**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

**x**                              Quarterlyreport pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe quarterly period ended June 30, 2006 or**

**o**                                 Transitionreport pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe transition period from             to             **

**Commissionfile number 0-15071**

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**ADAPTEC, INC.**

(Exact name of registrantas specified in its charter)

| **DELAWARE**                                                    | **94-2748530**                        |
|-----------------------------------------------------------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **691 S. MILPITAS BLVD.,  MILPITAS, CALIFORNIA**                | **95035**                             |
| (Address of principal executive offices)                        | (Zip Code)                            |

 

Registrant’s telephonenumber, including area code **(408) 945-8600**

**N/A**

(Former name, formeraddress and former fiscal year, if changed since last report)

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Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days.

Yes x  No  ̈

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer (asdefined in Rule 12b-2 of the Exchange Act).

Large Accelerated Filer o            Accelerated Filer x            Non-AcceleratedFiler o

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

The number of shares of Adaptec’s common stockoutstanding as of August 2, 2006 was 115,986,020.

 

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**TABLEOF CONTENTS**
|               | ** ** | **Page**               |
|---------------|------------|------------------------|
| Part I.  |       | Financial  Information |   |   |
|          |       | Item  1.               |   | Financial  Statements: |   |   |
|          |       |                   |   | Unaudited  Condensed Consolidated Statements of Operations |   | 3 |
|          |       |                   |   | Unaudited  Condensed Consolidated Balance Sheets |   | 4 |
|          |       |                   |   | Unaudited  Condensed Consolidated Statements of Cash Flows |   | 5 |
|          |       |                   |   | Notes  to Unaudited Condensed Consolidated Financial Statements |   | 6 |
|          |       | Item 2.                |   | Management’s Discussion  and Analysis of Financial Condition and Results of Operations |   | 22 |
|          |       | Item 3.                |   | Quantitative  and Qualitative Disclosures About Market Risk |   | 32 |
|          |       | Item 4.                |   | Controls  and Procedures |   | 32 |
| Part II. |       | Other Information      |   |   |
|          |       | Item  1A.              |   | Risk  Factors |   | 34 |
|          |       | Item 6.                |   | Exhibits |   | 47 |
|          |       | Signatures             |   | 48 |

 

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**PART I.   FINANCIALINFORMATION**

**Item 1.**                        FinancialStatements

**ADAPTEC, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(unaudited)**

 

