Merix (MERX)

Stock-Based Compensation

Effective May 28, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment.” The Company elected to use the modified prospective transition method as provided by SFAS No. 123R and, accordingly, financial statement amounts for the prior periods presented in this Form 10-K have not been restated to reflect the fair value method of expensing stock-based compensation. Under this method, the provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. In addition, the unrecognized expense of awards not yet vested at the date of adoption is recognized in net income in the periods after the date of adoption over the remainder of the requisite service period. The Company’s deferred stock-based compensation balance of $1.1 million as of May 27, 2006, which was accounted for under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” was reclassified to common stock upon the adoption of SFAS No. 123R.

Prior to May 28, 2006, the Company accounted for stock-based compensation using the intrinsic value method as prescribed by APB Opinion No. 25 and related interpretations. No stock-based compensation related to option grants or the employee stock purchase plan was reflected in earnings in fiscal 2006 or 2005, as all stock options granted under those plans had an exercise price equal to or greater than the market value of the underlying common stock on the date of grant. Had compensation cost for the plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income

61

Table of Contents

(loss) and basic and diluted net income (loss) per share for fiscal 2006 and 2005 would have been changed to the pro forma amounts indicated below (in thousands, except per share amounts):

The above pro forma compensation expense related to options granted pursuant to our stock incentive plans was determined based on the estimated fair values using the Black-Scholes Option Pricing Model and the following weighted average assumptions:

Pro forma stock-based compensation expense under SFAS No. 123, among other computational differences, does not consider potential pre-vesting forfeitures. Because of these differences, the pro forma stock-based compensation expense presented above for fiscal 2006 and 2005 under SFAS No. 123 and the stock-based compensation expense recognized during fiscal 2007 under SFAS No. 123R are not directly comparable.

Stock-Based Compensation

On May 28, 2006, we adopted SFAS No. 123R, “Share-Based Payment,” which requires the measurement and recognition of compensation expense for all share-based payment awards granted to our employees and directors based on the estimated fair value of the award on the grant date. We elected to use the modified prospective transition method as provided by SFAS No. 123R and, accordingly, financial statement amounts for the prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of expensing stock-based compensation. Under this method, the provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. In addition, the unrecognized expense of awards not yet vested at the date of adoption is recognized in net income in the periods after the date of adoption over the remainder of the requisite service period. Our deferred stock-based compensation balance of $1.1 million as of May 27, 2006, which was accounted for under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” was reclassified to common stock upon the adoption of SFAS No. 123R. As of February 24, 2007, unrecognized stock-based compensation related to outstanding, but unvested stock options and restricted stock awards was $2.5 million and $1.0 million, respectively, which will be recognized over the weighted-average remaining vesting periods of 1.8 years and 2.9 years, respectively.

Prior to May 28, 2006, we accounted for stock-based compensation using the intrinsic value method as prescribed by APB Opinion No. 25 and related interpretations. Upon the adoption of SFAS No. 123R, we maintained our method of valuation for stock option awards using the Black-Scholes Option Pricing Model which has historically been used for the purpose of providing pro-forma financial disclosures in accordance with SFAS No. 123.

21

Table of Contents

The use of the Black-Scholes Option Pricing Model to estimate the fair value of stock option awards requires us to make judgments on assumptions regarding the risk-free interest rate, expected dividend yield, expected term and expected volatility over the expected term of the award. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of expense could be materially different in the future.

Compensation expense is only recognized on awards that ultimately vest. Therefore, we have reduced the compensation expense to be recognized over the vesting period for anticipated future forfeitures. Forfeiture estimates are based on historical forfeiture patterns. We update our forfeiture estimates quarterly and recognize any changes to accumulated compensation expense in the period of change. If actual forfeitures differ significantly from our estimates, our results of operations could be materially impacted.

On May 25, 2005, our Board of Directors accelerated vesting of outstanding “underwater” employee stock options with exercise prices greater than $8.00 per share. Approximately 1.3 million options, or approximately 39% of our total outstanding options as of May 25, 2005, with varying remaining vesting schedules, were subject to this acceleration and became immediately exercisable. As a result of this acceleration, we estimated that we would reduce the amount of compensation expense recorded due to the effects of SFAS No. 123R by approximately $329,000 for fiscal 2007 and an additional $300,000 in total for subsequent years. This acceleration only related to specific underwater options, and, accordingly, is not representative of the overall impact that SFAS No. 123R will have on the results of our operations, our cash flows or our liquidity.

