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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF
THE SECURITIES EXCHANGE ACT OF 1934 For the Quarter Ended April 3, 2005
Commission File Number 0-16852 KOMAG, INCORPORATED  Incorporated in the State of Delaware
I.R.S. Employer Identification Number 94-2914864
1710 Automation Parkway, San Jose, California 95131
Telephone: (408) 576-2000 Indicate by check mark whether the Registrant (1) has filed all reports required to
be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the
preceding 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 an accelerated filer (as defined in
Exchange Act rule 12b-2). Yes þ No o Indicate by check mark whether the Registrant has filed all reports required to be
filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the
distribution of securities under a plan confirmed by a court. Yes þ No o On April 3, 2005, 28,962,074 shares of the Registrants common stock, $0.01 par
value, were issued and outstanding.




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INDEX
KOMAG, INCORPORATED Page No.PART I. FINANCIAL INFORMATIONItem 1. Condensed Consolidated Financial Statements (Unaudited)Condensed Consolidated Statements of Income  three months ended April 3, 2005 and April 4, 2004
    
    
    3Condensed Consolidated Balance Sheets  April 3, 2005 and January 2, 2005
    
    
    4Condensed Consolidated Statements of Cash Flows  three months ended April 3, 2005 and April 4, 2004
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6-13Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14-33Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    34Item 4. Controls and Procedures
    
    
    34PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    35Item 2. Unregistered Sales of Equity Securities
    
    
    35Item 3. Defaults Upon Senior Securities
    
    
    35Item 4. Submission of Matters to a Vote of Security Holders
    
    
    36Item 5. Other Information
    
    
    36Item 6. Exhibits
    
    
    36SIGNATURES
    
    
    37EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 10.3EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32
  2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 KOMAG, INCORPORATED 
 CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts
 Three Months EndedApril 3, 2005
    
    
    April 4, 2004Net sales
    
    $
    140,275
    
    
    $
    123,585Cost of sales
    
    
    105,212
    
    
    
    86,656Gross profit
    
    
    35,063
    
    
    
    36,929Operating expenses:Research, development, and engineering
    
    
    11,155
    
    
    
    11,622Selling, general, and administrative
    
    
    5,535
    
    
    
    5,354Gain on disposal of assets
    
    
    (389
    )
    
    
    (190
    )16,301
    
    
    
    16,786Operating income
    
    
    18,762
    
    
    
    20,143Other income (expense):Interest income
    
    
    750
    
    
    
    281Interest expense
    
    
    (441
    )
    
    
    (1,862
    )Other, net
    
    
    (28
    )
    
    
    (50
    )281
    
    
    
    (1,631
    )Income before income taxes
    
    
    19,043
    
    
    
    18,512Provision for income taxes
    
    
    516
    
    
    
    539Net income
    
    $
    18,527
    
    
    $
    17,973Basic net income per share
    
    $
    0.66
    
    
    $
    0.68Diluted net income per share
    
    $
    0.59
    
    
    $
    0.61Number of shares used in basic per share computations
    
    
    28,261
    
    
    
    26,307Number of shares used in diluted per share computations
    
    
    32,313
    
    
    
    29,778
 See notes to condensed consolidated financial statements. 3




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KOMAG, INCORPORATED 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
 April 3, 2005
    
    
    January 2, 2005ASSETSCurrent assetsCash and cash equivalents
    
    $
    31,811
    
    
    $
    26,410Short-term investments
    
    
    84,700
    
    
    
    77,700Accounts receivable (less allowances of $2,666 and $1,075, respectively)
    
    
    85,655
    
    
    
    79,213Inventories
    
    
    41,982
    
    
    
    35,815Prepaid expenses and deposits
    
    
    831
    
    
    
    1,815Total current assets
    
    
    244,979
    
    
    
    220,953Property, plant, and equipment (net of accumulated depreciation of
$109,061 and $99,065, respectively)
    
    
    212,103
    
    
    
    205,642Intangible assets, net
    
    
    581
    
    
    
    1,523Other assets
    
    
    2,939
    
    
    
    2,977$
    460,602
    
    
    $
    431,095LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilitiesTrade accounts payable
    
    $
    55,853
    
    
    $
    43,082Accrued expenses and other liabilities
    
    
    14,154
    
    
    
    19,887Total current liabilities
    
    
    70,007
    
    
    
    62,969Long-term debt
    
    
    80,500
    
    
    
    80,500Long-term deferred rent
    
    
    640
    
    
    
    Total liabilities
    
    
    151,147
    
    
    
    143,469Stockholders equityCommon stock, $0.01 par value per share:Authorized - 50,000 sharesIssued and outstanding - 28,962 and 28,065 shares, respectively
    
    
    289
    
    
    
    281Additional paid-in capital
    
    
    253,848
    
    
    
    241,960Deferred stock-based compensation
    
    
    (8,685
    )
    
    
    (91
    )Retained earnings
    
    
    64,003
    
    
    
    45,476Total stockholders equity
    
    
    309,455
    
    
    
    287,626$
    460,602
    
    
    $
    431,095
 See notes to condensed consolidated financial statements. 4




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KOMAG, INCORPORATED 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands
 Three Months EndedApril 3, 2005
    
    
    April 4, 2004Operating ActivitiesNet income
    
    $
    18,527
    
    
    $
    17,973Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization of property, plant, and equipment
    
    
    10,100
    
    
    
    9,464Tax adjustment to additional paid-in capital
    
    
    297
    
    
    
    Amortization and adjustments of intangible assets
    
    
    942
    
    
    
    1,060Stock-based compensation
    
    
    841
    
    
    
    235Deferred rent
    
    
    640
    
    
    
    Non-cash interest charges
    
    
    38
    
    
    
    321Gain on disposal of assets
    
    
    (389
    )
    
    
    (190
    )Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (6,442
    )
    
    
    (11,937
    )Inventories
    
    
    (6,167
    )
    
    
    (13,143
    )Prepaid expenses and deposits
    
    
    984
    
    
    
    324Trade accounts payable
    
    
    12,771
    
    
    
    9,220Accrued expenses and other liabilities
    
    
    (5,733
    )
    
    
    (7,773
    )Net cash provided by operating activities
    
    
    26,409
    
    
    
    5,554Investing ActivitiesAcquisition of property, plant, and equipment
    
    
    (16,615
    )
    
    
    (23,706
    )Purchases of short-term investments
    
    
    (67,150
    )
    
    
    (24,000
    )Proceeds from short-term investments
    
    
    60,150
    
    
    
    19,850Proceeds from disposal of property, plant, and equipment
    
    
    443
    
    
    
    386Other
    
    
    
    
    
    
    (161
    )Net cash used in investing activities
    
    
    (23,172
    )
    
    
    (27,631
    )Financing ActivitiesPayment of debt
    
    
    
    
    
    
    (116,341
    )Proceeds from the issuance of long-term debt
    
    
    
    
    
    
    77,419Proceeds from sale of common stock, net of issuance costs
    
    
    2,164
    
    
    
    67,649Net cash provided by financing activities
    
    
    2,164
    
    
    
    28,727Increase in cash and cash equivalents
    
    
    5,401
    
    
    
    6,650Cash and cash equivalents at beginning of period
    
    
    26,410
    
    
    
    27,208Cash and cash equivalents at end of period
    
    $
    31,811
    
    
    $
    33,858
 See notes to condensed consolidated financial statements 5




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KOMAG, INCORPORATED 
 
 Note 1. Basis of Presentation and Summary of Significant Accounting Policies The accompanying unaudited condensed consolidated financial statements include the accounts of
Komag, Incorporated, a Delaware corporation (the Company), and its wholly-owned subsidiaries. These
financial statements have been prepared in accordance with accounting principles generally accepted
in the United States of America for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United States of America.
While the financial information furnished is unaudited, in the opinion of management, all normal
recurring adjustments considered necessary for a fair presentation of the condensed consolidated
financial position, operating results, and cash flows for the periods presented, have been
included. Operating results for the three months ended April 3, 2005, are not necessarily
indicative of the results that may be expected for the year ending January 1, 2006. The
accompanying unaudited condensed consolidated financial statements should be read in conjunction
with the Companys consolidated financial statements for the year ended January 2, 2005 included in
its Annual Report on Form 10-K. Use of Estimates in the Preparation of Financial Statements:The preparation of financial
statements in conformity with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect the reported amount of
assets and liabilities and disclosures of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. Fiscal Year:The Company uses a 52-53 week fiscal year ending on the Sunday closest to
December 31. The Companys 2005 fiscal year will include 52 weeks; accordingly, the Companys
three-month reporting period included in this report included 13 weeks. Because the Companys 2004
fiscal year included 53 weeks, its three-month reporting period ended April 4, 2004 included 14
weeks. Reclassification:Certain amounts in fiscal 2004 as reported on the Condensed Consolidated
Balance Sheet and Condensed Consolidated Statements of Cash Flows have been reclassified to conform
to the current year presentation. The Company reclassified $77.7 million in auction rate securities
from cash and cash equivalents to short-term investments on the condensed Consolidated Balance
Sheet as of January 2, 2005. The reclassification to short-term investments is based on the latest
interpretation of cash equivalents pursuant to Financial Accounting Standards Board (FASB)
Statement of Financial Accounting Standards (SFAS) No. 95, Statement of Cash Flows. Cash and Cash Equivalents:The Company considers as a cash equivalent any bank deposits,
money market investments and any highly-liquid investment that mature within three months of its
purchase date. 6