| ** **                                             | ** ** | **Three-Month Period Ended**                                                              | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **      June 30, 2006      ** | ** ** | **      June 30, 2005      ** | ** ** |
| ** **                                             | ** ** | **(in thousands, except per share amounts)**                               | ** ** |
| Net revenues                                           |       |                                                                                                | $          | 69,071 |   |   |   | $ | 83,813 |   |   |
| Cost of revenues                                       |       |                                                                                                | 46,801     |   |   |   | 59,725 |   |   |
| Gross profit                                           |       |                                                                                                | 22,270     |   |   |   | 24,088 |   |   |
| Operating  expenses:                                   |       |                                                                                                |       |   |   |   |   |   |   |
| Research and development                               |       |                                                                                                | 17,294     |   |   |   | 18,380 |   |   |
| Selling, marketing and administrative                  |       |                                                                                                | 15,394     |   |   |   | 18,461 |   |   |
| Amortization of acquisition-related intangible  assets |       |                                                                                                | 1,586      |   |   |   | 3,056 |   |   |
| Restructuring charges                                  |       |                                                                                                | 3,011      |   |   |   | 40 |   |   |
| Impairment of intangibles and other charges            |       |                                                                                                | 13,942     |   |   |   | — |   |   |
| Total operating expenses                               |       |                                                                                                | 51,227     |   |   |   | 39,937 |   |   |
| Loss from  continuing operations                       |       |                                                                                                | (28,957    | ) |   |   | (15,849 | ) |   |
| Interest and  other income                             |       |                                                                                                | 5,903      |   |   |   | 3,608 |   |   |
| Interest expense                                       |       |                                                                                                | (876       | ) |   |   | (973 | ) |   |
| Loss from  continuing operations before income taxes   |       |                                                                                                | (23,930    | ) |   |   | (13,214 | ) |   |
| Provision for  income taxes                            |       |                                                                                                | 894        |   |   |   | 846 |   |   |
| Loss from  continuing operations                       |       |                                                                                                | (24,824    | ) |   |   | (14,060 | ) |   |
| Discontinued operations,  net of taxes                 |       |                                                                                                |       |   |   |   |   |   |   |
| Income (loss) from discontinued operations             |       |                                                                                                | 264        |   |   |   | (21,913 | ) |   |
| Income from disposal of discontinued operations        |       |                                                                                                | 1,290      |   |   |   | — |   |   |
| Income (loss)  from discontinued operations            |       |                                                                                                | 1,554      |   |   |   | (21,913 | ) |   |
| Net loss                                               |       |                                                                                                | $          | (23,270 | ) |   |   | $ | (35,973 | ) |   |
| Net loss per  share:                                   |       |                                                                                                |       |   |   |   |   |   |   |
| Basic                                                  |       |                                                                                                |       |   |   |   |   |   |   |
| Continuing operations                                  |       |                                                                                                | $          | (0.21 | ) |   |   | $ | (0.13 | ) |   |
| Discontinued operations                                |       |                                                                                                | $          | 0.01 |   |   |   | $ | (0.19 | ) |   |
| Net loss                                               |       |                                                                                                | $          | (0.20 | ) |   |   | $ | (0.32 | ) |   |
| Diluted                                                |       |                                                                                                |       |   |   |   |   |   |   |
| Continuing operations                                  |       |                                                                                                | $          | (0.21 | ) |   |   | $ | (0.13 | ) |   |
| Discontinued operations                                |       |                                                                                                | $          | 0.01 |   |   |   | $ | (0.19 | ) |   |
| Net loss                                               |       |                                                                                                | $          | (0.20 | ) |   |   | $ | (0.32 | ) |   |
| Shares used in  computing net loss per share:          |       |                                                                                                |       |   |   |   |   |   |   |
| Basic                                                  |       |                                                                                                | 115,609    |   |   |   | 112,445 |   |   |
| Diluted                                                |       |                                                                                                | 115,609    |   |   |   | 112,445 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

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**ADAPTEC, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(unaudited)**

| ** **                                              | ** ** | **June 30, 2006** | ** ** | **March 31, 2006** | ** ** |
|---------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                              | ** ** | **(in thousands)**     | ** ** |
| **Assets**                                              |       |                        |       |                         |       |   |   |   |   |
| Current assets:                                         |       |                        |       |                         |       |   |   |   |   |
| Cash and cash equivalents                               |       |                        | $          | 101,867                      |       |   |   | $ | 131,373 |   |   |
| Marketable securities                                   |       |                        | 453,791    |                         |       |   | 425,179 |   |   |
| Restricted cash and marketable securities               |       |                        | 1,659      |                         |       |   | 1,663 |   |   |
| Accounts receivable, net                                |       |                        | 45,207     |                         |       |   | 47,876 |   |   |
| Inventories                                             |       |                        | 35,149     |                         |       |   | 28,259 |   |   |
| Prepaid expenses and other current assets               |       |                        | 26,097     |                         |       |   | 26,294 |   |   |
| Total current assets                                    |       |                        | 663,770    |                         |       |   | 660,644 |   |   |
| Property and  equipment, net                            |       |                        | 29,298     |                         |       |   | 30,665 |   |   |
| Restricted  marketable securities, less current portion |       |                        | 2,282      |                         |       |   | 3,086 |   |   |
| Other intangible  assets, net                           |       |                        | 16,156     |                         |       |   | 32,524 |   |   |
| Other long-term  assets                                 |       |                        | 9,816      |                         |       |   | 10,480 |   |   |
| Total assets                                            |       |                        | $          | 721,322                      |       |   |   | $ | 737,399 |   |   |
| **Liabilities  and Stockholders’ Equity**          |       |                        |       |                         |       |   |   |   |   |
| Current liabilities:                                    |       |                        |       |                         |       |   |   |   |   |
| Accounts payable                                        |       |                        | $          | 48,635                       |       |   |   | $ | 40,246 |   |   |
| Accrued liabilites                                      |       |                        | $          | 82,994                       |       |   |   | $ | 87,722 |   |   |
| 3% Convertible Subordinated Notes                       |       |                        | 10,637     |                         |       |   | 10,637 |   |   |
| Total current liabilities                               |       |                        | 142,266    |                         |       |   | 138,605 |   |   |
| 3¤4%  Convertible Senior Subordinated Notes        |       |                        | 225,000    |                         |       |   | 225,000 |   |   |
| Other long-term  liabilities                            |       |                        | 3,555      |                         |       |   | 4,349 |   |   |
| Commitments and  contingencies (Note 12)                |       |                        |       |                         |       |   |   |   |   |
| Stockholders’ equity:                              |       |                        |       |                         |       |   |   |   |   |
| Common stock                                            |       |                        | 116        |                         |       |   | 115 |   |   |
| Additional paid-in capital                              |       |                        | 178,439    |                         |       |   | 174,648 |   |   |
| Deferred stock-based compensation                       |       |                        | —     |                         |       |   | (319 | ) |   |
| Accumulated other comprehensive income, net of taxes    |       |                        | (2,566     | )                            |       |   | (2,781 | ) |   |
| Retained earnings                                       |       |                        | 174,512    |                         |       |   | 197,782 |   |   |
| Total stockholders’ equity                         |       |                        | 350,501    |                         |       |   | 369,445 |   |   |
| Total liabilities  and stockholders’ equity        |       |                        | $          | 721,322                      |       |   |   | $ | 737,399 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

