OVERLAND STORAGE INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2003

Commission File Number: 000-22071

OVERLAND STORAGE, INC.

(Exact name of registrant as specified in its charter)

California		95-3535285
(State or other jurisdiction of incorporation)		(IRS Employer Identification No.)

4820 Overland Avenue, San Diego, California 92123-1599

(Address of principal executive offices, including zip code)

(858) 571-5555

(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 ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

As of November 5, 2003, there were 13,303,076 shares of the registrant’s common stock, no par value, issued and outstanding.

OVERLAND STORAGE, INC.

FORM 10-Q

For the quarterly period ended September 30, 2003

Table of Contents

PART I -	FINANCIAL INFORMATION

Item 1.	Financial Statements:

	Consolidated Condensed Statement of Operations — Three months ended September 30, 2003 and 2002

	Consolidated Condensed Balance Sheet — September 30, 2003 and June 30, 2003

	Consolidated Condensed Statement of Cash Flows — Three months ended September 30, 2003 and 2002

	Notes to Consolidated Condensed Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

PART II -	OTHER INFORMATION

Item 1.	Legal Proceedings

Item 6.	Exhibits and Reports on Form 8-K

	Signature

PART I — FINANCIAL INFORMATION

Item 1. — Financial Statements

OVERLAND STORAGE, INC.
CONSOLIDATED CONDENSED STATEMENT OF OPERATIONS
(Unaudited)
(In thousands, except per share data)

	Three Months Ended September 30,
	2003			2002
Net revenues:
Product sales	$	56,139		$	33,994
Royalties & services	430			546
Total net revenues	56,569			34,540

Cost of revenues	40,992			25,528
Gross profit	15,577			9,012

Operating expenses:
Sales and marketing	7,851			6,051
Research and development	1,810			1,694
General and administrative	2,582			2,151
Total operating expenses	12,243			9,896
Income (loss) from operations	3,334			(884		)

Other income (expense):
Interest income, net	96			68
Other expense, net	(10		)	(34		)

Income (loss) before income taxes	3,420			(850		)
Provision (benefit) for income taxes	1,197			(293		)

Net income (loss)	$	2,223		$	(557	)

Earnings (loss) per share:
Basic	$	0.17		$	(0.05	)
Diluted	$	0.16		$	(0.05	)

Number of shares used in computing earnings (loss) per share:
Basic	12,972			11,024
Diluted	14,178			11,024

See accompanying notes o consolidated condensed financial statements.

OVERLAND STORAGE, INC.
CONSOLIDATED CONDENSED BALANCE SHEET
(In thousands)

	September 30, 2003			June 30, 2003
	(unaudited)
ASSETS:
Current assets:
Cash and cash equivalents	$	53,595		$	55,020
Accounts receivable, less allowance for doubtful accounts of $272 and $413, respectively	34,532			31,850
Inventories	18,402			19,262
Deferred income taxes	4,351			4,351
Other current assets	2,933			2,461
Total current assets	113,813			112,944

Property and equipment, net	8,061			8,171
Intangible assets	8,534			8,983
Other assets	901			824
	$	131,309		$	130,922

LIABILITIES AND SHAREHOLDERS’ EQUITY:
Current liabilities:
Accounts payable	$	13,942		$	15,546
Accrued liabilities	5,312			4,526
Accrued payroll and employee compensation	2,966			3,194
Income taxes payable	1,084			2,292
Accrued warranty	2,095			2,129
Current portion of long-term debt	1,009			931
Total current liabilities	26,408			28,618

Long-term debt	2,715			3,026
Deferred tax liabilities	4,091			4,091
Other liabilities	2,227			1,923
Total liabilities	35,441			37,658

Shareholders’ equity:
Common stock, no par value, 25,000 shares authorized; 12,996 and 12,959 shares issued and outstanding, respectively	64,261			63,884
Accumulated other comprehensive loss	(188		)	(192		)
Retained earnings	31,795			29,572
Total shareholders’ equity	95,868			93,264
	$	131,309		$	130,922

See accompanying notes to consolidated condensed financial statements.

OVERLAND STORAGE, INC.
CONSOLIDATED CONDENSED STATEMENT OF CASH FLOWS
(Unaudited)
(In thousands)

	Three Months Ended September 30,
	2003			2002
OPERATING ACTIVITIES:
Net income (loss)	$	2,223		$	(557	)
Adjustments to reconcile net income (loss) to cash used in operating activities:
Depreciation and amortization	1,040			582
Changes in operating assets and liabilities:
Accounts receivable	(2,682		)	(884		)
Inventories	860			10
Accounts payable and accrued liabilities	(2,059		)	247
Accrued payroll and employee compensation	(228		)	(155		)
Other, net	(246		)	(1,216		)

Net cash used in operating activities	(1,092		)	(1,973		)

INVESTING ACTIVITIES:
Capital expenditures	(481		)	(189		)

Net cash used in investing activities	(481		)	(189		)

FINANCING ACTIVITIES:
Payments on long-term debt	(233		)	—
Proceeds from the exercise of stock options and the sale of stock under the employee stock purchase plan	377			211

Net cash provided by financing activities	144			211

Effect of exchange rate changes on cash	4			8

Net decrease in cash and cash equivalents	(1,425		)	(1,943		)
Cash and cash equivalents at the beginning of the period	55,020			26,884

Cash and cash equivalents at the end of the period	$	53,595		$	24,941

See accompanying notes to consolidated condensed financial statements.

OVERLAND STORAGE, INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Unaudited)

Note 1 — Basis of Presentation

The accompanying condensed consolidated financial statements of Overland Storage, Inc. and its subsidiaries (“Overland Storage” or the “Company”) have been prepared without audit pursuant to the rules and regulations of the Securities and Exchange Commission for Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, these statements reflect all normal recurring adjustments necessary for a fair presentation of the financial position, results of operations and cash flows for all periods presented. The results of operations for such periods are not necessarily indicative of the results expected for the full fiscal year. Our first fiscal quarter ends on the Sunday closest to September 30. For ease of presentation, our first fiscal quarter end is deemed to be September 30. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2003 on file with the Securities and Exchange Commission.

Certain prior period amounts have been reclassified to conform to the current year presentation.

