e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)


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

For the quarterly period ended July 31, 2006


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: 000-21287

PEERLESS SYSTEMS CORPORATION

(Exact name of registrant as specified in its charter)


Delaware (State or Other Jurisdiction of Incorporation or Organization)		95-3732595 (I.R.S. Employer Identification No.)

2381 Rosecrans Avenue, El Segundo, CA (Address of Principal Executive Offices)		90245 (Zip Code)

(310) 536-0908
(Registrant’s telephone number, including area code)

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

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):

Large accelerated filer o Accelerated filer o Non-accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The number of shares of Common Stock outstanding as of September 7, 2006 was 17,165,357.

TRADEMARKS

Peerless^®, Memory Reduction Technology^® (MRT), PeerlessPowered^®, PeerlessPrint^®, AccelePrint^®, SyntheSys^®, QuickPrint^®, PerfecTone^® and VersaPage^® are registered trademarks of Peerless Systems Corporation. MagicPrint™, PeerlessPage™, ImageWorks™, PeerlessDriver™, PeerlessColor™, PeerlessNet™, PeerlessSPS™, PeerlessTrapping™, PeerlessXPS™, and WebWorks™ are trademarks of Peerless Systems Corporation. Peerless Systems, P logo, and Peerless logo are trademarks and service marks of Peerless Systems Corporation registered in Japan. Peerless is a trademark of Peerless Systems Corporation that is registered in Australia, China, France, Hong Kong, Spain, Taiwan, and the United Kingdom, and is the subject of applications for registration pending in the European Union, Italy, and Korea. PeerlessPrint is a trademark of Peerless Systems Corporation that is the subject of an application for registration pending in Japan. PeerlessPrint (in Katakana) is a trademark of Peerless Systems Corporation that is the subject of an application for registration pending in Japan.

Statements made by us in this report and in other reports and statements released by us that are not historical facts constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21 of the Securities Exchange Act of 1934. These forward-looking statements are necessarily estimates reflecting the best judgment of our senior management based on our current estimates, expectations, forecasts and projections and include comments that express our current opinions about trends and factors that may impact future operating results. Disclosures that use words such as we “believe,” “anticipate,” “estimate,” “intend,” “could,” “plan,” “expect,” “project” or the negative of these, as well as similar expressions, are intended to identify forward-looking statements. These statements are not guarantees of future performance, rely on a number of assumptions concerning future events, many of which are outside of our control, and involve known and unknown risks and uncertainties that could cause our actual results, performance or achievements, or industry results, to differ materially from any future results, performance or achievements, expressed or implied by such forward-looking statements. We discuss such risks, uncertainties and other factors throughout this report and specifically under the caption “Risk Factors” in Part II, Item 1A. below. Any such forward-looking statements, whether made in this report or elsewhere, should be considered in the context of the various disclosures made by us about our businesses including, without limitation, the risk factors discussed below. Except as required under the federal securities laws and the rules and regulations of the U.S. Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events, changes in assumptions, or otherwise.

PART I — FINANCIAL INFORMATION

Item 1 — Financial Statements.

PEERLESS SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)


	July 31,			January 31,
	2006			2006
ASSETS

Current assets:
Cash and cash equivalents	$	11,929		$	13,220
Trade accounts receivable, net		1,551			2,128
Unbilled receivables		5,590			3,032
Inventory		46			—
Prepaid expenses and other current assets		595			559

Total current assets		19,711			18,939
Property and equipment, net		794			904
Other assets		191			191

Total assets	$	20,696		$	20,034


LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:
Accounts payable	$	489		$	479
Accrued wages		663			693
Accrued compensated absences		979			872
Accrued product licensing costs		2,881			4,325
Other current liabilities		704			743
Deferred revenue		587			708

Total current liabilities		6,303			7,820
Other liabilities		157			275

Total liabilities		6,460			8,095

Stockholders’ equity:
Common stock		17			17
Additional paid-in capital		51,540			50,939
Accumulated deficit		(37,209	)		(38,925	)
Accumulated other comprehensive income		1			21
Treasury stock		(113	)		(113	)

Total stockholders’ equity		14,236			11,939

Total liabilities and stockholders’ equity	$	20,696		$	20,034

The accompanying notes are an integral part of these condensed consolidated financial statements.

PEERLESS SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)


	Three Months Ended						Six Months Ended
	July 31						July 31
	2006			2005			2006		2005
Revenues:
Product licensing	$	5,156		$	5,556		$	10,670	$	8,478
Engineering services and maintenance		2,725			2,843			5,675		6,013
Hardware sales		15			1,259			355		2,382

Total revenues		7,896			9,658			16,700		16,873

Cost of revenues:
Product licensing		1,352			1,878			1,852		2,599
Engineering services and maintenance		2,245			1,945			4,203		3,915
Hardware sales		23			1,108			181		1,716

Total cost of revenues		3,620			4,931			6,236		8,230

Gross margin		4,276			4,727			10,464		8,643

Operating expenses:
Research and development		2,116			1,304			4,172		2,566
Sales and marketing		756			843			1,550		1,783
General and administrative		1,842			1,456			3,233		2,733

Total operating expenses		4,714			3,603			8,955		7,082

Income (loss) from operations		(438	)		1,124			1,509		1,561
Other income (expense)		108			(6	)		219		(27	)

Income (loss) before income taxes		(330	)		1,118			1,728		1,534
Provision (benefit) for income taxes		(3	)		18			12		20

Net income	$	(327	)	$	1,100		$	1,716	$	1,514

Basic earnings (loss) per share	$	(0.02	)	$	0.07		$	0.10	$	0.09

Diluted earnings (loss) per share	$	(0.02	)	$	0.06		$	0.09	$	0.09

Weighted average common shares outstanding — basic		17,142			16,409			17,057		16,314

Weighted average common shares outstanding — diluted		17,142			18,261			19,329		17,796

The accompanying notes are an integral part of these condensed consolidated financial statements.

PEERLESS SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)


	Six Months Ended
	July 31,
	2006			2005
Cash flows from operating activities:
Net income	$	1,716		$	1,514
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization		467			754
Share-based compensation		279			—
Other		(20	)		22
Changes in operating assets and liabilities:
Trade accounts receivables		577			(1,368	)
Unbilled receivables		(2,558	)		952
Inventory		(46	)		323
Prepaid expenses and other assets		2			(107	)
Accounts payable		10			(655	)
Accrued product licensing costs		(1,444	)		1,043
Deferred revenue		(121	)		(5	)
Other liabilities		(80	)		991

Net cash provided by (used in) operating activities		(1,218	)		3,464

Cash flows from investing activities:
Proceeds from sale of available-for-sale securities		—			1,012
Purchases of property and equipment		(189	)		(126	)
Purchases of software licenses		(206	)		(147	)

Net cash used (provided) by investing activities		(395	)		739

Cash flows from financing activities:
Proceeds from issuance of common stock		—			163
Proceeds from exercise of common stock options		322			339

Net cash provided by financing activities		322			502

Net increase (decrease) in cash and cash equivalents		(1,291	)		4,705
Cash and cash equivalents, beginning of period		13,220			5,099

Cash and cash equivalents, end of period	$	11,929		$	9,804

The accompanying notes are an integral part of these condensed consolidated financial statements.

PEERLESS SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation:

The accompanying unaudited condensed consolidated financial statements of Peerless Systems Corporation (the “Company” or “Peerless”) have been prepared pursuant to the rules of the Securities and Exchange Commission (the “SEC”) for Quarterly Reports on Form 10-Q and do not include all of the information and note disclosures required by generally accepted accounting principles. The financial statements and notes herein are unaudited, but in the opinion of management, include all the adjustments (consisting only of normal, recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows of the Company. These statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on May 1, 2006. The results of operations for the interim periods shown herein are not necessarily indicative of the results to be expected for any future interim period or for the entire year.

2. Significant Accounting Policies:

Liquidity: Historically, the Company has incurred losses from operations and has reported negative operating cash flows. As of July 31, 2006, the Company had an accumulated deficit of $37.2 million and cash and cash equivalents of $11.9 million. The Company has no material financial commitments other than those under operating lease agreements. The Company believes that its existing cash and short-term investments, and any cash generated from operations will be sufficient to fund its working capital requirements, capital expenditures and other obligations through the next twelve months.

On March 1, 2005, the Company entered into a binding Memorandum of Understanding (“MOU”) with Kyocera-Mita Corporation (“Kyocera-Mita”) to provide a range of non-exclusive engineering services and product development services. Pursuant to the MOU, Kyocera-Mita has agreed to pay the Company an aggregate of $24.0 million, which will be paid in $2.0 million quarterly payments over the initial three-year term of the MOU. The long term liquidity of the Company is dependent upon this MOU. Should the MOU be terminated and Kyocera-Mita and the Company not enter into definitive agreements, the Company’s cash flow assumptions would be materially affected, and the Company would need to scale its operations to match the decrease in cash flows and may need to raise additional capital. The Company currently does not have a credit facility. Long term, the Company may face significant risks associated with the successful execution of its business strategy and may need to raise additional capital in order to fund more rapid expansion, to expand its marketing activities, to develop new or enhance existing services or products, and to respond to competitive pressures or to acquire complementary services, businesses, or technologies. If the Company is not successful in generating sufficient cash flow from operations, it may need to raise additional capital through public or private financing, strategic relationships, or other arrangements.

Revenue Recognition: The Company recognizes software revenues in accordance with Statement of Position 97-2 “Software Revenue Recognition” as amended by Statement of Position 98-9.

Development license revenues from the licensing of source code or software development kits (“SDKs”) for the Company’s standard products are recognized upon delivery to and acceptance by the customer of the software if no significant modification or customization of the software is required and collection of the resulting receivable is probable. If modification or customization is essential to the functionality of the software, the development license revenues are recognized over the course of the modification work.

