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 March 31,				Nine Months Ended March 31,
	2005		2004		2005		2004
Net revenues:
Product sales	$	57,817	$	58,422	$	178,678	$	181,737
Royalties & services	465		367		1,655		1,371
Total net revenues	58,282		58,789		180,333		183,108

Cost of revenues	43,396		42,622		131,612		133,692
Gross profit	14,886		16,167		48,721		49,416

Operating expenses:
Sales and marketing	8,548		7,597		25,261		22,989
Research and development	2,324		1,659		7,718		5,442
General and administrative	3,062		2,808		8,582		8,359
Total operating expenses	13,934		12,064		41,561		36,790

Income from operations	952		4,103		7,160		12,626

Other income:
Interest income, net	417		159		1,050		368
Other income, net	20		63		107		64

Income before income taxes	1,389		4,325		8,317		13,058
Provision for income taxes	32		1,449		2,457		4,505

Net income	$	1,357	$	2,876	$	5,860	$	8,553

Earnings per share:
Basic	$	0.10	$	0.21	$	0.42	$	0.64
Diluted	$	0.09	$	0.20	$	0.41	$	0.59

Number of shares used in computing earnings per share:
Basic	13,990		13,587		13,850		13,288
Diluted	14,609		14,551		14,444		14,400

See accompanying notes to consolidated condensed financial statements.

OVERLAND STORAGE, INC.

CONSOLIDATED CONDENSED BALANCE SHEET

(Unaudited)

(In thousands)

	March 31, 2005			June 30, 2004
ASSETS:
Current assets:
Cash and cash equivalents	$	6,032		$	12,397
Short-term investments	71,583			57,260
Accounts receivable, less allowance for doubtful accounts of $284 and $296, respectively	38,587			33,794
Inventories	23,483			15,126
Deferred income taxes	4,515			4,681
Other current assets	6,935			6,513

Total current assets	151,135			129,771

Property and equipment, net	8,702			7,945
Intangible assets, net	5,626			6,924
Other assets	1,357			590

	$	166,820		$	145,230

LIABILITIES AND SHAREHOLDERS’ EQUITY:
Current liabilities:
Accounts payable	$	20,098		$	11,166
Accrued liabilities	9,538			7,542
Accrued payroll and employee compensation	3,282			3,107
Income taxes payable	1,127			1,058
Accrued warranty	5,039			3,577

Total current liabilities	39,084			26,450

Deferred tax liabilities	2,611			3,211
Other liabilities	2,290			2,055

Total liabilities	43,985			31,716

Shareholders’ equity:
Common stock, no par value, 25,000 shares authorized; 13,930 and 13,694 shares issued and outstanding, respectively	77,223			73,573
Accumulated other comprehensive loss	(445		)	(256		)
Retained earnings	46,057			40,197

Total shareholders’ equity	122,835			113,514

	$	166,820		$	145,230

See accompanying notes to consolidated condensed financial statements.

OVERLAND STORAGE, INC.

CONSOLIDATED CONDENSED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)

	Nine Months Ended March 31,
	2005			2004
OPERATING ACTIVITIES:
Net income	$	5,860		$	8,553
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization	3,244			3,096
Deferred tax benefit	(434		)	(834		)
Changes in operating assets and liabilities:
Accounts receivable	(4,793		)	(5,371		)
Inventories	(8,357		)	(526		)
Accounts payable and accrued liabilities	12,459			4,254
Accrued payroll and employee compensation	175			(280		)
Other, net	(224		)	(1,166		)

Net cash provided by operating activities	7,930			7,726

INVESTING ACTIVITIES:
Purchases of short-term investments	(117,992		)	(53,553		)
Proceeds from maturities and sales of short-term investments	103,512			—
Capital expenditures	(2,703		)	(1,687		)

Net cash used in investing activities	(17,183		)	(55,240		)

FINANCING ACTIVITIES:
Payments on long-term debt	—			(3,957		)
Proceeds from the exercise of stock options and the sale of stock under the employee stock purchase plan	2,920			6,012

Net cash provided by financing activities	2,920			2,055

Effect of exchange rate changes on cash	(32		)	(31		)

Net decrease in cash and cash equivalents	(6,365		)	(45,490		)
Cash and cash equivalents at the beginning of the period	12,397			55,020

Cash and cash equivalents at the end of the period	$	6,032		$	9,530

See accompanying notes to consolidated condensed financial statements.