Note 2 – Accounting for Stock-Based Compensation

The Company accounts for employee stock-based compensation using the intrinsic value method. In most cases, the Company does not recognize compensation expense for its employee stock option grants, as they have been granted at the fair market value of the underlying Common Stock at the grant date. Similarly, the Company has not recognized compensation expense for purchase rights under its qualified Employee Stock Purchase Plan, or ESPP, as the Plan is considered non-compensatory. Had compensation expense for the Company’s employee stock-based compensation awards been determined based on the fair value at the grant date for awards through September 30, 2003 consistent with the provisions of SFAS No. 123, its after-tax net income and after-tax net income per share would have been reduced to the pro forma amounts indicated below (in thousands, except net income per share):

	Three Months Ended September 30,
	2003			2002
	(unaudited)

Net income (loss), as reported	$	2,223		$	(557	)
Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	(1,599		)	(1,105		)
Pro forma net income (loss)	$	624		$	(1,662	)
Earnings (loss) per share:
Basic - as reported	$	0.17		$	(0.05	)
Basic - pro forma	$	0.05		$	(0.15	)
Diluted - as reported	$	0.16		$	(0.05	)
Diluted - pro forma	$	0.04		$	(0.15	)

Note 3 — Inventories

Inventories consist of the following (in thousands):

	September 30, 2003		June 30, 2003
	(unaudited)

Raw materials	$	7,718	$	8,029
Work-in-process	2,310		2,244
Finished goods	8,374		8,989

	$	18,402	$	19,262

Note 4 — Earnings Per Share

Basic earnings per share (“EPS”) is computed based on the weighted-average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock outstanding during the period increased by the weighted average number of common stock equivalents outstanding during the period, using the treasury stock method. Anti-dilutive common stock equivalents excluded from the computation of diluted earnings per share amounted to 88,750 and 3,383,666 at September 30, 2003 and 2002, respectively.

A reconciliation of the calculation of basic and diluted EPS is as follows (in thousands, except per share data):

	Three Months Ended September 30,
	2003		2002
	(unaudited)

Net income (loss)	$	2,223	$	(557	)

BASIC EPS:
Weighted average number of common shares outstanding	12,972		11,024
Basic earnings (loss) per share	$	0.17	$	(0.05	)

DILUTED EPS:
Weighted average number of common shares outstanding	12,972		11,024
Common stock equivalents from the issuance of options using the treasury stock method	1,206		—
	14,178		11,024
Diluted earnings (loss) per share	$	0.16	$	(0.05	)

Note 5 – Comprehensive Income

Comprehensive income includes, in addition to net income, foreign currency translation effects which are charged or credited to accumulated other comprehensive income within shareholders’ equity.

Comprehensive income for the three months ended September 30, 2003 and 2002 was as follows (in thousands):

	Three Months Ended September 30,
	2003		2002
	(unaudited)

Net income (loss)	$	2,223	$	(557	)
Foreign currency translation effect	4		8
Comprehensive income (loss)	$	2,227	$	(549	)

Note 6 — Bank Borrowings and Debt Arrangements

At September 30, 2003, the Company had a credit facility consisting of a $4,655,000 five-year term note for capital equipment purchases that matures on August 28, 2007 and a $10,000,000 two-year revolving line of credit for working capital purposes that expires on November 30, 2003. Both the term note and the line of credit are collateralized by the Company’s assets. Interest on the term note is set at variable rates equal to the bank’s prime rate (4.00% on September 30, 2003) in effect from time to time. Interest on the line of credit is set at the bank’s prime rate in effect from time to time minus 0.25% or, at the Company’s option, a rate equal to LIBOR plus 2.25%. The loan agreement that governs the credit facility contains certain financial and non-financial covenants. The term note provided for a nine-month draw period through August 28, 2002, during which period only interest was paid. Upon expiration of the draw period, all amounts outstanding under the note became payable in 60 equal payments of principal plus interest. At September 30, 2003, $3,724,000, including $1,009,000 due within one year, was outstanding under the term note and no amounts were outstanding under the line of credit.

Note 7 – Legal Proceedings

The Company is subject to various legal proceedings and claims that arise in the ordinary course of business. In the opinion of management, the amount of any ultimate liability with respect to these actions will not materially affect the Company’s consolidated financial statements or results of operations.

In January 2003, Raytheon Company filed a lawsuit against the Company and various other companies in the United States District Court for the Eastern District of Texas. The complaint alleges that the Company’s products infringe United States Patent No. 5,412,791, entitled Mass Data Storage Library. In the complaint, Raytheon demands that the defendants stop selling infringing products, pay Raytheon for their past use of the invention under the patent and pay Raytheon’s costs and expenses and its reasonable attorney fees. In February 2003, Raytheon filed a First Amended Complaint stating its original claim with more particularity. The Company filed its answer to Raytheon’s First Amended Complaint in March 2003, denying all material allegations in the complaint and asserting counterclaims seeking to have Raytheon’s ‘791 patent declared invalid, unenforceable and not infringed by the Company. In April 2003, Raytheon filed a Second Amended Complaint against the defendants containing the same substantive infringement allegations and also adding a ninth defendant. In May 2003, the Company responded to Raytheon’s Second Amended Complaint with its Answer and Amended Counterclaims, again contesting infringement, invalidity and enforceability of the ‘791 patent. The lawsuit is in its early stages and discovery is just commencing. The District Court held a scheduling conference in this matter in May 2003 and has set a case schedule with trial currently set for June 2004.

The Company has not recorded any accrual for contingent liability associated with the legal proceedings described above based on the Company’s belief that a liability, while possible, is not probable. Further, any possible range of loss cannot be estimated at this time.

Note 8 — Accrued Restructuring Charges

During the fourth quarter of fiscal year 2001, the Company recorded a pretax charge of approximately $2.5 million, including $2.2 million in inventory and fixed asset impairments and $363,000 of restructuring charges, related to the sale of its Travan-based WS30 and EDT40 tape drive designs and related assets and its exit from the entry-level tape drive business including the closure of its Longmont, Colorado facility.

During fiscal year 2002, the Company increased the restructuring accrual for facility rent by $228,000 to reflect an adjustment in the estimated liability related to the closure of the Longmont facility, based upon the increased amount of time the Company believed would be required to sublease the facility, given the weakening real estate market in Longmont, Colorado.

Subsequent to the termination of the Travan based development project in May 2002, the Company temporarily used the Longmont facility for certain engineering operations primarily related to its software products. During the third quarter of fiscal year 2003, the Company completed its relocation of all operations from the Longmont facility to its San Diego headquarters. After the relocation the Company re-evaluated its accrual related to the Longmont facility lease. While the Company continues to pursue sub-lease opportunities, based upon the current commercial real estate market in Longmont, it determined that it is unlikely that it will be able to sub-lease the property and recorded an additional charge of $156,000 as an operating expense within research and development to accrue all of the remaining payments due under the lease. The accrued facility costs are expected to be paid over the remaining life of the lease, which expires in November 2005.

The following table summarizes the activity and balances of the accrued restructuring charges through September 30, 2003 (in thousands):

	Employee Related			Lease and Facility			Total

Restructuring charge	159			204			$	363
Cash payments	(31		)	—			(31		)
Accrued restructuring charges at June 30, 2001	128			204			332

Cash payments	(128		)	—			(128		)
Adjustments	—			228			228
Accrued restructuring charges at June 30, 2002	$	—		$	432		$	432

Cash payments	—			(72		)	(72		)
Adjustments	—			156			156
Accrued restructuring charges at June 30, 2003	$	—		$	516		$	516

Cash payments	—			(49		)	(49		)
Adjustments	—			—			—
Accrued restructuring charges at September 30, 2003	$	—		$	467		$	467

Note 9 — Guarantees

The Company’s standard warranty is a three year advance replacement return-to-factory warranty that covers both parts and labor. For products that it distributes and for drives and tapes used in its products that are manufactured by a third party, the Company passes on to the customer the warranty provided by the manufacturer. The Company also provides on-site service for the first warranty year of its higher-end products, for which it contracts with third-party service providers.

