You should read the following discussion and analysis in conjuction with our Consolidated Financial Statements and related Notes thereto included in Part II, Item 8 of this Report and the "Risk Factors" included in Part I, Item 1A of this Annual Report on Form 10-K for the year ended June 30, 2012 (the "Report"), as well as other cautionary statements and risks described elsewhere in this Report, before deciding to purchase, hold or sell our common stock.

Overview

Lantronix, Inc. (the "Company," "Lantronix," "we" or "us") designs, develops, markets and sells secure communication technologies that simplify access to and communication with and between almost any electronic device. Our smart machine-to-machine ("M2M") connectivity solutions enable sharing data between devices and applications to empower better decisions based on real-time information, and gain a competitive advantage by generating new revenue streams, improving productivity and increasing efficiency and profitability. Easy to integrate and deploy, Lantronix products remotely and securely connect devices via networks and the Internet. We have one operating and reportable business segment, device networking, which includes device enablement and device management product lines. Our device enablement solutions enable digital and analog devices and sensors to be connected to a wired or wireless network for the primary purposes of remote access, control and data acquisition. Our device management solutions primarily serve information technology deployments; offering remote access, control and printing for data center, enterprise, manufacturing, branch office and home applications.

Our innovative networking solutions include fully-integrated hardware and software devices, as well as software tools, to develop related customer applications We provide technologically agnostic solutions to broad market segments, including industrial and building automation, security, medical, transportation, retail/point-of-sale ("POS"), financial services, governmental, manufacturing, consumer electronics/appliances, information technology ("IT"), data centers and others.

During the fourth quarter of the fiscal year ended June 30, 2012, we raised an aggregate amount of approximately $9.5 million in two separate equity transactions in which we issued an aggregate of 3,957,109 shares of our common stock. These offerings consisted of a private placement sale of 1,605,709 shares of our common stock to our largest shareholder and director, Bernhard Bruscha and a firm commitment public offering of 2,351,400 shares of our common stock.

Recent Accounting Pronouncements

Refer to Note 1 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Report for a discussion of recent accounting pronouncements.

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in accordance with accounting principles generally accepted in the U.S. requires us to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses during the reporting period. We regularly evaluate our estimates and assumptions related to net revenue, allowances for doubtful accounts, sales returns and allowances, inventory valuation, valuation of deferred income taxes, goodwill valuation, warranty reserves, restructuring costs, litigation and other contingencies. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected.

We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our consolidated financial statements:

Revenue Recognition

We do not recognize revenue until all of the following criteria are met:
persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; our price to the buyer is fixed or determinable; and collectability is reasonably assured. A significant portion of our sales are made to distributors under agreements which contain a limited right to return unsold product and price protection provisions. Therefore, the recognition of net revenue and related cost of revenue from sales to distributors are deferred until the distributor resells the product.

When product revenue is recognized, we establish an estimated allowance for future product returns based on historical returns experience. Actual product returns or pricing adjustments that exceed our estimates could result in additional reductions to revenue.

Our products typically carry a one- to two-year warranty. In the current fiscal year, we began offering a five-year warranty on certain new products. Although we engage in extensive product quality programs and processes, our warranty obligation is affected by product failure rates, use of materials or service delivery costs that differ from our estimates. As a result, additional warranty reserves could be required, which could reduce our gross margins. Additionally, we sell extended warranty services, which extend the warranty period for an additional one to three years, depending upon the product. Warranty net revenue is deferred and recognized ratably over the warranty service period.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Our allowance for doubtful accounts is based on our assessment of the collectability of specific customer accounts, the aging of accounts receivable, our history of bad debts and the general condition of the industry. If a major customer's credit worthiness deteriorates, or our customers' actual defaults exceed our historical experience, our estimates could change and impact our reported financial results.

Inventory Valuation

Our policy is to value inventories at the lower of cost or market on a part-by-part basis. This policy requires us to make estimates regarding the market value of our inventories, including an assessment of excess and obsolete inventories. We determine excess and obsolete inventories based on an estimate of the future sales demand for our products within a specified time horizon, generally three to twelve months. The estimates we use for demand are also used for near-term capacity planning and inventory purchasing. In addition, specific reserves are recorded to cover risks in the area of end of life products, inventory located at our contract manufacturers, deferred inventory in our sales channel and warranty replacement stock.

If our sales forecast is less than the inventory we have on hand at the end of an accounting period, we may be required to take excess and obsolete inventory charges, which will decrease our gross margin and net operating results for that period.

