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Hauppauge Digital Inc (HAUP) SEC Filing 10-K Annual report for the fiscal year ending Sunday, September 30, 2007

Hauppauge Digital Inc

CIK: 930803 Ticker: HAUP
                                                                                                            Exhibit 99.1

Investor Contacts: Gerald Tucciarone
Chief Financial Officer
631/434-1600, extension 306                                                                                                

HAUPPAUGE DIGITAL REPORTS FISCAL 2007
THIRD QUARTER AND NINE MONTH RESULTS
________________________________________________________________

Reports third quarter sales of  $23.5  million and net income of $0.02 per share,
Nine month sales of $83.4 million and net income of $.35 per share

 ________________________________________________________________

 
HAUPPAUGE, NY – August 8, 2007
- Hauppauge Digital, Inc. (NASDAQ: HAUP), a leading developer of digital video TV and data broadcast receiver products for personal computers, today reported financial results for the third fiscal quarter and nine month period ended June 30, 2007.
 
THIRD QUARTER RESULTS
 
Net sales were $23.5 million for the third quarter of fiscal 2007 compared to $23.8 million for the previous year’s third quarter, a decrease of approximately 1%.
 
 
Selling, general and administrative expenses increased by $82,684, for the third quarter of fiscal 2007 compared to 2006. Increases in compensation expenses and sales office  expenses were the primary reasons for the increase.
 
 
The Company recorded net income of $181,452  for the third quarter compared to net income of $380,341 for the third quarter of fiscal 2006.  Basic and diluted net income per share for the third fiscal quarter of 2007 was $0.02 compared to basic and diluted net income per share of $0.04 for the third fiscal quarter of 2006.
 
NINE MONTH RESULTS
 
Net sales were $83.4 million for the nine months ended June 30, 2007 compared to $75.5 million for the nine months ended June 30, 2006, an increase of approximately 10%.
 
 
Selling, general and administrative expenses increased by $595,959 compared to nine the months ended June 30, 2006. Increases in sales related marketing expenses such as commissions and advertising due to higher sales plus higher compensation expenses were the primary reasons for the increase.

The following information was filed by Hauppauge Digital Inc (HAUP) on Thursday, August 9, 2007 as an 8K 2.02 statement, which is an earnings press release pertaining to results of operations and financial condition. It may be helpful to assess the quality of management by comparing the information in the press release to the information in the accompanying 10-K Annual Report statement of earnings and operation as management may choose to highlight particular information in the press release.
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K

(Mark One)

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

For the fiscal year ended September 30, 2007 

OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________________ to ________________

Commission file number 1-13550

HAUPPAUGE DIGITAL, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
 
11-3227864
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S Employer
Identification No.)
 
91 Cabot Court, Hauppauge, New York
 
11788
(Address of principal executive offices)
 
(Zip Code)
 
Issuer's telephone number, including area code (631) 434-1600

Securities registered pursuant to Section 12 (b) of the Act:
 
Title of each class
 
Name of each exchange on which registered
     
Common Stock, $.01 par value
 
The NASDAQ Stock Market LLC
 
Securities registered pursuant to Section 12 (g) of the Act:

None
(Title of class)
 

 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

o Yes    x No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.

o Yes    x No

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 twelve (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 ninety (90) days
 
x Yes    o No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer’ in Rule 12b-2 of the Exchange Act. (Check One):

o Large Accelerated Filer
 
o Accelerated Filer
 
x Non-Accelerated Filer
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange act).

o Yes       x No

The aggregate market value of the voting stock held by non-affiliates of the registrant as of the close of business on March 31, 2007 was approximately $53,394,775 based upon the [last] price reported on such date on the NASDAQ Global Market. Non-affiliates include all stockholders other than officers, directors and 5% stockholders of the registrant.

As of December 28, 2007, the number of shares of Common Stock, $0.01 par value, outstanding was 9,844,288.
 
 DOCUMENTS INCORPORATED BY REFERENCE

Part III of this Annual Report on Form 10-K incorporates by reference information from the registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders to be held during 2008.
 

 
PART I
Special Note Regarding Forward Looking Statements

This Annual Report on Form 10-K contains forward-looking statements as that term is defined in the federal securities laws. The events described in forward-looking statements contained in this Annual Report on Form 10-K may not occur. Generally these statements relate to business plans or strategies, projected or anticipated benefits or other consequences of our plans or strategies, projected or anticipated benefits from acquisitions to be made by us, or projections involving anticipated revenues, earnings or other aspects of our operating results. The words “may,” “will,” “expect,” “believe,” “anticipate,” “project,” “plan,” “intend,” “estimate,” and “continue,” and their opposites and similar expressions are intended to identify forward-looking statements. We caution you that these statements are not guarantees of future performance or events and are subject to a number of uncertainties, risks and other influences (including, but not limited to, those set forth in “Item 1A-Risk Factors”), many of which are beyond our control, that may influence the accuracy of the statements and the projections upon which the statements are based. Any one or more of these uncertainties, risks and other influences could materially affect our results of operations and whether forward looking statements made by us ultimately prove to be accurate. Our actual results, performance and achievements could differ materially from those expressed or implied in these forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether from new information, future events or otherwise. All cautionary statements made in this Annual Report on Form 10-K should be read as being applicable to all related forward-looking statements wherever they appear.
 
ITEM 1. BUSINESS
 
OVERVIEW

We are a developer of analog and digital TV receiver and other products for the personal computer market. Through our Hauppauge Computer Works, Inc. and Hauppauge Digital Europe SARL subsidiaries, we design, develop, manufacture and market analog, digital and other types of TV receivers that allow PC users to watch television on a PC screen in a resizable window. Most of our products also enable the recording of TV shows to a PC’s hard disk, digital video editing, video conferencing, receiving of digital TV data transmissions, and the display of digital media stored on a computer to a TV set via a home network We were incorporated in Delaware in August 1994 and are headquartered in Hauppauge, New York. We have administrative offices in Luxembourg, Ireland and Singapore and have sales offices in Germany, London, Paris, The Netherlands, Sweden, Italy, Spain, Singapore, Taiwan and California.

OUR STRATEGY

Since our entry into the PC video market in 1991, management believes that we have become a leader in bringing TV content to PCs by focusing on five primary strategic fronts:

 
·
innovating and diversifying our products
     
 
·
introducing new and desirable features in our products
     
 
·
expanding our domestic and international sales and distribution channels
     
 
·
forging strategic relationships with key industry players
     
 
·
outsourcing our production to contract manufacturers

As more people are looking to PCs for a total entertainment experience, we believe that our products are able to enhance the capabilities of the PC to enable it to become a one-stop integrated entertainment system. We feel our current products and products we may introduce in the future have the potential to be ubiquitous in PC-based home entertainment systems.
 
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Our engineering group works on updating our current products to add new and innovative features that the marketplace seeks, while remaining vigilant in keeping our manufacturing costs low and trying to ensure that our products are compatible with new operating systems. This work is done in addition to our research and development efforts in designing, planning and building new products. our engineering department introduced seven new products with internal project names During fiscal 2007, our engineering department introduced seven new products, the WinTV-HVR-1250, WinTV-HVR1500, WinTV-HVR-1600 and WinTV-HVR1800 for the North American market, and the WinTV-HVR-1200, WinTV-HVR-1400 and WinTV-HVR-1750 for the European market. All of these products will run under the Microsoft Vista operating system in addition to Windows XP. The products for North America all support the NTSC analog cable TV standard plus over-the-air ATSC high definition TV and clear QAM digital cable TV.

We believe that strategic relationships with key suppliers, PC manufacturers, technology providers, and internet and e-commerce solutions providers give us important advantages in developing new technologies and marketing our products.  By jointly working with, and sharing our engineering expertise with a variety of other companies, we seek to leverage our investment in research and development and minimize time to market.

Our domestic and international sales and marketing team cultivates a variety of distribution channels comprised of computer and electronic retailers, computer products distributors and PC manufacturers. Electronic retailers include retail stores, web stores and third-party catalogs, both print and on-line, among others.  We work closely with our retailers to enhance sales through joint advertising campaigns and promotions. We believe that developing our international presence contributes to our strategic position, allowing us to benefit from investments in product development, and more firmly establishing our Hauppauge®, WinTV® and MediaMVP™ brand names in the international marketplace. We currently have nine sales offices in countries outside of the U.S. In fiscal 2004, we established a sales and R&D facility in Taiwan to service the growing Asian market.

We seek to maintain and improve our profit margins by, among other things, outsourcing our production to contract manufacturers suited to accommodate the type and volume of our needs. We also leverage international supplier relationships to assist us in receiving competitive prices for the component parts we buy. We believe this two-tiered approach allows us to be the lowest cost / highest quality producer in our marketplace. This approach enables us to focus our human and financial resources on developing, marketing and distributing our products. Successfully engineering products to have low production costs and commonality of parts along with the use of single platforms for multiple models are other important ways that we believe our design and build strategy contributes to our financial performance.
 
PRODUCTS
 
Our products fall under three product categories:

 
·
Analog TV receivers
     
 
·
Digital TV receivers, and combination analog + digital TV receivers
     
 
·
Other non TV receiver products

See “Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements comprising part of this Annual Report on Form 10-K for additional information relating to our operating segments.
 
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Analog TV Receivers
 
Our analog TV receiver products enable, among other things, a PC user to watch analog cable TV in a resizable window on a PC. In fiscal 2007, we have stopped developing pure analog TV receivers, concentrating our engineering resources on Digital TV receivers and combination analog and digital TV receivers, which is detailed in the section entitled “Digital TV Receivers".

Our WinTV analog TV receiver products include cable-ready TV tuners with automatic channel scan and a video digitizer which allows the user to capture still and motion video images. Some of our analog TV receiver products allow the user to listen to FM radio, video-conference over the internet (with the addition of a camera or camcorder), and control these functions with a handheld remote control. In Europe, our WinTV® analog TV receiver products can be used to receive teletext data broadcasts, which allow the reception of digital data that is transmitted along with the “live” TV signal.

Some WinTV analog TV receiver products are available as external devices which connect to the PC through the USB port. The USB models are encased in an attractive case making USB models freely portable from PC to PC and from one desktop, laptop or notebook computer to another.

Our WinTV-PVR TV recording products include all of the basic features of our analog TV receiver products, such as TV on the PC screen, channel changing and volume adjustment. They also add the ability to record TV shows to disk using a built-in high quality hardware MPEG 2 encoder. This technology allows a typical desktop computer system to record up to hundreds of hours of video to disk, limited only by the size of the disk (or storage medium). In addition, the WinTV-PVR user can pause a live TV show, and then resume watching the TV show at a later time. The maximum amount of recording time and the maximum amount of paused TV is dependent upon the hard disk space available on the PC.

The WinTV-PVR user can record a TV show to the hard disk using a TV scheduler and then play the recording back, edit it, and record the show onto a CD-ROM or DVD-ROM, using a CD or DVD writer, for playback on a home or portable DVD player or on a PC. The user can re-size the window during viewing, recording or playback. Our WinTV-PVR products also provide for instant replay and are available in both internal and external USB models.

An added feature to the WinTV-PVR-150, WinTV®-PVR-250, WinTV-PVR-500 and WinTV-PVR-USB2 is that they support Microsoft®’s Windows® XP Media Center Edition. Microsoft’s Windows XP Media Center Edition integrates digital entertainment experiences including “live” television, PVR, digital music, digital video, DVDs and pictures. Users can pause, jump forward or watch “live” TV, record a program or a whole series, and manage digital music, home movies, videos, photos and DVDs on the PC. Users can also access and control this new entertainment device with a large, easy-to-use-on-screen menus and the Media Center Remote Control.

We provide Microsoft certified Media Center drivers for these products to PC manufacturers and value added resellers for integration into their Windows XP Media Center PC systems.

With the global shift to digital TV broadcasts, the sales of our analog family products have been declining and we expect this decline to continue during the transition from analog to digital broadcasts.
 
Digital TV and combination analog and digital TV receiver products
 
Our digital TV receiver products enable, among other things, a PC user to watch digital television in a resizable window on a PC or laptop screen. There are many different digital TV standards throughout the world, and we develop products to receive on a PC many of these digital TV broadcasts. Examples of digital TV broadcasts we can receive on our TV tuner products include: over-the-air high definition ATSC, clear QAM digital cable, DVB-T, DVB-S, DVB-S2 and DVB-C. To support these digital TV broadcasts, we are experiencing an on-going transition from analog TV receivers to either digital only or combination analog plus digital TV receivers. In 2007 we discontinued development of pure analog TV receivers, thereby concentrating our resources on Digital TV Receiver products.
 
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Our WinTV-NOVA products are digital only TV receivers for PCs. They support the various forms of digital TV and come in either an internal or external form factor.

Our WinTV-NOVA-T is a DVB-T digital terrestrial receiver for our European markets which allows for the viewing of digital terrestrial TV and listening to digital radio on a PC. The product also allows recording of digital TV and radio to a hard drive. This product is available as either a PCI card or an external USB device.