The Company provides for the estimated cost of product warranties at the time revenue is recognized. The Company’s product warranty liability reflects its best estimate of probable liability under its product warranties. The Company estimates the warranty based on expected product failure rates, historical experience, and other currently available information.

The Company also sells extended on-site warranties for certain products for which revenue is deferred and recognized over the warranty period.

Changes in the liability for product warranty and deferred revenue associated with extended warranties for the three months ended September 30, 2003 were as follows (in thousands):

	Product Warranty			Deferred Revenue
Liability at June 30, 2003	$	2,129		$	1,458

Settlements made during the period	(631		)	(498		)
Change in liability for warranties issued during the period	641			778
Change in liability for preexisting warranties	(44		)	23
Liability at September 30, 2003	$	2,095		$	1,761

Under the Company’s sales agreements with certain customers, subject to certain exceptions and limitations, the Company has agreed to indemnify its customers for damages and costs, including attorneys fees, resulting from infringement by its products of third-party intellectual property rights. In certain circumstances, the Company may have an obligation to defend its customer against claims of such infringement by third parties. Subject to expiration or termination of third party intellectual property rights and to statutes of limitation that bar third party claims, the terms of the Company’s indemnifications are generally perpetual from the effective date of the agreement. Based on historical experience, the Company does not believe any significant payments will result, accordingly, no amounts have been accrued for its indemnification. However, there can be no assurances that the Company will not have any future financial exposure under these indemnifications.

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

The discussion in this section contains certain statements of a forward-looking nature relating to future events or our future performance. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the only means of identifying forward-looking statements. Such statements are only predictions and actual events or results may differ materially. In evaluating such statements, you should specifically consider various factors identified in this Report, including the matters set forth under the caption “Risk Factors,” which could cause actual results to vary from those indicated by such forward-looking statements.

Overview

We design, develop, manufacture, market and support magnetic tape data automation solutions. Businesses use these solutions for backup, archival and data interchange functions in high-availability network computing environments.

Our primary products are automated tape libraries, powerloaders and loaders which combine electro-mechanical robotics, electronic hardware and firmware developed by us with an emphasis on efficiency of design, functionality and reliability. We also distribute products manufactured by other original equipment manufacturers (“OEMs”) and market various other products including spare parts and tape media. We also license a proprietary tape encoding technology that we developed under the name Variable Rate Randomizer or “VR²”.

In addition, we have introduced our first software product, the Overland Storage Resource Manager. To date, sales generated from the Overland Storage Resource Manager have not been material.

In June 2003, we announced the acquisition of Okapi Software, Inc., a privately-owned company based in San Diego, California. Through this acquisition, we entered the emerging market of intelligent, disk-based appliances based on iSCSI and Serial ATA disk technologies. The Okapi backup accelerator product complements our existing family of tape automation products. In August 2003, we announced the availability of three new Overland-branded disk-based products based on the Okapi Technology.

Formerly known as Overland Data, Inc., we changed our name on June 28, 2002 to Overland Storage, Inc. to reflect our expanded commitment to both hardware and software storage solutions.

Risk Factors

Our business is highly dependent on our level of sales to one major customer.

Hewlett Packard, including the former Compaq which HP acquired in May 2002, has been our largest customer accounting for approximately 58% of net revenue in fiscal year 2003, 62% of net revenues in fiscal year 2002 and 63% of net revenues in fiscal year 2001. Sales to HP accounted for approximately 60% of our net revenues for the quarter ended September 30, 2003. No other customer accounted for more than 10% of net revenues during the quarter ended September 30, 2003.

Our sales to HP may be affected adversely by various factors relating to HP’s business, liquidity, results of operation and financial position. We expect that HP will continue to represent a significant portion of our revenues in future periods. Consequently, our business, liquidity, results of operation and financial position would be materially and adversely affected by the loss of the HP account or the reduction, delay or cancellation of HP orders. Neither HP nor any other customer is obligated to purchase a specific amount of our products or provide binding forecasts of purchases for any period.

The market price of our common stock may be very volatile.

The market price of our common stock has experienced significant fluctuations since it commenced trading in February 1997. The market price of our common stock may continue to fluctuate significantly in the future. Many factors could cause the market price of our common stock to fluctuate, including:

• announcements concerning us or our competitors;

• changes in earnings estimates by analysts;

• purchasing decisions of HP and other significant customers;

• quarterly variations in operating results;

• the introduction of new technologies or products;

• changes in product pricing policies by us or our competitors; and

• changes in general economic conditions.

In addition, stock markets have experienced extreme price and volume volatility in recent years. This volatility has had a substantial effect on the market prices of securities of many smaller public companies for reasons frequently unrelated or disproportionate to the operating performance of the specific companies. These market fluctuations may adversely affect the market price of our common stock.

Our financial results may fluctuate substantially for many reasons, and past results should not be relied on as indications of future performance.

All of the markets that we serve are volatile and subject to market shifts, which we may not be able to discern in advance. A slowdown in the demand for workstations, mid-range computer systems, networks and servers could have a significant adverse effect on the demand for our products in any given period. We have experienced delays in receipt of purchase orders and, on occasion, anticipated purchase orders have been rescheduled or have not materialized due to changes in customer requirements. Our customers may cancel or delay purchase orders for a variety of reasons, including the rescheduling of new product introductions, changes in their inventory practices or forecasted demand, general economic conditions affecting our customers’ markets, changes in our pricing or the pricing of our competitors, new product announcements by us or others, quality or reliability problems related to our products or selection of competitive products as alternate sources of supply. In particular, our ability to forecast sales to distributors, integrators and value-added resellers is especially limited as these customers typically provide to us relatively short order lead times or are permitted to change orders on short notice. Given that a large portion of our sales are generated by our European channel, our first fiscal quarter (July through September) is commonly impacted by seasonally slow European orders, reflecting the summer holiday period in Europe.

In addition, our financial results have fluctuated and will continue to fluctuate quarterly and annually based on many other factors such as:

• changes in customer mix (e.g., OEM vs. branded);

• the level of utilization of our production capacity;

• changes in product mix;

• fluctuations in average selling prices;

• manufacturing yields;

• increases in production and engineering costs associated with initial production of new products;

• changes in the cost of or limitations on availability of materials; and

• labor shortages.

Based on all of the foregoing, we believe that our revenues and operating results will continue to fluctuate, and period-to-period comparisons are not necessarily meaningful and should not be relied on as indications of future performance. Furthermore, in some future quarters, our revenues and operating

results could be below the expectations of public market analysts or investors, which could result in a material adverse effect on the price of our common stock. In addition, portions of our expenses are fixed and difficult to reduce if revenues do not meet our expectations. These fixed expenses magnify the material adverse effect of any revenue shortfall.

