Edgar Filing: LANTRONIX INC

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

-----------

FORM 10-Q/A
AMENDMENT NO. 1

[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934

For the quarterly period ended September 30, 2001

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the transition period from _________ to ___________.

Commission file number: 1-16027

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LANTRONIX, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 33-0362767
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

15353 Barranca Parkway Irvine, California 92618
(Address of principal executive offices and zip code)

(949) 453-3990
(Registrant's telephone number, including area code)

-----------

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(D) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]

As of October 31, 2001, 49,985,328 shares of the Registrant's common stock
were outstanding.

================================================================================

EXPLANATORY NOTE

This Amendment No. 1 to Quarterly Report on Form 10-Q/A of Lantronix, Inc.
(the "Company") amends Part I of the Company's Quarterly Report on Form 10-Q for
the quarter ended September 30, 2001, as filed by the Company on November 14,
2001 (the "Original 10-Q"), to reflect the changes described below.

The Company changed its accounting method for recognizing revenue on sales
to distributors effective as of the beginning of fiscal 2001, July 1, 2000.
Under the new accounting method, recognition of revenue and related gross profit
on sales to distributors is deferred until the distributor resells the product
to an end customer. Previously, the Company had recognized revenue from these
transactions upon shipment of product to the distributor, net of estimates for
possible returns and allowances. In addition, for the quarterly period ended
September 30, 2001, the Company also made further corrections to its condensed
consolidated financial statements (1) to defer the recognition of certain sales
made to customers who were not distributors as revenue because they did not meet
all of the criteria for revenue recognition at the time of shipment, and (2) to
reclassify to other expense certain amounts originally charged in error to other
comprehensive income. The effect of these matters is to reduce net revenues by
$438,000 and $393,000 and increase loss before cumulative effect of accounting
change by $123,000 or $0.00 per share and $206,000 or $0.01 per share in the
quarters ended September 30, 2001 and 2000, respectively. Additionally, the
cumulative effect of the accounting change recorded as of July 1, 2000 was a
charge of $773,000 (net of income taxes of $0) or $0.02 per share. See Note 2 to
the financial statements, "Accounting Change and Restatement of Financial
Statements," for more detail. Conforming changes reflecting the foregoing are
made in: Part I - Item 1 Financial Statements (and footnotes thereto); and Item
2 Management's Discussion and Analysis of Financial Condition and Results of
Operations.

In addition, the Company made changes to the Original 10-Q to clarify or
correct information with respect to the following:

. Part I Item 1 "Financial Statements": separation in the condensed
consolidated balance sheet of accounts as follow: "Goodwill" and
"Purchased intangible assets, net"; and "Officer loans" and "Other
assets";
. Part I Item 1 "Financial Statements": additions to Note 3 "Recent
Accounting Pronouncements" and Note 6 "Goodwill and Purchased
Intangible Assets" to provide additional information concerning the
Company's adoption of SFAS 142 "Goodwill and Other Intangible
Assets";
. Part I Item 1 "Financial Statements": clarification in Note 8
"Stockholders' Equity" of the number of shares sold in the secondary
offering;
. Part I Item 1 "Financial Statements": addition to Note 3 "Recent
Accounting Pronouncements" for newly issued SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets";
. Part I Item 2 "Management's Discussion and Analysis of Financial
Condition and Results of Operations": Clarification of the number of
shares sold in our secondary offering;
. Part I Item 2 "Management's Discussion and Analysis of Financial
Condition and Results of Operations": clarification under the heading
"Net Revenues" as to European sales;
. Part I Item 2 "Management's Discussion and Analysis of Financial
Condition and Results of Operations": clarification under the heading
"Gross Profit" as to royalty payments to Gordian;
. Part I Item 2 "Management's Discussion and Analysis of Financial
Condition and Results of Operations": additional information under
the heading "Impact of Adoption of New Accounting Standards";
. Part I Item 3 "Quantitative and Qualitative Disclosure About Market
Risk": clarification of inclusion of short-term investments and
foreign cash and cash equivalent balances in discussion;
. Part II Item 2 "Changes in Securities and Use of Proceeds":
clarification of the number of shares sold in our secondary offering;
and
. Part II Item 2 "Changes in Securities and Use of Proceeds":
clarification regarding the acquisition of U.S. Software.

Except as noted above, this Form 10-Q does not reflect events occurring after
the filing of the Original 10-Q on November 14, 2001, nor does it modify or
update the disclosures contained in such original report, except as necessary or
appropriate to reflect the effects of the restatement.

LANTRONIX, INC.

FORM 10-Q/A
FOR THE QUARTER ENDED SEPTEMBER 30, 2001

INDEX

Page
----

PART I. FINANCIAL INFORMATION ............................................................................ 4

Item 1. Financial Statements ............................................................................. 4

Condensed Consolidated Balance Sheets at September 30, 2001 (unaudited) and June 30, 2001
(restated) .................................................................................... 4

Unaudited Condensed Consolidated Statements of Operations for the Three Months
Ended September 30, 2001 and 2000 (restated) .................................................. 5

Unaudited Condensed Consolidated Statements of Cash Flows for the Three Months Ended
September 30, 2001 and 2000 (restated) ........................................................ 6

Notes to Unaudited Condensed Consolidated Financial Statements ................................... 7

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ............ 13

Item 3. Quantitative and Qualitative Disclosures About Market Risk ....................................... 26

PART II. OTHER INFORMATION ................................................................................ 27

Item 1. Legal Proceedings ................................................................................ 27

Item 2. Change in Securities and Use of Proceeds ......................................................... 27

Item 3. Defaults Upon Senior Securities .................................................................. 27

Item 4. Submission of Matters to a Vote of Security Holders .............................................. 27

Item 5. Other Information ................................................................................ 27

Item 6. Exhibits and Reports on Form 8-K ................................................................. 27

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

LANTRONIX, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)

September 30, June 30,
2001 2001
---- ----
(Unaudited)
(Restated - Note 2)

ASSETS
------

Current assets:
Cash and cash equivalents ....................................................... $ 58,223 $ 15,367
Short-term investments .......................................................... 1,974 1,973
Accounts receivable, net ........................................................ 11,552 9,134
Inventories ..................................................................... 13,172 13,560
Deferred income taxes ........................................................... 4,005 3,621
Prepaid income taxes ............................................................ 543 973
Prepaid expenses and other current assets ....................................... 4,666 3,805
--------- ---------
Total current assets ........................................................ 94,135 48,433

Property and equipment, net .......................................................... 6,367 5,492
Long-term investments ................................................................ 3,287 2,424
Goodwill ............................................................................. 43,695 42,273
Purchased intangible assets, net ..................................................... 11,283 13,328
Officer loans ........................................................................ 4,131 4,131
Other assets ......................................................................... 796 780
--------- ---------
Total assets ................................................................ $ 163,694 $ 116,861
========= =========

LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------

Current liabilities:
Accounts payable ................................................................ $ 5,681 $ 5,698
Due to related party ............................................................ 1,130 787
Accrued payroll and related expenses ............................................ 1,534 1,243
Other current liabilities ....................................................... 3,487 3,742
--------- ---------
Total current liabilities ................................................... 11,832 11,470

Deferred income taxes ................................................................ 5,829 5,895

Stockholders' equity:
Common stock .................................................................... 5 4
Additional paid-in capital ...................................................... 157,757 109,871
Employee notes receivable ....................................................... (790) (790)
Deferred compensation ........................................................... (9,253) (10,020)
Retained earnings (accumulated deficit) ......................................... (1,696) 582
Accumulated other comprehensive income (loss) ................................... 10 (151)
--------- ---------
Total stockholders' equity .................................................. 146,033 99,496
--------- ---------
Total liabilities and stockholders' equity .................................. $ 163,694 $ 116,861
========= =========

See accompanying notes.

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)

Three Months Ended
September 30,
-------------
2001 2000
---- ----
(Restated - Note 2)

Net revenues (A)................................................................... $ 15,831 $ 11,644
Cost of revenues (B)............................................................... 7,539 5,236
-------- --------

Gross profit....................................................................... 8,292 6,408
-------- --------

Operating expenses:
Selling, general and administrative (C)....................................... 7,577 5,153
Research and development (C).................................................. 2,092 1,052
Stock-based compensation (B) (C).............................................. 1,172 652
Amortization of purchased intangible assets .................................. 286 203
-------- --------
Total operating expenses........................................................... 11,127 7,060
-------- --------
Loss from operations............................................................... (2,835) (652)
Interest income (expense), net..................................................... 536 497
Other expense, net................................................................. (628) (74)
-------- --------
Loss before income taxes and cumulative effect of accounting change................ (2,927) (229)
Benefit for income taxes........................................................... (649) --
-------- --------
Loss before cumulative effect of accounting change................................. (2,278) (229)
Cumulative effect of accounting change, net of income tax benefit of $0 (Note 2)... -- (773)
-------- --------
Net loss........................................................................... $ (2,278) $ (1,002)
======== ========

Basic and diluted loss per share before cumulative effect of accounting change..... $ (0.05) $ (0.01)
Cumulative effect of accounting change per share................................... -- (0.02)
-------- --------
Basic and diluted net loss per share............................................... $ (0.05) $ (0.03)
======== ========

Weighted average shares (basic and diluted)........................................ 47,500 32,817
======== ========

(A) Includes net revenues from related parties.................................... $ 517 $ 917
======== ========

(B) Cost of revenues includes the following:
Amortization of purchased intangible assets................................... $ 338 $ --
Stock-based compensation...................................................... 27 11
-------- --------
$ 365 $ 11
======== ========

(C) Stock-based compensation is excluded from the following:
Selling, general and administrative expenses.................................. $ 833 $ 571
Research and development expenses............................................. 339 81
-------- --------
$ 1,172 $ 652
======== ========

See accompanying notes.