Our WinTV-NOVA-T-500 is a dual tuner DVB-T receiver for our European markets which allows for the viewing of digital terrestrial program while recording another program. The product also allows recording of two digital TV programs simultaneously or watching one channel while recording another.

Our WinTV-NOVA-T-USB2 is an external high performance DVB-T digital TV receiver, with dual tuners for both recording of two digital TV programs simultaneously or watching one channel while recording another.

Our WinTV-NOVA-T-Stick is a pocket sized external DVB-T receiver for our European markets which allows for the viewing of digital terrestrial TV and the listening of digital radio on a PC or laptop. The product also allows recording of digital TV and radio to a hard drive. The product’s pocket size and UPC plug in capability is good for use in laptops while traveling.

Our WinTV-NOVA-TD-Stick, introduced during fiscal 2007, is a pocket sized external DVB-T receiver for our European markets employs the use of two antennas to maximize the reception for the viewing of digital terrestrial TV on a PC or laptop. The product also allows recording of digital TV to a hard drive in high quality MPEG-2 format. The product’s pocket size and UPC plug in capability is good for use in laptops while traveling.

Our WinTV-HVR products are combinations of both digital TV and analog TV receivers in one board or USB ‘box’.

Our WinTV-HVR-900-Stick is a pocket sized external receiver for our European markets which allows for the viewing of digital terrestrial and analog terrestrial TV on a PC or laptop. Allows the recording of digital and analog programs to a hard drive in high quality MPEG-2 format. The product’s pocket size and UPC plug in capability is good for use in laptops while traveling.

Our WinTV-HVR-950-Stick is a pocket sized external receiver for our North American markets which allows for the viewing of ATSC high definition TV and NTSC cable TV on a PC or laptop. The product also allows recording of digital and analog programs to a hard drive in high quality MPEG-2 format. The product’s pocket size and UPC plug in capability is good for use in laptops while traveling.

Our WinTV-HVR-1100 and WinTV-HVR-1300 are PCI based receivers for our European markets which allow for the viewing of digital terrestrial and analog terrestrial TV on a PC in addition to the ability to listen to FM radio and DVB-T radio. These products also allow the recording of digital and analog programs to a hard drive in high quality MPEG-2 format. The WinTV-HVR-1300 is a higher performance of the two models, in that it includes a hardware MPEG-2 encoder for recording analog TV directly to a PC’s hard disk.
 
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Our WinTV-HVR-1400, introduced during fiscal 2007, is a dual tuner ExpressCard/54 for our European markets which allow for the viewing of digital and analog TV on a laptop. This product also allows the recording of digital programs to a hard drive in high quality MPEG-2 format and the recording of analog programs using a Soft PVR!MPEG-2 encoder.

Our WinTV-HVR-1600, introduced during fiscal 2007, is dual tuner PCI receiver for our North American markets which allow for the viewing of ATSC high definition TV and NTSC cable TV on a PC. The HVR-1600 allows the recording of all ATSC formats, including the 1080i format. This product also allows the recording of digital and analog programs to a hard drive in high quality MPEG-2 format. The WinTV-HVR-1600 also supports viewing and recording clear QAM channels and includes a remote control and IR blaster which changes the channels on your satellite or cable TV set top box.

Our WinTV-HVR-1800, introduced during fiscal 2007, is a dual tuner single slot PCI express receiver for our North American markets which allow for the viewing of ATSC high definition TV, QAM TV and NTSC cable TV on a PC. These products also allow the recording of digital and analog programs to a hard drive in high quality MPEG-2 format. The WinTV-HVR-1800 allows viewing and recording of all ATSC formats, including the 1080i format.

Our WinTV-HVR-3000 is a tri-mode TV tuner PCI based receiver for our European markets which allows for the viewing of digital terrestrial(DVB-T), satellite (DVB-S) and analog cable TV on a PC in addition to the ability to listen to FM radio and DVB-T radio. The product also allows the recording of digital, satellite and analog programs to a hard drive.

Our WinTV-HVR-4000 is a quad-mode TV tuner PCI based receiver for our European markets which allows for the viewing of digital terrestrial (DVB-T), satellite (DVB-S), high definition digital satellite (DVB-S2) and analog cable TV on a PC in addition to the ability to listen to FM radio and DVB-T radio. The product also allows the recording of digital, satellite and analog programs to a hard drive, in addition to having the ability to listen to FM, digital DVB or DVB-S satellite radio.

Our WinTV-NOVA-S is a low cost DVB-S receiver for our European markets which allows for the viewing of satellite based digital programming on a PC. The product also allows for recording and playback of digital TV, using the high quality MPEG 2 format, and for listening to digital radio.

Other Non TV receiver products
 
(i) Media MVP™
 
Our MediaMVP™ is a Linux-based digital media device, and is one of a new class of PC products which link TV sets and PCs. Media, such as music, digital pictures, and digital videos, are transmitted from the PC, where they are stored, to the MediaMVP™, where they are converted from a digital format into an analog format, enabling playback on a TV connected to the MediaMVP™. MediaMVP™ was introduced to the market in fiscal 2003, and the first shipments to customers were made at the start of our 2004 fiscal year.

Our MediaMVP™ enables a user to watch and listen to PC-based videos, music and pictures on a TV set through a home network. The MediaMVP™ connects to TV sets or home theater systems and, via an Ethernet network, plays back MP3 music, MPEG-1 and MPEG-2 videos, JPEG and GIF digital pictures that have been recorded and stored on a PC. The MediaMVP™ decodes this media and then outputs video through composite and S-Video connections for high quality video on TV sets and high quality audio through stereo audio output connectors to TV sets or home theater systems.
 
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Our MediaMVP™ also provides an on-TV-screen display of media directory listings. It receives commands from the supplied remote control, and sends these commands to the PC server. The TV menus are created on the PC server, sent over the Ethernet LAN and displayed by the MediaMVP™’s browser. The MediaMVP™’s remote control allows a user to pause, fast forward and rewind through videos, plus pause music and picture shows. A user can adjust the audio volume from MediaMVP™’s remote control, avoiding the need to use the TV’s remote control. The MediaMVP™ is also available in a wired or wireless version.

(ii) Video Capture Products

Our ImpactVCB Video Capture Board (“ImpactVCB”) is a low cost PCI board for high performance access to digitized video. Designed for PC-based video conferencing and video capture in industrial applications, the ImpactVCB features “live” video-in-a-window, still image capture and drivers for Windows® 2000, Windows® XP, Windows® NT and Windows® 98. There are third party drivers and applications for use with the Linux operating system.

Our USB Live is an easy way to watch video, grab images and video conference on the PC with the addition of a camera. It plugs into the PC’s USB port for easy installation and brings video into users’ PCs from their camcorder or VCR. Users can create video movies, save still and motion video images onto their hard disk with our software, and video conference over the internet with the addition of a camera or camcorder.
 
(iii) Software Recording Products
 
Our “Wing” software enables the user to record TV shows on a personal computer for playback on the Sony Playstation Portable (PSP), Apple iPod and other portable video players. Wing can also convert existing TV recordings to the PSP and iPod formats. With the emergence and popularity of portable video players, our Wing product provides an easy solution for recording live TV shows for playback on these devices.

(iv) WinTV-CI common interface module

Our WinTV-CI common interface module when coupled with a WinTV card, CAM and SmartCard subscription allows the user to watch popular pay TV channels, such as movies and sporting events on a user’s WinTV application.

(v) Xfones Wireless Headphones for PC’s and Macs:

Our XFones wireless headsets allows users to listen to the audio produced by their PC or Mac through a wireless over the ear headphone. The XPhone has the ability to broadcast to more than one headphone allowing multiple users to listen to the audio from their PC or Mac.

(vi) Digital Entertainment Center (“DEC”)

Our DEC products, introduced in Europe during fiscal 2002, are set top boxes that enable analog TV sets to receive digital satellite and digital terrestrial broadcasts. DEC products enable an owner of an analog TV set to enjoy the benefits of digital broadcasts, such as a greater choice of channels, clearer picture quality and superior audio quality. The multi-purpose DEC set top box displays new digital channels while continuing to allow a TV to display analog programs. DEC set top boxes have the ability to receive, decode and display wide screen broadcasts, and can re-format the wide screen broadcast to fit older analog TV models without the need to purchase a costly digital ready TV. Digital radio, interactive television services and digital teletext are other features that the DEC set top boxes deliver. In fiscal 2004, we introduced the DEC1100-T, a low cost digital TV receiver “box” for the free-to-air digital TV markets in the UK and Germany.
 
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During fiscal 2007, the combination of changing market trends and the high cost of the product caused sales to decline for this product family. We are evaluating the long term potential for this product.
 
TECHNOLOGY
 
Analog TV Technology
 
We have developed four generations of products which convert analog video into digital video since our first such product was introduced in 1991.
 
The first generation of WinTV® products put the TV image on the PC screen using chroma keying, requiring a dedicated “feature connector cable” between the WinTV® and the VGA (video) board. Our initial customers were mostly professional PC users, such as financial market professionals who needed to be able to view stock market related TV shows while spending many hours on their PCs, who found having TV in a window on their desktop useful and entertaining.

In 1993, we invented a technique called “smartlock”, which eliminated the need for the “feature connector cable.” In 1994, we introduced the WinTV®-Celebrity generation of TV tuner boards based on this smartlock technology, greatly improving customer satisfaction. At the time, our CinemaPro series of WinTV® boards then used smartlock and other techniques to further reduce cost and improve performance.

In June 1996, we introduced the WinTV®-PCI line of TV tuner boards for PCs. These boards were developed to eliminate the relatively expensive smartlock circuitry and memory used on the WinTV®-Celebrity and CinemaPro products. The WinTV®-PCI used a technique called “PCI Push” and was designed to be used in the then emerging Intel® Pentium® market. These Pentium®-based PCs had a new type of system expansion “bus”, called the PCI bus, which allowed data to be moved at a much higher rate than the older ISA bus, which the previous WinTV® generations used. The “PCI Push” technique moves the video image 30 times per second (in Europe the image is moved 25 times per second) over the PCI bus. In addition to being less expensive to manufacture, the WinTV®-PCI had higher digital video movie capture performance than the previous generations, capturing video at up to 30 quarter screen frames per second. With this higher performance capture capability, the WinTV®-PCI found new uses in video conferencing, video surveillance and internet streaming video applications.

The fourth generation analog TV receivers are the WinTV®-PVR models which were first developed during fiscal 2000 and introduced to the market in early fiscal 2001. The WinTV®-PVRs include both internal PCI and external USB TV receivers which are designed to add the ability to record TV shows to a PC’s hard disk. The core technology in the WinTV®-PVR products is a hardware MPEG encoder, which compresses analog video from a TV tuner or external video source into an MPEG format in real time. MPEG is the compression format used on DVDs and for the transmission of digital TV. This MPEG encoder is a purchased chip, to which we add our driver and application software to create the recording and program pause functions. Our WinTV®2000 application was enhanced to add the functions needed to record, pause and play back TV on a PC screen.
 
Digital TV Technology
 
Our WinTV®-D board, developed during the 1999 fiscal year and delivered to the market in the beginning of fiscal 2000, was the first digital TV receiver for the U.S. market which allowed PCs to receive, display and record digital TV signals, in addition to watching conventional analog TV. The software to control the digital TV reception is based on our WinTV®-2000 software, which was developed during fiscal 1999. In fiscal 1999, we also introduced the WinTV®-DVB board for the European market. This board brings digital TV to PCs, and is based on the European Digital Video Broadcast standard. Both the WinTV®-D and the WinTV®-DVB have the ability to receive special data broadcasts which some broadcasters may send along with the digital TV signal, in addition to displaying digital TV in a resizable window. Data broadcasts on digital TV are transmitted at several million bits per second. Our proprietary software can decode and display some of these special data broadcasts. We may work on standardized reception and display software, if such broadcasts become standardized.
 
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Over the three fiscal years ended September 30, 2007, we have further developed the digital TV reception capabilities of our digital family of products and as of September 30, 2007 we have 11 products for DVB-T terrestrial, DVB-S and DVB-S2 satellite, ATSC and clear QAM digital TV reception.

Our MediaMVP™ contains our newest technology. Based on the Linux operating system, the MediaMVP™ works in a client/server system with a PC, communicating with the PC ‘server’ and receiving digital media from the PC and displaying the media on a TV set. The core technology to the MediaMVP™ comprises the configuration and enhancements to the Linux operating system, the user interface displayed on the TV set, and the technology to transmit digital media reliably over the local area network. The MediaMVP™ is also available in a wired or wireless version.
 
RESEARCH AND DEVELOPMENT
 
Our development efforts are focused on extending the range and features of the our existing products and developing additional externally attached TV products and additional high-definition digital TV products. We intend to develop more highly integrated versions of hardware products to further improve performance and price points, and new versions of software to add features, improve ease of use, and provide support for new operating systems.

