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, 2004

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 Act).

Yes ý No o

As of November 5, 2004, there were 13,779,810 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, 2004

Table of Contents

PART I — FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited):

	Consolidated Condensed Statement of Operations — Three months ended September 30, 2004 and 2003

	Consolidated Condensed Balance Sheet — September 30, 2004 and June 30, 2004

	Consolidated Condensed Statement of Cash Flows — Three months ended September 30, 2004 and 2003

	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

	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,
	2004		2003
Net revenues:
Product sales	$	59,008	$	56,139
Royalties & services	518		430

Total net revenues	59,526		56,569

Cost of revenues	43,509		40,992

Gross profit.	16,017		15,577

Operating expenses:
Sales and marketing	7,812		7,851
Research and development	2,929		1,810
General and administrative	2,612		2,582

Total operating expenses.	13,353		12,243

Income from operations.	2,664		3,334

Other income (expense):
Interest income, net	274		96
Other expense, net.	69		(10		)

Income before income taxes	3,007		3,420
Provision for income taxes	1,107		1,197

Net income	$	1,900	$	2,223

Earnings per share:
Basic	$	0.14	$	0.17
Diluted	$	0.13	$	0.16

Number of shares used in computing earnings per share:
Basic	13,739		12,972
Diluted	14,254		14,178

See accompanying notes to consolidated condensed financial statements.

OVERLAND STORAGE, INC.

CONSOLIDATED CONDENSED BALANCE SHEET

(In thousands)

	September 30,			June 30,
	2004			2004
ASSETS:	(unaudited)
Current assets:
Cash and cash equivalents	$	56,537		$	58,422
Short-term investments	16,182			11,235
Accounts receivable, less allowance for doubtful accounts of $473 and $296, respectively	34,960			31,424
Inventories	20,388			16,163
Deferred income taxes	4,810			4,810
Other current assets	5,842			6,513

Total current assets	138,719			128,567

Property and equipment, net	8,150			7,945
Intangible assets	6,491			6,924
Other assets	773			590

	$	154,133		$	144,026

LIABILITIES AND SHAREHOLDERS’ EQUITY:
Current liabilities:
Accounts payable	$	17,051		$	11,166
Accrued liabilities	6,066			6,209
Accrued payroll and employee compensation	3,524			3,107
Income taxes payable	1,407			1,401
Accrued warranty	4,173			3,577

Total current liabilities	32,221			25,460

Deferred tax liabilities	2,824			2,997
Other liabilities	2,990			2,055

Total liabilities	38,035			30,512

Shareholders’ equity:
Common stock, no par value, 25,000 shares authorized; 13,770 and 13,694 shares issued and outstanding, respectively	74,253			73,573
Accumulated other comprehensive loss	(252		)	(256		)
Retained earnings	42,097			40,197

Total shareholders’ equity	116,098			113,514

	$	154,133		$	144,026

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,
	2004			2003
OPERATING ACTIVITIES:
Net income	$	1,900		$	2,223
Adjustments to reconcile net income to cash used in operating activities:
Depreciation and amortization	1,078			1,040
Deferred tax benefit	(173		)	—
Changes in operating assets and liabilities:
Accounts receivable	(3,536		)	(2,682		)
Inventories	(4,225		)	860
Accounts payable and accrued liabilities	6,344			(2,059		)
Accrued payroll and employee compensation	417			(228		)
Other, net	1,488			(246		)

Net cash provided by (used in) operating activities	3,293			(1,092		)

INVESTING ACTIVITIES:
Purchases of short-term investments	(6,252		)	—
Proceeds from maturities and sales of short-term investments	1,286			—
Capital expenditures	(849		)	(481		)

Net cash used in investing activities	(5,815		)	(481		)

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	614			377

Net cash provided by financing activities	614			144

Effect of exchange rate changes on cash	23			4

Net decrease in cash and cash equivalents	(1,885		)	(1,425		)
Cash and cash equivalents at the beginning of the period	58,422			55,020

Cash and cash equivalents at the end of the period	$	56,537		$	53,595

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. The Company operates its business in one operating segment. 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, 2004 on file with the Securities and Exchange Commission.

