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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
   FORM 10-Q   (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the Quarterly Period Ended July 4, 2004 OR [   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the transition period from _______ to ________ Commission File Number: 0-11674   LSI LOGIC CORPORATION (Exact name of registrant as specified in its charter)
 Delaware
    
    94-2712976(State of Incorporation)
    
    (I.R.S. Employer Identification Number)
 1621 Barber Lane
Milpitas, California 95035
(Address of principal executive offices)
(Zip code) (408) 433-8000
(Registrants telephone number, including area code)   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 [X] NO [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act) YES [X] NO [   ] As of August 6, 2004, there were 384,900,567 shares of the registrants Common
Stock, $.01 par value, outstanding.




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LSI LOGIC CORPORATION
Form 10-Q
For the Quarter Ended June 30, 2004
INDEX PageNo.PART I. FINANCIAL INFORMATIONItem 1
    
    Financial StatementsConsolidated Balance Sheets  June 30, 2004 (unaudited) and December 31, 2003
    
    
    3Consolidated Statements of Operations  Three and Six Months Ended June 30, 2004 and 2003 (unaudited)
    
    
    4Consolidated Statements of Cash Flows  Six Months Ended June 30, 2004 and 2003 (unaudited)
    
    
    5Notes to Unaudited Consolidated Financial Statements
    
    
    6Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    19Item 3
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    34Item 4
    
    Controls and Procedures
    
    
    34PART II. OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    
    34Item 2
    
    Changes in Securities, Use of Proceeds
    
    
    34Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    34Item 6
    
    Exhibits and Reports on Form 8-K
    
    
    35Signatures
    
    
    37Index to ExhibitsEXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I  FINANCIAL INFORMATION 
 Item 1. Financial Statements LSI LOGIC CORPORATION 
 CONSOLIDATED BALANCE SHEETS
 (UNAUDITED)
 June 30,
    
    December 31,2004
    
    2003(In thousands, except per-share amounts)AssetsCash and cash equivalents
    
    $
    198,403
    
    
    $
    269,682Short-term investments
    
    
    649,008
    
    
    
    544,007Accounts receivable, less allowances of $5,911 and $7,415
    
    
    288,957
    
    
    
    231,184Inventories
    
    
    209,941
    
    
    
    198,517Deferred tax assets
    
    
    7,642
    
    
    
    8,116Prepaid expenses and other current assets
    
    
    125,115
    
    
    
    138,531Total current assets
    
    
    1,479,066
    
    
    
    1,390,037Property and equipment, net
    
    
    451,511
    
    
    
    481,489Intangibles, net
    
    
    152,124
    
    
    
    161,236Goodwill
    
    
    973,014
    
    
    
    968,483Deferred tax assets
    
    
    7,333
    
    
    
    7,484Non-current assets and deposits
    
    
    285,378
    
    
    
    318,176Investment in equity securities
    
    
    20,826
    
    
    
    35,455Other assets
    
    
    87,463
    
    
    
    85,541Total assets
    
    $
    3,456,715
    
    
    $
    3,447,901Liabilities and Stockholders EquityAccounts payable
    
    $
    111,870
    
    
    $
    102,632Accrued salaries, wages and benefits
    
    
    75,815
    
    
    
    75,968Other accrued liabilities
    
    
    145,826
    
    
    
    153,857Income taxes payable
    
    
    62,471
    
    
    
    58,417Current portion of long-term obligations
    
    
    351
    
    
    
    377Total current liabilities
    
    
    396,333
    
    
    
    391,251Long-term debt and capital lease obligations
    
    
    858,232
    
    
    
    865,606Other non-current liabilities
    
    
    135,547
    
    
    
    141,096Total long-term obligations and other liabilities
    
    
    993,779
    
    
    
    1,006,702Commitments and contingencies (Note 14 and Note 15)Minority interest in subsidiary
    
    
    763
    
    
    
    7,498Stockholders equity:Preferred shares; $.01 par value; 2,000 shares authorized; none
outstanding
    
    
    
    
    
    
    Common stock; $.01 par value; 1,300,000 shares authorized;
384,864 and 381,491 shares outstanding
    
    
    3,849
    
    
    
    3,815Additional paid-in capital
    
    
    2,958,324
    
    
    
    2,950,051Deferred stock compensation
    
    
    (11,661
    )
    
    
    (24,839
    )Accumulated deficit
    
    
    (904,463
    )
    
    
    (920,790
    )Accumulated other comprehensive income
    
    
    19,791
    
    
    
    34,213Total stockholders equity
    
    
    2,065,840
    
    
    
    2,042,450Total liabilities and stockholders equity
    
    $
    3,456,715
    
    
    $
    3,447,901
 The accompanying notes are an integral part of these Consolidated Financial Statements. 3




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LSI LOGIC CORPORATION 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (UNAUDITED)
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share amounts)Revenues
    
    $
    447,897
    
    
    $
    407,213
    
    
    $
    900,254
    
    
    $
    779,998Cost of revenues
    
    
    239,081
    
    
    
    238,469
    
    
    
    490,006
    
    
    
    486,537Gross profit
    
    
    208,816
    
    
    
    168,744
    
    
    
    410,248
    
    
    
    293,461Research and development
    
    
    110,098
    
    
    
    111,326
    
    
    
    219,039
    
    
    
    226,453Selling, general and administrative
    
    
    63,757
    
    
    
    56,870
    
    
    
    124,915
    
    
    
    114,499Restructuring of operations and other items, net
    
    
    3,029
    
    
    
    124,527
    
    
    
    2,431
    
    
    
    160,193Amortization of non-cash deferred stock
compensation (*)
    
    
    2,003
    
    
    
    8,884
    
    
    
    3,829
    
    
    
    19,427Amortization of intangibles
    
    
    19,398
    
    
    
    19,267
    
    
    
    37,672
    
    
    
    39,392Income/ (loss) from operations
    
    
    10,531
    
    
    
    (152,130
    )
    
    
    22,362
    
    
    
    (266,503
    )Interest expense
    
    
    (6,067
    )
    
    
    (7,314
    )
    
    
    (11,979
    )
    
    
    (16,145
    )Interest income and other, net
    
    
    8,778
    
    
    
    3,360
    
    
    
    17,944
    
    
    
    10,139Income/ (loss) before income taxes
    
    
    13,242
    
    
    
    (156,084
    )
    
    
    28,327
    
    
    
    (272,509
    )Provision for income taxes
    
    
    6,000
    
    
    
    6,000
    
    
    
    12,000
    
    
    
    12,000Net income/(loss)
    
    $
    7,242
    
    
    $
    (162,084
    )
    
    $
    16,327
    
    
    $
    (284,509
    )Net income/(loss) per share:Basic
    
    $
    0.02
    
    
    $
    (0.43
    )
    
    $
    0.04
    
    
    $
    (0.76
    )Dilutive
    
    $
    0.02
    
    
    $
    (0.43
    )
    
    $
    0.04
    
    
    $
    (0.76
    )Shares used in computing per share amounts:Basic
    
    
    383,522
    
    
    
    376,619
    
    
    
    382,571
    
    
    
    375,745Dilutive
    
    
    388,586
    
    
    
    376,619
    
    
    
    389,102
    
    
    
    375,745
  (*) Amortization of non-cash deferred stock compensation recorded in
connection with acquisitions, if not shown separately, would have been
included in cost of revenues, research and development and selling,
general and administrative expenses, as shown below: Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003(In thousands)Cost of revenues
    
    $
    46
    
    
    $
    88
    
    
    $
    96
    
    
    $
    270Research and development
    
    
    1,530
    
    
    
    7,391
    
    
    
    2,711
    
    
    
    15,541Selling, general and administrative
    
    
    427
    
    
    
    1,405
    
    
    
    1,022
    
    
    
    3,616Total
    
    $
    2,003
    
    
    $
    8,884
    
    
    $
    3,829
    
    
    $
    19,427
 The accompanying notes are an integral part of these Consolidated Financial Statements. 4




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LSI LOGIC CORPORATION 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (UNAUDITED)
 Six Months EndedJune 30,2004
    
    2003(In thousands)Operating activities:Net income/(loss)
    
    $
    16,327
    
    
    $
    (284,509
    )Adjustments:Depreciation and amortization
    
    
    92,441
    
    
    
    152,111Amortization of non-cash deferred stock compensation
    
    
    3,829
    
    
    
    19,427Non-cash restructuring and other items
    
    
    6,385
    
    
    
    127,323Gain on sale and exchange of equity securities, loss on write down
    
    
    (8,104
    )
    
    
    9,074Loss on repurchase of Convertible Subordinated Notes
    
    
    
    
    
    
    2,029Gain on sale of property and equipment
    
    
    (3,937
    )
    
    
    (2,560
    )Changes in deferred tax assets and liabilities
    
    
    625
    
    
    
    37Changes in assets and liabilities, net of assets acquired and
liabilities assumed in acquisition:Accounts receivable
    
    
    (56,980
    )
    
    
    8,500Inventories
    
    
    (11,701
    )
    
    
    (10,040
    )Prepaid expenses and other assets
    
    
    (5,777
    )
    
    
    52,440Accounts payable
    
    
    10,263
    
    
    
    12,028Accrued and other liabilities
    
    
    (5,178
    )
    
    
    18,205Net cash provided by operating activities
    
    
    38,193
    
    
    
    104,065Investing activities:Purchase of debt securities available-for-sale
    
    
    (454,756
    )
    
    
    (1,409,529
    )Maturities and sales of debt securities available-for-sale
    
    
    339,458
    
    
    
    1,455,927Purchases of equity securities
    
    
    (2,250
    )
    
    
    Proceeds from sales of equity securities
    
    
    10,518
    
    
    
    Purchases of property and equipment
    
    
    (25,218
    )
    
    
    (31,518
    )Proceeds from sale of property and equipment
    
    
    5,836
    
    
    
    11,855Proceeds from the sale-lease back of equipment
    
    
    
    
    
    
    160,000Increase in non-current assets and deposits
    
    
    (40
    )
    
    
    (389,393
    )Decrease in non-current assets and deposits
    
    
    39,633
    
    
    
    243,625Acquisition of companies, net of cash acquired
    
    
    (32,025
    )
    
    
    Net cash (used in)/provided by investing activities
    
    
    (118,844
    )
    
    
    40,967Financing activities:Repayment of debt obligations
    
    
    (216
    )
    
    
    (174
    )Purchase of minority interest in subsidiary
    
    
    (7,453
    )
    
    
    Issuance of common stock
    
    
    17,810
    
    
    
    15,890Proceeds from borrowings
    
    
    
    
    
    
    350,000Repurchase of Convertible Subordinated Notes
    
    
    
    
    
    
    (288,587
    )Cash paid for call spread options
    
    
    
    
    
    
    (28,000
    )Debt issuance costs
    
    
    
    
    
    
    (10,566
    )Net cash provided by financing activities
    
    
    10,141
    
    
    
    38,563Effect of exchange rate changes on cash and cash equivalents
    
    
    (769
    )
    
    
    3,722(Decrease)/increase in cash and cash equivalents
    
    
    (71,279
    )
    
    
    187,317Cash and cash equivalents at beginning of period
    
    
    269,682
    
    
    
    448,847Cash and cash equivalents at end of period
    
    $
    198,403
    
    
    $
    636,164
 The accompanying notes are an integral part of these Consolidated Financial Statements. 5




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LSI LOGIC CORPORATION 
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 NOTE 1  BASIS OF PRESENTATION In the opinion of LSI Logic Corporation (the Company or LSI), the
accompanying unaudited consolidated financial statements contain all
adjustments (consisting only of normal recurring adjustments and restructuring
and other items, net as discussed in Note 5 to the Unaudited Consolidated
Financial Statements, hereafter referred to as the Notes), necessary to
present fairly the financial information included herein. While the Company
believes that the disclosures are adequate to make the information not
misleading, it is suggested that these financial statements be read in
conjunction with the audited consolidated financial statements and accompanying
notes included in the Companys Annual Report on Form 10-K for the year ended
December 31, 2003. For financial reporting purposes, the Company reports on a 13 or 14-week
quarter with a year ending December 31. The current quarter ended July 4,
2004. For presentation purposes, the consolidated financial statements refer
to the calendar quarters for convenience. The results of operations for the
quarter ended July 4, 2004, are not necessarily indicative of the results to be
expected for the full year. The first six months of 2004 ended on July 4, 2004,
and consisted of approximately 27 weeks, while the first six months of 2003
ended on June 29, 2003, and consisted of approximately 26 weeks. The second
quarter of 2004 and 2003 both consisted of 13 weeks. 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 amounts
of assets and liabilities and disclosure of contingent assets and liabilities
at the date of the consolidated financial statements and the reported amounts
of revenues and expenses during the reporting periods. Actual results could
differ significantly from these estimates. Certain items previously reported in specific financial statement captions
have been reclassified to conform to the current period presentation. Recent Accounting Pronouncements In July 2004, the Emerging Issues Task Force (EITF) issued EITF Issue
No. 02-14, Whether an Investor Should Apply the Equity Method of Accounting to
Investments Other Than Common Stock. This issue addresses the determination
of whether an investment is in-substance common stock and when to perform that
evaluation, but does not address the determination of whether an investor has
the ability to exercise significant influence over the operating and financial
policies of the investee. The pronouncement is effective for fiscal periods
beginning after September 15, 2004. For existing investments, the investor
should make an initial determination as to whether the investment is
in-substance common stock based on the circumstances existing as of the date of
first application of this issue. The Company does not believe that the
adoption of this standard will have a material impact on its consolidated
balance sheet or statement of operations. In March 2004, the EITF issued EITF Issue No. 03-06, Participating
Securities and the Two-class Method Under FASB Statement No. 128, Earnings Per
Share. EITF Issue No. 03-06 addresses a number of questions regarding the
computation of earnings per share (EPS) by companies that have issued
securities other than common stock that contractually entitle the holder to
participate in dividends and earnings of the company when, and if, it declares
dividends on its common stock. The issue also provides further guidance in
applying the two-class method of calculating EPS. It clarifies what constitutes
a participating security and how to apply the two-class method of computing EPS
once it is determined that a security is participating, including how to
allocate undistributed earnings to such a security. This pronouncement is
effective for fiscal periods beginning after March 31, 2004. The adoption of
this standard did not have a material impact on the Companys computation of
EPS. In March 2004, the EITF reached a consensus on Issue No. 03-01, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments. EITF No. 03-01 provides guidance on recording
other-than-temporary impairments of cost method investments and requires
additional disclosures for those investments. The recognition and measurement
guidance in EITF No. 03-01 should be applied to other-than-temporary impairment
evaluations in reporting periods beginning after June 15, 2004. The disclosure
requirements are effective for fiscal years ending after June 15, 2004, and are
required only for annual periods. The Company does not believe that the
adoption of this standard will have a material impact on its consolidated
balance sheet or statement of operations. 6




