Statements in this Quarterly Report on Form 10-Q concerning the future business, operating results and financial condition of Qualstar including estimates, projections, statements relating to our business plans, objectives and operating results, and the assumptions upon which those statements are based, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements inherently are subject to risks and uncertainties, some of which we cannot predict or quantify. Our actual results may differ materially from the results projected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2008 in "ITEM 1 Business," "Item 1A Risk Factors," and in "ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations." You generally can identify forward-looking statements by the use of forward-looking terminology such as "believes," "may," "expects," "intends," "estimates," "anticipates," "plans," "seeks," or "continues," or the negative thereof or variations thereon or similar terminology. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statements to reflect the occurrence of events or circumstances in the future.

We design, develop, manufacture and sell automated magnetic tape libraries used to store, retrieve and manage electronic data primarily in network computing environments. We currently offer tape libraries for two popular tape drive technologies, LTO (Linear Tape-Open tape format) and AIT (Advanced Intelligent Tape).

We have developed a network of value added resellers who specialize in delivering complete storage solutions to end users. End users of our products range from small businesses requiring simple automated backup solutions to large organizations needing complex storage management solutions. We also sell our products to original equipment manufacturers that incorporate our products into theirs, which they sell as a complete system or solution. We assist our customers with marketing and technical support.

We also design, develop and sell high-efficiency switching power supplies used in telecommunications equipment, servers, routers, switches, RAIDs, and similar applications. Our power supplies are sold under the N2Power brand name through independent sales representatives and distributors. The primary customers are original equipment manufacturers and contract manufacturers. We also utilize these power supplies in our tape libraries.

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

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

Revenue is recognized when persuasive evidence of an arrangement exists, shipment has occurred or services have been rendered, the fee is fixed or determinable and collectibility is reasonably assured (less estimated returns, for which provision is made at the time of sale) in accordance with SAB 104, Revenue Recognition. For product sales, title and risk of loss transfer to the customer when the product leaves our dock in Simi Valley, California, or another shipping location designated by us. Customers are allowed to return the product within thirty days of shipment if the product does not meet specifications.

We record an allowance for estimated sales returns based on past experience and current knowledge of our customer base. Our experience has been such that only a very small percentage of libraries are returned. Should our experience change, however, we may require additional allowances for sales returns.

Revenues from technical support services and other services are recognized at the time services are performed. Revenues from service contracts entered into with third party service providers are recognized at the time of the contract sale, net of costs.

All of Qualstar's marketable securities were classified as available-for-sale as it is possible that some securities will be sold prior to maturity. Available-for-sale securities are recorded at market value. Unrealized holding gains and losses, net of the related income tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of shareholders' equity until realized. Dividend and interest income are recognized when earned. Realized gains and losses for securities classified as available-for-sale are included in earnings when the underlying securities are sold and are derived using the specific identification method for determining the cost of securities sold.

We measure fair value on all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) in accordance with SFAS No. 157, "Fair Value Measurements." See "Note 6 - Financial Instruments."

We estimate our allowance for doubtful accounts based on an assessment of the collectibility of specific accounts and the overall condition of accounts receivable. In evaluating the adequacy of the allowance for doubtful accounts, we analyze specific trade receivables, historical bad debts, customer credits, customer credit-worthiness and changes in customers' payment terms and patterns. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make additional payments, then we may need to make additional allowances. Likewise, if we determine that we could realize more of our receivables in the future than previously estimated, we would adjust the allowance to increase income in the period we made this determination.

We record inventories at the lower of cost or market value. We assess the value of our inventories periodically based upon numerous factors including expected product or material demand, current market conditions, technological obsolescence, current cost and net realizable value. If necessary, we write down our inventory for estimated obsolescence, potential shrinkage, or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If technology changes more rapidly than expected, or market conditions become less favorable than those projected by management, additional inventory write-downs may be required.

We provide for the estimated cost of product warranties at the time revenue is recognized. We engage in extensive product quality programs and processes, including active monitoring and evaluation of product failure rates, material usage and estimation of service delivery costs incurred in correcting a product failure. However, should actual product failure rates, material usage, or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. Historically our warranty costs have not been significant.