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 March 31, 2005 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 March 31,						Nine Months Ended March 31,
	2005			2004			2005			2004
Net income, as reported	$	1,357		$	2,876		$	5,860		$	8,553

Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	(938		)	(1,254		)	(2,907		)	(3,981		)
Pro forma net income	$	419		$	1,622		$	2,953		$	4,572

Earnings per share:


Basic - as reported	$	0.10		$	0.21		$	0.42		$	0.64
Basic - pro forma	$	0.03		$	0.12		$	0.21		$	0.34
Diluted - as reported	$	0.09		$	0.20		$	0.41		$	0.59
Diluted - pro forma	$	0.03		$	0.11		$	0.20		$	0.32

Note 3 – Revision in the Classification of Certain Securities

In connection with the preparation of this report, the Company concluded that it was appropriate to classify its auction rate municipal bonds as short-term investments. Previously, such investments had been classified as cash and cash equivalents. Accordingly, the Compnay has revised the classification to report these securities under the short-term investments caption on the Consolidated Condensed Balance Sheet as of March 31, 2005 and June 30, 2004. Corresponding adjustments have also been made to the Consolidated Condensed Statement of Cash Flows for the period ended March 31, 2004, to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. This change in classification does not affect previously reported cash flows from operations or from financing activities in the Consolidated Condensed Statement of Cash Flows, or the previously reported Consolidated Condensed Statement of Operations for any period.

As of June 30, 2004, $46 million of these short-term investments were previously classified as cash and cash equivalents on our Consolidated Condensed Balance Sheet.

For the nine months ended March 31, 2004, net cash used in investing activities related to these short-term investments of $50 million were included in our Consolidated Condensed Statement of Cash Flows.

Note 4 – 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):

	March 31, 2005		June 30, 2004

Cash	$	6,032	$	12,397
Total cash and cash equivalents	6,032		12,397

Asset-backed securities	17,322		3,234
United States government and agency securities	1,970		1,977
State and municipal securities	50,213		51,802
Corporate debt securities	2,000		—
Certificates of deposit	78		247
Total short-term investments	71,583		57,260

Total cash and cash equivalents and short-term investments	$	77,615	$	69,657

At March 31, 2005, all of the Company’s investments in marketable securities were classified as available-for-sale, and as a result, are reported at fair value with unrealized gains/losses from changes in fair values reported in other comprehensive income. Net unrealized losses on the Company’s marketable securities at March 31, 2005 amounted to $190,000. Fair values of marketable securities are generally estimated based on quoted market prices for these securities. Investments in auction rate securities are recorded at cost, which approximates fair value due to their variable interest rates, which typically reset every 28 to 35 days, and, despite the long-term nature of their stated contractual maturities, the Company has the ability to quickly liquidate these securities.

Proceeds from the sales of short-term investments during the first nine months of fiscal year 2005 and 2004 were $92,841,000 and none, respectively. A $2,000 gain was realized on those sales for the first nine months of fiscal year 2005.

As of March 31, 2005, 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.

The following table summarizes the contractual maturities of the Company’s short-term investments at March 31, 2005 and June 30, 2004.

	March 31, 2005		June 30, 2004

Less than one year	$	2,048	$	4,247
Due in 1-2 years	1,713		3,754
Due in 2-5 years	1,979		—
Due after 5 years	65,843		49,259
	$	71,583	$	57,260

Note 5 — Inventories

Inventories consist of the following (in thousands):

	March 31, 2005		June 30, 2004

Raw materials	$	10,278	$	6,266
Work-in-process	1,744		2,444
Finished goods	11,461		6,416
	$	23,483	$	15,126

Note 6 — 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 503,158 and 68,553 at March 31, 2005 and 2004, respectively.

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

	Three Months Ended March 31,				Nine Months Ended March 31,
	2005		2004		2005		2004

Net income	$	1,357	$	2,876	$	5,860	$	8,553

BASIC EPS:
Weighted average number of common shares outstanding	13,990		13,587		13,850		13,288
Basic earnings per share	$	0.10	$	0.21	$	0.42	$	0.64

DILUTED EPS:
Weighted average number of common shares outstanding	13,990		13,587		13,850		13,288

Common stock equivalents from the issuance of options using the treasury stock method	619		964		594		1,112
	14,609		14,551		14,444		14,400
Diluted earnings per share	$	0.09	$	0.20	$	0.41	$	0.59

Note 7 – 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 and nine months ended March 31, 2005 and 2004 was as follows (in thousands):