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In December 2003, the Financial Accounting Standards Board (FASB)
released a revision to FASB Interpretation No. 46 (FIN 46), Consolidation of
Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires
certain variable interest entities to be consolidated by the primary
beneficiary of the entity if the equity investors in the entity do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. A public entity shall apply
the provisions of the FIN 46 revision no later than the end of the first
reporting period that ends after March 15, 2004. However, a public entity
shall apply FIN 46 to entities considered to be special-purpose entities no
later than as of the end of the first reporting period that ends after December
15, 2003. The adoption of this standard did not have a material impact on the
consolidated balance sheet or statement of operations. NOTE 2  SEPARATION OF LSI LOGIC STORAGE SYSTEMS, INC. On November 13, 2003, the Company announced its intention to separate its
wholly-owned subsidiary, Engenio Information Technologies, Inc. (Engenio or
Storage Systems segment), and create an independent storage systems company.
Engenio was formerly referred to as LSI Logic Storage Systems, Inc. The
Company has entered into agreements to implement this separation and to address
various arrangements between Engenio and the Company. On February 19, 2004,
Engenio filed a registration statement on Form S-1 (the Registration
Statement) with the Securities and Exchange Commission (SEC). On July 27,
2004, Engenio filed Amendment No. 8 to the Registration Statement. On July 29,
2004, LSI announced jointly with Engenio the postponement of the initial public
offering of its common stock due to market conditions. The Company has
capitalized approximately $1.5 million in professional services that are
directly and solely related to the initial public offering of Engenio common
stock. If the offering does not occur, the Company will record such expenses
as selling, general and administrative (SG&A) expenses in the statement of
operations. The separation of Engenio from the Company, including the transfer of
related assets, liabilities and intellectual property rights, was substantially
completed in December 2003. At that time, the Company and Engenio entered into
a Master Separation Agreement, General Assignment and Assumption Agreement,
Intellectual Property Agreement, Employee Matters Agreement and an
Indemnification and Insurance Matters Agreement as more fully described in the
Companys Annual Report on Form 10-K. In March 2004, the Company and Engenio
entered into the following additional agreements that further specify the terms
of the separation. Tax Sharing Agreement.The Tax Sharing Agreement sets forth the principal
arrangements between the Company and Engenio regarding the filing of tax
returns, the payment of taxes and the conduct of tax audits or disputes. The
Tax Sharing Agreement provides that Engenios stand-alone tax liability equals
its taxable income multiplied by the highest corporate tax rate in effect for
the year, modified by taking into account its losses and loss carryovers from
prior years and, to the extent actually used, its credits. Engenio is
obligated to pay the Company the amount of its stand-alone tax liability to the
extent Engenio is included in any consolidated, combined or unitary tax return
with the Company. Under the Tax Sharing Agreement, the Company is required to prepare and
file all consolidated, combined or unitary tax returns of the Company and
Engenio through the date that Engenio ceases to be a member of the Companys
consolidated or combined group, including the final consolidated federal income
tax return. The Company has the right to review and consent to the federal and
state income tax returns filed for the first tax year after Engenio ceases to
be a member of the Companys consolidated group, which may not be withheld
unreasonably. In addition, the Company has sole and complete authority to
control and resolve all tax audits and other disputes relating to any
consolidated, combined or unitary returns filed by the Company. However, the
Company may not enter into any dispute settlement that would materially
increase Engenios liability under the Tax Sharing Agreement without Engenios
consent, which cannot be withheld unreasonably. Transition Services Agreement.The Transition Services Agreement governs
the provisions by the Company to Engenio of services such as finance,
accounting and treasury, human resources, sales support, legal matters and
information technology. Real Estate Matters Agreement.The Real Estate Matters Agreement
describes the manner in which the Company will transfer to or share with
Engenio various properties leased and owned by the Company. The agreement
provides that all reasonable costs required to effect the transfers, including
landlord consent fees and landlord attorneys fees, will be paid by the
Company. Investor Rights Agreement.The Investor Rights Agreement provides for
specified registration and other rights relating to the Companys ownership of
Engenios shares of Class B common stock. 7




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NOTE 3  BUSINESS COMBINATIONS Acquisition of Accerant Inc.On May 11, 2004, the Company acquired
Accerant Inc. (Accerant). The acquisition is anticipated to expand consumer
product offerings within the Semiconductor segment. The acquisition was
accounted for as a purchase of a business. The Company paid approximately $14.1 million in cash for the acquisition.
The Company will also issue approximately 234,000 restricted common shares to
certain Accerant employees hired as part of the transaction. Resulting
deferred stock compensation will be amortized over a vesting period of two
years using the straight-line method. The total purchase price was allocated to
the estimated fair value of net assets acquired based on management estimates
as follows: (In thousands)Fair value of tangible net assets acquired
    
    $
    31Current technology
    
    
    5,700Non-compete agreements
    
    
    400Goodwill
    
    
    7,972Total purchase price excluding deferred stock compensation
    
    
    14,103Deferred stock compensation
    
    
    1,765Total purchase price
    
    $
    15,868
 The Company may also pay additional cash of up to $4.0 million if certain
revenue targets are achieved over a period ending December 31, 2005. Such
contingent consideration will represent additional purchase price and
accordingly goodwill when and if such targets are met. Useful lives of intangible assets.The amounts allocated to current
technology and non-compete agreements are being amortized over their estimated
useful lives of 5 and 2 years, respectively using the straight-line method. Acquisition of Velio Communications.On April 2, 2004, the Company
acquired Velio Communications, Inc. (Velio). The acquisition is
anticipated to expand product offerings for high-speed interconnect and switch
fabric application specific standard products (ASSPs) in the global
communications market within the Semiconductor segment. The acquisition was
accounted for as a purchase of a business. The Company paid approximately $19.8 million in cash for the acquisition.
The Company will also issue approximately 100,000 restricted common shares to
certain Velio employees hired as part of the transaction. Resulting deferred
stock compensation will be amortized over a vesting period of two years using
the straight-line method. The total purchase price was allocated to the
estimated fair value of net assets acquired based on management estimates as
follows: (In thousands)Fair value of tangible net assets acquired
    
    $
    1,529Current technology
    
    
    8,788Customer base
    
    
    8,788Non-compete agreements
    
    
    450Existing purchase orders
    
    
    200Total purchase price excluding deferred stock compensation
    
    
    19,755Deferred stock compensation
    
    
    1,000Total purchase price
    
    $
    20,755
 Useful lives of intangible assets.The amounts allocated to current
technology, customer base, non-compete agreements and existing purchase orders
are being amortized over their estimated useful lives of 9 months to 5.5 years
using the straight-line method. Pro forma statements of earnings information have not been presented
because the effect of these acquisitions was not material either individually
or on an aggregate basis. 8




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NOTE 4  STOCK-BASED COMPENSATION The following table provides pro forma disclosures as if the Company had
recorded compensation costs based on the estimated grant date fair value, as
defined by the Statement of Financial Accounting Standards (SFAS) No. 123,
for awards granted under its stock option and stock purchase plans. The
estimated weighted-average grant date fair value, as defined by SFAS No. 123,
was calculated using the Black-Scholes model. The Black-Scholes model was
developed to estimate the fair value of freely tradable, fully transferable
options without vesting restrictions, which significantly differ from the
Companys stock option awards. These models also require highly subjective
assumptions, including future stock price volatility and expected time until
exercise, which greatly affect the calculated grant date fair value. Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share amounts)Net income/(loss), as reported
    
    $
    7,242
    
    
    $
    (162,084
    )
    
    $
    16,327
    
    
    $
    (284,509
    )Add: Amortization of
non-cash deferred stock
compensation determined under
the intrinsic value method as
reported in net income/(loss), net of
related tax effects *
    
    
    748
    
    
    
    2,228
    
    
    
    2,022
    
    
    
    6,129Deduct: Total stock-based
employee compensation expense
determined under fair value
method for all awards, net of
related tax effects
    
    
    (32,756
    )
    
    
    (52,385
    )
    
    
    (70,597
    )
    
    
    (108,191
    )Pro forma net loss **
    
    $
    (24,766
    )
    
    $
    (212,241
    )
    
    $
    (52,248
    )
    
    $
    (386,571
    )Income/(loss) per share:Basic-as reported
    
    $
    0.02
    
    
    $
    (0.43
    )
    
    $
    0.04
    
    
    $
    (0.76
    )Basic-pro forma
    
    $
    (0.06
    )
    
    $
    (0.56
    )
    
    $
    (0.14
    )
    
    $
    (1.03
    )Diluted-as reported
    
    $
    0.02
    
    
    $
    (0.43
    )
    
    $
    0.04
    
    
    $
    (0.76
    )Diluted-pro forma
    
    $
    (0.06
    )
    
    $
    (0.56
    )
    
    $
    (0.14
    )
    
    $
    (1.03
    )
 * This amount excludes amortization of non-cash deferred stock compensation on
restricted stock awards. ** The amounts for the three and six months ended June 30, 2003 have been
adjusted to reflect higher calculated fair values for the Employee Stock
Purchase Plan, which resulted in a 1% increase in the pro forma net loss for the
three months and six months ended June 30, 2003, respectively. NOTE 5  RESTRUCTURING AND OTHER ITEMS The Company recorded charges of $3.0 million and $2.4 million in
restructuring of operations and other items for the three and six months ended
June 30, 2004, respectively primarily in the Semiconductor segment. The
Company recorded a charge of $125 million and $160 million in restructuring of
operations and other items for the three and six months ended June 30, 2003,
respectively. For a complete discussion of the 2003 restructuring actions,
please refer to the Companys Annual Report on Form 10-K. Restructuring and impairment of long-lived assets: First quarter of 2004: The Company recorded a gain of $3.3 million on the sale of fixed assets
that had previously been held for sale and an expense of $1.1 million for the
abandonment of fixed assets that had previously been held for sale. In
addition, an expense of $1.1 million was recorded for the write-down of fixed
assets due to impairment. An expense of $0.3 million was recorded to reflect the change in time
value of accruals for facility lease termination costs, net of adjustments for
changes in sublease assumptions for certain previously accrued facility lease
termination costs. An expense of $0.2 million was recorded primarily for
severance and termination benefits for four employees involved in research and
development. 9




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##### Table of Contents



Second quarter of 2004: The Company recorded a gain of $1.0 million on the sale of fixed assets
that had previously been held for sale and an expense of $4.0 million primarily
for the write-down of the Colorado Springs fabrication facility to reflect a
decline in fair market value and to write down certain spare parts for fixed
assets. An expense of $0.4 million was recorded to reflect the change in time
value of accruals for facility lease termination costs, net of adjustments for
changes in sublease assumptions for certain previously accrued facility lease
termination costs. Previously accrued contract termination fees of $0.4
million were reversed as the result of more favorable than expected
negotiations to terminate those contracts. The fair values of impaired equipment and facilities were estimated by
management. Given that current market conditions for the sale of older
fabrication facilities and related equipment may fluctuate, there can be no
assurance that the Company will realize the current net carrying value of the
assets held for sale. The Company reassesses the realizability of the carrying
value of these assets at the end of each quarter until the assets are sold or
otherwise disposed of and additional adjustments may be necessary. Assets
held for sale of $25 million and $30 million were included as a component of
prepaid expenses and other current assets as of June 30, 2004 and December 31,
2003, respectively. Assets classified as held for sale are not depreciated. The following table sets forth the Companys restructuring reserves as of
June 30, 2004, which are included in other accrued liabilities on the balance
sheet: Utilized
    
    
    
    
    
    
    
    
    
    Release
    
    
    
    
    
    BalanceBalance at
    
    Restructuring
    
    during
    
    Balance at
    
    Restructuring
    
    of
    
    Utilized
    
    atDecember
    
    Expense
    
    Q1
    
    March 31,
    
    Expense
    
    reserves
    
    during
    
    June 30,31, 2003
    
    Q1 2004
    
    2004
    
    2004
    
    Q2 2004
    
    Q2 2004
    
    Q2 2004
    
    2004(in thousands)Write-down of
excess assets (a)
    
    $
    2,661
    
    
    $
    (1,118
    )
    
    $
    718
    
    
    $
    2,261
    
    
    $
    3,203
    
    
    $
    (160
    )
    
    $
    (3,414
    )
    
    $
    1,890Lease terminations
and maintenance
contracts (b)
    
    
    21,021
    
    
    
    252
    
    
    
    (1,886
    )
    
    
    19,387
    
    
    
    379
    
    
    
    (375
    )
    
    
    (2,312
    )
    
    
    17,079Facility closure
and other exit
costs (c)
    
    
    2,136
    
    
    
    64
    
    
    
    (782
    )
    
    
    1,418
    
    
    
    
    
    
    
    
    
    
    
    (369
    )
    
    
    1,049Payments to
employees for
severance (d)
    
    
    874
    
    
    
    204
    
    
    
    (767
    )
    
    
    311
    
    
    
    
    
    
    
    (18
    )
    
    
    (227
    )
    
    
    66Total
    
    $
    26,692
    
    
    $
    (598
    )
    
    $
    (2,717
    )
    
    $
    23,377
    
    
    $
    3,582
    
    
    $
    (553
    )
    
    $
    (6,322
    )
    
    $
    20,084
  (a)
    
    The amounts utilized in 2004 reflect $6.3 million of non-cash write-downs
of long-lived assets in the U.S. due to impairment and $0.6 million in
cash payments to decommission and sell assets, offset by $4.3 million
realized gain on the sale of fixed assets previously held for sale. The
write-downs of long-lived assets were accounted for as a reduction of the
assets and did not result in a liability. The $1.9 million balance as of
June 30, 2004, relates to machinery and equipment decommissioning costs in
the U.S. and estimates of selling costs for assets held for sale and is
expected to be utilized during 2004.  (b)
    