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, 2004 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,
	2004			2003
	(unaudited)

Net income, as reported	$	1,900		$	2,223

Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	(973		)	(1,599		)

Pro forma net income	$	927		$	624

Earnings per share:

Basic - as reported	$	0.14		$	0.17

Basic - pro forma	$	0.07		$	0.05

Diluted - as reported	$	0.13		$	0.16

Diluted - pro forma	$	0.06		$	0.04

Note 3 — Cash, Cash Equivalents and Short-Term Investments

The following table summarizes the fair value of the Company’s cash and available-for-sale securities held in its short-term investment portfolio, recorded as cash and cash equivalents or short-term investments (in thousands):

	September 30,			June 30,
	2004			2004
	(unaudited)

Cash	$	9,887		$		12,397
State and municipal securities	46,650			46,025
Total cash and cash equivalents	56,537			58,422

Asset-backed securities	9,150			3,234
United States government and agency securities	1,987			1,977
State and municipal securities	4,967			5,777
Certificates of deposit	78			247
Total short-term investments	16,182			11,235

Total cash and cash equivalents and short-term investments	$		72,719	$	69,657

At September 30, 2004, all of the Company’s investments in marketable securities were classified as available-for-sale, and as a result, are reported at fair value. Net unrealized losses on the Company’s marketable securities at September 30, 2004 amounted to $52,000. Fair values of marketable securities are estimated based on quoted market prices for these securities.

Proceeds from the sales of short-term investments during the first quarter of fiscal year 2005 and 2004 were $1,087,000 and none, respectively. A $2,000 gain was realized on those sales for the first quarter of fiscal year 2005.

As of September 30, 2004, the Company did not have any investments in individual securities that have been in a continuous unrealized loss position deemed to be temporary for more than 12 months.

As of September 30, 2004, $8,211,000 of the Company’s short-term investments had underlying maturities of between one and two years. The remaining short-term investments as of September 30, 2004 all had maturities of between three and twelve months. As of June 30, 2004, $6,285,000 of the Company’s short-term investments had underlying maturities of between one and two years. The remaining short-term investments as of June 30, 2004 all had maturities of between three and twelve months.

Note 4 — Inventories

Inventories consist of the following (in thousands):

	September 30,		June 30,
	2004		2004
	(unaudited)

Raw materials	$	9,193	$	6,266
Work-in-process	1,537		2,444
Finished goods	9,658		7,453
	$	20,388	$	16,163

Note 5 — 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 1,063,943 and 88,750 at September 30, 2004 and 2003, 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,
	2004		2003
	(unaudited)

Net income	$	1,900	$	2,223

BASIC EPS:
Weighted average number of common shares outstanding	13,739		12,972

Basic earnings per share	$	0.14	$	0.17

DILUTED EPS:
Weighted average number of common shares outstanding	13,739		12,972

Common stock equivalents from the issuance of options using the treasury stock method	515		1,206

	14,254		14,178

Diluted earnings per share	$	0.13	$	0.16

Note 6 — Comprehensive Income

Comprehensive income includes, in addition to net income, foreign currency translation effects and unrealized gains and losses on available-for-sale securities which are charged or credited to accumulated other comprehensive income within shareholders’ equity.

Comprehensive income for the three months ended September 30, 2004 and 2003 was as follows (in thousands):

	Three Months Ended
	September 30,
	2004			2003
	(unaudited)

Net income.	$	1,900		$	2,223
Foreign currency translation effect	23			4
Unrealized loss on available-for-sale securities	(19		)	—
Comprehensive income	$	1,904		$	2,227

Note 7 — Bank Borrowings and Debt Arrangements

At September 30, 2004, the Company had a credit facility consisting of a $10,000,000 revolving line of credit for working capital purposes that expires on November 30, 2004. The line of credit is collateralized by the Company’s assets. Interest on the line of credit is set at the bank’s prime rate (4.75% at September 30, 2004) 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. At September 30, 2004, no amounts were outstanding under the line of credit.

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, included in accrued liabilities, through September 30, 2004 (in thousands):

	Employee			Lease and
	Related			Facility			Total

Restructuring charge	$	159		$	204		$	363

Cash payments	(159		)	(265		)	(424		)
Adjustments	—			384			384

Accrued restructuring charges at June 30, 2004	—			323			323

Cash payments	—			(71		)	(71		)

Accrued restructuring charges at September 30, 2004	$	—		$	252		$	252

Note 9 — Guarantees and Purchase Obligations

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, 2004 were as follows (in thousands):

	Product			Deferred
	Warranty			Revenue

Liability at June 30, 2004	$	3,577		$	3,091

Settlements made during the period	(1,166		)	(732		)
Change in liability for warranties issued during the period	1,631			1,325
Change in liability for preexisting warranties	131			(128		)

Liability at September 30, 2004	$	4,173		$	3,556

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.