Share-based compensation is accounted for in accordance with SFAS 123R, Share-Based Payment. We use the Black-Scholes option pricing model to determine fair value of the award at the date of grant and recognize compensation expense over the vesting period. The inputs we use for the model require the use of judgment, estimates and assumptions regarding the expected volatility of the stock, the expected term the average employee will hold the option prior to the date of exercise, and the amount of share-based awards that are expected to be forfeited. Changes in these inputs and assumptions could occur and actual results could differ from these estimates, and our results of operations could be materially impacted.

We adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48) in the first quarter of fiscal year 2008. See Note 11 - Income Taxes to the consolidated condensed financial statements included in this Form 10-Q for further discussion.

We estimate our tax liability based on current tax laws in the statutory jurisdictions in which we operate. These estimates include judgments about deferred tax assets and liabilities resulting from temporary differences between assets and liabilities recognized for financial reporting purposes and such amounts recognized for tax purposes, as well as about the realization of deferred tax assets.

We maintain a valuation allowance to reduce our deferred tax assets due to the uncertainty surrounding the timing of realizing the benefits of net deferred tax assets in future years. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for such a valuation allowance. In the event we were to determine that we would be able to realize all or part of our net deferred tax asset in the future, the valuation allowance would be decreased accordingly.

We may periodically undergo examinations by the federal and state regulatory authorities and the Internal Revenue Service. We may be assessed additional taxes and/or penalties contingent on the outcome of these examinations. Our previous examinations have not resulted in any unfavorable or significant assessments.

                             RESULTS OF OPERATIONS

The following table reflects, as a percentage of net revenues, statements of
operations data for the periods indicated:

                                               Three Months Ended
                                                  September 30,
                                               2008           2007
                Net revenues                     100.0 %       100.0 %
                Cost of goods sold                65.1          69.5
                Gross profit                      34.9          30.5
                Operating expenses:
                Research and development          13.8          13.7
                Sales and marketing               12.9          14.2
                General and administrative        14.2          13.9
                Total operating expenses          40.9          41.8
                Loss from operations              (6.0 )       (11.3 )
                Investment income                  5.2           7.8
                Loss before income taxes          (0.8 )        (3.5 )
                Provision for income taxes         0.0           0.3
                Net loss                          (0.8 )%       (3.8 )%

We have two operating segments for financial reporting purposes: tape libraries and power supplies, as discussed in Note 12 of the Notes to Consolidated Financial Statements in Item 1 of this report. The following table summarizes our revenue by major product line and by operating segment:

                                              Three Months Ended
                                                 September 30,
                                               2008          2007
                  Tape Library revenues:
                  TLS                             23.6 %       32.6 %
                  RLS                              9.4         10.9
                  XLS                              8.1          6.6
                                                  41.1         50.1
                  Other library revenues:
                  Service                         13.2         12.3
                  Media                           11.8         17.3
                  Upgrades, spares                 4.0          6.7
                                                  29.0         36.3

                  Total Library revenues          70.1         86.4

                  Power Supply revenues           29.9         13.6

                                                 100.0 %      100.0 %

Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007

Net Revenue. Net revenues increased to $5.4 million for the three months ended September 30, 2008 from $5.3 million for the three months ended September 30, 2007, an increase of $0.1 million, or 1.3%. Two customers accounted for 11.1% and 10.6%, respectively, or 21.7% in the aggregate, of the Company's consolidated revenue for the three-month period ended September 30, 2008. No single customer accounted for more than ten percent of the Company's consolidated revenue for the three-month period ended September 30, 2007.

Segment Revenue

Tape Libraries - Net tape library revenues decreased to $3.8 million for the three months ended September 30, 2008 from $4.6 million for the three months ended September 30, 2007, a decrease of $.8 million, or 18%. The decrease in revenues is attributed primarily to a $0.5 million decline in revenues from our TLS tape library product line and a $0.3 million decline in revenues from sales of tape media, as well as smaller declines in sales of our RLS tape libraries and of upgrades and spares. These declines were partially offset by a $0.1 million increase in revenue from sales of our XLS tape library product line and a small increase in service revenue.

One customer accounted for 15.8% of tape library revenues for the three-month period ended September 30, 2008. No single customer accounted for more than ten percent of tape library revenues for the three-month period ended September 30, 2007.