LANTRONIX, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

Three Months Ended
September 30,
-------------
2001 2000
---- ----
(Restated - Note 2)

Cash flows from operating activities:
Net loss ............................................................................... $ (2,278) $ (1,002)
Adjustments to reconcile net loss to net cash used in operating activities:
Cumulative effect of accounting change, net of income taxes of $0 ................. -- 773
Depreciation ...................................................................... 560 157
Amortization of purchased intangible assets ....................................... 624 203
Stock-based compensation .......................................................... 1,199 663
Provision for doubtful accounts ................................................... 165 76
Deferred income taxes ............................................................. (450) (63)
Revaluation of investment ......................................................... 500 --
Equity losses from unconsolidated business ........................................ 294 --
Changes in operating assets and liabilities:
Accounts receivable .............................................................. (2,583) (573)
Inventories ...................................................................... 388 (2,155)
Prepaid income taxes ............................................................. 430 75
Prepaid expenses and other assets ................................................ (877) 40
Accounts payable ................................................................. 326 (121)
Other current liabilities ........................................................ 36 (563)
-------- --------

Net cash used in operating activities .................................................. (1,666) (2,490)
-------- --------

Cash flows from investing activities:
Purchase of property and equipment, net ........................................... (1,435) (1,152)
Purchase of minority investments, net ............................................. (1,524) --
-------- --------
Net cash used in investing activities .................................................. (2,959) (1,152)
-------- --------
Cash flows from financing activities:
Net proceeds from underwritten offerings of common stock .......................... 47,113 54,286
Net proceeds from other issuances of common stock ................................. 341 12
-------- --------
Net cash provided by financing activities .............................................. 47,454 54,298
Effect of foreign exchange rates on cash ............................................... 27 (6)
-------- --------
Increase in cash and cash equivalents .................................................. 42,856 50,650
Cash and cash equivalents at beginning of period ....................................... 15,367 1,988
-------- --------
Cash and cash equivalents at end of period ............................................. $ 58,223 $ 52,638
======== ========

See accompanying notes.

LANTRONIX, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2001

1. Basis of Presentation

The condensed consolidated financial statements included herein are
unaudited. They contain all normal recurring accruals and adjustments which, in
the opinion of management, are necessary to present fairly the consolidated
financial position of Lantronix, Inc. and its subsidiaries (collectively, the
"Company") at September 30, 2001, and the consolidated results of its operations
and its cash flows for the three months ended September 30, 2001 and 2000. All
intercompany accounts and transactions have been eliminated. It should be
understood that accounting measurements at interim dates inherently involve
greater reliance on estimates than at year-end. The results of operations for
the three months ended September 30, 2001 are not necessarily indicative of the
results to be expected for the full year or any future interim periods.

These financial statements do not include certain footnotes and
financial presentations normally required under generally accepted accounting
principles. Therefore, they should be read in conjunction with the audited
consolidated financial statements and notes thereto for the year ended June 30,
2001, included in the Company's Annual Report on Form 10-K/A filed with the
Securities and Exchange Commission ("SEC") in June 2002.

In May 2002, the Company undertook a special investigation of its
accounting and determined that certain sales to distributors and others made in
fiscal 2001 and 2002 did not qualify for recognition as revenue upon shipment.
As a result, the Company has restated its condensed consolidated financial
statements contained herein as well as all other interim and annual financial
statements for periods within fiscal 2001 and the first six months of fiscal
2002 (July 1, 2000 through December 31, 2001) as further described in Note 2. In
addition to the Form 10-Q/A, the Company has also filed a Form 10-K/A for the
fiscal year ended June 30, 2001, and a Form 10-Q/A for the quarterly period
ended December 31, 2001 to reflect the restatement.

Also effective July 1, 2001, the Company elected to early adopt
Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets" ("SFAS No. 142"). As a result, the Company will no
longer amortize goodwill and certain intangible assets deemed to have indefinite
lives (Note 3).

2. Accounting Change and Restatement of Financial Statements

In originally preparing the condensed consolidated financial statements
at December 31, 2001, the Company changed its accounting method for recognizing
revenue on sales to distributors effective as of July 1, 2001, the beginning of
fiscal 2002. Under the new accounting method, the recognition of revenue and
related gross profit on sales to distributors is deferred until the distributor
resells the product to an end customer. Formerly, the Company recognized revenue
from these transactions upon shipment of product to the distributor, net of
estimates for possible returns and allowances.

In May 2002, the Company undertook a special investigation of its
accounting, which revealed that beginning in the third and fourth quarters of
fiscal 2001 certain shipments made to distributors and recorded as revenues in
fiscal 2001 and 2002 did not qualify for revenue recognition upon shipment due
to terms present in agreements with the distributors that were not considered in
the Company's original accounting decisions. As a result, the Company's new
method of accounting for distributor sales, which is based on recognizing
revenue and related gross profit on sales to distributors only as the
distributor resells the product to end customers, has been adopted effective as
of July 1, 2000, the beginning of fiscal 2001, or one year earlier. This manner
of correcting the errors in sales recognition made in previously issued
financial statements for fiscal 2001 is deemed to be preferable in the
circumstances because (1) it eliminates from revenue any effect of shipping
excessive levels of inventory to the distributors; (2) all revenue from
distributor sales in fiscal 2001 and 2002 will be recognized on a common basis;
and (3) there is assurance that any additional agreements with distributors that
may have existed with respect to specific orders but are presently unknown will
not have an impact on amounts reported as revenue after the restatement. The
restatement for the year ended June 30, 2001, results in a reduction in revenue
of approximately $6.2 million and an increase in the loss before cumulative
effect of accounting change of $2.9 million or $0.07 per share. The cumulative
effect of the accounting change for the three months ended September 30, 2000
recorded as of July 1, 2000 was a charge of $773,000 (net of income tax benefit
of $0) or $0.02 per share.

Management believes that the new accounting method better reflects the
substance of the transactions considering the Company's recent entry into the
semiconductor marketplace and the changing business environment; is consistent
with other

companies in the Company's industry thereby providing greater comparability in
the presentation of financial results among the Company and its peers, and
better focuses the Company on end customer sales.

In the special investigation conducted in May 2002, the Company also
discovered (i) that the terms and circumstances of certain sales made in the
first six months of fiscal 2002 to customers who were not distributors also
preclude revenue from being recognized upon shipment, as originally reported and
(ii) that certain amounts initially reported as other comprehensive income
(loss) should be accounted for as elements of net loss. Accordingly, in the
accompanying restated condensed consolidated financial statements, the Company
has made corrections to defer the recognition of such sales as revenue
until all revenue recognition criteria have been met and to reclassify to other
expense the amounts improperly charged to other comprehensive income (loss).
These corrections result in a reduction in revenue of approximately
$438,000 and an increase in the loss before cumulative effect of accounting
change of $123,000 or $0.00 per share in the three months ended September 30,
2001.

The effects of the corrections on net revenues; loss before cumulative
effect of accounting change, net of income tax benefit; cumulative effect of
accounting change; net loss; and related per share amounts for the three months
ended September 30, 2001 and 2000 are shown in the tables below (in thousands,
except per share amounts):

Three Months Ended
September 30,
-------------
2001 2000
---- ----

As reported:
Net revenues ............................................................................ $16,269 $12,037
======= =======

Loss before cumulative effect of accounting change ...................................... $(2,155) $ (23)
Cumulative effect of accounting change, net of income tax benefit of $1,049 ............. (2,557) -
------- -------
Net loss ................................................................................ $(4,712) $ (23)
======= =======

Loss per share before cumulative effect of accounting change ............................ $ (0.05) $ (0.00)
Cumulative effect of accounting change per share ........................................ (0.05) -
------- -------
Basic and diluted net loss per share .................................................... $ (0.10) $ (0.00)
======= =======

As restated:
Net revenues ............................................................................ $16,269 $12,037
Corrections ............................................................................. (438) (393)
------- -------
Net revenues, as restated ............................................................... $15,831 $11,644
======= =======

Loss before cumulative effect of accounting change ...................................... $(2,155) $ (23)
Corrections, net of tax ................................................................. (123) (206)
------- -------
Loss before cumulative effect of accounting change, as restated ......................... (2,278) (229)
Cumulative effect of accounting change, net of income tax benefit of $0, as restated .... - (773)
------- -------
Net loss, as restated ................................................................... $(2,278) $(1,002)
======= =======

Loss per share before cumulative effect of accounting change, as restated ............... $ (0.05) $ (0.01)
Cumulative effect of accounting change per share, as restated ........................... - (0.02)
------- -------
Basic and diluted net loss per share, as restated ....................................... $ (0.05) $ (0.03)
======= =======

*As reported information for the three months ended September 30, 2001 reflects
the accounting change made in the second quarter of fiscal 2002, but effective
as of July 1, 2001 to defer revenue recognition of revenue and related gross
profit until the distribution resells the product to an end customer.

3. Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 141, "Business Combinations" ("SFAS No. 141"), effective for
acquisitions consummated after June 30, 2001, and SFAS No. 142, effective for
fiscal years beginning after December 15, 2001. Under the new rules, goodwill
and certain intangible assets deemed to have indefinite lives will no longer be
amortized but will be subject to annual impairment tests in accordance with SFAS
Nos. 141 and 142. Other intangible assets will continue to be amortized over
their useful lives.

The Company has elected to early adopt the new rules set forth in SFAS
No. 142 on accounting for goodwill and other intangibles as of July 1, 2001. For
the three months ended September 30, 2001, early adoption resulted in
non-amortization of goodwill of $1.7 million or $0.03 per share based on the
weighted average shares outstanding for the three months ended September 30,
2001.