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Short-Term Investments:The Company invests its excess cash in high-quality, short-term debt
instruments and auction rate preferred securities (which the Company rolls over every three months
or less). Interest and dividends on the investments are included in interest income. The cost of
the Companys investments approximates fair value. Inventories:Inventories are stated at the lower of cost (first-in, first-out method) or
market, and consist of the following (in thousands): April 3, 2005
    
    
    January 2, 2005Raw materials
    
    $
    23,293
    
    
    $
    20,647Work in process
    
    
    6,934
    
    
    
    7,785Finished goods
    
    
    11,755
    
    
    
    7,383$
    41,982
    
    
    $
    35,815
 Stock-Based Compensation:The Company uses the intrinsic value method to account for employee
stock-based compensation. The intrinsic value method is in accordance with the recognition and
measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
to Employees. Accordingly, compensation cost is recorded on the date of grant to the extent that
the fair value of the underlying share of common stock exceeds the exercise price for a stock
option or the purchase price for a share of common stock. In accordance with SFAS No. 123, Accounting for Stock-Based Compensation(SFAS 123), and SFAS
No. 148, Accounting for Stock-Based Compensation - Transition
and Disclosure - an Amendment of SFAS
123, the Company provides pro forma disclosure of the effect on net income and earnings per share
had the fair value method, as prescribed by SFAS 123, been used. 7




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The following table reflects the effect on the Companys net income and income per share had
the fair value method been applied to all outstanding and unvested awards. The table is in
thousands, except per share data. Three Months EndedApril 3, 2005
    
    
    April 4, 2004Net income, as reported
    
    $
    18,527
    
    
    $
    17,973Add: Stock-based employee compensation expense included
in reported net income, net of related tax effects
    
    
    841
    
    
    
    235Deduct: Stock-based compensation expense determined under
the fair value method for all awards, net of related tax effects
    
    
    (1,566
    )
    
    
    (987
    )Pro forma net income
    
    $
    17,802
    
    
    $
    17,221Net income per share:Basic - as reported
    
    $
    0.66
    
    
    $
    0.68Diluted - as reported
    
    $
    0.59
    
    
    $
    0.61Basic - pro forma
    
    $
    0.63
    
    
    $
    0.65Diluted - pro forma
    
    $
    0.56
    
    
    $
    0.59
 For pro forma disclosure purposes, the Company used the Black-Scholes option pricing
model to estimate the fair value of each option and stock purchase right grant on the date of
grant. The following assumptions were used to estimate the fair value of option grants in the first
three months of 2005 and 2004: risk-free interest rates of 4.04% and 2.46%, respectively;
volatility factors of the expected market price of the Companys common stock of 71.8% and 82.6%,
respectively; and a weighted-average expected option life of 4.0 years. The weighted-average fair
value of options granted during the first three months of 2005 and 2004 was $11.43 and $11.58,
respectively. The following assumptions were used to estimate the fair value of employee purchase rights
under the Amended and Restated 2002 Employee Stock Purchase Plan (ESPP) for the first three months
of 2005 and 2004: risk-free interest rates of 1.68% and 1.00%, respectively; volatility factors of
50.77% and 73.5%, respectively; and weighted-average expected purchase rights lives of six months.
The weighted-average fair value of those purchase rights granted in the first three months of 2005
and 2004 was $3.12 and $4.64, respectively. Because the Company does not pay dividends, there was no dividend yield included in the pro
forma disclosure calculation. In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment(SFAS 123R). SFAS 123R
is a revision of SFAS 123, which addresses financial accounting and reporting for costs associated
with stock-based compensation. SFAS 123 addresses all forms of share-based payment (SBP) awards,
including shares issued under employee stock purchase plans, stock options, restricted stock, and 8




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stock appreciation rights. SFAS 123R requires the Company to adopt the new accounting provisions
beginning in its first quarter of 2006, and applies to all outstanding and unvested SBP awards at
the Companys adoption date. The Company is allowed to select one of three alternative transition
methods  each having different reporting implications. On March 29, 2005, the Securities and
Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) on SFAS 123R to assist
preparers by simplifying some of the implementation challenges of SFAS 123R. The Company has not
completed its evaluation or determined the impact of adopting SFAS 123R; however, we expect the
adoption to have a significant impact on our net income and net income per share. Computation of Net Income Per Share:The Company determines net income per share in
accordance with SFAS No. 128, Earnings per Share. Basic net income per common share is computed by dividing income available to common
stockholders by the weighted-average number of shares of common stock outstanding during the
period. Diluted net income per share is computed by dividing income available to common
stockholders by the weighted-average number of shares and dilutive potential shares of common stock
outstanding during the period. The dilutive effect of outstanding options and stock purchase rights
is reflected in diluted net income per share by application of the treasury stock method. 9




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The following table sets forth the computation of net income per share. The table is in
thousands, except per share amounts. Three Months EndedApril 3, 2005
    
    
    April 4, 2004Numerator for basic net income per share:Net income as reported
    
    $
    18,527
    
    
    $
    17,973Numerator for diluted net income per share:Net income as reported
    
    $
    18,527
    
    
    $
    17,973Interest adjustment related to contigently convertible debt
    
    
    441
    
    
    
    327$
    18,968
    
    
    $
    18,300Denominator for basic income per share:Weighted average shares
    
    
    28,261
    
    
    
    26,307Denominator for diluted income per share:Weighted average shares
    
    
    28,261
    
    
    
    26,307Effect of dilutive securities:Contingently convertible shares under convertible debt
    
    
    3,049
    
    
    
    2,116Stock options
    
    
    522
    
    
    
    629Warrants
    
    
    460
    
    
    
    528Stock purchase rights
    
    
    21
    
    
    
    19832,313
    
    
    
    29,778Basic net income per share
    
    $
    0.66
    
    
    $
    0.68Diluted net income per share
    
    $
    0.59
    
    
    $
    0.61
 Incremental common shares attributable to outstanding common stock options (assuming
proceeds would be used to purchase treasury stock) of approximately 21,131 for the three months
ended April 3, 2005, and 17,741 for the three months ended April 4, 2004 were not included in the
diluted net income per share computation because the effect would have been anti-dilutive. In January 2004, the Company issued $80.5 million of 2.0% Convertible Subordinated Notes (the
Notes). The Notes are convertible, under certain circumstances, into shares of the Companys common
stock at an initial conversion price of $26.40, or approximately 3,049,000 shares. In October 2004,
the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 04-08, Accounting Issues
Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per
Share.This consensus, which became effective in the fourth quarter of 2004, requires the Company
to include these additional shares in its calculation of diluted earnings per share as of the date
of issuance of the Notes (the first quarter of 2004). Accordingly, these shares have been included
in the Companys diluted earnings per 10




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share calculations for the first quarters of 2005 and 2004. Therefore, diluted net income per
share has been adjusted for the first quarter of 2004 to $0.61 from $0.65. Recent Accounting Pronouncements:In December 2003, the FASB issued FASB Interpretation No.
46 (revised December 2003), Consolidation of Variable Interest Entities(FIN 46R), which addresses
how a business enterprise should evaluate whether it has a controlling financial interest in an
entity through means other than voting rights and accordingly should consolidate the entity. FIN
46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities(VIE), which
was issued in January 2003. The Company is required to apply FIN 46R to variable interests in VIEs
created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, the
Interpretation has been applied beginning on January 1, 2005. For any VIEs that must be
consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and
non-controlling interests of the VIE initially would be measured at their carrying amounts with any
difference between the net amount added to the balance sheet and any previously recognized interest
being recognized as the cumulative effect of an accounting change. If determining the carrying
amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the
assets, liabilities and non-controlling interest of the VIE. The Companys adoption of FIN 46R had
no impact on its consolidated financial statements. In December 2004, the FASB issued SFAS No. 151 (SFAS 151), Inventory Costs.SFAS 151 clarifies
the accounting for inventory when there are abnormal amounts of idle facility expense, freight,
handling costs, and wasted materials. Under existing generally accepted accounting principles,
items such as idle facility expense, excessive spoilage, double freight, and re-handling costs may
be so abnormal as to require treatment as current period charges rather than recorded as
adjustments to the value of the inventory. SFAS 151 requires that those items be recognized as
current-period charges regardless of whether they meet the criterion of so abnormal. In addition,
this Statement requires that allocation of fixed production overheads to the costs of conversion be
based on the normal capacity of the production facilities. The provisions of this Statement shall
be effective for inventory costs incurred during fiscal years beginning after June 15, 2005.
Earlier application is permitted for inventory costs incurred during fiscal years beginning after
the date this Statement is issued. The adoption of SFAS 151 is not expected to have a material
effect on the Companys financial position or results of operations. Note 2. Concentration of Customer, Supplier and Geographic Risk The following table reflects the percentage of the Companys revenue by major customer: Three Months EndedApril 3, 2005
    