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**ADAPTEC, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)**

| ** **                                                                                                          | ** ** | **Three-Month Period Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                          | ** ** | **June 30, 2006**            | ** ** | **June 30, 2005** | ** ** |
| ** **                                                                                                          | ** ** | **(in thousands)**                | ** ** |
| **Cash Flows From Operating  Activities:**                                                                          |       |                                   |       |   |   |   |   |   |   |
| Loss from  continuing operations                                                                                    |       |                                   | $          | (24,824 | ) |   |   | $ | (14,060 | ) |   |
| Adjustments to reconcile  loss from continuing operations to net cash provided by (used for) operating  activities: |       |                                   |       |   |   |   |   |   |   |
| Impairment of intangible assets                                                                                     |       |                                   | 13,203     |   |   |   | — |   |   |
| Stock-based compensation                                                                                            |       |                                   | 2,544      |   |   |   | 274 |   |   |
| Gain on extinguishment of debt                                                                                      |       |                                   | —     |   |   |   | 86 |   |   |
| Depreciation and amortization                                                                                       |       |                                   | 5,013      |   |   |   | 7,630 |   |   |
| Other non-cash items                                                                                                |       |                                   | 444        |   |   |   | 133 |   |   |
| Changes in assets and liabilities                                                                                   |       |                                   | (979       | ) |   |   | (13,139 | ) |   |
| **Net  Cash Used for Operating Activities of Continuing Operations**                                                |       |                                   | (4,599     | ) |   |   | (19,076 | ) |   |
| **Net  Cash Provided by Operating Activities of Discontinued Operations**                                           |       |                                   | 1,554      |   |   |   | (3,939 | ) |   |
| **Net  Cash Used for Operating Activities**                                                                         |       |                                   | $          | (3,045 | ) |   |   | $ | (23,015 | ) |   |
| **Cash Flows From Investing  Activities:**                                                                          |       |                                   |       |   |   |   |   |   |   |
| Maturities of  restricted marketable securities                                                                     |       |                                   | 844        |   |   |   | 844 |   |   |
| Purchases of  property and equipment                                                                                |       |                                   | (812       | ) |   |   | (3,886 | ) |   |
| Purchases of  marketable securities                                                                                 |       |                                   | (68,910    | ) |   |   | (364,679 | ) |   |
| Sales of marketable securities                                                                                      |       |                                   | 32,910     |   |   |   | 43,473 |   |   |
| Maturities of  marketable securities                                                                                |       |                                   | 7,120      |   |   |   | 3,362 |   |   |
| **Net  Cash Used for Investing Activities of Continuing Operations**                                                |       |                                   | (28,848    | ) |   |   | (320,886 | ) |   |
| **Net  Cash Used for Investing Activities of Discontinued Operations**                                              |       |                                   | —     |   |   |   | (1,215 | ) |   |
| **Net  Cash Used for Investing Activities**                                                                         |       |                                   | (28,848    | ) |   |   | (322,101 | ) |   |
| **Cash Flows From Financing  Activities:**                                                                          |       |                                   |       |   |   |   |   |   |   |
| Repurchases and  redemption of long-term debt                                                                       |       |                                   | —     |   |   |   | (18,645 | ) |   |
| Proceeds from  issuance of common stock                                                                             |       |                                   | 1,567      |   |   |   | 121 |   |   |
| **Net  Cash Provided by (Used for) Financing Activities**                                                           |       |                                   | 1,567      |   |   |   | (18,524 | ) |   |
| **Effect  of Foreign Currency Translation on Cash and Cash Equivalents**                                            |       |                                   | 820        |   |   |   | (772 | ) |   |
| **Net  Decrease in Cash and Cash Equivalents**                                                                      |       |                                   | (29,506    | ) |   |   | (364,412 | ) |   |
| **Cash  and Cash Equivalents at Beginning of Period**                                                               |       |                                   | 131,373    |   |   |   | 441,588 |   |   |
| **Cash and Cash Equivalents at  End of Period**                                                                     |       |                                   | $          | 101,867 |   |   |   | $ | 77,176 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