The transition provisions of SFAS No. 142 require that the Company
complete its assessment of whether impairment may exist as of the date of
adoption by December 31, 2001 and complete its determination of the amount of
any impairment as of the

date of adoption by June 30, 2002. Any impairment that is required to be
recognized when adopting SFAS 142 will be reflected as the cumulative effect of
a change in accounting principle as of July 1, 2001. The Company has completed
its initial assessment and concluded that goodwill arising from the acquisition
of United States Software Corporation (USSC), having a carrying amount of
approximately $5.4 million as of July 1, 2001, may be impaired. The Company
expects to complete its determination of the amount of the impairment charge, if
any, to be reflected as a cumulative effect of a change in accounting principle
during the fourth fiscal quarter ending June 30, 2002.

The Company intends to perform the first of the required annual
impairment tests of goodwill under the guidelines of SFAS No. 142 effective as
of April 1, 2002. The Company has not yet determined the effect, if any, that
this test will have on its consolidated statement of operations or financial
position. An impairment charge, if any, identified as a result of completing the
Company's annual impairment test will be reflected as an operating expense in
the fourth quarter of fiscal 2002.

In August 2001, the Financial Accounting Standards Board issued SFAS No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which
supersedes SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" ("SFAS No. 121") and the accounting and
reporting provisions of Accounting Principles Board Opinion No. 30, "Reporting
the Results of Operations-Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions." This statement retains certain requirements of SFAS No. 121
relating to the recognition and measurement of impairment of long-lived assets
to be held and used. Additionally, this statement results in one accounting
model, based on the framework established in SFAS No. 121, for long-lived assets
to be disposed of by sales and also addresses certain implementation issues
related to SFAS No. 121, including the removal of goodwill from its scope due to
the issuance of SFAS No. 142. SFAS No. 144 is effective for fiscal years
beginning after December 15, 2001, and interim periods within those fiscal
years. The Company has not yet determined the effect, if any, on the carrying
value of its long-lived assets resulting from the adoption of SFAS No. 144.

4. Net Loss per Share

Basic net loss per share is calculated by dividing net loss by the
weighted average number of common shares outstanding during the period. Diluted
net loss per share is calculated by adjusting outstanding shares assuming any
dilutive effects of options. However, for periods in which the Company incurred
a net loss, these shares are excluded because their effect would be to reduce
recorded net loss per share. The following table sets forth the computation of
net loss per share (in thousands, except per share amounts):

Three Months Ended
September 30,
-------------
2001 2000
---- ----
(Restated)

Numerator:
Loss before cumulative effect of accounting change ...................... $(2,278) $ (229)
Cumulative effect of accounting change, net of income taxes of $0 ....... -- (773)
------- -------
Net loss ................................................................ $(2,278) $(1,002)
======= =======

Denominator:
Weighted-average shares outstanding ..................................... 48,140 32,817
Less: non-vested common shares outstanding ............................. (640) --
------- -------
Denominator for basic and diluted loss per share ........................ 47,500 32,817
======= =======

Loss per share before cumulative effect of accounting change ............ $ (0.05) $ (0.01)
Cumulative effect of accounting change per share ........................ -- (0.02)
------- -------
Basic and diluted net loss per share .................................... $ (0.05) $ (0.03)
======= =======

5. Inventories

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

September 30, June 30,
2001 2001
---- ----

(Restated)

Raw materials ......................................................... $ 4,816 $ 6,752
Finished goods ........................................................ 7,554 6,526
Inventory at distributors ............................................. 3,192 2,772
--------- ---------
15,562 16,050
Reserve for excess and obsolete inventory ............................. (2,390) (2,490)
--------- ---------
$ 13,172 $ 13,560
========= =========

6. Goodwill and Purchased Intangible Assets

Goodwill

The changes in the carrying amount of goodwill for the three months
ended September 30, 2001, are as follows (in thousands):

Balance as of July 1, 2001 .............................................................. $ 43,025
Reclassification of assembled workforce in connection with adoption of
SFAS No. 142 at July 1, 2001 .......................................................... 1,458
---------
44,483
Less: accumulated amortization .......................................................... (788)
---------
Balance as of September 30, 2001 ........................................................ $ 43,695
=========

Purchased Intangible Assets

The composition of purchased intangible assets is as follows (in thousands):

September 30, 2001 June 30, 2001
------------------ -------------

Useful Accumulated Accumulated
Lives Gross Amortization Net Gross Amortization Net
----- ----- ------------ --- ----- ------------ ---

Existing technology ......... 5 years $ 6,745 $ (558) $ 6,187 $ 6,745 $ (188) $ 6,557
Customer lists .............. 5 3,500 (219) 3,281 3,500 (44) 3,456
Patent/core technology ...... 5 299 (165) 134 299 (150) 149
Tradename/trademark ......... 5 1,162 (123) 1,039 1,162 (65) 1,097
Assembled workforce ......... 5 -- -- -- 1,458 (68) 1,390
Distribution network ........ 5 755 (113) 642 755 (76) 679
-------- --------- --------- -------- ------- ---------

Total $ 12,461 $ (1,178) $ 11,283 $ 13,919 $ (591) $ 13,328
======== ========= ========= ======== ======= =========

As required by SFAS No. 142, assembled workforce was reclassified as goodwill
effective July 1, 2001.

The amortization expense for purchased intangible assets for the three
months ended September 30, 2001 was $624,000, of which $338,000 was amortized to
cost of revenues and $286,000 was amortized to operating expenses. The estimated
amortization expense for the remainder of fiscal 2002 and the next four years is
as follows:

Fiscal year ending Cost of Operating
June 30: Revenues Expenses Total
-------- -------- -----

2002 ............................... $ 1,012 $ 857 $ 1,869
2003 ............................... 1,349 1,146 2,495
2004 ............................... 1,349 1,113 2,462
2005 ............................... 1,349 1,083 2,432
2006 ............................... 1,128 897 2,025
-------- -------- --------
Total $ 6,187 $ 5,096 $ 11,283
======== ======== ========

7. Long-term Investments

In September 2001, the Company purchased a convertible promissory note from
Xanboo Inc. ("Xanboo") in the principal amount of $1.5 million. The note has a
ten year maturity and will automatically convert into the next round of equity
securities of Xanboo that raises at least $5.0 million. If Xanboo does not
complete such a financing prior to February 1, 2002, the Company can convert the
note into a newly created series of preferred stock of Xanboo. The Company is
considering investing additional money in this company as well as other
companies (Note 11).

The Company periodically reviews its investments for which fair value is
less than cost to determine if the decline in value is other than temporary. If
the decline in value is judged to be other than temporary, the cost basis of the
security is written down to fair value. During the three months ended September
30, 2001, the Company recorded a $500,000 revaluation of a non-marketable equity
investment resulting from an other-than-temporary decline in its value. This
amount is included within the condensed consolidated statement of operations as
other expense.

8. Stockholders' Equity

In July 2001, the Company completed a public offering of 8,534,000 shares
of its common stock, including an underwriters' over-allotment option to
purchase an additional 534,000 shares, at an offering price of $8.00 per share.
The Company sold 6,000,000 shares and selling stockholders sold 2,000,000 shares
of the primary offering. Additionally, the Company sold 400,500 shares and
selling stockholders sold 133,500 shares of the over-allotment option. The
Company received net proceeds of approximately $47.1 million in connection with
this offering.

In August 2001, the Company began negotiations with the former owners of
U.S. Software to remove the earn-out provisions of the merger agreement in
exchange for the issuance of a specified number of shares of the Company's stock
to the former owners of U.S. Software. In August 2001, in order to eliminate an
employee bonus arrangement related to the acquisition, the Company issued
250,000 stock options to employees who were not former owners of U.S. Software.
The issuance of these stock options was unrelated to and did not remove the
earn-out provisions of the merger agreement. The estimated value of $500,000
related to these stock options will be accounted for as compensation expense
over the vesting period of options of up to four years.

9. Comprehensive Loss

SFAS No. 130, "Reporting Comprehensive Income (Loss)," establishes
standards for reporting and displaying comprehensive income (loss) and its
components in the condensed consolidated financial statements. The components of
comprehensive loss are as follows (in thousands):

Three Months ended
September 30,
-------------
2001 2000
---- ----
(Restated)

Net loss .......................................................... $ (2,278) $ (1,002)
Other comprehensive loss:
Change in net unrealized loss on investment .................... 134 --
Change in accumulated translation adjustments .................. 27 (6)
--------- --------
Total comprehensive loss .......................................... $ (2,117) $ (1,008)
========= ========

10. Litigation

From time to time, we have received letters claiming that our products
infringe upon patents or other intellectual property of third-parties. On July
3, 2001, Digi International, Inc. filed a complaint against us in the United
States District Court for the District of Minnesota claiming patent infringement
and alleging that certain of our Multiport Device Servers, specifically our ETS
line of products, when coupled with a device driver called the Comm Port
Redirector, infringe upon U.S. Patent No. 6,047,319 owned by Digi. Digi alleges
that Lantronix has willfully and intentionally infringed Digi's patent, and its
complaint seeks injunctive relief as well as unspecified damages, treble
damages, attorney's fees, interest and costs. On August 17, 2001, Lantronix
filed its answer to the complaint, asserting affirmative defenses, and
counterclaiming for a declaratory judgment that the patent in issue is invalid.
To date discovery has not begun and a trial date has not been set. Based on the
facts known to date, Lantronix believes that the claims are without merit and
intends to vigorously defend this suit.

11. Subsequent Events

On October 18, 2001, the Company completed the acquisition of Synergetic
Micro Systems, Inc. (Synergetic), a provider of embedded network communication
solutions. In connection with the acquisition, the Company paid cash
consideration of $2.7 million and issued an aggregate of 2,234,715 shares of its
common stock in exchange for all outstanding shares of Synergetic common stock
and reserved 615,705 additional shares of common stock for issuance upon
exercise of outstanding employee stock options and other rights of Synergetic.
The transaction was exempt from registration pursuant to section 4 (2) of the
Securities Act of 1933, as amended. Portions of the cash consideration and
shares issued will be held in escrow pursuant to the terms of the acquisition
agreement. In connection with the acquisition, the Company will record a
one-time charge for purchased in-process research and development expenses
related to the acquisition in its second fiscal quarter ending December 31,
2001.