    Amounts utilized represent cash payments. The balance remaining for
primarily real estate lease terminations and maintenance contracts will be
paid during the remaining terms of these contracts, which extend through
2011.  (c)
    
    Amounts utilized represent cash payments. The balance remaining for
facility closure and other exit costs will be paid during 2004.  (d)
    
    Amounts utilized represent cash severance payments to twenty employees
during the six months ended June 30, 2004. The balance remaining for
severance is expected to be paid during 2004. Other Items During the second quarter of 2004, the Company reclassified a parcel of
land in Colorado with a book value of $1.4 million from a long-term asset to a
current asset held for sale. The land is part of total assets in the
Semiconductor segment. The Company expects to sell the property within the
next 12 months for an amount in excess of book value. 10




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NOTE 6 INVESTMENTS June 30,
    
    December 31,2004
    
    2003(In thousands)Available-for-sale debt securitiesAsset and mortgage-backed securities
    
    $
    332,012
    
    
    $
    345,625U.S. government and agency securities
    
    
    242,962
    
    
    
    104,173Corporate and municipal debt securities
    
    
    74,034
    
    
    
    90,730Auction rate preferred stock
    
    
    
    
    
    
    3,150Foreign debt securities
    
    
    
    
    
    
    329Total short-term investments
    
    $
    649,008
    
    
    $
    544,007Long-term investment in equity securities
    
    $
    20,826
    
    
    $
    35,455
 An unrealized gain on available-for-sale securities of $4 million, net of
the related tax effect of $2 million, and $8 million, net of the related tax
effect of $4 million, was included in accumulated other comprehensive income as
of June 30, 2004 and December 31, 2003, respectively. Net realized losses on
sales of available-for-sale debt securities were $0.3 million for the three
months ended June 30, 2004. Net realized gains on sales of available-for-sale
debt securities were $0.6 million for the six months ended June 30, 2004. Net
realized gains on sales of available-for-sale debt securities were $2 million
and $9 million for the three and six months ended June 30, 2003, respectively. The Company realized pre-tax gains of $8 million related to the following
for the six months ended June 30, 2004:  A $5 million pre-tax gain related to the sales of certain marketable
available-for-sale equity securities in the second quarter of 2004; and  A $3 million pre-tax gain associated with marketable available-for-sale
equity securities of a certain technology company that was acquired by another
technology company in the first quarter of 2004. The following table includes the details of pre-tax losses related to
investments in equity securities that the Company has recorded during the first
six months of 2004 and 2003. Management believed that the declines in value
were other than temporary. Non-marketable
    
    Marketableequity
    
    equityinvestments
    
    investments(in millions)Pre-tax loss:Three months ended June 30, 2004
    
    $
    0.1
    
    
    $
    Six months ended June 30, 2004
    
    
    1.0
    
    
    
    Pre-tax loss:Three months ended June 30, 2003
    
    $
    3.0
    
    
    
    Six months ended June 30, 2003
    
    
    7.4
    
    
    
    2.7Total carrying value of impaired investments as
of June 30, 2004
    
    $
    4.0
    
    
    Sold during 2004
 11




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##### Table of Contents



NOTE 7  DERIVATIVE FINANCIAL INSTRUMENTS Foreign currency risk The Company enters into forward contracts that are designated as foreign
currency cash-flow hedges of forecasted payments in Euros. Changes in the fair
value of the forward contracts due to changes in time value are excluded from
the assessment of effectiveness and are recognized in interest income and
other, net. As of June 30, 2004 and December 31, 2003, the Company held
forward contracts designated as foreign currency cash flow hedges of forecasted
Euro payment transactions that were set to expire over six-month and
twelve-month periods, respectively. For the three months and six months ended
June 30, 2004 and 2003, the change in time value of these forward contracts was
not significant. As of June 30, 2004, unrealized losses included in
accumulated other comprehensive income, which will be recorded in the income
statement over the next six months, were not significant. There were no
unrealized gains or losses included in accumulated other comprehensive income
as of December 31, 2003. The expense for the three months and six months ended
June 30, 2004 and the benefit for three months and six months ended June 30,
2003 recorded in the income statement was not significant. The Company did not
record any gains or losses due to hedge ineffectiveness for the three months
and six months ended June 30, 2004 and 2003. Forward exchange contracts and options are also used to hedge certain
foreign currency-denominated assets or liabilities. These derivatives do not
qualify for SFAS No. 133 hedge accounting treatment. Accordingly, changes in
the fair value of these hedges are recorded immediately in earnings to offset
the changes in fair value of the assets or liabilities being hedged. The
related gains and losses included in interest income and other, net were not
significant. Interest rate risk With the objective of protecting cash flows and earnings of the Company
from the impact of fluctuations in interest rates, while minimizing the cost of
capital, the Company may enter into or terminate interest rate swaps, such as
the below mentioned transactions. In the second quarter of 2003, the Company entered into an interest rate
swap transaction to effectively convert the LIBOR-based floating rate interest
payments on the equipment operating leases discussed in Note 14 of the Notes,
with an initial notional amount of $395 million, to a fixed interest rate (the
Lease Swap). The Lease Swap qualifies to be accounted for as a cash flow
hedge of the forecasted interest payments attributable to the benchmark
interest rate on the equipment operating leases through September 2006. The
unrealized gains or losses included in accumulated other comprehensive income
will be recorded in cost of revenues on a quarterly basis as lease payments are
made. An unrealized gain as of June 30, 2004, which is expected to be recorded
in cost of revenues within the next 12 months, was not significant. An
unrealized loss of approximately $1 million, net of tax of $1 million was
included in accumulated other comprehensive income as of December 31, 2003, and
is expected to be recorded in cost of revenues within the next 12 months. The
gain due to ineffectiveness recorded in interest income and other, net during
the three months and six months ended June 30, 2004 was not significant. The
loss due to ineffectiveness recorded in interest income and other, net during
the three months ended June 30, 2003 was not significant. Under the terms of
the Lease Swap, the Company must provide collateral to match any mark-to-market
exposure on the swap. As of June 30, 2004 and December 31, 2003, collateral of
approximately $8 million was included in other long-term assets. 12




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##### Table of Contents



NOTE 8  BALANCE SHEET DETAIL June 30,
    
    December 31,2004
    
    2003(In thousands)Cash and cash equivalents:Cash in financial institutions
    
    $
    55,073
    
    
    $
    108,989Cash equivalents
    
    
    143,330
    
    
    
    160,693$
    198,403
    
    
    $
    269,682Inventories:Raw materials
    
    $
    17,703
    
    
    $
    15,352Work-in-process
    
    
    138,873
    
    
    
    116,340Finished goods
    
    
    53,365
    
    
    
    66,825$
    209,941
    
    
    $
    198,517Intangible assets, net of accumulated amortization:Semiconductor segment
    
    $
    134,453
    
    
    $
    137,230Storage Systems segment
    
    
    17,671
    
    
    
    24,006$
    152,124
    
    
    $
    161,236
 The changes in the carrying amount of goodwill for the six months ended
June 30, 2004 are as follows (in thousands): Semiconductor
    
    Storage Systemssegment
    
    segment
    
    TotalBalance as of January 1, 2004
    
    $
    887,992
    
    
    $
    80,491
    
    
    $
    968,483Goodwill acquired during the year
    
    
    8,045
    
    
    
    
    
    
    
    8,045Adjustment to goodwill acquired in a
prior year for the resolution of a
pre-acquisition income tax
contingency
    
    
    (4,463
    )
    
    
    
    
    
    
    (4,463
    )Adjustment to goodwill acquired in
prior periods
    
    
    
    
    
    
    142
    
    
    
    142Purchase of minority interest
    
    
    807
    
    
    
    
    
    
    
    807Balance as of June 30, 2004
    
    $
    892,381
    
    
    $
    80,633
    
    
    $
    973,014
 The Company monitors the recoverability of goodwill recorded in connection
with acquisitions annually, or sooner if events or changes in circumstances
indicate that the carrying amount may not be recoverable. An impairment, if
any, would be determined in accordance with SFAS No. 142, which uses a fair
value model for determining the carrying value of goodwill. See the Companys
Annual Report on Form 10-K for further discussion. 13




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##### Table of Contents



NOTE 9  DEBT June 30,
    
    December 31,Interest
    
    ConversionMaturity
    
    Rate *
    
    Price
    
    2004
    
    2003(In thousands)2003 Convertible Subordinated
Notes
    
    
    2010
    
    
    
    4.00
    %
    
    $
    13.4200
    
    
    $
    350,000
    
    
    $
    350,0002001 Convertible Subordinated
Notes
    
    
    2006
    
    
    
    4.00
    %
    
    $
    26.3390
    
    
    
    490,000
    
    
    
    490,000Deferred gain on terminated swap
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,232
    
    
    
    25,416Capital lease obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    351
    
    
    
    567858,583
    
    
    
    865,983Current portion of long-term debt
and capital lease obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (351
    )
    
    
    (377
    )Long-term debt and capital
lease obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    858,232
    
    
    $
    865,606
 * The interest rate on a portion of the Convertible Subordinated Notes
(Convertible Notes) was converted to floating rates through interest rate
swaps. Interest rate swaps with a notional amount of $740 million were
terminated in the second quarter of 2003. The weighted average interest rate
on the Convertible Subordinated Notes, after adjusting for the impact of the
interest rate swaps, for the three months ended June 30, 2004 and 2003, was
4.00% and 2.94%, respectively and 4.00% and 2.54% for the six months ended June
30, 2004 and 2003, respectively. NOTE 10  COMMON STOCK Stock purchase plans.In May 2004, the stockholders approved an increase
in the number of shares of common stock reserved for issuance under the
Companys Employee Stock Purchase Plan by 10 million shares. As of June 30,
2004 there were approximately 19 million shares of common stock reserved for
issuance under the Employee Stock Purchase Plan. NOTE 11  RECONCILIATION OF BASIC AND DILUTED INCOME/(LOSS) PER SHARE A reconciliation of the numerators and denominators of the basic and
diluted income/(loss) per share computations is as follows: Three Months Ended June 30,2004
    
    2003Per-Share
    
    
    
    
    
    
    
    
    
    Per-ShareIncome*
    
    Shares+
    
    Amount
    
    Loss*
    
    Shares+
    
    Amount(In thousands except per share amounts)Basic EPS:Net income/(loss) available to common stockholders
    
    $
    7,242
    
    
    
    383,522
    
    
    $
    0.02
    
    
    $
    (162,084
    )
    
    
    376,619
    
    
    $
    (0.43
    )Stock options and restricted stock awards
    
    
    
    
    
    
    5,064
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Diluted EPS:Net income/(loss) available to common stockholders
    
    $
    7,242
    
    
    
    388,586
    
    
    $
    0.02
    
    
    $
    (162,084
    )
    
    
    376,619
    
    
    $
    (0.43
    )
 Six Months Ended June 30,2004
    
    2003Per-Share
    
    
    
    
    
    
    
    
    
    Per-ShareIncome*
    
    Shares+
    
    Amount
    
    Loss*
    
    Shares+
    
    Amount(In thousands except per share amounts)Basic EPS:Net income/(loss) available to common stockholders
    
    $
    16,327
    
    
    
    382,571
    
    
    $
    0.04
    
    
    $
    (284,509
    )
    
    
    375,745
    
    
    $
    (0.76
    )Stock options and restricted stock awards
    
    
    
    
    
    
    6,531
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Diluted EPS:Net income/(loss) available to common stockholders
    
    $
    16,327
    
    
    
    389,102
    
    
    $
    0.04
    
    
    $
    (284,509
    )
    
    
    375,745
    
    
    $
    (0.76
    )
 * Numerator + Denominator 14




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##### Table of Contents



Weighted average options to purchase 53,566,120 and 50,709,797 shares were
outstanding during the three and six months ended June 30, 2004, respectively,
but were not included in the computation of diluted shares because the exercise
prices of these options were greater than the average market price of common
shares for the above period. The exercise price of these options ranged from
$8.24 to $72.25 and from $9.12 to $72.25 as of June 30, 2004, respectively.
Weighted average options to purchase 54,111,587 and 55,140,797 shares were
outstanding during the three and six months ended June 30, 2003, respectively,
but were not included in the computation of diluted shares because the exercise
prices of these options were greater than the average market price of common
shares for the above period. The exercise price of these options ranged from
$5.86 to $72.25 and from $5.38 to $72.25 as of June 30, 2004, respectively. For the three months and six months ended June 30, 2004, weighted average
potentially dilutive shares of 44,684,052 shares associated with the 2003 and
2001 Convertible Notes were excluded from the calculation of diluted shares
because of their antidilutive effect on net income per share. For the three and
six months ended June 30, 2003, weighted average potentially dilutive shares of
54,720,989 and 49,819,986, respectively, associated with the 2003, 2001, 2000
and 1999 Convertible Notes were excluded from the calculation of diluted shares
because of their antidilutive effect on loss per share. NOTE 12  COMPREHENSIVE INCOME/(LOSS) Comprehensive income/(loss) is defined as a change in equity of a company
during a period from transactions and other events and circumstances, excluding
transactions resulting from investments by owners and distributions to owners.
Comprehensive income/(loss), net of taxes for the current reporting period and
comparable period in the prior year is as follows: Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003(In thousands)Net income/(loss)
    
    $
    7,242
    
    
    $
    (162,084
    )
    
    $
    16,327
    
    
    $
    (284,509
    )Change in unrealized gain/loss on derivative
instruments designated as and qualifying
as cash-flow hedges
    
    
    2,373
    
    
    
    (16
    )
    
    
    1,470
    
    
    
    464Change in unrealized gain/loss on
available-for-sale securities
    
    
    (10,716
    )
    
    
    1,454
    
    
    
    (11,412
    )
    
    
    1,711Change in foreign currency translation adjustments
    
    
    (9,653
    )
    
    
    6,178
    
    
    
    (4,480
    )
    
    
    8,422Comprehensive income/(loss)
    
    $
    (10,754
    )
    
    $
    (154,468
    )
    