The Company has agreements with suppliers to purchase inventory and other goods and services and estimates its noncancelable obligations under these agreements to be approximately $14,800,000 in the next twelve months.

Note 10 — Intangible Assets

At September 30, 2004, the Company had intangible assets net of accumulated amortization of $6,491,000 and $6,924,000 at September 30, 2004 and June 30, 2004, respectively, consisting solely of the technology purchased in the acquisition of Okapi Software, Inc. during fiscal year 2003. During the three months ended September 30, 2004 and 2003, $433,000 and $449,000 were amortized, respectively. The Okapi technology is being amortized over five years.

Estimated annual amortization expense for this intangible asset will be approximately $1,700,000.

Note 11 — Common Stock

On August 11, 2004, the Board of Directors authorized the purchase of up to $10,000,000 of the Company’s common stock on the open market or through negotiated transactions. This repurchase authority allows the Company, at management’s discretion, to selectively repurchase its common stock from time to time in the open market or in privately negotiated transactions depending on market price and other factors. The share repurchase authorization has no stated expiration date. During the three months ended September 30, 2004, no shares were repurchased.

During the quarter ended September 30, 2004, employees exercised stock options to purchase 75,653 shares of common stock for a total of approximately $614,000. The Company recorded an increase in additional paid-in capital of approximately $66,000 as a result of the income tax benefit related to these stock option exercises and disqualifying dispositions of previously exercised stock options.

Note 12 — Recent Accounting Pronouncement

In March 2004, the Financial Accounting Standards Board, or FASB, issued EITF issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, as amended, which provides new guidance assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company will evaluate the impact of EITF 03-1 once final guidance is issued.

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 data storage management solutions used by businesses 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 an internally developed and patented tape encoding technology under the name Variable Rate Randomizer or “VR^2®” that is used by tape drive manufacturers to increase the capacity and performance of their products.

In June 2003, we acquired 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.

In the first quarter of fiscal 2005, we increased revenue by 5%, however, net income and earnings per share fell by 15% and 19%, respectively. Our performance reflects flat revenues in our OEM business and 19% revenue growth in our branded channel business. Our largest customer accounted for approximately 54% of total net revenues in the first quarter of fiscal 2005, down from 60% during the comparable period of fiscal 2004. Our gross profit margin dipped slightly from 27.5% in the first quarter of fiscal 2004 to 26.9% in the first quarter of fiscal 2005. This decrease was due primarily to average selling prices falling faster than unit product costs and increased warranty expenses related to the increase of units under warranty. While we experienced only 5% growth in revenue, operating expenses grew by 9%. The spending increase was concentrated in research and development which included a one-time cost for outside design services related to a new tape automation product and continued investment in our REO™ development.

During the first quarter of fiscal 2005 we produced positive cash flow that added another $3.1 million to our cash and investment balances. We achieved this positive cash flow despite an inventory increase of 26% and an increase in accounts receivable of 11%, both related to the increased level of business over the fourth quarter of fiscal year 2004. We ended the quarter with almost $73 million of cash and investments on hand and no outstanding debt.

We believe we are well positioned to execute on our strategy to leverage our current position as the leader in mid-range tape automation into a similar leadership position in intelligent disk-based backup and recovery appliances. Although it is a relatively new market, we believe it has great promise and can significantly expand our total addressable market. Success in the disk-based appliance market will require us to introduce a steady stream of new products that are feature-rich and competitively priced. In order to accomplish this, we must significantly enhance our software development team and commit additional sales and marketing resources to promote and sell the products. Our investment in this new market involves risks that the market will fail to grow as expected, and even if it does grow, that our products will not compete successfully, either of which could negatively impact our future profitability.