In October 2001, the Company purchased an additional $1.5 million
convertible promissory note from Xanboo. The note has a ten year maturity and
will automatically convert into the next round of equity securities of Xanboo
that raises at least $5.0 million. If Xanboo does not complete such a financing
prior to February 1, 2002, the Company can convert the note into a newly created
series of preferred stock of Xanboo.

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

You should read the following discussion and analysis in conjunction with
the Unaudited Condensed Consolidated Financial Statements and related Notes
thereto contained elsewhere in this Report. The information in this Quarterly
Report on Form 10-Q/A is not a complete description of our business or the risks
associated with an investment in our common stock. We urge you to carefully
review and consider the various disclosures made by us in this Report and in
other reports filed with the SEC, including our restated Annual Report on Form
10-K/A for the fiscal year ended June 30, 2001, our restated Quarterly Report on
Form 10-Q/A for the fiscal quarter ended December 31, 2001, and our subsequent
reports on Form 8-K, that discuss our business in greater detail.

We have restated our consolidated financial statements for the fiscal
quarter covered hereby and for our fiscal year ended June 30, 2001 and each
fiscal quarter therein in a Form 10-K/A filed in June 2002. To the extent
the following discussion and analysis refers to data from our consolidated
financial statements for such periods, such references are to the data as
restated.

The section entitled "Risk Factors" set forth below, and similar
discussions in our other SEC filings, discuss some of the important factors that
may affect our business, results of operations and financial condition. You
should carefully consider those factors, in addition to the other information in
this Report and in our other filings with the SEC, before deciding to invest in
our company or to maintain or increase your investment.

This report contains forward-looking statements which include, but are not
limited to, statements concerning projected net revenues, expenses, gross profit
and income (loss), the need for additional capital, market acceptance of our
products, our ability to consummate acquisitions and integrate their operations
successfully, our ability to achieve further product integration, the status of
evolving technologies and their growth potential and our production capacity.
These forward-looking statements are based on our current expectations,
estimates and projections about our industry, our beliefs, and certain
assumptions made by us. Words such as "anticipates," "expects," "intends,"
"plans," "believes," "seeks," "estimates," "may," "will" and variations of these
words or similar expressions are intended to identify forward-looking
statements. In addition, any statements that refer to expectations, projections
or other characterizations of future events or circumstances, including any
underlying assumptions, are forward-looking statements. These statements are not
guarantees of future performance and are subject to certain risks, uncertainties
and assumptions that are difficult to predict. Therefore, our actual results
could differ materially and adversely from those expressed in any
forward-looking statements as a result of various factors. We undertake no
obligation to revise or update publicly any forward-looking statements for any
reason.

Accounting Change and Restatement of Financial Statements

In originally preparing the condensed consolidated financial statements at
December 31, 2001, we changed our accounting method for recognizing revenue on
sales to distributors effective as of July 1, 2001, the beginning of fiscal
2002. Under the new accounting method, the recognition of revenue and related
gross profit on sales to distributors is deferred until the distributor resells
the product to an end customer. Formerly, we recognized revenue from these
transactions upon shipment of product to the distributor, net of estimates for
possible returns and allowances.

In May 2002, we undertook a special investigation of our accounting, which
revealed that beginning in the third and fourth quarters of fiscal 2001 certain
shipments made to distributors and recorded as revenues in fiscal 2001 and 2002
did not qualify for revenue recognition upon shipment due to terms present in
agreements with the distributors that were not considered in our original
accounting decisions. As a result, our new method of accounting for distributor
sales, which is based on recognizing revenue and related gross profit on sales
to distributors only as the distributor resells the product to end customers,
has been adopted effective as of July 1, 2000, the beginning of fiscal 2001, or
one year earlier. This manner of correcting the errors in sales recognition made
in previously issued financial statements for fiscal 2001 is deemed to be
preferable in the circumstances because (1) it eliminates from revenue any
effect of shipping excessive levels of inventory to the distributors; (2) all
revenue from distributor sales in fiscal 2001 and 2002 will be recognized on a
common basis; and (3) there is assurance that any additional agreements with
distributors that may have existed with respect to specific orders but are
presently unknown will not have an impact on amounts reported as revenue after
the restatement. The restatement for the year ended June 30, 2001, results in a
reduction in revenue of approximately $6.2 million and an increase in the loss
before cumulative effect of accounting change of $2.9 million or $0.07 per
share. The cumulative effect of the accounting change for the three months ended
September 30, 2000 recorded as of July 1, 2000 was a charge of $773,000 (net of
income tax benefit of $0) or $0.02 per share.

We believe that the new accounting method better reflects the substance of
the transactions considering our recent entry into the semiconductor marketplace
and the changing business environment; is consistent with other companies in our
industry

thereby providing greater comparability in the presentation of financial results
among us and our peers, and better focuses us on end customer sales.

In the special investigation conducted in May 2002, we also discovered
that (i) the terms and circumstances of certain sales made in the first six
months of fiscal 2002 to customers who were not distributors also preclude
revenue from being recognized upon shipment, as originally reported and (ii)
that certain amounts initially reported as other comprehensive income (loss)
should be accounted for as elements of net loss. Accordingly, in the
accompanying restated condensed consolidated financial statements, we have made
corrections to defer the recognition of such sales as revenue until all revenue
recognition criteria have been met and reclassify to other expense the amounts
improperly charged to other comprehensive income (loss). These corrections
result in a reduction in revenue of approximately $438,000 and an increase in
the loss before cumulative effect of accounting change of $123,000 or $0.00 per
share in the three months ended September 30, 2001.

Three Months Ended
September 30,
-------------
2001 2000
---- ----

As reported:
Net revenues ........................................................................... $ 16,269 $ 12,037
======== ========

Loss before cumulative effect of accounting change ..................................... $ (2,155) $ (23)
Cumulative effect of accounting change, net of income tax benefit of $1,049 ............ (2,557) -
-------- --------
Net loss ............................................................................... $ (4,712) $ (23)
======== ========

Loss per share before cumulative effect of accounting change ........................... $ (0.05) $ (0.00)
Cumulative effect of accounting change per share ....................................... (0.05) -
-------- --------
Basic and diluted net loss per share ................................................... $ (0.10) $ (0.00)
======== ========

As restated:
Net revenues ........................................................................... $ 16,269 $ 12,037
Corrections ............................................................................ (438) (393)
-------- --------
Net revenues, as restated .............................................................. $ 15,831 $ 11,644
======== ========

Loss before cumulative effect of accounting change ..................................... $ (2,155) $ (23)
Corrections, net of tax ................................................................ (123) (206)
-------- --------
Loss before cumulative effect of accounting change, as restated ........................ (2,278) (229)
Cumulative effect of accounting change, net of income tax benefit of $0, as restated ... - (773)
-------- --------
Net loss, as restated .................................................................. $ (2,278) $ (1,002)
======== ========

Loss per share before cumulative effect of accounting change, as restated .............. $ (0.05) $ (0.01)
Cumulative effect of accounting change per share, as restated .......................... - (0.02)
-------- --------
Basic and diluted net loss per share, as restated ...................................... $ (0.05) $ (0.03)
======== ========

* As reported information for the three months ended September 30, 2001
reflects the accounting change made in the second quarter of fiscal 2002,
but effective as of July 1, 2001 to defer revenue recognition of revenue
and related gross profit until the distributor resells the product to an
end customer.

Under the leadership of new management, we are actively working to
strengthen our policies, procedures, personnel, controls and internal
communications in response to the circumstances that led to the restatement.

Overview

Lantronix designs network-enabling and system management solutions
consisting of hardware and software that permit almost any electronic device to
be accessed, managed, controlled over the Internet, Intranets or other networks.
Since our inception in 1989, we have developed an array of network-enabling
products including external Device Servers, embedded Device Servers, Multiport
Device Servers, Print Servers and other products. Beginning in fiscal year 1999,
we began to experience an increase in sales of our Device Servers reflecting our
focus on this higher margin product line. At the same time, we began to
experience a decline in sales of Print Server and other products as we shifted
resources to our Device Server business, which we believe represents a greater
opportunity for long-term growth. We believe sales in our Device Server business
will continue to represent an increasing percentage of our net revenues in the
future. Our strategy for continuing to increase sales of our Device Server
product line involves a two-fold approach. First, we intend to substantially
increase our research and development expenditures to enhance our Device Server
product line and develop new products. Second, we intend to grow our

Device Server business through strategic acquisitions, investments and
partnerships, which we believe will support our product lines and allow us to
secure additional intellectual property, increase our customer base and provide
access to new markets.

Our products are sold to original equipment manufacturers (OEMs), value
added resellers (VARs), systems integrators and distributors, as well as
directly to end-users. One of our distributors, Ingram Micro, accounted for
12.6% of our net revenues for the three months ended September 30, 2001,
compared to 11.5% for the three months ended September 30, 2000. Another
distributor, Tech Data, accounted for 6.7% of our net revenues for the three
months ended September 30, 2001, compared to 15.2% for the three months ended
September 30, 2000. transtec AG, an international OEM and related party due to
common ownership by our Chairman and major stockholder, accounted for 3.3% of
net revenues for the three months ended September 30, 2001, compared to 6.6% for
the three months ended September 30, 2000.

On October 18, 2001, we completed the acquisition of Synergetic Micro
Systems, Inc. ("Synergetic"), a provider of embedded high performance network
communication solutions that complement our external device products. In
connection with the acquisition, we paid cash consideration of $2.7 million and
issued an aggregate of 2,234,715 shares of our common stock in exchange for all
outstanding shares of Synergetic common stock and reserved 615,705 additional
shares of common stock for issuance upon exercise of outstanding employee stock
options and other rights of Synergetic. Portions of the cash consideration and
shares issued will be held in escrow pursuant to the terms of the acquisition
agreement.