    $
    1,905
    
    
    $
    (273,912
    )
 NOTE 13  SEGMENT REPORTING The Company operates in two reportable segments: the Semiconductor segment
and the Storage Systems segment. The Storage Systems segment may also be
referred to as Engenio. In the Semiconductor segment, the Company uses advanced
process technology and comprehensive design methodologies to design, develop,
manufacture and market highly complex integrated circuits. These
system-on-a-chip solutions include application specific integrated circuits,
commonly referred to as ASICs, RapidChip Platform ASICs and application
specific standard products in silicon, or ASSPs. Semiconductor segment product
offerings also include RAID host bus adapters and related products, and
services. In the Storage Systems segment, the Company provides modular,
high-performance, disk storage systems and sub-assemblies to server and storage
original equipment manufacturers. The products of the Storage Systems segment
are sold as complete storage systems or sub-assemblies configured from modular
components, including storage controller modules, disk drive enclosure modules
and related management software. 15




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##### Table of Contents



The following is a summary of operations by segment for the three months
and six months ended June 30, 2004 and 2003: Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003(In thousands)Revenues:Semiconductor
    
    $
    335,626
    
    
    $
    306,150
    
    
    $
    672,524
    
    
    $
    579,214Storage Systems
    
    
    112,271
    
    
    
    101,063
    
    
    
    227,730
    
    
    
    200,784Total
    
    $
    447,897
    
    
    $
    407,213
    
    
    $
    900,254
    
    
    $
    779,998Income/(loss) from operations:Semiconductor
    
    $
    3,992
    
    
    $
    (160,532
    )
    
    $
    5,166
    
    
    $
    (268,426
    )Storage Systems
    
    
    6,539
    
    
    
    8,402
    
    
    
    17,196
    
    
    
    1,923Total
    
    $
    10,531
    
    
    $
    (152,130
    )
    
    $
    22,362
    
    
    $
    (266,503
    )
 Intersegment revenues for the periods presented above were not
significant. For the three and six months ended June 30, 2004, restructuring of
operations and other items, net of $3 million and $2.4 million, respectively
were primarily included in the Semiconductor segment. For the three months
ended June 30, 2003, restructuring of operations and other items, net of $125
million primarily impacted the Semiconductor segment. For the six months ended
June 30, 2003, restructuring of operations and other items, net of $145 million
and $15 million were included in the Semiconductor segment and the Storage
Systems segment, respectively. Significant
Customers.The following table summarizes the number of the
Companys
significant customers, each of whom accounted for 10% or more of the
Companys revenues,
along with the percentage of revenues they individually represent on a
consolidated basis and by segment: Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003Semiconductor segment:Number of significant customers
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    2Percentage of segment revenues
    
    
    
    
    
    
    14%, 11
    %
    
    
    
    
    
    
    13%, 10
    %Storage Systems segment:Number of significant customers
    
    
    2
    
    
    
    3
    
    
    
    3
    
    
    
    3Percentage of segment revenues
    
    
    55%, 14
    %
    
    
    50%, 13%, 11
    %
    
    
    53%, 14%, 11
    %
    
    
    45%, 14%, 12
    %Consolidated:Number of significant customers
    
    
    1
    
    
    
    2
    
    
    
    1
    
    
    
    1Percentage of consolidated
revenues
    
    
    16
    %
    
    
    14%, 11
    %
    
    
    15
    %
    
    
    14
    %
 The following is a summary of total assets by segment as of June 30, 2004
and December 31, 2003: June 30,
    
    December 31,2004
    
    2003(In thousands)Total assets:Semiconductor
    
    $
    3,068,814
    
    
    $
    3,115,610Storage Systems
    
    
    387,901
    
    
    
    332,291Total
    
    $
    3,456,715
    
    
    $
    3,447,901
 Revenues from domestic operations were $243 million, representing 54% of
consolidated revenues for the second quarter of 2004 compared to $217 million,
representing 53% of consolidated revenues for the same period of 2003. 16




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##### Table of Contents



Revenues from domestic operations were $488 million, representing 54% of
consolidated revenues, for the first six months of 2004 compared to $424
million, representing 54% of consolidated revenues, for the same period of
2003. NOTE 14  COMMITMENTS AND CONTINGENCIES On March 28, 2003, the Company entered into two lease and security
agreements, each with Bank of America, National Association (BANA), acting as
the Lessor, and Wells Fargo Bank Northwest, as the Agent, for a total of $395
million for certain wafer fabrication equipment (the Equipment). The leases
qualify for operating lease accounting treatment. As of March 31, 2004, the
amount under both leases was fully drawn. Each lease has a term of 3.5 years
with no option for renewal. The Company may, at the end of the lease term,
return or purchase, at a pre-determined amount, all of the Equipment. The
first lease was for $235 million and was for equipment that was previously on
lease immediately prior to closing this transaction. In October 2003, BANA,
with the Companys approval, assigned its rights as Lessor on the first lease
to Bank of the West. The second lease was for $160 million and was for
Equipment that was sold to BANA and then immediately leased back in a
transaction commonly referred to as a sale-leaseback. The Equipment sold had a
book value of approximately $103 million. The resulting $57 million gain on
the sale of the Equipment will be deferred until the end of the lease term and
has been recorded as a non-current liability as of June 30, 2004. The Company
has $328 million in cash that is posted as collateral for the leases as of June
30, 2004. The lessor has access to the Companys cash collateral only in the
event of a default. Of this cash collateral, $51 million, representing the
amount of cash collateral to be released in the next 12 months, is reflected in
other current assets and the remaining cash collateral of $277 million is
recorded in other non-current assets. In addition, the Company is required to
maintain unrestricted cash and short-term investments reserves in an amount no
less than $350 million. The Company was in compliance with this requirement as
of June 30, 2004. The Company guarantees residual values related to leased equipment. As of
June 30, 2004, its maximum potential exposure to residual value guarantees was
approximately $163 million and the Company does not expect to have a loss on
such guarantees. The fair value of the guarantee of the residual value of the
equipment was determined using management estimates and was recorded as a
non-current asset and liability each in the amount of $7 million as of June 30,
2004. In connection with the equipment operating leases described above, the
Company entered into standby letters of credit for $63 million to expire at the
end of the lease term. These instruments are off-balance sheet commitments to
extend financial guarantees. The fair value of the letters of credit
approximates the contract amount. No officer or employee of the Company has any financial interest in these
leasing arrangements. The minimum lease payments, excluding the residual value
guarantees, under the two lease agreements are $32 million, $62 million and $45
million in 2004, 2005 and 2006, respectively. The Company leases the majority of its facilities under non-cancelable
operating leases, which expire through 2014. The facility lease agreements
typically provide for base rental rates that are increased at various times
during the terms of the lease and for renewal options at the fair market rental
value. During the first six months of 2004, the Company renegotiated the
existing lease agreements for six buildings located in California. The future
minimum payments for these renegotiated building leases will be $2 million, $3
million, $4 million, $5 million, $5 million and $21 million for the years
ending December 31, 2004, 2005, 2006, 2007, 2008 and thereafter, respectively. The Company is a party to a variety of agreements pursuant to which it may
be obligated to indemnify the other party with respect to certain matters.
Typically, these obligations arise in connection with contracts and license
agreements or the sale of assets, under which the Company customarily agrees to
hold the other party harmless against losses arising from a breach of
warranties, representations and covenants related to such matters as title to
assets sold, validity of certain intellectual property rights, non-infringement
of third-party rights, and certain income tax related matters. In each of
these circumstances, payment by the Company is typically subject to the other
party making a claim to and cooperating with the Company pursuant to the
procedures specified in the particular contract. This usually allows the
Company to challenge the other partys claims or, in case of breach of
intellectual property representations or covenants, to control the defense or
settlement of any third-party claims brought against the other party. Further,
the Companys obligations under these agreements may be limited in terms of
activity (typically to replace or correct the products or terminate agreement
with a refund to the other party), duration and/or amounts. In some instances,
the Company may have recourse against third parties and/or insurance covering
certain payments made by the Company. 17




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##### Table of Contents



NOTE 15  LEGAL MATTERS In February 1999, a lawsuit alleging patent infringement was filed in the
United States District Court for the District of Arizona by the Lemelson
Medical, Education & Research Foundation, Limited Partnership (Lemelson)
against 88 electronics industry companies, including us. The case number is
CIV990377PHXRGS. The patents involved in this lawsuit are alleged to relate to
semiconductor manufacturing and computer imaging, including the use of bar
coding for automatic identification of articles. The plaintiff has sought a
judgment of infringement, an injunction, treble damages, attorneys fees and
further relief as the court may provide. In September 1999, the Company filed
an answer denying infringement and raising affirmative defenses. In addition,
the Company asserted a counterclaim for declaratory judgment of
non-infringement, invalidity and unenforceability of Lemelsons patents. As of
June 30, 2004, a claim construction hearing has been set to be held in November
of 2004, but no trial date has been set. While the Company cannot make any
assurance regarding the eventual resolution of this matter, the Company does
not believe it will have a material adverse effect on the consolidated results
of operations or financial condition. On June 14, 2002, Plasma Physics Corporation (Plasma Physics) filed suit
against the Company in the United States District Court for the Eastern
District of New York, alleging that the Company is willfully and deliberately
infringing two U.S. patents. LSI was served with the lawsuit in December of
2002. The case is number CV 02-3462 (LDW) (WDW). The two Plasma Physics
patents at issue are numbered 5,470,784 and 6,245,648. No specific Company
products were identified in the complaint. The plaintiff has sought a judgment
of infringement, an injunction, treble damages, attorneys fees and further
relief as the court may provide. Similar lawsuits were also filed at the same
time against several other corporations. In January of 2003, the Company
answered the complaint denying infringement and asserting affirmative defenses.
In addition, the Company asserted counterclaims seeking declaratory judgments
of patent non-infringement, patent invalidity, and that the patents are
unenforceable. In June of 2004, the parties agreed to submit to the Court a
Voluntary Notice of Dismissal with Prejudice. Although the terms of the
agreement are confidential, the agreement did not have a material adverse
effect on the consolidated results of operations or financial condition. The Company is a party to other litigation matters and claims that are
normal in the course of its operations, and while the results of such
litigation and claims cannot be predicted with certainty, the Company believes
that the final outcome of such matters is not expected to have a material
adverse effect on the Companys consolidated results of operations and
financial condition. NOTE 16  SUBSEQUENT EVENTS Restructuring of operations: In July of 2004, the Company continued to consolidate non-manufacturing
facilities and recorded $4.7 million for costs associated with exiting certain
operating leases for real estate as the facilities ceased being used. In
addition, the Company recorded severance and termination benefits of $0.5
million for 38 employees involved in manufacturing operations and research and
development activities. Commitments and Contingencies: On August 6, 2004, the Company entered into two lease and security
agreements, each with Wells Fargo Bank Northwest, acting as the Agent. One
lease for $134 million is with Bank of the West acting as the Lessor, and the
second lease for $201 million is with
BTM Capital Corporation acting as the Lessor. The leases are for wafer
fabrication equipment (the Equipment) that was previously on lease
immediately prior to closing this transaction. See Note 14 for a discussion of
these former leases entered into on March 28, 2003. The new leases qualify for
operating lease accounting treatment. Each lease has a term of 3 years. The
Company may, at the end of the lease term, return or purchase, at a
pre-determined amount, all of the Equipment. The Company has $313 million in
cash that is posted as collateral for the leases as of August 6, 2004. The
Company is required to maintain unrestricted cash and short-term investments
reserves in an amount no less than the higher of a) the sum of $100 million
plus the principal amount of the Companys 2001 Convertible Subordinated Notes due in
2006 or b) $350 million. The Company was in compliance with this requirement
as of August 6, 2004. The Company guarantees residual values related to the leased equipment.
As of August 6, 2004, its maximum potential exposure to residual value
guarantees was approximately $142 million and the Company does not expect to
have a loss on such guarantees. Separation of LSI Logic Storage Systems. Inc. or Engenio: On July 29, 2004, LSI announced jointly with Engenio the postponement of
the initial public offering of its common stock due to market conditions. 18




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations SAFE HARBOR REGARDING FORWARD-LOOKING STATEMENTS This Form 10-Q contains forward-looking statements. In many cases you can
identify forward-looking statements by terminology such as may, will,
should, expect, plan, anticipate, believe, estimate, predict,
potential, intend or continue, or the negative of such terms and other
comparable terminology. In addition, forward-looking statements in this
document include, but are not limited to, those regarding: our expectation
that revenues will be in the $435 million to $465 million range for the third
quarter of 2004; our expectation that our consolidated
gross profit margin will be in the range of 44% to 46% in the third quarter of
2004; our expectation that products utilizing RapidChip technology will have
performance comparable to cell-based ASICs at a cost significantly lower than
Field Programmable Gate Arrays; our expectation that we will sell a parcel of
land in Colorado within the next 12 months; our expectation that capital
expenditures will be approximately $100 million in 2004; our belief that our
existing liquid resources and funds generated from operations, combined with
funds from such financing and our ability to borrow funds, will be adequate to
meet our operating and capital requirements and obligations for the foreseeable
future; our belief that if our convertible notes do not convert to equity, that
our current cash position and expected future operating cash flows will be
adequate to meet these obligations as they mature; and the impact regarding the
adoption of new accounting standards on our consolidated balance sheet or
statement of operations. We assume no obligation to update any such
forward-looking statements, and these statements involve risks and
uncertainties that could cause actual results to differ materially from those
in the forward-looking statements. For a summary of such risks and
uncertainties, please see the paragraphs located at the end of this Item 2
entitled Factors that May Affect Future Operating Results and please also see
the risk factors located in the Form 10-K for our fiscal year ended December
31, 2003. OVERVIEW Revenues for the second quarter ended June 30, 2004 were $448 million
representing a 10% increase over the second quarter of 2003 and a 1% decrease
from the first quarter of 2004. Cash, cash equivalents and short-term
investments totaled $847 million as of June 30, 2004. We generated positive
operating cash flows for the ninth consecutive quarter. Late in the second
quarter of 2004, we experienced some slowing of the overall business that will
carry over into the third quarter of 2004. Accordingly, we expect revenues to
be in the $435 million to $465 million range for the third quarter of 2004. Design wins and product shipments for RapidChip platform products
continued to increase in the second quarter of 2004, and we expect steady
growth in this area leading to higher volumes in 2005. Separation of our Storage Systems business.On November 13, 2003, we
announced our intention to separate our storage systems operations  Engenio
Information Technologies, Inc. (Engenio or Storage Systems segment) and
create an independent storage systems company. Engenio was formerly referred
to as LSI Logic Storage Systems, Inc. We have entered into agreements to
implement this separation and to address various arrangements between Engenio
and us. A more comprehensive discussion of the separation agreements is set
forth in Note 2 of the Notes. On February 19, 2004, Engenio filed a
Registration Statement on Form S-1, (the Registration Statement) with the
Securities and Exchange Commission (SEC). On July 27, 2004, Engenio filed
Amendment No. 8 to the Registration Statement. On July 29, 2004, we announced
jointly with Engenio the postponement of the initial public offering of its
common stock due to market conditions. Significant acquisitions.We are continually exploring strategic
acquisitions that build upon our existing library of intellectual property,
human capital and engineering talent, and increase our leadership position in
the markets in which we operate. We acquired Velio Communications, Inc.
(Velio) during the first quarter of 2004 and Accerant Inc. (Accerant)
during the second quarter of 2004. Both were accounted for as purchases of
businesses and, accordingly, the estimated fair value of assets acquired and
liabilities assumed and the results of operations were included in our
Consolidated Financial Statements as of the effective date of the acquisitions.
The transactions are summarized in the table below. There were no significant
differences between our accounting policies and those of the companies
acquired. (See Note 3 of the Notes.) 19




