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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2004

or

For the transition period from              to             

Commission File Number 000-31623

SIMPLETECH, INC.

(Exact name of Registrant as specified in its charter)

(949) 476-1180

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as described in Exchange Act Rule 12b-2).    Yes  ¨    No  x

The number of shares outstanding of the registrant’s common stock, par value $0.001, as of September 30, 2004 was 47,353,780.

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SIMPLETECH, INC.

INDEX TO FORM 10-Q FOR THE

QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

Except as otherwise noted in this report, “SimpleTech,” the “Company,” “we,” “us” and “our” collectively refer to SimpleTech, Inc.

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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SIMPLETECH, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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SIMPLETECH, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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SIMPLETECH, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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SIMPLETECH, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1—Basis of Presentation

The accompanying interim consolidated financial statements of SimpleTech, Inc., a California corporation (the “Company”), are unaudited and have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of the consolidated financial position of the Company at September 30, 2004, the consolidated results of operations for the three months and nine months ended September 30, 2004 and 2003, and the consolidated results of cash flows for the nine months ended September 30, 2004 and 2003, have been included. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in the most recent Annual Report on Form 10-K filed with the SEC. The December 31, 2003 balances reported herein are derived from the audited consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2003. The results for the interim periods are not necessarily indicative of results to be expected for the full year.

The consolidated financial statements of the Company include the accounts of the Company’s subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Note 2—Revision of Financial Statements

In its Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 31, 2004, the Company revised its previously issued consolidated financial statements for the three months and nine months ended September 30, 2003 for the following four items:

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In the three months ended September 30, 2003, the combined effect of these revisions had no impact on the Company’s gross profit, decreased operating expenses by $106,000, increased net income by $65,000, and had no impact on fully diluted earnings per share. In the nine months ended September 30, 2003, the combined effect of these revisions increased the Company’s gross profit by $141,000, decreased operating expenses by $344,000, decreased net loss by $290,000, and increased fully diluted earnings per share by $0.01.

The effect of the revisions described above, before the discontinued operations described in Note 3, on the three months and nine months ended September 30, 2003 is as follows (in thousands, except per share data):

Statement of Operations:

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Note 3—Discontinued Operations of Xiran Division

In June 2004, the Company discontinued the operation of its Xiran Division, which was formed in 2002 as a result of its acquisition of the assets of Irvine Networks, LLC. The Xiran Division developed advanced board-level solutions that optimized server performance for networked storage applications, including IP storage. In the second quarter of 2004, in addition to the $1.7 million loss from operations of the discontinued Xiran Division, the Company took a charge of approximately $3.0 million that included a $1.5 million write-off of inventory, an $802,000 write-off reflecting the net book value of Xiran Division fixed assets that will no longer be used, a $310,000 write-off of the net book value of the intangible asset recorded at the date of acquisition, a $173,000 lease impairment charge related to the Xiran Division office space that will no longer be used, $102,000 in severance costs of Xiran Division employees who are no longer employed by the Company, and approximately $51,000 in other charges. Monthly rent on the Xiran Division office lease, which expires on June 30, 2005, is approximately $22,000. In calculating the lease impairment charge, the Company reduced the total lease liability by the estimated fair market value of sublease rental income. The closure of the Xiran Division had no impact on net revenues, gross profit or net income in the three months ended September 30, 2004.

Note 4—Summary of Significant Accounting Policies

Use of Estimates:

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities (e.g., bad debt reserves and inventory reserves), disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Concentrations:

As shown in the table below, customer concentrations of accounts receivable and revenues of greater than 10% were as follows:

Concentrations

For the three and nine months ended September 30, 2004, international sales comprised 15% and 19%, respectively, of the Company’s revenues. For each of the three and nine months ended September 30, 2003, international sales comprised 21% of the Company’s revenues. During these periods, no single foreign country accounted for more than 10% of total revenues. For the nine months ended September 30, 2003, Europe accounted for 10.4% of the Company’s total revenues. Other than Europe in the nine months ended September 30, 2003, no other foreign geographical area accounted for more than 10% of the Company’s total revenues in the three months and nine months ended September 30, 2004 and 2003. Substantially all of the Company’s international sales are export sales, which are shipped from the Company’s domestic facility to foreign customers.

Warranties:

The Company’s memory products are generally sold under various limited warranty arrangements, which range from one year to the product’s lifetime. Estimated warranty costs are recorded concurrently with the recognition of revenue. The estimated future costs of repair or replacement are immaterial and have approximated management’s estimates.

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Sales and marketing incentives:

Sales and marketing incentives are offset against revenues or charged to operations in accordance with Emerging Issues Task Force Issue No. 01-09. Sales and marketing incentives amounted to $2.0 million and $2.1 million for the three months ended September 30, 2004 and 2003, respectively, of which $1.6 million and $1.4 million, respectively, were offset against revenues, and $456,000 and $747,000, respectively, were charged as operating expense. Sales and marketing incentives amounted to $5.4 million and $6.5 million for the nine months ended September 30, 2004 and 2003, respectively, of which $3.8 million and $3.8 million, respectively, were offset against revenues, and $1.6 million and $2.7 million, respectively, were charged as an operating expense.