In September and October 2001, we purchased convertible promissory notes
from Xanboo totaling $3.0 million. The notes have ten year maturities and will
automatically convert into the next round of equity securities of Xanboo that
raises at least $5.0 million. If Xanboo does not complete such a financing prior
to February 1, 2002, we can convert the notes into a newly created series of
preferred stock of Xanboo. We are considering investing additional money in this
company as well as other companies.

Stock-based compensation primarily relates to deferred compensation
recorded in connection with the grant of stock options to employees where the
option exercise price is less than the estimated fair value of the underlying
shares of common stock as determined for financial reporting purposes, as well
as the fair market value (determined using the Black-Scholes option pricing
model) of the vested portion of non-employee stock options determined. Deferred
compensation also includes the value of employee stock options assumed in
connection with acquisitions of businesses calculated in accordance with current
accounting guidelines. Deferred compensation is presented as a reduction to
stockholders' equity and is amortized over the vesting period of the related
stock options, which is generally four years. At September 30, 2001, a deferred
compensation balance of $9.3 million remains and will be amortized as follows:
$2.2 million in the remainder of fiscal 2002, $3.0 million in fiscal 2003, $2.5
million in fiscal 2004, $1.4 million in fiscal 2005 and $153,000 in fiscal 2006.
The amount of stock-based compensation in future periods will increase if we
grant stock options where the exercise price is less than the quoted market
price of the underlying shares or if we assume employee stock options in
connection with additional acquisitions of businesses. The amount of stock-based
compensation actually recognized in future periods could decrease if options for
which deferred compensation has been recorded are forfeited.

Results of Operations

The following table sets forth certain statement of operations data expressed as
a percentage of total net revenues:

Three Months
Ended
September 30,
-------------
(Restated)
2001 2000
---- ----

Net revenues .............................................................. 100.0% 100.0%
Cost of revenues .......................................................... 47.6 45.0
------- --------
Gross profit .............................................................. 52.4 55.0
------- --------
Operating expenses:
Selling, general and administrative ................................. 47.9 44.3
Research and development ............................................. 13.2 9.0
Stock based-compensation ............................................. 7.4 5.6
Amortization of purchased intangible assets ......................... 1.8 1.7
------- --------
Total operating expenses .................................................. 70.3 60.6
------- --------
Loss from operations ...................................................... (17.9) (5.6)
Interest income (expense), net ............................................ 3.4 4.3
Other income (expense), net .............................................. (4.0) (0.6)
------- --------
Loss before income taxes and cumulative effect of accounting change ...... (18.5) (2.0)
Benefit for income taxes .................................................. (4.1) --
------- --------
Loss before cumulative effect of accounting change ........................ (14.4) (2.0)
Cumulative effect of accounting change, net of income taxes of $176 ....... -- (6.6)
------- --------
Net loss .................................................................. (14.4)% (8.6)%
======= ========

Net Revenues

Net revenues increased $4.2 million, or 36.0%, to $15.8 million for the
three months ended September 30, 2001 from $11.6 million for the three months
ended September 30, 2000. The increase was primarily attributable to an increase
in net revenues of our Multiport Device Server products, partially offset by a
decline in our Device Server, Print Server and other products. Multiport Device
Server net revenues increased $5.1 million, or 174.8%, to $8.0 million or 50.6%
of net revenues for the three months ended September 30, 2001 from $2.9 million
or 25.0% of net revenues for the three months ended September 30, 2000. The
increase in our Multiport Device Server net revenues is primarily attributable
to the acquisition of Lightwave Communications, Inc. ("Lightwave"). Device
Server net revenues decreased $574,000, or 7.4%, to $7.2 million or 45.4% of net
revenues for the three months ended September 30, 2001 from $7.8 million or
66.7% of net revenues for the three months ended September 30, 2000. Device
Server net revenues for the three months ended September 30, 2001 includes
$501,000 of software revenue generated from United States Software Corporation
("USSC"). No software revenue was recorded for the three months ended September
30, 2000. Print Server and other net revenues decreased $331,000, or 34.2%, to
$636,000, or 4.0% of net revenues for the three months ended September 30, 2001
from $966,000, or 8.3% of net revenues for the three months ended September 30,
2000. The decreases in our Print Server and other products net revenues are due
to an increasinghly rapid transition to our Multiport Device Server and Device
Server products.

Net revenues generated from sales in the Americas increased $5.4 million,
or 63.3%, to $13.9 million or 87.5% of net revenues for the three months ended
September 30, 2001 from $8.5 million or 72.9% of net revenues for the three
months ended September 30, 2000. Our net revenues derived from customers located
in Europe decreased $1.1 million, or 40.4%, to $1.5 million or 9.8% of net
revenues for the three months ended September 30, 2001 from $2.6 million or
22.3% of net revenues for the three months ended September 30, 2000. The
decrease in European sales is primarily due to the decrease in sell-through
revenue from our largest European distributor, which is due to the economic
downturn in Europe. Our net revenues derived from customers located in Europe as
a percentage of total net revenues decreased due to the acquisition of Lightwave
who primarily sells in the Americas. Our net revenues derived from customers
located in other geographic areas decreased slightly to $425,000 or 2.7% of net
revenues for the three months ended September 30, 2001 from $566,000 or 4.9% of
net revenues for the three months ended September 30, 2000.

The decrease in European sales is primarily due to the decrease in
sell-through revenue from our largest European distributor, which is due to the
economic downturn in Europe.

Gross Profit

Gross profit represents net revenues less cost of revenues. Cost of
revenues consists primarily of the cost of raw material components, subcontract
labor assembly from outside manufacturers and associated overhead costs.
Additionally, cost of revenues for the three months ended September 30, 2001
consisted of $338,000 of non-cash amortization of purchased intangible assets.
No charges were recorded for the three months ended September 30, 2000. We pay
Gordian, Inc., an outside research and development firm, a royalty based on the
sale of certain of our products. As a result, a royalty charge is included in
cost of revenues and is calculated based on the related products sold. Gross
profit increased by $1.9 million, or 29.4%, to $8.3 million or 52.4% of net
revenues for the three months ended September 30, 2001 from $6.4 million or
55.0% of net revenues for the three months ended September 30, 2000. For the
three months ended September 30, 2001 and 2000, Gordian royalties were $416,000
and $522,000, respectively. The increase in gross profit was mainly attributable
to the significant increase in the Multiport Device Server product. The decrease
in gross profit as a percentage of net revenues is primarily attributable to
non-cash amortization of acquisition related charges, volume-pricing agreements
and competitive pricing strategies.

Selling, General and Administrative

Selling, general and administrative expenses consist primarily of
personnel-related expenses including salaries and commissions, facility
expenses, information technology, trade show expenses, advertising, and
professional fees. Selling, general and administrative expenses increased $2.4
million, or 47.0%, to $7.6 million or 47.9% of net revenues for the three months
ended September 30, 2001 from $5.2 million or 44.3% of net revenues for the
three months ended September 30, 2000. This increase is due primarily to
depreciation of deployed fixed assets, increased personnel-related costs and
facilities costs from the acquisitions of USSC and Lightwave as well as hiring
of sales personnel, legal and other professional fees. We expect selling,
general and administrative expenses in absolute dollars will continue to
increase in the foreseeable future to support the global expansion of our
operations and decrease as a percentage of net revenues due to increased net
revenue.

Research and Development

Research and development expenses consist primarily of salaries and the
related costs of employees, as well as expenditures to third-party vendors for
research and development activities. Research and development expenses increased
$1.0 million, or 98.9%, to $2.1 million or 13.2% of net revenues for the three
months ended September 30, 2001 from $1.1 million or 9.0% of net revenues for
the three months ended September 30, 2000. This increase resulted primarily from
increased personnel- related costs due to the acquisition of USSC and Lightwave
as well as hiring of senior management and expenses related to new product
development.

Stock-based Compensation

Stock-based compensation generally represents the amortization of deferred
compensation. We recorded approximately $496,000 of deferred compensation for
the three months ended September 30, 2001 and a total of $4.2 million of
deferred compensation in fiscal 2001. Deferred compensation represents the
difference between the fair value of the underlying common stock for accounting
purposes and the exercise price of the stock options at the date of grant.
Deferred compensation is presented as a reduction of stockholders' equity and is
amortized ratably over the respective vesting periods of the applicable options,
which is generally four years. Stock-based compensation increased $520,000 or
79.8% to $1.2 million or 7.4% of net revenues for the three months ended
September 30, 2001 from $652,000 or 5.6% of net revenues for the three months
ended September 30, 2000. The increase in stock-based compensation primarily
reflects stock options assumed in two purchase transactions completed during
fiscal 2001 that were accounted for in accordance with the Financial Accounting
Standards Board ("FASB") Interpretation No. 44, "Accounting for Certain
Transactions Involving Stock Compensation--An Interpretation of APB Opinion No.
25." We expect to incur additional stock-based compensation in future periods as
a result of the continued amortization of deferred compensation related to these
and other stock option grants. Included in cost of revenues is stock-based
compensation of $27,000 and $11,000 for the three months ended September 30,
2001 and 2000, respectively.

Amortization of Purchased Intangible Assets

In connection with the two purchase transactions completed during fiscal
2001, we recorded approximately $12.1 million of identified purchased intangible
assets. Goodwill is recorded as the difference, if any, between the aggregate
consideration paid for an acquisition and the fair value of the net tangible and
intangible assets acquired. Generally, we obtain independent appraisals of the
fair value of tangible and intangible assets acquired in order to allocate the
purchase price. Purchased intangible assets are amortized on a straight-line
basis over the economic lives of the respective assets, generally three to five
years. The amortization of purchased intangible assets charged to operating
expenses increased $83,000 or 40.9%, to $286,000 or 1.8% of net revenues for the
three months ended September 30, 2001 from $203,000 or 1.7% of net revenues for
the three months ended September 30, 2000. In addition, approximately $338,000
of amortization of purchased intangible assets has been classified as cost of
revenue

for the three months ended September 30, 2001. No comparable amortization of
purchased intangible assets was classified as cost of revenue for the three
months ended September 30, 2000.