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##### Table of Contents



Fair Value ofEntity Name;
    
    
    
    
    
    
    
    
    
    
    
    
    
    Tangible NetSegment Included in;
    
    
    
    
    
    Total
    
    
    
    
    
    Assets/
    
    
    
    
    
    
    
    
    
    
    
    
    
    DeferredDescription of Acquired
    
    
    
    
    
    Purchase
    
    Type of
    
    (Liabilities)
    
    
    
    
    
    Amortizable
    
    
    
    
    
    StockBusiness
    
    Acquisition Date
    
    Price
    
    Consideration
    
    Acquired
    
    Goodwill
    
    Intangible Assets
    
    IPR&D
    
    Compensation(in millions)Accerant Inc.;Semiconductor segment;
    
    
    
    
    
    
    
    
    
    $14.1 cash; and 0.2Consumer product
    
    May 11, 2004
    
    $
    15.9
    
    
    million restricted
    
    
    
    
    
    $
    8.0
    
    
    $
    6.1
    
    
    
    
    
    
    $
    1.8applications
    
    
    
    
    
    
    
    
    
    common sharesVelio Communications, Inc;Semiconductor segment;
    
    
    
    
    
    
    
    
    
    $19.8 cash; andHigh-speed interconnect
    
    
    
    
    
    
    
    
    
    0.1 millionand switch fabric
    
    
    
    
    
    
    
    
    
    restricted commonapplication specific
    
    April 2, 2004
    
    $
    20.8
    
    
    shares
    
    $
    1.5
    
    
    
    
    
    
    $
    18.3
    
    
    
    
    
    
    $
    1.0standard products
 Where more than one significant factor contributed to changes in results
from year to year, we have quantified such factors throughout the Managements
Discussion & Analysis, where practicable. RESULTS OF OPERATIONS Revenues: Three months ended
    
    Six months endedJune 30, 2004
    
    March 31, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003(in millions)Semiconductor segment
    
    $
    335.6
    
    
    $
    336.9
    
    
    $
    306.2
    
    
    $
    672.5
    
    
    $
    579.2Storage Systems segment
    
    
    112.3
    
    
    
    115.5
    
    
    
    101.0
    
    
    
    227.8
    
    
    
    200.8Consolidated
    
    $
    447.9
    
    
    $
    452.4
    
    
    $
    407.2
    
    
    $
    900.3
    
    
    $
    780.0
 There were no significant intersegment revenues during the periods presented. Second quarter of 2004 compared to the first quarter of 2004 Total consolidated revenues for the second quarter of 2004 decreased $4.5
million or 1% from the first quarter of 2004. Revenues for the Semiconductor segment decreased slightly by $1.3 million
in the second quarter of 2004 as compared to the first quarter of 2004. The
decrease in the Semiconductor segment was primarily attributable to a decrease
in demand for semiconductors used in storage component applications, such as
storage ASICs products, partially offset by an increase in demand for
semiconductors used in consumer product applications, such as DVD-recordable. Revenues for the Storage Systems segment decreased $3.2 million or 3% from
the first quarter of 2004. The decrease is primarily attributable to a $7.0
million decline in revenues from the Teradata division of NCR. This decline
was due to the timing of two large customer shipments for our controllers and
disk enclosure related products in the first quarter of 2004 and led to strong
sales to the Teradata division of NCR in that quarter. The decline was
partially offset by a $2.2 million increase in revenues from IBM and a net
increase of $1.6 million in revenues from our other customers. 20




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##### Table of Contents



Three and six months ended June 30, 2004 compared to the same periods of
2003 Total consolidated revenues for the second quarter of 2004 increased $40.7
million or 10% as compared to the second quarter of 2003. For the six months
ended June 30, 2004, revenues increased $120.3 million or 15% as compared to
the same period of the prior year. Revenues for the Semiconductor segment increased $29.4 million or 10% for
the second quarter of 2004 and increased $93.3 million or 16% for the first six
months of 2004 as compared to the same periods of the previous year. The
increase in revenues in the Semiconductor segment in the second quarter and
first six months of 2004 as compared to the same periods of 2003 is
attributable to an increased demand for semiconductors used in storage
component applications, communications ASIC applications such as routers and
switches and certain consumer product applications, such as DVD-recordable.
These increases were partially offset by lower demand for semiconductors used
in other consumer product applications such as video games platforms. Revenues for the Storage Systems segment increased $11.3 million or 11%
for the second quarter of 2004 and increased $27.0 million or 13% for the first
six months of 2004 as compared to the same periods of 2003. The increase in
revenues in the Storage Systems segment for the second quarter and first six
months of 2004 as compared to the same periods of 2003, is primarily due to a
significant increase in demand from IBM, StorageTek and SGI for new controller
products that were introduced in late April 2003 and increased demand for our
other controller and disk enclosure related products. Although revenues from
the Teradata division of NCR declined to less than 10% of Storage Systems
revenues in the second quarter of 2004, this decline was primarily the result
of the timing of two large customer shipments for our high-end controllers and
disk enclosure related products, which occurred in the first quarter of 2004
and led to strong sales to the Teradata division of NCR in that quarter.
Revenues from this customer represented 11% of Storage Systems revenues in the
six months ended June 30, 2004. As a percentage of total Storage Systems
revenues, revenues from IBM increased from 50% in the second quarter of 2003 to
55% in the second quarter of 2004 and from 45% to 53% during the six months
ended June 30, 2003 and 2004, respectively. Significant Customers.The following table summarizes the number of our
significant customers, each of whom accounted for 10% or more of our revenues,
along with the percentage of revenues they individually represent on a
consolidated basis and by segment: Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003Semiconductor segment:Number of significant customers
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    2Percentage of segment revenues
    
    
    
    
    
    
    14%, 11
    %
    
    
    
    
    
    
    13%, 10
    %Storage Systems segment:Number of significant customers
    
    
    2
    
    
    
    3
    
    
    
    3
    
    
    
    3Percentage of segment revenues
    
    
    55%, 14
    %
    
    
    50%, 13%, 11
    %
    
    
    53%, 14%, 11
    %
    
    
    45%, 14%, 12
    %Consolidated:Number of significant customers
    
    
    1
    
    
    
    2
    
    
    
    1
    
    
    
    1Percentage of consolidated
revenues
    
    
    16
    %
    
    
    14%, 11
    %
    
    
    15
    %
    
    
    14
    %
 Revenues by geography.The following table summarizes our revenues by
geography: Three months ended
    
    Six months endedJune 30, 2004
    
    March 31, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003(in millions)Revenues:North America
    
    $
    243.3
    
    
    $
    244.8
    
    
    $
    216.7
    
    
    $
    488.1
    
    
    $
    423.6Asia, including Japan
    
    
    164.9
    
    
    
    164.7
    
    
    
    154.6
    
    
    
    329.6
    
    
    
    279.6Europe
    
    
    39.7
    
    
    
    42.9
    
    
    
    35.9
    
    
    
    82.6
    
    
    
    76.8Total
    
    $
    447.9
    
    
    $
    452.4
    
    
    $
    407.2
    
    
    $
    900.3
    
    
    $
    780.0
 21




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##### Table of Contents



Second quarter of 2004 compared to the first quarter of 2004 In the second quarter of 2004, revenues remained relatively flat in North
America and Asia, including Japan, as compared to the first quarter of 2004.
Revenues decreased in Europe in the second quarter of 2004 as compared to the
first quarter of 2004 due mainly to a decline in demand for semiconductors used
in communication ASIC applications, such as routers and switches. Three and six months ended June 30, 2004 compared to the same periods of
2003 Revenues in North America and Asia, including Japan and Europe increased
in the second quarter of 2004 as compared to the second quarter of 2003. The
growth in North America is mainly due to an increase in demand for
semiconductors used in communication ASIC applications, such as routers and
switches, and modular storage products associated with Engenio. The increase
in revenues from Asia is primarily due to increased demand for semiconductors
used in consumer and storage standard product applications, such as
DVD-recordable and disk drive solutions. The majority of the increase from
Europe was attributable to an increase in demand for semiconductors used in
storage and communication ASIC applications, such as routers, switches and disk
drive solutions. In the first six months of 2004, revenues increased in all geographic
regions as compared to the same period in 2003. Demand for semiconductors used
in consumer products, such as DVD-recorders, increased, although demand
decreased for semiconductors used in video games platforms. Operating costs and expenses.Key elements of the consolidated statements of
operations for the respective segments are as follows: Gross profit margin: Three months ended
    
    Six months endedJune 30, 2004
    
    March 31, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003(in millions)Semiconductor segment
    
    $
    166.5
    
    
    $
    156.2
    
    
    $
    130.2
    
    
    $
    322.7
    
    
    $
    218.8Percentage of revenues
    
    
    50
    %
    
    
    46
    %
    
    
    43
    %
    
    
    48
    %
    
    
    38
    %Storage Systems segment
    
    $
    42.3
    
    
    $
    45.2
    
    
    $
    38.5
    
    
    $
    87.5
    
    
    $
    74.7Percentage of revenues
    
    
    38
    %
    
    
    39
    %
    
    
    38
    %
    
    
    38
    %
    
    
    37
    %Consolidated
    
    $
    208.8
    
    
    $
    201.4
    
    
    $
    168.7
    
    
    $
    410.2
    
    
    $
    293.5Percentage of revenues
    
    
    47
    %
    
    
    45
    %
    
    
    41
    %
    
    
    46
    %
    
    
    38
    %
 Second quarter of 2004 compared to the first quarter of 2004 The consolidated gross profit margin as a percentage of revenues increased
to 47% in the second quarter of 2004 from 45% in the first quarter of 2004. The gross profit margin as a percentage of revenues for the Semiconductor
segment increased to 50% in the second quarter of 2004 from 46% in the first
quarter of 2004. The improvement in gross profit margin for the semiconductor
segment was primarily attributable to the following factors:  
    
    A favorable shift in product mix to selling products with relatively
higher margins;  
    
    Improved efficiencies and higher utilization in the Gresham
manufacturing facility; and  
    
    Lower compensation-related costs. The favorable impacts on gross profit margin in the Semiconductor segment
were partially offset by the following factors:  
    
    Slightly lower sales of previously reserved inventory in the second quarter
of 2004, as compared to the first quarter of 2004; and 22




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##### Table of Contents




    
    Slightly higher inventory charges for excess and obsolescence in the second
quarter of 2004 as compared to the first quarter of 2004. The gross profit margin as a percentage of revenues for the Storage
Systems segment decreased to 38% in the second quarter of 2004 from 39% in the
first quarter of 2004. The decrease is mainly a result of an unfavorable change
in the mix of products sold and higher charges for warranties. We expect our consolidated gross profit margin to be in the range of 44%
to 46% in the third quarter of 2004. Three and six months ended June 30, 2004 compared to the same periods of
2003 The consolidated gross profit margin as a percentage of revenues increased
to 47% in the second quarter of 2004 from 41% in the second quarter of 2003.
The consolidated gross profit margin as a percentage of revenues increased to
46% in the first six months of 2004 as compared to 38% in the same period of
2003. The gross profit margin as a percentage of revenues for the Semiconductor
segment increased to 50% in the second quarter of 2004 from 43% in the second
quarter of 2003. The gross profit margin as a percentage of revenues for the
Semiconductor segment increased to 48% in the first six months of 2004 as
compared to 38% in the same period of 2003. The improvement in gross profit
margin for the Semiconductor segment was primarily attributable to the
following factors:  
    
    Higher revenues and a favorable shift in product mix to selling products
with higher margins in the second quarter and first six months of 2004 as
compared to the same periods of 2003;  
    
    Lower manufacturing variances in the Gresham manufacturing facility
associated with yield improvements, improved operating efficiencies and
better utilization;  
    
    A reduction in cost of revenues as a result of the sale of our Japanese
manufacturing facility in the fourth quarter of 2003;  
    
    Lower compensation-related costs; and  
    
    Lower inventory charges for non-marketable inventory for the six month
period ended June 30, 2004 compared to the same period of 2003. The favorable impacts on gross margin in the Semiconductor segment were
partially offset by a one percentage point decrease in gross margin due to
lower sales of previously reserved inventory in the second quarter and first
six months of 2004 as compared to the same periods of 2003. The gross profit margin as a percentage of revenues for the Storage
Systems segment remained flat at 38% in the second quarter of 2004 as compared
with the second quarter of 2003. The gross profit margin as a percentage of
revenues for the Storage Systems segment increased to 38% in the first six
months of 2004 from 37% in the first six months of 2003. The improvement in
gross profit margin as a percentage of Storage Systems segment revenues is
primarily a result of a reduction in the amortization of capitalized software
due to the restructuring actions taken during the first quarter of 2003, lower
charges for excess and obsolete inventory, a favorable mix of products sold,
and lower freight charges. The improvements noted above were offset in part by
higher compensation costs due to increased headcount, and higher expenses for
outside services related to production line modifications to meet new customer
requirements. Factors that may affect gross profit margins We have advanced wafer-manufacturing operations in Gresham, Oregon, which
is our primary manufacturing site. We also acquire wafers from foundries in
other locations. Utilizing a diversity of manufacturing locations allows us to
better manage potential disruption in the manufacturing process due to economic
and geographic risks associated with each location. Our operating environment, combined with the resources required to operate
in the Semiconductor and Storage Systems industries, requires that we manage a
variety of factors which impact gross margin. These factors include, among
other things:  
    