The Company also enters into engineering services contracts with certain of its OEMs to provide a turnkey solution, adapting the Company’s software and supporting electronics to specific OEM requirements. Revenues on such contracts are generally recognized over the course of the engineering work on a percentage-of-completion basis. Progress-to-completion under percentage-of-completion is generally determined based on direct costs, consisting primarily of labor and materials, expended on the arrangement. The Company provides for any anticipated losses on such contracts in the period in which such losses are first determinable. At July 31, 2006 and 2005 the Company had no significant loss contracts. The Company also provides engineering support based on a time-and-material basis. Revenues from this support are recognized as the services are performed.

PEERLESS SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

Recurring licensing revenues are derived from per unit fees paid by the Company’s customers upon manufacturing and subsequent commercial shipment of products incorporating Peerless technology and certain third party technology, of which the Company is a sub-licensor. These recurring licensing revenues are recognized on a per unit basis as products are shipped commercially. The Company sells block licenses, that is, specific quantities of licensed units that may be shipped in the future, or the Company may require the customer to pay minimum royalty commitments. Associated payments are typically made in one lump sum or extend over a period of four or more quarters. The Company generally recognizes revenues associated with block licenses and minimum royalty commitments on delivery and acceptance of software, when collection of the resulting receivable is probable, when the fee is fixed and determinable, and when the Company has no future obligations. In cases where block licenses or minimum royalty commitments have extended payment terms and the fees are not fixed and determinable, revenue is recognized as payments become due. Further, when earned royalties exceed minimum royalty commitments, revenues are recognized on a per unit basis as products are shipped commercially.

For fees on multiple element software arrangements, values are allocated among the elements based on vendor specific objective evidence of fair value (“VSOE”). The Company generally establishes VSOE based upon the price charged when the same elements are sold separately. When VSOE exists for all undelivered elements, but not for the delivered elements, revenue is recognized using the “residual method” as prescribed by Statement of Position 98-9. If VSOE does not exist for the undelivered elements, all revenue for the arrangement is deferred until the earlier of the point at which such VSOE does exist for the undelivered elements or all elements of the arrangement have been delivered.

For certain of the Company’s multiple element arrangements that do not directly involve licensing, selling, leasing or otherwise marketing of the Company’s software (including its MOU with Kyocera-Mita), the Company applies the guidance under EITF 00-21 “Revenue Arrangements with Multiple Deliverables.” With respect to the Kyocera-Mita MOU, the Company applied the provisions of EITF 00-21 and determined that there were two elements that required separate accounting: a) engineering services over the three year term of the MOU and b) future maintenance services. The Company determined the fair value of future maintenance services to be $400 thousand based upon stand alone sales of the maintenance agreements and used the residual method to allocate the remaining portion of the $24 million service fee to the engineering services element. The Company has deferred the value of the future maintenance and is recognizing the remainder of the $24 million fee over the three year term of the arrangement.

The Company derived revenues from the sale of controllers for MFP devices. The Company recognized this revenue in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin 104, “Revenue Recognition in Financial Statements” (SAB 104). SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Peerless sold its controllers to certain OEM dealers for distribution to end users. Because it was a relatively new product, the Company was unable to establish a history regarding returns of product shipped. Therefore, the Company recognizes revenue only upon sales through to end users based on meeting the revenue recognition criteria under Statement of Financial Accounting Standards (SFAS) No. 48, “Revenue Recognition When Right of Return Exists.” The sale of these controllers was discontinued during the quarter ended January 31, 2006.

Deferred revenue consists of prepayments of licensing fees, payments billed to customers in advance of revenue recognized on engineering services or support contracts, and shipments of controllers that have not been sold to end users. Unbilled receivables arise when the revenue recognized on engineering support or block license contracts exceeds billings due to timing differences related to billing milestones as specified in the contract.

Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

PEERLESS SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

The Company provides an accrual for estimated product licensing costs owed to third party vendors whose technology is included in the products sold by the Company. The accrual is impacted by estimates of the mix of products shipped under certain of the Company’s block license agreements. The estimates are based on historical data and available information as provided by the Company’s customers concerning projected shipments. Should actual shipments under these agreements vary from these estimates, adjustments to the estimated accruals for product licensing costs may be required. Actual results have historically been consistent with management’s estimates.

The Company grants credit terms in the normal course of business to its customers. The Company continuously monitors collections and payments from its customers and maintains allowances for doubtful accounts for estimated losses resulting from the inability of any customers to make required payments. Estimated losses are based primarily on specifically identified customer collection issues. If the financial condition of any of the Company’s customers, or the economy as a whole, were to deteriorate, resulting in their inability to make payments, additional allowances may be required. Actual results have historically been consistent with management’s estimates.

The Company’s recurring product licensing revenues are dependent, in part, on the timing and accuracy of product sales reports received from the Company’s OEM customers. These reports are provided only on a calendar quarter basis and, in any event, are subject to delay and potential revision by the OEM. Therefore, the Company is required to estimate all of the recurring product licensing revenues for the last month of each fiscal quarter and to further estimate all of its quarterly revenues from an OEM when the report from such OEM is not received in a timely manner. In the event the Company is unable to estimate such revenues accurately prior to reporting financial results, the Company may be required to adjust revenues in subsequent periods. Revenues subject to such estimates were minimal for the three month periods ended July 31, 2006 and 2005.

3. Earnings Per Share:

Earnings per share for the three and six months ended July 31, is calculated as follows (in thousands, except for per share amounts):


	2006								2005
						Per							Per
	Net					Share			Net				Share
	Loss			Shares		Amount			Income		Shares		Amount
Basic EPS for three months ended July 31
Earnings (loss) available to common stock holders	$	(327	)		17,142	$	(0.02	)	$	1,100		16,409	$	0.07


Effect of Dilutive Securities
Options		—			—					—		1,852


Diluted EPS

Earnings (loss) available to common stockholders with assumed conversions	$	(327	)		17,142	$	(0.02	)	$	1,100		18,261	$	0.06


	2006						2005
					Per						Per
	Net				Share		Net				Share
	Income		Shares		Amount		Income		Shares		Amount
Basic EPS for six months ended July 31
Earnings available to common stock holders	$	1,716		17,057	$	0.10	$	1,514		16,314	$	0.09


Effect of Dilutive Securities
Options		—		2,272				—		1,482


Diluted EPS

Earnings available to common stockholders with assumed conversions	$	1,716		19,329	$	0.09	$	1,514		17,796	$	0.09

PEERLESS SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

4. Stock-Based Compensation Plans

The Company has several long-term incentive plans which provide for the grant of incentive stock options to employees and non-statutory stock options, restricted stock purchase awards and stock bonuses to employees, directors and consultants. The terms of stock options granted under these plans generally may not exceed 10 years. Options granted under the incentive plans vest at the rate specified in each optionee’s option agreement, generally over three or four years. An aggregate of 6.2 million shares of common stock have been authorized for issuance under the various option plans.

Prior to the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” in fiscal 2007, the Company accounted for its stock option plans in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees” and included pro forma disclosures for stock compensation under the provisions of SFAS 123, “Accounting for Stock Based Compensation”. Under APB Opinion No. 25, no compensation expense is recognized if the exercise price of the Company’s employee stock options equaled the market price of the underlying stock at the date of the grant.

The following disclosures are based on stock options granted to Peerless Systems’ employees and directors. In the first quarter of fiscal 2007, the Company adopted the provisions of SFAS No. 123(R) using the modified- prospective method. Under that transition method, compensation expense recognized subsequent to adoption includes: a) compensation cost for all share-based payment granted prior to, but not yet vested as of adoption, based on values estimated in accordance with the original provisions of SFAS No. 123, and b) compensation cost of all share-based payments granted subsequent to adoption, based on the grant-date fair values estimated in accordance with the provisions of SFAS No. 123(R). Consistent with the modified-prospective method, our results of operations for prior periods have not been restated.

Upon adoption of SFAS 123(R), the Company changed its method of attributing the value of stock-based compensation expense from the multiple-option (i.e., accelerated) approach to the single-option (i.e., straight-line) method. Compensation expense for share-based awards granted through January 31, 2006 will continue to be subject to the accelerated multiple-option method, while compensation expense for share-based awards granted on or after January 31, 2006 will be recognized using a straight-line, or single-option method. The Company recognizes these compensation costs over the service period of the award, which is generally the option vesting term of four years.

For the first six months of fiscal 2007, the Company recorded a total of $279 thousand in stock option expense related to stock options awarded after the adoption of SFAS No. 123(R) and for stock options which were not vested by the date of adoption of SFAS No. 123(R). The impact of the adoption of SFAS No. 123(R) was $0.02 on basic and diluted net income per share for the six months ended July 31, 2006. In fiscal 2007, the Company expects approximately $567 thousand in stock option compensation expense based on the fair value of stock options granted after the adoption of SFAS No. 123(R) and stock options which were not vested by the date of adoption of SFAS No. 123(R), as well as, current assumptions regarding the estimated fair value of expected stock option grants during the remainder of the year. However, our assessment of the estimated compensation expense is affected by our stock price as well as assumptions regarding a number of complex and subjective variables and the related tax impact. These variables include, but are not limited to, the volatility of our stock price and employee stock option exercise behaviors. No compensation expense related to employee stock options was recorded in fiscal 2006 or in prior years. During the first six months ended July 31, 2006, the total intrinsic value of stock options exercised was $1,624 thousand. Cash received from stock option exercises in the first six months of fiscal 2007 was $323 thousand. The excess tax benefit was negligible for the six months ended July 31, 2006. The Company issues shares of common stock reserved for such plans upon the exercise of stock options. No modifications to outstanding stock options were made prior to the adoption of SFAS No. 123(R).

The Company granted 330 thousand stock options in the first six months ended July 31, 2006. The valuation methodologies and assumptions in estimating the fair value of stock options that may be granted in fiscal 2007 will be similar to those used in estimating the fair value of stock options granted in fiscal 2006. The Company uses historical volatility of Peerless’ stock price as a basis to determine the expected volatility assumption to value stock

PEERLESS SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

options. The Company used its actual stock trading history over a period that approximates the expected term of its options. The expected dividend yield is based on Peerless’ practice of not paying dividends. The risk-free rate of return is based on the yield of U.S. Treasury Strips with terms equal to the expected life of the option as of the grant date. The expected life in years is based on historical actual stock option exercise experience. The Company had historically estimated forfeitures at the time of grant and the adoption of FAS No. 123(R) had no material impact on forfeitures.