Interest Income (Expense), Net

Interest income (expense), net consists primarily of interest earned on
cash, cash equivalents, short-term and long-term investments. Interest income
(expense), net was $536,000 and $497,000 for the three months ended September
30, 2001 and 2000, respectively. The increase is primarily due to higher average
investment balances for the three months ended September 30, 2001 compared to
September 30, 2000, as a result of the proceeds from our secondary public
offering completed in July 2001.

Other Income (Expense), Net

Other income (expense), net consists primarily of the revaluation of a
strategic investment and the effects of exchange gains and losses from foreign
currency transactions. Other income (expense), net was $(628,000) and $(74,000)
for the three months ended September 30, 2001 and 2000, respectively. The
increase is primarily attributable to the $500,000 revaluation of a strategic
investment, less gains on foreign currency translation.

Provision for Income Taxes - Effective Tax Rate

We utilize the liability method of accounting for income taxes as set
forth in Financial Accounting Standards Board, or Statement of Financial
Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Our
effective tax rate was 22% for the three months ended September 30, 2001, and 0%
for the three months ended September 30, 2000. The federal statutory rate was
34% for both periods. Our effective tax rate associated with the income tax
benefit for the three months ended September 30, 2000, was lower than the
federal statutory rate primarily due to foreign losses and amortization of
stock-based compensation for which no current year tax benefit was provided. Our
effective tax rate associated with the income tax benefit for the three months
ended September 30, 2000, was lower than the statutory rate primarily due to the
nondeductible goodwill amortization, amortization of stock-based compensation
for which no benefit was provided, and the effects of an unfavorable foreign tax
rate variance.

Impact of Adoption of New Accounting Standards

In June 2001, the FASB issued SFAS No. 141, "Business Combinations"
("SFAS No. 141"), effective for acquisitions consummated after June 30, 2001,
and SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"),
effective for fiscal years beginning after December 15, 2001. Under the new
rules, goodwill and certain intangible assets deemed to have indefinite lives
will no longer be amortized but will be subject to annual impairment tests.
Other intangible assets will continue to be amortized over their useful lives.

We have elected to early adopt the rules set forth in SFAS No. 142 on
accounting for goodwill and other intangibles effective as of July 1, 2001. For
the three months ended September 30, 2001, early adoption resulted in
non-amortization of goodwill of $1.7 million or $0.03 per share based on the
weighted average shares outstanding for the three months ended September 30,
2001.

The transition provisions of SFAS No. 142 require that we complete our
assessment of whether impairment may exist as of the date of adoption by
December 31, 2001 and complete our determination of the amount of any impairment
as of the date of adoption by June 30, 2002. Any impairment that is required to
be recognized when adopting SFAS No. 142 will be reflected as the cumulative
effect of a change in accounting principle as of July 1, 2001. We have completed
our initial assessment and concluded that goodwill arising from the acquisition
of USSC having a carrying amount of approximately $5.4 million as of July 1,
2001 may be impaired. We expect to complete our determination of the amount of
the impairment charge, if any, to be reflected as a cumulative effect of a
change in accounting principle during the fourth fiscal quarter ending June 30,
2002.

We intend to perform the first of the required annual impairment tests of
goodwill under the guidelines of SFAS No. 142 effective as of April 1, 2002. We
have not yet determined the effect, if any, that this test will have on our
consolidated statement of operations or financial position. An impairment
charge, if any, identified as a result of completing our annual impairment test
will be reflected as an operating expense in the fourth quarter of fiscal 2002.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets", which supersedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of" ("SFAS No. 121") and the accounting and reporting provisions of
Accounting Principles Board Opinion No. 30, "Reporting the Results of
Operations-Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions." This
statement retains certain requirements of SFAS No. 121 relating to the
recognition and measurement of impairment of long-lived assets to be held and
used. Additionally, this statement results in one accounting model,

based on the framework established in SFAS No. 121, for long-lived assets to be
disposed of by sales and also addresses certain implementation issues related to
SFAS No. 121, including the removal of goodwill from its scope due to the
issuance of SFAS No. 142. SFAS No. 144 is effective for fiscal years beginning
after December 15, 2001, and interim periods within those fiscal years. We have
not yet determined the effect, if any, on the carrying value of our long-lived
assets resulting from the adoption of SFAS No. 144.

Liquidity and Capital Resources

Since inception, we have financed our operations through the issuance of
common stock and through net cash generated from operations. We consider all
highly liquid investments purchased with original maturities of 90 days or less
to be cash equivalents. Cash and cash equivalents consisting of money-market
funds and commercial paper totaled $58.2 million at September 30, 2001. Short-
term investments consist of investments maturing in twelve months or less and
totaled $2.0 million at September 30, 2001. Long-term investments consist of
investments in two privately held companies and totaled $3.3 million at
September 30, 2001.

Our operating activities used cash of $1.7 million for the three months
ended September 30, 2001. We incurred a net loss of $2.3 million, which includes
amortization and depreciation of $1.2 million, amortization of stock-based
compensation of $1.2 million, the revaluation of a strategic investment of
$500,000 and equity losses from investments of $294,000, offset by increased
deferred income taxes of $450,000, all of which are non-cash. This was reduced
by increased accounts receivable of $2.6 million, and increased prepaid expenses
and other current assets of $877,000 offset by a decrease in inventory of
$388,000 and prepaid income taxes of $430,000. The increase in accounts
receivable was due to increased sales in the last month of the quarter as well
as slower collections from some of our U.S. distributors and European customers
and extended payment terms. The increase in prepaid expenses and other current
assets is primarily attributable to a deposit to secure inventory. We decreased
our inventory as we transition from procuring our own raw materials to having
our contract manufacturers procure our raw materials. Our operating activities
used cash of $2.5 million for the three months ended September 30, 2000.

Our investing activities used $3.0 million of cash for the three months
ended September 30, 2001. We used $1.5 million of our public offering proceeds
to purchase a note with a ten year maturity that will automatically convert into
the next round of equity securities of Xanboo. We also used cash to purchase
property and equipment, primarily computer hardware and software of $1.3 million
pertaining to Oracle software enhancements, support of our international
operations and a software package to support our sales force. Our investing
activities used cash of $1.2 million for the three months ended September 30,
2000, primarily related to the purchase of property and equipment.

Cash provided by financing activities was $47.5 million for the three
months ended September 30, 2001, primarily related to the net proceeds from our
secondary public offering completed in July 2001. Cash provided by financing
activities was $54.3 million for the three months ended September 30, 2000,
primarily related to the net proceeds from our initial public offering on August
4, 2000.

We intend to use a portion of the proceeds from our recent public offering
to substantially increase our research and development activities. Specific
amounts allocated to future research and development and sales and marketing
expenditures will be budgeted based upon market conditions existing at that
time.

We believe that our existing cash, cash equivalents and short-term
investments and any available borrowings under our line of credit facility 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 and research and development and
infrastructure investments as well as our intentions to make strategic
acquisitions or investments in other companies, which will affect our ability to
generate additional cash. If cash generated from operations and financing
activities is insufficient to satisfy our working capital requirements, we may
need to borrow funds through bank loans, sales of securities or other means.
There can be no assurance that we will be able to raise any such capital on
terms acceptable to us, if at all. If we are unable to secure additional
financing, we may not be able to develop or enhance our products, take advantage
of future opportunities, respond to competition or continue to operate our
business.

Risk Factors

You should carefully consider the risks described below before making an
investment decision. The risks and uncertainties described below are not the
only ones facing our company. Our business operations may be impaired by
additional risks and uncertainties that we do not know of or that we currently
consider immaterial.

Our business, results of operations or cash flows may be adversely affected
if any of the following risks actually occur. In such case, the trading price of
our common stock could decline, and you may lose all or part of your investment.

Variations in quarterly operating results, due to factors including changes
in demand for our products and changes in our mix of net revenues, could cause
our stock price to decline.

Our quarterly net revenues, expenses and operating results have varied in
the past and might vary significantly from quarter to quarter in the future. 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
price. Our short-term expense levels are relatively fixed and are based on our
expectations of future net revenues. If we were to experience a reduction in net
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 quarter
would be harmed. If our operating results in future 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 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;

. short-term fluctuations in the cost or availability of our critical
components, such as flash memory;

. changes in demand for our products generally;

. loss of significant customers;

. announcements or introductions of new products by our competitors;

. defects and other product quality problems; and

. changes in demand for devices that incorporate our connectivity
products.

If we make unprofitable acquisitions or are unable to successfully
integrate any future acquisitions, our business could suffer.

We have in the past and intend to continue in the future to acquire
businesses, client lists, products or technologies that we believe complement or
expand our existing business. In October 1998, we acquired ProNet GmbH, a German
supplier of industrial application Device Server technology. In December 2000,
we acquired USSC, a company that provides software solutions for use in embedded
technology applications. In June 2001, we acquired Lightwave, a company that
provides console management solutions. In October 2001, we acquired Synergetic,
a provider of embedded network communication solutions. We have also announced
that we may acquire Premise Systems, a developer of client-side software
applications. Acquisitions of this type involve a number of risks, including:

. difficulties in assimilating the operations and employees of acquired
companies;

. diversion of our management's attention from ongoing business
concerns;

. our potential inability to maximize our financial and strategic
position through the successful incorporation of acquired technology
and rights into our products and services;

. additional expense associated with amortization of acquired assets;

. maintenance of uniform standards, controls, procedures and policies;
and

. impairment of existing relationships with employees, suppliers and
customers as a result of the integration of new management employees.