	Three Months Ended March 31,						Nine Months Ended March 31,
	2005			2004			2005			2004

Net income.	$	1,357		$	2,876		$	5,860		$	8,553
Foreign currency translation effect	13			(5		)	(32		)	(31		)
Unrealized loss on available-for-sale securities	(95		)	—			(156		)	—
Comprehensive income	$	1,275		$	2,871		$	5,672		$	8,522

Note 8 — Bank Borrowings and Debt Arrangements

At March 31, 2005, 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, 2006. 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 (5.75% at March 31, 2005) 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 March 31, 2005, the Company was in compliance with all covenants under the agreement. At March 31, 2005, no amounts were outstanding under the line of credit.

Note 9 — Restructuring Charges

Outsource of Manufacturing Operations

During the first quarter of fiscal year 2005, the Company approved a restructuring plan to discontinue manufacturing operations at their California location and transfer such operations to Sanmina-SCI Corporation, a contract manufacturer. The Company began transferring the manufacturing of all of its product lines to Sanmina in the second quarter of fiscal year 2005. The Company expects the transition to be completed by end of the fourth quarter of fiscal year 2005.

Under the restructuring plan, the Company expects to terminate approximately 100 full-time employees and an additional 35 temporary employees. In addition, the Company expects to incur charges associated with excess facilities and other transition expenses. In total, the Company expects to incur between $2.5 million and $3.0 million of pretax charges related to the transition with the bulk of theses costs occurring during the third and fourth quarters of fiscal year 2005. The remaining one-time employee termination benefits are expected to be paid during the fourth quarter of fiscal year 2005 and the excess facility costs will be paid over the remaining life of the lease, approximately nine years.

One-time Termination benefits are measured at fair value at the communication date and charged to expense ratably over the remaining employee service period as employees are required to work through the service period in order to obtain the termination benefit. During the second and third quarters of fiscal year 2005, the Company recorded charges of $538,000 and $1,093,000, respectively, in cost of revenues associated with the transition. These charges were primarily comprised of accruals for a pro-rated portion of the one-time termination benefits and other out of pocket transition costs which were recorded as incurred.

The following table summarizes charges recorded for these actions (in thousands):

	Employee Related			Other			Total

Restructuring charge	$	1,340		$	291		$	1,631
Cash payments	(73		)	(291		)	(364		)
Accrued restructuring charges at March 31, 2005	$	1,267		$	—		$	1,267

Note 10 – 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 for the nine months ended March 31, 2005 and 2004 were as follows (in thousands):

	Nine Months Ended March 31,
	2005			2004

Balance at beginning period	$	3,577		$	2,129

Settlements made during the period	(4,363		)	(1,850		)
Change in liability for warranties issued during the period	5,603			2,851
Change in liability for preexisting warranties	222			(177		)
Balance at end of period	$	5,039		$	2,953

Changes in the liability for deferred revenue associated with extended warranties for the nine months ended March 31, 2005 and 2004 were as follows (in thousands):

	Nine Months Ended March 31,
	2005			2004
Balance at beginning period	$	3,091		$	1,458

Settlements made during the period	(2,901		)	(1,557		)
Change in liability for warranties issued during the period	4,492			2,645
Change in liability for preexisting warranties	(108		)	(88		)
Balance at end of period	$	4,574		$	2,458

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 $13,300,000 in the next twelve months.

Note 11 – Intangible Assets

The Company had intangible assets net of accumulated amortization of $5,626,000 and $6,924,000 at March 31, 2005 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 March 31, 2005 and 2004, $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 12 – 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 nine months ended March 31, 2005, no shares were repurchased.

During the nine months ended March 31, 2005, employees exercised stock options to purchase 359,031 shares of common stock for a total of approximately $2,900,000. The Company recorded an increase in additional paid-in capital of approximately $700,000 as a result of the income tax benefit related to these stock option exercises and disqualifying dispositions of previously exercised stock options.

Note 13 – Recent Accounting Pronouncements

In November 2004, the FASB issued Statement of Financial Accounting Standards, or SFAS, 151, “Inventory Costs - An amendment of ARB No. 43, Chapter 4”. SFAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs and spoilage should be expensed as incurred and not included in overhead. Further, SFAS 151 requires that allocation of fixed production overhead to conversion costs should be based on normal capacity of the production facilities. The provisions in SFAS 151 are effective for inventory costs incurred during fiscal years beginning after June 15, 2005 and must be applied prospectively. The Company believes that its current accounting policies comply with the new rules and the adoption of this statement will not have a material impact on the Company’s consolidated financial position or results of operations.