As of September 30, 2007, we had two research and development operations: one based in our Hauppauge, New York headquarters and one based in Taiwan, ROC. The New York and Taiwan R&D operation is aimed at extending the range and features of our digital/analog products, developing additional externally attached TV products, additional high-definition digital TV products and portable digital players.

The technology underlying our products and certain other products in the computer industry, in general, is subject to rapid change, including the potential introduction of new types of products and technologies, which may have a material adverse impact upon our business. See, “Item 1A -- Risk Factors”.

We maintain an ongoing research and development program. Our future success, of which there can be no assurances, will depend, in part, on our ability to respond quickly to technological advances by developing and introducing new products, successfully incorporating such advances in existing products, and obtaining licenses, patents, or other proprietary technologies to be used in connection with new or existing products. We continue to invest in research and development. We spent approximately $3,480,000, $3,165,000 and $2,494,000 for research and development expenses for the years ended September 30, 2007, 2006 and 2005, respectively. There can be no assurance that our future research and development will be successful or that we will be able to foresee, and respond to, advances in technological developments and to successfully develop other products. Additionally, there can be no assurances that the development of technologies and products by competitors will not render our products or technologies non-competitive or obsolete. See “Item 1A- Risk Factors.”
 
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PRODUCTION AND SUPPLIERS
 
We design the hardware for most models of the WinTV, and MediaMVP products, and also write the operating software to be used in conjunction with many versions of the popular Microsoft Windows and Apple Macintosh operating systems, including Windows Vista. During fiscal 2007 we subcontracted the manufacturing and assembly of most of these products to five independent third parties at facilities in various Asian countries. We monitor and test the quality of the completed products at any one of our facilities in the U.S. (Hauppauge, New York), Singapore, and Ireland before packaging the products and shipping them to our customers. We also buy finished products, such as the WinTV-Nova-T digital stick, WinTV-Nova-T-TD stick, some models of WinTV-HVR hybrid stick, WinTV-CI module and XFones from other companies, add Hauppauge software and sell under our name or on a private label basis.

Certain component parts, such as TV tuners, video decoder chips and software compression chips, plus certain assembled products, such as the WinTV-HVR stick products that are essential to our business, are available from a single source or limited sources. Other essential component parts that are generally available from multiple sources may be obtained by us from only a single source or limited sources because of pricing concerns. See “Item 1A-Risk Factors.”

Components are subject to industry wide availability and pricing pressures. Any availability limitations, interruption in supplies, or price increases could have a material adverse effect on our business, operating results and financial condition. In addition, our new products may initially utilize custom components obtained from only one source. See “Item 1A-Risk Factors.” We typically attempt to evaluate and qualify additional suppliers for these components.

Where a product utilizes a new component, initial capacity constraints of the supplier of that component may exist until such time as the supplier's yields have matured.

Components are normally acquired through purchase orders, either issued by us or by our contract manufacturers, typically covering our requirements for a 60-120 day period from the date of issue. Purchased assembled products are normally covered by longer term purchase orders.

If the supply of a key component, or a purchased assembled product, were to be delayed or curtailed, or in the event a key manufacturing vendor delays shipment of completed products to us or our contract manufacturer, our ability to ship products in desired quantities, and in a timely manner, will be adversely affected. Our business, operating results and financial condition will likely be adversely affected, depending on the time required to obtain sufficient quantities from the original source or, if possible, to identify and obtain sufficient quantities from an alternative source. See “Item 1A-Risk Factors.” We attempt to mitigate these potential risks by working closely with our key suppliers on product introduction plans, strategic inventories, coordinated product introductions, and internal and external manufacturing schedules and levels.

We have, from time to time, experienced significant price increases and limited availability of certain components. Similar occurrences in the future could have a material adverse effect on our business, operating results and financial condition. See “Item 1A-Risk Factors.”
 
During fiscal 2007, 2006 and 2005, other than for purchased assembled products like the Nova-T digital stick, the Nova-T-TD stick, the HVR hybrid stick and WinTV-USB2, all manufacturing was performed by three unrelated contract manufacturers in Asia, which produce products for our domestic, Asian and European markets. Product design specifications are provided to ensure proper assembly. Contract manufacturing is primarily done on a consignment basis, in which we provide all the significant component parts and we pay for assembly charges and for certain parts for each board produced. Some boards are purchased on a turnkey basis, in which all components and labor are provided by the manufacturer, and the manufacturing price includes parts and assembly costs. We monitor the quality of the finished product produced by our contract manufacturers. As of September 30, 2007, we have five qualified contract manufacturers who are capable of producing our products to our standards, but only utilize two out of the five contract manufacturers. If demand were to increase dramatically, we believe additional production could be absorbed by these and the other qualified contract manufacturers.
 
11

 
For fiscal 2007, 2006 and 2005, we did not engage any contract manufacturers in Europe.
 
CUSTOMER SERVICE AND TECHNICAL SUPPORT
 
We maintain customer service and technical support departments in our Hauppauge, New York headquarters, as well as in the U.K., Germany, France, Italy, Scandinavia, Taiwan, the Netherlands and in Singapore. Technical support is provided to help with installation problems or pre-sale and post-sale questions on our products, while customer service provides repair service free of charge for product that is within the warranty period.
 
CUSTOMERS AND MARKETS
 
We primarily market our products to the personal computer market, including both Microsoft Windows and Apple Macintosh based systems. To reach this market, we sell to a network of computer retailers in the U.S., Europe and Asia and through computer products distributors and manufacturers. To attract new users to our products, from time to time we run special promotions and participate in cooperative advertising with computer retailers. We actively participate in trade shows to educate and train key computer retail marketing personnel. Most of our sales and marketing budget is aimed at the consumer market.

Apart from the typical home user, we also target business users. One example of a business application is in the securities brokerage industry where our product is primarily used to display financial TV shows in a window on a broker’s PC screen while the PC continues to receive financial information. We have sold our WinTV® products on a direct corporate sales basis to two large financial services information providers for incorporation into their workstations, and several independent financial institutions. This market segment is typically project-based.

We also offer our products to PC manufacturers that either embed a WinTV® product in a PC that they sell, or sell the WinTV® as an accessory to the PC.
 
Sales Channels for Our Products
 
We primarily sell through a sales channel which consist of retailers, PC manufacturers and distributors. We have no exclusive distributors and retailers. For fiscal 2007 we had two customers, Hon Hai Precision Industry Co. LTD and Asustek Computer Inc., each of which accounted for more than 10% of our sales. For fiscal 2006 and 2005 we had no single customer which accounted for more than 10% of our net sales.
 
Marketing and Sales
 
We market our products both domestically and internationally through our sales offices in the U.S. (New York and California), Germany, the United Kingdom, France, Taiwan and Singapore, plus through independent sales representative offices in the Netherlands, Spain, Scandinavia, Poland and Italy. For the fiscal years ended September 30, 2007, 2006 and 2005, approximately 56%, 46% and 46% of our net sales were made within the U.S., respectively, while approximately 44%, 54% and 54% were made outside the United States, respectively.

More information on our geographic segments can be obtained from “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the notes to the “Consolidated Financial Statements” which comprise part of this Annual Report on Form 10-K.
 
12

 
From time to time we advertise our products in a number of consumer computer magazines. We also participate in retailers’ market promotion programs, such as store circulars and promotions and retail store displays. These in-store promotional programs, magazine advertisements, plus a public relations program aimed at editors of key PC computer magazines and an active website on the internet, are the principal means of getting our product introduced to end users. Our sales in computer retail stores are closely related to the effectiveness of these programs, along with the technical capabilities of the products. We also list our products in catalogs of various mail order companies and attend trade shows.

We currently have fourteen sales people located in Europe, three sales people in the Far East and three sales people in the U.S. located in New York and California. In addition to our sales people we also utilize the services of 7 manufacturer representatives in the United States and 6 manufacturer representatives in Europe.

See “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations” with reference to a discussion on the impact seasonality has on our sales.
 
FOREIGN CURRENCY FLUCTUATIONS
 
For each of the three fiscal years ended September 30, 2007, 2006 and 2005 at least 40 % of our sales were generated by our European subsidiary and were invoiced and collected in local currency, which was primarily the Euro. On the supply side, since we predominantly deal with North American and Asian suppliers and contract manufacturers, approximately 90% of the our inventory required to support our European sales is purchased and paid in U.S. Dollars.

The combination of sales billed in Euros supported by inventory purchased in U.S. Dollars results in an absence of a natural local currency hedge. Consequently, our financial results are subject to market risks resulting from the fluctuations in the Euro to U.S. Dollar exchange rates.

See “Item 1A-Risk Factors”, “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 7A-Quantitative and Qualitative Disclosures About Market Risks” with reference to the impact of foreign currency exchange fluctuations.
 
COMPETITION
 
Our business is subject to significant competition. Competition exists from larger companies that possess substantially greater technical, financial, human, sales and marketing resources than we do. The dynamics of competition in this market involve short product life cycles, declining selling prices, evolving industry standards and frequent new product introductions. We compete against companies such as ATI Technologies Inc., a division of AMD Corp., and Avid Technologies . Our MediaMVP™ product competes in the consumer electronics market, where competition comes from Sony Corp., Toshiba Corporation, Cisco Systems Inc. and others.

We believe that competition from new entrants into our market will increase as the market for television in a PC expands. There can be no assurance that we will not experience increased competition in the future. Such increased competition may have a material adverse affect on our ability to successfully market our products. Competition is expected to remain intense and, as a result, we may lose some of our market share to our competitors. Further, we believe that the market for our products will continue to be price competitive and thus we could continue to experience lower selling prices, lower gross profit margins and reduced profitability levels for such products than in the past. “Item 1A-Risk Factors”.
 
13

 
Though management believes that the delivery of TV via the internet will become more popular in the future, we believe that TV delivered to the PC via cable, broadcast or satellite will continue to dominate. As our products connect directly to cable, broadcast and satellite receivers, and deliver a high quality image, we view our products as the preferred way to watch TV on the PC versus the delivery of TV via the internet.
 
PATENTS, COPYRIGHTS AND TRADEMARKS
 
With the proliferation of new products and rapidly changing technology, there is a significant volume of patents and other intellectual property rights held by third parties with regard to our market. There are a number of companies that hold patents for various aspects of the technologies incorporated in some of the PC and TV industries' standards. Given the nature of our products and development efforts, there are risks that claims associated with such patents or intellectual property rights could be asserted by third parties against us. We expect that parties seeking to gain competitive advantages will increase their efforts to enforce any patent or intellectual property rights that they may have. The holders of patents from which we may have not obtained licenses may take the position that we are required to obtain a license from them.

If a patent holder refuses to offer such a license or offers such a license on terms unacceptable to us, there is a risk of incurring substantial litigation or settlement costs regardless of the merits of the allegations or which party eventually prevails. If we do not prevail in a litigation suit, we may be required to pay significant damages and/or cease sales and production of infringing products and accordingly, may incur significant defense costs. Additionally, we may need to attempt to design around a given technology, although there can be no assurances that this would be possible or economical.

We currently use technology licensed from third parties in certain products. Our business, financial condition and operating results could be adversely affected by a number of factors relating to these third-party technologies, including:
 
 
·
failure by a licensor to accurately develop, timely introduce, promote or support the technology
     
 
·
delays in shipment of products
     
 
·
excess customer support or product return costs due to problems with licensed technology and
     
 
·
termination of our relationship with such licensors
 
We may not be able to adequately protect our intellectual property through patent, copyright, trademark and other means of protection. If we fail to adequately protect our intellectual property, our intellectual property rights may be misappropriated by others, invalidated or challenged, and our competitors could duplicate our technology or may otherwise limit any competitive technological advantage we may have. Due to the rapid pace of technological change, we believe our success is likely to depend more upon continued innovation, technical expertise, marketing skills and customer support and service rather than upon legal protection of our proprietary rights. However, we shall aggressively assert our intellectual property rights when necessary.

Even though we independently develop most of our products and copyright the operating software which our products use, our success will depend, in a large part, on our ability to innovate, obtain or license patents, protect trade secrets and operate without infringing on the proprietary rights of others. We maintain copyrights on certain of our designs and software programs, but currently we have no patent on the WinTV® board or other products.

The trade marks “Hauppauge®”, “SoftPVR®”, “HardPVR®” , “MediaMVP®” and , "WinTV®", have been registered with the United States Patent and Trademark Office.

See “Item 1A-Risk Factors” and “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 
14

 
EMPLOYEES
 
As of September 30, 2007, we employed 145 people domestically and internationally, including our executive officers, all of which are employed on a full-time basis, and none of which are represented by a union.
 