Any acquisition or investment could result in the incurrence of debt and
the loss of key employees. Moreover, we often assume specified liabilities of
the companies we acquire. Some of these liabilities, such as environmental and
tort liabilities, are difficult or impossible to quantify. If we do not receive
adequate indemnification for these liabilities our business may be harmed. In
addition, acquisitions are likely to result in a dilutive issuance of equity
securities. For example, we issued common stock and

assumed options to acquire our common stock in connection with our acquisitions
of USSC, Lightwave and Synergetic. We cannot assure you that any acquisitions or
acquired businesses, client lists, products or technologies associated therewith
will generate sufficient net revenues to offset the associated costs of the
acquisitions or will not result in other adverse effects. Moreover, from time to
time we may enter into negotiations for the acquisition of businesses, client
lists, products or technologies, but be unable or unwilling to consummate the
acquisition under consideration. This could cause significant diversion of
managerial attention and out of pocket expenses to us. We could also be exposed
to litigation as a result of an unconsummated acquisition, including claims that
we failed to negotiate in good faith, misappropriated confidential information
or other claims.

In addition, from time to time we intend to invest in businesses that we
believe present attractive investment opportunities, or provide other synergetic
benefits. For example, in March 2001, we purchased 283,476 shares of Series A
Preferred Stock of Premise Systems for $2.0 million. In September and October
2001, we paid an aggregate of $3.0 million to Xanboo Inc. for notes with ten
year maturities that are convertible into equity securities of Xanboo. These
investments are speculative in nature, and there is a significant chance we will
lose part or all of our investments.

Terrorist attacks or threats or attacks, and business interruptions caused
by such attacks, natural disasters and electrical blackouts in the state of
California, could adversely affect our business.

Interruptions in business as a result of actual or threatened terrorist
attacks or military action could disrupt our operations in the United States and
worldwide. Disruptions could include, but are not limited to, physical damage to
our facilities, and disruptions caused by trade restrictions imposed by the
United States or foreign governments. In addition, a general economic downturn
in any of our target markets or general disruption of the financial markets
caused by such attacks could substantially harm our business. Moreover, our
operations are vulnerable to interruption by fire, earthquake, power loss,
telecommunications failure and other events beyond our control. We do not have a
detailed disaster recovery plan. Our facilities in the State of California may
be subject to electrical blackouts as a consequence of a shortage of available
electrical power. In the event these blackouts continue or increase in severity,
they could disrupt the operations of our affected facilities.

Stock-based compensation will negatively affect our operating results.

We have recorded deferred compensation in connection with the grant of
stock options to employees where the option exercise price is less than the
estimated fair value of the underlying shares of common stock as determined for
financial reporting purposes. We have recorded deferred compensation net of
forfeitures within stockholders' equity of $496,000 at September 30, 2001 and a
total of $14.2 million of deferred compensation through fiscal 2001, which is
being amortized over the vesting period of the related stock options, which is
generally four years. A balance of $9.3 million remains at September 30, 2001
and will be amortized as follows: $2.2 million in the remainder of fiscal 2002,
$3.0 million in fiscal 2003, $2.5 million in fiscal 2004, $1.4 million in fiscal
2005, and $153,000 in fiscal 2006.

The amount of stock-based compensation in future periods will increase if
we grant stock options where the exercise price is less than the quoted market
price of the underlying shares. The amount of stock-based compensation
amortization in future periods could decrease if options for which accrued, but
unvested deferred compensation has been recorded are forfeited.

We intend to continue to devote significant resources to our research and
development, which, if not successful, could cause a decline in our revenues and
could harm our business.

We intend to continue to devote significant resources to research and
development in the coming years to enhance and develop additional products. For
the three months ended September 30, 2001, research and development expenses
comprised 13.2% of our net revenues. If we are unable to develop new products as
a result of this effort, 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 revenue from these
products will be sufficient to justify our investment in research and
development.

Net revenues from our legacy products, which include our Print Servers,
switches, hubs and other products, have decreased significantly and we expect
that net revenues from these lines of products will continue to decline in the
future as we focus our efforts on the development of other product lines.

Since 1993, net revenues from our legacy products have accounted for a
significant portion of our net revenues but have declined significantly
recently. For example, revenues from our legacy products were approximately
$636,000 or 4.0% of our net revenues, compared to $966,000 or 8.3% of our total
net revenues for the three months ended September 30, 2001 and 2000,
respectively. We anticipate that net revenues from our legacy products will
continue to decline in the future as we plan to continue to focus on the
development of our current Device Server and Multiport Device Server product
lines. We do not know if this transition in product development will be
successful. We do not know whether our new product lines will be accepted by our

current and future target markets to the extent we anticipate. If the expected
decline in net revenues attributable to our legacy products is not offset by
increases in net revenues from our Device Server and Multiport Device Server
lines of product, our business could be harmed.

There is a risk that our OEM customers will develop their own internal
expertise in network-enabling products, which could result in reduced sales of
our products.

For most of our existence we primarily sold our products to VARs, system
integrators and OEMs. Although we intend to continue to use all of these sales
channels, we have begun to focus more heavily on selling our products to OEMs.
Selling products to OEMs involves unique risks, including the risk that OEMs
will develop internal expertise in network-enabling products or will otherwise
provide network functionality to their products without using our Device Server
Technology. If this were to occur, our stock price could decline in value and
you could lose part or all of your investment.

We might be unable to manage our growth, and if we cannot do so, our
business could be harmed.

Our business has grown rapidly. At September 30, 2001, we had 249 employees
and as of September 30, 2000 we had 158 employees. In addition, we have
experienced expansion in our manufacturing and shipping requirements, our
product lines and our customer base. This rapid expansion has placed significant
strain on our administrative, operational and financial resources. These changes
have increased the complexity of managing our company. Our current systems,
management and other resources will need to grow rapidly in order to meet the
demands of any future growth. If we are unable to successfully expand and
improve our systems as required, or if we are otherwise unable to manage any
future growth, our business will be harmed.

New product introductions and pricing strategies by our competitors could
adversely affect our ability to sell our products and could reduce our market
share or result in pressure to reduce the price of our products.

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, 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 offer an open
architecture, 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. See Competition.

We primarily depend on three third-party manufacturers to manufacture all
of our products, which reduces our control over the manufacturing process. If
these manufacturers are unable or unwilling to manufacture our products at the
quality and quantity we request, our business could be harmed and our stock
price could decline.

We primarily outsource all of our manufacturing to three third-party
manufacturers, APW, Inc., Irvine Electronics and Express Manufacturing. We have
only recently entered into relationships with APW, Inc. and Irvine Electronics,
and we intend to transition a significant portion of our workload to these
manufacturers during approximately the next six months. 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 third-party 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 in required volumes, at acceptable quality,
quantity, yields and costs, or in a timely manner, our business would be
seriously harmed. We may also experience unforeseen problems as we attempt to
transition a significant portion of our manufacturing requirements to APW, Inc.
and Irvine Electronics. We do not have a significant operating history with
either of these entities and if these entities are unable to provide us with
satisfactory service, or we are unable to successfully complete the transition,
our operations could be interrupted. 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.
In addition, a natural disaster could disrupt our manufacturers' facilities and
could inhibit our manufacturers' ability to provide us with manufacturing
capacity on a timely basis, 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. In addition, we are responsible for
forecasting the demand for our individual products by regional location. 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 expedite charges which would
increase our cost of sales or we may be unable to fulfill customer orders thus
reducing net revenues and therefore earnings.

Inability or delays in deliveries from our component suppliers could damage
our reputation and could cause our net revenues to decline and harm our results
of operations.

Our contract manufacturers and we 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 available from a single source. From time to
time in the past, integrated circuits we use in our products have been 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 rely on a number of different component suppliers. Because we do
not have long-term supply arrangements with any vendor 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.

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

Our top five customers accounted for 30.6% and our top ten customers
accounted for 37.0% of our net revenues for the three months ended September 30,
2001. Ingram Micro, a domestic distributor, accounted for 12.6% of our net
revenues for the three months ended September 30, 2001. The number and timing of
sales to our customers have been difficult for us to predict. For the three
months ended September 30, 2001, large individual sales have occurred in the
last weeks or even days of a quarter, which has resulted in a substantial
portion of the net revenues for that quarter being realized in the last month of
the quarter. The loss or deferral of one or more significant sales 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 and the growth of our business 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 Server Technology. Our sales are usually completed on a
purchase order basis and we have no long-term purchase commitments from our
customers.

Our future success also depends on our ability to attract new customers,
which often involves an extended process. The sale of our products often
involves a significant technical evaluation, and we often face delays because of
our customers' internal procedures used to evaluate and deploy 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 on a timely basis or at all. This would cause our net revenues to
decrease and could cause the price of our stock to decline.

The average selling prices of our products might decrease, which could
reduce our gross margins.

In the past, we have experienced some reduction in the average selling
prices of products and we expect that this will continue for our products as
they mature. In the future, we expect competition to increase, and we anticipate
this could result in additional pressure on our pricing. In addition, 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. Average selling
prices and gross margins for our products also might decline as the products
mature in their life cycles. In addition, we might not be able to increase the
price of our products in the event that the price of components or our overhead
costs increase. If this were to occur, our gross margins would decline.

We might become involved and are currently involved in litigation over
proprietary rights, which could be costly and time consuming.

Substantial litigation regarding intellectual property rights exists in our
industry. There is a risk that third-parties, including current and potential
competitors, current developers of our intellectual property, our manufacturing
partners, or parties with which we have contemplated a business combination will
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 infringe on the proprietary rights we use.
Any of these third parties might make a claim of infringement against us.