Stock option transactions for Peerless’ employee stock option plans for the three and six months ended July 31, 2006 are summarized as follows (in thousands, except for exercise price amounts):


				Weighted		Weighted Average
				Average Exercise		Remaining Contractual		Aggregate
	Shares			Price		Term (Years)		Intrinsic Value
Beginning balance		3,310		$	2.46
Granted		—		$	—
Exercised		(233	)	$	1.30
Canceled or expired		(18	)	$	7.44

Balance April 30, 2006		3,059		$	2.52		6.05	$	10,284

Stock options exercisable at April 30, 2006		2,103		$	2.95		5.11	$	6,189

Granted		330		$	6.73
Exercised		(29	)	$	1.43
Canceled or expired		(19	)	$	2.06

Balance July 31, 2006		3,341		$	2.96		6.14	$	5,993

Stock options exercisable at July 31, 2006		2,178		$	2.93		4.99	$	3,964

Prior to adoption of the provisions of SFAS No. 123(R), the Company provided pro forma disclosures of estimated stock-based compensation expense as permitted under SFAS No. 123. The following table illustrates the effect on net income and earnings (loss) per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”:


	Three Months Ended			Six Months Ended
	July 31, 2005			July 31, 2005
	(Unaudited)			(Unaudited)
	(In thousands,			(In thousands,
	except per share			except per share
	amounts)			amounts)
Net income as reported	$	1,100		$	1,514
Stock-based compensation, net of taxes	$	(129	)	$	(232	)

Pro forma net income	$	971		$	1,296

Basic earnings per share as reported	$	0.07		$	0.09

Pro forma basic earnings per share	$	0.06		$	0.08

Diluted earnings per share as reported	$	0.06		$	0.09

Pro forma diluted earnings per share	$	0.05		$	0.07

In determining the fair value for the pro forma disclosure for the three months ended July 31, 2005, the Company used the Black-Scholes model, assumed no dividends per year, used expected lives ranging from 2 to 10 years, expected volatility of 79.0%, and risk free interest rate of 3.71%.

Concentration of Revenues:

Second quarter Fiscal year 2007 vs. Fiscal year 2006

During the second quarter of fiscal year 2007, two customers each generated greater than 10% of the revenues of the Company and collectively contributed 83% of such revenues. Block license revenues for the same time period were 53% of the revenues of the Company. During the second quarter of fiscal year 2006, two customers each

PEERLESS SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

generated greater than 10% of the revenues of the Company and collectively contributed 59% of such revenues. Block license revenues for the same time period were 46% of the revenues of the Company.

Six months ending July 31, 2006 vs. July 31, 2005

During the first six months of fiscal year 2007, two customers each generated greater than 10% of the revenues of the Company and collectively contributed 73% of such revenues. Block license revenues for the same time period were 49% of the revenues of the Company. During the first six months of fiscal year 2006, four customers each generated greater than 10% of the revenues of the Company and collectively contributed 62% of such revenues. Block license revenues for the same time period were 35% of the revenues of the Company.

6. Income Taxes:

For the three and the six months ended July 31, 2006 and 2005, the Company had minimal provision for income taxes as all taxable income is offset by the net operating loss carried forward.

The Company has provided a full valuation allowance on its net deferred tax assets because of the uncertainty with respect to its ability to generate future taxable income to realize its deferred tax assets.

7. Kyocera-Mita MOU:

On March 1, 2005, the Company entered into a binding MOU with Kyocera-Mita to provide a range of non-exclusive engineering services and product development services. Pursuant to the MOU, Kyocera-Mita has agreed to pay the Company an aggregate of $24.0 million, which will be paid in $2.0 million quarterly payments over the initial three-year term of the MOU. The Company is also eligible for certain performance incentives and may be due license fees from Kyocera-Mita for all Peerless and its third-party technologies that are incorporated into Kyocera-Mita products. The MOU, which states that it is binding, is effective as of February 1, 2005, and extends to January 31, 2008. The MOU will automatically renew on an annual basis after January 31, 2008, unless terminated by either party.

For the three and six months ended July 31, 2006, the Company recognized revenues of approximately $2.0 million and $3.9 million respectively under the MOU, including $0.3 million and $0.5 million, respectively for incentive bonus for performance.

PEERLESS SYSTEMS CORPORATION

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

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this Quarterly Report on Form 10-Q that are not purely historical 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, including without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Quarterly Report on Form 10-Q are based on current expectations, estimates, forecasts and projections about the industry in which Peerless operates, our beliefs and assumptions. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. We undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Highlights

Consolidated revenues for the second quarter of fiscal year 2007 were $7.9 million versus $9.7 million in the second quarter of fiscal 2006, and $8.8 million in this year’s first quarter. Second quarter product licensing revenue was $5.2 million compared with $5.6 million in second quarter of fiscal year 2006 and $5.5 million reported in this year’s first quarter. Hardware revenue was $15,000 in the second quarter of fiscal year 2007 versus $1.3 million in the second quarter last fiscal year and $0.3 million in the first quarter of this fiscal year. The expected decline in hardware revenue resulted from the discontinuation of Everest controller sales and the wind-down of certain ASIC product sales.

Engineering services and maintenance contract backlog at July 31, 2006 was approximately $0.4 million; this compares to $0.3 million as of January 31, 2006. The contract backlog does not include additional amounts expected under the Kyocera Mita MOU.

General

We generate revenue from our OEMs through the sale of imaging solutions in either turnkey or software development kit, or SDK, form. Historically, original equipment manufacturer, or OEM, demand for turnkey solutions had exceeded demand for SDK solutions. However, beginning in fiscal year 2000, we experienced a shift in demand away from turnkey solutions towards demand for SDKs, particularly for our mature monochrome solutions. We have attempted to expand our high performance color solutions by incorporating our networking technologies and related imaging technologies licensed from third parties.

Our product licensing revenues are comprised of both recurring per unit and block licensing revenues and development licensing fees for source code or SDKs. Licensing revenues are derived from per unit fees paid periodically by our OEM customers upon manufacturing and subsequent commercial shipment of products incorporating our technology. Licensing revenues are also derived from arrangements in which we enable third party technology, such as solutions from Adobe or Novell, to be used with our OEM partners’ products.

Block licenses are per-unit licenses in large volume quantities to an OEM for products either in or about to enter into distribution into the marketplace. Payment schedules for block licenses are negotiable and payment terms are often dependent on the size of the block and other terms and conditions of the block license being acquired. Typically, payments are made in either one lump sum or over a number of quarters.

Revenue received for block licenses is recognized in accordance with SOP 97-2, which requires that revenue be recognized after acceptance by the OEM and if fees are fixed and determinable and the collection of fees is probable. For block licenses that have a significant portion of the payments due within twelve months, revenue is generally recognized at the time the block license becomes effective assuming all other revenue recognition criteria have been met.

We also have engineering services revenues that are derived primarily from adapting our software and supporting electronics to specific OEM requirements. We provide our engineering services to OEMs seeking a turnkey imaging solution for their digital document products. Our maintenance revenues are derived from software maintenance agreements. Maintenance revenues currently constitute a small portion of total revenue.

As part of the total solution offered to our OEMs, we developed a direct distribution channel for our application specific integrated circuit, or ASIC, chips. Under this model, we supply ASIC chips from the foundry directly to the OEMs through third-party distributors, which include Arrow Electronics and Marubun Corporation. We are responsible for marketing and sales administration, including the billings and collections to and from our OEMs and distributors, and the third party is responsible for the coordination of production with the foundry, maintenance of necessary inventories and providing just-in-time delivery to OEMs and distributors.

We derive revenues from the sale of controllers for multifunction product, or MFP, devices. We sell our controllers to certain OEM dealers for distribution to end users. Because it is a relatively new product, we have been unable to establish a history regarding returns of the products shipped. Therefore, we recognize revenue only upon sales through to end users.

Historically, a limited number of customers have provided a substantial portion of our revenues. Therefore, the availability and successful closing of new contracts, or modifications and additions to existing contracts with these customers may materially impact our financial position and results of operations from quarter to quarter.

Our technology has addressed the worldwide market for monochrome printers (21-69 pages per minute) and MFP (21-110 pages per minute). This market has been consolidating, and the demand for our offerings and products declined in the second quarter of fiscal year 2007. We believe that unit volume for these types of printers could grow at lower rates than in past years. Available data indicate that retail prices are declining in these segments. There has been a decline in the number of monochrome contracts that we have with OEMs under which we are currently performing services and granting licenses, and this decline is likely to continue along with the demand for OEM devices with monochrome technology and products we presently offer. Competitors have merged into larger business units with the resulting strength to acquire and impose a competitive advantage in our market segments.

Sales decreased during the quarter ended July 31, 2006, as OEMs have reported reduced demand for their lower-end, higher-cost imaging devices, and many of these products incorporate the Company’s older monochrome imaging software. OEMs have continued to reduce the absolute number of new products being developed and in some instances, OEMs have performed in-house development projects for the products that they are developing and/or planning to launch. Although there have been fewer opportunities for us to sell our turnkey services and SDKs, we continue to support our current OEM controller customers in the digital printing devices business with our existing and new technologies.

In response to the apparent lower demand for our core monochrome offerings and as we may continue to meet sales resistance from our customers, we have developed and commercialized high performance color imaging and printing technologies and a new open architecture named Peerless Sierra Technologies. We believe that our products based on Peerless Sierra Technologies address key growth areas in the imaging market including: increased demand for color imaging, the emergence of MFPs, and continued demand for faster low cost monochrome printing solutions.