CORPORATE STRUCTURE
 
Hauppauge Digital Inc. was incorporated in the state of Delaware on August 2, 1994. Listed below is a chart depicting our corporate structure.

corporte
 
Hauppauge Digital Inc. was incorporated in Delaware and is the parent holding company. Our subsidiaries function as follows:

Hauppauge Computer Works, Inc., incorporated in New York, is our United States operating company. It has locations in Hauppauge, New York and Danville, California. The Hauppauge, New York location functions as our company headquarters and houses the executive offices and is responsible for some or all of the following functions:

 
·
Sales
     
 
·
Technical Support
     
 
·
Research and development
     
 
·
Warehousing and shipping
     
 
·
Finance and Administrative
     
 
·
Inventory planning and forecasting
 
15

 
Hauppauge Digital Europe SARL, incorporated in Luxembourg, is our European subsidiary. It has the
following wholly-owned subsidiaries:
 
 
·
Hauppauge Digital Asia Pte Ltd (incorporated in Singapore)
     
 
·
Hauppauge Computer Works, GmbH (incorporated in Germany)
     
 
·
Hauppauge Computed Works Limited (incorporated in the United Kingdom)
     
 
·
Hauppauge Computer Works SARL (incorporated in France)
 
The subsidiaries above function as sales and commission agents, and are primarily responsible for some or all of the following functions:
 
 
·
Directing and overseeing European sales, marketing and promotional efforts
     
 
·
Procuring sales and servicing customers
     
 
·
Sales administration
     
 
·
Technical support
     
 
·
Product and material procurement support
     
 
·
Contract manufacturer and production support

In addition to Hauppauge Digital Europe SARL’s wholly owned subsidiaries, Hauppauge Digital Europe SARL also has a branch office in Blanchardstown, Ireland, which functions as our European distribution center and is responsible for some or all of our following functions:
 
 
·
Warehousing of product
     
 
·
Shipment of product
     
 
·
Repair center
     
 
·
European logistics center
 
Hauppauge Digital Taiwan was incorporated during fiscal 2004 in Taiwan, ROC and is responsible for some or all of the following functions:
 
 
·
Sales administration for Asia and China
     
 
·
Research and development activities
 
Hauppauge Computer Works, Inc. is in turn the holding company of a foreign sales corporation, Hauppauge Computer Works, Ltd (incorporated in the U.S. Virgin Islands).

HCW Distributing Corp., incorporated in New York, is an inactive company
 
Our executive offices are located at 91 Cabot Court, Hauppauge, New York 11788, and our telephone number at that address is (631) 434-1600. Our internet address is http://www.hauppauge.com.
 
ITEM 1A. RISK FACTORS
 
Our operating results and financial condition are subject to various risks and uncertainties, including those described below, that could adversely affect our business, operating results and financial condition, any of which could negatively affect the trading price of our Common Stock. Because of the following factors, as well as other variables affecting our business, operating results and financial condition, past performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends for future periods.
 
16

 
If TV technology for the PC, or our implementation of this technology, is not accepted, we will not be able to sustain or expand our business.

Our future success depends on the growing use and acceptance of TV and video applications for PCs. The market for these applications is still evolving, and may not develop to the extent necessary to enable us to further expand our business. We have invested, and continue to invest, significant time and resources in the development of new products for this market.

Our:

·
dependence on sales of TV and video products for the PC
 
·
lack of market diversification
 
·
lack of development of the market for our products
 
·
potential inability to remain ahead of the development of competing technologies
 
could each have a material adverse effect on our business, operating results and financial condition if we are unable to address any of the factors listed above.

We rely upon sales of a small number of product lines, and the failure of any one product line to be successful in the market could substantially reduce our sales.

We currently rely upon sales from our existing product lines of internal and external products to generate a majority of our sales. While we continue to develop additional products within these and other product lines, there can be no assurance that we will be successful in doing so. Consequently, if the existing or future products are not successful, sales could decline substantially, which would have a material adverse effect on our business, operating results and financial condition.

We rely heavily on the success of dealers and PC manufacturers to market, sell and distribute our products. If these channels are not effective in distributing our products, our sales could be reduced.

These resellers and manufacturers may not effectively promote or market our products or they may experience financial difficulties and even close operations. Our sales channels are not contractually obligated to sell our products, and they typically sell on an “as needed” basis. Therefore, they may, at any time:

 
·
refuse to promote our products
     
 
·
discontinue the use of our products in favor of a competitor's product
 
Also, with a distribution channel standing between us and the actual end user, we may not be able to accurately gauge current demand and anticipate future demand for our products. For example, dealers and manufacturers may place large initial orders for a new product just to keep their stores and products stocked with the newest TV receivers and not because there is a significant demand for them.

We operate in a highly competitive market, and many of our competitors have much greater resources, which may make it difficult for us to remain competitive.
 
Our business is subject to significant competition. Competition exists from larger companies that possess substantially greater technical, financial, human, sales and marketing resources than we do. The dynamics of competition in this market involve short product life cycles, declining selling prices, evolving industry standards and frequent new product introductions. We compete against companies such as ATI Technologies Inc., a division of AMD Corp. and Avid Technologies Our MediaMVP™ product competes in the consumer electronics market, where competition comes from Sony Corp., Toshiba Corporation, Cisco Systems Inc. and others.
 
17

 
We believe that competition from new entrants will increase as the market for digital video in a PC expands. There can be no assurance that we will not experience increased competition in the future. Such increased competition may have a material adverse affect on our ability to successfully market our products. Competition is expected to remain intense and, as a result, we may lose some of our market share to our competitors. Further, we believe that the market for our products will continue to be price competitive and thus we could continue to experience lower selling prices, lower gross profit margins and reduced profitability levels for such products than in the past.

Rapid technological changes and short product life cycles in our industry could harm our business.

The technology underlying our products and other products in the computer industry, in general, is subject to rapid change, including the potential introduction of new types of products and technologies, which may have a material adverse impact upon our business, operating results and financial condition. We will need to maintain an ongoing research and development program, and our potential future success, of which there can be no assurances, will depend, in part, on our ability to respond quickly to technological advances by developing and introducing new products, successfully incorporating such advances in existing products, and obtaining licenses, patents, or other proprietary technologies to be used in connection with new or existing products. We expended approximately $3,480,000, $3,165,000 and $2,494,000 for research and development expenses for the fiscal years ended September 30, 2007, 2006 and 2005, respectively. There can be no assurance that our research and development will be successful or that we will be able to foresee and respond to such advances in technological developments and to successfully develop additional products. Additionally, there can be no assurances that the development of technologies and products by competitors will not render our products or technologies non-competitive or obsolete.

If TV or video capabilities are included in PCs or in operating systems, it could result in a reduction in the demand for add-on TV and video devices. Although we believe that our software is a competitive strength, as operating systems such as Windows move to integrate and standardize software support for video capabilities, we will be challenged to further differentiate our products. Our operating results and ability to retain our market share are also dependent on continued growth in the underlying markets for PC, TV and video products.

We may not be able to timely adopt emerging industry standards, which may make our products unacceptable to potential customers, delay our product introductions or increase our costs.

Our products must comply with a number of current industry standards and practices established by various international bodies. Failure to comply with evolving standards, including video compression standards, TV transmission standards, and PC interface standards, will limit acceptance of our products by the market. If new standards are adopted in the industry, we will be required to adopt those standards in our products. It may take a significant amount of time to develop and design products incorporating these new standards, and we may not succeed in doing so. We may also become dependent upon products developed by third parties and have to pay royalty fees, which may be substantial, to the developers of the technology that constitutes the newly adopted standards.
 
18

 
We are dependent upon foreign markets for sales of our products, primarily the European market, and adverse changes in these markets could reduce our sales.
 
Our future performance will likely be dependent, in large part, on our ability to continue to compete successfully in the European markets, where a large portion of our current and potential customers are located. Our ability to compete in these markets will depend on many factors, including:

 
·
the economic conditions in these regions
     
 
·
the stability of the political environment in these regions
     
 
·
adverse changes in the relationships between major countries in these regions
     
 
·
the state of trade relations among these regions and the United States
     
 
·
restrictions on trade in these regions
     
 
·
the imposition or changing of tariffs by the countries in these regions on products of the type that we sell
     
 
·
changes in the regulatory environment in these regions
     
 
·
export restrictions and export license requirements
     
 
·
restrictions on the export of critical technology
     
 
·
our ability to develop PC TV products that meet the varied technical requirements of customers in each of these regions
     
 
·
our ability to maintain satisfactory relationships with our foreign customers and distributors
     
 
·
changes in freight rates
     
 
·
our ability to enforce agreements and other rights in the countries in these regions
     
 
·
difficulties in staffing and managing international operations
     
 
·
difficulties assessing new and existing international markets and credit risks
     
 
·
potential insolvency of international customers and difficulty in collecting accounts

If we are unable to address any of these factors, it could have a material adverse effect on our business, operating results and financial condition.
 
We are heavily dependent upon foreign manufacturing facilities for our products, primarily facilities in Asia, which exposes us to additional risks.

The majority of our products are built at contract manufacturing facilities in Asia . Our ability to successfully build products at overseas locations will depend on several factors, including:

 
·
the economic conditions in these regions
     
 
·
the stability of the political environment in these regions
     
 
·
adverse changes in the relationships between major countries in these regions
     
 
·
the state of trade relations among these regions and the United States
     
 
·
restrictions on trade in these regions
     
 
·
the imposition or changing of tariffs by the countries in these regions on products of the type that we sell
     
 
·
changes in the regulatory environment in these regions
     
 
·
import restrictions and import license requirements
     
 
·
our ability to maintain satisfactory relationships with our foreign manufacturers
     
 
·
changes in freight rates
     
 
·
difficulties in staffing and managing international operations
     
 
·
potential insolvency of vendors and difficulty in obtaining materials

If we are unable to address any of these factors, it could have a material adverse effect on our business, operating results and financial condition.
 
19

 
Foreign currency exchange fluctuations could adversely affect our results.

For the three fiscal years ended September 30, 2007, 2006 and 2005 at least 40 % of our sales were generated by our European subsidiary and were invoiced and collected in local currency, which was primarily the Euro. On the supply side since we predominantly deal with North American and Asian suppliers and contract manufacturers, approximately 90% of our inventory required to support our European sales are purchased and paid in U.S. Dollars.

The combination of sales billed in Euros supported by inventory purchased in U.S. Dollars results in an absence of a natural local currency hedge. Consequently, our financial results are subject to market risks resulting from the fluctuations in the Euro to U.S. Dollar exchange rates.
 
See “Item 7--Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 7A - Quantitative and Qualitative Disclosures About Market Risk” with reference to the impact of foreign currency exchange fluctuations.

We may be unable to develop new products that meet customer requirements in a timely manner.

Our success is dependent on our ability to continue to introduce new products with advanced features, functionality and performance that our customers demand. We may not be able to introduce new products on a timely basis, that are accepted by the market, and that sell in quantities sufficient to make the products viable for the long-term. Sales of new products may negatively impact sales of existing products. In addition, we may have difficulty establishing our products' presence in markets where it does not currently have significant brand recognition.

We may experience declining margins.
 
For several years we have experienced declining gross margins due to the following factors, among others:

 
·
larger sales mix of lower margin products
     
 
·
changes in foreign currency exchange rates
     
 
·
allowances for excess inventory
     
 
·
increases in costs charged by contract manufacturers
     
 
·
increases in duty and tariff rates
     
 
·
increases in shipping costs
     
 
·
lower average selling prices
     
 
·
increases in material acquisition costs and
     
 
·
different gross margins for like products in different markets

Consequently, as margins may decline, our profitability will be more dependent upon effective cost management controls. There can be no assurances that such cost and management controls can be implemented and maintained, and if implemented, that they will be successful.

We have experienced, and expect to continue to experience, intense downward pricing pressure on our products, which could substantially impair our operating performance.

We are experiencing, and are likely to continue to experience, downward pricing pressure on our products. As a result, we have experienced, and we expect to continue to experience, declining average sales prices for our products. Increases in the number of units that we are able to sell and reductions in per unit costs may not be sufficient to offset reductions in per unit sales prices, in which case our net income would be reduced and we could incur losses. Since we typically negotiate supply arrangements far in advance of delivery dates, we may need to commit to price reductions for our products before we are aware of how, or if, these cost reductions can be obtained. As a result, any current or future price reduction commitments and our inability to respond to increased price competition could have a material adverse effect on our business, operating results and financial condition.
 
20

 
We are dependent upon contract manufacturers for our production. If these manufacturers do not meet our requirements, either in volume or quality, then we could be materially harmed.

During fiscal 2007 we subcontracted the manufacturing and assembly of our products to two independent third parties at facilities in various Asian countries.

Relying on subcontractors involves a number of significant risks, including:
 
·
loss of control over the manufacturing process
     
 
·
potential absence of adequate production capacity
     
 
·
potential delays in production lead times
     
 
·
unavailability of certain process technologies
     
 
·
reduced control over delivery schedules, manufacturing yields, quality and costs, and
     
 
·
unexpected increases in component costs
 
We may need to hold more inventory than is immediately required to compensate for potential manufacturing disruptions.