We achieved a number of major milestones during fiscal 2004 centered around our new REO disk-based appliance. In August 2003, we began shipping our REO 2000™ series of disk-based products based on technology acquired from Okapi Software, Inc. in June 2003. In May 2004, we began shipping our second-generation REO 4000™ disk-based products, which replaced our REO 2000 product, and in July 2004 we announced the availability of the REO 1000™, the industry’s first disk-based alternative to entry-level tape autoloaders. In September 2004, we announced the REO 9000™, a larger platform to address the enterprise market.

On the tape automation side of our business, in January 2004, we began shipping our newest and largest tape library, the NEO 8000. Built on the NEO architecture and designed for larger data centers, the NEO 8000 offers performance, scalability, data availability and field-proven technology, combining high-end functionality with mid-range affordability.

In September 2004, we announced our plan to outsource all of our manufacturing and certain related activities. As a result, we plan to transfer all of our manufacturing operations, currently located in California, to an outsource manufacturer by the end of June 2005.

As a result of these events, we expect to incur between $2.5 million and $3.0 million of pretax charges for severance costs and other obligations. We expect these costs to begin late in the second quarter of fiscal year 2005 and to continue through the second quarter of fiscal year 2006, with the bulk of the costs incurred during the third and fourth quarters of fiscal year 2005. As of September 30, 2004, the contract with the outsource manufacturer was still being negotiated, no employees had been notified of termination dates or benefits and all manufacturing assets were still in service. Therefore, no expense related to the outsource activities was recorded during the first quarter of fiscal year 2005.

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 59% of net revenues in fiscal year 2004, 58% of net revenues in fiscal year 2003 and 62% of net revenues in fiscal year 2002. No other customer accounted for more than 10% of net revenues during the three months ended September 30, 2004.

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 volatile.

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

• announcements concerning us, our competitors, our customers or our industry;

• changes in earnings estimates by analysts;

• purchasing decisions of HP and other significant customers;

• 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;

• currency exchange fluctuations;

• manufacturing yields;

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

• increases 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 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, any of which could have a material adverse effect on our business, liquidity, results of operation and financial position.

Our business is highly dependent on the continued 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 fiscal year 1997, we experienced problems with the supply of a newly-introduced tape drive and these problems materially adversely affected our sales and earnings for that year. 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 disk-based technology, and development costs could exceed budgeted amounts. In addition, there can be no assurance that the licensees of our VR²technology 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.

We are planning to transition our manufacturing operations to an outsourced provider.

In September 2004, we announced our intention to outsource our manufacturing to a third party manufacturer located in the U.S. Our transition to an outsourced project is a complex task. If not properly executed, delays in transition may occur, product quality may decline and product cost may increase. If our manufacturer is unable or unwilling to complete the transition in a timely and satisfactory manner, we may be required to continue to manufacture longer than originally intended or to locate an acceptable alternative manufacturer. Assuming a successful transition is completed, we still may have to change to another manufacturer because of problems with delivery schedules, manufacturing quality, product costs or other factors. In addition to the above, reliance on outsourced manufacturing involves a number of risks, including reduced control over delivery schedules, manufacturing quality and product costs. Any problems associated with the matters discussed above could result in significant expense, delays in shipment, a significant loss of potential revenues and may adversely impact the market price of our common stock

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 affect on our business, liquidity, results of operation and financial position.

We are subject to exchange rate risk in connection with our international operations.

We do not currently engage in foreign currency hedging activities and therefore we are exposed to some level of currency risk. As foreign currency exchange rates vary, the fluctuations in revenues and expenses may materially impact the financial statements upon consolidation. A weaker U.S. dollar would result in an increase to revenues and expenses upon consolidation, and a stronger U.S. dollar would result in a decrease to revenues and expenses upon consolidation. Currently, nearly all of our international sales are denominated in U.S. dollars.

Furthermore, the results of operations of our foreign subsidiaries are exposed to foreign exchange rate fluctuations as the financial results of the subsidiaries are translated from the local currency to U.S. dollars upon consolidation. Because of the significance of the operations of our subsidiaries to our consolidated operations, as exchange rates vary, net sales and other operating results, when translated, may differ materially from our prior performance and our expectations. In addition, because of the significance of our overseas operations, we could also be significantly affected by weak economic conditions in foreign markets that could reduce demand for our products and further negatively impact the results of our operations in a material and adverse manner.

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 U.S. or foreign countries. In addition, 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.