From time to time we have received letters claiming that our products
infringe upon patents or other intellectual property of third-parties. On July
3, 2001, Digi International, Inc. filed a complaint against us in the United
States District Court for the District of Minnesota claiming patent infringement
and alleging that certain of our Multiport Device Servers, specifically our ETS
line of products, when coupled with a device driver called the Comm Port
Redirector, infringe upon U.S. Patent No. 6,047,319 owned by Digi. Digi alleges
that Lantronix has willfully and intentionally infringed Digi's patent, and its
complaint seeks injunctive relief as well as unspecified damages, treble
damages, attorneys fees, interest and costs. On August 17, 2001, Lantronix filed
its answer to the complaint, asserting affirmative defenses, and counterclaiming
for a declaratory judgment that the patent in issue is invalid. To date
discovery has not begun and a trial date has not been set. Based on the facts
known to date, Lantronix believes that the claims are without merit and intends
to vigorously defend this suit.

Although we believe that the claims or any litigation arising there from
will have no material impact on us or our business, the litigation is in the
preliminary stage, and we cannot predict its outcome with certainty. The
litigation process is inherently uncertain and we may not prevail. Patent
litigation is particularly complex and can extend for a protracted time, which
can substantially increase the cost of such litigation. The Digi litigation will
likely divert the efforts and attention of some of our key management and
technical personnel. Should the outcome of the litigation be adverse to us, we
would be required to pay monetary damages to Digi and we could be enjoined from
selling those of our products found to infringe Digi's patent unless and until
we are able to negotiate a license from Digi which may not be available on
acceptable terms or at all. If we are required to pay significant monetary
damages, are enjoined from selling any of our products or are required to make
substantial royalty payments pursuant to any such license agreement, our
business would be harmed. This litigation, or other similar litigation brought
by us or others, could result in the expenditure of significant financial
resources and the diversion of management's time and efforts.

In addition, from time to time we could encounter other disputes over
rights and obligations concerning intellectual property. We cannot assume that
we will prevail in intellectual property disputes regarding infringement,
misappropriation or other disputes. Litigation in which we are accused of
infringement or misappropriation might cause a delay in the introduction of new
products, require us to develop non-infringing technology, require us to enter
into royalty or license agreements, which might not be available on acceptable
terms, or at all, or require us to pay substantial damages, including treble
damages if we are held to have willfully infringed. In addition, we have
obligations to indemnify certain of our customers under some circumstances for
infringement of third-party intellectual property rights. If any claims from
third-parties were to require us to indemnify customers under our agreements,
the costs could be substantial, and our business could be harmed. If a
successful claim of infringement were made against us and we could not develop
non-infringing technology or license the infringed or similar technology on a
timely and cost-effective basis, our business could be significantly harmed.

If our agreement with Gordian, Inc. is terminated, we could lose the rights
to valuable intellectual property.

Gordian, Inc. developed intellectual property used in our Micro Serial
Server, or MSS, Print Servers and ETS and LRS lines of Multiport Device Server
products. These products represent a substantial portion of our net revenues.
Under the terms of an agreement dated February 29, 1989 between Gordian and us,
Gordian owns the rights to the intellectual property developed by it. The
agreement with Gordian currently provides that we are required to pay royalties
based on the gross margin of products sold under the agreement. For the three
months ended September 30, 2001 and 2000, we paid Gordian approximately $416,000
and $522,000 in royalties, respectively. In the event that the Gordian agreement
is terminated, we could lose our rights to the intellectual property developed
under the Gordian agreement and this might prevent us from marketing some or all
of our MSS line of products in the future. If the Gordian contract is cancelled,
we could lose customers and net revenues, which would harm our business.

Because we are dependent on international sales for a substantial amount of
our net revenues, we face the risks of international business and associated
currency fluctuations, which might adversely affect our operating results.

Net revenues from international sales represented 12.5% and 27.2% of net
revenues for the three months ended September 30, 2001 and 2000, respectively.
Net revenues from Europe represented 9.8% and 22.3% of our net revenues for the
three months ended September 30, 2001 and 2000, respectively.

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 additional risks. For
example, because the products we sell abroad and the products and services we
buy abroad are priced in foreign currencies, we are affected by fluctuating
exchange rates. In the past, we have from time to time 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 face other risks of doing business internationally, 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;

. changes in a country's or region's political or economic conditions;

. 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.

Our executive officers and technical personnel are critical to our
business, and without them we might not be able to execute our business
strategy.

Our financial performance depends substantially on the performance of our
executive officers and key employees. We are dependent in particular on
Frederick G. Thiel, who serves as our President and Chief Executive Officer, and
Steven V. Cotton, who serves as our Chief Operating Officer and Chief Financial
Officer. We are also dependent upon our technical personnel, due to the
specialized technical nature of our business. If we lose the services of Mr.
Thiel, Mr. Cotton or any of our key personnel and are 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.

We might be unable to hire and retain the skilled personnel necessary to
develop our operations, sales, technical and support capabilities in order to
continue to grow, which could harm our business.

Our business cannot continue to grow if we do not hire and retain qualified
technical personnel. Competition for these individuals is intense, and we might
not be able to attract, assimilate or retain highly qualified technical
personnel in the future. In addition, we need to continue to hire and retain
operations, sales and support personnel. Our failure to attract and retain
highly trained personnel in these areas might limit the rate at which we can
develop, which would harm our business.

The market for our products is new and rapidly evolving. If we are not able
to develop or enhance our products to respond to changing market conditions, our
net revenues will suffer.

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. The demand for network-enabled products
is relatively new and can change as a result of innovations or changes. For
example, industry segments might adopt new or different standards, giving rise
to new customer requirements. Any failure by us to develop and introduce new
products or enhancements directed at new industry standards could harm our
business, financial condition and results of operations. These customer
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 revenue might not grow at the rate we
anticipate, or could decline.

Undetected product errors or defects could result in loss of net revenues,
delayed market acceptance and claims against us.

We currently offer warranties ranging from 90 days to five 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. Because of our recent introduction of our line of
Device Servers, we do not have a long history with which to assess the risks of
unexpected product failures or defects for this 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.

Our intellectual property protection might be limited.

We do not rely on patents to protect our proprietary rights. We do rely 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
of marks that precede the registration of our marks;

. 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;

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

. the companies we acquire may not have taken similar precautions to
protect their proprietary rights.

Also, the laws of other countries in which we market our products might
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, which could significantly harm our business.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

There has not been any material change in our exposure to interest rate and
foreign currency risks since the date of our Annual Report on Form 10-K/A for
the year ended June 30, 2001.

Interest Rate Risk. Our exposure to interest rate risk is limited to the
exposure related to our cash, cash equivalents, short-term investments and our
credit facilities, which are tied to market interest rates. As of September 30,
2001, we had cash, cash equivalents and short-term investments of $60.2 million,
which consisted of both domestic and foreign cash, cash equivalents and
short-term investments. We believe our short term investments will decline in
value by an insignificant amount if interest rates increase, and therefore would
not have a material effect on our financial condition or results of operations.

Foreign Currency Risk. We sell products internationally. As a result, our
financial results could be harmed by factors such as changes in foreign currency
exchange rates or weak economic conditions in foreign markets.

Investment Risk. At September 30, 2001 our investments in two privately
held companies totaled $3.3 million, both of which can still be considered in
the start-up or development stages. These investments are inherently risky as
the market for the technologies or products they have under development are
typically in the early stages and may never materialize. We could lose our
entire initial investment in these companies.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Item 2. Changes in Securities and Use of Proceeds

In July 2001, we completed a public offering of 8,534,000 shares of our
common stock, including an underwriter's over-allotment option to purchase an
additional 534,000 shares, at an offering price of $8.00 per share. The Company
sold 6,000,000 shares and selling stockholders sold 2,000,000 shares of the
primary offering. Additionally, we sold 400,500 shares and selling stockholders
sold 133,500 shares of the over-allotment option. We received net proceeds of
approximately $47.1 million in connection with this offering.

In August 2001, we began negotiations with the former owners of U.S.
Software to remove the earn-out provisions of the merger agreement in exchange
for the issuance of a specified number of shares of our stock to the former
owners of U.S. Software. In August 2001, in order to eliminate an employee bonus
arrangement related to the acquisition, we issued 250,000 stock options to
employees who were not former owners of U.S. Software. The issuance of these
stock options was unrelated to and did not remove the earn-out provisions of the
merger agreement. The estimated value of $500,000 related to these stock options
will be accounted for as compensation expense over the vesting period of the
options of up to four years.

On October 18, 2001, we completed the acquisition of Synergetic Micro
Systems, Inc. (Synergetic), a provider of embedded network communication
solutions. In connection with the acquisition, we paid cash consideration of
$2.7 million and issued an aggregate of 2,234,715 shares of our common stock in
exchange for all outstanding shares of Synergetic common stock and reserved
615,705 additional shares of common stock for issuance upon exercise of
outstanding employee stock options and other rights of Synergetic. The
transaction was exempt from registration pursuant to section 4(2) of the
Securities Act of 1933, as amended. Portions of the cash consideration and
shares issued will be held in escrow pursuant to the terms of the acquisition
agreement as well as various employee share repurchase agreements. In connection
with the acquisition, we will record a one- time charge for purchased in-process
research and development expenses related to the acquisition in our second
fiscal quarter ending December 31, 2001.

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 and Reports on Form 8-K

(a) Exhibits

Exhibit
Number Description of Document

2.1* Agreement and Plan of Reorganization by and among Lantronix, Inc.,
S Company Acquisition Corporation, and Synergetic Micro Systems,
Inc.

* Incorporated by reference to exhibit 5.1 previously filed with
Lantronix's Report on Form 8-K, originally filed September 20, 2001.

(b) Reports on Form 8-K

Date Item Reported On

September 20, 2001 Lantronix announced it had entered into an agreement to
acquire Synergetic Micro Systems, Inc.

SIGNATURES

Pursuant to the requirements of the Securities Act of 1934, as amended,
Lantronix has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Irvine, State of
California, on the 24 day of June, 2002

LANTRONIX, INC.

By: /s/ James Kerrigan
------------------------------------------
James Kerrigan
Interim Chief Financial Officer