    
    April 4, 2004Maxtor Corporation
    
    
    35
    %
    
    
    45
    %Hitachi Global Storage Technologies
    
    
    25
    %
    
    
    21
    %Western Digital Corporation
    
    
    19
    %
    
    
    19
    %Seagate
    
    
    16
    %
    
    
    8
    %
 11




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The Company relies on a limited number of suppliers for some of the materials and equipment
used in its manufacturing processes, including aluminum blanks, aluminum substrates, nickel plating
solutions, polishing and texturing supplies, and sputtering target materials. Kobe Steel, Ltd. is
the Companys sole supplier of aluminum blanks, which is a fundamental component in producing
disks. The Company also relies on a single supplier, Heraeus Incorporated, for a substantial
quantity of its sputtering target requirements, and on OMG Fidelity, Incorporated for supplies of
nickel plating solutions. A majority of our long-lived assets is located at our Malaysian manufacturing facilities.
These assets totaled $195.7 million as of April 3, 2005, and $190.0 million as of January 2, 2005. Note 3. Income Taxes The Companys estimated annual effective income tax rate for 2005 is 2.7% and reflects income
tax expenses related to the Companys U.S. and international operations. In the first quarter of
2004, the Companys estimated annual effective tax rate was approximately 3.0%. The Companys manufacturing facilities located in Malaysia have been granted various tax
holidays. These holidays expire at various times beginning in December 2006 through June 2011. In the first quarter of 2005 and 2004, the Company utilized tax credits and net operating loss
carryforwards. The Company provided a full valuation allowance against all tax assets; therefore,
upon utilization of the tax credits and net operating loss carryforwards, the Company first reduced
intangible assets (as these were related to time periods that were pre-emergence from bankruptcy)
and then credited additional paid-in capital. Future usage of net operating loss carryforwards and
tax credit carryforwards will be credited to additional paid-in capital. Note 4. Accrued Expenses and Other Liabilities The following table summarizes accrued expenses and other liabilities balances at April 3,
2005 and January 2, 2005 (in thousands): April 3, 2005
    
    
    January 2, 2005Accrued compensation and benefits
    
    $
    104,794
    
    
    $
    15,777Other liabilities
    
    
    3,360
    
    
    
    4,110$
    14,154
    
    
    $
    19,887
 Note 5. Stock Purchase Rights On February 15, 2005, the Company issued a total of 453,110 stock purchase rights with an
exercise price of $0.01. The vesting for the stock purchase rights grants is one-third at the end
of each of 12




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the first three anniversaries of the date of grant, subject to the employee continuing
to be a service provider of the Company on each such date. In the first quarter of 2005, the
Company recorded deferred stock-based compensation of $9.4 million, which is being amortized to
expense ratably over the vesting period. 13




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the condensed consolidated
financial statements and the accompanying notes included in Part I. Financial Information, Item 1.
Condensed Consolidated Financial Statements of this report. The following discussion contains predictions, estimates, and other forward-looking statements
that involve a number of risks and uncertainties about our business, including but not limited to:
our belief that we are a leading independent supplier of disks; our belief that we have developed a
deep understanding of market needs in the disk drive market; our belief that our manufacturing and
technology development programs provide us with competitive advantages in maintaining and growing
our market share; our belief that we have developed strong relationships with many of the leading
disk drive manufacturers; our belief that our manufacturing operations, together with our
experience in the industry and our economies of scale, provide us with timing and cost advantages
in delivering consistently high-quality products to our customers in high volumes; our plan to
continue to generate cash from our operations for the remainder of 2005; our belief that we will
continue to investigate areas where we can expand our presence in the disk market; our expectation
that we will continue to generate cash from operations; and our belief that the estimates and
judgments made regarding future events in connection with the preparation of our financial
statements are reasonable. These statements may be identified by the use of words such as
expects, anticipates, intends, plans, and similar expressions. In addition, forward-looking
statements include, but are not limited to, statements about our beliefs, estimates, or plans about
our ability to maintain low manufacturing and operating costs and costs per unit, our ability to
estimate revenues, shipping volumes, pricing pressures, returns, reserves, demand for our disks,
selling, general, and administrative expenses, taxes, research, development, and engineering
expenses, spending on property, plant, and equipment, expected sales of disks and the market for
disk drives generally and certain customers specifically, and our beliefs regarding our liquidity
needs. Forward-looking statements are estimates reflecting the best judgment of our senior
management, and they involve a number of risks and uncertainties that could cause actual results to
differ materially from those suggested by the forward-looking statements. Our business is subject
to a number of risks and uncertainties. While this discussion represents our current judgment on
the future direction of our business, these risks and uncertainties could cause actual results to
differ materially from any future performance suggested herein. Some of the important factors that
may influence possible differences are continued competitive factors, technological developments,
pricing pressures, changes in customer demand, and general economic conditions, as well as those
discussed in the Risk Factors section below. We undertake no obligation to update forward-looking
statements to reflect events or circumstances occurring after the date of such statements. Readers
should review the Risk Factors section below, as well as other documents filed from time to time by
us with the Securities and Exchange Commission. 14




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Results of Operations Overview We design, manufacture, and market thin-film media (disks), which are incorporated into disk
drives. Disks, such as the ones we manufacture, serve as a primary storage medium for digital data.
Our net sales are driven by the level of demand for disks by disk drive manufacturers and the
average selling prices of our disks. Demand for our disks is dependent on unit growth in the disk
drive market, the growth of storage capacity in disk drives, which affects the number of disks
needed per drive, and the number of disks our customers purchase from external suppliers. Average
selling prices are dependent on overall supply and demand for disks and our product mix. Our business is capital-intensive and is characterized by high fixed costs, making it
imperative that we sell disks in high volume. Our contribution margin per disk sold varies with
changes in selling price, input material costs and production yield. As demand for our disks
increases, our total contribution margin increases, improving our financial results because we do
not have to increase our fixed cost structure in proportion to increases in demand and resultant
capacity utilization. Conversely, our financial results would deteriorate rapidly if the disk
market were to worsen and our production volume were to decrease. Our three-month reporting period ended April 3, 2005 included 13 weeks. Because our 2004
fiscal year contained 53 weeks, our three-month reporting period ended April 4, 2004 included 14
weeks. Net Sales Consolidated net sales increased by 13.5%, to $140.3 million in the first quarter of 2005,
from $123.6 million in the first quarter of 2004. The overall increase primarily reflected an
increase in finished unit sales volume, to 22.2 million units in the first quarter of 2005 from
19.2 million units in the first quarter of 2004, partially offset by a decrease in the finished
unit average selling price, to $5.53 in the first quarter of 2005 from $5.94 in the first quarter
of 2004. The finished unit shipment increase in the first quarter of 2005 compared to the same
period in 2004 resulted from an overall improvement in industry conditions. Sales of 80 GB per platter disks increased to 94% of net sales in the first quarter of 2005,
compared to 79% in the same period of 2004. The increase reflected the continued customer evolution
to higher storage densities. Finished disk shipments for desktop and consumer applications
together represented 94% of our first quarter of 2005 unit shipment volume, compared to 89% in the
first quarter of 2004. The remaining finished disk shipments in the first quarters of 2005 and
2004 were disks for high-end server (enterprise) drives. Net other disk sales in the first quarter of 2005 were $17.4 million, compared to $9.6 million
in the first quarter of 2004. Aluminum substrate, polished disk, textured disks and single sided
disk sales were all higher in the first quarter of 2005 compared to the first quarter of 2004.
Disk substrate sales vary from period to period based on customer requirements. 15