Valuation of Deferred Income Taxes

We have recorded a valuation allowance to reduce our net deferred tax assets to zero, primarily due to historical net operating losses and uncertainty of generating future taxable income. We consider estimated future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If we determine that it is more likely than not that we will realize a deferred tax asset that currently has a valuation allowance, we would be required to reverse the valuation allowance, which would be reflected as an income tax benefit at that time.

Goodwill Impairment Testing

During the fiscal year ended June 30, 2012, we early adopted the new provisions issued by the Financial Accounting Standards Board that intended to simplify goodwill impairment testing. The updated guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we conduct a two-step goodwill impairment test. The first step of the impairment test involves comparing the fair value of our single reporting unit with its carrying value, including goodwill, and recording an impairment charge if the carrying amount of the reporting unit exceeds its estimated fair value. If the carrying amount of the reporting unit exceeds the reporting unit's fair value, we perform the second step of the analysis, which involves comparing the implied fair value of the reporting unit's goodwill with the carrying value of that goodwill, the difference of which represents the impairment loss. The determination of the reporting unit's fair value requires significant judgment and is based on management's best estimate. We generally use valuation techniques based on our market capitalization and multiples of revenue for similar companies. In addition, management may consider the reporting unit's expected future earnings, and a control premium, which is the amount that a buyer is willing to pay over the current market price of a company as indicated by the traded price per share (i.e., market capitalization), in order to acquire a controlling interest. If our actual financial results are not consistent with our assumptions and judgments used in estimating the fair value of our reporting unit, we may be exposed to goodwill impairment losses.

During the fiscal year ended June 30, 2012, we made a qualitative assessment of whether goodwill impairment exists. Since we did not determine that it was more likely than not that the fair value of our single reporting unit is less than its carrying amount, we were not required to perform the two-step goodwill impairment test. As of June 30, 2012, our book value was $21.9 million while our market capitalization was $29.7 million.

Share-Based Compensation

We record share-based compensation in the statements of operations as an expense, based on the estimated grant date fair value of our share-based awards, whereby such fair values are amortized to expense over the requisite service period. Our share-based awards are currently comprised of common stock options and certain restricted stock awards. The fair value of our common stock option awards is generally estimated on the grant date using the Black-Scholes-Merton ("BSM") option-pricing formula. To the extent that certain stock option grants included market conditions, we used a lattice model to estimate the fair value of such grants. While utilizing the BSM model meets established requirements, the estimated fair values generated by it may not be indicative of the actual fair values of our common stock option awards as it does not consider certain factors important to those awards to employees, such as continued employment and periodic vesting requirements as well as limited transferability. The fair value of our restricted stock is based on the closing market price of our common stock on the grant date. If there are any modifications or cancellations of the underlying unvested share-based awards, we may be required to accelerate, increase or cancel any remaining unearned share-based compensation expense.

Results of Operations

Fiscal Years Ended June 30, 2012 and 2011



Net Revenue by Product Line



The following table presents net revenue by product line:



                                  Years Ended June 30,
                                 % of Net                   % of Net             Change
                      2012        Revenue        2011        Revenue         $            %
                                        (In thousands, except percentages)
Device enablement   $ 35,831         79.0%     $ 39,608         80.3%     $ (3,777 )     (9.5%)
Device management      9,551         21.0%        9,713         19.7%         (162 )     (1.7%)
Net revenue         $ 45,382        100.0%     $ 49,321        100.0%     $ (3,939 )     (8.0%)

For reporting purposes in the table above, we have reclassified net revenues from our non-core products, which currently represent less than 2% of net revenue, into the device management product line. Non-core products are primarily comprised of legacy products such as print servers, software and other miscellaneous products. The 8.0% decrease in net revenue was substantially the result of a 9.5% decrease in net revenue from our device enablement product line. We believe that our net revenue was negatively impacted by worldwide general economic conditions, as well as by certain supply constraints that we experienced during the current fiscal year. In addition, net revenue for the prior fiscal year ended June 30, 2011 included approximately $900,000 of deferred revenue that was recognized as a result of entering into contracts that removed certain distributors' rights to stock rotation and price protection in connection with an initiative to streamline our sales distribution channel. There was no similar revenue recognized during the fiscal year ended June 30, 2012.

The decrease in net revenue from our device enablement product line was primarily due to a decrease in unit sales of some of our embedded device enablement products, in particular our xPort and, to a lesser extent, our Micro, which is a legacy embedded serial-to-ethernet solution, partially offset by an increase in unit sales of our new products, xPort Pro and PremierWave EN. In addition, we had a $275,000 royalty sale in the prior fiscal year that did not recur in the current fiscal year. To a lesser extent, the decrease in net revenue from our device enablement product line was impacted by a decrease in unit sales of our external device enablement products, in particular our Micro Serial Server ("MSS") product family, a legacy product, partially offset by an increase in unit sales of our Xpress product family.