Stock-Based Compensation

On May 28, 2006, we adopted SFAS No. 123R, “Share-Based Payment,” which requires the measurement and recognition of compensation expense for all share-based payment awards granted to our employees and directors based on the estimated fair value of the award on the grant date. We elected to use the modified prospective transition method as provided by SFAS No. 123R and, accordingly, financial statement amounts for the prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of expensing stock-based compensation. Under this method, the provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. In addition, the unrecognized expense of awards not yet vested at the date of adoption is recognized in net income in the periods after the date of adoption over the remainder the requisite service period. Our deferred stock-based compensation balance of $1.1 million as of May 27, 2006, which was accounted for under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” was reclassified to common stock upon the adoption of SFAS No. 123R. As of November 25, 2006, unrecognized stock-based compensation related to outstanding, but unvested stock options and restricted stock awards was $2.85 million and $1.14 million, respectively, which will be recognized over the weighted-average remaining vesting periods of 1.86 years and 1.84 years, respectively.

Prior to May 27, 2006, 2006, we accounted for stock-based compensation using the intrinsic value method as prescribed by APB Opinion No. 25 and related interpretations. Upon the adoption of SFAS No. 123R, we maintained our method of valuation for stock option awards using the Black-Scholes Option Pricing Model which has historically been used for the purpose of providing pro-forma financial disclosures in accordance with SFAS No. 123.

The use of the Black-Scholes Option Pricing Model to estimate the fair value of stock option awards requires us to make judgments on assumptions regarding the risk-free interest rate, expected dividend yield, expected term and expected volatility over the expected term of the award. The assumptions used in calculating the fair

21

Table of Contents

value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of expense could be materially different in the future.

Compensation expense is only recognized on awards that ultimately vest. Therefore, we have reduced the compensation expense to be recognized over the vesting period for anticipated future forfeitures. Forfeiture estimates are based on historical forfeiture patterns. We update our forfeiture estimates quarterly and recognize any changes to accumulated compensation expense in the period of change. If actual forfeitures differ significantly from our estimates, our results of operations could be materially impacted.

On May 25, 2005, our Board of Directors accelerated vesting of outstanding “underwater” employee stock options with exercise prices greater than $8.00 per share. Approximately 1.3 million options, or approximately 39% of our total outstanding options as of May 25, 2005, with varying remaining vesting schedules, were subject to this acceleration and became immediately exercisable. As a result of this acceleration, we estimated that we would reduce the amount of compensation expense recorded due to the effects of SFAS No. 123R by approximately $329,000 for fiscal 2007 and an additional $300,000 in total for subsequent years. This acceleration only related to specific underwater options, and, accordingly, is not representative of the overall impact that SFAS No. 123R will have on the results of our operations, our cash flows or our liquidity.

Stock-Based Compensation

On May 28, 2006, the Company adopted Statement of Financial Accounting Standard No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which replaced SFAS 123 “Accounting for Stock-Based Compensation” and superseded Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” The Company elected to use the modified prospective transition method provided by SFAS 123(R). Under the modified prospective transition method, the provisions of SFAS 123(R) apply to all awards granted or modified after the date of adoption. The modified prospective transition method requires the recognition of compensation expense for all share-based payments granted on or subsequent to the date of adoption over the service period for all awards expected to vest. This method also requires the recognition of compensation expense for all share-based payments granted prior to, but not yet vested, as of the date of adoption, May 28, 2006. Compensation expense is measured based on the fair value of the award at the grant date. The fair value of non-vested share-based grants is based on the number of shares granted and the quoted market price of our common stock. In accordance with the modified prospective transition method, results for prior periods have not been restated. See Note 13 to the consolidated financial statements.

The Company uses the Black-Scholes option-pricing model to estimate the fair values of stock options. The option-pricing model requires a number of assumptions, including: (1) expected stock price volatility, (2) the expected pre-vesting forfeiture rate and (3) the expected option term (the amount of time from the grant date until the options are exercised or expire). Expected volatility is calculated based upon actual historical stock price movements over the most recent periods ending August 26, 2006 equal to the expected option term. The expected option term is calculated using the “simplified” method permitted by SAB 107.