    Competitive pricing pressures; 23




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##### Table of Contents




    
    Product mix;
    
    Factory capacity and utilization;
    
    Manufacturing yields;
    
    Availability of certain raw materials;
    
    Terms negotiated with third-party subcontractors; and
    
    Foreign currency fluctuations. These and other factors could have a significant effect on our gross
profit margin in future periods. Research and development: Three months ended
    
    Six months endedJune 30, 2004
    
    March 31, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003(in millions)Semiconductor segment
    
    $
    96.1
    
    
    $
    94.8
    
    
    $
    100.4
    
    
    $
    190.9
    
    
    $
    205.6Percentage of revenues
    
    
    29
    %
    
    
    28
    %
    
    
    33
    %
    
    
    28
    %
    
    
    35
    %Storage Systems segment
    
    $
    14.0
    
    
    $
    14.1
    
    
    $
    10.9
    
    
    $
    28.1
    
    
    $
    20.9Percentage of revenues
    
    
    12
    %
    
    
    12
    %
    
    
    11
    %
    
    
    12
    %
    
    
    10
    %Consolidated
    
    $
    110.1
    
    
    $
    108.9
    
    
    $
    111.3
    
    
    $
    219.0
    
    
    $
    226.5Percentage of revenues
    
    
    25
    %
    
    
    24
    %
    
    
    27
    %
    
    
    24
    %
    
    
    29
    %
 Second quarter of 2004 compared to the first quarter of 2004 Research and development (R&D) expenses increased $1.2 million or 1% in
the second quarter of 2004 as compared to the first quarter of 2004 on a
consolidated basis. As a percentage of revenues, consolidated R&D expenses
increased to 25% in the second quarter of 2004 from 24% in the first quarter of
2004. R&D expenses in the Semiconductor segment increased $1.3 million or 1% in
the second quarter of 2004 as compared to the first quarter of 2004. The
increase in R&D expenses for the Semiconductor segment is primarily related to
continued research and development spending associated with the acquisitions in
the first six months of 2004 (see Note 3 of the Notes). R&D expenses for the
Semiconductor segment increased to 29% of revenues in the second quarter of
2004 from 28% in the first quarter of 2004. We continued the build-out of the RapidChip platform infrastructure in the
second quarter of 2004. Products utilizing RapidChip technology combine the
high-density, high-performance and proven intellectual property benefits of
cell-based ASICs with the advantages of lower development costs and faster time
to market. We expect products utilizing RapidChip technology to have
performance comparable to cell-based ASICs at a cost significantly lower than
Field Programmable Gate Arrays (FPGAs). Markets for our RapidChip platform
ASIC solutions will include communications, storage, consumer, industrial and
others. Our customer base for RapidChip technology encompasses a range from
small start-up companies to major system OEMs throughout all of our geographic
markets. We shipped our first RapidChip platform products in the fourth quarter
of 2003. Design wins and product shipments for RapidChip platform products
continued to increase in the second quarter of 2004. R&D expenses in the Storage Systems segment remained relatively flat in
the second quarter of 2004 as compared to the first quarter of 2004. R&D
expenses as a percentage of revenues for the Storage Systems segment remained
unchanged at 12% in the first and second quarters of 2004. 24




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Three and six months ended June 30, 2004 compared to the same periods of
2003 R&D expenses, on a consolidated basis, decreased $1.2 million or 1% during
the second quarter of 2004 as compared to the second quarter of 2003. R&D
expenses for the first six months of 2004 decreased by $7.5 million or 3% as
compared to the first six months of 2003 on a consolidated basis. R&D expenses for the Semiconductor segment decreased $4.3 million or 4% in
the second quarter of 2004 and $14.7 million or 7% for the first six months of
2004 as compared to the same periods of 2003. The decrease in R&D expenses for
the Semiconductor segment is primarily a result of benefits from the
cost-cutting measures implemented as part of the restructuring actions in 2003
(see Note 5 of the Notes), partially offset by increased spending for RapidChip
technology development. R&D expenses as a percentage of revenues for the Semiconductor segment
decreased to 29% in the second quarter of 2004 compared to 33% in the same
quarter of 2003. R&D expenses as a percentage of revenues for the
Semiconductor segment decreased to 28% in the first six months of 2004 as
compared to 35% in the same period of 2003. R&D expenses for the Storage Systems segment increased by $3.1 million or
28% in the second quarter of 2004 and $7.2 million or 34% in the first six
months of 2004 as compared to the same periods of 2003 primarily as a result of
increased compensation costs due to higher headcount and related expenses,
higher expenses for outside service providers related to development programs
and higher depreciation related to new assets purchased for product
development. R&D expenses as a percentage of revenues for the Storage Systems segment
increased to 12% in the second quarter of 2004 from 11% in the same quarter of
2003. R&D expenses as a percentage of revenues for the Storage Systems segment
increased to 12% in the first six months of 2004 as compared to 10% in the same
period of 2003. Selling, general and administrative: Three months ended
    
    Six months endedJune 30, 2004
    
    March 31, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003(in millions)Semiconductor segment
    
    $
    45.2
    
    
    $
    43.9
    
    
    $
    40.8
    
    
    $
    89.1
    
    
    $
    83.8Percentage of revenue
    
    
    13
    %
    
    
    13
    %
    
    
    13
    %
    
    
    13
    %
    
    
    14
    %Storage Systems segment
    
    $
    18.6
    
    
    $
    17.3
    
    
    $
    16.1
    
    
    $
    35.9
    
    
    $
    30.7Percentage of revenue
    
    
    17
    %
    
    
    15
    %
    
    
    16
    %
    
    
    16
    %
    
    
    15
    %Consolidated
    
    $
    63.8
    
    
    $
    61.2
    
    
    $
    56.9
    
    
    $
    125.0
    
    
    $
    114.5Percentage of revenue
    
    
    14
    %
    
    
    14
    %
    
    
    14
    %
    
    
    14
    %
    
    
    15
    %
 Second quarter of 2004 compared to the first quarter of 2004 Selling, general and administrative (SG&A) expenses increased $2.6
million or 4% during the second quarter of 2004 from the first quarter of 2004
on a consolidated basis. As a percentage of revenues, consolidated SG&A
expenses remained unchanged at 14% in the second quarter of 2004 as compared
with the first quarter of 2004. SG&A expenses for the Semiconductor segment increased $1.3 million or 3%
in the second quarter of 2004 as compared to the first quarter of 2004. This
increase is mainly due to higher spending for professional services, such as
legal services. For the Semiconductor segment, SG&A expenses, as a percentage
of revenues, remained unchanged at 13% in the second quarter of 2004 as
compared with the first quarter of 2004. SG&A expenses for the Storage Systems segment increased $1.3 million or 8%
in the second quarter of 2004 as compared to the first quarter of 2004. The
increase is primarily a result of $1.0 million in expenses associated with the
proposed initial public offering and the separation from LSI. On July 29,
2004, we announced jointly with Engenio the postponement of the initial public
offering of its common stock due to market conditions. We capitalized $1.5
million of professional fees that were directly and solely related to the
initial public offering of Engenios common stock. If the offering does not
occur, we will record such fees as SG&A expenses in the statement of
operations. 25




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For the Storage Systems segment, SG&A expenses, as a percentage of
revenues increased to 17% in the second quarter of 2004 as compared with 15% in
the first quarter of 2004. Three and six months ended June 30, 2004 compared to the same periods of
2003 Consolidated SG&A expenses increased $6.9 million or 12% during the second
quarter of 2004 and $10.5 million or 9% during the first six months of 2004 as
compared to the same periods of 2003. As a percentage of revenues, SG&A
expenses remained unchanged at 14% in the second quarter of 2004 as compared
with the second quarter of 2003. As a percentage of revenues, SG&A expenses
decreased to 14% in the first six months of 2004 as compared with 15% during
the first six months of 2003. SG&A expenses for the Semiconductor segment increased $4.4 million or 11%
for the second quarter of 2004 and $5.3 million or 6% for the first six months
of 2004, as compared to the same periods of 2003. The increase for the
Semiconductor segment was primarily attributable to compensation-related costs
and higher spending on professional services such as legal services, partially
offset by lower depreciation expense. SG&A expenses as a percentage of revenues for the Semiconductor segment
remained unchanged at 13% in the second quarter of 2004 as compared to the same
quarter of 2003. SG&A expenses as a percentage of revenues for the
Semiconductor segment decreased to 13% in the first six months of 2004 as
compared with 14% during the first six months of 2003. The decrease is a
result of higher revenues, offset in part by an increase in SG&A expenses in
the first six months of 2004 as compared to the same period of 2003. SG&A expenses for the Storage Systems segment increased by $2.5 million or
16% in the second quarter of 2004 and $5.2 million or 17% in the first six
months of 2004 as compared to the same periods of 2003 primarily as a result of
higher compensation related costs. These increases are the result of employees
hired for customer training and customer engineering support, as well as
administrative employees hired and other expenses incurred in anticipation of
the potential initial public offering of Engenios common stock. During the
second quarter of 2004, we also recorded $1.0 million in expenses associated
with the proposed initial public offering and the separation from LSI. These
increases were offset in part by higher reimbursements of selling expenses
related to the master distributor agreement with StorageTek due to the timing
of billings and the underlying level of revenues. SG&A expenses as a percentage of revenues for the Storage Systems segment
increased to 17% in the second quarter of 2004 from 16% in the same quarter of
2003. SG&A expenses as a percentage of revenues for the Storage Systems
segment increased to 16% in the first six months of 2004 as compared to 15% in
the same period of 2003. Restructuring of operations and other items:We recorded charges of $3.0
million and $2.4 million in restructuring of operations and other items for the
three and six months ended June 30, 2004, respectively, which was primarily
associated with the Semiconductor segment. We recorded a charge of $124.5
million and $160.2 million in restructuring of operations and other items for
the three and six months ended June 30, 2003, respectively. For a complete
discussion of the 2003 restructuring actions, please refer to our
Annual Report on Form 10-K. Restructuring and impairment of long-lived assets: First quarter of 2004: We recorded a gain of $3.3 million on the sale of fixed assets that had
previously been held for sale and an expense of $1.1 million for the
abandonment of fixed assets that had previously been held for sale. In
addition, an expense of $1.1 million was recorded for the write-down of fixed
assets due to impairment. An expense of $0.3 million was recorded to reflect the change in time
value of accruals for facility lease termination costs, net of adjustments for
changes in sublease assumptions for certain previously accrued facility lease
termination costs. An expense of $0.2 million was recorded primarily for
severance and termination benefits for four employees involved in research and
development. Second quarter of 2004: We recorded a gain of $1.0 million on the sale of fixed assets that had
previously been held for sale and an expense of $4.0 million primarily for the
write-down of the Colorado Springs fabrication facility to reflect a decline in
fair market value and to write down certain spare parts for fixed assets. 26




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An expense of $0.4 million was recorded to reflect the change in time
value of accruals for facility lease termination costs, net of adjustments for
changes in sublease assumptions for certain previously accrued facility lease
termination costs. Previously accrued contract termination fees of $0.4
million were reversed as the result of favorable negotiations to terminate
those contracts. Subsequent to the end of our second quarter of 2004, we continued to
consolidate non-manufacturing facilities and recorded $4.7 million for costs
associated with exiting certain operating leases for real estate as the
facilities ceased being used and the impairment of related leasehold
improvements. We also recorded severance and termination benefits of $0.5
million for 38 employees involved in manufacturing operations and research and
development activities in July of 2004. The fair values of impaired equipment and facilities were estimated by
management. Given that current market conditions for the sale of older
fabrication facilities and related equipment may fluctuate, there can be no
assurance that we will realize the current net carrying value of the assets
held for sale. We reassess the realizability of the carrying value of these
assets at the end of each quarter until the assets are sold or otherwise
disposed of and additional adjustments may be necessary. Assets held for sale
of $25 million and $30 million were included as a component of prepaid expenses
and other current assets as of June 30, 2004 and December 31, 2003,
respectively. Assets classified as held for sale are not depreciated. The following table sets forth our restructuring reserves as of June 30,
2004, which are included in other accrued liabilities on the balance sheet: Utilized
    
    
    
    
    
    
    
    
    
    ReleaseBalance at
    
    Restructuring
    
    during
    
    Balance at
    
    Restructuring
    
    of
    
    Utilized
    
    Balance atDecember
    
    Expense
    
    Q1
    
    March 31,
    
    Expense
    
    reserves
    
    during
    
    June 30,31, 2003
    
    Q1 2004
    
    2004
    
    2004
    
    Q2 2004
    
    Q2 2004
    
    Q2 2004
    
    2004(in thousands)Write-down of
excess assets (a)
    
    $
    2,661
    
    
    $
    (1,118
    )
    
    $
    718
    
    
    $
    2,261
    
    
    $
    3,203
    
    
    $
    (160
    )
    
    $
    (3,414
    )
    
    $
    1,890Lease terminations
and maintenance
contracts (b)
    
    
    21,021
    
    
    
    252
    
    
    
    (1,886
    )
    
    
    19,387
    
    
    
    379
    
    
    
    (375
    )
    
    
    (2,312
    )
    
    
    17,079Facility closure
and other exit
costs (c)
    
    
    2,136
    
    
    
    64
    
    
    
    (782
    )
    
    
    1,418
    
    
    
    
    
    
    
    
    
    
    
    (369
    )
    
    
    1,049Payments to
employees for
severance (d)
    
    
    874
    
    
    
    204
    
    
    
    (767
    )
    
    
    311
    
    
    
    
    
    
    
    (18
    )
    
    
    (227
    )
    
    
    66Total
    
    $
    26,692
    
    
    $
    (598
    )
    
    $
    (2,717
    )
    
    $
    23,377
    
    
    $
    3,582
    
    
    $
    (553
    )
    
    $
    (6,322
    )
    
    $
    20,084
  (a)
    