If our significant subcontractors become unable or unwilling to continue to manufacture these products in required volumes, we will have to identify qualified alternate subcontractors. Additional qualified subcontractors may not be available, or may not be available on a timely or cost competitive basis. Any interruption in the supply of, or increase in, the cost of the products manufactured by third party subcontractors could have a material adverse effect on our business, operating results and financial condition.

We are dependent upon single or limited source suppliers for our components and assembled products. If these suppliers do not meet the demand, either in volume or quality, then we could be materially harmed.

If the supply of a key component or assembled product, such as the HVR-900, Nova-T-Stick and Nova-TD-stick were to be delayed or curtailed or in the event a key manufacturing or sole vendor delays shipment of such components or completed products, our ability to ship products in desired quantities and in a timely manner would be adversely affected. Our business, operating results and financial condition could also be adversely affected, depending on the time required to obtain sufficient quantities from the original source or, if possible, to identify and obtain sufficient quantities from an alternative source. We attempt to mitigate these potential risks by working closely with our key suppliers on product introduction plans, strategic inventories, coordinated product introductions, and internal and external manufacturing schedules and levels. We are also seeking out alternative sources for assembled products, making us less dependent on a single or limited source.

We may need to hold more inventory than is immediately required to compensate for potential component shortages or discontinuation. This could lead to an increase in the costs of manufacturing or assembling our products.

If any single or limited source supplier becomes unable or unwilling to continue to supply these components or assembled products in required volumes, we will have to identify and qualify acceptable replacements or redesign our products with different components. Additional sources may not be available, or product redesign may not be feasible on a timely basis. Any interruption in the supply of or increase in the cost of the components and assembled products provided by single or limited source suppliers could have a material adverse effect on our business, operating results and financial condition.
 
21

 
We may incur excessive expenses if we are unable to accurately forecast sales of our products.
 
We generally ship products within one to four weeks after receipt of orders. Therefore, our sales backlog is typically minimal. Accordingly, our expectations of future net sales and our product manufacturing and materials planning are based largely on our own estimates of future demand and not on firm customer orders.

If we obtain orders in excess of our internal forecasts, we may be unable to timely increase production to meet demand which could have a material adverse effect on our business, operating results and financial condition. If our net sales do not meet expectations, our business, operating results and financial condition would be adversely affected, we may be burdened with excess inventory, and we may be subject to excess costs or inventory write-offs.

We may experience a reduction in sales if we are unable to respond quickly to changes in the market for our products.

Our net sales can be affected by changes in the quantity of products that our distributor and PC manufacturer customers maintain in their inventories. We may be directly and rapidly affected by changes in the market, including the impact of any slowdown or rapid increase in end user demand. Despite efforts to reduce distribution channel inventory exposure, distribution partners and PC manufacturer customers may still choose to alter their inventory levels, which could cause a reduction in our net sales; this could have a material adverse effect on our business, operating results and financial condition.

We may accumulate inventory to minimize the impact of shortages from manufacturers and suppliers, which may result in obsolete inventory that we may need to write off resulting in losses.

Managing our inventory is complicated by fluctuations in the demand for our products as well as the issues of using contract manufacturers and procuring components from suppliers mentioned above. As we must plan to have sufficient quantities of products available to satisfy our customers' demands, we sometimes accumulate inventory for a period of time to minimize the impact of possible insufficient capacity or availability of components from our manufacturers and suppliers. Although we expect to sell the inventory within a short period of time, products may remain in inventory for extended periods of time and may become obsolete because of the passage of time and the introduction of new products or new components within existing products. In these situations, we would be required to write off obsolete inventory which could have a material adverse effect on our business, operating results and financial condition.

We may need financing, and may not be able to raise financing on favorable terms, if at all, which could limit our ability to grow and increase our costs.

We anticipate that we may need to raise additional capital in the future to continue our long term expansion plans, to respond to competitive pressures or to respond to unanticipated requirements. We cannot be certain that we will be able to obtain additional financing on commercially reasonable terms, if at all. Our failure or inability to obtain financing on acceptable terms could require us to limit our plans for expansion, incur indebtedness that has high rates of interest or substantial restrictive covenants, issue equity securities that will dilute existing stockholders’ holdings or discontinue a portion of our operations, each of which could have a material adverse effect on our business, operating results and financial condition.
 
22

 
We may become involved in costly intellectual property disputes.

With the proliferation of new products and rapidly changing technology, there is a significant volume of patents and other intellectual property rights held by third parties. There are a number of companies that hold patents for various aspects of the technologies incorporated in some of the PC and TV industries' standards. Given the nature of our products and development efforts, there are risks that claims associated with such patents or intellectual property rights could be asserted by third parties against us. We expect that parties seeking to gain competitive advantages will increase their efforts to enforce any patent or intellectual property rights that they may have. The holders of patents from which we may have not obtained licenses may take the position that it is required to obtain a license from them.

If a patent holder refuses to offer such a license or offers such a license on terms unacceptable to us, there is a risk of incurring substantial litigation or settlement costs regardless of the merits of the allegations, or which party eventually prevails. If we do not prevail in a litigation suit, we may be required to pay significant damages and/or to cease sales and production of infringing products and accordingly, may incur significant defense costs. Additionally, we may need to attempt to design around a given technology, although there can be no assurances that this would be possible or economical.

We currently use technology licensed from third parties in certain products. Our business, financial condition and operating results could be adversely affected by a number of factors relating to these third-party technologies, including:
 
 
·
failure by a licensor to accurately develop, timely introduce, promote or support the technology
     
 
·
delays in shipment of products
     
 
·
excess customer support or product return costs due to problems with licensed technology
     
 
·
termination of our relationship with such licensors

We may be unable to enforce our intellectual property rights.
 
We may not be able to adequately protect our intellectual property through patent, copyright, trademark and other means of protection. If we fail to adequately protect our intellectual property, our intellectual property rights may be misappropriated by others, invalidated or challenged, and our competitors could duplicate our technology or may otherwise limit any competitive technological advantage we may have. Due to the rapid pace of technological change, we believe our success is likely to depend more upon continued innovation, technical expertise, marketing skills and customer support and service rather than upon legal protection of our proprietary rights. However, we intend to aggressively assert our intellectual property rights when necessary.

Even though we typically develop our products independently, our success, of which there can be no assurances, will depend, in a large part, on our ability to innovate, obtain or license patents, protect trade secrets, copyrights and trademarks, and draw upon our proprietary technology without infringing on the proprietary rights of others. We maintain copyrights on our designs and software programs, but currently we have no patent on the WinTV® board as we believe that such technology cannot be patented.

We have no patents issued or pending that relate to our technology. We are subject to a number of risks relating to intellectual property rights, including the following:

 
·
the means by which we seek to protect our proprietary rights may not be adequate to prevent others from misappropriating our technology or from independently developing or selling technology or products with features based on or similar to our products
 
23

 
 
·
our products may be sold in foreign countries that provide less protection to intellectual property than is provided under U.S. laws
     
 
·
our intellectual property rights may be challenged, invalidated, violated or circumvented and may not provide us with any competitive advantage

We may not be able to attract and retain qualified managerial and other skilled personnel.
 
Our success, of which there can be no assurances, depends, in part, on our ability to identify, attract, motivate and retain qualified managerial, technical and sales personnel. Our success, of which there can be no assurances, is dependent on our ability to manage effectively the enhancement and introduction of existing and new products and the marketing of such products. We are particularly dependent on our ability to identify, attract, motivate and retain qualified managers, engineers and salespersons. The loss of the services of a significant number of engineers or sales people or one or more senior officers or managers could be disruptive to product development efforts or business relationships and could seriously harm our business.

We depend on a limited number of key personnel, and the loss of any of their services could adversely affect our future growth and profitability and could substantially interfere with our operations.

Our products are complex and our market is evolving. The success of our business depends in large part upon the continuing contributions of our management and technical personnel. The loss of the services of any of our key officers or employees could adversely affect our future growth and profitability and could have a material adverse effect on our business, operating results and financial condition.

Our dependence upon our key officers and employees is increased by the fact that they are responsible for our sales and marketing efforts as well as our overall operations. We do not have key person life insurance policies covering any of our employees other than Mr. Plotkin, our President, Chairman of the Board, Chief Executive Officer, Chief Operating Officer. The insurance coverage that we have on him may be insufficient to compensate us for the loss of his services.

We may not be able to effectively integrate businesses or assets that we acquire

We may identify and pursue acquisitions of complementary companies and strategic assets, such as customer bases, products and technology. However, there can be no assurance that we will be able to identify suitable acquisition opportunities.

If any such opportunity involves the acquisition of a business, we cannot be certain that:

 
·
we will successfully integrate the operations of the acquired business with our own
     
 
·
all the benefits expected from such integration will be realized
     
 
·
management's attention will not be diverted or divided, to the detriment of current operations
     
 
·
amortization of acquired intangible assets will not have a negative effect on operating results or other aspects of our business
     
 
·
delays or unexpected costs related to the acquisition will not have a detrimental effect on our business, operating results and financial condition
     
 
·
customer dissatisfaction with, or performance problems at, an acquired company will not have an adverse effect on our reputation
     
 
·
respective operations, management and personnel will be compatible

In most cases, acquisitions will be consummated without seeking and obtaining stockholder approval, in which case stockholders will not have an opportunity to consider and vote upon the merits of such an acquisition.
 
Although we will endeavor to evaluate the risks inherent in a particular acquisition, there can be no assurance that we will properly ascertain or assess such risks.
 
24

 
Our products could contain defects, which could result in delays in recognition of sales, loss of sales, loss of market share, or failure to achieve market acceptance, or claims against us.

We develop complex products for TV and video processing. Despite testing by our engineers, subcontractors and customers, errors may be found in existing or future products. This could result in, among other things, a delay in recognition of sales, loss of sales, loss of market share, failure to achieve market acceptance or substantial damage to our reputation. We could be subject to material claims by customers, and may need to incur substantial expenses to correct any product defects. We do not have product liability insurance to protect against losses caused by defects in our products, and we also do not have "errors and omissions" insurance. As a result, any payments that we may need to make to satisfy our customers may be substantial and may result in a substantial charge to earnings.

We may experience fluctuations in our future operating results, which will make predicting our future results difficult.

Historically, our quarterly and annual operating results have varied significantly from period to period, and we expect that our results will continue to do so. These fluctuations result from a variety of factors, including:
 
 
·
market acceptance of our products
     
 
·
changes in order flow from our customers, and their inability to forecast their needs accurately
     
 
·
the timing of our new product announcements and of announcements by our competitors
     
 
·
increased competition, including changes in pricing by us and our competitors
     
 
·
delays in deliveries from our limited number of suppliers and subcontractors; and
     
 
·
difficulty in implementing effective cost management constraints
 
As our sales are primarily to the consumer market, we have experienced certain seasonal revenue trends. Our peak sales quarter, due to holiday season sales of computer equipment, is typically our first fiscal quarter (October to December), followed by our second fiscal quarter (January to March). In addition, our international sales, mostly in the European market, were 44%, 54% and 54% of sales for the fiscal years ended September 30, 2007, 2006 and 2005 respectively. Our fiscal fourth quarter sales (July to September) can be potentially impacted by the reduction of activity experienced in Europe during the July and August summer holiday period. Accordingly, any sales or net income in any particular period may be lower than the sales and net income in a preceding or comparable period. Period-to-period comparisons of our results of operations may not be meaningful, and should not be relied upon as indications of our future performance. In addition, our operating results may be below the expectations of securities analysts and investors in future periods. Failure to meet such expectations, should such an event occur, will likely cause our share price to decline.

Our Common Stock price is highly volatile.
 
The market price of our Common Stock has been, and may continue to be, subject to a high degree of volatility. Numerous factors may have a significant impact on the market price of our Common Stock, including:
 
·
general conditions in the PC and TV industries
     
 
·
product pricing
     
 
·
new product introductions
     
 
·
market growth forecasts
     
 
·
technological innovations
     
 
·
mergers and acquisitions
 
25

 
·
announcements of quarterly operating results
     
 
·
overall U.S. and international economic health
     
 
·
stability of the U.S. and international securities markets
 
In addition, stock markets have experienced extreme price volatility and broad market fluctuations in recent years. This volatility has had a substantial effect on the market price of securities issued by many high technology companies in many cases for reasons unrelated to the operating performance of the specific companies. The price of our Common Stock has experienced volatility not necessarily related to our performance.

Our Amended and Restated By-Laws and the Rights Agreement in which we are party to may have anti-takeover effects, limiting the ability of outside stockholders to seek control of management, and any premium over market price that an acquirer might otherwise pay may be reduced and any merger or takeover may be delayed.