We face intense competition and price pressure, and many of our competitors have substantially greater resources than we do.

The worldwide storage market is intensely competitive as a number of manufacturers of tape automation solutions and storage management software products compete for a limited number of customers. In addition, barriers to entry are relatively low in these markets. We currently participate in the mid-range of the tape backup market. In this segment, some of our competitors have substantially greater financial and other resources, larger research and development staffs, and more experience and capabilities in manufacturing, marketing and distributing products. Our hardware products currently compete with products made by Advanced Digital Information Corporation, Quantum Corporation and Storage Technology Corporation. Our disk-based and software products currently compete with products made by International Business Machines Corporation, HP, Computer Associates International, Inc., EMC Corporation, Veritas Software Corporation, Quantum Corporation, Network Appliance, Inc. and numerous small startups. The markets for our products are characterized by significant price competition, and we anticipate that our products will face increasing price pressure. This pressure could result in significant price erosion, reduced profit margins and loss of market share, which could have a material adverse effect on our business, liquidity, results of operation and financial position.

Our business is highly dependent on the continued availability and market acceptance of the tape technologies incorporated in our products.

We derive a majority of our revenue from products that incorporate tape drives purchased from other manufacturers and based on unique formats and tape technologies. Certain of these tape drives are only available from a single manufacturer, and we expect to continue to derive a substantial amount of our revenue from products incorporating these tape drives for the foreseeable future. In particular, a portion of our products incorporate DLTtape drives manufactured by Quantum Corporation. Quantum also is one of our competitors because Quantum markets its own tape automation products. We do not have a long-term contract with Quantum, which could cease supplying tape drives directly to us. Although Quantum has licensed Tandberg Data to be a second source manufacturer of DLTtape drives, we have not qualified Tandberg as an alternative supplier.

In addition, from time to time in the past, we have not obtained as many drives as we have needed from various vendors due to drive shortages or quality issues. Any prolonged inability to obtain adequate deliveries could require us to pay more for components, parts and other supplies, seek alternative sources of supply, delay shipment of products and damage relationships with current and prospective customers. This type of delay or damage could have a material adverse effect on our business, liquidity, results of operation and financial position. In the past, we have experienced problems with the supply of newly-introduced tape drives and these problems adversely affected our sales and earnings. We cannot assure you that these or similar problems will not reoccur, or that we will not experience similar or more serious disruptions in supply in the future with current or new versions of tape drives.

Our future operating results depend on the continued availability and market acceptance of the current tape technologies that we use. If tape drives incorporating other technologies gain comparable or superior market acceptance than those currently incorporated in our products, then we might have to modify the design of our tape automation products to incorporate these tape drives. Our inability to do so or to obtain sufficient quantities of these tape drives could have a material adverse effect on our business, liquidity, results of operation and financial position.

Our tape-based storage solutions compete with other storage technologies, such as hard disk drives, and may face competition in the future from other emerging technologies. The prices of hard disk drives continue to decrease while capacity and performance have increased. If hard disk drives or products incorporating other technologies gain comparable or superior market acceptance to tape drive technology, or their costs decline far more rapidly than tape drive and media costs, we would face increased competition from these alternative technologies. If we are not able to respond to such

competition through increased performance and lower prices for our products, or the introduction of competitive new products incorporating new technologies, our business, financial condition and operating results could be materially and adversely affected.

Our success depends on our ability to anticipate rapid technological changes and develop new and enhanced products.

As an advanced technology company, we are subject to numerous risks and uncertainties, generally characterized by rapid technological change and intense competition. In this environment, our future success will depend on our ability to anticipate changes in technology, to develop new and enhanced products on a timely and cost-effective basis and to introduce, manufacture and achieve market acceptance of these new and enhanced products. Development schedules for high technology products are inherently subject to uncertainty. We may not meet our product development schedules, including those for products based on our VR² technology or storage management software products, and development costs could exceed budgeted amounts. In addition, there can be no assurance that our licensees, in the case of our VR²technology, or our licensors, in the case of our software products, will meet their product development schedules. Our business, liquidity, results of operation and financial position may be materially and adversely affected if the products or product enhancements that we develop are delayed or not delivered due to developmental problems, quality issues or component shortage problems, or if our products or product enhancements do not achieve market acceptance or are unreliable. The introduction, whether by us or our competitors, of new products embodying new technologies, such as new sequential or random access mass storage devices, and the emergence of new industry standards could render existing products obsolete or not marketable, which may have a material adverse effect on our business, liquidity, results of operation and financial position.

We rely on outside suppliers to provide a large number of components and subassemblies incorporated in our products.

Our products have a large number of components and subassemblies produced by outside suppliers. Accordingly, we depend greatly on these suppliers for tape drives, printed circuit boards and integrated circuits, which are essential to the manufacture of our products. In addition, for certain of these items, we qualify only a single source, which can magnify the risk of shortages and decrease our ability to negotiate with our suppliers on the basis of price. If these shortages occur, or if we experience quality problems with suppliers, then our product shipments could be significantly delayed or costs significantly increased, which would have a material adverse effect on our business, liquidity, results of operation and financial position.

Our international operations are important to our business and involve unique risks.

Historically, sales to customers outside of the U.S. have represented a significant portion of our sales and we expect them to continue representing a significant portion of sales. Sales to customers outside the U.S. are subject to various risks, including:

• the imposition of governmental controls mandating compliance with various foreign and U.S. export laws;

• currency exchange fluctuations;

• political and economic instability;

• trade restrictions;

• changes in tariffs and taxes;

• longer payment cycles (typically associated with international sales); and

• difficulties in staffing and managing international operations.

Furthermore, we cannot assure that we will be able to comply with changes in foreign standards in the future, even though we endeavor to meet standards established by foreign regulatory bodies. Our inability to design products that comply with foreign standards could have a material adverse effect on our business, liquidity, results of operation and financial position. Currently, nearly all of our international sales are denominated in U.S. dollars and fluctuations in the value of foreign currencies relative to the U.S. dollar could, therefore, make our products less price competitive. Additionally, the expenses of our international subsidiaries are denominated in their local currencies. We currently do not engage in foreign currency hedging transactions, and are therefore exposed to some level of currency risk.

Our ability to compete effectively depends in part on our ability to protect effectively our intellectual property rights.

We rely on a combination of patent, copyright, trademark, trade secret and other intellectual property laws to protect our intellectual property rights. These rights, however, may not prevent competitors from developing products that are substantially equivalent or superior to our products. To the extent we have or obtain patents, such patents may not afford meaningful protection for our technology and products. Others may challenge our patents and, as a result, our patents could be narrowed, invalidated or unenforceable. In addition, current or future patent applications may not result in the issuance of patents in the United States or foreign countries. The laws of certain foreign countries may not protect our intellectual property to the same extent as U.S. laws. Furthermore, competitors may independently develop similar products, duplicate our products or, if patents are issued to us, design around these patents.