The Black-Scholes valuation model does not take into account vesting requirements or restrictions on transferability. In addition, the valuation model requires the input of highly subjective assumptions, including the expected stock price volatility. Employee stock options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate. The estimation of stock awards that will ultimately vest requires significant estimates, and to the extent that actual results or updated estimates differ from current estimates, such amounts will be recorded as a cumulative adjustment in the period that the estimates are revised. Actual results and future changes in estimates may differ substantially from the current estimates.

Prior to the adoption of SFAS 123(R), the Company presented any tax benefits of deductions resulting from the exercise of stock options within operating cash flows in the consolidated statement of cash flows. SFAS 123(R) requires tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (“excess tax benefits”) to be classified and reported as both an operating cash outflow and a financing cash inflow upon adoption of SFAS 123(R). The excess tax benefits that would otherwise be available to reduce income taxes payable have the effect of increasing the Company’s net operating loss carry forwards. Accordingly, because the Company is not able to realize these excess tax benefits, such benefits have not been recognized in the statement of cash flows for the 13-week period ended August 26, 2006.

On May 28, 2006, the Company adopted Staff Accounting Bulletin No. 107 (“SAB 107”), which provides the Staff’s views on a variety of matters relating to stock-based payments upon adoption of SFAS 123(R). SAB 107 requires that stock-based compensation be classified in the same expense line items as cash compensation. Accordingly, stock-based compensation for the thirteen week period ended August 26, 2006 has been reclassified in the statement of operations to correspond to current year presentation within the same operating expense line items as cash compensation paid to employees.

For a complete description of our critical accounting policies and estimates, refer to our 2006 Annual Report on Form 10-K filed with the Securities and Exchange Commission on August 24, 2006.

36

Table of Contents

Stock-Based Compensation

We account for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and we comply with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure” (“SFAS 148”). In accordance with APB No. 25, no compensation expense is recorded if stock options are granted with an exercise price equal to the market value of the underlying stock as of the date of grant. Income tax benefits, if any, related to stock option exercises are added to the recorded value of common stock. Adjustments for forfeitures are made as they occur.

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) finalized SFAS No. 123R “Share-Based Payment” (“SFAS 123R”), which, after the Securities and Exchange Commission (“SEC”) amended the compliance dates on April 15, 2005, will be effective for our fiscal year beginning on May 28, 2006. The new standard will require us to record compensation expense for stock options using a fair value method. On March 29, 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”), which provides the Staff’s views regarding interactions between SFAS 123R and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public companies. We are currently evaluating SFAS 123R and SAB 107. We estimate that the adoption of these pronouncements will result in approximately $500 thousand of stock option expense being recorded during the first quarter of the fiscal year 2007.

On May 25, 2005, our Board of Directors accelerated vesting of outstanding “underwater” employee stock options with exercise prices greater than $8.00 per share. Approximately 1.3 million options, or approximately 39% of our total outstanding options as of May 25, 2005, with varying remaining vesting schedules, were subject to this acceleration and became immediately exercisable. As a result of this acceleration, we expect to reduce the amount of compensation expense recorded due to the effects of SFAS 123R. We currently estimate a reduction in stock-based compensation expense associated with this acceleration of approximately $329 thousand for the fiscal year 2007 and an additional $300 thousand in total for subsequent years. This acceleration only relates to specific underwater options, and accordingly, is not representative of the overall impact that SFAS 123R will have on the results of our operations, our cash flows or our liquidity upon implementation of SFAS 123R.

33

Table of Contents

Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and complies with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure.” Under APB No. 25, because the exercise price of stock options granted to date equals the market price of the underlying stock on the date of grant, no compensation expense is recorded. Income tax benefits, if any, related to stock option exercises are added to the recorded value of common stock. See Note 9.

If the Company had used the fair value based method of accounting for its plans, the Company’s net income (loss) and net income (loss) per share would approximate the pro forma disclosures below:

The following weighted average assumptions were used in the Black-Scholes option pricing model for valuing all stock options granted during fiscal years 2005, 2004 and 2003:

Using the Black-Scholes methodology, the total value of stock options granted during 2005, 2004 and 2003 was $4,324, $3,127 and $8,122, respectively. If the fair value based methodology of accounting were in use, the Company would expense this value over the vesting period of the options (typically four years). The weighted average fair value of options granted during 2005, 2004 and 2003 was $5.38, $10.04 and $6.13 per share, respectively.