Shipping and handling costs:

Shipping and handling costs incurred in a sales transaction to ship products to a customer are included in sales and marketing. For the three months ended September 30, 2004 and 2003, shipping and handling costs were approximately $402,000 and $561,000, respectively. For the nine months ended September 30, 2004 and 2003, shipping and handling costs were approximately $1.5 million and $1.7 million, respectively.

Income taxes:

Deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end based on enacted tax laws and statutory rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred income tax assets to the amount expected to be realized. The provision for income taxes represents the tax payable for the year and the change during the year in deferred income tax assets and liabilities.

For quarterly reporting purposes, the Company estimates their annual effective tax rate and applies this rate to interim results. The Company allocated the provision (benefit) for income taxes to continuing and discontinued operations using a “with-and-without” approach.

There may be limitations on the Company’s ability to utilize net operating loss carryforwards with future changes in ownership.

Reclassifications:

Certain reclassifications have been made to prior period amounts to conform with the current period presentation.

Note 5—Net Income (Loss) Per Share

Basic earnings per share is computed by dividing net income (loss) by the weighted average number of shares outstanding. In computing diluted earnings per share, the weighted average number of

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shares outstanding is adjusted to reflect the potentially dilutive securities. Options to purchase 8,482,906 and 9,257,568 shares of common stock were outstanding at September 30, 2004 and 2003, respectively. For the three months and nine months ended September 30, 2004, potentially dilutive securities consisted solely of options and resulted in potential common shares of 1,018,261 and 1,793,081, respectively. For the three months and nine months ended September 30, 2003, potentially dilutive securities consisted solely of options and resulted in potential common shares of 3,037,147 and 1,624,646, respectively.

Pursuant to SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company has elected to continue the intrinsic value method of accounting for stock options granted to employees and directors in accordance with APB Opinion No. 25 and related interpretations in accounting for stock option plans. Had compensation cost been determined based on the fair value at the grant dates for stock options under the Plan consistent with the method promulgated by SFAS No. 123, the Company’s net income (loss) for the three months and nine months ended September 30, 2004 and 2003, would have resulted in the pro forma amounts below:

Note 6—Supplemental Balance Sheet Information

Inventory consists of the following:

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Note 7—Commitments and Contingencies

DPAC Technologies, Inc.—Patent Infringement

On September 23, 1998, the Company filed a lawsuit against DPAC Technologies, Inc., formerly Dense-Pac Microsystems, Inc. (“DPAC”), in the United States District Court for the Central District of California for infringement of the Company’s IC Tower stacking patent, U.S. Patent No. 5,514,907. On March 29, 2001, the District Court entered final judgment finding DPAC did not infringe the Company’s patent and that the Company did not infringe DPAC’s patent. The Appeals Court affirmed the final judgment on March 7, 2002. On June 3, 2002, the Company filed a petition for certiorari with the U.S. Supreme Court. On October 7, 2002, the petition to the Supreme Court was granted and the matter was remanded to the Circuit Court of Appeals. DPAC filed a motion for summary affirmance with the Circuit Court of Appeals. The Court of Appeals denied the motion and remanded the matter back to District Court to reconsider the case in light of a recent decision by the U.S. Supreme Court. On September 15, 2003, the District Court re-entered judgment that DPAC does not infringe the Company’s patent. Subsequently, the Company filed the appropriate documents to seek review of the last decision.

On March 8, 2004, the Company entered into a confidential settlement agreement whereby it agreed to dismiss with prejudice its appeal of the case. Under the settlement, the Company granted DPAC a paid-up, non-exclusive license under the affected patents. This settlement is a complete and amicable resolution and should not be construed as an admission by any of the parties to this litigation of any wrongdoing.

Lemelson Medical, Education & Research Foundation, LLP—Patent Infringement

The Company received notice on November 26, 2001 that the Lemelson Medical, Education & Research Foundation, LLP (“Lemelson Foundation”) filed a complaint on November 13, 2001 against the Company and other defendants. The complaint was filed in the District Court of Arizona and alleges that the Company’s manufacturing processes infringe several patents that the Lemelson Foundation allegedly owns. The complaint also states that these allegedly infringed patents relate to machine vision technology and bar coding technology. On March 7, 2002, the Company was served with the Lemelson Foundation complaint. Thereafter, the case was stayed pending the outcome of related cases against other parties involving the same patents. Because of the preliminary stage of this case, an estimate of potential damages, if any, would be premature and speculative. The Company has not made any such estimate at this time since it is not probable there will be an unfavorable outcome.