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**ADAPTEC, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(unaudited)**

**1.   Basis ofPresentation**

In the opinion of management, the accompanyingUnaudited Condensed Consolidated Interim Financial Statements (“financialstatements”) of Adaptec, Inc. and its wholly-owned subsidiaries(collectively, the “Company”) have been prepared on a consistent basis with theMarch 31, 2006 audited consolidated financial statements and include alladjustments, consisting of only normal recurring adjustments, necessary tofairly state the information set forth therein. The financial statements havebeen prepared in accordance with the regulations of the SEC, and, therefore,omit certain information and footnote disclosure necessary to present thestatements in accordance with accounting principles generally accepted in theUnited States of America. These financial statements should be read inconjunction with the audited consolidated financial statements and notesthereto included in the Company’s Annual Report on Form 10-K for theyear ended March 31, 2006, which was filed with the SEC on June 14,2006. The first quarters of fiscal 2007 and 2006 ended June 30, 2006 and July 1,2005, respectively. For presentation purposes, the accompanying financialstatements have been shown as ending on the last day of the calendar month. Theresults of operations for the first quarter of fiscal 2007 are not necessarilyindicative of the results to be expected for the entire fiscal year.

As discussed in Note 4, in September 2005, the Companycompleted the sale of its IBM i/p Series RAID component business (“IBM i/pSeries RAID Business”) to International Business Machines (“IBM”) and theCompany’s Board of Directors approved management’s recommendation to divest itssystems business. In January 2006, the Company sold the block-basedportion of its systems business to Sanmina-SCI, and in the quarter ended June 30,2006, management terminated its ongoing efforts to sell the Snap Server portionof the systems business. For comparison purposes, financial information for allhistorical periods have been reclassified to present the results of IBM i/p Series RAIDBusiness and the block-based portion of the systems business as discontinuedoperations. Likewise, the planned divestiture of the systems business had beenaccounted for as discontinued operation, however, with the decision of theCompany’s Board of Directors in the first quarter of fiscal 2007 to retain theSnap Server portion of the systems business, the related amounts have beenreclassified as part of continuing operations. For purposes of comparison,results from prior periods also reflect this reclassification.

The glossary of acronymsand accounting rules and regulations referred to within this QuarterlyReport on Form 10-Q is listed in alphabetical order in Note 16.

**2.   RecentAccounting Pronouncements**

In June 2005, the FASB issued SFAS No. 154,which changes the requirements for the accounting for, and reporting of, achange in accounting principle. Previously, most voluntary changes inaccounting principles were required to be recognized by way of a cumulativeeffect adjustment within net income during the period of the change. SFAS No. 154requires retrospective application to prior periods’ financial statements,unless it is impracticable to determine either the period-specific effects orthe cumulative effect of the change. SFAS No. 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005;however, the statement does not change the transition provisions of anyexisting accounting pronouncements. The Company’s results of operations andfinancial condition will only be impacted following the adoption of SFAS No. 154if it implements changes in accounting principles that are addressed by thestandard or corrects accounting errors in future periods.