We believe that the launch of our high performance color MFP controller into the distribution channels and the development agreement with Kyocera Mita was a validation of our strategy of moving into high performance color technologies. However, “If we are unable to achieve our expected level of sales of Peerless Sierra Technologies on a timely basis, our future revenue and operating results may be harmed” and “If the marketplace does not accept Peerless Sierra Technologies, our future revenues and operating results may be harmed” in the section entitled. See “Risk Factors” of this Quarterly Report on Form 10-Q. We believe that our new Peerless Sierra Technologies will contribute an increasing percentage of our overall revenue in the future.

We have addressed the changing demands in the marketplace by investing in newer technologies. We have also addressed the changing dynamics of the market place by expanding our offerings in new geographic regions and restructuring our sales organization by expanding our sales force in Japan.

A significant element of our growth strategy consists of reducing the total cost of imaging products by incorporating our intellectual property (IP) into complex semiconductor chips used in digital imaging. Our semiconductor hardware strategy has several components: 1) the licensing of specific technologies to OEMs and chip manufacturers, 2) design and fabless manufacture and sale of ASIC (Application Specific Integrated Circuit) devices to OEMs and 3) support and licensing of specific technologies to SoC (System on a Chip) suppliers who sell to the devices to OEMs. Our business model also includes leveraging the semiconductor IP by additionally licensing software to OEMs after the ASIC or SoC devices have been sold to the OEMs. In March 2006, we entered into a SoC development agreement with PMC-Sierra Corporation (“PMC”). In June 2006, PMC terminated this agreement. See “Item 1A. Risk Factors – If the digital imaging market does not accept all or some of our semiconductor hardware strategy and our plans to leverage our IP licensing sales to OEMs, or takes more time to accept our solutions than we expect the growth of our business may be harmed.”

As a result of the complexities of the imaging industry, we continue to explore opportunities to enhance our value, including aggressive marketing of our new technologies, developing new market opportunities, raising additional capital and evaluating potential merger and acquisition candidates.

Liquidity and Capital Resources

Compared to January 31, 2006, total assets at July 31, 2006 increased 3% to $20.7 million and stockholders’ equity increased 19 % to $14.2 million, primarily the result of the net income and the issuance of common stock as a result of exercises of stock options. The Company’s cash and investment portfolio at July 31, 2006 was $11.9 million, a decrease of 10% from $13.2 million as of January 31, 2006, and the ratio of current assets to current liabilities was 3.1:1, which is an increase from the 2.4:1 ratio as of January 31, 2006. The increase was primarily the result of the operating profit generated during the six-month period. The Company’s operations used $1.2 million in cash during the six months ended July 31, 2006, compared to $3.5 million in cash provided by operations during the six months ended July 31, 2005.

During the six months ended July 31, 2006, $0.4 in cash was used by the Company’s investing activities. It is the Company’s policy to invest the majority of its unused cash in low risk government and commercial debt securities. The Company has not historically purchased, nor does it expect to purchase in the future, derivative instruments or enter into hedging transactions. During the six months ended July 31, 2006 and 2005, the Company invested $0.2 million in property, equipment and leasehold improvements.

At July 31, 2006, the Company’s principal source of liquidity, cash and cash equivalents was $11.9 million, a decrease of $1.3 million from January 31, 2006. Peerless does not have a credit facility. The Company may require additional long-term capital to finance working capital requirements.

The Company believes that the net cash provided by operating activities, and existing cash and equivalents, will provide the Company with sufficient resources to meet working capital requirements and other cash needs over at least the next twelve months. If the Company does not generate anticipated cash flow from sales, or if expenditures are greater than expected, the Company most likely will reduce discretionary spending, which would require the Company to delay, scale back or eliminate some or all of its development efforts, any of which could have a material adverse effect on the Company’s business, results of operations and prospects. Further, if the Company’s expected positive cash flows are not achieved, and is unable to increase revenues or cut costs so that revenues generated from operating activities are sufficient to meet the Company’s obligations, the Company will exhaust its current capital resources, and will be required to obtain additional capital from other sources. Such sources might include issuance of debt or equity securities, bank financing or other means that might be available to the Company

to increase its working capital. Under such circumstances, there is substantial doubt as to whether the Company would be able to obtain additional capital on commercially acceptable terms or at all. The inability to obtain such resources on commercially acceptable terms would have a material adverse effect on the Company, its operations, liquidity and financial condition, its prospects and the scope of strategic alternatives and initiatives available to the Company.

Critical Accounting Policies

Management’s Discussion and Analysis of Financial Condition and Results of Operations addresses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments. Management bases its estimates and judgments on historical experience and on various other factors that they believe are 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.

Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

We account for our software revenues in accordance with Statement of Position, or SOP, 97-2, “Software Revenue Recognition” as amended by SOP 98-9 and Staff Accounting Bulletin No. 104, “Revenue Recognition”. Over the past several years, we entered into block license agreements that represent unit licenses for products that will be licensed over a period of time. In accordance with SOP 97-2, revenue is recognized when the following attributes have been met: 1) an agreement exists between us and the OEM selling product utilizing our intellectual property and/or a third party’s intellectual property for which we are an authorized licensor, 2) delivery and acceptance of the intellectual property has occurred, 3) the fees associated with the sale are fixed and determinable and 4) collection of the fees are probable. Under our accounting policies, fees are fixed and determinable if 90% of the fees are to be collected within a twelve-month period, in accordance with SOP 97-2. If more than 10% of the payments of fees extend beyond a twelve-month period, they are recognized as revenues when they are due for payment, in accordance with SOP 97-2. As of July 31, 2006, we had no revenues to be recognized in future periods resulting from extended payment terms.

For fees on multiple element arrangements, values are allocated among the elements based on vendor specific objective evidence of fair value, VSOE. We generally establish VSOE based upon the price charged when the same elements are sold separately. When VSOE exists for all undelivered elements, but not for the delivered elements, revenue is recognized using the “residual method” as prescribed by Statement of Position 98-9. If VSOE does not exist for the undelivered elements, all revenue for the arrangement is deferred until the earlier of the point at which such VSOE does exist for the undelivered elements or all elements of the arrangement have been delivered.

We recognize revenues for certain of our engineering services projects on a percentage-of-completion basis, in accordance with Accounting Research Bulletin 45, “Long-Term Construction-Type Contracts” and SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” The estimates to complete the projects are determined by the individual project-engineering manager responsible for the oversight of the individual projects. The estimates are made at the end of each accounting period and are subject to unforeseen circumstances that can increase or decrease the hours necessary to complete the efforts. For fiscal year 2006 and the second quarter ended July 31 2006 of fiscal year 2007, we reported no engineering services revenues on a percentage-of-completion basis.

We derived revenues from the sale of controllers for MFP devices. We recognized this revenue in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin 104, “Revenue Recognition in Financial Statements” (SAB 104). SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the

fee is fixed and determinable; and (4) collectibility is reasonably assured. We sold the controllers to certain OEM dealers for distribution to end users. Because it was a relatively new product, we were unable to establish a history regarding returns of product shipped. Therefore, we recognized revenue only upon sales through to end users based on meeting the revenue recognition criteria under Statement of Financial Accounting Standards (SFAS) No. 48, “Revenue Recognition When Right of Return Exists.” The sale of these controllers was discontinued during the quarter ended January 31, 2006.

We provide an accrual for estimated product licensing costs owed to third party vendors whose technology is included in the products sold by us. The accrual is impacted by estimates of the mix of products shipped under certain of our block license agreements. The estimates are based on historical data and available information as provided by our customers concerning projected shipments. Should actual shipments under these agreements vary from these estimates, adjustments to the estimated accruals for product licensing costs may be required. Such adjustments have historically been within management’s expectations.

We have provided a valuation allowance for all of our net deferred tax assets because of the uncertainty with respect to our ability to generate future taxable income to realize the deferred tax assets. The realization of these assets is based upon management’s estimates of future taxable income. With a change in management’s assessment of the uncertainty, the valuation allowance will be adjusted accordingly.

We grant credit terms in the normal course of business to our customers. We continuously monitor collections and payments from our customers and maintain allowances for doubtful accounts for estimated losses resulting from the inability of any customers to make required payments. Estimated losses are based primarily on specifically identified customer collection issues. If the financial condition of any of our customers, or the economy as a whole, were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Actual results have historically been consistent with management’s estimates.

Our recurring product licensing revenues are dependent, in part, on the timing and accuracy of product sales reports received from our OEM customers. These reports are provided only on a calendar quarter basis and, in any event, are subject to delay and potential revision by the OEM. Therefore, we are required to estimate all of the recurring product licensing revenues for the last month of each fiscal quarter and to further estimate all of our quarterly revenues from an OEM when the report from such OEM is not received in a timely manner. In the event we are unable to estimate such revenues accurately prior to reporting financial results, we may be required to adjust revenues in subsequent periods. For the six months ended July 31, 2006 revenues subject to such estimates were minimal. Actual results have historically been consistent with management’s estimates.

Stock Based Compensation

On February 1, 2006, we adopted SFAS No. 123(R) using the modified-prospective transition method. Under this method, prior period results are not restated. Compensation cost recognized subsequent to adoption includes: (i) compensation cost for all share-based payments granted prior to, but unvested as of January 1, 2006, based on the grant date fair value, which is determined in accordance with the original provision of SFAS No. 123 using a Black-Scholes option pricing model, and (ii) compensation cost for all share-based payments granted subsequent to February 1, 2006, based on the grant-date fair value, which is determined in accordance with the provisions of SFAS No. 123(R) using a Black-Scholes option pricing model to estimate the grant date fair value of share-based awards.

The Company uses its actual stock trading history as a basis to calculate the expected volatility assumption to value stock options. The expected dividend yield is based on Peerless’ practice of not paying dividends. The risk-free rate of return is based on the yield of U.S. Treasury Strips with terms equal to the expected life of the option as of the grant date. The expected life in years is based on historical actual stock option exercise experience.

SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. If actual forfeitures vary from our estimates, we will recognize the difference in compensation cost in the period the actual forfeitures occur.