Staktek Corporation—Patent Infringement

On July 30, 2003, the Company filed a lawsuit against Staktek Corporation in the United States District Court for the Central District of California for infringement of its IC Tower stacking patent, U.S. Patent No. Re. 36,916. The Company sought monetary damages, an injunction against further infringement of its patent, attorneys’ fees and trebled damages. Staktek answered the complaint denying infringement and alleged that the patent is invalid.

On October 10, 2003, Staktek Group, L.P., a subsidiary of Staktek Corporation, filed a lawsuit against the Company in the United States District Court for the Western District of Texas which alleged that the Company’s IC Tower stacking products infringe on Staktek’s U.S. patents Nos. 6,025,642 and 6,049,123. Staktek sought a permanent injunction against further infringement of the ‘642 and ‘123 patents, monetary damages, interest on damages, costs and attorneys’ fees and trebled damages.

On March 31, 2004, the Company resolved its two lawsuits with Staktek Group L.P. The parties agreed to a mutual dismissal with prejudice of the intellectual property infringement lawsuits. In settlement of these matters, both parties agreed not to sue each other, its customers, or licensees in the future for patent infringement in connection with making or selling the products related to the lawsuits. Under the terms of the settlement, no money was exchanged, and neither party licensed its technology to the other.

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Other Legal Proceedings

The Company is currently not a party to any other material legal proceedings. However, the Company is involved in other suits and claims in the ordinary course of business, and the Company may from time to time become a party to other legal proceedings arising in the ordinary course of business.

Indemnification

The Company has agreements whereby the Company indemnifies its officers and directors over his or her lifetime for certain events or occurrences while the officer or director is, or was serving, at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a Director and Officer insurance policy that limits the Company’s exposure and should enable the Company to recover a portion of any future amounts paid. As a result of the Company’s insurance coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of September 30, 2004.

As is common in the industry, the Company currently has in effect a number of agreements in which the Company has agreed to defend, indemnify and hold harmless certain of its suppliers and customers from damages and costs which may arise from the infringement by the Company’s products of third-party patents, trademarks or other proprietary rights. The scope of such indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorneys’ fees. The Company’s insurance does not cover intellectual property infringement. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of September 30, 2004.

Other Commitments

The Company is subject to repurchase agreements with various financial institutions in connection with wholesale inventory financing. Under these agreements, the Company may be required to repurchase inventory upon customer default with a financing institution and then resell the inventory through normal distribution channels. As of September 30, 2004, the Company has not been required to repurchase inventory in connection with the customer default agreements noted above. However, it may be possible that the Company will be required to repurchase inventory, upon customer default, in the future. Sales under such agreements were approximately $256,000 and $167,000 in the three months ended September 30, 2004 and 2003, respectively and $861,000 and $677,000 in the nine months ended September 30, 2004 and 2003, respectively.

Note 8—Segment Information

The Company reports financial results for two reportable operating segments: Consumer and OEM. Previously, the Company also reported financial results for its Xiran Division, which discontinued operations in June 2004. The accounting policies for the reportable operating segments are the same as those described in Note 3 from the Company’s Annual Report on Form 10-K and reflect the information used by the Company’s management to evaluate the performance of its segments. For the Consumer and OEM segments, the Company tracks separately net sales and gross profit, but does not track separately operating expenses, interest or income taxes. The Company does not maintain separate records to identify assets by operating segment.

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Summarized financial information regarding the Company’s two reportable segments is shown in the following table:

Note 9—Stock Repurchase

In June 2004, the Company’s board of directors authorized the repurchase of up to $15 million of its outstanding common stock from time to time over the next 18 months. The Company repurchased 749,309 shares of common stock at an average share price of $3.56, including commissions, in the third quarter of 2004. No common stock was repurchased prior to the third quarter of 2004. Shares may be purchased from time to time at prevailing market prices through open market or unsolicited negotiated transactions, depending on market conditions and other considerations. There is no guarantee as to the exact number of shares that will be repurchased by the Company, and the Company may discontinue purchases at any time when its management determines that additional purchases are not warranted. Repurchased shares would be returned to the status of authorized but unissued shares of common stock. The Company believes that all funds required for the repurchase of common stock will be obtained from its available cash resources and marketable securities.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Statement

Certain statements in this report, including statements regarding our strategy, financial performance and revenue sources, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, and are subject to the safe harbors created by those sections. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs, and certain assumptions made by us. Such statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. The section entitled “Risk Factors” set forth in this Form 10-Q and similar discussions in filings with the Securities and Exchange Commission made from time to time, including other quarterly reports on Form 10-Q, our Annual Reports on Form 10-K, and in our other SEC filings, discuss some of the important risk factors that may affect our business, results of operations and financial condition.

The following discussion should be read in conjunction with our consolidated financial statements and notes thereto.