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Based on continuing strong market demand from all customers, we expect total revenue for
the second quarter of 2005 could be comparable to or up to 10% higher than the first quarter of
2005. In the first quarter of 2005, sales to Maxtor Corporation (Maxtor), Hitachi Global Storage
Technologies (HGST), Western Digital Corporation (Western Digital), and Seagate Technology
(Seagate) accounted for 35%, 25%, 19%, and 16%, respectively, of our revenues. In the first
quarter of 2004, sales to Maxtor, HGST, Western Digital, and Seagate accounted for 45%, 21%, 19%,
and 8%, respectively, of our revenue. We expect to continue to derive a substantial portion of our
sales from these customers. Gross Profit Our overall gross profit percentage for the first quarter of 2005 was 25.0% compared to a
gross profit percentage of 29.9% for the first quarter of 2004. The decrease is primarily related
to the lower finished unit average selling price in the first quarter of 2005 compared to the first
quarter of 2004. We expect to maintain our variable cost per unit at levels similar to the first quarter of
2005 while continuing to advance our technology. We expect our fixed cost per unit in the remainder
of 2005 to vary based on changes in production volumes from the level achieved in the first three
months of 2005. Research, Development, and Engineering Expenses Research, development, and engineering (R&D) expenses of $11.2 million in the first quarter of
2005 were $0.4 million lower compared to the $11.6 million in the first quarter of 2004. Expenses
in the first quarter of 2004 included a $1.4 million non-recurring payroll-related charge and an
additional week of expenses as compared to the first quarter of 2005. Higher development costs,
including increased payroll related costs, in the first quarter of 2005 mostly offset the effect of
the absence of the non-recurring charge and the return to a thirteen-week fiscal quarter in 2005
compared to a fourteen-week fiscal quarter in 2004. We expect R&D spending in the second quarter
of 2005 to be relatively flat with the first quarter of 2005, as a percentage of net sales. Selling, General, and Administrative Expenses Selling, general, and administrative (SG&A) expenses of $5.5 million in the first quarter of
2005 were $0.1 million higher compared to the $5.4 million incurred in the first quarter of 2004.
The increase was primarily due to higher consulting, audit and payroll-related costs, offset by the
return to a thirteen-week fiscal quarter in 2005 . We expect SG&A spending in the second quarter of
2005 to be relatively flat with the first quarter of 2005 as a percentage of net sales. Interest Expense Interest expense in the first quarter of 2005 was $0.4 million. This amount reflected
interest expense on the $80.5 million, 2% Convertible Subordinated Notes, which were issued on
January 28, 2004. 16




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Interest expense in the first quarter of 2004 was $1.9 million and included $1.6 million of
interest expense on the Senior Secured Notes and certain promissory notes and $0.3 million of
interest expense on the 2% Convertible Subordinated Notes. The Senior Secured Notes and promissory
notes were redeemed in full, including accrued interest, in February 2004. There was no gain or
loss on the redemption, and there were no unamortized debt issuance costs. Income Taxes Our estimated annual effective income tax rate for 2005 is 2.7% and reflects tax expenses
related to our U.S. and international operations. In the first quarter of 2004, our estimated
annual effective income tax rate for 2004 was approximately 3.0%. The Companys manufacturing facilities located in Malaysia have been granted various tax
holidays. These holidays expire at various times beginning in December 2006 through June 2011. Critical Accounting Policies In the ordinary course of business, we have made a number of estimates and assumptions
relating to the reporting of results of operations and financial condition in the preparation of
our consolidated financial statements in conformity with accounting principles generally accepted
in the United States of America. We regularly evaluate our estimates, including those related to
our revenues, allowance for inventories, commitments and contingencies, income taxes, and asset
impairments. We base our estimates on historical experience and on various other assumptions that
we believe to be reasonable under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities. Actual results could differ
significantly from those estimates if our assumptions are incorrect. We believe that the following
discussion addresses our most critical accounting policies. These policies are most important to
the portrayal of our financial condition and results and require managements most difficult,
subjective and complex judgments, often as a result of the need to make estimates about the effect
of matters that are inherently uncertain. Allowance for Sales Returns We estimate our allowance for sales returns based on historical data as well as current
knowledge of product quality. We have not experienced material differences between our estimated
reserves for sales returns and actual results. It is possible that the failure rate on products
sold could be higher than it has historically been, which could result in significant changes in
future returns. Since estimated sales returns are recorded as a reduction in revenues, any significant
difference between our estimated and actual experience or changes in our estimate would be
reflected in our reported revenues in the period we determine that difference. There were no significant changes from prior year estimates in the first quarter of 2005. 17




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Impairment of Long-lived Assets Long-lived assets are evaluated for impairment whenever events or changes in circumstances
indicate that these assets may be impaired or the estimated useful lives are no longer appropriate.
We consider the primary indicators of impairment to include significant decreases in unit volumes,
unit prices or significant increases in production costs. We review our long-lived assets for
impairment based on estimated future undiscounted cash flows attributable to the assets. In the
event that these cash flows are not expected to be sufficient to recover the recorded value of the
assets, the assets are written down to their estimated fair values utilizing discounted estimates
of future cash flows. The discount rate used is based on the estimated incremental borrowing rate
at the date of the event that triggers the impairment. There were no impairments of long-lived assets in the first quarter of 2005. Inventory Obsolescence Our policy is to provide for inventory obsolescence based upon an estimated obsolescence
percentage applied to the inventory based on age, historical trends, and requirements to support
forecasted sales. In addition, and as necessary, we may provide additional charges for future known
or anticipated events. There were no significant changes from prior year estimates in the first quarter of 2005. Liquidity and Capital Resources Cash, cash equivalents, and short-term investments of $116.5 million at the end of the first
quarter of 2005 increased by $12.4 million from the end of the 2004 fiscal year. The increase
primarily reflected a $26.4 million increase resulting from consolidated operating activities and
$2.2 million in proceeds from the sale of common stock, offset by $16.6 million of spending on
property, plant, and equipment. Consolidated operating activities generated $26.4 million in cash in the first three months of
2005. The primary components of this change include the following:  
    net income of $18.5 million, net of non-cash depreciation and amortization of
property, plant and equipment of $10.1 million and other non-cash charges/gains which
net to $2.3 million;
    an accounts receivable increase of $6.4 million primarily due to an increase
in sales during the first quarter of 2005 compared to the fourth quarter of 2004;
    an inventory increase of $6.2 million;
    a prepaid expense decrease of $1.0 million primarily due to amortization of
insurance premiums;
    an accounts payable increase of $12.8 million related to increased inventory
and higher capital spending; and
    an accrued expenses and other liabilities decrease of $5.7 million, which
primarily reflected payment of accrued incentive compensation. 18




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Our total capital spending in the first quarter of 2005 was $16.6 million, which included
capital expenditures to increase our substrate capacity, to improve our equipment capability for
the manufacture of advanced products, and for projects designed to improve yield and productivity.
There are no significant non-cancelable capital commitments as of April 3, 2005. For 2005, we plan
to spend approximately $85 million to $90 million on property, plant, and equipment in order to
increase our finished disk and related substrate capacity and continue to ramp new production
processes. We have $80.5 million of 2% Convertible Subordinated Notes (the Notes) outstanding. The Notes
mature on February 1, 2024, bear interest at 2.0%, and require semiannual interest payments
beginning on August 1, 2004. The Notes will be convertible, under certain circumstances, into
shares of the Companys common stock based on an initial effective conversion price of $26.40.
Holders of the Notes may convert the Notes into shares of the Companys common stock prior to
maturity if: 1) the sale price of the Companys common stock equals or exceeds $31.68 for at least
20 trading days in any 30 consecutive trading day period within any fiscal quarter of the Company;
2) the trading price of the Notes falls below a specified threshold prior to February 19, 2019; 3)
the Notes have been called for redemption; or 4) specified corporate transactions (as described in
the offering prospectus for the Notes) occur. The Company may redeem the Notes on or after February
6, 2007, at specified declining redemption premiums. Holders of the Notes may require the Company
to purchase the Notes on February 1, 2011, 2014, or 2019, or upon the occurrence of a fundamental
change, at a purchase price equal to 100% of the principal amount of the Notes, plus accrued and
unpaid interest. There are no financial covenants, guarantees, or collateral associated with the
Notes. We have a Malaysian ringgit 12.5 million (approximately $3.3 million) bank guarantee. There is
no expiration date on the bank guarantee. No interest will be charged on the bank guarantee, but
there is a commission of 0.05% on the amount of bank guarantee utilized. As of April 3, 2005, there
were no liabilities outstanding related to this bank guarantee. We have a Malaysian ringgit 4.0 million (approximately $1.1 million) stand-by letter of credit
(LOC), which expires on September 30, 2005. The LOC is secured by a fixed deposit of Malaysian
ringgit 4.0 million. We lease our research and administrative facility in San Jose, California under an operating
lease, which expires in 2014. We also lease, and have sublet, another building in San Jose. This
lease was terminated after the end of the first quarter of 2005 and the related sublease was
assigned to the landlord. Additionally, we lease certain equipment under operating leases. These
leases expire on various dates through 2008. We have no capital leases. 19




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At April 3, 2005, our long-term debt obligations, operating lease obligations, and
unconditional purchase obligations were as follows (in thousands): Remainderof2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    Thereafter
    
    
    TotalLong-Term Debt Obligations
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    80,500
    
    
    $
    80,500Operating Lease Obligations (1)
    
    
    980
    
    
    
    3,096
    
    
    
    2,261
    
    
    
    2,042
    
    
    
    3,144
    
    
    
    16,382
    
    
    
    27,905Unconditional Purchase Obligations (2)
    
    
    10,711
    
    
    
    1,266
    
    
    
    1,129
    
    
    
    1,129
    
    
    
    1,129
    
    
    
    3,387
    
    
    