Upon adoption of SFAS 123(R), the Company changed its method of attributing the value of stock-based compensation expense from the multiple-option (i.e. accelerated) approach to the single-option (i.e. straight- line)

method. Compensation expense for share-based awards granted through January 31, 2006 will continue to be subject to the accelerated multiple-option method, while compensation expense for share-based awards granted on or after January 31, 2006 will be recognized using a straight-line, or single-option method. The Company recognizes these compensation costs over the service period of the award, which is generally the options vesting term of four years.

We recorded $279 thousand in share-based compensation expense during the six months ended July 31, 2006. The Company granted 330 thousand stock options in the second quarter.

Results of Operations

Comparison of Quarters Ended July 31, 2006 and 2005


	Percentage of						Percentage
	Total Revenues						Change
	Three Months						Three Months
	Ended						Ended
	July 31						July 31,
	2006			2005			2006 vs. 2005
Statements of Operations Data:
Revenues:
Product licensing		65	%		58	%		(7	)%
Engineering services and maintenance		35			29			(4	)
Hardware sales		0			13			(99	)

Total revenues		100			100			(18	)

Cost of revenues:
Product licensing		17			20			(28	)
Engineering services and maintenance		28			20			15
Hardware sales		—			11			(98	)

Total cost of revenues		46			51			(27	)

Gross margin		54			49			(10	)

Operating expenses:
Research and development		27			13			62
Sales and marketing		10			9			(10	)
General and administrative		23			15			27

Total operating expenses		60			37			31

Income (loss) from operations		(6	)		12			(139	)
Other income (expense), net		1			—			1900

Income (loss) before income taxes		(4	)		12			(130	)

Provision for income taxes		—			1			(128	)

Net income (loss)		(4	)%		11	%		(130	)%

Net Income

Our net loss in the second quarter of fiscal year 2007 was $0.3 million, or $0.02 per basic share and diluted share, compared to a net income of $1.1 million, or $0.07 per basic share and $0.06 per diluted share, in the second quarter of fiscal year 2006.

Revenues

Consolidated revenues were $7.9 million for the second quarter of fiscal year 2007, compared to $9.7 million for the second quarter of fiscal year 2006. Licensing revenues decreased $0.4 million in the second quarter of fiscal year 2007, primarily as a result of lower per unit sell-through of Peerless product on OEM devices. Engineering services and maintenance revenues decreased $0.1 million, primarily as a result of lower bonus incentives achieved on the Kyocera-Mita MOU. Hardware sales decreased $1.2 million as a result of the discontinuation of sales of the Everest Controllers in the fourth quarter of fiscal year 2006 as well as a decrease in ASIC sales.

Cost of Revenues

Total cost of revenues was $3.6 million in the second quarter of fiscal year 2007, compared to $4.9 million in the second quarter of fiscal year 2006. Product licensing costs decreased $0.5 million in the period as a result of a higher level of our intellectual property contained in the licenses entered into during the second quarter of this fiscal year. Engineering services and maintenance costs in the second quarter of fiscal year 2007 increased $0.3 million in the period primarily due to the recognition of a specific loss realized on a maintenance contract with one of our OEM customers. Hardware sales costs were lower in the second quarter of fiscal year 2007 as a result of a lower level of ASICs and Everest Controller revenues.

Gross Margin

Our gross margin increased to 54% in the second quarter of fiscal year 2007 compared with 49% in the second quarter of fiscal year 2006. The increase in fiscal year 2007 was due primarily to a higher-than-normal level of Peerless intellectual property being sold-through on OEM devices.

Operating Expenses

Total operating expenses for the second quarter of fiscal year 2007 increased 31% to $4.7 million, compared with $3.6 million for the same period one year ago.

	•		Research and development expenses increased 62% to $2.1 million in the second quarter of fiscal year 2007 from $1.3 million in the comparable quarter of fiscal year 2006. The increase was primarily the result of increase development efforts associated with new and enhanced technologies being offered to our customers in SDK form. These include print output enhancements for lower cost imaging devices (Trapping), networking web services and security and software to utilize the new capabilities of the new Microsoft Vista operating system.

	•		Sales and marketing expenses decreased 10% to $0.8 million in the second quarter of fiscal year 2007 from $0.8 million in the comparable quarter of fiscal year 2006. The decrease during the current fiscal year was the result of lower sales bonuses and commissions which are now focused on rewarding the sale of new technologies on new devices. There was also a reduction in travel expense compared to last year as a result of the timing of international travel. Offsetting these decreases was the staffing increase of two in our Japan office to enhance our capabilities in working with our customer in Japan to identify and satisfy their needs.

	•		General and administrative expenses increased 27% to $1.8 million in the second quarter of fiscal year 2007 from $1.5 million in the comparable quarter of fiscal year 2006. Costs in the second quarter of fiscal year 2007 were higher as a result of higher professional services during that quarter as compared to the second quarter of fiscal 2006. It is expected that general and administrative expenses will increase approximately 10% over the next two quarters as a result of cost associated with compliance with the Sarbanes-Oxley 404 Act.

Income Taxes

Our tax provision is currently based primarily on the alternative minimum tax. We have net operating loss carry-forwards and tax credits sufficient to offset profits, which has minimized our income tax expense. We have provided a valuation allowance on our net deferred tax assets because of the uncertainty with respect to our ability to generate future taxable income to realize our deferred tax assets.

Comparison of Six Months Ended July 31, 2006 and 2005


	Percentage of						Percentage
	Total Revenues						Change
	Six Months						Six Months
	Ended						Ended
	July 31,						July 31,
	2006			2005			2006 vs. 2005
Statements of Operations Data:
Revenues:
Product licensing		64	%		50	%		26	%
Engineering services and maintenance		34			36			(6	)
Hardware sales		2			14			(85	)

Total revenues		100			100			(1	)

Cost of revenues:
Product licensing		11			15			(29	)
Engineering services and maintenance		25			23			7
Hardware sales		1			10			(89	)

Total cost of revenues		37			49			(24	)

Gross margin		63			51			21

Operating expenses:
Research and development		25			15			63
Sales and marketing		9			11			(13	)
General and administrative		19			16			18

Total operating expenses		54			42			26

Income from operations		9			9			(3	)
Other income, net		1			—			911

Income before income taxes		10			9			13
Provision for income taxes		—			—			(40	)

Net income		10	%		9	%		13	%

Net Income

Our net income in the first six months of fiscal year 2007 was $1.7 million, or $0.10 per basic share and $0.09 per diluted share, compared to a net income of $1.5 million, or $0.09 per basic share and $0.09 per diluted share, in the first six months of fiscal year 2006.

Revenues

Consolidated revenues were $16.7 million for the first six months of fiscal year 2007, compared to $16.9 million for the first six months of fiscal year 2006. Licensing revenues increased $2.2 million in the first six months of fiscal year 2007, primarily as a result of a higher level of shipments by our customers resulting in three new block licenses valued at $8.0 million. Engineering services and maintenance revenues decreased $0.3 million, primarily as a result of increased start up revenues associated with the Kyocera Development arrangement last year. Hardware sales decreased as a result of a $2.0 million decrease in sales of the Everest Controllers which were discontinued in the fourth quarter of fiscal year 2006.

Cost of Revenues

Total cost of revenues was $6.2 million in the first six months of fiscal year 2007, compared to $8.2 million in the first six months of fiscal year 2006. Product licensing costs decreased $0.7 million in the period as a result of a higher level of our intellectual property contained in the licenses entered into during the first six months of this fiscal year. Engineering services and maintenance costs in the first six months of fiscal year 2007 were comparable to those in the first six months of fiscal 2006. Hardware sales costs were lower in the first six months of fiscal year 2007 as a result of a lower level of ASICs and Everest Controller revenues.

Gross Margin

Our gross margin increased to 63% in the first six months of fiscal year 2007 compared with 51% in the first six months of fiscal year 2006. The increase in fiscal year 2007 was due primarily to increased margins associated with three new license agreements valued at $8.0 million being primarily our intellectual property and due to the lower level of lower margin hardware sales.

Operating Expenses

Total operating expenses for the first six months of fiscal year 2007 increased 26% to $9 million, compared with $7.1 million for the same period one year ago.

	•		Research and development expenses increased 63% to $4.2 million in the first six months of fiscal year 2007 from $2.6 million in the comparable quarter of fiscal year 2006. The increase was primarily the result of new development efforts. These include print output enhancements for lower cost imaging devices (Trapping), networking web services and security and software to utilize the new capabilities of the new Microsoft Vista operating system.

	•		Sales and marketing expenses decreased 13% to $1.6 million in the first six months of fiscal year 2007 from $1.8 million in the comparable quarter of fiscal year 2006. The decrease during the current fiscal year was the result of lower sales bonuses and commissions which are now focused on rewarding the sale of new technologies on new devices. There was also a reduction in travel expense compared to last year as a result of the timing of international travel. Offsetting these decreases was the staffing increase of two in our Japan office to enhance our capabilities in working with our customer in Japan to identify and satisfy their needs.

	•		General and administrative expenses increased 18% to $3.2 million in the first six months of fiscal year 2007 from $2.7 million in the comparable quarter of fiscal year 2006. Costs in the first six months of fiscal year 2007 were higher as a result of higher professional services during that quarter as compared to the first six months of fiscal 2006. It is expected that general and administrative expenses will increase approximately 10% over the next two quarters as a result of cost associated with compliance with the Sarbanes-Oxley 404 Act.

Income Taxes

Item 3 — Quantitative and Qualitative Disclosures About Market Risk.

The Company is exposed to a variety of risks in its investments, mainly a lowering of interest rates. The primary objective of the Company’s investment activities is to preserve the principal of its investments, while at the same time maximizing yields without significantly increasing risk. To achieve this objective, the Company from time to time maintains its portfolio of cash equivalents, fixed rate debt instruments of the U.S. Government and high-quality corporate issuers and short-term investments in money market funds. Although the Company is subject to interest rate risks, the Company believes an effective increase or decrease of 10% in interest rate percentages would not have a material adverse effect on its results from operations.