In December 2004, the FASB issued FASB Staff Position, or FSP, 109-1, “Application of FASB Statement 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004.” The FSP provides guidance on the application of FASB Statement 109, “Accounting for Income Taxes”, to the provision within the American Jobs Creation Act of 2004 that provides a tax deduction on qualified production activities. According to FSP 109-1, the deduction should be accounted for as a special deduction in accordance with Statement 109. The Company is reviewing the potential impact of the deduction for fiscal 2006.

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.

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. We have been shipping our disk-based appliances under the name REO^TM since August 2003.

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 the third quarter of fiscal 2005, revenues decreased by 1%, compared to the third quarter of fiscal year 2004, and net income and earnings per share fell 53% and 55%, respectively. Our performance reflects a 12% decrease in revenues from our OEM customers partially offset by 21% revenue growth from our branded channel customers. Our largest customer accounted for approximately 54% of total net revenues in the third quarter of fiscal 2005, down from 59% during the comparable period of fiscal 2004. Our gross profit margin decreased from 27.5% in the third quarter of fiscal 2004 to 25.5% in the third quarter of fiscal 2005. The decline in our gross profit included $1.1 million of transition costs related to the outsourcing of our manufacturing process. While we experienced a decline in revenues and gross profit, operating expenses grew by 16%. The spending increase was in (i) sales and marketing, reflecting our continued investment in our branded sales channel, (ii) research and development which included continued investment in our REO™ development and (iii) general and administrative as a result of increased costs associated with compliance with the Sarbanes-Oxley Act of 2002.

During the third quarter of fiscal 2005 we produced positive cash flow that added $1.7 million to our cash and investment balances. We achieved this positive cash flow despite an increase in our inventory position of 25% accompanied by a 43% increase in accounts payable both compared to December 31, 2004. We increased inventory levels to ensure product availability during the transition of manufacturing operations during the fourth quarter of fiscal year 2005. We ended the quarter with approximately $78 million of cash and investments on hand and no outstanding debt.

Our strategy is 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 October 2004, we began shipping 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 that in order to enhance our strategic competitiveness and increase our flexibility we plan to outsource all of our manufacturing and certain related activities. In November 2004, we began to outsource all of our manufacturing, currently located in California, to a U.S. third party manufacturer. We expect to transfer all of our manufacturing operations by the end of the fourth quarter of fiscal 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 recorded $538,000 and $1.1 million, respectively, of these charges in the second and third quarters of fiscal year 2005 as a cost of revenue. We expect these costs to continue through the end of fiscal year 2005, with the bulk of the costs incurred during the third and fourth quarters of fiscal year 2005. In November 2004, the contract with the outsource manufacturer was finalized and all employees had been notified of termination dates and benefits. The results for the third quarter of fiscal year 2005 include an accrual of $861,000, representing a pro-rata portion of the one-time termination benefits and $232,000 of other transition costs which are recorded as incurred.

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 53% of net revenues in the nine months ended March 31, 2005, 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 or nine months ended March 31, 2005.

Our sales to HP may be affected adversely by various factors relating to HP’s business, liquidity, results of operation and financial position. 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 in the process of transitioning our manufacturing operations to a single third party manufacturer.

In November 2004, we entered into a manufacturing services agreement with Sanmina–SCI Corporation under which we have agreed to outsource the manufacturing of all our products exclusively to Sanmina, which is located in Rapid City, South Dakota. We began the transition of our manufacturing to Sanmina in the second quarter of fiscal year 2005 and anticipate the full transfer to occur by June 30, 2005. If this transition is not properly executed, delays may occur, product quality may decline and product cost may increase. If Sanmina 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

In addition, we expect to purchase all of our products from Sanmina on a purchase order basis. Sanmina is not obligated to accept every purchase order we submit and therefore may elect not to supply products to us on the terms we request, including terms related to specific quantities, pricing or timing of deliveries. If Sanmina were to refuse to fulfill our purchase orders on terms that we request or on terms that would enable us to recover our expenses and make a profit, we may lose sales or experience reduced margins, either of which would adversely affect our results of operations. If Sanmina were to cease manufacturing

our products on acceptable terms, we might not be able to identify and secure the services of a new third party manufacturer in a timely manner or on commercially reasonable terms.