In order to protect or enforce our patent rights, we may initiate interference proceedings, oppositions, or patent litigation against third parties, such as infringement suits. These lawsuits could be expensive, take significant time and divert management’s attention from other business concerns. The patent position of information technology firms generally is highly uncertain, involves complex legal and factual questions, and has recently been the subject of much litigation. No consistent policy has emerged from the U.S. Patent and Trademark Office or the courts regarding the breadth of claims allowed or the degree of protection afforded under information technology patents.

Raytheon Company has sued us for patent infringement. This litigation subjects us to significant liabilities, costs and expenses.

• subject us to significant liabilities;

• require us to license disputed rights from Raytheon or others; or

• require us to cease marketing or using some products.

Any of these events could have a material adverse effect on our business, liquidity, results of operation and financial position. In addition, even if we do not experience an adverse outcome in the Raytheon litigation, or similar proceedings, the legal fees and other costs and expenses associated with litigation have been and may continue to be substantial and may adversely impact our business, liquidity, results of operation and financial position.

Our success will depend partly on our ability to operate without infringing on or misappropriating the proprietary rights of others.

In addition to the Raytheon litigation discussed above, we may be sued for infringing on the patent rights or misappropriating the proprietary rights of others. Intellectual property litigation is costly, and, even if we prevail, the cost of such litigation could adversely affect our business, financial condition and results of

operations. In addition, litigation is time consuming and could divert management attention and resources away from our business. If we do not prevail in any litigation, we could be required to stop the infringing activity and/or pay substantial damages. Under some circumstances in the United States, these damages could be triple the actual damages the patent holder incurs. If we have supplied infringing products to third parties for marketing or licensed third parties to manufacture, use or market infringing products, we may be obligated to indemnify these third parties for any damages they may be required to pay to the patent holder and for any losses the third parties may sustain themselves as the result of lost sales or damages paid to the patent holder.

If a third party holding rights under a patent successfully asserts an infringement claim with respect to any of our products, we may be prevented from manufacturing or marketing our infringing product in the country or countries covered by the patent we infringe, unless we can obtain a license from the patent holder. Any required license may not be available to us on acceptable terms, or at all. Some licenses may be non-exclusive, and therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to market some of our products, which could have a material adverse effect on our business, financial condition and results of operations.

Our new software and disk-based products involve many significant risks.

In June 2002, we announced the launch of our first software product, the Overland Storage Resource Manager and in August 2003 we began shipping our REO Series of disk-based products based on technology acquired from Okapi Software, Inc. To date, our sales generated from these products have not been material.

The success of these new products is uncertain and subject to significant risks, any of which could have a material adverse effect on our business, liquidity, results of operation and financial position. We must commit significant resources to these new products before determining whether they will result in any success. In addition, our disk-based business is highly dependent upon the general industry acceptance and adoption of the new iSCSI standard. If these new products are not adopted by customers or do not achieve anticipated sales levels, any related intangible assets we have recorded may be impaired. Such impairment would result in a charge against earnings in the period for which impairment is determined to exist, and reduce our assets and shareholders’ equity

We have not been involved previously in the development, marketing and sale of software or disk-based products, and these areas are new to many of our personnel. We will need to continuously update and periodically upgrade these products to stay competitive. Any delay in the commercial release of new or enhanced software or disk-based products could result in a significant loss of potential revenues and may adversely impact the market price of our common stock.

The software industry is highly competitive. Some of our competitors may have an advantage due to their relationships with their customers and other third parties and their significantly greater financial, technical, marketing and other resources. Our competitors also may have the ability to respond more quickly than we can to new or emerging technologies and changes in customer requirements. This competition could seriously impede our ability to sell software products on terms favorable to us. In addition, our current and potential competitors may develop and market new software products that render our existing or future products obsolete, unmarketable or less competitive. Our current and potential competitors may make strategic acquisitions or establish cooperative relationships among themselves or with other competitors, thereby increasing the availability of their services to address the needs of our current and prospective customers. We may not be able to compete successfully against our current and future competitors, and competitive pressures that we encounter may seriously harm our business.

We license the majority of our software code from another company and depend on that software developer for the timely delivery of competitive, defect-free software that forms the basis for our software products. In April 2003, EMC Corporation, one of our software competitors, acquired our software licensor. As a result of this acquisition, our software licensor has available substantially greater financial and other resources, including an enhanced capability to develop and market similar and competitive software offerings. Although EMC Corporation announced that it intends to continue our software license

relationship, our commercial arrangement may not develop successfully and EMC Corporation could compete more directly with us.

If our software or disk-based products do not achieve market acceptance or success, then the association of our brand name with these products may adversely affect our reputation and our sales of other products, as well as dilute the value of our brand name.

Our warranty reserves may not adequately cover our warranty obligations.

We have established reserves for the estimated liability associated with our product warranties. However, we could experience unforeseen circumstances where these or future reserves may not adequately cover our warranty obligations. For example, the failure or inadequate performance of product components that we purchase could increase our warranty obligations beyond these reserves.

Our credit facility is collateralized by a general security interest in our assets. If we were to default, then the lender would have the right to foreclose on our assets.

At September 30, 2003, our credit facility consisted of a $4.7 million five-year term note for capital equipment purchases which matures on August 28, 2007 and a $10.0 million two-year revolving line of credit for working capital purposes which expires on November 30, 2003. At September 30, 2003, $3.7 million, including $1.0 million due within one year, was outstanding under the term note and no amounts were outstanding under the line of credit. Both the term note and the line of credit are collateralized by a general security interest in our assets. If we were to default under our credit facility, then the lender would have the right to accelerate the indebtedness outstanding under our credit facility and foreclose on our assets in order to satisfy our indebtedness. A foreclosure could have a material adverse effect on our business, liquidity, results of operation and financial position.

Our credit facility requires that we comply with several financial and non-financial covenants. If we fail to comply with these covenants, then we will be in default of the credit facility.

The loan agreement that governs our credit facility requires us to comply with several financial and non-financial covenants. Our ability to comply with these covenants may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A violation of one or more of these covenants would constitute a default under the credit facility, which would enable the lender, at its option without notice, to accelerate all then-outstanding indebtedness under the credit facility and/or terminate the lender’s obligation to extend credit under the credit facility, either of which could materially and adversely impact our business, liquidity, results of operation and financial position.

Our success depends on our ability to attract, retain and motivate our executives and other key personnel.

Our future success depends in large part on our ability to attract, retain and motivate our executives and other key personnel, many of whom have been instrumental in developing new technologies and setting strategic plans. Our growth also depends in large part on our continuing ability to hire, motivate and retain highly qualified management, technical, sales and marketing team members. Competition for qualified personnel is intense and there can be no assurance that we will retain existing personnel or attract additional qualified personnel in the future.