The Company has not entered into any derivative financial instruments. Currently all of the Company’s contracts, including those involving foreign entities, are denominated in U.S. dollars. The Company has experienced no significant foreign exchange gains or losses to date. The Company has not engaged in foreign currency hedging activities to date and has no intention of doing so. The Company’s international business is subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and to a lesser extent foreign exchange rate volatility. Accordingly, the Company’s future results could be materially and adversely affected by changes in these or other factors.

Item 4 — Controls and Procedures.

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to Peerless management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13(a)-15(b) under the Securities Exchange Act of 1934, the Company carried out an evaluation, under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the disclosure controls and procedures. Based on the foregoing, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were not effective at ensuring that the information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported as required in applicable SEC rules and forms because of the deficiency in internal controls over financial reporting described below. Management has determined that this deficiency constitutes a material weakness in the Company’s internal controls over financial reporting. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

Software Revenue Recognition

As a result of substantial turnover in accounting staff and the retirement of the chief financial officer, the Company did not maintain effective controls over the revenue recognition process. Our controls were not adequate to capture and analyze all the various terms and conditions of all contracts to ensure proper recording of revenue contracts with standard and non-standard terms. Certain of our revenue transactions are accounted for in accordance with AICPA’s Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended, which includes complex revenue recognition criteria that were not always adequately assessed. Specifically, the Company misapplied generally accepted accounting principles to a certain software license arrangements signed during the six months ended July 31, 2006. This weakness resulted in the identification of adjustments by our independent registered public accounting firm during its review of our revenues. Management has responded to the identification of this material weakness by engaging the services of an outside consultant with sufficient software revenue recognition expertise to assist in the design and development of policy and procedure to ensure that the Company’s revenues and costs are reported in accordance with SOP 97-2, as well as Staff Accounting Bulletin No. 104 “Revenue in Financial Statements” and EITF 00-21 “Revenue Arrangements with Multiple Deliverables.”

There was no impact associated with this deficiency to the financial results for the six months ended July 31, 2006. However, the potential for a material impact exists if the discovered material weakness is not remediated. Management believes that the actions described above will achieve such remediation. Management is also implementing a process to more rigorously analyze, document and review all revenue contracts.

Except as described above, there have been no significant changes in the Company’s internal controls over financial reporting during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

PART II — OTHER INFORMATION

Item 1 — Legal Proceedings.

None.

Item 1A — Risk Factors

Certain Factors and Trends Affecting Peerless and Its Business

We rely on relationships with certain customers and any adverse change in those relationships will harm our business.

A limited number of OEM customers continue to provide a substantial portion of our revenues. Presently, there are only a small number of OEM customers in the digital document product market to which we can market our technology and services. Therefore, our ability to offset a significant decrease in the revenues from a particular customer or to replace a lost customer is severely constrained.

We currently rely upon our OEM block license agreements to maintain our current revenue levels. If we were unable to continue to recognize revenue upon the execution of some of our block license agreements there may be an immediate and significant drop in the amount of revenue being reported as earned in the short term and this may have a material adverse effect on our business, results of operations and prospects.

During the second quarter of fiscal year 2007, two customers, Kyocera-Mita Corporation and Konica-Minolta Corporation each generated greater than 10% of our revenues, and collectively contributed 83% of revenues. Block license revenues during the same period were $4.2 million, or 53% of revenues. During the second quarter of fiscal year 2006, two customers, Kyocera-Mita Corporation and Konica-Minolta each generated greater than 10% of our revenues, and collectively contributed 59% of revenues. Block license revenues during the same period were $4.4 million, or 46% of revenues.

Our existing capital resources may not be sufficient and if we are unable to raise additional capital, our business may suffer.

Our principal source of liquidity is our cash and cash equivalents, which, as of July 31, 2006 were approximately $11.9 million in the aggregate. The current ratio of current assets to current liabilities was 3.1:1. For the six months ended July 31, 2006, our operations used $1.2 million in cash.

On March 1, 2005, we entered into a binding Memorandum of Understanding, or MOU, with Kyocera-Mita Corporation to provide a range of non-exclusive engineering services and product development services. Pursuant to the MOU, Kyocera-Mita has agreed to pay us an aggregate of $24.0 million, which will be paid in $2.0 million quarterly payments over the initial three-year term of the MOU. Our long term liquidity is dependent upon this MOU. Should the MOU be terminated and we not enter into definitive agreements on similar terms with Kyocera-Mita, our cash flow assumptions would be materially affected.

If we do not generate anticipated cash flow from licensing and services, or if expenditures are greater than expected, we most likely will reduce discretionary spending, which could require a delay, scaling back or elimination of some or all of our development efforts, any of which could have a material adverse effect on our business, results of operations and prospects. Furthermore, if we do not experience positive cash flows as is anticipated, and we are unable to increase revenues or cut costs so that revenues generated from operating activities are sufficient to meet our obligations, we will be required to obtain additional capital from other sources. Such

sources might include issuances of debt or equity securities, bank financing or other means that might be available to increase our working capital. Under such circumstances, there is substantial doubt as to whether we would be able to obtain additional capital on commercially reasonable terms or at all. The inability to obtain such resources on commercially acceptable terms could have a material adverse effect on our operations, liquidity and financial condition, our prospects, and the scope of strategic alternatives and initiatives available to us.

We rely on relationships with Adobe Systems Incorporated and Novell Inc., and any adverse change in those relationships will harm our business.

We have licensing agreements with Adobe Systems Incorporated and Novell Inc. to bundle and sublicense their licensed products with our licensed software. These relationships accounted for $4.1 million in revenues and an associated $1.4 million in cost of revenues during the three months ended of July 31, 2006. Should the agreements with either of these vendors be terminated or canceled, there is no assurance that we could replace that source of revenue within a short period of time, if at all. Such an event would have a material adverse effect on our operating results.

We have negotiated with Adobe Systems Incorporated and Canon Inc. to remedy a contract dispute, which, if not remedied, could result in the loss of the Adobe agreement and could harm our business.

We have negotiated with Canon Inc. regarding the PostScript sublicense agreement between us and Canon executed as of April 1, 2001. The sublicense did not include several terms required to be included in all OEM sublicenses by our license with Adobe. Although Adobe has indicated to us that it has no current intention to pursue claims for alleged breach of the Adobe Peerless PostScript Sublicensing Agreement, Adobe has not agreed to waive the requirement that the missing terms be included in the Canon sublicense. To date, we have been unable to amend the Canon sublicense in a manner acceptable to both Canon and Adobe. Furthermore, there is no assurance that we will be able to resolve the issues in a manner acceptable to both Adobe and Canon. Thus, Adobe may exercise its right to terminate its license agreement with us and take other legal action against us, if it so chooses. Termination of the Adobe agreement would have a material adverse effect on our future operating results. Approximately 34% of our revenue for the six months ended July 31, 2006 and approximately 37% of Peerless’ revenue for the six months ended July 31, 2005 were derived from its licensing arrangement with Adobe Systems Incorporated. See “We rely on relationships with Adobe Systems Incorporated and Novell Inc., and any adverse change in those relationships will harm our business” above.

If we do not enter into definitive agreements relating to the Memorandum of Understanding, or MOU, with Kyocera Mita Corporation, it may harm our financial results.

We may never come to agreement with Kyocera Mita on the terms of definitive agreements regarding the development of Kyocera Mita products by us or enter into definitive agreements relating to their relationship with us described in the MOU. If the parties do not enter into definitive agreements, our financial results may be harmed. We have not yet defined with Kyocera-Mita the products that will utilize our technologies, and we have not negotiated the terms and conditions associated with the licensing of our and any third party’s technologies arising out of this development relationship.

We may be unable to implement our business plan effectively.

Our ability to implement our business plan, develop and offer products and manage expansion in rapidly developing and disparate marketplaces requires comprehensive and effective planning and management. The growth in the complexity of business relationships with current and potential customers and third parties has placed, and will continue to place, a significant strain on management systems and resources. Our failure to continue to improve upon the operational, managerial and financial controls, reporting systems and procedures in our imaging business or our failure to expand and manage our workforce could have a material adverse effect on our business and financial results.

The increased use of low-cost offshore engineering and test labor by our customers and competitors poses significant risks to our competitive position.

Our OEM customers, potential customers and competitors continue to seek lower cost alternatives for their engineering needs. Some of our OEM customers, potential customers and competitors have developed extensive offshore operations that may be capable of delivering lower cost solutions than we are able to deliver. The expanding use of lower cost offshore engineering and test labor may make it difficult for us to compete based on the price of our services and result in a significant loss of sales. Similarly, our research and development costs may be higher than those of our OEM customers, potential customers and competitors who are using lower cost offshore engineering services, which may result in our development of less technology for a given research and development budget than our OEM customers, potential customers and/or competitors. Either, or both of these trends could have a negative impact on our competitive position and financial results.

Our increased use of low-cost offshore engineering and test labor could significantly harm our business.

We continue to investigate ways to effectively increase our use of offshore engineering and test labor. In addition to the general risks of doing international business as noted below, our relationships with offshore companies pose specific risks. For example, although we have entered into confidentiality agreements with these offshore companies, we cannot ensure that they will not end their relationships with us and use information they gain from their relationship with us to launch competing products or offer competing services. Similarly, we cannot assure you that key personnel of these offshore companies will not be successfully solicited by our competitors especially in geographic regions where aggressive solicitation of skilled personal is common, such as India and China. Should these companies, their personnel or others with specific knowledge of our business and technology, decide to compete with us, it could significantly harm our business.

The impact of Microsoft’s Vista™ operating system could have an adverse impact on our future licensing revenues.

Among the changes announced for Microsoft’s Vista™ operating system are fundamental changes to the printing and networking subsystems within the operating system. Of particular relevance to us is Microsoft’s development of a new page description language, or PDL, and peripheral device connectivity methods, the format of which would be licensed by Microsoft on a royalty-free basis to both OEMs and 3rd party technology providers such as us. Should we fail to support these technologies on a timely basis, or should OEMs decide to support these technologies on their own without the use of our products, it could have an adverse impact on our potential licensing revenues from these enhanced products. In addition, to the extent that our current PDL products are perceived as being gradually rendered obsolete over the long term by these new Microsoft technologies, it could have an adverse impact on our ability to generate new sales of our current PDL products.