Power Supplies - Net revenues from power supplies increased to $1.6 million for the three months ended September 30, 2008 from $.7 million for the three months ended September 30, 2007, an increase of $.9 million, or 122.8%. The increase in revenues is attributed to the launch of new power supply models and sales to a new original equipment manufacturer customer under a nine-month contract. Two customers accounted for 35.3% and 11.3%, respectively, or 46.6% in the aggregate, of power supply sales for the three months ended September 30, 2008. Three customers accounted for 19.9%, 13.4% and 9.4%, respectively, or 42.7% in the aggregate, of power supply sales for the three months ended September 30, 2007.

Gross Profit. Gross profit represents the difference between our net revenues and cost of goods sold. Cost of goods sold consists primarily of purchased parts, direct and indirect labor costs, rent, technical support costs, depreciation of plant and equipment, utilities, and packaging costs. Gross profit increased to $1.9 million for the three months ended September 30, 2008 from $1.6 million for the three months ended September 30, 2007. The increase of $.3 million, or 15.9%, is primarily due to efficiencies achieved in labor and material management.

Research and Development. Research and development expenses consist of engineering salaries, benefits, outside consultant fees, and purchased parts and supplies used in development activities. Research and development expenses increased to $743,000 for the three months ended September 30, 2008 from $728,000 for the three months ended September 30, 2007. The increase of $15,000, or 2.1%, is primarily due to an increase in compensation related expenses.

Sales and Marketing. Sales and marketing expenses consist primarily of employee salaries and benefits, sales commissions, trade show costs, advertising and travel related expenses. Sales and marketing expenses decreased to $695,000 for the three months ended September 30, 2008 from $759,000 for the three months ended September 30, 2007. The decrease of $64,000, or 8.4%, is primarily due to lower advertising and promotion expenses.

General and Administrative. General and administrative expenses include employee salaries and benefits and professional service fees. General and administrative expenses increased to $766,000 for the three months ended September 30, 2008 from $739,000 for the three months ended September 30, 2007. The increase of $27,000, or 3.7%, is primarily due to an increase in compensation related expenses.

Investment Income. Investment income decreased to $280,000 for the three months ended September 30, 2008 from $413,000 for the three months ended September 30, 2007. The decrease of $133,000, or 32.2% is primarily due to the lower interest rate environment in the recent quarter and partially due to having approximately $2.6 million less cash, cash equivalents and marketable securities in the quarter ended September 30, 2008 compared to the prior year quarter.

Provision for Income Taxes. We recorded a benefit for income taxes of $2,000 for the three months ended September 30, 2008. We recorded a provision for income taxes of $17,000 for the three months ended September 30, 2007 relating to state income taxes paid during the quarter and interest expense accrued as part of our liability resulting from our adoption on July 1, 2007 of FIN 48, Accounting for Uncertainties in Income Taxes - an Interpretation of FASB Statement No. 109.

Net cash used by operating activities was $507,000 in the three months ended September 30, 2008, primarily attributed to an increase in receivables, inventories and prepaid expenses and a decrease in accrued payroll and related liabilities. Net cash provided by operating activities was $387,000 in the three months ended September 30, 2007, primarily attributed to an increase in accounts payable and a decrease in receivables and inventories, partially offset by an increase in prepaid expenses and other assets, and a decrease in accrued payroll and related liabilities and other accrued liabilities.

Cash provided by investing activities was $3,024,000 in the three months ended September 30, 2008, primarily attributed to the sale of marketable securities, partially offset by the purchase of marketable securities. Cash provided by investing activities was $518,000 in the three months ended September 30, 2007, primarily attributed to the sale of marketable securities, partially offset by the purchase of marketable securities.

Cash used in financing activities was $735,000 in the three months ended September 30, 2008, attributed to the payment of a cash dividend of $0.06 per share that we declared in June 2008 and paid on September 5, 2008 on shares of our common stock. Cash was not used in or provided by financing activities during the three months ended September 30, 2007.

As of September 30, 2008, we had $8.5 million in cash and cash equivalents and $22.5 million in marketable securities. We believe that our existing cash and cash equivalents and anticipated cash flows from our operating activities, plus funds available from the sale of our marketable securities, will be sufficient to fund our working capital and capital expenditure needs for at least the next 12 months. We may utilize cash to invest in businesses, products or technologies that we believe are strategic. We regularly evaluate other companies and technologies for possible investment by us. In addition, we have made and may in the future make investments in companies with whom we have identified potential synergies. However, we have no present commitments or agreements with respect to any material acquisition of other businesses or technologies.