Future mergers and acquisitions may increase the risks associated with our business.

In the future, we may pursue mergers and acquisitions of complementary businesses, products or technologies as we seek to expand and increase the value-added component of our product offerings. Mergers and acquisitions involve numerous risks, including liabilities that we may assume from the acquired company, difficulties in the assimilation of the operations and personnel of the acquired business, the diversion of management’s attention from other business concerns, risks of entering markets in which we have no direct prior experience, and the potential loss of key employees of the acquired business.

Future mergers and acquisitions by us also may result in dilutive issuances of our equity securities and the incurrence of additional debt and amortization expenses related to intangible assets. Any of these factors could adversely affect our business, liquidity, results of operation and financial position.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of consolidated financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventories, income taxes, warranty obligations and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

Revenue on direct product sales (excluding sales to commercial distributors and certain OEM customers) is recognized upon shipment of products to our customers. These customers are not entitled to any specific right of return or price protection, except for any defective product that may be returned under our warranty policy. Title and risk of loss transfer to the customer when the product leaves our dock. Product sales to commercial distribution customers are subject to certain rights of return, stock rotation privileges and price protection. Because we are unable to estimate our exposure for returned product or price adjustments, revenue from shipments to these customers is not recognized until the related products are in turn sold to the ultimate customer by the commercial distributor. At September 30, 2003, $831,000 of product had been shipped to our commercial distributors, but not yet shipped to their ultimate customers. As part of our existing agreements with certain OEM customers, we ship products to various distribution hubs around the world and retain ownership of that inventory until it is pulled by these OEM customers to fulfill their customer orders, at which time, generally the same business day, we record the sale.

We have entered into various licensing agreements relating to our VR²technology. These agreements typically call for royalty fees based on sales by licensees of products containing VR². Royalties on sales by licensees of products containing VR²are recorded when earned, generally in the period during which the licensee ships the products containing VR²technology. In certain instances, the customer has elected to purchase the ASIC chips from us embodying VR², which are priced to include the cost of the chip plus an embedded royalty fee. In these instances, revenues on ASIC chip sales are recorded as product revenue when earned, which is upon the shipment of the underlying ASIC chip incorporating the VR²technology to the customer.

In some cases, these licensing agreements include initial payments to us for the delivery of the VR²technology platform, consulting services or both. We recognize revenues related to the transfer of the technology platform upon delivery and acceptance by the customer, which entitles us to the initial fee and eliminates any further obligations under the agreement. We recognize revenue related to consulting services as earned, typically based on time committed to the project.

We recognize software revenues in accordance with the American Institute of Certified Public Accountants’ (AICPA) Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” (SOP 98-9). We license software under noncancelable perpetual agreements. License revenues are recognized in the period in which the license agreement is in place, the fee is fixed and determinable, delivery of the technology has occurred and collectibility is probable. Sales through our resellers are evidenced by a master agreement governing the relationship together with binding purchase

orders placed electronically on our business-to-business ordering system. We considered the license to be delivered, and the license revenue is recognized, when the reseller is issued a license key in the name of a specifically identified end user.

For software arrangements that include multiple elements, SOP 97-2 requires that we allocate the fee to the individual elements based on vendor-specific objective evidence of fair value (VSOE), regardless of the prices stated within the contract. VSOE is limited to the price charged when the element is sold separately or, for an element that is not yet sold separately, the price established by management having the relevant authority. When there is VSOE for the undelivered elements in multiple-element arrangements that are not accounted for using contract accounting, we allocate revenue to the delivered elements of the arrangement using the residual value method. Therefore, we defer revenues from the arrangement fee equal to the fair value of the undelivered elements and the difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. The fair value of maintenance and postcontract customer support obligations are based upon separate sales of renewals to other customers or upon renewal rates quoted in the contracts.

When VSOE does not exist to allocate revenue to each of the various elements of an arrangement we cannot allocate revenue using the residual value method, we defer the entire fee from the arrangement until the earlier of the establishment of VSOE or the delivery of all the elements of the arrangement.

Allowance for Doubtful Accounts

We prepare our estimate of allowance for doubtful accounts based on identification of the collectibility of specific accounts and the overall condition of the receivable portfolio. When evaluating the adequacy of the allowance for doubtful accounts, we analyze specific trade and other receivables, historical bad debts, customer credits, customer concentrations, customer credit-worthiness, current economic trends and changes in customers’ payment terms and/or patterns. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make additional payments, then we may need to make additional allowances. Likewise, if we determine that we could realize more of our receivables in the future than previously estimated, we would adjust the allowance to increase income in the period we made this determination. We review the allowance for doubtful accounts on a quarterly basis and record adjustments as deemed necessary.

Inventory Valuation

We record inventories at the lower of cost or market value. We assess the value of our inventories periodically based upon numerous factors including expected product or material demand, current market conditions, technological obsolescence, current cost and net realizable value. If necessary, we adjust our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value. Likewise, we record an adverse purchase commitment liability when anticipated market sales prices are lower than committed costs. If actual market conditions are less favorable than what we projected, then we may need to record additional inventory adjustments and adverse purchase commitments.

Income Taxes

We estimate our tax liability based on current tax laws in the statutory jurisdictions in which we operate. These estimates include judgments about deferred tax assets and liabilities resulting from temporary differences between assets and liabilities recognized for financial reporting purposes and such amounts recognized for tax purposes, as well as about the realization of deferred tax assets. If we cannot realize certain deferred tax assets or if the tax laws change unfavorably, we could experience potential significant losses in excess of provisions established. Likewise, if we can realize additional deferred tax assets or if tax laws change favorably, we could experience potential significant gains.

Warranty Obligations

We generally provide a three year advance replacement return-to-factory warranty on our NEO Series,

PowerLoader, and LoaderXpress products. We also provide on-site service for the first warranty year of the NEO Series products located in the United States and Canada, for which we contract with third-party service providers. For most products, we offer a program called XchangeNOW as part of our return-to-factory warranty which enables customers to receive an advance replacement unit shipped within two business days after placing a service request. The customer ships the defective unit back to us using the shipping materials from the replacement unit. Separately priced on-site warranties are offered for sale to customers of other product lines.

We provide for the estimated cost of product warranties at the time revenue is recognized. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by product failure rates and material usage or service delivery costs incurred in correcting a product failure. If actual product failure rates, material usage or service delivery costs differ from our estimates, then we would need to revise the estimated warranty liability.

Impairment of Assets

We also consider potential impairment of both tangible and intangible assets when circumstances indicate that the carrying amount of an asset may not be recoverable. In such circumstances, we may incur material charges relating to the impairment of such asset. We would measure any required impairment loss as the amount by which the asset’s carrying value exceeds its fair value and we would record it as a reduction in the carrying value of the related assets and charge it to results of operations.

Results Of Operations

The following table sets forth items in our statement of operations as a percentage of net revenues for the periods presented. The data has been derived from our unaudited condensed consolidated financial statements.