Effective August 16, 2001, the Board of Directors unanimously approved Amended and Restated By-Laws for us (the “By-Laws”). The By-Laws do not permit stockholders to call a special meeting of stockholders and consequently, an expensive proxy contest cannot occur other than in connection with the annual meeting of stockholders. The By-Laws also impose strict requirements for shareholder proposals and nominations of prospective Board members other than those nominated by or at the discretion of the Board of Directors. These amendments may collectively or individually impact a person’s decision to purchase voting securities in our Company and may have anti-takeover effects in that any merger or takeover may be delayed. Accordingly, any premium over market price that an acquirer might otherwise pay may be reduced.

On July 19, 2001, the Board of Directors declared a dividend distribution of one Right for each outstanding share of our Common Stock to stockholders of record at the close of business on August 5, 2001. Each Right entitles the registered holder to purchase from us one Common Share at a purchase price of $11.00 per share, subject to adjustment and terms set out in the Rights Agreement between us and Continental Stock Transfer & Trust Company, as Rights Agent. The Rights may have certain anti-takeover effects. The Rights will cause substantial dilution to a person or group that attempts to acquire us in a manner which causes the Rights to become discount Rights unless the offer is conditional on a substantial number of Rights being acquired. Accordingly, any premium over market price that an acquirer might otherwise pay may be reduced.

No dividends and none anticipated.

We have never paid any cash dividends on our Common Stock and do not contemplate or anticipate paying any cash dividends on our Common Stock in the foreseeable future. It is currently anticipated that earnings, if any, will be used to finance the development and expansion of the business.

Forward looking statements.

From time to time, information provided by us, statements made by our employees or information provided in our Securities and Exchange Commission filings, including information contained in this Annual Report on Form 10-K, may contain forward looking information. Our actual future results may differ materially from those projections or statements made in such forward looking information as a result of various risks and uncertainties, including, but not limited to, rapid changes in technology, lack of funds for research and development, competition, proprietary patents and rights of others, loss of major customers, loss of sources of supply for our components, non-availability of management, government regulation, currency fluctuations and our inability to profitably sell our products. The market price of our Common Stock may be volatile at times in response to fluctuations in our quarterly operating results, changes in analysts' earnings estimates, market conditions in the computer hardware industry, seasonality of the business cycle, as well as general conditions and other external factors.
 
26

 
ITEM 1B. UNRESOLVED STAFF COMMENTS
 
Not applicable
 
ITEM 2. PROPERTIES
 
We occupy a facility located at 91 Cabot Court, Hauppauge, New York we use it for executive offices and for the testing, storage and shipping of our products. In February 1990, Hauppauge Computer Works, Inc., (“HCW”), entered into a lease for the premises (the “1990 Lease”), with Ladokk Realty Co., a real estate partnership which is principally owned by Kenneth Plotkin, our President, Chairman of the Board, Chief Executive Officer, Chief Operating Officer and the holder of approximately 8.1% of our shares of Common Stock as of September 30, 2007, Dorothy Plotkin, the wife of Kenneth Plotkin, holder of approximately 5.6% of our shares of Common Stock as September 30, 2007, and Laura Aupperle, believed by us to be the holder of approximately 7.8% of our shares of Common Stock, including shares of Common Stock attributed to the Estate of Kenneth R. Aupperle, as of September 30, 2007. Ladokk Realty Co., LLC is the successor to Ladokk Realty Co. (“Ladokk”) As of February 2004, the 1990 Lease provided for annual rent of approximately $454,000, payable monthly, and subject to 5% annual increases effective February 1st of each year. We were also obligated to pay real estate taxes and operating costs of maintaining the premises subject to the 1990 Lease. Until February 17, 2004, the premises subject to such lease were subject to two mortgages guaranteed by us.

On February 17, 2004, HCW and Ladokk terminated the 1990 Lease and HCW entered into a new lease agreement with Ladokk (the “2004 Lease”). The 2004 Lease term was for five years and terminated on February 16, 2009. The annual rent under the 2004 Lease was $360,000, payable monthly. We were also obligated to pay real estate taxes and operating costs of maintaining the premises subject to such lease. Concurrently with the new lease, Ladokk completed a refinancing of its mortgages, and the new lender did not require us to sign a guarantee. Accordingly, we no longer guarantee the landlord’s mortgages.

On October 17, 2006, HCW executed an amendment to the 2004 Lease with Ladokk for the premises (the “Lease Amendment”). The Lease Amendment commenced as of September 1, 2006 and ends on August 31, 2011. The base rent under the Lease Amendment for the first year of the term is $300,000, payable monthly in the amount of $25,000. Rent is subject to an annual increase of 3% over the term. The execution of the Lease Amendment was approved by our Board of Directors, following the recommendation of our Audit Committee.

The Lease Amendment provides for the payment of rent arrearages in the aggregate amount of $108,667 (the “Arrearage”) to be paid in the amount of $5,000 per month tendered with rent until the Arrearage is paid in full. Subject to the terms and conditions of the 2004 Lease, HCW is obligated to pay for utilities, repairs to the Premises, and taxes during the term.

The Lease Amendment provides that HCW has the option to renew the current lease term for an additional 5 year term after the expiration of the current lease term upon written notice given to Ladokk between six and twelve months prior to expiration of the current lease. Rent due during the first year of the renewal term is to be equal to the market rate at the end of the current lease, but not less than rent paid during the last year of the current lease, and is subject to rent increases for the second through fifth years of the renewal term by CPI plus 1% per annum.  

HCW occupies a shared office facility at the Danville Business Center in Danville, California. We use the California office as our western region sales office and for marketing our Eskape™ Labs product line. The lease expires on May 31, 2008 and requires us to pay an annual rent, which includes telecommunications services, of approximately $9,600.

27

 
Our German subsidiary, Hauppauge Computer Works GmbH, occupies approximately 6,000 square feet in Mönchengladbach, Germany. It is used as our European sales office and customer support center. It also has a product demonstration room and a storage facility. Hauppauge Computer Works GmbH pays an annual rent of approximately $52,000 for this facility pursuant to a rental agreement, which expires on October 31, 2008.

Our Singapore subsidiary, Hauppauge Digital Asia Pte. Ltd., occupies approximately 5,400 square feet in Singapore, which it uses as a sales and administration office and for the testing, storage and shipping of our products. The lease expires on November 30, 2008 and calls for an annual rent of approximately $63,000. The rent includes an allocation for common area maintenance charges.

On May 1, 2001, Hauppauge Digital SARL. commenced a lease of a 15,642 square foot building in Blanchardstown, Dublin, Ireland. The facility houses our European warehousing and distribution center. The lease, which is for the standard twenty-five year term in Ireland with the right to terminate on the fifth and tenth year of the lease, calls for an annual rent of approximately $222,000. The rent includes an allocation for common area maintenance charges.
 
ITEM 3. LEGAL PROCEEDINGS
 
We are presently party to no pending material legal proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
None.
 
PART II
 
ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our Common Stock trades on the Nasdaq Global Market under the symbol HAUP. The range of high and low sales prices for our Common Stock during the two fiscal years ended September 30, 2007, were as follows:
 
Year ended September 30, 2007
 
High
 
Low
 
First Quarter
   
7.46
   
4.82
 
Second Quarter
   
9.06
   
6.68
 
Third Quarter
   
7.27
   
4.89
 
Fourth Quarter
   
5.28
   
3.48
 
               
Year ended September 30, 2006
   
High
   
Low
 
First Quarter
   
6.53
   
3.12
 
Second Quarter
   
5.69
   
3.61
 
Third Quarter
   
4.35
   
3.61
 
Fourth Quarter
   
5.50
   
3.66
 

We have been advised by our transfer agent, Continental Stock Transfer & Trust Company that the approximate number of holders of record of our Common Stock as of November 14, 2007 was 161. We believe there are in excess of 4,000 beneficial holders of our Common Stock.

No cash dividends have been paid during the two fiscal years ended September 30, 2007. We have no present intention of paying any cash dividends in our foreseeable future and intend to use our net income, if any, in our operations.

28

 
On November 8, 1996, we approved a stock repurchase program. The program authorized us to repurchase up to 850,000 shares of our own stock. The stock repurchase program was extended by a resolution of our Board of Directors on December 17, 1997. At our August 3, 2007 Board meeting, our Board of Directors approved an increase in the number of shares which can be repurchased under the plan to 1,200,000.

The table below summarized repurchases of our Common Stock under our stock repurchase program:

           
Total Number
 
Maximum
 
       
Average
 
of Shares
 
Number
 
   
Total
 
Price
 
Purchased as
 
Of Shares
 
   
Number
 
Paid
 
Part of
 
That May Yet
 
   
of
 
per
 
Publicly
 
Be Purchased
 
   
Shares
 
Paid
 
Announced
 
Under the
 
   
Purchased
 
Share
 
Plan
 
Plan
 
Purchases as of September 30, 2006
   
607,547
 
$
2.89
   
607,547
   
592,453
 
June 1 to June 30, 2007
   
10,000
 
$
5.34
   
10,000
   
582,453
 
July 1 to July 31, 2007
   
10,000
 
$
4.92
   
10,000
   
572,453
 
August 1 to August 31, 2007
   
88,830
   
4.21
   
88,830
   
483,623
 
   
33,202
   
3.89
   
33,202
   
450,421
 
Purchases as of September 30, 2007
   
749,579
 
$
3.15
             
 
29

 
The following graph shows a five year comparison of cumulative total stockholder return, calculated on a dividend reinvested basis, for us, the NASDAQ Market Index and the Hemscott Group (Computer Peripheral) Index (the “Hemscott Group Index”). The graph assumes $100 was invested in each of our shares of Common Stock, the NASDAQ Market Index and the Hemscott Group Index on October 1, 2002 and that all dividends were reinvested. Data points on the graph are annual. Note that historic stock price performance is not necessarily indicative of future stock performance.
 
pg30
 
30

 
ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data with respect to our financial position and our results of operations for each of the five fiscal years in the period ended September 30, 2007 set forth below has been derived from our audited consolidated financial statements. The selected financial information presented below should be read in conjunction with the Consolidated Financial Statements and related notes thereto and “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Annual Report on Form 10-K.

Consolidated Statement of Operations Data
 
2007
 
2006
 
2005
 
2004
 
2003
 
(In thousands except for per share amounts)
                     
Net Sales
 
$
110,896
 
$
97,662
 
$
78,458
 
$
65,339
 
$
50,956
 
Cost of sales
   
88,652
   
77,817
   
60,599
   
48,045
   
38,715
 
Gross Profit
   
22,244
   
19,845
   
17,859
   
17,294
   
12,241
 
                                 
Selling , general and administrative expenses
   
14,668
   
14,116
   
13,903
   
12,320
   
10, 818
 
Research and development expenses
   
3,480
   
3,165
   
2,494
   
2,021
   
1,902
 
Legal expenses related to arbitration and litigation proceedings
   
-
   
-
   
-
   
354
   
78
 
Arbitration proceeding
   
-
   
-
   
-
   
206
   
-
 
Litigation proceeding
   
-
   
-
   
-
   
427
   
-
 
Income (loss) from operations
   
4,096
   
2,564
   
1,462
   
1,966
   
(557
)
                                 
Other Income (Expense):
                               
Interest income
   
43
   
28
   
13
   
7
   
16
 
Foreign currency
   
(31
)
 
7
   
61
   
2
   
34
 
Income (loss) before taxes
   
4,108
   
2,599
   
1,536
   
1,975
   
(507
)
Income tax provision (benefit)
   
(1,197
)
 
190
   
149
   
150
   
307
 
Net income (loss)
 
$
5,305
 
$
2,409
 
$
1,387
 
$
1,825
 
$
(814
)
Net income (loss) per share:
                               
Basic
 
$
0.54
 
$
0.25
 
$
0.15
 
$
0.20
 
$
(0.09
)
Diluted
 
$
0.51
 
$
0.24
 
$
0.14
 
$
0.19
 
$
(0.09
)
                                 
Weighted average shares outstanding:
                               
   
9,863
   
9,593
   
9,431
   
8,999
   
8,867
 
Diluted
   
10,368
   
10,019
   
9,988
   
9,668
   
8,867
 
Consolidated Balance Sheet Data (at period end):
                     
Working capital
 
$
21,198
 
$
17,084
 
$
15,335
 
$
13,760
 
$
10,860
 
Total assets
   
51,920
   
36,650
   
32,116
   
32,071
   
21,650
 
Stockholders’ equity
   
22,941
   
17,780
   
15,941
   
14,327
   
11,468
 
 
31

 
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Results of operations
Twelve months ended September 30, 2007 compared to September 30, 2006.
 