The decrease in net revenue from our device management product line was due to a decrease in unit sales of our Secure Lantronix Console ("SLC") and Secure Console Server ("SCS") console server product families, which were offset by sales of our new xPrintServer-Network Edition that began shipping in January 2012 and an increase in unit sales of our Secure Lantronix Spider ("SLS") product family.

Net Revenue by Geographic Region



The following table presents net revenue by geographic region:



                             Years Ended June 30,
                            % of Net                   % of Net              Change
                 2012        Revenue        2011        Revenue         $             %
                                    (In thousands, except percentages)
Americas       $ 24,120         53.1%     $ 25,648         52.0%     $ (1,528 )      (6.0%)
EMEA             13,740         30.3%       15,370         31.2%       (1,630 )     (10.6%)
Asia Pacific      7,522         16.6%        8,303         16.8%         (781 )      (9.4%)
Net revenue    $ 45,382        100.0%     $ 49,321        100.0%     $ (3,939 )      (8.0%)

The decrease in net revenue for the fiscal year ended June 30, 2012 compared to the fiscal year ended June 30, 2011 reflects decreased unit sales in the Europe, Middle East and Africa ("EMEA"), Americas, and Asia Pacific regions. We believe that our net revenue was negatively impacted by worldwide general economic conditions and, in particular the EMEA region, which experienced a year-over-year 10.6% decline in net revenue. The decrease in net revenue from the EMEA region was in large part due to a decrease in unit sales in our embedded device enablement products and, to a lesser extent, our external device enablement products and device management line. In addition, net revenue for the fiscal year ended June 30, 2011 included approximately $900,000 of deferred revenue that was recognized as a result of entering into contracts that removed certain distributors' rights to stock rotation and price protection in connection with an initiative to streamline our sales distribution channel. The decrease in net revenue from the Americas and Asia Pacific regions was primarily due to a decrease in unit sales in our embedded device enablement product line.

Gross Profit

Gross profit represents net revenue less cost of revenue. Cost of revenue consisted primarily of the cost of raw material components, subcontract labor assembly from contract manufacturers, manufacturing overhead, establishing or relieving inventory reserves for excess and obsolete products or raw materials, warranty costs, royalties and share-based compensation.

The following table presents gross profit:

                              Years Ended June 30,
                             % of Net                    % of Net             Change
                 2012        Revenue         2011        Revenue          $            %
                                    (In thousands, except percentages)

The decrease in gross profit as a percentage of net revenue for the fiscal year ended June 30, 2012 as compared to the prior fiscal year was primarily due to a charge taken for excess and obsolete inventories primarily as a result of a reduction in the sales forecasts for certain products, partially offset by a favorable change in product mix as a result of lower embedded device enablement unit sales.

Selling, General and Administrative

Selling, general and administrative expenses consisted of personnel-related expenses including salaries and commissions, share-based compensation, facility expenses, information technology, trade show expenses, advertising and professional legal and accounting fees.

The following table presents selling, general and administrative expenses:

                                        Years Ended June 30,
                                       % of Net                    % of Net              Change
                           2012        Revenue         2011        Revenue          $             %
                                               (In thousands, except percentages)
Personnel-related
expenses                 $ 10,427                    $ 11,293                    $   (866 )      (7.7%)
Professional fees and
outside services            2,403                       4,679                      (2,276 )     (48.6%)
Advertising and
marketing                   1,483                       1,940                        (457 )     (23.6%)
Facilities                  1,216                       1,149                          67          5.8%
Share-based
compensation                  449                       1,114                        (665 )     (59.7%)
Depreciation                  472                         661                        (189 )     (28.6%)
Other                       1,234                       1,537                        (303 )     (19.7%)
Selling, general and
administrative           $ 17,684          39.0%     $ 22,373          45.4%     $ (4,689 )     (21.0%)

The decrease in selling, general and administrative expense for the fiscal year ended June 30, 2012, as compared to the fiscal year ended June 30, 2011 was primarily due to (i) a decrease in professional fees and outside services related to the special investigation that was completed during the first quarter of the current fiscal year and the contested proxy that occurred in the prior fiscal year; (ii) a decrease in personnel-related expenses due primarily to separation costs related to the departure of our former CEO and CFO that were recorded in the June 2011 and a reduction in headcount directly related to the restructuring activities that occurred in November 2011, which were partially offset by an increase in salaries due to annual merit increases in the current fiscal year; (iii) a decrease in share-based compensation as consideration for performance bonuses, a reduction in head count and a lower average stock price for options; and (iv) other cost reduction efforts and the completion of our e-commerce website resulting in a decrease in advertising and marketing fees.