    The amounts utilized in 2004 reflect $6.3 million of non-cash write-downs
of long-lived assets in the U.S. due to impairment and $0.6 million in
cash payments to decommission and sell assets, offset by $4.3 million
realized gain on the sale of fixed assets previously held for sale. The
write-downs of long-lived assets were accounted for as a reduction of the
assets and did not result in a liability. The $1.9 million balance as of
June 30, 2004, relates to machinery and equipment decommissioning costs in
the U.S. and estimates of selling costs for assets held for sale and is
expected to be utilized during 2004.  (b)
    
    Amounts utilized represent cash payments. The balance remaining for
primarily real estate lease terminations and maintenance contracts will be
paid during the remaining terms of these contracts, which extend through
2011.  (c)
    
    Amounts utilized represent cash payments. The balance remaining for
facility closure and other exit costs will be paid during 2004.  (d)
    
    Amounts utilized represent cash severance payments to twenty employees
during the six months ended June 30, 2004. The balance remaining for
severance is expected to be paid during 2004. Other Items During the second quarter of 2004, we reclassified a parcel of land in
Colorado with a book value of $1.4 million from a long-term asset to a current
asset held for sale. The land is part of total assets in the Semiconductor
segment. We expect to sell the property within the next 12 months for an
amount in excess of book value. 27




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Amortization of non-cash deferred stock compensation:Amortization of
non-cash deferred stock compensation was $2.0 million for the three months
ended June 30, 2004, $1.8 million for the three months ended March 31, 2004 and
$8.9 million for the three months ended June 30, 2003. For the six months ended
June 30, 2004 and 2003, the amortization of non-cash deferred stock
compensation was $3.8 million and $19.4 million, respectively. The
acquisitions for which deferred stock compensation and related amortization
were recorded consisted primarily of the Accerant transaction in the second
quarter of 2004 and the Velio transaction in the first quarter of 2004 (see
Note 3 of the Notes); an acquisition in the fourth quarter of 2002; the
acquisitions of C-Cube, and the RAID business from AMI in 2001; and the
acquisition of DataPath in 2000. We also recorded non-cash deferred stock
compensation for restricted common shares issued to Engenio and our employees
and non-employee directors of Engenio during the first and second quarters of
2004. We amortize deferred stock compensation ratably over the related vesting
periods. Deferred stock compensation is adjusted to reflect the forfeitures
prior to vesting. Amortization of intangibles:Amortization of intangible assets was $19.4
million for the second quarter of 2004 as compared to $18.3 million for the
first quarter of 2004. The slight increase over the prior quarter is due to
amortization expense recorded in the second quarter of 2004 related to the
intangible assets acquired from Accerant in the second quarter of 2004 and
Velio in the first quarter of 2004 (see Note 3 of the Notes). No amortization
expense was recorded in the first quarter of 2004 related to the intangible
assets acquired from Velio as they were acquired on the last day of the first
quarter of 2004. Amortization of intangible assets for the second quarter of 2004 slightly
increased from $19.3 million for the same period in 2003. For the six months
ended June 30, 2004 and 2003, amortization of intangible assets was $37.7
million and $39.4 million, respectively. The decrease is attributable to the
write-down in the first quarter of 2003 of $15.1 million of intangible assets
in the Semiconductor segment and $9.0 million of intangible assets in the
Storage Systems segment. In the third quarter of 2003 we wrote-down an
additional $21.0 million of intangible assets originally acquired in connection
with the acquisition of C-Cube, which was added to our Semiconductor segment in
the second quarter of 2001. The charges were recorded in restructuring and
other items, net in 2003. These decreases were more than offset by amortization
of intangible assets acquired in the first and second quarter of 2004. As of
June 30, 2004, we had approximately $152.1 million of intangible assets, net of
accumulated amortization that will continue to amortize. We monitor the recoverability of goodwill recorded in connection with
acquisitions annually, or sooner if events or changes in circumstances indicate
that the carrying amount may not be recoverable. Impairment, if any, would be
determined in accordance with SFAS No. 142, which uses a fair value model for
determining the carrying value of goodwill. We plan to perform our annual
impairment review in the fourth quarter of 2004. Interest expense:Interest expense increased slightly to $6.1 million in
the second quarter of 2004 from $5.9 million in the first quarter of 2004.
Interest expense decreased by $1.2 million during the three months ended June
30, 2004 from $7.3 million during the same period in 2003. Interest expense
decreased $4.1 million to $12.0 million in the first six months of 2004 from
$16.1 million in the same period of 2003. The decrease is due to the
repurchase/redemption of $710.0 million of Convertible Notes during 2003 and
changes in the benefit received from the interest rate swaps before/after
termination, offset by the issuance of $350.0 million of Convertible Notes
during the second quarter of 2003. Interest income and other, net:Interest income and other, net, was $8.8
million in the second quarter of 2004 as compared to $9.2 million in the first
quarter of 2004. Interest income decreased to $3.5 million in the second
quarter of 2004 from $5.4 million in the first quarter of 2004. The decrease
in interest income is mainly due to lower returns on our short-term
investments. Other income, net of $5.3 million in the second quarter of 2004
included a pre-tax gain of $5.1 million on sales of certain marketable
available-for-sale equity securities in the three months ended June 30, 2004,
and other miscellaneous items. Other income, net of $3.8 million in the first
quarter of 2004 included a pre-tax gain of $3.0 million associated with our
investment in marketable available-for-sale equity securities of a certain
technology company that was acquired by another publicly traded technology
company during the first quarter of 2004, and other miscellaneous items. In the second quarter of 2003, interest income and other, net, was $3.4
million. Interest income was $7.1 million in the second quarter of 2003. The
decrease in interest income for the second quarter of 2004 as compared to the
second quarter of 2003 is mainly due to lower realized gains on the sale of
short-term investments and lower returns. Other expense, net, of $3.7 million
in the second quarter of 2003 included a write-down of three investments in
equity securities by $2.1 million due to impairment considered to be other than
temporary (see Note 6 of the Notes), a net loss on the repurchase of
Convertible Notes of $2.0 million, and currency option premium expenses, offset
in part by net foreign exchange gains and gains on sale of assets. 28




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Interest income and other, net increased to $17.9 million in the first six
months of 2004 from $10.1 million in the same period of 2003. Interest income
decreased by $10.5 million to $8.9 million in the first six months of 2004 from
$19.4 million in the same period of 2003. The decrease in interest income is
mainly due to lower realized gains on the sale of short-term investments and
lower returns during the first six months of 2004. Other income, net of $9.0
million in the first six months of 2004 included a pre-tax gain of $3.0 million
associated with our investment in marketable available-for-sale equity
securities of a certain technology company that was acquired by another
publicly traded technology company during the first quarter of 2004, a pre-tax
gain of $5.1 million on sales of certain marketable available-for-sale equity
securities in the three months ended June 30, 2004, and other miscellaneous
items. Other expense, net of $9.3 million in the first six months of 2003
included write-downs of investments in equity securities by $9.1 million due to
impairment considered to be other than temporary (see Note 6 of the Notes), a
net loss on the repurchase of Convertible Notes of $2.0 million, and currency
option premium expenses, offset in part by net foreign exchange gains, gains on
sale of assets and other miscellaneous expenses that were individually
insignificant. Provision for income taxes:During the three and six months ended June
30, 2004, we recorded an income tax expense of $6.0 million and $12.0 million,
respectively. The expense relates to foreign income taxes and U.S. alternative
minimum taxes. Income taxes within the U.S. have been partially offset by the
utilization of current foreign tax and research and development tax credits.
For the three months and six months ended June 30, 2003, we recorded an income
tax expense of $6.0 million and $12 million, respectively. The expense relates
to foreign income taxes. Excluding certain foreign jurisdictions, the future
benefit of temporary differences, including operating losses, is not being
recognized. FINANCIAL CONDITION, CAPITAL RESOURCES AND LIQUIDITY Cash, cash equivalents and short-term investments increased to $847.4
million at June 30, 2004, from $813.7 million at December 31, 2003. As
described below, the increase is mainly due to net cash inflows from operating
and financing activities, and net cash inflows from investing activities
excluding purchases of short-term investments in debt securities available for
sale. Working capital.Working capital increased by $83.9 million to $1.1
billion at June 30, 2004, from $998.8 million at December 31, 2003. Working
capital in the first six months of the current year was impacted by the
following activities:  
    
    Cash, cash equivalents and short-term investments increased by $33.7
million to $847.4 million at June 30, 2004, as compared to $813.7
million at December 31, 2003;
    
    Accounts receivable increased by $57.8 million to $289.0 million at
June 30, 2004 from $231.2 million at December 31, 2003. The increase is
mainly attributable to higher billings in the last month of the second
quarter of 2004 as compared to the last month of the fourth quarter of
2003, and better cash collections in the fourth quarter of 2003 as
compared to the second quarter of 2004;
    
    Inventories increased by $11.4 million to $209.9 million as of June
30, 2004 from $198.5 million as of December 31, 2003. This is mainly due
to the purchase of raw materials during the second quarter of 2004 in
anticipation of inventory to be required in the second half of 2004,
part of which still remained as work-in-process inventories at the end
of the second quarter of 2004; and
    
    Other accrued liabilities decreased by $8.0 million to $145.8 million
as of June 30, 2004 from $153.8 million as of December 31, 2003. This is
mainly due to utilization of our restructuring reserves. The increase in working capital was offset, in part, by the following:  
    
    Prepaid expenses and other current assets decreased by $13.4 million
primarily due to a $6.8 million decrease in the current portion of
collateral balance on the equipment operating leases (see Note 14 of the
Notes), a $4.6 million decrease in other receivables mainly due to a
$6.6 million income tax refund received in the first quarter of 2004,
and a $4.9 million decrease in assets held for sale due to sales and
retirements (see Note 5 of the Notes), offset in part by other
miscellaneous items;
    
    Accounts payable increased by $9.2 million primarily due to timing of
invoice receipts and payments; and 29




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##### Table of Contents




    
    Income taxes payable increased by $4.1 million primarily due to the
timing of tax payments made and income tax provision recorded in the
first six months of 2004. Cash and cash equivalents generated from operating activities.During the
first six months of 2004, we generated $38.2 million of net cash and cash
equivalents from operating activities compared to $104.1 million generated in
the same period of 2003. Cash and cash equivalents generated by operating
activities for the six months ended June 30, 2004 were the result of the
following:  
    
    Higher income (before depreciation and amortization, non-cash
restructuring and other items, amortization of non-cash deferred stock
compensation, gains on sale and exchange of equity securities, loss on
write-down of equity securities, and gains on the sale of property and
equipment) over the six months ended June 30, 2004 as compared to the
same period in 2003, offset by lower net changes in assets and
liabilities, net of assets acquired and liabilities assumed in business
combinations. The non-cash items and other non-operating adjustments are
quantified in our Consolidated Statements of Cash Flows included in this
Current report on Form 10-Q; and
    
    Changes in working capital components from December 31, 2003 to June
30, 2004 as discussed above. Cash and cash equivalents used in investing activities.Cash and cash
equivalents used in investing activities were $118.8 million for the six months
ended June 30, 2004, compared to $41.0 million provided by investing activities
in the same period in 2003. The primary investing activities during the six
months ended June 30, 2004 were as follows:  
    
    Purchases of debt and equity securities available for sale, net of sales and maturities;
    
    Purchases of property and equipment;
    
    Proceeds from the sale of property and equipment;
    
    Acquisition of companies (see Note 3 of the Notes); and
    
    Lower non-current assets and deposits in the six months ended June
30, 2004, primarily as a result of the refund of collateral from the
equipment operating lease during the first six months of 2004 (see Note
14 of the Notes) and a terminated letter of credit during the first
quarter of 2004. We believe that maintaining technological leadership in the highly
competitive worldwide semiconductor manufacturing industry requires access to
advanced manufacturing capacity. Our focus is on establishing strategic
supplier alliances with foundry semiconductor manufacturers, which enables us
to supplement internal manufacturing capability with additional external
manufacturing capacity, and reduces our capital spending requirements. We
expect capital expenditures to be approximately $100 million in 2004. Cash and cash equivalents provided by financing activities. Cash and cash
equivalents provided by financing activities during the six months ended June
30, 2004 were $10.1 million as compared to $38.6 million in the same period in
2003. The primary financing activities during the six months ended June 30,
2004 were as follows:  
    
    Additional purchase of minority interests in subsidiary;
    
    Issuance of common stock under our employee stock option and purchase plans; and
    
    Repayment of debt obligations. We may seek additional equity or debt financing from time to time. We
believe that our existing liquid resources and funds generated from operations,
combined with funds from such financing and our ability to borrow funds, will
be adequate to meet our operating and capital requirements and obligations for
the foreseeable future. However, we cannot be certain that additional financing
will be available on favorable terms. Moreover, any future equity or
convertible debt financing will decrease the percentage of equity ownership of
existing stockholders and may result in dilution, depending on the price at
which the equity is sold or the debt is converted. 30




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On February 19, 2004, Engenio filed a registration statement on Form S-1
(the Registration Statement) with the Securities and Exchange Commission
(SEC). On July 27, 2004, Engenio filed Amendment No. 8 to the Registration
Statement. On July 29, 2004, we announced jointly with Engenio the
postponement of the initial public offering of its common stock due to market
conditions. Contractual Obligations The following table summarizes our contractual obligations at June 30,
2004, and the effect these obligations are expected to have on our liquidity
and cash flow in future periods. Payments due by period4  5
    
    After 5Contractual Obligations
    
    Less than 1 year
    
    1  3 years
    
    years
    
    years
    
    Total(in millions)Convertible Subordinated
Notes
    
    $
    
    
    
    $
    490.0
    
    
    $
    
    
    
    $
    350.0
    
    
    $
    840.0Operating lease obligations
    
    
    122.3
    
    
    
    169.2
    
    
    
    37.5
    
    
    
    40.8
    
    
    
    369.8Capital lease obligations
    
    
    0.4
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.4Purchase commitment
    
    
    307.9
    
    
    
    2.3
    
    
    
    
    
    
    
    
    
    
    