	Three Months Ended September 30,
	2003		2002
Net revenues	100.0	%	100.0	%
Cost of revenues	72.5		73.9
Gross profit	27.5		26.1

Operating expenses:
Sales and marketing	13.9		17.5
Research and development	3.2		4.9
General and administrative	4.5		6.2
Total operating expenses	21.6		28.6

Income (loss) from operations	5.9		(2.5	)
Other income:
Interest income, net	0.1		0.2
Other expense, net	—		(0.1	)

Income (loss) before income taxes	6.0		(2.4	)
Provision (benefit) for income taxes	2.1		(0.8	)

Net income (loss)	3.9	%	(1.6	)%

For the three months ended September 30, 2003 and 2002

Net Revenues. Net revenues of $56.6 million in the first quarter of fiscal year 2004 were $22.0 million or 63.8% above net revenues of $34.5 million in the first quarter of fiscal year 2003. Revenues from our OEM customers as a group during the first quarter of fiscal year 2003 increased by $17.6 million or 91.5% when compared to the first quarter of fiscal year 2003. This revenue increase was driven largely by a depressed quarter in the prior year as a result of transitional issues within our largest OEM customer. In addition, this increase also reflects an entire quarter of IBM as a NEO OEM. Sales to HP accounted for 60.0% of net revenues in the first quarter of fiscal year 2004, compared to 53.7% in the first quarter of fiscal year 2003.

Net revenues from Overland branded products during the first quarter of fiscal year 2004 grew 28.9% over the first quarter of fiscal year 2003 from $14.6 million to $18.9 million. This increase reflects our increased focus on the Overland branded channel over the past year including the addition of two private label customers in Asia and an increase in U.S. Government sector activity.

We also launched our new REO Series disk-based products, derived from the technology acquired in the acquisition of Okapi Software, Inc., during the first quarter of fiscal year 2004. While the amount of revenue generated from REO sales was immaterial, unit shipments during the first quarter were encouraging.

VR² revenues during the first quarter of fiscal year 2004 amounted to $613,000 and were comprised of royalties of $408,000 and chip sales of $205,000. VR² revenues during the first quarter of fiscal year 2003 amounted to $655,000 and were comprised of royalties of $296,000, engineering service fees of $250,000 and chip sales of $109,000.

A summary of the sales mix by product for the periods presented in the statement of operations follows:

	Three Months Ended September 30,
	2003		2002
Library products:
Neo series	64.9	%	60.3	%
Loaders	10.8		14.8
LibraryPro	1.3		8.2
	77.0		83.3
Other:
Spare parts, controllers, other	21.9		14.8
VR²royalties and services	1.1		1.9
	100.0	%	100.0	%

Gross Profit. Gross profit amounted to $15.6 million in the first quarter of fiscal year 2004, an increase of $6.6 million or 72.8% from $9.0 million in the first quarter of fiscal year 2003, resulting primarily from the increased sales volumes. The gross margin percentage increased to 27.5% in the first quarter of fiscal year 2004 from 26.1% in the first quarter of fiscal year 2003. The increase in gross margin as a percentage of revenue was due to a combination of increased revenue volumes spread across relatively fixed manufacturing overhead costs compared to the prior year when these fixed manufacturing cost were artificially high as a percentage of revenue due to the depressed revenue during the HP/Compaq merger transition; lower material costs achieved through cost reduction efforts as our NEO Series products mature; and lower shrinkage/scrap charges. Partially offsetting these favorable effects on the gross margin percentage was an unfavorable channel mix of lower margin OEM revenues versus the higher margin Overland branded revenues and $449,000 of amortization expense related to the $9.0 million purchased intangible asset from the Okapi acquisition in June of 2003. This amount is being amortized to cost of revenues over five years, the estimated useful life of the acquired products.

Sales and Marketing Expense. Sales and marketing expense amounted to $7.9 million, representing 13.9% of net revenues in the first quarter of fiscal year 2004, compared to $6.1 million or 17.5% of net revenues in the first quarter of fiscal year 2003. Increased expenditures were due primarily to salary and related expenses associated with the expansion of our Overland branded sales force, incremental expenses associated with the acquisition of the Okapi sales and marketing function, acquired in June of 2003, and expenses associated with the launch of our new REO Series disk-based and NEO 8000 library products including our inaugural world-wide partner conference.

Research and Development Expense. Research and development expense of $1.8 million, representing 3.2% of net revenues in the first quarter of fiscal year 2004, were relatively flat in absolute dollars compared to $1.7 million or 4.9% of net revenues in the first quarter of fiscal year 2003. Increases from the addition of the Okapi research and development team and expenses associated with the development of our recently announced high-end of the mid-range data library were nearly offset by the restructure of our advanced research group. Most of the personnel from this group were reassigned elsewhere within the company.

General and Administrative Expense. General and administrative expense amounted to $2.6 million, representing 4.5% of net revenues in the first quarter of fiscal year 2004, compared to $2.2 million or 6.2% of net revenues in the first quarter of fiscal year 2003. This increase was primarily due to legal fees related to Raytheon patent infringement lawsuit. Also contributing to this increase were higher consulting and employee related costs.

Interest Income, net. During the first quarter of fiscal year 2004, we generated net interest income of $96,000 compared to $68,000 during the same period of the prior fiscal year. This increase was due to higher average cash balances combined with lower average amounts of outstanding debt.

Income Taxes. Our effective tax rate in the first quarter of fiscal year 2004 was 35.0%, based on the estimated effective tax rate for the entire fiscal year 2004, compared to 34.5% in the first quarter of fiscal year 2003. The effective tax rate for the entire fiscal year 2003 was 34.4%.

Liquidity and Capital Resources. Our primary source of liquidity has historically been cash generated from operations. In the fourth quarter of fiscal year 2003, we raised an aggregate of $20.6 million in net proceeds through the sale of our common stock in a private placement. In addition, during fiscal year 2002, we supplemented cash generated from operations by borrowing on a term loan under our credit facility (described below) to fund tenant improvements and equipment purchases for our headquarters facility. During the first quarter of fiscal year 2004, our cash and cash equivalents decreased by $1.4 million as operating cash outflows of $1.1 million and capital expenditures of $481,000 exceeded inflows from financing activities of $144,000. Operating cash outflows during the first quarter of fiscal year 2004 resulted primarily from an increase in accounts receivable and a pay-down of accounts payable, partially offset by net income for the quarter and reduced inventory levels. Capital expenditures during the first quarter of fiscal year 2004 were comprised primarily of computer and related equipment. Financing cash inflows during the first quarter of fiscal year 2003 were a result of stock option exercises and the sale of stock under the employee stock purchase plan partially offset by the pay-down of our long-term debt.

In fiscal year 2001, we entered into a lease for our headquarters in San Diego, California. The headquarters comprise two buildings, representing approximately 160,000 total square feet. The buildings were completed in March 2002 at which time we occupied the buildings and the lease commenced. The lease is for a period of 12 years and can be renewed for one additional five-year period.