Results of operations for the twelve months ended September 30, 2007 compared to September 30, 2006 are as follows:
 
 
 
Twelve
Months
Ended
 
Twelve
Months
Ended
 
Variance
 
Percentage of sales
 
 
 
9/30/07
 
9/30/06
 
$
 
2007
 
2006
 
Variance
 
Net Sales
 
$
110,896,010
 
$
97,662,326
 
$
13,233,684
   
100.00
%
 
100.00
%
 
-
 
Cost of sales
   
88,651,881
   
77,817,275
   
10,834,606
   
79.94
%
 
79.68
%
 
0.26
%
Gross Profit
   
22,244,129
   
19,845,051
   
2,399,078
   
20.06
%
 
20.32
%
 
-0.26
%
Gross Profit %
   
20.06
%
 
20.32
%
 
-0.26
%
                 
Expenses:
                               
Sales & marketing
   
10,132,587
   
9,565,730
   
566,857
   
9.14
%
 
9.79
%
 
-0.65
%
Technical support
   
600,074
   
556,865
   
43,209
   
0.54
%
 
0.57
%
 
-0.03
%
General & administrative
   
3,618,813
   
3,730,031
   
(111,218
)
 
3.26
%
 
3.82
%
 
-0.56
%
Selling, general and administrative stock compensation expense
   
316,292
   
263,363
   
52,929
   
0.29
%
 
0.27
%
 
0.02
%
Total Selling, general and administrative expense
   
14,667,766
   
14,115,989
   
551,777
   
13.23
%
 
14.45
%
 
-1.22
%
Research and development
   
3,294,441
   
3,072,001
   
222,440
   
2.97
%
 
3.15
%
 
-0.18
%
Research and development stock compensation expense
   
185,576
   
92,923
   
92,653
   
0.17
%
 
0.10
%
 
0.07
%
Total expenses
   
18,147,783
   
17,280,913
   
866,870
   
16.37
%
 
17.70
%
 
-1.33
%
Net operating income
   
4,096,346
   
2,564,138
   
1,532,208
   
3.69
%
 
2.62
%
 
1.07
%
                 
 
 
                 
Other income :
                                     
Interest income
   
43,135
   
28,422
   
14,713
   
0.04
%
 
0.03
%
 
0.01
%
Foreign currency
   
(31,676
)
 
7,292
   
(38,968
)
 
-0.03
%
 
0.01
%
 
-0.04
%
Total other income
   
11,459
   
35,714
   
(24,255
)
 
0.01
%
 
0.04
%
 
-0.03
%
Income before taxes (benefit) on income
   
4,107,805
   
2,599,852
   
1,507,953
   
3.70
%
 
2.66
%
 
1.04
%
Income tax provision (benefit)
   
(1,197,579
)
 
190,240
   
(1,387,819
)
 
-1.08
%
 
0.19
%
 
-1.26
%
Net income
 
$
5,305,384
 
$
2,409,612
 
$
2,895,772
   
4.78
%
 
2.47
%
 
2.31
%

Net sales for the twelve months ended September 30, 2007 increased $13,233,684 compared to the twelve months ended September 30, 2006 as shown on the table below.

 
 
 
 
 
 
Increase
 
 
 
 
 
 
 
Twelve Months
 
Twelve Months
 
(decrease)
Dollar
 
Increase
(decrease)
 
Percentage of sales by
Geographic region
 
Location
 
Ended 9/30/07
 
Ended 9/30/06
 
Variance
 
Variance %
 
2007
 
2006
 
Domestic
   
62,649,883
   
45,231,986
   
17,417,897
   
39
%
 
56
%
 
46
%
Europe
   
45,585,721
   
49,803,392
   
(4,217,671
)
 
-8
%
 
42
%
 
51
%
   
2,660,406
   
2,626,948
   
33,458
   
1
%
 
2
%
 
3
%
Total
 
$
110,896,010
 
$
97,662,326
 
$
13,233,684
   
14
%
 
100
%
 
100
%
 
Net sales to domestic customers were 56% of net sales for the fiscal year ended September 30, 2007 and 46% of net sales for the fiscal year ended September 30, 2006. Net sales to European customers were 42% of net sales for the fiscal year ended September 30, 2007 and 51% of net sales for the fiscal year ended September 30, 2006. Net sales to Asian customers were 2% of net sales for the fiscal year ended September 30, 2007 and 3% of net sales for the fiscal year ended September 30, 2006. We experienced an increase in unit sales of about 22% while the dynamics of new production and changes in sales mix lowered the average sales price by about 7%.
 
32

 
Seasonal nature of sales
 
pg33
 
As the chart above indicates, there is a seasonal pattern to our quarterly sales. Listed below are the primary causes of our
seasonal sales:

 
·
We primarily sell through a sales channel which consist of retailers, PC manufacturers and distributors. Spurred on by the holiday spending, our sales during our first fiscal quarter, which encompasses the holiday season, have historically been either the highest or the second highest of our fiscal year.
     
 
·
Post holiday sales, mid year school computer purchases, gift certificates, holiday cash gifts and disposable income generated from year end bonuses fuel the sales of our second quarter and have historically resulted in sales for our second quarter being either the highest or second highest of our fiscal year.
     
 
·
For each of the fiscal years ended September 30, 2007 and 2006 at least 40% of our sales were generated by our European subsidiary. During our fiscal third quarter and into the first half of our fiscal fourth quarter, we typically experience a slowdown due to the summer holiday period in Europe. We also see decreased spending in the U.S during the summer months. This has historically caused sales for the last six months of our fiscal year to be lower than the first six months of our fiscal year. As the chart above indicates our sales for the last six months of fiscal 2006 and 2007 were lower than the sales for the first six months of fiscal 2006 and fiscal 2007.

Although our strategy has been to diversify our sales to minimize the seasonal nature of our business, we anticipate similar seasonal trends for the near term future.

Gross profit

Gross profit increased $2,399,078 for the twelve months ended September 30, 2007 compared to the twelve months ended September 30, 2006.
 
The increases and (decreases) in the gross profit are detailed below:
 
   
Increase
 
   
(decrease)
 
Due to increased sales
 
$
3,726,900
 
Lower gross profit on sales mix
   
(909,934
)
Production and production related costs
   
(417,888
)
Total increase in gross profit
 
$
2,399,078
 

33

 
Gross profit percentage for the twelve months ended September 30, 2007 was 20.06% compared to 20.32% for the twelve months ended September 30, 2006, a decrease of 0.26%.

The increases and (decreases) in the gross profit percent are detailed below:

   
Increase
 
   
(decrease)
 
Lower gross profit on sales mix
   
(0.82
)%
   
0.56
%
Net decrease in gross profit percent
   
(0.26
)%
 
The decrease in the gross profit percent of 0.26 % for the twelve months ended September 30, 2007 compared to the twelve months ended September 30, 2006 was primarily due to:
 
·
A higher percentage of lower gross profit margin products contributed to a 0.82% decrease in gross profit.
 
 
·
Production and production related costs declined as a percentage of sales which contributed to a 0.56% increase in gross profit percent. The increase in net sales was about 14% while the increase in production and production related costs was about 5%.
 
Volatility of gross profit percentage:
 
pg34
 
The chart above indicates the quarterly fluctuations in gross profit percent. Over the eight quarters ended with the fourth quarter of fiscal 2007, the gross profit percent has ranged from a low of 18.79% to a high of 22.79%.

Factors affecting the volatility of our gross profit percentages are:

 
·
Mix of product. Gross profit percentages vary within our retail family of products as well as for products sold to manufacturers. Varying sales mix of these different product lines affect the quarterly gross profit percentage
 
34

 
 
·
Fluctuating quarterly sales caused by seasonal trends. Included in cost of sales are certain fixed costs, mainly for production labor, warehouse labor and the overhead cost of our Ireland distribution facility. Due to this, when unit and dollar sales decline due to seasonal sales trends these fixed costs get spread over lower unit and dollar sales, which increase the product unit costs and increase the fixed costs as a percentage of sales.
     
 
·
Competitive pressures. Our market is constantly changing with new competitors joining our established competitors. These competitive pressures from time to time result in a lowering of our average sales prices which can reduce gross profit.
     
 
·
Supply of component parts. In times when component parts are in short supply we have to manage price increases. Conversely, when component parts’ supply is high we may be able to secure price decreases.
     
 
·
Sales volume. As unit sales volume increases we have more leverage in negotiating volume price decreases with our component suppliers and our contract manufacturers.
     
 
·
Cost reductions. We evaluate the pricing we receive from our suppliers and our contract manufacturers and we often seek to achieve component part and contract manufacturer cost reductions.
     
 
·
Volatility of fuel prices. Increases in fuel costs are reflected in the amounts we pay for the delivery of product from our suppliers and the amounts we pay for deliveries to our customers. Therefore increasing fuel prices increase our freight costs and negatively impact our gross profit.

Managing product mix through market strategy and new products, moderating seasonal trends, efficiently managing shipments and achieving cost reductions are a company priority and are critical to our competitive position in the market. Although our goal is to optimize gross profit and minimize gross profit fluctuations, in light of the dynamics of our market we anticipate the continuance of gross profit percent fluctuations.
 
Selling, general and administrative expenses

The chart below illustrates the components of Selling, general and administrative expenses.

   
Twelve months ended September 30,
 
   
Dollar Costs
 
Percentage of Sales
 
           
Increase
         
Increase
 
   
2007
 
2006
 
(Decrease)
 
2007
 
2006
 
(decrease)
 
Sales and marketing
 
$
10,132,587
 
$
9,565,730
 
$
566,857
   
9.14
%
 
9.79
%
 
-0.65
%
Technical support
   
600,074
   
556,865
   
43,209
   
0.54
%
 
0.57
%
 
-0.03
%
General and administrative
   
3,618,813
   
3,730,031
   
(111,218
)
 
3.26
%
 
3.82
%
 
-0.56
%
   
316,292
   
263,363
   
52,929
   
0.29
%
 
0.27
%
 
0.02
%
Total
 
$
14,667,766
 
$
14,115,989
 
$
551,777
   
13.23
%
 
14.45
%
 
-1.22
%
 
Selling, general and administrative expenses increased $551,777 from the prior fiscal year. As a percentage of sales, Selling, general and administrative expenses decreased by 1.22% when compared to the twelve months ended September 30, 2006. The increase in sales and marketing expense of $566,857 was mainly due to increased commission expense due to higher sales and higher sales compensation expense due to sales personnel increases. The increase in technical support expenses of $43,209 was primarily due to higher compensation expenses in Asia and Europe due to increased personnel. The decrease in general and administrative expenses of $111,218 was primarily due to lower rent expense due to a rent reduction negotiated under a new lease, lower professional fees due lower usage of outside consultants and lower bank and credit card processing fees.

35

 
Stock compensation expense related to SG&A personnel was $52,929 higher than in fiscal 2006. During fiscal 2006, we had run out of options authorized in our stock option plan. Accordingly, we did not issue as many options as we would have in fiscal 2006 had there been additional shares authorized. At our October 2006 Annual Meeting of Stockholders, our stockholders approved the addition of 1 million shares of Common Stock to our 2003 Performance and Equity Incentive Plan. As a result, we were able to grant more options in fiscal 2007 than fiscal 2006, thus increasing the stock compensation expense recorded in fiscal 2007.

Selling general and administrative expenses as a percentage of sales

pg36

The chart above indicates the quarterly fluctuations for technical support, general and administrative, sales and marketing and total selling, general and administrative expenses. Due to fixed costs which fluctuate minimally with changes in sales coupled with the seasonal nature of our business, selling general and administrative expenses as a percentage of sales are sensitive to seasonal sales fluctuations. Over the eight quarters ending with the fourth quarter of fiscal 2007, the pattern of selling general and administrative expenses as a percentage of sales has resulted in the following trends:

 
·
Due to our first and second quarters yielding the highest quarterly sales levels of our fiscal year, our selling, general and administrative expenses as a percentage of sales have typically been the lowest during our first quarter and second quarter. As reflected in the chart, selling, general and administrative expense as a percentage of sales were the lowest in the first and second quarters of fiscal 2006 and 2007.
     
 
·
Reflecting the seasonal trend in which our third and fourth quarters yield the lowest quarterly sales of our fiscal year, our selling, general and administrative expenses for the third and fourth quarters are the highest as a percentage of sales. As reflected in the chart, selling, general and administrative expense as a percentage of sales were the highest in the third and fourth quarters of fiscal 2006 and 2007.
     
 
·
Selling, general and administrative expenses as a percent of sales for the twelve months ended September 30, 2007 declined to its lowest level of the two fiscal years ended September 30, 2007, the result of sales percentage increases growing in excess of percentage increases in selling, general and administrative expenses.

With the expectation that the seasonal nature sales will continue for the near future, we expect selling, general and administrative expenses as a percentage of sales to reflect a future trend that is similar to the historical trends we have experienced over the prior two fiscal years.  

36

 
Research and development expenses

Research and development expenses increased $315,093. The increase was mainly due to the hiring of additional engineering personnel and increased program development expenses due to higher volume of new product and product enhancement programs. Stock compensation expense related to research and development personnel was $92,653 higher than fiscal 2007.