    18,751Total Contractual Cash Obligations
    
    $
    11,691
    
    
    $
    4,362
    
    
    $
    3,390
    
    
    $
    3,171
    
    
    $
    4,273
    
    
    $
    100,269
    
    
    $
    127,156
   (1)
    
    These represent gross operating lease obligations, and are not reduced by sublease income.
The gross lease obligations include $2.0 million for a lease, which was terminated subsequent
to the end of the first quarter of 2005.(2)
    
    Unconditional purchase obligations are defined as agreements to purchase goods or services
that are enforceable and legally binding, and that specify all significant terms, including:
fixed or minimum quantities to be purchased; fixed, minimum, or variable pricing provisions;
and the approximate timing of the transactions. The amounts are based on our contractual
commitments. 20




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RISK FACTORS These risks and uncertainties are not the only ones facing our company. Additional risks and
uncertainties that we are unaware of or currently deem immaterial may also become important factors
that may harm our business. If any of the following risks actually occur, or other unexpected
events occur, our business, financial condition or results of operations could be materially
adversely affected, the value of our stock could decline, and you may lose part or all of your
investment. Further, thisForm 10-Qcontains forward-looking statements and actual results may
differ significantly from the results contemplated by our forward-looking statements. Risks Related to Our Business Our business is concentrated in the disk drive market, so downturns in the disk drive manufacturing
market and related markets may decrease our revenues and margins. The market for our products depends on economic conditions affecting the disk drive
manufacturing and related markets. Our products are incorporated into disk drives manufactured by
our customers for the desktop personal computer market as well as the enterprise storage systems
market and electronic device market. Because of the concentration of our products in the disk drive
market, which we expect to continue, our business is linked to the success of this market. The disk
drive market has historically been seasonal and cyclical, and has experienced periods of oversupply
and reduced production levels, resulting in significantly reduced demand for disks and pricing
pressures. The effect of these cycles on suppliers has been magnified by disk drive manufacturers
practice of ordering components, including disks, in excess of their needs during periods of rapid
growth, thereby increasing the severity of the drop in the demand for components during periods of
reduced growth or contraction. Accordingly, downturns in the disk drive market may cause disk drive
manufacturers to delay or cancel projects, reduce their production, or reduce or cancel orders for
our products. This, in turn, may lead to longer sales cycles, delays in payment and collection,
pricing pressures, and unused capacity, causing us to realize lower revenues and margins. For
example, in the fourth quarter of fiscal year 2003, disk drive manufacturers appear to have
overbuilt product, which resulted in an excess of supply of disk drives that was not fully
corrected until approximately the third quarter of fiscal year 2004. If our production capacity is underutilized, our gross margin will be adversely affected and we
could sustain significant losses. Our business is characterized by high fixed overhead costs including expensive plant

facilities and production equipment. Our per-unit costs and our gross profit are significantly
affected by the number of units we produce and the amount of our production capacity that we
utilize. In the third quarter of 2004, we completed the installation of additional equipment, which
increased our production capacity from approximately 20 million disks a quarter to approximately 24
million disks a quarter. Our finished disk shipments were below this capacity level in the third
quarter and fourth quarter of 2004. In the first quarter of 2005, we increased our capacity to
approximately 25 million disks per quarter. If we are unable to utilize our expanded capacity, we
may be unable to increase or sustain our gross margins. 21




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If our capacity utilization decreases for any reason, including lack of customer demand or
cancellation or delay of customer orders, we could experience significantly higher unit production
costs, lower margins and potentially significant losses, as occurred for several years prior to
2003. Underutilization of our production capacity could also result in equipment write-offs,
restructuring charges, and employee layoffs. If our production capacity is underutilized for any
reason, our financial results and our business would be severely harmed. If future demand for our products exceeds the production capability of our existing facilities, we
may be required to invest significant capital expenditures to increase capacity or else risk losing
market share. In the third quarter of 2004, we completed the installation of additional equipment, which
increased our production capacity to approximately 24 million disks a quarter. In the first quarter
of 2005, we increased our capacity to 25 million disks per quarter. We believe that our ability to
expand further our production capacity using our existing facilities is limited. As a result, if
demand for our products were to exceed significantly our current capacity levels, we may not be
able to satisfy this increased demand. To increase our production capacity to meet significant
increases in demand for our disks, we would be required to expand our existing facilities,
construct new facilities, or acquire entities with additional production capacities. These
alternatives would require significant capital investments by us and would require us to seek
additional equity or debt financing. There can be no assurance that such financing would be
available to us when needed on acceptable terms, or at all. If we were unable to expand capacity on
a timely basis to meet increases in demand, we could lose market opportunities for sales, and our
market share could decline. Further, we cannot assure you that the increased demand for our disk
products would continue for a sufficient period of time to recoup our capital investments
associated with increasing our production capacity. We receive a large percentage of our net sales from only a few disk drive manufacturing customers,
the loss of any of which would adversely affect our sales. Our customers are disk drive manufacturers. A relatively small number of disk drive
manufacturers dominates the disk drive market. In the first quarter of 2005, four of these
manufacturers (HGST, Maxtor, Seagate, and Western Digital) accounted for approximately 80% of
worldwide hard disk drive sales. Accordingly, we expect that the success of our business will
continue to depend on a limited number of customers that have comparatively strong bargaining power
in negotiating contracts with us. In the first quarter of 2005, 35% of our net sales were to Maxtor, 25% were to HGST, 19% were
to Western Digital, and 16% were to Seagate. In 2004, 47% of our net sales were to Maxtor, 29%
were to HGST, and 14% were to Western Digital. If any one of our significant customers reduces its
disk requirements, cancels existing orders or develops or expands capacity to produce its own
disks, and we are unable to replace these orders with sales to new customers, our sales would be
reduced and our business would suffer. 22




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Because we depend on a limited number of suppliers, if our suppliers experience capacity
constraints or production failures, our production, operating results and growth potential could be
harmed. We rely on a limited number of suppliers for some of the materials and equipment used in our
manufacturing processes, including aluminum blanks, aluminum substrates, nickel plating solutions,
polishing and texturing supplies, and sputtering target materials. For example, Kobe Steel, Ltd. is
our sole supplier of aluminum substrate blanks, which is a fundamental component in producing our
disks. Further, as a result of current increased worldwide demand, the supply of sputtering target
materials is constrained, resulting in longer lead times and product allocation from certain
suppliers. We rely on a single supplier, Heraeus Incorporated, for a substantial quantity of our
sputtering target requirements. In addition, we also rely on OMG Fidelity, Inc. for supplies of
nickel plating solutions. The supplier base has been weakened by the poor financial condition of
the industry in recent years, and some suppliers have exited the business. Additionally, the
increasing demand for many of these materials provides our sole-source suppliers with additional
bargaining power. Our production capacity would be limited if one or more of these materials were
to become unavailable or available in reduced quantities, or if we were unable to find alternative
suppliers. For example, due to the significant growth in demand for our disk products in the fourth
quarter of 2002, our sales were lower during the quarter than the available market opportunity due
to our inability to acquire additional aluminum substrates. If our sources of materials and
supplies were limited or unavailable for a significant period of time or the costs of such
materials were to increase, our production, operating results, and ability to grow our business
could be adversely affected. We had a history of operating losses, and emerged from chapter 11 bankruptcy in 2002. Despite
operating profitability during each of our nine most recent fiscal quarters, we cannot be assured
that we will be able to maintain or improve our profitability in the future. In 2001, after defaulting on our debt obligations, we filed a voluntary petition for relief
under chapter 11 of the United States Bankruptcy Code. We emerged from chapter 11 bankruptcy in
June 2002. Although we have been profitable in our most recent nine quarters, we had a history of
losses prior to 2003. Due to the factors discussed in this Risk Factors section, including the very
competitive, capital-intensive, and historically cyclical nature of the disk and disk drive markets
on which our business is dependent, we cannot assure you that we will be able to sustain or improve
our profitability in the future. Price competition may force us to lower our prices, causing our gross margin to suffer. We face significant price competition in the disk industry. High levels of competition have
historically put downward pressure on prices per unit. Additionally, the average selling price of
disks and disk drives rapidly declines over their commercial life as a result of technological
enhancements, productivity improvements and industry supply increases. We may be forced to lower
our prices or add new products and features at lower prices to remain competitive, and we may
otherwise be unable to introduce new products at higher prices. We cannot be assured that we will
be able to compete successfully in this kind of price competitive environment. Lower prices would
reduce our ability to generate sales, and our gross margin would suffer. If we fail to mitigate the
effect of these pressures through increased sales volume or changing our product mix, our net sales
and gross margin could be adversely affected. Price 23