Overview

SimpleTech, Inc. was originally incorporated in California in March 1990 as Simple Technology, Inc. Our name was then changed to SimpleTech, Inc. in May 2001. SimpleTech designs, manufactures and markets custom and open-standard memory solutions based on Flash memory and DRAM technologies. Headquartered in Santa Ana, California, SimpleTech offers a comprehensive line of over 2,500 products and specializes in developing high-density memory modules, memory cards and storage drives.

In June 2004, we discontinued the operation of our Xiran Division, which was formed in 2002 as a result of our acquisition of the assets of Irvine Networks, LLC.

In the second quarter of 2004, we executed several initiatives that contributed to the increased profitability in the third quarter of 2004. We expect that these initiatives, such as discontinuing the operations of our Xiran Division and reducing our general and administrative costs, including legal and litigation costs, will result in a decrease in operating expenses of nearly $10 million per year.

We expect our OEM Division to continue to expand its high-capacity IC Tower stacking DRAM module business with our networking and server customers. Our Flash memory engineers are also expected to introduce several new proprietary products by the end of 2004. These products are aimed at the high-capacity Flash storage market. With chipmakers working to find viable channels to place their increased output, we believe the supply of competitively-priced Flash chips is improving.

After we experienced revenue growth of 57.5% from 1998 to 1999 and 60.1% in 2000, revenues declined 46.7% in 2001. Revenues increased 7.5% in 2002 and 20.0% in 2003. Annual revenues in 2001 and 2002 were negatively impacted by deteriorating macroeconomic conditions, severe declines in the price of DRAM components, and significantly reduced sales to customers in the communications and networking markets. These negative conditions began to improve during the second quarter of 2003 and have continued to improve through the third quarter of 2004 as demand for DRAM products increased and component prices stabilized. However, there can be no assurance that the demand for DRAM products will increase or component prices will remain stable or that such trends will continue in the future.

In the past five quarters, we have experienced significant growth in demand for our IC Tower stacking DRAM products from customers in the networking and server market sectors. Our high-capacity IC Tower stacking DRAM modules are used by our customers in their high-end switching equipment and enterprise servers where maximizing memory content in the device is a priority. Our IC Tower stacking DRAM revenues have grown from $2.6 million in the second quarter of 2003 to $17.2 million in the second quarter of 2004, and then increased by 97.1% sequentially in the third quarter of 2004 to $33.9 million.

In recent years, we have experienced an increase in demand for our Flash products as the result of the growth in consumer electronics and OEM applications, such as the replacement of rotating disk drives with Flash products. Our Flash revenues increased from $24.9 million for the year ended December 31, 1999 to $80.3 million for the year ended December 31, 2003. Despite this growth, our revenues from Flash products in the fourth quarter of 2003 and the first nine months of 2004 were negatively impacted by Flash supply constraints and negative Flash component pricing dynamics. We believe the expected addition of new Flash suppliers in the industry and increased Flash capacity in the second half of 2004 will reduce the supply constraint and have a positive impact on our Flash revenues and gross margins as well as our competitiveness in the market.

We sell our products through our Consumer Division and our OEM Division. Our Consumer Division sells our products through the following channels: VAR, mail order, distributor and mass-market retailer. Our OEM Division was created in late 1998 to enhance the marketing of our customized products to OEMs.

Gross profit as a percentage of revenues for our OEM Division is typically higher than our Consumer Division. We track revenues and gross margins for our Consumer and OEM Divisions. We do not track separately, and do not intend to track separately, operating expenses for our Consumer and OEM Divisions.

Historically, a small number of customers have accounted for a significant percentage of our revenues. Our ten largest customers accounted for an aggregate of 77% and 67% of our total revenues in three months and nine months ended September 30, 2004, respectively, compared to 53% and 50% of our total revenues in the three months and nine months ended September 30, 2003, respectively. CDW Computer Centers, Micron Semiconductor and SMART Modular accounted for 19%, 16% and 13%, respectively, of our total revenues in the nine months ended September 30, 2004. Micron Semiconductor, CDW Computer Centers and SMART Modular accounted for 22%, 18% and 15%, respectively, of our total revenues in the three months ended September 30, 2004. CDW Computer Centers accounted for 20% of our total revenues in each of the three months and nine months ended September 30, 2003. Other than CDW Computer Centers, Micron Semiconductor and SMART Modular, no customer accounted for more than 10% of our total revenues in the three months and nine months ended September 30, 2004 or September 30, 2003. The composition of our major customer base changes from quarter to quarter as the market demand for our products changes, and we expect this variability will continue in the future. We expect that sales of our products to a limited number of customers will continue to account for a majority of our revenues in the foreseeable future. The loss of, or a significant reduction in purchases by any of our major customers, would harm our business, financial condition and results of operations. See “Risk Factors—Sales to a limited number of customers represent a significant portion of our revenues, and the loss of any key customer would materially reduce our revenues.”