Other income

Other income for the twelve months ended September 30, 2007 was $11,459 compared to other income of $35,714 for the twelve months ended September 30, 2006 as detailed below:
 
   
 Twelve months ended September 30,
 
 
 
  2007
 
  2006
 
Interest income
 
$
43,135
 
$
28,422
 
Foreign currency transaction gains (losses)
   
(31,676
)
 
7,292
 
Total other income (expense)
 
$
11,459
 
$
35,714
 
 
Accumulated other comprehensive income (loss)

Accumulated other comprehensive income (loss) consists of two components: translation gains and losses and FAS 133 mark to market gains and losses on our open foreign exchange contracts.

During fiscal 2007 we recorded on our balance sheet in the equity section under “ Accumulated other comprehensive (loss)” a loss of $816,652, which consisted of translation losses of $726,629 and a loss of $90,023 due to the mark to market differences between the value of the Company’s open forward exchange contracts at the contract rates versus the same contracts valued at the period ending forward rate. The table below details the gains and losses that make up the accumulated other comprehensive loss of $1,325,971 recorded on our balance sheet as of September 30, 2007:

Accumulated Other Comprehensive Income (Loss)
 
Balance as of
 
Oct 06 to Sept 07
 
Balance as of
 
Fiscal 2007 activity
 
Sept 30, 2006
 
(losses)
 
Sept 30, 2007
 
Translation gains and losses
 
$
(531,289
)
$
(726,629
)
$
(1,257,918
)
   
21,970
   
(90,023
)
 
(68,053
)
   
$
(509,319
)
$
(816,652
)
$
(1,325,971
)
 
Tax provision

Our net tax provision for the year ended September 30, 2007 and 2006 is as follows:
     
   
  Twelve months ended September 30,
   
  2007
 
  2006
 
AMT Tax attributable to U.S operations
 
$
108,343
 
$
60,000
 
Income tax benefit due reduction of valuation allowance
   
(1,490,689
)
 
-
 
Tax expense European operations
   
146,767
   
110,240
 
State taxes
   
38,000
   
20,000
 
Net tax (benefit) provision
 
$
(1,197,579
)
$
190,240
 
 
37

 
The deferred tax assets and the offsetting tax valuation allowance is attributable to our domestic operations. For the last three fiscal years our domestic operation has had taxable income. As of September 30, 2007, we evaluated the future realization of our deferred tax assets and the corresponding valuation allowance. We took into consideration:
 
 
·
the taxable income of our domestic operations for the last three fiscal years ended September 30, 2007 2006 and 2005
 
 
·
anticipated taxable income for fiscal 2008
 
 
·
the utilization in fiscal 2007 of the remainder of our net operating loss carry forward
 
After evaluating the circumstances listed above, it was our opinion to reduce the deferred tax valuation allowance by $3,010,253 which was reduced by deferred tax expense, resulting in a tax benefit for fiscal 2007 of $1,490,689.

As a result of all of the above items mentioned in the Management’s Discussion and Analysis of Financial Condition and Results of Operations, we had net income of $5,305,384 for the twelve months ended September 30, 2007, which resulted in basic net income per share of $0.54 and diluted net income per share of $0.51 on weighted average basic and diluted shares of 9,862,655 and 10,367,775, respectively, compared to net income of $2,409,612 for the twelve months ended September 30, 2006, which resulted in basic net income per share of $0.25 and diluted net income per share of $0.24 on weighted average basic and diluted shares of 9,593,050 and 10,019,514, respectively.
 
Options to purchase 540,250, 193,856 and 48,453 shares of Common Stock at prices ranging $4.67 to $ 8.75, $4.13 to $8.75 and 4.40 to $8.75, respectively, were outstanding as of September 30, 2007, 2006 and 2005, respectively, but were not included in the computation of diluted net income per share of Common Stock because they were anti-dilutive.
 
38

 
Results of operations
Twelve months ended September 30, 2006 compared to September 30, 2005.
 
Results of operations for the twelve months ended September 30, 2006 compared to September 30, 2005 are as follows:

   
Twelve
 
Twelve
                 
   
Months
 
Months
                 
   
Ended
 
Ended
 
Variance
 
Percentage of sales
 
   
9/30/06
 
9/30/05
 
 $
 
2006
 
2005
 
Variance
 
Net Sales
 
$
97,662,326
 
$
78,457,785
 
$
19,204,541
   
100.00
%
 
100.00
%
 
-
 
Cost of sales
   
77,817,275
   
60,599,066
   
17,218,209
   
79.68
%
 
77.24
%
 
2.44
%
Gross Profit
   
19,845,051
   
17,858,719
   
1,986,332
   
20.32
%
 
22.76
%
 
-2.44
%
Gross Profit %
                     
 
 
 
 
 
 
 
 
Expenses:
                                     
Sales & marketing
   
9,565,730
   
9,907,606
   
(341,876
)
 
9.79
%
 
12.63
%
 
-2.84
%
Technical support
   
556,865
   
516,533
   
40,332
   
0.57
%
 
0.66
%
 
-0.09
%
General & administrative
   
3,730,031
   
3,479,278
   
250,753
   
3.82
%
 
4.44
%
 
-0.62
%
Selling, general and administrative stock compensation expense
   
263,363
   
-
   
263,363
   
0.27
%
 
0.00
%
 
0.27
%
Total Selling, general and administrative expense
   
14,115,989
   
13,903,417
   
212,572
   
14.45
%
 
17.73
%
 
-3.28
%
Research and development
   
3,072,001
   
2,493,710
   
578,291
   
3.15
%
 
3.18
%
 
-0.03
%
Research and development stock compensation expense
   
92,923
   
-
   
92,923
   
0.10
%
 
0.00
%
 
0.10
%
Total expenses
   
17,280,913
   
16,397,127
   
883,786
   
17.70
%
 
20.91
%
 
-3.21
%
Net operating income
   
2,564,138
   
1,461,592
   
1,102,546
   
2.62
%
 
1.85
%
 
0.77
%
                                       
Other income :
                                     
Interest income
   
28,422
   
13,684
   
14,738
   
0.03
%
 
0.02
%
 
0.01
%
Foreign currency
   
7,292
   
60,833
   
(53,541
)
 
0.01
%
 
0.08
%
 
-0.07
%
Total other income
   
35,714
   
74,517
   
(38,803
)
 
0.04
%
 
0.10
%
 
-0.06
%
Income before taxes on income
   
2,599,852
   
1,536,109
   
1,063,743
   
2.66
%
 
1.95
%
 
0.71
%
Taxes on income
   
190,240
   
149,356
   
40,884
   
0.19
%
 
0.19
%
 
0.00
%
Net income
 
$
2,409,612
 
$
1,386,753
 
$
1,022,859
   
2.47
%
 
1.76
%
 
0.71
%
 
Net sales for the twelve months ended September 30, 2006 increased $19,204,541 compared to the twelve months ended September 30, 2005 as shown on the table below.

           
Increase
           
   
Twelve Months
 
Twelve Months
 
(decrease)
Dollar
 
Increase(decrease)
 
Percentage of sales by
 Geographic region
 
   
Ended 9/30/06
 
Ended 9/30/05
 
Variance
 
Variance %
 
2006
 
2005
 
Domestic
   
45,231,986
 
$
36,508,354
 
$
8,723,632
   
24
%
 
46
%
 
46
%
Europe
   
49,803,392
   
39,928,765
   
9,874,627
   
25
%
 
51
%
 
51
%
   
2,626,948
   
2,020,666
   
606,282
   
30
%
 
3
%
 
3
%
Total
 
$
97,662,326
 
$
78,457,785
 
$
19,204,541
   
24
%
 
100
%
 
100
%
 
Net sales to domestic customers were 46% of net sales for the fiscal years ended September 30 2006 and 2005. Net sales to European customers were 51% of net sales for the fiscal years ended September 30, 2006 and 2005, respectively. Net sales to Asian customers were 3% of net sales for the fiscal years ended September 30, 2006 and 2005, respectively. We experienced an increase in unit sales of about 54% while the dynamics of new production and changes in sales mix lowered the average sales price by about 19%.
 
39

 
Seasonal nature of sales
 
pg40 
 
As the chart above indicates, there is a seasonal pattern to our quarterly sales. Listed below are the primary causes of our seasonal sales:

 
·
We sell primarily sell through a sales channel which consist of retailers, PC manufacturers and distributors. Spurred on by the holiday spending, our sales during our first fiscal quarter, which encompasses the holiday season, have historically been either the highest or the second highest of our fiscal year.
     
 
·
Post holiday sales, mid year school computer purchases, gift certificates, holiday cash gifts and disposable income generated from year end bonuses fuel the sales of our second quarter and have historically resulted in sales for our second quarter being either the highest or second highest of our fiscal year.
     
 
·
For each of the fiscal years ended September 30, 2006 and 2005 at least 50% of our sales were generated by our European subsidiary. During our fiscal third quarter and into the first half of our fiscal fourth quarter, we typically experience a slowdown due to the summer holiday period in Europe. We also see decreased spending in the U.S during the summer months. This has historically caused sales for the last six months of our fiscal year to be lower than the first six months of our fiscal year. As the chart above indicates our sales for the last six months of fiscal 2005 and 2006 were lower than the sales for the first six months of fiscal 2005 and fiscal 2006

Although our strategy has been to diversify our sales to minimize the seasonal nature of our business, we anticipate similar seasonal trends for the near term future.

Gross profit

Gross profit increased $1,986,332 for the twelve months ended September 30, 2006 compared to the twelve months ended September 30, 2005.
 
The increases and (decreases) in the gross profit are detailed below:
 
   
Increase
 
   
(decrease)
 
Due to increased sales
 
$
5,938,681
 
Lower gross profit on sales mix
   
(2,559,581
)
Production and production related costs
   
(1,392,768
)
Total increase in gross profit
 
$
1,986,332
 

40

 
Gross profit percentage for the twelve months ended September 30, 2006 was 20.32% compared to 22.76% for the twelve months ended September 30, 2005, a decrease of 2.44%.

The increases and (decreases) in the gross profit percent are detailed below:

   
Increase
 
   
(decrease)
 
Lower gross profit on sales mix
   
(2.62
)%
   
0.18
%
Net decrease in gross profit percent
   
(2.44
)%
 
The decrease in the gross profit percent of 2.44 % for the twelve months ended September 30, 2006 compared to the twelve months ended September 30, 2005 was primarily due to:
 
·
A higher percentage of lower gross profit margin products contributed to a 2.62% decrease in gross profit
 
 
·
Production and shipping costs declined as a percentage of sales which contributed to a 0.18% increase in gross profit percent. The increase in net sales was about 24% while the increase in production costs was about 22%
 
Volatility of gross profit percentage:
 
pg41

The chart above indicates the quarterly fluctuations in gross profit percent. Over the last eight quarters ending with the fourth quarter of fiscal 2006, the gross profit percent has ranged from a low of 19.42% to a high of 23.67%.

Factors affecting the volatility of our gross profit percentages are:

 
·
Mix of product. Gross profit percentages vary within our retail family of products as well as for products sold to manufacturers. Varying sales mix of these different product lines affect the quarterly gross profit percentage
     
 
·
Fluctuating quarterly sales caused by seasonal trends. Included in cost of sales are certain fixed costs, mainly for production labor, warehouse labor and the overhead cost of our Ireland distribution facility. Due to this, when unit and dollar sales decline due to seasonal sales trends these fixed costs get spread over lower unit and dollar sales, which increase the product unit costs and increase the fixed costs as a percentage of sales.
 
41

 
 
·
Competitive pressures. Our market is constantly changing with new competitors joining our established competitors. These competitive pressures from time to time result in a lowering of our average sales prices which can reduce gross profit.
     
 
·
Supply of component parts. In times when component parts are in short supply we have to manage price increases. Conversely, when component parts’ supply is high we may be able to secure price decreases.
     
 
·
Sales volume. As unit sales volume increases we have more leverage in negotiating volume price decreases with our component suppliers and our contract manufacturers.
     
 
·
Cost reductions. We evaluate the pricing we receive from our suppliers and our contract manufacturers and we often seek to achieve component part and contract manufacturer cost reductions.
     
 
·
Volatility of fuel prices. Increases in fuel costs are reflected in the amounts we pay for the delivery of product from our suppliers and the amounts we pay for deliveries to our customers. Therefore increasing fuel prices increase our freight costs and negatively impact our gross profit.

Managing product mix through market strategy and new products, moderating seasonal trends, efficiently managing shipments and achieving cost reductions are a company priority and are critical to our competitive position in the market. Although our goal is to optimize gross profit and minimize gross profit fluctuations, in light of the dynamics of our market we anticipate the continuance of gross profit percent fluctuations.
 
Selling, general and administrative expenses

The chart below illustrates the components of Selling, general and administrative costs.

   
Twelve months ended September 30,
 
   
Dollar Costs
 
Percentage of Sales
 
           
Increase
         
Increase
 
   
2006
 
2005
 
(Decrease)
 
2006
 
2005
 
(decrease)
 
Sales and marketing
 
$
9,565,730
 
$
9,907,606
 
$
(341,876
)