Our near term revenue may drop as a result of the timing of licensing revenues and the reduced demand for our existing monochrome technologies.

We have traditionally generated our revenue from the licensing and sale of monochrome solutions to OEMs. While we are continuing to provide monochrome solutions to OEM customers and continuing to seek out additional distribution channels and customers for our monochrome solutions, we continue to focus our research and development and marketing efforts on our Peerless Sierra Technologies product line of high performance, high speed, color imaging solutions. Until our Peerless Sierra Technologies becomes accepted in the marketplace — if such technology does become accepted in the marketplace — our overall license revenue may stagnate or even decrease and result in a material adverse effect on our business and financial results. We recently decided to end production of our first product based on Peerless Sierra Technologies, the Everest controller, due to poor customer acceptance.

If we are unable to achieve our expected level of sales of Peerless Sierra Technologies on a timely basis, our future revenue and operating results may be harmed.

Our future operating results will depend to a significant extent on the success of our new Peerless Sierra Technologies. We have spent a significant amount of time and capital developing our new Peerless Sierra Technologies. Any delay in licensing Peerless Sierra Technologies in the future could harm our financial results.

If the marketplace does not accept Peerless Sierra Technologies, our future revenue and operating results may be harmed.

Peerless Sierra Technologies may not be accepted by the marketplace for many reasons including, among others, incompatibility with existing or forthcoming systems, lack of perceived need by customers, uncertainty whether the benefits exceed the cost, the availability of alternatives and the unwillingness to use new or unproven products. If the marketplace does not accept Peerless Sierra Technologies or if the marketplace takes additional time to accept Peerless Sierra Technologies than we expect, our future revenues and operating results may be harmed.

Our licensing revenue is subject to significant fluctuations.

Our recurring licensing revenue model has shifted from per-unit royalties paid upon OEM shipment of our product and guaranteed quarterly minimum royalties to a model that results in revenues associated with the sale of SDKs and block licenses. The reliance on block licenses has occurred due to aging OEM products in the marketplace, OEM demands in negotiating licensing agreements, reductions in the number of OEM products shipping and a design win mix that changed from object code licensing arrangements to SDKs. Revenues may continue to fluctuate significantly from quarter to quarter as the number and value of design wins vary, or if the signing of block licenses are delayed or the licensing opportunities are lost to competitors. Any of these factors could have a material adverse effect on our operating results.

Our revenue from engineering services is subject to significant fluctuations.

We have experienced a significant reduction in the financial performance of our engineering services that has been caused by many factors, including:

	•		product development delays;

	•		potential non-recurring engineering reduction for product customization;

	•		third party delays; and

	•		loss of new engineering services contracts.

There can be no assurance that these and similar factors will not continue to impact future engineering services results adversely.

We may be unable to deploy our employees effectively in connection with changing demands from our OEM customers.

The industry in which we operate has experienced significant downturns, both in the United States and abroad, often in connection with, or in anticipation of, maturing product cycles and declines in general economic conditions. Over the past two years, we have experienced a shift in OEM demand from the historically prevailing requirement for turnkey solutions toward SDKs. Because Peerless has experienced a general decrease in demand for engineering services, engineering services resources have been re-deployed to research and development. Should this trend abruptly change, we may be unable to re-deploy labor effectively and in a timely manner, which inability could have a material adverse effect on our operating results.

The future demand for our products is uncertain.

Our monochrome technology and products have been in the marketplace for an average of more than 34 months as of July 31, 2006. The average age of current technology and products in the marketplace reflects the aging of our monochrome technology and products. Although we continue to license our current technology and products to certain OEMs, there can be no assurance that the OEMs will continue to need or utilize the products and technology we currently offer.

We have a history of losses.

Although we were profitable in the first six months of fiscal year 2007 and were profitable in fiscal year 2006, we had been unprofitable in four of the previous five fiscal years. There is no assurance that we will continue to be profitable at any time in the future.

We may be unable to develop additional new and enhanced products that achieve market acceptance.

Our future success also depends in part on our ability to address the rapidly changing needs of potential customers in the marketplace, to introduce high-quality, cost-effective products, product enhancements and services on a timely basis, and to keep pace with technological developments and emerging industry standards. Our failure to achieve our business plan to develop and to successfully introduce new products and product enhancements in our prime markets is likely to materially and adversely affect our business and financial results.

If we are not in compliance with our licensing agreements, we may lose our rights to sublicense technology; our competitors are aggressively pursuing the sale of licensed third party technology.

We currently sublicense third party technologies to our OEM customers, which sublicenses account for a significant amount of our gross revenues. Such sublicense agreements are non-exclusive. If Peerless is determined not to be in compliance with agreements between us and our licensors, we may forfeit our right to sublicense these technologies. Likewise, if such sublicense agreements were canceled, we would lose our right to sublicense the affected technologies. Additionally, the licensing of these technologies has become very competitive, with competitors possessing substantially greater financial and technical resources and market penetration than us. As competitors are pursuing aggressive strategies to obtain similar rights as held by us to sublicense these third party technologies, there is no assurance that we can remain competitive in the marketplace if one or more competitors are successful. See “We have negotiated with Adobe Systems Incorporated and Canon, Inc. to remedy a contract dispute, which, if not remedied, could result in the loss of the Adobe agreement and harm our business.”

The industry for imaging systems for digital document products involves intense competition and rapid technological changes, and our business may suffer if our competitors develop superior technology.

The market for imaging systems for digital document products is highly competitive and characterized by continuous pressure to enhance performance, to introduce new features and to accelerate the release of new products. We compete on the basis of technology expertise, product functionality, development time and price. Our technology and services primarily compete with solutions developed internally by OEMs. Virtually all of our OEM customers have significant investments in their existing solutions and have the substantial resources necessary to enhance existing products and to develop future products. These OEMs possess or may develop competing imaging systems technologies and may implement these systems into their products, thereby replacing our current or proposed technologies, eliminating a need for our services and products and limiting our future opportunities. Therefore, we must persuade these OEMs to outsource the development of their imaging systems to us and to provide products and solutions to these OEMs that cost-effectively compete with their internally developed products. We also compete with software and engineering services provided in the digital document product marketplace by other systems suppliers to OEMs.

As the digital document printing industry continues to develop, competition and pricing pressures will increase from OEMs, existing competitors and other companies that may enter our existing or future markets with similar or substitute solutions that may be less costly or provide better performance or functionality. We anticipate increasing competition for our color products under development, particularly as new competitors develop and sell competing products. Some of our existing competitors, many of our potential competitors, and virtually all of our OEM customers have substantially greater financial, technical, marketing and sales resources than we have. If price competition increases, competitive pressures could require us to reduce the amount of royalties received on new licenses and to reduce the cost of our engineering services in order to maintain existing business and generate additional product licensing revenues. This could reduce profit margins and result in losses and a decrease in market share. We cannot assure you that we have the ability to compete favorably with the internal development capabilities of our current and prospective OEM customers or with other third party digital imaging system suppliers and the failure to compete effectively would have a material adverse effect on our operating results.

Our reserves for accounts receivable may not be adequate.

Our net trade accounts receivable was $1.6 million as of July 31, 2006, a decrease from $2.1 million as of January 31, 2006. Although we believe that our reserves for accounts receivable are adequate for the remainder of fiscal year 2007, our reserves may prove to be inadequate. If our reserves for accounts receivable are inadequate, it could have a material adverse effect on our results of operations.

If we fail to adequately protect our intellectual property or face a claim of intellectual property infringement by a third party, we could lose our intellectual property rights or be liable for damages.

Our success is heavily dependent upon our proprietary technology. To protect our proprietary rights, we rely on a combination of patent, copyright, trade secret and trademark laws, as well as the early implementation and enforcement of nondisclosure and other contractual restrictions. As part of our confidentiality procedures, we enter into written nondisclosure agreements with our employees, consultants, prospective customers, OEMs and strategic partners and take affirmative steps to limit access to and distribution of our software, intellectual property and other proprietary information.

Despite these efforts, we may be unable to effectively protect our proprietary rights and the enforcement of our proprietary rights may be cost prohibitive. Unauthorized parties may attempt to copy or otherwise obtain, distribute, or use our products or technology. Monitoring unauthorized use of our products is difficult. We cannot be certain that the steps we take to prevent unauthorized use of our technology, particularly in countries where the laws may not protect proprietary rights as fully as in the United States, will be effective.

Our source code also is protected as a trade secret. However, from time to time we license our source code to OEMs, which subjects us to the risk of unauthorized use or misappropriation despite the contractual terms restricting disclosure, distribution, copying and use. In addition, it may be possible for unauthorized third parties to copy our products or to reverse engineer our products in order to obtain and subsequently use and distribute our proprietary information.

We hold patents issued in the United States, France, Germany, Great Britain, Japan, Taiwan and Hong Kong. The issued patents relate to techniques developed by us for generating output for continuous synchronous raster output devices, such as laser printers, compressing data for use with output devices, filtering techniques for use with output devices and communicating with peripheral devices over a network. We also have patent applications pending in the United States, the European Patent Office, Japan, Hong Kong, Taiwan, China, Australia, Korea, and India. There can be no assurance that patents we hold will not be challenged or invalidated, that patents will issue from any of our pending applications or that any claims allowed from existing or pending patents will be of sufficient scope or strength (or issue in the countries where products incorporating our technology may be sold) to provide meaningful protection or be of any commercial advantage to us. In any event, effective protection of intellectual property rights may be unavailable or limited in certain countries. The status of United States patent protection in the software industry will evolve as the United States Patent and Trademark Office grants additional patents. Patents have been granted to fundamental technologies in software after the development of an industry around such technologies and patents may be issued to third parties that relate to fundamental technologies related to our technology.