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

Our business is such that we may in the future be sued for infringing 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 disk-based products involve many significant risks.

In August 2003 we began shipping our REO 2000 of disk-based products based on technology acquired from Okapi Software, Inc. In May 2004, we began shipping our next-generation REO 4000 product and in July of 2004 we announced the availability of the REO 1000, the industry’s first disk-based alternative to entry-level tape loaders.

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, these products are somewhat 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 limited experience in the development, marketing or sale of disk-based products, and this area is 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 disk-based products could result in a significant loss of potential revenues and may adversely impact the market price of our common stock.

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

Our 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 under our credit facility, then the lender would have the right to foreclose on our assets.

At September 30, 2004, our credit facility consisted of a $10.0 million revolving line of credit for working capital purposes which expires on November 30, 2004. At September 30, 2004, no amounts were outstanding under the line of credit. The line of credit is 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 evaluation of internal controls and remediation of potential problems will be costly and time consuming and could expose weaknesses in our financial reporting.

The regulations implementing Section 404 of the Sarbanes-Oxley Act of 2002 require us to provide our assessment of the effectiveness of our internal control over financial reporting beginning with our Annual Report on Form 10-K for the fiscal year ending June 30, 2005. Our Independent Registered Public Accounting Firm will be required to confirm in writing whether our assessment of the effectiveness of our internal control over financial reporting is fairly stated in all material respects, and separately report on whether they believe we maintained, in all material respects, effective internal control over financial reporting as of June 30, 2005.

To date and going forward, this process has been, and will continue to be, both expensive and time consuming requiring significant attention of management. We cannot assure you that we will not discover material weaknesses in our internal controls. We also cannot assure you that we will complete the process of our evaluation and the Independent Registered Public Accounting Firm’s attestation on time. If we do discover a material weakness, corrective action may be time consuming, costly and further divert the attention of management. The disclosure of a material weakness, even if quickly remedied, could reduce the market’s confidence in our financial statements and harm our stock price.

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, 2004, $915,000 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.

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,
	2004		2003
Net revenues	100.0	%	100.0	%
Cost of revenues	73.1		72.5
Gross profit	26.9		27.5

Operating expenses:
Sales and marketing	13.1		13.9
Research and development	4.9		3.2
General and administrative	4.4		4.5
Total operating expenses	22.4		21.6

Income (loss) from operations	4.5		5.9
Other income:
Interest income, net	0.5		0.1
Other expense, net	0.1		—

Income (loss) before income taxes	5.1		6.0
Provision (benefit) for income taxes	1.9		2.1

Net income (loss)	3.2	%	3.9	%

For the three months ended September 30, 2004 and 2003

Net Revenues. Net revenues of $59.5 million in the first quarter of fiscal year 2005 were $3.0 million or 5.2% above net revenues of $56.6 million in the first quarter of fiscal year 2004. Revenues from our OEM customers, as a group, during the first quarter of fiscal year 2005 remained relatively flat when compared to the first quarter of fiscal year 2004. Revenues from HP during the first quarter of fiscal year 2005 fell $1.7 million or 4.9% when compared to the same period of fiscal year 2004. However, during the three months ended September 30, 2004, revenues from IBM increased $1.2 million or 49.1% over the comparable period of the prior fiscal year. Sales to HP accounted for 54.3% of net revenues in the first quarter of fiscal year 2005, compared to 60.0% in the first quarter of fiscal year 2004.

Net revenues from Overland branded products during the first quarter of fiscal year 2005 grew 19.1% over the first quarter of fiscal year 2004 from $19.1 million to $22.7 million. This increase was driven by a $1.2 million increase in revenue from our disk-based products, primarily in North America, a $1.1 million increase in revenue from our private label business in Asia and shipments under a large contract with a European governmental agency.

VR² revenues during the first quarter of fiscal year 2005 amounted to $518,000 and were comprised of royalties of $443,000 and engineering service fees of $75,000. 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 recorded as product sales.