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 the first of our 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 product, the industry’s first disk-based alternative to entry-level tape loaders. In October 2004, we began shipping the REO 9000, a larger platform to address the enterprise market.

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 March 31, 2005, our credit facility consisted of a $10.0 million revolving line of credit for working capital purposes which expires on November 30, 2006. At March 31, 2005, 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 opine on 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 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 March 31, 2005, $1.2 million of revenue was deferred for product that 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 March 31,				Nine Months Ended March 31,
	2005		2004		2005		2004
Net revenues	100.0	%	100.0	%	100.0	%	100.0	%
Cost of revenues	74.5		72.5		73.0		73.0
Gross profit	25.5		27.5		27.0		27.0

Operating expenses:
Sales and marketing	14.7		12.9		14.0		12.5
Research and development	4.0		2.8		4.3		3.0
General and administrative	5.2		4.8		4.7		4.6
Total operating expenses	23.9		20.5		23.0		20.1

Income from operations	1.6		7.0		4.0		6.9
Other income:
Interest income, net	0.8		0.3		0.6		0.2
Other income, net	—		0.1		—		—

Income before income taxes	2.4		7.4		4.6		7.1
Provision for income taxes	0.1		2.5		1.4		2.4

Net income	2.3	%	4.9	%	3.2	%	4.7	%

For the three months ended March 31, 2005 and 2004

Net Revenues. Net revenues of $58.3 million in the third quarter of fiscal year 2005 were $507,000 or 0.9% below net revenues of $58.8 million in the third quarter of fiscal year 2004. Revenues from our OEM customers, as a group, during the third quarter of fiscal year 2005 fell $4.1 million or 10.7% compared to the third quarter of fiscal year 2004. This decrease was due primarily to a decline in shipments to HP. Sales to HP accounted for 54% of net revenues in the third quarter of fiscal year 2005, compared to 59% in the third quarter of fiscal year 2004.

Net revenues from Overland branded products during the third quarter of fiscal year 2005 grew 21.0% over the third quarter of fiscal year 2004 from $19.5 million to $23.6 million. This increase was driven by a $2.7 million increase in shipments of our disk-based products, primarily in North America, and $897,000 increase in revenue, from our Europe, Middle East and Africa, or EMEA channel from the last tranch of shipments under a large contract with a European governmental agency.

VR² revenues during the third quarter of fiscal year 2005 amounted to $465,000 and were comprised solely of royalties. VR² revenues during the third quarter of fiscal year 2004 amounted to $1.0 million and were comprised of royalties of $367,000 and chip sales, which are recorded as product sales, of $610,000.

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

	Three Months Ended March 31,				Nine Months Ended March 31,
	2005		2004		2005		2004
Library products:
Neo Series	65.0	%	66.3	%	68.5	%	68.8	%
Loaders	7.9		10.3		8.9		10.2
	72.9		76.6		77.4		79.0

Other:
Spare parts, controllers, other	21.1		21.1		17.5		19.1
Disk-based	5.2		0.6		4.0		0.5
VR²royalties and services	0.8		1.7		1.1		1.4
	100.0	%	100.0	%	100.0	%	100.0	%

Gross Profit. Gross profit amounted to $14.9 million in the third quarter of fiscal year 2005, a decrease of $1.3 million or 7.9% from $16.2 million in the third quarter of fiscal year 2004. The gross margin percentage fell to 25.5% in the third quarter of fiscal year 2005 from 27.5% in the third quarter of fiscal year 2004. Gross profit for the third quarter of fiscal year 2005 included a $1.1 million expense associated with transition of our manufacturing to an outsourced provider. The decrease in gross margin percentage was due to the combination of (i) the transition costs associated with the transition to an outsource manufacturer, (ii) pricing pressures within the branded channel driven by competition and (iii) an increase in warranty cost as a result of more products under warranty compared to the prior year period. For the fourth quarter of fiscal year 2005, we expect our gross margin percentage to benefit from anticipated 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 benefit will be offset somewhat by ongoing transition costs related to outsourced manufacturing. 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 $8.5 million, representing 14.7% of net revenues in the third quarter of fiscal year 2005, compared to $7.6 million or 12.9% of net revenues in the third quarter of fiscal year 2004. This growth reflects the continued expansion of our branded sales force. We expect sales and marketing expenses to increase as we continue to invest in the promotion of our disk-based products.