International sales of our products constituted 19% and 21% of our total revenues for the first nine months of 2004 and the first nine months of 2003, respectively. Except for Europe, which accounted for 10% of our revenues in the first nine months of 2003, no other foreign geographical area or single foreign country accounted for more than 10% of our revenues in the first nine months of 2004 or 2003. During the first nine months of 2004 and 2003, over 95% of our international sales were denominated in U.S. dollars. In addition, our purchases of IC components are currently denominated in U.S. dollars. However, we do face risks associated with doing business in foreign countries. See “Risk Factors—We face risks associated with doing business in foreign countries, including foreign currency fluctuations and trade barriers, that could lead to a decrease in demand for our products or an increase in the cost of the components used in our products.”

In the past, we have been impacted by seasonal purchasing patterns resulting in lower sales in the first and second quarters of each year. Other factors, including component price fluctuations, may distort the effect of seasonality. Our ability to adjust our short-term operating expenses in response to fluctuations in revenues is limited. As a result, should revenues decrease to a level lower than expected in any given period, our results of operations would be harmed.

Revenues are recognized when title and risk of loss has passed to the customer. We face risks associated with declines in the market value of our products, product returns, inventory write-downs, price protection and rebates. See “Risk Factors—Order cancellations, product returns, inventory write-downs, price protection and rebates could adversely affect our results of operations.”

Revision of Financial Statements

Our Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 31, 2004 reflects revisions to our previously issued consolidated financial statements for the three months and nine months ended September 30, 2003 for the following four items:

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In the three months ended September 30, 2003, the combined effect of these revisions had no impact on our gross profit, decreased operating expenses by $106,000, increased net income by $65,000, and had no impact on fully diluted earnings per share. In the nine months ended September 30, 2003, the combined effect of these revisions increased our gross profit by $141,000, decreased operating expenses by $344,000, decreased net loss by $290,000, and increased fully diluted earnings per share by $0.01.

The effect of the revisions described above on the three months and nine months ended September 30, 2003 are as follows (in thousands, except per share data):

Statement of Operations:

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Discontinued Operations of Xiran Division

In June 2004, we discontinued the operation of our Xiran Division, which was formed in 2002 as a result of our acquisition of the assets of Irvine Networks, LLC. The Xiran Division developed advanced board-level solutions that optimized server performance for networked storage applications, including IP storage. In the first half of 2004, the discontinued Xiran Division recorded a $4.1 million operating loss before benefit for income taxes. In addition, we took a pre-tax charge of approximately $3.0 million that included a $1.5 million write-off of inventory, an $802,000 write-off reflecting the net book value of Xiran Division fixed assets that will no longer be used, a $310,000 write-off of the net book value of the intangible asset recorded at the date of acquisition, a $173,000 lease impairment charge related to the Xiran Division office space that will no longer be used, $102,000 in severance costs of Xiran Division employees who are no longer employed by us, and approximately $51,000 in other charges. Monthly rent on the Xiran Division office lease, which expires on June 30, 2005, is approximately $22,000. In calculating the lease impairment charge, we reduced the total lease liability by the estimated fair market value of sublease rental income. The closure of the Xiran Division had no impact on net revenues, gross profit or net income in the three ended September 30, 2004.

Results of Operations—Comparison of the Third Quarter of 2004 to the Third Quarter of 2003

Net Revenues. Our revenues were $75.0 million in the third quarter of 2004, compared to $57.5 million in the same period in 2003. Revenues increased 30.4% in the third quarter of 2004 due to a 55.0% increase in average sales price, partially offset by a 15.8% decrease in units shipped. The increase in our average sales price resulted primarily from a shift in revenue mix toward OEM Division revenue, which typically is comprised of higher-capacity products with higher average sales prices, such as our stacked DRAM products. The mix of products sold varies from quarter to quarter and may vary in the future, affecting our overall average sales prices and gross margins.

Our OEM Division revenues increased 150.0% from $15.6 million in the third quarter of 2003 to $39.0 million in the third quarter of 2004. The increase in OEM Division revenues was due to a 106.8% increase in average sales price and a 21.0% increase in units shipped. During the third quarter of 2004, the composition of OEM Division revenues shifted towards higher priced high-capacity stacked DRAM products. In addition, the increase in OEM Division revenues is also partially attributable to greater demand and increased market share in the high-end server and telecom sectors. Our Consumer Division revenues decreased 14.1% from $41.9 million in the third quarter of 2003 to $36.0 million in the third quarter of 2004. Consumer Division revenues decreased in the third quarter of 2004 due primarily to a 23.9% decrease in units shipped, partially offset by a 13.0% increase in average sales price. This reduction in Commercial Division unit volume is primarily a result of our decision to reduce the sales of our Flash products into certain unprofitable sales channels.