At September 30, 2003, we had a credit facility consisting of a $4,655,000 five-year term note for capital equipment purchases that matures on August 28, 2007 and a $10,000,000 two-year revolving line of credit for working capital purposes that expires on November 30, 2003. Both the term note and the line of credit are collateralized by a general security interest in our assets. Interest on the term note is set at variable rates equal to the bank’s prime rate (4.00% on September 30, 2003) in effect from time to time. Interest on the line of credit is set at the bank’s prime rate in effect from time to time minus 0.25% or, at our option, a rate equal to LIBOR plus 2.25%. The loan agreement that governs the credit facility contains certain financial and non-financial covenants. The term note provided for a nine-month draw period through August 28, 2002, during which period only interest was paid. Upon expiration of the draw period, all amounts outstanding under the note became payable in 60 equal payments of principal plus interest. At September 30, 2003, $3,724,000, including $1,009,000 due within one year, was outstanding under the term note and no amounts were outstanding under the line of credit.

In addition, the credit facility requires us to comply with several financial and non-financial covenants. A violation of one or more of these covenants would constitute a default under the credit facility, which would enable the lender, at its option without notice, to accelerate all then outstanding indebtedness under the credit facility and/or terminate the lender’s obligation to extend credit under the credit facility.

At September 30, 2003, we had $53.6 million of cash and cash equivalents and an unused bank line of credit of $10.0 million, which matures in November 2003. We believe that these resources will be sufficient to fund our operations and to provide for our growth for the next twelve months and into the foreseeable future.

Off-Balance Sheet Arrangements and Contractual Obligations. We have no off-balance sheet arrangements or significant guarantees to third parties not fully recorded in our Balance Sheets or fully disclosed in our Notes to Consolidated Financial Statements.

The following schedule summarizes the our contractual obligations to make future payments as of September 30, 2003: (in thousands)

	Payments Due by Period
Contractual Obligations	Total		Less than 1 year		1-3 years		3-5 years		After 5 years

Operating Leases	$	36,130	$	3,275	$	6,427	$	6,373	$	20,055
Debt	3,724		1,009		1,862		853		—

Total Contractual Cash Obligations	$	39,854	$	4,284	$	8,289	$	7,226	$	20,055

Item 3. — Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk in the areas of changes in United States interest rates and changes in foreign currency exchange rates as measured against the United States dollar. These exposures are directly related to our normal operating and funding activities. Historically, we have not used derivative instruments or engaged in hedging activities.

Interest Rate Risk. Our financial instruments with market risk exposure are cash equivalents, short-term investments, term note and, to the extent utilized, revolving line of credit. At September 30, 2003 $3,724,000, including $1,009,000 due within one year, was outstanding under the term note and no amounts were outstanding under the line of credit. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. To achieve this objective, we currently maintain a portfolio of high-grade commercial paper and money market funds.

Interest on our term note is set at variable rates equal to the bank’s prime rate in effect from time to time. Interest on the line of credit is set at the bank’s prime rate from time to time minus 0.25% or, at our option, a rate equal to LIBOR plus 2.25%. Our objective in maintaining access to these variable rate borrowings is the flexibility obtained regarding early repayment without penalties and lower overall cost as compared with fixed rate borrowings.

Under our current policies, we do not use interest rate derivative instruments to manage our exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would result in no material change in our pre-tax earnings and cash flow.

Foreign Currency Risk. We conduct business on a global basis and essentially all of our products sold in international markets are denominated in U.S. dollars. Historically, export sales have represented a significant portion of our sales and are expected to continue to represent a significant portion of sales.

Our wholly-owned subsidiaries in the United Kingdom, France and Germany incur costs that are denominated in local currencies. As exchange rates vary, these results when translated may vary from expectations and adversely affect overall results. The effect of exchange rate fluctuations on foreign currency transactions during the first quarter of 2004 was not material.

Item 4. — Controls and Procedures

We maintain disclosure controls and procedures designed to ensure that material information related to Overland, including our consolidated subsidiaries, is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms.

(a) As of the end of the period covered by this report, we carried out an evaluation under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded, as of the date of such evaluation, that the design and operation of such disclosure controls and procedures were effective.

(b) No significant changes were made in our internal controls over financial reporting (as defined in rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the most recent fiscal quarter.

PART II — OTHER INFORMATION

Item 1. — Legal Proceedings

In January 2003, Raytheon Company filed a lawsuit against us and various other companies in the United States District Court for the Eastern District of Texas. The complaint alleges that our products infringe United States Patent No. 5,412,791, entitled Mass Data Storage Library. In the complaint, Raytheon demands that the defendants stop selling infringing products, pay Raytheon for their past use of the invention under the patent and pay Raytheon’s costs and expenses and its reasonable attorney fees. In February 2003, Raytheon filed a First Amended Complaint stating its original claim with more particularity. We filed an Answer and Counterclaims to Raytheon’s First Amended Complaint in March 2003, denying all material allegations in the complaint and asserting counterclaims seeking to have Raytheon’s ‘791 patent declared invalid, unenforceable and not infringed by us. In April 2003, Raytheon filed a Second Amended Complaint against the defendants containing the same substantive infringement allegations and also adding a ninth defendant. In May 2003, we responded to Raytheon’s Second Amended Complaint with an Answer and Amended Counterclaims, again contesting infringement, invalidity and enforceability of the ‘791 patent. This lawsuit is in its early stages and discovery is just commencing. The District Court held a scheduling conference in this matter in May 2003 and has set a case schedule with trial currently set for June 2004.

In addition to the foregoing matter, we are from time to time involved in various lawsuits and legal proceedings which arise in the ordinary course of business. We are currently not aware of any such legal proceedings or claims which we believe will have, individually or in the aggregate, a material adverse affect on our business, financial condition or operating results. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business.

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

(a) Exhibits

3.1		Overland’s Amended and Restated Bylaws.

10.1		Product Purchase Agreement No. 1585-042103 dated July 31, 2003 between Overland and Hewlett-Packard Company. +

10.2	*	Amended and Restated 1996 Employee Stock Purchase Plan.

31.1		Certification of Christopher Calisi, President and Chief Executive Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Vernon A. LoForti, Vice President and Chief Financial Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxely Act of 2002, executed by Christopher Calisi, President and Chief Executive Officer, and Vernon A. LoForti, Vice President and Chief Financial Officer.

+		We have requested confidential treatment for certain portions of this Exhibit.

*		Management contract or compensation plan or arrangement.

(b) Reports on Form 8-K.

On August 12, 2003, we furnished a current report on Form 8-K under Item 12 containing the August 12, 2003 press release related to our announcement of fourth quarter fiscal 2003 results.

SIGNATURE

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

	OVERLAND STORAGE, INC.

Date: November 12, 2003	By:	/s/	Vernon A. LoForti
			Vernon A. LoForti Vice President, Chief Financial Officer and Secretary

PART II -

OTHER INFORMATION