Research and Development Expense. Research and development expense was $2.3 million, representing 4.0% of net revenues in the third quarter of fiscal year 2005, compared to $1.7 million or 2.8% of net revenues in the third quarter of fiscal year 2004. The increase in research and development spending was due primarily to the continued investment in our REO development. We plan to increase our REO development team during 2005 to ensure a steady flow of new products.

General and Administrative Expense. General and administrative expense of $3.1 million, representing 5.2% of net revenues in the third quarter of fiscal year 2005, compared to $2.8 million or 4.8% of net revenues in the third quarter of fiscal year 2004. In the third quarter of fiscal year 2005, legal fees declined due the settlement in April 2004 of the Raytheon patent infringement lawsuit. However, a $459,000 increase in consulting and auditing fees associated with compliance with the Sarbanes-Oxley Act of 2002 more than offset this decrease. We expect general and administrative expense to remain relatively flat for the remainder of fiscal year 2005.

Interest Income, net. During the third quarter of fiscal year 2005, we generated net interest income of $417,000 compared to $159,000 during the same period of the prior fiscal year. This increase was due primarily to higher average cash balances combined with higher average yields when compared to the 2004 period.

Income Taxes. Our effective tax rate in the third quarter of fiscal year 2005 was 2.3% compared to 34.4% for all of fiscal year 2004. The decrease was the result of revisions to our estimated annual effective tax rate for the year which reflects an increase in the expected benefit from foreign sales and an increase in estimated tax exempt interest income. The third quarter also reflects a $156,000 discrete benefit resulting primarily from a refinement of our tax benefit pertinent to our Extraterritorial Income Inclusion (ETI) on our foreign sales that was recognized in connection with the filing of our fiscal year 2004 income tax returns in March of 2005. Therefore the third quarter of fiscal year 2005 includes the increased benefit from foreign sales for the first nine months of fiscal year 2005 along with the discrete benefit, resulting in the unusually low income tax rate for the third quarter of fiscal year 2005. We expect our fiscal year 2005 effective tax rate to be approximately 29.9%.

For the nine months ended March 31, 2005 and 2004

Net Revenues. Net revenues of $180.3 million in the first nine months of fiscal year 2005 were $2.8 million or 1.5% below net revenues of $183.1 million in the first nine months of fiscal year 2004. Revenues from our OEM customers, as a group, during the first nine months of fiscal year 2005 fell $14.0 million or 11.6% compared to the first nine months of fiscal year 2004. This decrease was due primarily to a decline in shipments to HP. Sales to HP accounted for 53% of net revenues in the first nine months of fiscal year 2005, compared to 60% in the first nine months of fiscal year 2004.

Net revenues from Overland branded products during the first nine months of fiscal year 2005 grew 20.1% over the first nine months of fiscal year 2004 from $59.8 million to $71.9 million. This increase was driven by a $7.2 million increase in shipments of our disk-based products, primarily in North America and a $4.2 million increase in revenue from our EMEA channel from shipments under a large contract with a European governmental agency.

VR² revenues during the first nine months of fiscal year 2005 amounted to $1.9 million and were comprised of royalties of $1.6 million, chip sales of $225,000 and engineering service fees of $75,000. VR² revenues during the first nine months of fiscal year 2004 amounted to $2.6 million and were comprised of royalties of $1.4 million and chip sales of $1.2 million.

Gross Profit. Gross profit amounted to $48.7 million in the first nine months of fiscal year 2005, a decrease of $695,000 or 1.4% from $49.4 million in the first nine months of fiscal year 2004. Gross profit for the first nine months of fiscal year 2005 included a $1.6 million expense associated with transition of our manufacturing to an outsourced provider. Despite the transition expense, the gross margin percentage in the first nine months of fiscal year 2005 remained flat at 27.0% compared to the first nine months of fiscal year 2004. We saw favorable impacts to the gross margin percentage due to (i) a combination of a higher concentration of higher margin branded products versus lower margin OEM products and (ii) cost reduction efforts outpacing the decline in average selling prices, primarily during the first six months of the fiscal year. Directly offsetting the favorable channel mix and cost reduction efforts were the transition costs associated with the transition to an outsource manufacturer and an increase in warranty cost as a result of more products under warranty compared to the prior year period.

Sales and Marketing Expense. Sales and marketing expense amounted to $25.3 million, representing 14.0% of net revenues in the first nine months of fiscal year 2005, compared to $23.0 million or 12.5% of

net revenues in the first nine months of fiscal year 2004. This growth was driven primarily by our continued expansion of our branded sales force.