Sales of our products are made under short-term cancelable purchase orders. We include in our backlog only those customer orders for which we have accepted purchase orders and to which we have assigned shipment dates within the upcoming six months. Since orders constituting our backlog are subject to change due to, among other things, customer cancellations and reschedulings, and our ability to procure necessary components, backlog is not necessarily an indication of future revenues. In addition, there can be no assurance that current backlog will necessarily lead to revenues in any future period. Our combined backlog was $13.0 million as of September 30, 2004, compared to $7.7 million as of September 30, 2003. Our OEM Division backlog was $9.1 million as of September 30, 2004, compared to $4.6 million as of September 30, 2003 due primarily to increased order bookings for our stacking memory products with our high-end server and telecom customers in the third quarter of 2004 compared to the same period in 2003. Our Consumer Division backlog was $3.9 million as of September 30, 2004, compared to $3.1 million as of September 30, 2003.

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Consumer Division backlog is typically nominal since substantially all Consumer Division orders are filled on a same-day or next-day basis. Our ability to predict future sales is limited because a majority of our quarterly product revenues come from orders that are received and fulfilled in the same quarter.

Gross Profit. Our gross profit was $13.5 million in the third quarter of 2004, compared to $9.8 million in the same period in 2003. Gross profit as a percentage of revenues was 18.0% in the third quarter of 2004, compared to 17.0% in the same period in 2003. Gross profit for our OEM Division as a percentage of OEM Division revenues was 20.2% in the third quarter of 2004, compared to 17.5% in the third quarter of 2003. Gross profit for our Consumer Division as a percentage of Consumer Division revenues was 15.5% in the third quarter of 2004, compared to 16.9% in the third quarter of 2003. The change in our OEM Division and Consumer Division gross profit as a percentage of revenues resulted primarily from a shift in product and customer revenue mix.

In June 2004, we discontinued the operation of our Xiran Division. No revenues or operating expenses were recorded in the third quarter of 2004 related to our discontinued Xiran Division. The operating expense figures for the third quarter of 2003 below do not include expenses related to our discontinued Xiran Division.

Sales and Marketing. Sales and marketing expenses are primarily comprised of personnel costs and travel expenses for our domestic and international sales and marketing employees, commissions paid to internal salespersons and independent manufacturers’ representatives, shipping costs and marketing programs. Sales and marketing expenses were $5.0 million in the third quarter of 2004, compared to $4.1 million in the same period in 2003. Sales and marketing expenses increased due primarily to higher sales commissions and marketing costs related to the increased revenue base. Sales and marketing expenses as a percentage of revenues were 6.7% in the third quarter of 2004, compared to 7.1% in the same period in 2003. Sales and marketing expenses as a percentage of revenues decreased as a result of leveraging certain fixed sales and marketing expenses over a larger revenue base.

General and Administrative. General and administrative expenses are comprised primarily of personnel costs for our executive and administrative employees, professional fees and facilities overhead. General and administrative expenses were $2.5 million in the third quarter of 2004, compared to $2.6 million in the same period in 2003. General and administrative expenses as a percentage of revenues were 3.3% in the third quarter of 2004 and 4.5% in the third quarter of 2003. General and administrative expenses as a percentage of revenues decreased as a result of leveraging certain fixed general and administrative expenses over a larger revenue base.

Research and Development. Research and development expenses are comprised primarily of personnel costs for our engineering and design staff and the cost of prototype supplies. Research and development expenses were $1.2 million in the third quarter of 2004, compared to $613,000 in the same period in 2003. Research and development expenses as a percentage of revenues were 1.6% in the third quarter of 2004, compared to 1.1% in the same period in 2003. Research and development expenses increased primarily due to additional engineers hired and product development costs incurred in order to expand our OEM Division Flash and storage product offerings.

Interest Income. Interest income was $291,000 in the third quarter of 2004 and $100,000 in the third quarter of 2003. Interest income is comprised primarily of interest earned on our cash, cash equivalents and marketable securities. This increase in interest income resulted from higher average interest rates and an increase in our average cash balance in the third quarter of 2004 compared to the third quarter of 2003.

Provision for Income Taxes from Continuing Operations. Provision for income taxes was $2.0 million in the third quarter of 2004. Provision for income taxes from continuing operations was $896,000 in the third quarter of 2003. As a percentage of income from continuing operations before provision for income taxes, provision for income taxes was 39.9% and 34.4% in the third quarter of 2004 and 2003, respectively. Provision for income taxes as a percentage of income from continuing operations before provision for income taxes was higher in the first three months of 2004 due to a more significant impact of income tax credits on near break-even results in the first three months of 2003.

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Income from Continuing Operations. Income from continuing operations was $3.1 million and $1.7 million in the third quarters of 2004 and 2003, respectively.

Results of Operations—Comparison of the first nine months of 2004 to the first nine months of 2003

Net Revenues. Our revenues were $197.8 million in the first nine months of 2004, compared to $143.1 million in the same period in 2003. Revenues increased 38.2% in the first nine months of 2004 due to a 61.3% increase in average sales price, partially offset by a 14.3% decrease in units shipped. The increase in our average sales price resulted primarily from a shift in revenue mix toward OEM Division revenue, which typically is comprised of higher capacity products with higher average sales prices, such as our stacked DRAM products. The mix of products sold varies from quarter to quarter and may vary in the future, affecting our overall average sales price and gross margins.