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declines are also affected by any imbalances between demand and supply. For most of 2002, as
in the several years prior, disk supply exceeded demand. As independent suppliers like us struggled
to utilize their capacity, the excess disk supply caused average selling prices for disks to
decline. Supply and demand conditions have improved since 2002, resulting in a more stable pricing
environment. Supply and demand factors and industry-wide competition could adjust in the future and
force disk prices down, which, in turn, would put pressure on our gross margin. Internal disk operations of disk drive manufacturers may adversely affect our ability to sell our
disk products. Disk drive manufacturers such as HGST, Maxtor, and Seagate have large internal thin-film media
manufacturing operations, and are able to produce a substantial percentage of their disk
requirements. We compete directly with these internal operations when we market our products to
these disk drive companies, and compete indirectly when we sell our disks to customers who must
compete with vertically-integrated disk drive manufacturers. Vertically-integrated companies have
the opportunity to keep their disk-making operations fully utilized, thus lowering their costs of
production. This cost advantage contributes to the pressure on us and other independent disk
manufacturers to sell disks at lower prices and can severely affect our profitability.
Vertically-integrated companies are also able to achieve a large manufacturing scale that supports
the development resources necessary to advance technology rapidly. HGST previously announced that
it intends to consolidate its internal thin-film media manufacturing operations in China, which
could result in decreased demand for our products by HGST or increased pricing pressure. We may not
have sufficient resources or manufacturing scale to be able to compete effectively with these
companies as to production costs or technology development, which would negatively impact our net
sales and market share. All of our manufacturing operations have been consolidated in Malaysia and our foreign operations
and international sales subject us to additional risks inherent in doing business on an
international level that make it more costly or difficult to conduct our business. As a result of our consolidation of manufacturing operations in Malaysia, technology developed
at our U.S.-based research and development center must now be first implemented for high-volume
production at our Malaysian facilities without the benefit of being implemented at a U.S. factory.
Therefore, we rely heavily on electronic communications between our U.S. headquarters and our
Malaysian facilities to transfer specifications and procedures, diagnose operational issues, and
meet customer requirements. If our operations in Malaysia or overseas communications are disrupted
for a prolonged period for any reason, including a failure in electronic communications with our
U.S. operations, the manufacture and shipment of our products would be delayed, and our results of
operations would suffer. Additionally, because a large portion of our payroll, certain manufacturing and operating
expenses, and inventory and capital purchases is transacted in the Malaysian ringgit (ringgit), we
are particularly sensitive to any change in the foreign currency exchange rate for the ringgit. For
approximately the last six years, the exchange rate between the ringgit and the U.S. dollar has
been pegged at 3.8 ringgits to one U.S. dollar by the Malaysian government. News reports and
certain Malaysian government officials 24




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have indicated that the Malaysian government may be considering a change in the exchange rate.
If the Malaysian government elects to change the pegging of the ringgit to the U.S. dollar and the
ringgit proves to be undervalued, the change in exchange rates could adversely affect the amount we
spend on our payroll, certain manufacturing and operating expenses, and raw materials and capital
purchases. In the first quarter of 2005, our spending on payroll, manufacturing, and operating
expenses, and raw materials and capital purchases that were denominated in ringgit was
approximately $42.6 million. Additionally, in the first quarter of 2005, we paid approximately
$16.9 million for raw materials purchases from a vendor we pay in U.S. dollars, based on a cost
plus a percentage arrangement. This vendor incurs costs that are denominated in ringgit; therefore,
any change in the valuation of the ringgit in the future could materially adversely impact the cost
per unit we pay for such raw materials. Furthermore, our ability to transfer funds from our Malaysian operations to the United States
is subject to Malaysian rules and regulations. In 1999, the Malaysian government repealed a
regulation that restricted the amount of dividends that a Malaysian company may pay to its
stockholders. Had it not been repealed, this regulation would have potentially limited our ability
to transfer funds to the United States from our Malaysian operations. Because a significant
percentage of our revenues is generated from our Malaysian operations, we would be unable to
finance our U.S.-based research and development and/or repay our U.S. debt obligations if similar
regulations are enacted in the future. Additionally, there are a number of risks associated with conducting business outside of the
United States. Our sales to Asian customers, including the foreign subsidiaries of domestic disk
drive companies, account for substantially all of our net sales. While our Asian customers assemble
a substantial portion of their disk drives in Asia, they subsequently sell these products
throughout the world. Therefore, our high concentration of Asian sales does not accurately reflect
the eventual point of consumption of the assembled disk drives. We anticipate that international
sales will continue to represent the majority of our net sales, and as a result the success of our
business is subject to factors affecting global markets generally. We are subject to these risks to a greater extent than most companies because, in addition to
selling our products outside the United States, our Malaysian operations account for substantially
all of our net sales. Accordingly, our operating results are subject to the risks inherent with
international operations, including, but not limited to:  
    compliance with changing legal and regulatory requirements of foreign jurisdictions;
    fluctuations in tariffs or other trade barriers;
    foreign currency exchange rate fluctuations;
    difficulties in staffing and managing foreign operations;
    political, social and economic instability;
    increased exposure to threats and acts of terrorism;
    exposure to taxes in multiple jurisdictions;
    local infrastructure problems or failures including but not limited to loss
of power and water supply; and
    transportation delays and interruptions. 25




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If we are unable to perform successfully in the highly competitive and increasingly concentrated
disk industry, we may not be able to maintain or gain additional market share, and our operating
results would be harmed. The market for our products is highly competitive, and we expect competition to continue in
the future. Competitors in the thin-film media industry fall primarily into two groups: Asian-based
independent disk manufacturers, and captive disk manufacturers. Our major Asian-based independent
competitors include Fuji Electric, Hoya, and Showa Denko (of which Trace Storage Technology became
a part in mid-2004). The captive disk manufacturers who produce thin-film media internally for
their own use include HGST, Maxtor, and Seagate. Many of these competitors have greater financial
resources than we have, which could allow them to adjust to fluctuating market conditions better
than we. Further, they may have greater technical and manufacturing resources, more extensive name
recognition, more marketing power, a broader array of product lines and preferred vendor status. To
the extent our competitors continue to consolidate and achieve greater economies of scale, we will
face additional competitive challenges. If we are not able to compete successfully in the future,
we would not be able to gain additional market share for our products, or we may lose our existing
market share, and our operating results could be harmed. Because our products require a lengthy sales cycle with no assurance of high volume sales, we may
expend significant financial and other resources without a return. With short product life cycles and the rapid technological change experienced in the disk
drive industry, we must frequently qualify new products with our disk drive manufacturing
customers, based on criteria such as quality, storage capacity, performance, and price. Qualifying
disks for incorporation into new disk drive products requires us to work extensively with our
customer and the customers other suppliers to meet product specifications. Therefore, customers
often require a significant number of product presentations and demonstrations, as well as
substantial interaction with our senior management, before making a purchasing decision.
Accordingly, our products typically have a lengthy sales cycle, which can range from six to twelve
months or longer. During this time, we may expend substantial financial resources and management
time and effort, while having no assurances that a sale will result, or that disk drive programs
ultimately will result in high-volume production. To the extent we expend significant resources to
qualify products without realizing sales, our operations will suffer. If our customers cancel orders, our sales could suffer and we are generally not entitled to receive
cancellation penalties to offset the loss of sales revenue. Our sales are generally made pursuant to purchase orders that are subject to cancellation,
modification, or rescheduling without significant penalties. As a result, if a customer cancels,
modifies, or reschedules an order, we may have already made expenditures that are not recoverable,
and our profitability will suffer. Furthermore, if our current customers do not continue to place
orders with us or if we are unable to obtain orders from new customers, our sales and operating
results will suffer. 26




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Disk drive program life cycles are short, and disk drive programs are highly customized. If we fail
to respond to our customers demanding requirements, we will not be able to compete effectively. The disk industry is subject to rapid technological change, and if we are unable to anticipate
and develop products and production technologies on a timely basis, our competitive position could
be harmed. In general, the life cycles of disk drive programs are short. Additionally, disks must
be more customized to each disk drive program. Short program life cycles and customization have
increased the risk of product obsolescence, and as a result, supply chain management, including
just-in-time delivery, has become a standard industry practice. In order to sustain customer
relationships and sustain profitability, we must be able to develop new products and technologies
in a timely fashion in order to help customers reduce their time-to-market performance, and
continue to maintain operational excellence that supports high-volume manufacturing ramps and tight
inventory management throughout the supply chain. Accordingly, we have invested, and intend to
continue to invest heavily, in our research and development program. If we cannot respond to this
rapidly changing environment or fail to meet our customers demanding product and qualification
requirements, we will not be able to compete effectively. As a result, we would not be able to
maximize the use of our production facilities, and our profitability would be negatively impacted. If we do not keep pace with the rapid technological change in the disk drive industry, we will not
be able to compete effectively, and our operating results could suffer. Our products primarily serve the 3 1/2-inch disk drive market where product performance,
consistent quality, price and availability are of great competitive importance. Advances in disk
drive technology require continually lower flying heights and higher areal density. Until recently,
areal density was roughly doubling from year-to-year and even today continues to increase rapidly,
requiring significant improvement in every aspect of disk design. These advances require
substantial on-going process and technology development. New process technologies, including SAF
and PMR, must support cost-effective, high-volume production of disks that meet these
ever-advancing customer requirements for enhanced magnetic recording performance. We may not be
able to develop and implement these technologies in a timely manner in order to compete effectively
against our competitors products or entirely new data storage technologies. In addition, we must
transfer our technology from our U.S.-based research and development center to our Malaysian
manufacturing operations. If we cannot advance our process technologies or do not successfully implement those advanced
technologies in our Malaysian operations, or if technologies that we have chosen not to develop
prove to be viable competitive alternatives, we would not be able to compete effectively. As a
result, we would lose market share and face increased price competition from other manufacturers,
and our operating results would suffer. Further, as we introduce more technologically advanced
product offerings, they can result in lower introductory yields, which would negatively impact our
gross margins. 27