Research and Development Expense. Research and development expense was $7.7 million, representing 4.3% of net revenues in the first nine months of fiscal year 2005, compared to $5.4 million or 3.0% of net revenues in the first nine months of fiscal year 2004. The increase in research and development spending included a cost of approximately $600,000 related to outside design services for a new tape automation product and continued investment in REO development.

General and Administrative Expense. General and administrative expense was $8.6 million, representing 4.7% of net revenues in the first nine months of fiscal year 2005, compared to $8.4 million or 4.6% of net revenues in the first nine months of fiscal year 2004. In the first nine months of fiscal year 2005, legal fees declined due to the settlement in April 2004 of the Raytheon patent infringement lawsuit. However, a $727,000 increase in consulting and auditing fees associated with compliance with the Sarbanes-Oxley Act of 2002 more than offset this decrease.

Interest Income, net. During the first nine months of fiscal year 2005, we generated net interest income of $1.0 million compared to $368,000 during the same period of the prior fiscal year. This increase was due primarily to higher average cash balances combined with higher average yields when compared to the 2004 period. Also contributing to the increase was the absence of debt in the 2005 period.

Income Taxes. Our effective tax rate in the first nine months of fiscal year 2005 was 29.5%, compared to 34.4% for all of fiscal year 2004. The decrease was due primarily to an increase in our estimated benefit from our foreign sales and a benefit related to tax exempt investments. In addition, the nine month period in fiscal year 2005 reflects a $156,000 discrete benefit resulting primarily from a refinement of our tax benefit pertinent to our Extraterritorial Income Inclusion (ETI) on our foreign sales that was recognized in connection with the filing of our fiscal year 2004 income tax returns in March of 2005.

Liquidity and Capital Resources. At March 31, 2005, we had $77.6 million of cash, cash equivalents and short-term investments. In addition, we have an 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 since going public in 1997 has 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.

Cash provided by operating activities was $7.2 million for the first nine months of fiscal year 2005 compared to $7.7 million for the first nine months of fiscal year 2004. To support the transition of our manufacturing operations to an outsourced provider during the fourth quarter of fiscal year 2005, at the end of the third quarter of fiscal year 2005 we increased our finished good and assembly inventory levels to ensure product availability during the transition process. As a result, operating cash flows during the first nine months of fiscal year 2005 were provided by an increase in accounts payable and used to support the increased inventory position. Accounts receivable increased by $4.8 million during the first nine months of fiscal year 2005 as a result of the increased level of business during the third quarter of fiscal year 2005 compared to the fourth quarter of fiscal year 2004. In the first nine months of fiscal year 2004, operating cash flows were provided by net income for the period and an increase in accounts payable. These sources were partially offset by a use of cash to fund an increase in accounts receivable as a result of the increased revenue in fiscal year 2004.

Cash used in investing activities was $17.2 million for the first nine months of fiscal year 2005 compared to $55.2 million for the first nine months of fiscal year 2004. During the first nine months of fiscal year 2005, we purchased $118.0 million of marketable debt securities and received proceeds of $103.5 million from the sale and the maturity of marketable debt securities. During the first nine months of fiscal year 2004 we purchased $53.6 million of marketable debt securities. Capital expenditures during the first nine months of fiscal years 2005 and 2004 of $2.7 million and $1.7 million, respectively, were comprised

primarily of purchases of computers, related equipment, and in the 2005 period, manufacturing tools associated with a new tape automation product.

Cash provided by financing activities was $3.7 million for the first nine months of fiscal year 2005 compared to $2.1 million for the first nine months of fiscal year 2004. Proceeds from the issuance of common stock under our Employee Stock Purchase Plan and the exercise of stock options were $3.7 million and $6.0 million in the first nine months 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 nine months of fiscal year 2004, principal payments of $4.0 million, representing the entire outstanding balance, were made towards the term note.

We have a credit facility consisting of a $10.0 million revolving line of credit for working capital purposes that expires on November 30, 2006. 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 (5.75% at March 31, 2005) 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 March 31, 2005, 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 March 31, 2005, no amounts were outstanding under the line of credit.

In August 2004, the Board of Directors authorized the purchase of up to $10.0 million 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 March 31, 2005.