Research and Development

Research and development expenses consisted of personnel-related expenses including share-based compensation, as well as expenditures to third-party vendors for research and development activities.

The following table presents research and development expenses:

                                        Years Ended June 30,
                                       % of Net                    % of Net              Change
                           2012        Revenue         2011        Revenue          $             %
                                               (In thousands, except percentages)
Personnel-related
expenses                 $  4,753                    $  4,610                    $    143          3.1%
Facilities                    823                         997                        (174 )     (17.5%)
Professional fees and
outside services              649                         677                         (28 )      (4.1%)
Share-based
compensation                  278                         293                         (15 )      (5.1%)
Depreciation                   28                          42                         (14 )     (33.3%)
Other                         379                         414                         (35 )      (8.5%)
Research and
development              $  6,910          15.2%     $  7,033          14.3%     $   (123 )      (1.7%)

The decrease in research and development expenses for the fiscal year ended June 30, 2012, compared to the fiscal year ended June 30, 2011 was primarily due to a decrease in facilities expenses and a decrease in the use of share-based compensation as consideration for bonuses and a lower average stock price for options granted during the fiscal year ended June 30, 2012. Other expenses decreased as a result of various cost savings measures, including a reduction in travel expenses. These decreases were partially offset by an increase in personnel-related expenses as a result of annual merit increases, despite the reduction in salary expense undertaken in November 2011 as a result of restructuring activities.

Interest Expense, Net



The following table presents interest expense, net:



                                    Years Ended June 30,
                                   % of Net                 % of Net            Change
                        2012       Revenue       2011       Revenue         $           %
                                         (In thousands, except percentages)

The change in interest expense, net, is primarily due to lower interest expenses related to capital leases in the current fiscal year as well as a lower term loan balance.

Other Expense, Net



The following table presents other expense, net:



                                 Years Ended June 30,
                                % of Net                 % of Net           Change
                     2012       Revenue       2011       Revenue        $          %
                                     (In thousands, except percentages)

The change in other expense, net, is primarily due to foreign currency remeasurement and transaction adjustments related to our foreign subsidiaries whose functional currency is the U.S. dollar. In addition, during the fiscal year ended June 30, 2012, we wrote off the remaining carrying value of a former director's non-recourse loan from 2001 due to the unlikelihood of collection, which resulted in a $42,000 charge to other expense.

Restructuring Charges

During the second quarter of the fiscal year ended June 30, 2012, we implemented a restructuring plan to reduce operating expenses and to improve future results of operations. As part of the restructuring plan, the workforce was reduced by 14 employees. We recorded a restructuring charge of $286,000, which consisted primarily of severance-related payments. The restructuring plan was substantially completed as of December 31, 2011 and substantially all severance-related payments were made by June 30, 2012.

Provision for Income Taxes

The following table presents the income tax provision:

Years Ended June 30, % of Net % of Net Change 2012 Revenue 2011 Revenue $ %

Provision for income taxes $ 73 0.2% $ 56 0.1% $ 17 30.4%

The following table presents our effective tax rate based upon our income tax provision:

Years Ended June 30, 2012 2011

Effective tax rate (2.5%) (1.1%)

We utilize the liability method of accounting for income taxes. The difference between our effective tax rate and the federal statutory rate resulted primarily from the effect of our domestic losses recorded without a tax benefit, as well as the effect of foreign earnings taxed at rates differing from the federal statutory rate. We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. As a result of our cumulative losses and uncertainty of generating future taxable income, we provided a full valuation allowance against our net deferred tax assets for the fiscal years ended June 30, 2012 and 2011.

Due to the "change of ownership" provision of the Tax Reform Act of 1986, utilization of our net operating loss ("NOL") carryforwards and tax credit carryforwards may be subject to an annual limitation against taxable income in future periods. As a result of the annual limitation, a portion of these carryforwards may expire before ultimately becoming available to reduce future income tax liabilities. The following table summarizes our NOLs:

                                           June 30,
                                             2012
                                        (In thousands)
                           Federal     $         84,245
                           State       $         58,445

Our NOL carryovers for federal and state income tax purposes begin to expire in fiscal years 2021 and 2013, respectively. At June 30, 2012, our fiscal 2003 through fiscal 2010 tax years remain open to examination by federal, state, and foreign taxing authorities. However, we have NOLs beginning in fiscal 2001 which would cause the statute of limitations to remain open for the year in which the NOL was incurred.