As the number of patents, copyrights, trademarks and other intellectual property rights in our industry increases, products based on our technologies may become the subjects of infringement claims. There can be no assurance that third parties will not assert infringement claims against us in the future. Any such claims, regardless of merit, could be time consuming, divert the efforts of our technical and management personnel from productive tasks, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us, or at all, which could have a material adverse effect on our operating results. In addition, we may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. Litigation to determine the validity of any claims, whether or not such litigation is determined in our favor, could result in significant expenses and divert the efforts of our technical and management personnel from productive tasks. In

addition, we may lack sufficient resources to initiate a meritorious claim. In the event of an adverse ruling in any litigation regarding intellectual property, we may be required to pay substantial damages, discontinue the use and sale of infringing products and expend significant resources to develop non-infringing technology or obtain licenses to infringing or substituted technology. Our failure to develop, or license on acceptable terms, a substitute technology, if required, could have a material adverse effect on our operating results.

Our international activities may expose us to risks associated with international business.

We are substantially dependent on our international business activities. Risks inherent in these international business activities include:

	•		major currency rate fluctuations;

	•		changes in the economic condition of foreign countries;

	•		the imposition of government controls;

	•		tailoring of products to local requirements;

	•		trade restrictions;

	•		changes in tariffs and taxes; and

	•		the burdens of complying with a wide variety of foreign laws and regulations, any of which could have a material adverse effect on our operating results.

If we are unable to adapt to international conditions, our business may be adversely affected.

Our stock price may experience extreme price and volume fluctuations.

Our common stock has experienced price volatility. In the 60-day period ending September 7, 2006, the closing price of the stock ranged from $2.93 per share to $7.17 per share, and, since the beginning of fiscal year 2006, the stock has closed as low as $1.31 per share. Such price volatility may occur in the future. Factors that could affect the trading price of our common stock include:

	•		macroeconomic conditions;

	•		actual or anticipated fluctuations in quarterly results of operations;

	•		announcements of new products or significant technological innovations by us or our competitors;

	•		developments or disputes with respect to proprietary rights;

	•		losses of major OEM customers;

	•		general trends in the industry; and

	•		overall market conditions and other factors.

In addition, the stock market historically has experienced extreme price and volume fluctuations, which have particularly affected the market price of securities of many related high technology companies and which at times have been unrelated or disproportionate to the operating performance of such companies.

Our common stock was moved to the Nasdaq SmallCap Market and may not provide adequate liquidity.

On July 30, 2004, we announced that our common stock had been transferred from the Nasdaq National Market to the Nasdaq SmallCap Market. There can be no assurance, however, that we will be able to maintain compliance with the continued listing standards of the Nasdaq SmallCap Market. For example, if the minimum bid price of our common stock falls below $1.00, and remains below $1.00 for thirty consecutive business days, we will not be in compliance with the Nasdaq SmallCap Market minimum bid requirements under Marketplace Rule 4310(c)(4).

If we are not able to maintain compliance, our common stock may be subject to removal from listing on the Nasdaq SmallCap Market. Trading in our common stock after a delisting, if any, would likely be conducted in the over-the-counter markets in the so-called “pink sheets” or the National Association of Securities Dealers’ Electronic Bulletin Board and could also be subject to additional restrictions. As a consequence of a delisting, our stockholders would find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, our common stock. In addition, a delisting would make our common stock substantially less attractive as collateral for margin and purpose loans, for investment by financial institutions under their internal policies or state legal investment laws or as consideration in future capital raising transactions.

Our business may suffer if our third party distributors are unable to distribute our products and address customer needs effectively.

We have developed a distribution model for the sale of ASICs. We have no direct distribution experience and we rely on third party distributors to maintain inventories to address OEM needs, manage manufacturing logistics and distribute our products in a timely manner. There can be no assurance that these distribution agreements will be maintained or will prove adequate to meet our needs and contractual requirements.

We rely on certain third party providers for applications to develop our ASICs. As a result, we are vulnerable to any problems experienced by these providers, which may delay product shipments to our customers.

We rely on two independent parties, IBM Microelectronics and NEC Microelectronics, each of which provides unique ASICs incorporating our imaging technology for use by our OEM partners. These sole source providers are subject to materials shortages, excess demand, reduction in capacity and/or other factors that may disrupt the flow of goods to our customers thereby adversely affecting our customer relationships. Any such disruption could limit or delay production or shipment of the products incorporating our technology, which could have a material adverse effect on our operating results.

We, as a sublicensor of third party intellectual property, are subject to audits of our licensing fee costs.

Certain of our licensing agreements include third party intellectual property and result in royalties contractually due and payable to the third parties. The rates are subject to the language of the contract and intent of the contracting parties, and may result in disputes as to the correct rates. We are subject to audits of our data serving as the basis for the royalties due. Such audits may result in adjustments to the royalty amounts due.

Under new regulations required by the Sarbanes-Oxley Act of 2002 (SOX), an adverse opinion on internal controls over financial reporting could be issued by our independent registered public accounting firm, and this could have a negative impact on our stock price.

Section 404 of SOX requires that we establish and maintain an adequate internal control structure and procedures for financial reporting and assess on an on-going basis the design and operating effectiveness of the internal control structure and procedures for financial reporting. Our independent registered public accounting firm will be required to attest audit both the design and operating effectiveness of our internal controls and management’s assessment of the design and the effectiveness of our internal controls beginning with the fiscal year ending on January 31, 2007 because we became an accelerated filer as defined by the SEC rules on July 31, 2006. As such, we will be required to comply with Section 404 of the Sarbanes-Oxley Act. If we are unable to remediate material weaknesses, our independent registered public accounting firm would be required to issue an adverse opinion on our internal controls. During management’s assessment of internal controls for the first quarter of fiscal year 2007, management determined that a material weakness existed with regard to our revenue recognition process. The material weakness if not remediated, could have a material adverse effect on our results of operation in future periods. To remediate the weakness, management has engaged the services of a consultant with sufficient expertise in revenue recognition to assist us in the development of controls that will reduce the risk of future errors. Management believes that these actions will completely remediate the weakness and that there will be no material impact on our results of operation and no misleading results will be reported as a result of the weakness.

Recent and proposed regulations related to equity incentives could adversely affect our ability to attract and retain key personnel.

Since our inception, we have used stock options and other long-term equity incentives as a fundamental component of our employee retention packages. We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value and, through the use of vesting, encourage employees to remain with us. The Financial Accounting Standards Board has announced changes that we have implemented in the first fiscal 2007 quarter ending April 30, 2006 requiring us to record a charge to earnings for employee stock option grants and issuances of stock under employee stock purchase plans. This regulation negatively impacts our results of operations. In addition, new regulations implemented by the Nasdaq National Market requiring shareholder approval for all stock option plans could make it more difficult for us to grant options to employees in the future. To the extent that new regulations make it more difficult or expensive to grant options to employees, incur increased costs, change our equity incentive strategy or find it difficult to attract, retain and motivate employees, could materially and adversely affect our business.

If the digital imaging market does not accept all or some of our semiconductor hardware strategy and our plans to leverage our IP licensing sales to OEMs, or takes more time to accept our solutions than we expect, the growth of our business may be harmed.”

A significant element of our growth strategy consists of reducing the total cost of imaging products by incorporating our intellectual property (IP) into complex semiconductor chips used in digital imaging. Our semiconductor hardware strategy has several components: 1) the licensing of specific technologies to OEMs and chip manufacturers, 2) design and fabless manufacture and sale of ASIC (Application Specific Integrated Circuit) devices to OEMs and 3) support and licensing of specific technologies to SoC (System on a Chip) suppliers who sell to the devices to OEMs. Our business model also includes leveraging the semiconductor IP by additionally licensing software to OEMs after the ASIC or SoC devices have been sold to the OEMs . If the digital imaging market does not accept our solutions, or takes more time to accept our solutions than we expect, the growth of our business may be harmed. Our digital imaging strategy may not be accepted by the marketplace as rapidly as we anticipate, or at all, for many reasons, including, among others, lack of perceived need by customers, uncertainty as to whether the benefits outweigh the cost, the availability of alternative solutions and the unwillingness of manufacturers to use new or unproven products. In March 2006, we entered into our first SoC development agreement with PMC-Sierra Corporation (“PMC”). In June 2006, PMC terminated this agreement.

Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3 — Defaults Upon Senior Securities.

None.

Item 4 — Submission of Matters to a Vote of Security Holders.

None.


		Page No.
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements

Unaudited Condensed Consolidated Balance Sheets at July 31, 2006 and January 31, 2006		4

Unaudited Condensed Consolidated Statements of Income for the Three and Six Month Periods Ended July 31, 2006 and 2005		5

Unaudited Condensed Consolidated Statements of Cash Flows for the Six Month Periods Ended July 31, 2006 and 2005		6

Notes to Unaudited Condensed Consolidated Financial Statements		7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		13

Item 3. Quantitative and Qualitative Disclosures About Market Risk		21

Item 4. Controls and Procedures		22

PART II — OTHER INFORMATION

Item 1. Legal Proceedings		23

Item 1A. Risk Factors		23

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		31

Item 3. Defaults Upon Senior Securities		31

Item 4. Submission of Matters to a Vote of Security Holders		31

Item 5. Other Information		32

Item 6. Exhibits		32

Signatures		33
EXHIBIT 10.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32

	10.1		Letter of agreement relating to the employment of John V. Rigali as Vice President and Chief Financial Officer.

	31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002.

	31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002.

	32.1		Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes Oxley Act of 2002.


		Peerless Systems Corporation

	By:	/s/ Howard J. Nellor Howard J. Nellor
		President and Chief Executive Officer
		(Principal Executive Officer)

Date: September 14, 2006

	By:	/s/ John V. Rigali John V. Rigali
		Vice President of Finance and
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

Date: September 14, 2006


Exhibit
Number		Description

	10.1	Letter of agreement relating to the employment of John V. Rigali as Vice President and Chief Financial Officer.¹

	31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002.

	31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002.

	32.1	Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes Oxley Act of 2002.

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Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents


¹		Filed herewith.