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	72.6	%	68.4	%
Loaders	9.5		10.8
	82.1		79.2
Other:
Spare parts, controllers, other	14.7		19.3
Disk-based	2.3		0.4
VR²royalties and services	0.9		1.1
	100.0	%	100.0	%

Gross Profit. Gross profit amounted to $16.0 million in the first quarter of fiscal year 2005, an increase of $440,000 or 2.8% from $15.6 million in the first quarter of fiscal year 2004, resulting primarily from the increased sales volumes. The gross margin percentage decreased to 26.9% in the first quarter of fiscal year 2005 from 27.5% in the first quarter of fiscal year 2004. The decrease in gross margin percentage was due to average selling prices declining faster than unit product costs, primarily in the branded channel as we faced increased pricing pressures, combined with an increase in warranty costs as a result of more products under warranty compared to the prior year. For the remainder of fiscal year 2005, we expect our gross margin percentage to improve over the course of the year and approach 29% by the fourth quarter. This projection anticipates rapid growth in sales of our REO products, all of which are expected to be sold on a higher-margin branded basis rather than through a combination of OEM and branded customers. This expectation of gross margin is subject to risks and uncertainties more fully discussed under the heading “Risk Factors” above, including but not limited to those under the heading “Our new disk-based products involve many significant risks.”

Sales and Marketing Expense. Sales and marketing expense amounted to $7.8 million, representing 13.1% of net revenues in the first quarter of fiscal year 2005, essentially flat when compared to $7.9 million or 13.9% of net revenues in the first quarter of fiscal year 2004. We expect sales and marketing expense in the second quarter of fiscal year 2005 to grow approximately 23% over the first quarter. This growth includes the cost of our annual reseller conference and the continued expansion of our branded sales force.

Research and Development Expense. Research and development expense was $2.9 million, representing 4.9% of net revenues in the first quarter of fiscal year 2005, was up significantly compared to $1.8 million or 3.2% of net revenues in the first quarter of fiscal year 2004. The increase in research and development spending included a one-time cost of approximately $400,000 related to outside design services for a new tape automation product and continued investment in our REO development. While the outside design service costs will not recur, we do plan to significantly increase our REO development team during 2005 to ensure a steady flow of new products.

General and Administrative Expense. General and administrative expense amounted to $2.6 million, representing 4.4% of net revenues in the first quarter of fiscal year 2005, relatively flat compared to $2.6 million or 4.5% of net revenues in the first quarter of fiscal year 2004. We expect general and administrative expense to remain relatively flat for the remainder of fiscal year 2005.

Interest Income, net. During the first quarter of fiscal year 2005, we generated net interest income of $274,000 compared to $96,000 during the same period of the prior fiscal year. This increase was due to higher average cash balances and the absence of debt in the 20056 period. $3.7 million of debt was outstanding at September 30, 2003.

Income Taxes. Our effective tax rate in the first quarter of fiscal year 2005 was 36.8%, compared to 34.4% for all of fiscal year 2004. The increase was the result of (i) a higher tax bracket as we expect annual taxable income in fiscal year 2005 to push us over a bracket threshold, (ii) fiscal year 2004 benefited from a return to provision adjustment that we do not expect to repeat in fiscal year 2005, and (iii) a federal tax credit for research and development expired at the end of fiscal year 2004. We expect our fiscal year 2005 effective tax rate to be approximately 36.2% as a result of the tax credit legislation passed in October 2004.

Liquidity and Capital Resources. At September 30, 2004, we had $72.7 million of cash, cash equivalents and short-term investments and our unused bank line of credit of $10.0 million. 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. We have no other unused sources of liquidity at this time.

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 addition, during fiscal year 2002, we supplemented cash generated from operations by borrowing on a term loan under our credit facility to fund tenant improvements and equipment purchases for our new headquarter facilities. During fiscal year 2003, principal payments of $698,000 were made towards the term note and in fiscal year 2004 the outstanding balance of $4.0 million was paid in full.

Cash provided by operating activities was $3.3 million for the first quarter of fiscal year 2005 compared to cash used by operating activities of $1.1 million for the first quarter of fiscal year 2004. In the first quarter of fiscal year 2005, operating cash flows were provided by an increase in accounts payable as a result of the increased level of business and the associated increase of inventory, net income for the period and a decrease in income taxes receivable. These cash inflows were partially offset by an increase in inventories and accounts receivable, both as a result of the increased business level as compared to the fourth quarter of fiscal year 2004. In the first quarter of fiscal year 2004, operating cash flows were used to fund increases in accounts receivable and a pay down of accounts payable. These uses were partially offset by net income for the first quarter of fiscal year 2004 and a decrease in inventory.