    310.2Total
    
    $
    430.6
    
    
    $
    661.5
    
    
    $
    37.5
    
    
    $
    390.8
    
    
    $
    1,520.4
 Convertible Subordinated Notes As of June 30, 2004, we have $490 million of Convertible Subordinated
Notes due in October 2006 (2001 Convertible Notes) and $350 million of
Convertible Subordinated Notes due in May 2010 (2003 Convertible Notes). All
of the Convertible Notes are subordinated to all existing and future senior
debt and are convertible at the holders option, at any time prior to the
maturity date of the Convertible Notes, into shares of our common stock. The
2001 and 2003 Convertible Notes have conversion prices of approximately $26.34
per share and $13.42 per share, respectively. The 2001 Convertible Notes are
redeemable at our option, in whole or in part, on at least 30 days notice at
any time on or after the call date, which is two years before the due date. We
cannot elect to redeem the 2003 Convertible Notes prior to maturity. Each
holder of the 2001 and 2003 Convertible Notes has the right to cause us to
repurchase all of such holders convertible notes at 100% of their principal
amount plus accrued interest upon the occurrence of any fundamental change to
us, which includes a transaction or event such as an exchange offer,
liquidation, tender offer, consolidation, merger or combination. Interest is
payable semiannually. Fluctuations in our stock price impact the prices of our outstanding
convertible securities and the likelihood of the convertible securities being
converted into cash or equity. If we are required to redeem any of the
Convertible Notes for cash, it may affect our liquidity position. However, in
the event they do not convert to equity, we believe that our current cash
position and expected future operating cash flows will be adequate to meet
these obligations as they mature. From time to time, we may buy back
Convertible Notes. Operating Lease Obligations As of June 30, 2004, we had operating leases financing certain wafer
fabrication equipment (see Note 14 of the Notes). Under these leases, we are
required to maintain unrestricted cash and short-term investment reserves in an
amount no less than $350 million. We were in compliance with this requirement
as of June 30, 2004. We guarantee residual values of equipment on these leases. As of June 30,
2004, we do not expect to realize a loss on the guarantee at the end of the
lease term, and accordingly, no additional rent expense has been recognized
(see Note 14 of the Notes). In connection with the equipment operating leases described above, we
entered into standby letters of credit for $63 million to expire at the end of
the lease term. These instruments are off-balance sheet commitments to extend
financial guarantees. The fair value of the letters of credit approximates the
contract amount (see Note 14 of the Notes). We also lease real estate, certain other equipment and software under
non-cancelable operating leases. We renegotiated the existing lease agreements
for six buildings located in California in the first and second quarters of
2004. The future minimum 31




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payments for these renegotiated building leases will be $2 million, $3 million,
$4 million, $5 million, $5 million and $21 million for the years ending
December 31, 2004, 2005, 2006, 2007, 2008 and thereafter, respectively. On August 6, 2004, we entered into two lease and security agreements, each
with Wells Fargo Bank Northwest, acting as the Agent. One lease for $134
million is with Bank of the West acting as the Lessor, and the second lease for
$201 million is with BTM Capital Corporation acting as the Lessor. The leases
are for wafer fabrication equipment (the Equipment) that was previously on
lease immediately prior to closing this transaction. See Note 14 of the Notes
for a discussion of these former leases entered into on March 28, 2003. The
new leases qualify for operating lease accounting treatment. Each lease has a
term of 3 years. We may, at the end of the lease term, return or purchase, at
a pre-determined amount, all of the Equipment. We have $313 million in cash
that is posted as collateral for the leases as of August 6, 2004. We are
required to maintain unrestricted cash and short-term investments reserves in
an amount no less than the higher of a) the sum of $100 million plus the
principal amount of our 2001 Convertible Subordinated Notes due in 2006 or b)
$350 million. We were in compliance with this requirement as of August 6,
2004. We guarantee residual values related to the leased equipment. As of
August 6, 2004, its maximum potential exposure to residual value guarantees was
approximately $142 million and we do expect to have a loss on such
guarantees. Purchase Commitments We maintain certain purchase commitments primarily for raw materials with
suppliers and for some non-production items. Purchase commitments for
inventory materials are generally restricted to a forecasted time-horizon as
mutually agreed upon between the parties. This forecast time-horizon can vary
amongst different suppliers. Critical Accounting Policies The discussion and analysis of our financial condition and results of
operations are based on the consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires
estimates and assumptions that affect the reported amounts and disclosures.
For a detailed discussion of our critical accounting policies, please see the
Critical Accounting Policies contained in Part II, Item 7 of the Managements
Discussion and Analysis of Financial Condition and Results of Operations in our
Annual Report on Form 10-K for the year ended December 31, 2003. Recent Accounting Pronouncements In July 2004, the EITF issued EITF Issue No. 02-14, Whether an Investor
Should Apply the Equity Method of Accounting to Investments Other Than Common
Stock. This issue addresses the determination of whether an investment is
in-substance common stock and when to perform that evaluation, but does not
address the determination of whether an investor has the ability to exercise
significant influence over the operating and financial policies of the
investee. The pronouncement is effective for fiscal periods beginning after
September 15, 2004. For existing investments, the investor should make an
initial determination as to whether the investment is in-substance common stock
based on the circumstances existing as of the date of first application of this
issue. We do not believe that the adoption of this standard will have a
material impact on our consolidated balance sheet or statement of operations. In March 2004, the Emerging Issues Task Force (EITF) issued EITF Issue
No. 03-06, Participating Securities and the Two-class Method Under FASB
Statement No. 128, Earnings Per Share. EITF Issue No. 03-06 addresses a number
of questions regarding the computation of earnings per share (EPS) by
companies that have issued securities other than common stock that
contractually entitle the holder to participate in dividends and earnings of
the company when, and if, it declares dividends on its common stock. The issue
also provides further guidance in applying the two-class method of calculating
EPS. It clarifies what constitutes a participating security and how to apply
the two-class method of computing EPS once it is determined that a security is
participating, including how to allocate undistributed earnings to such a
security. This pronouncement is effective for fiscal periods beginning after
March 31, 2004. The adoption of this standard did not have a material impact
on our computation of EPS. In March 2004, the Emerging Issues Task Force (EITF) reached a consensus
on Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments. EITF No. 03-01 provides guidance on
recording other-than-temporary impairments of cost method investments and
requires additional disclosures for those investments. The recognition and
measurement guidance in EITF No. 03-01 should be applied to
other-than-temporary impairment evaluations in reporting periods 32




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beginning after June 15, 2004. The disclosure requirements are effective for
fiscal years ending after June 15, 2004 and are required only for annual
periods. We do not believe that the adoption of this standard will have a
material impact on our consolidated balance sheet or statement of operations. In December 2003, the Financial Accounting Standards Board (FASB)
released a revision to FASB Interpretation No. 46 (FIN 46), Consolidation of
Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires
certain variable interest entities to be consolidated by the primary

beneficiary of the entity if the equity investors in the entity do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. A public entity shall apply
the provisions of the FIN 46 revision no later than the end of the first
reporting period that ends after March 15, 2004. However, a public entity
shall apply FIN 46 to entities considered to be special-purpose entities no
later than as of the end of the first reporting period that ends after December
15, 2003. The adoption of this standard did not have a material impact on our
consolidated balance sheet or statement of operations. FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS We believe that our future operating results will continue to be subject
to quarterly variations based upon a wide variety of factors detailed in the
Risk Factors in Part I of our Annual Report on Form 10-K for the year ended
December 31, 2003, which information is incorporated by reference. Our actual
results in future periods may be significantly different from any future
performance suggested in this report. Although we believe that the
expectations reflected in the forward-looking statements are reasonable, we
cannot guarantee future results, levels of activity, performance or
achievements. Risks and uncertainties that may affect our results include,
among others:  
    
    A general economic weakness may further reduce our revenues.
    
    Engenio represents a significant portion of our business, and an
initial public offering, sale or spin-off of Engenio, may cause our
operating results to suffer and may cause net revenues and income to
decline.
    
    The separation and possible IPO, sale or spin-off of Engenio from us
is a substantial undertaking that may disrupt our ongoing business and
may increase expenses, which may adversely affect our results of
operations and financial condition.
    
    We operate in highly competitive markets.
    
    Our new products may not achieve market acceptance.
    
    We operate highly complex and costly manufacturing facilities.
    
    We outsource a substantial portion of wafers manufactured.
    
    We have significant capital requirements to maintain and grow our business.
    
    We are exposed to fluctuations in foreign currency exchange rates.
    
    We procure parts and raw materials from limited domestic and foreign sources.
    
    We are dependent on a limited number of customers.
    
    We utilize indirect channels of distribution over which we have limited control.
    
    Our operations are affected by cyclical fluctuations.
    
    We engage in acquisitions and alliances giving rise to economic and technological risks.
    
    The price of our securities may be subject to wide fluctuations.
    
    We may rely on capital and bank markets to provide liquidity.
    
    We design and develop highly complex cell-based ASICs.
    
    Our global operations expose us to numerous international business risks.
    
    The high technology industry in which we operate is prone to intellectual property litigation.
    
    Our manufacturing facilities may not achieve desired margins.
    
    Our manufacturing facilities are subject to disruption. 33




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##### Table of Contents




    
    We must attract and retain key employees in a highly competitive environment.
    
    Future changes in financial accounting standards or practices or
existing taxation rules or practices may cause adverse unexpected
fluctuations and affect our reported results of operations. While management believes that the discussion and analysis in this report
is adequate for a fair presentation of the information, we recommend that you
read this discussion and analysis in conjunction with the Annual Report on Form
10-K. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk There have been no significant changes in the market risk disclosures
during the six months ended June 30, 2004, as compared to the discussion in
Part II of our Annual Report on Form 10-K for the year ended December 31, 2003. 
 Item 4. Controls and Procedures Our management evaluated, with the participation of our chief executive
officer and our chief financial officer, the effectiveness of our disclosure
controls and procedures pursuant to Rule 13a-15 promulgated under the
Securities Exchange Act as of June 30, 2004. Based on this evaluation, our
chief executive officer and our chief financial officer have concluded that our
disclosure controls and procedures are effective to ensure that information we
are required to disclose in reports that we file or submit under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in Securities and Exchange Commission rules and forms. There was no change in our internal control over financial reporting that
occurred during the period covered by this Quarterly Report on Form 10-Q that
has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting. We are aware that any system of
control, however well designed and operated, can only provide reasonable, and
not absolute, assurance that the objectives of this system are met, and that
maintenance of disclosure controls and procedures is an ongoing process that
may change over time. 
 PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings This information is included in Note 15 (Legal Matters) of the Notes to
the Unaudited Consolidated Financial Statements, which information is
incorporated herein by reference from Item 1 of Part I hereof. 
 Item 2. Changes of Securities, Use of Proceeds On July 28, 2000, the Companys Board of Directors authorized a new stock
repurchase program in which up to 5 million shares of the Companys common
stock may be repurchased in the open market from time to time. There is no
expiration date for the plan. No shares were repurchased under this plan during
the first six months of 2004. There are 3.5 million shares available for
repurchase under this plan as of June 30, 2004. 
 Item 4. Submission of Matters to a Vote of Security Holders Our Annual Meeting of Stockholders was held on May 6, 2004 in San Jose,
California. At the meeting, our stockholders voted on and approved the
following proposals. The results of the voting were as follows: 34




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Proposal 1. To elect eight directors to serve for the ensuing year and
until their successors are elected. Director
    
    Votes For
    
    Votes WithheldT.Z. Chu
    
    
    319,158,332
    
    
    
    17,273,593Wilfred J. Corrigan
    
    
    321,046,627
    
    
    
    15,385,298Malcolm R. Currie
    
    
    318,805,265
    
    
    
    17,626,660James H. Keyes
    
    
    319,256,650
    
    
    
    17,175,275R. Douglas Norby
    
    
    321,413,748
    
    
    
    15,018,177Matthew J. ORourke
    
    
    320,120,581
    
    
    
    16,311,344Gregorio Reyes
    
    
    323,868,137
    
    
    
    12,563,788Larry W. Sonsini
    
    
    315,814,258
    
    
    
    20,617,667
 Proposal 2. To approve an amendment to the Companys Employee Stock
Purchase Plan to increase the number of shares of common stock reserved for issuance thereunder by 9,000,000. Votes For
    
    Votes Against
    
    Abstentions
    
    Broker Non-Votes114,129,095
    
    
    86,275,334
    
    
    
    2,569,478
    
    
    
    0
 Proposal 3. To approve an amendment to the Companys International
Employee Stock Purchase Plan to increase the number of shares of
common stock reserved for issuance thereunder by 1,000,000. Votes For
    
    Votes Against
    
    Abstentions
    
    Broker Non-Votes175,334,835
    
    
    24,997,535
    
    
    
    2,640,738
    
    
    
    0
 Proposal 4. To approve the amendment and restatement of the Companys
Incentive Plan. Votes For
    
    Votes Against
    
    Abstentions
    
    Broker Non-Votes187,939,781
    
    
    12,291,223
    
    
    
    2,742,102
    
    
    
    0
 Proposal 5. To ratify the appointment of PricewaterhouseCoopers LLP as
independent accountants of the Company for its 2004 fiscal year. Votes For
    
    Votes Against
    
    Abstentions
    
    Broker Non-Votes324,030,110
    
    
    10,221,668
    
    
    
    2,180,146
    
    
    
    0
 
 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits  31.1
    
    Certification of the Chief Executive Officer pursuant to Securities
Exchange Act Rules 13a-15(e) and 15d-1(e), as adopted pursuant to
Section 302 of the Sarbarnes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer pursuant to Securities
Exchange Act Rules 13a-15(e) and 15d-1(e), as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. * 35




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32.2
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. * * Furnished not filed. (b) Reports on Form 8-K On April 28, 2004, the Company filed in part and furnished in part a Form
8-K pursuant to Items 5, 7 and 12 to report information regarding the financial
results for the fiscal quarter ended March 31, 2004 set forth in the
Registrants news release dated April 28, 2004. 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. LSI LOGIC CORPORATION
(Registrant)Date: August 13, 2004
    
    By
    
    /s/ Bryon LookBryon LookExecutive Vice President &Chief Financial Officer
 37




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INDEX TO EXHIBITS  31.1
    
    Certification of the Chief Executive Officer pursuant to Securities
and Exchange Act Rules 13a-15(e) and 15d-1(e), as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer pursuant to Securities
and Exchange Act Rules 13-15(e) and 15d-1(e), as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. *32.2
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. * * Furnished not filed.