Our OEM Division revenues increased 171.6% from $33.4 million in the first nine months of 2003 to $90.7 million in the first nine months of 2004. The increase in OEM Division revenue was due to a 148.1% increase in OEM Division average sales price in the first nine months of 2004 and a 9.4% increase in OEM Division unit volume during this period. The composition of OEM Division revenues shifted towards higher priced high-capacity stacked DRAM products. Our Consumer Division revenues decreased 2.4% from $109.7 million in the first nine months of 2003 to $107.1 million in the first nine months of 2004. Consumer Division revenues decreased in the first nine months of 2004 due to a 20.3% decrease in Consumer Division units shipped, partially offset by a 22.5% increase in Consumer Division average sales price. Our Consumer Division average sales price increased due to higher average DRAM component prices in the first nine months of 2004 compared to the same period in 2003. This reduction in Consumer Division unit volume is primarily a result of our decision to reduce the sales of our Flash products into certain unprofitable sales channels.

Gross Profit. Our gross profit was $33.2 million in the first nine months of 2004, compared to $24.6 million in the same period in 2003. Gross profit as a percentage of revenues was 16.8% in the first nine months of 2004, compared to 17.2% in the same period in 2003. Gross profit for our OEM Division as a percentage of OEM Division revenues was 18.8% in the first nine months of 2004, compared to 22.7% in the first nine months of 2003. This decrease in gross profit as a percentage of revenues for our OEM Division resulted primarily from a shift in product and customer revenue mix. Gross profit for our Consumer Division as a percentage of Consumer Division revenues was 15.1% in the first nine months of 2004, compared to 15.5% in the first nine months of 2003. Gross profit for our Consumer Division as a percentage of Consumer Division revenues for the first nine months of 2004 and 2003 was relatively flat.

In June 2004, we discontinued the operation of our Xiran Division, which had no impact on our net revenues or gross profit for the first nine months of 2004. There were no operating expenses incurred after June 2004 related to our discontinued Xiran Division. The operating expense figures below do not include expenses related to our discontinued Xiran Division.

Sales and Marketing. Sales and marketing expenses are comprised primarily of personnel costs and travel expenses for our domestic and international sales and marketing employees, commissions paid to internal salespersons and independent manufacturers’ representatives, shipping costs and marketing programs. Sales and marketing expenses were $14.2 million in the first nine months of 2004, compared to $13.6 million in the same period in 2003. Sales and marketing expenses as a percentage of revenues were 7.2% in the first nine months of 2004, compared to 9.5% in the same period in 2003. Sales and marketing expenses as a percentage of revenues decreased as a result of leveraging certain fixed sales and marketing expenses over a larger revenue base.

General and Administrative. General and administrative expenses are comprised primarily of personnel costs for our executive and administrative employees, professional fees and facilities overhead. General and administrative expenses were $7.5 million in the first nine months of 2004, compared to $7.1 million in the same period in 2003. General and administrative expenses as a percentage of revenues were 3.8% in the first nine months of 2004 and 5.0% in the first nine months of 2003. General and administrative expenses as a percentage of revenues decreased as a result of leveraging certain fixed general and administrative expenses over a larger revenue base.

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Research and Development. Research and development expenses are comprised primarily of personnel costs for our engineering and design staff and the cost of prototype supplies. Research and development expenses were $3.0 million in the first nine months of 2004, compared to $1.8 million in the same period in 2003. Research and development expenses as a percentage of revenues were 1.5% in the first nine months of 2004, compared to 1.3% in the same period in 2003. Research and development expenses increased due primarily to additional engineers hired and product development costs incurred in order to expand our OEM Division Flash and storage product offerings.

Interest Income. Interest income was $692,000 in the first nine months of 2004 and $376,000 in the first nine months of 2003. Interest income is comprised primarily of interest earned on our cash, cash equivalents and marketable securities. This increase in interest income resulted from higher interest rates and an increased average cash balance in the first nine months of 2004 compared to the first nine months of 2003.

Provision for Income Taxes from Continuing Operations. Provision for income taxes from continuing operations was $3.6 million in the first nine months of 2004, compared to $672,000 in the first nine months of 2003. As a percentage of income from continuing operations before provision for income taxes, provision for income taxes was 39.2% and 27.4% in the first nine months of 2004 and 2003, respectively. Provision for income taxes as a percentage of income from continuing operations before provision for income taxes was higher in the first nine months of 2004 due to a more significant impact of income tax credits on near break-even results in the first nine months of 2003.

Income from Continuing Operations. Income from continuing operations was $5.6 million and $1.8 million in the first nine months of 2004 and 2003, respectively.