In November 2004, we began to outsource all of our manufacturing, currently located in California, to Sanmina, a U.S. third party manufacturer. We expect to transfer all of our manufacturing operations by the end of the fourth quarter of fiscal 2005. As a result of these events, we expect to incur between $2.5 million and $3.0 million of pretax charges for one-time termination benefits, excess facilities and other transition expenses. Remaining payments of the one-time employee termination benefits of approximately $1.8 million and other transition expenses are expected to be paid during the fourth quarter of fiscal year 2005 and the excess facility costs will be paid over the remaining life of the lease, approximately nine years.

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

We have summarized our significant financial contractualobligations as of June 30, 2004 in our Annual Report on Form 10-K for the fiscal year ended June 30, 2004. There have been no subsequent material changes to our contractual obligations from that date with the exception of the severance benefits associated with the transition of our manufacturing operations to Sanmina.

Recent Accounting Pronouncements

rules and the adoption of this statement will not have a material impact on the Company’s consolidated financial position or results of operations.

In December 2004, the FASB issued FSP 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004”, effective upon issuance. The American Jobs Creation Act of 2004 provides for an elective one-time tax deduction of 85% on certain foreign earnings that are repatriated. The Company believes that the deduction will have no impact on the Company’s consolidated financial position or results of operations

In December 2004, the FASB issued SFAS 123(R), “Share-Based Payment”, to expand and clarify SFAS 123, “Accounting for Stock-Based Compensation,” in several areas. SFAS 123(R) requires companies to measure the cost of employee services received in exchange for an award of an equity instrument based on the grant-date fair value of the award. The cost is recognized over the requisite service period (usually the vesting period) for the estimated number of instruments where service is expected to be rendered. SFAS 123(R) is effective beginning in the first quarter of fiscal 2006. The Company is currently evaluating the method of adoption and the impact of FAS 123(R) on the Company’s financial position and results of operations, which is expected to be material. The Company is also evaluating the form of any stock based incentive compensation it may offer in the future.

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 third quarter of fiscal 2005, total interest income was $417,000 with investments yielding an annual average of 2.17% on a worldwide basis. The interest rate level was up approximately 114 basis points from 1.03% in fiscal 2004. If a similar change in overall interest rates (114 basis points) were to occur in the remainder of fiscal 2005, our interest income would change approximately $219,000, 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 March 31, 2005. The cash, cash equivalent and investment balances approximate fair value at March 31, 2005 (in thousands):

	Approximate Market value		Weighted Average Interest Rate

Cash and cash equivalents	$	6,032	2.21	%
Short-term investments:
Less than one year	2,048		2.17	%
Due in 1-2 years	1,713		3.87	%
Due in 2-5 years	1,979		4.12	%
Due after 5 years	65,843		2.58	%
Total cash, cash equivalents and investments	$	77,615	2.61	%

The table above includes the United States dollar equivalent of cash, cash equivalents and short-term investments, including $737,000, and $232,000 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 third 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 Storage, 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.

Because of their inherent limitations, disclosure controls and procedures may not prevent or detect misstatements or omissions in information required to be disclosed by us in the reports that we file or submit under the Exchange Act. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that disclosure controls and procedures may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.

Item 6. — Exhibits

(a) Exhibits

10.1 Executive Corporate MBO & Bonus Programs, Fiscal Year 2005.*

10.2 Summary Sheet of Director and Executive Officer Compensation.*

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.

99.1 Press release dated February 3, 2005 announcing the Registrant’s financial results for the quarter ended December 31, 2004.(1)

99.2 Conference call transcript dated February 3, 2005 announcing the Registrant’s financial results for the quarter ended December 31, 2004.(1)

* Management contract or compensation plan or arrangement.

(1) This exhibit is being furnished in lieu of disclosure under Item 2.02 to Form 8-K, and shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities of that section.

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: May 12, 2005	By:	/s/ Vernon A. LoForti
			Vernon A. LoForti
			Vice President,
			Chief Financial Officer and Secretary

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

PART I	-		FINANCIAL INFORMATION

Item 1.		Financial Statements (unaudited):

		Consolidated Condensed Statement of Operations — Three and nine months ended March 31, 2005 and 2004

		Consolidated Condensed Balance Sheet — March 31, 2005 and June 30, 2004

		Consolidated Condensed Statement of Cash Flows — Nine months ended March 31, 2005 and 2004

		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

Note 8 — Bank Borrowings and Debt Arrangements

Note 9 — Restructuring Charges

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

Risk Factors

Critical Accounting Policies and Estimates

Item 3. — Quantitative and Qualitative Disclosures About Market Risk

Item 4. — Controls and Procedures

PART II — OTHER INFORMATION