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If we fail to improve the quality of, and control contamination in our manufacturing processes, we
will lose our ability to remain competitive. The manufacture of our products requires a tightly-controlled, multi-stage process, and the
use of high-quality materials. Efficient production of our products requires utilization of
advanced manufacturing techniques and clean room facilities. Disk fabrication occurs in a highly
controlled, clean environment to minimize particles and other yield-limiting and quality-limiting
contaminants. In spite of stringent manufacturing controls, weaknesses in process control or minute
impurities in materials may cause a substantial percentage of the disks in a production lot to be
defective. The success of our manufacturing operations depends, in part, on our ability to maintain
process control and minimize such impurities in order to maximize yield of acceptable high-quality
disks. Minor variations from specifications could have a disproportionately adverse impact on our
manufacturing yields. If we are not able to continue to improve on our manufacturing processes or
maintain stringent quality controls, or if contamination problems arise, we will not remain
competitive, and our operating results would be harmed. An industry trend towards glass-based applications could negatively impact our ability to remain
competitive. Our finished disks are primarily manufactured from aluminum substrates, which are the primary
substrate used in desktop PC and enterprise applications. Some disk manufacturers emphasize the use
of glass as a basis for the manufacture of their disks to primarily serve the mobile PC market and
certain other consumer applications. These applications are expected to achieve significant growth
in the near future. To the extent glass-based applications were to achieve significant growth in
the market place, we may lose market share if we were unable to move rapidly to produce glass-based
disks to address the demand. If we are not able to attract and retain key personnel, our operations could be harmed. Our future success depends on the continued service of our executive officers, our
highly-skilled research, development, and engineering team, our manufacturing team, and our key
administrative, sales and marketing, and support personnel. Acquiring and retaining talented
personnel who possess the advanced skills we require has been difficult, particularly at our
Malaysian manufacturing facilities where there is high growth in the marketplace We may not be able
to attract, assimilate, or retain highly-qualified personnel to maintain the capabilities that are
necessary to compete effectively. Further, we do not have key person life insurance on any of our
key personnel. If we are unable to retain existing or hire key personnel, our business, financial
condition, and operating results could be harmed. If we do not protect our patents and other intellectual property rights, our revenues could suffer. It is commonplace to protect technology through patents and other forms of intellectual
property rights in technically sophisticated fields. In the disk and disk drive industries,
companies and individuals have initiated actions against others in the industry to enforce
intellectual property rights. Although we attempt to protect our intellectual property rights
through patents, copyrights, trade secrets, and other measures, we may not be able to protect
adequately our technology. In addition, we may not be able to 28




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discover significant infringements of our technology or successfully enforce our rights to our
technology if we discover infringing uses by others, and such infringements could have a negative
impact on our ability to compete effectively. Competitors may be able to develop similar technology
and also may have or may develop intellectual property rights and enforce those rights to prevent
us from using such technologies, or demand royalty payments from us in return for using such
technologies. Either of these events may affect our production, which could materially reduce our
revenues and harm our operating results. We may face intellectual property infringement claims that are costly to resolve, may divert our
managements attention, and may negatively impact our operations. We have occasionally received, and may receive in the future, communications from third
parties that assert violation of intellectual property rights alleged to cover certain of our
products or manufacturing processes or equipment. We evaluate on a case-by-case basis whether it
would be necessary to defend against such claims or to seek licenses to the rights referred to in
such communications. In certain cases, we may not be able to negotiate necessary licenses on
commercially reasonable terms, or at all. Also, if we have to defend such claims, we could incur
significant expenses and our managements attention could be diverted from our core business.
Further, we may not be able to anticipate claims by others that we infringe on their technology or
successfully defend ourselves against such claims. Any litigation resulting from such claims could
have a material adverse effect on our business and financial results. Historical quarterly results may not accurately predict our performance due to a number of
uncertainties and market factors, and as a result it is difficult to predict our future results. Our operating results historically have fluctuated significantly on both a quarterly and
annual basis. We believe that our future operating results will continue to be subject to quarterly
variations based on a wide variety of factors, including:  
    timing of significant orders, or order cancellations;
    changes in our product mix and average selling prices;
    modified, adjusted, or rescheduled shipments;
    availability of disks versus demand for disks;
    the cyclical nature of the disk drive industry;
    our ability to develop and implement new manufacturing process technologies;
    increases in our production and engineering costs associated with initial
design and production of new product programs;
    fluctuations in exchange rates, particularly between the U.S. dollar and the Malaysian ringgit;
    the ability of our process equipment to meet more stringent future product requirements;
    our ability to introduce new products that achieve cost-effective high-volume
production in a timely manner, timing of product announcements, and market acceptance
of new products;
    the availability of our production capacity, and the extent to which we can
use that capacity;
    changes in our manufacturing efficiencies, in particular product yields and
input costs for direct materials, operating supplies and other running costs;
    prolonged disruptions of operations at any of our facilities for any reason; 29




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
    changes in the cost of or limitations on availability of labor;
    structural changes within the disk industry, including combinations,
failures, and joint venture arrangements; and
    changes in tax regulations in foreign jurisdictions that could potentially
reduce our tax incentives in areas such as Malaysian capital allowances, tax holidays,
and exemptions on withholding tax on royalty payments made by our Malaysian operations
to our subsidiary in The Netherlands. We cannot forecast with certainty the impact of these and other factors on our revenues and
operating results in any future period. Our expense levels are based, in part, on expectations as
to future revenues. If our revenue levels are below expectations, our operating results are likely
to suffer. If we make unprofitable acquisitions or are unable to successfully integrate future acquisitions,
our business could suffer. We have in the past acquired, and in the future may acquire, businesses, products, equipment,
or technologies that we believe will complement or expand our existing business. Acquisitions
involve numerous risks, including the following:  
    difficulties in integrating the operations, technologies, products and
personnel of the acquired companies, especially given the specialized nature of our
technology;
    diversion of managements attention from normal daily operations of the
business;
    potential difficulties in completing projects associated with in-process
research and development;
    initial dependence on unfamiliar supply chains or relatively small supply partners; and
    the potential loss of key employees of the acquired companies. Acquisitions may also cause us to:  
    issue stock that would dilute our current stockholders percentage ownership;
    assume liabilities;
    record goodwill and non-amortizable intangible assets that will be subject to
impairment testing and potential periodic impairment charges;
    incur amortization expenses related to certain intangible assets;
    incur large and immediate write-offs; or
    become subject to litigation. Mergers and acquisitions of high-technology companies are inherently risky, and no assurance
can be given that any future acquisitions by us will be successful and will not materially
adversely affect our business, operating results, or financial condition. The failure to manage and
successfully integrate acquisitions we make could harm our business and operating results in a
material way. Even if an acquired company has already developed and marketed products, there can be
no assurance that product enhancements will be made in a timely fashion or that pre-acquisition due
diligence will have identified all 30




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possible issues that might arise with respect to products or the integration of the company
into our company. The nature of our operations makes us susceptible to material environmental liabilities, which
could result in significant compliance and clean-up expenses and adversely affect our financial
condition. We are subject to a variety of federal, state, local, and foreign regulations relating to:  
    the use, storage, discharge, and disposal of hazardous materials used during
our manufacturing process;
    the treatment of water used in our manufacturing process; and
    air quality management. We are required to obtain necessary permits for expanding our facilities. We must also comply
with new regulations on our existing operations, which may result in significant costs. Public
attention has increasingly been focused on the environmental impact of manufacturing operations
that use hazardous materials. If we fail to comply with environmental regulations or fail to obtain the necessary permits:  
    we could be subject to significant penalties;
    our ability to expand or operate in California or Malaysia could be restricted;
    our ability to establish additional operations in other locations could be restricted; or
    we could be required to obtain costly equipment or incur significant expenses
to comply with environmental regulations. Furthermore, our manufacturing processes rely on the use of hazardous materials, and any
accidental hazardous discharge could result in significant liability and clean-up expenses, which
could harm our business, financial condition, and results of operations. From time to time, we may have to defend lawsuits in connection with the operation of our business. We are subject to litigation in the ordinary course of our business. If we do not prevail in
any lawsuit which may occur we could be subject to significant liability for damages, our patents
and other proprietary rights could be invalidated, and we could be subject to injunctions
preventing us from taking certain actions. If any of the above occurs, our business and financial
position could be harmed. Earthquakes or other natural or man-made disasters could disrupt our operations. Our U.S. facilities are located in San Jose, California. In addition, Kobe and other Japanese
suppliers of our key manufacturing supplies and sputtering machines are located in areas with
seismic activity. Our Malaysian operations have been subject to temporary production interruptions
due to localized flooding, disruptions in the delivery of electrical power, and, on one occasion in
1997, by smoke generated 31