Liquidity and Capital Resources

As of September 30, 2004, we had working capital of $117.4 million, including $65.7 million of cash and cash equivalents and $10.0 million in marketable securities, compared to working capital of $114.1 million, including $30.8 million of cash and cash equivalents and $45.6 million in marketable securities as of December 31, 2003. Current assets were 5.5 times current liabilities at September 30, 2004 and December 31, 2003.

Net cash provided by operating activities was $2.3 million for the first nine months of 2004 and resulted primarily from a $3.0 million loss from the disposal of our Xiran Division, $2.5 million in depreciation and amortization, and $1.5 million in net income, partially offset by a $3.4 million increase in accounts receivable, net of allowances, and a $1.4 million increase in inventory, net.

Net cash provided by investing activities was $34.6 million for the first nine months of 2004, attributable primarily to a $35.7 million reduction in investments in marketable securities, partially offset by $1.3 million in purchases of furniture, fixtures and equipment. We expect to spend approximately $3.0 million to $5.0 million on capital expenditures during the next 24 months, primarily for the purchase of manufacturing, testing and engineering equipment.

Net cash used in financing activities was $1.9 million for the first nine months of 2004 and resulted primarily from $2.7 million of common stock repurchased under our stock buy back plan, partially offset by the receipt of $757,000 in proceeds from the issuance of common stock related to stock option exercises and purchases of stock by employees through our employee stock purchase plan.

In June 2004, our board of directors authorized the repurchase of up to $15 million of our outstanding common stock from time to time over the next 18 months. We repurchased 749,309 shares of common stock at an average share price of $3.56, including commissions, in the third quarter of 2004. No common stock was repurchased prior to the third quarter of 2004. Shares may be purchased from time to time at prevailing market prices through open market or unsolicited negotiated transactions, depending on market conditions and other considerations. There is no guarantee as to the exact number of shares that will

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be repurchased by us, and we may discontinue purchases at any time when management determines that additional purchases are not warranted. Repurchased shares would be returned to the status of authorized but unissued shares of common stock. We believe that all funds required for the repurchase of common stock will be obtained from our available cash resources and marketable securities.

We believe that our current assets, including cash and cash equivalents and expected cash flow from operations will be sufficient to fund our operations for at least the next twelve months. However, it is possible that we may need or elect to raise additional funds to fund our activities beyond the next year or to consummate acquisitions of other businesses, products or technologies. We could raise such funds by borrowing money or selling more stock to the public or to selected investors. In addition, even though we may not need additional funds, we may still elect to sell additional equity securities or obtain credit facilities for other reasons. We cannot assure you that we will be able to obtain additional funds on commercially favorable terms, or at all. If we raise additional funds by issuing additional equity or convertible debt securities, the ownership percentages of existing shareholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges senior to those of the holders of our common stock.

Although we believe we have sufficient capital to fund our activities for at least the next twelve months, our future capital requirements may vary materially from those now planned. The amount of capital that we will need in the future will depend on many factors, including:

Contractual Obligations

There have been no material changes to our Contractual Obligations described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

Inflation

Inflation was not a material factor in either revenue or operating expenses during the three and nine months ended September 30, 2004 and 2003.

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are 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 these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses for each period. The following represents a summary of our critical accounting policies, defined as those policies that we believe are: (a) the most important to the portrayal of our financial condition and results of operations, and (b) that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Consideration given by us to a customer is presumed to be a reduction of selling price, and therefore, a reduction of revenue. However, if we receive an identifiable benefit in return for the consideration given to our customer that is sufficiently separable from our sales to that customer, such that we could have paid an independent company to receive that benefit; and we can reasonably estimate the fair value of that benefit, then the consideration is characterized as an expense. We estimate the fair value of the benefits we receive by tracking the advertising done by our customers on our behalf and calculating the value of that advertising using a comparable rate for similar publications.

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income must be assessed and, to the extent that recovery is not likely, we establish a valuation allowance. Increases in valuation allowances result in the recording of additional tax expense. Further, if our ultimate tax liability differs from the periodic tax provision reflected in the consolidated statements of operations, additional tax expense may be recorded.

Risk Factors

This Report contains forward-looking statements based on the current expectations, assumptions, estimates and projections about our industry and us. These forward-looking statements involve risks and uncertainties. Our actual results could differ materially from those discussed in these forward-looking statements as a result of certain factors, as more fully described in this section and elsewhere in this Report. You should carefully consider the following risks before you decide to buy shares of our common stock. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties, including those risks set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” above, may also adversely impact and impair our business. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. In such case, the trading price of our common stock could decline, and you may lose all or part of the money you paid to buy our stock. We do not undertake to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

We expect our quarterly operating results to fluctuate in future periods, causing our stock price to fluctuate or decline.

Our quarterly operating results have fluctuated in the past, and we believe they will continue to do so in the future. Our future results of operations will depend on many factors including:

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