number	Description of Document
31.1	Certification of Principal Executive Officer and Principal Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Executive Officer and Principal Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

* Furnished, not filed.

 

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