Cash used in investing activities was $5.8 million for the first quarter of fiscal year 2005 and $481,000 for the first quarter of fiscal year 2004. During the first quarter of fiscal year 2005 we purchased $6.3 million of marketable debt securities and received proceeds of $1.3 million from the sale and the maturity of marketable debt securities. Capital expenditures during the first quarter of fiscal years 2005 and 2004 of $849,000 and $481,000, respectively, were comprised primarily of purchases of computer and related equipment.

Cash provided by financing activities was $614,000 for the first quarter of fiscal year 2005 and $144,000 for the first quarter of fiscal year 2004. Proceeds from the issuance of common stock under our Employee Stock Purchase Plan and the exercise of stock options were $614,000 and $377,000 in the first quarter of fiscal years 2005 and 2004, respectively. During fiscal year 2002, we borrowed $4.7 million under a term note agreement to fund capital expenditures associated with the construction of our new headquarter facilities. During the first quarter of fiscal year 2004, principal payments of $233,000 were made towards the term note.

We have a credit facility consisting of a $10,000,000 revolving line of credit for working capital purposes that expires on November 30, 2004. The line of credit is collateralized by a general security interest in our assets. Interest on the line of credit is set at the bank’s prime rate (4.75%atn September 30, 2004) in effect from time to time minus 0.25% or, at our option, a rate equal to LIBOR plus 2.25%. The credit facility requires us to comply with several financial and non-financial covenants. At September 30, 2004, we were in compliance with all covenants under the facility and we expect to remain in compliance through the term of the agreement. 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, 2004, no amounts were outstanding under the line of credit.

In August 2004, the Board of Directors authorized the purchase of up to $10,000,000 of our common stock on the open market or through negotiated transactions depending on market price and other factors.

The share repurchase authorization has no stated expiration date. No shares were repurchased during the three months ended September 30, 2004.

Off-Balance Sheet Arrangements

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.

Contractual Obligations

The following schedule summarizes our contractual obligations to make future payments as of September 30, 2004 (in thousands):

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

Operating Leases	$	33,207	$		3,280	$	6,420	$		6,628	$	16,879
Purchase Obligations	14,800		14,800			—		—			—
Total Contractual Cash Obligations	$	48,007	$	18,080		$	6,420	$	6,628		$		16,879

Inflation

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

Recent Accounting Pronouncement

In March 2004, the Financial Accounting Standards Board, or FASB, issued EITF issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, as amended, which provides new guidance assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. We will evaluate the impact of EITF 03-1 once final guidance is issued.

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. All of our fixed income investments are classified as available-for sale and therefore reported on the balance sheet at market value. Changes in the overall level of interest rates affect our interest income that is generated from our investments. For the first quarter of fiscal 2005, total interest income was $276,000 with investments yielding an annual average of 1.59% on a worldwide basis. The interest rate level was up approximately 56 basis points from 1.03% in fiscal 2004. If a similar change in overall interest rates (56 basis points) were to occur in the remainder of fiscal 2005, our interest income would change approximately $400,000, assuming consistent investment levels.

The table below presents, the cash, cash equivalents and short-term investment balances, related weighted average interest rates and maturities for our investment portfolio at September 30, 2004. The cash, cash equivalent and investment balances approximate fair value at September 30, 2004 (in thousands):

	Approximate		Weighted Average
	Market value		Interest Rate

Cash and cash equivalents	$	56,537	1.35	%
Short-term investments (91 days - 2 years)	16,182		3.47	%

Total cash, cash equivalents and investments	$	72,719	1.82	%

The table above includes the United States dollar equivalent of cash, cash equivalents and short-term investments, including $332,000, and $73,000 equivalents denominated in the British Pound Sterling and the Euro, respectively.

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 fiscal year 2005 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 changes were made in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Limitations of Disclosure Controls and Procedures.

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

PART II — OTHER INFORMATION

Item 1. — Legal Proceedings

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

(a) Exhibits

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-Oxley Act of 2002, executed by Christopher Calisi, President and Chief Executive Officer, and Vernon A. LoForti, Vice President and Chief Financial Officer.

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, 2004	By:	/s/	Vernon A. LoForti
			Vernon A. LoForti
			Vice President, Chief Financial Officer and Secretary