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by large, widespread fires in Indonesia. If any natural or man-made disasters do occur,
operations could be disrupted for prolonged periods, and our business would suffer. Anti-takeover provisions in our certificate of incorporation could discourage potential acquisition
proposals or delay or prevent a change of control. We have protective provisions in place designed to provide our board of directors with time to
consider whether a hostile takeover is in our best interests and that of our stockholders. Our
certificate of incorporation provides that we have three classes of directors. As a result, a
person could not take control of the board until the third annual meeting after the closing of the
takeover, since a majority of our directors will not stand for election until that third annual
meeting. This provision could discourage potential acquisition proposals and could delay or prevent
a change in control of the company and also could diminish the opportunities for a holder of our
common stock to participate in tender offers, including offers at a price above the then-current
market price for our common stock. These provisions also may inhibit fluctuations in our stock
price that could result from takeover attempts. Risks Related to our Indebtedness We are leveraged, and our debt obligations will continue to make us vulnerable to economic
downturns. In the first quarter of 2004, we completed a public common stock offering of 4.0 million
shares (of which 0.5 million were sold by selling stockholders) and a public $80.5 million
Convertible Subordinated Notes offering. Debt service obligations arising from the offering of our
Convertible Subordinated Notes could limit our ability to borrow more money for operations and
implement our business strategy in the future. We will continue to be more leveraged than some of
our competitors, which may place us at a competitive disadvantage because our interest and debt
repayment requirements makes us more susceptible to downturns in our business. Our holding company structure makes us dependent on cash flow from our subsidiaries to meet our
obligations. Most of our operations are conducted through, and most of our assets are held by, our
subsidiaries. Therefore, we are dependent on the cash flow of our subsidiaries to meet our debt
obligations. Our subsidiaries are separate legal entities that have no obligation to pay any
amounts due under the Convertible Subordinated Notes, or to make any funds available therefore,
whether by dividends, loans or other payments. Our subsidiaries have not guaranteed the payment of
the Convertible Subordinated Notes, and payments on the Convertible Subordinated Notes are required
to be made only by us. Except to the extent we may ourselves be a creditor with recognized claims
against our subsidiaries, subject to any limitations contained in our debt agreements, all claims
of creditors and holders of preferred stock, if any, of our subsidiaries will have priority with
respect to the assets of such subsidiaries over the claims of our creditors, including holders of
the Convertible Subordinated Notes. 32




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The assets of our subsidiaries may not be available to make payments on our debt obligations. We may not have direct access to the assets of our subsidiaries unless these assets are
transferred by dividend or otherwise to us. The ability of our subsidiaries to pay dividends or
otherwise transfer assets to us is subject to various restrictions, including restrictions under
other agreements to which we are a party under applicable law. 33




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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The primary objective of our investment activities is to preserve principal while at the same
time maximizing yields without significantly increasing risk. We invest primarily in high-quality,
short-term debt instruments and auction rate preferred securities (which the Company rolls over
every three months or less), and are accounted for as cash equivalents or short-term investments,
depending upon the period of time from the purchase date to the maturity date. We are exposed to foreign currency exchange rate risk. We currently do not use derivative
financial instruments to hedge such risk. A majority of our revenue, expense, and capital purchasing activities is transacted in U.S.
dollars. However, a large portion of our payroll, certain manufacturing and operating expenses, and
inventory and capital purchases are transacted in the Malaysian ringgit (ringgit). For
approximately the last six years, the exchange rate between the ringgit and the U.S. dollar has
been pegged at 3.8 ringgits to one U.S. dollar by the Malaysian government. News reports and
certain Malaysian government officials have indicated that the Malaysian government may be
considering a change in the exchange rate. If the Malaysian government elects to change the pegging
of the ringgit to the U.S. dollar and the ringgit proves to be undervalued, the change in exchange
rates could adversely affect the amount we spend on our payroll, certain manufacturing and
operating expenses, and raw materials and capital purchases. In the first quarter of 2005, our
spending on payroll, manufacturing, and operating expenses, and raw materials and capital purchases
that were denominated in ringgit was approximately $42.6 million. Additionally, we paid
approximately $16.9 million for raw materials purchases in the first quarter of 2005 from a vendor
we pay in U.S. dollars based on a cost plus a percentage arrangement. This vendor has costs that
are incurred which are denominated in ringgit; therefore, any change in the valuation of the
ringgit in the future could adversely impact the cost per unit we pay for such raw materials. We have $80.5 million in convertible subordinated notes outstanding. These notes bear interest
at 2% and mature in February 2024. A hypothetical 100 basis point increase in interest rates would
result in approximately $0.8 million of additional interest expense each year. 
 ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures As of April 3, 2005, our management, including our Chief Executive Officer (CEO) and Chief
Financial Officer (CFO), has conducted an evaluation of the effectiveness of our disclosure
controls and procedures pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation,
the CEO and CFO concluded that our disclosure controls and procedures are effective in ensuring
that all material information required to be filed in this quarterly report has been made known to
them in a timely manner. 34




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Internal Control over Financial Reporting Our internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles.
Internal control over financial reporting includes those policies and procedures that:  
    pertain to the maintenance of records that, in reasonable detail, accurately
and fairly reflect the transactions and dispositions of the assets of the company;
    provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are being
made only in accordance with authorizations of management and directors of the
company; and
    provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of the companys assets that could have a
material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. In addition, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become inadequate because of changes in
conditions and that the degree of compliance with the policies or procedures may deteriorate. Changes in Internal Control Over Financial Reporting There has been no change in our internal control over financial reporting during our first
fiscal quarter ended April 3, 2005 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting. 
 PART II. OTHER INFORMATION 
 ITEM 1. Legal Proceedings Not applicable. 
 ITEM 2. Unregistered Sales of Equity Securities Not applicable. 
 ITEM 3. Defaults Upon Senior Securities Not applicable. 35




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ITEM 4. Submission of Matters to a Vote of Security Holders Not applicable. 
 ITEM 5. Other Information Effective as of May 3, 2005, our Board of Directors approved a modification to our 2005
Target Incentive Plan to increase the target bonus percentage of the Chief Executive Officer under
the plan from 65% to 80%. Therefore, under the modified plan, if our actual performance meets our
target operating income goals for the year and our Chief Executive Officer meets individual
performance goals, the plan provides that our Chief Executive Officer may receive a target cash
incentive bonus payment equal to 80% of his eligible base salary (rather than 65% of his eligible
base salary), subject to the terms and conditions of the plan. A copy of the modified plan is
filed as Exhibit 10.2 to this report. On May 4, 2005, we entered into an Executive Retention Agreement with our executive officer
William G. Hammack, the Vice President of Human Resources. This agreement is a reinstatement of our
prior 2002 Executive Retention Agreement with Mr. Hammack, with the same terms and conditions. Mr.
Hammack left the Company in January 2005 and returned on March 14, 2005, resuming his position and
duties as Vice President of Human Resources. The new agreement continues to provide for base
salary compensation, a term of employment until July 16, 2005, benefits and certain other change of
control and severance benefits as approved by our Board of Directors. A copy of Mr. Hammacks
agreement is filed as Exhibit 10.3 to this report. 
 ITEM 6. Exhibits 10.1
    
    Amended and Restated 2002 Qualified Stock Option Plan10.2
    
    2005 Target Incentive Plan10.3
    
    Executive Retention Agreement dated May 4, 2005 with William G. Hammock31.1
    
    Rule 13a  14 (a) Certification of Chief Executive Officer31.2
    
    Rule 13a  14 (a) Certification of Chief Financial Officer32
    
    Section 1350 Certification of Chief Executive Officer and Chief Financial Officer
 36




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KOMAG, INCORPORATED
(Registrant) DATE: May 6, 2005
    BY:
    /s/ Thian Hoo TanThian Hoo TanChief Executive Officer DATE: May 6, 2005
    BY:
    /s/ Kathleen A. BaylessKathleen A. BaylessVice President, Chief Financial Officer 37




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EXHIBIT INDEX 10.1
    
    Amended and Restated 2002 Qualified Stock Option Plan10.2
    
    2005 Target Incentive Plan10.3
    
    Executive Retention Agreement dated May 4, 2005 with William G. Hammock31.1
    
    Rule 13a  14 (a) Certification of Chief Executive Officer31.2
    
    Rule 13a  14 (a) Certification of Chief Financial Officer32
    
    Section 1350 Certification of Chief Executive Officer and Chief Financial Officer