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In June 2005, the FASB issued FSP 143-1,which provides guidance in accounting for obligations associated with Directive2002/96/EC (the “Directive”) on Waste Electrical and Electronic Equipmentadopted by the European Union. FSP 143-1 is required to be applied to thelater of the first period ending after June 6, 2005 or the date of theDirective’s adoption into law by the applicable EU member countries in whichthe Company has significant operations. The Directive distinguishes between “new”and “historical” waste. New waste relates to products put on the market after August 13,2005. FSP 143-1 directs commercial users to apply the provisions of SFAS No. 143and the related FIN No. 47 for the measurement and recognition of theliability and asset retirement obligation associated with the historical wastemanagement requirements of the Directive. Additionally, FSP 143-1provides guidance for the accounting by producers for the financing of theobligations of historical waste held by private households. The Company iscontinuing to analyze the impact of the Directive and FSP 143-1 on itsfinancial position and results of operations and once it is completed expectsto adopt FSP143-1 sometime in fiscal 2007.

In November 2005, the FASB issued FSP 115-1and FAS 124-1, which clarifies when an investment is considered impaired,whether the impairment is other than temporary, and the measurement of animpairment loss. It also includes accounting considerations subsequent to therecognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. FSP 115-1 and FAS 124-1 areeffective for all reporting periods beginning after December 15, 2005. At June 30,2006, none of the Company’s unrealized investment losses were recognized asother-than-temporary impairments in its available-for-securities. The adoptionof FSP 115-1 and FAS 124-1 did not have a material effect on ourconsolidated financial position, results of operations or cash flow.

In June 2006, the FASB issued FIN No. 48,“Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies theaccounting for uncertainty in income taxes recognized in a company’s financialstatements in accordance with SFAS No. 109. FIN No. 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. This interpretation also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. FIN 48 is effective beginning with the Company’sfiscal year 2008. The Company is currently assessing the impact, if any, of FINNo. 48 on its financial position and results of operations.

**3.   StockBenefit Plans and Stock-Based Compensation**

*Stock Benefit Plans*

*2004 Equity Incentive Plan:*   Asof June 30, 2006, the Company had an aggregate of 31.7 million shares ofits common stock reserved for issuance under its 2004 Equity Incentive Plan, ofwhich 16.8 million shares are subject to outstanding options and 14.9 millionshares are available for future grants of option and other stock awards. Optionsare subject to terms and conditions as determined by the Company’s Board ofDirectors. Stock options are generally exercisable in increments of 25% duringeach year of employment beginning one year from the date of grant. Stockoptions expire seven years from the date of grant.

*The 2000 Director Stock Option Plan:*   Asof June 30, 2006, the Company had an aggregate of 1.1 million sharesof its common stock reserved for issuance under its 2000 Director Stock OptionPlan, of which 0.9 million shares are subject to outstanding options and 0.2 millionshares are available for future grants of options. Stock options vest overa one-year period and expire ten years after the date of grant.

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Theactivities under the stock option plan is summarized as follows (in thousands,except per share data):

| ** **                                 | ** ** | **Three Months Ended,  June 30, 2006** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Options**                                                | ** ** | **Weighted Average  Exercise Price** | ** ** |
| Outstanding at  March 31, 2006        |       | 19,937,115                                                 |       |   | $ | 8.89 |   |   |
| Granted                                    |       | 958,730                                                    |       |   | 4.47 |   |   |
| Exercised                                  |       | (440,493                                                   | )          |   | 3.56 |   |   |
| Cancelled                                  |       | (2,884,690                                                 | )          |   | 9.91 |   |   |
| Outstanding at June 30, 2006          |       | 17,570,662                                                 |       |   | 8.62 |   |   |
| Options  exercisable at June 30, 2006 |       | 12,019,819                                                 |       |   | $ | 10.20 |   |   |

 

The weighted average grant-date fair value of optionsgranted during the first quarter of 2007 and 2006 was $4.47 and $3.88,respectively. The total intrinsic value of options exercised during the firstquarter of 2007 and 2006 was $1.57 million and $0.1 million, respectively.As of June 30, 2006, the weighted average remaining contractual term foroutstanding options was 4.05 years, with an aggregate intrinsic value of$4.2 million. Of these options outstanding, those exercisable had anaggregate intrinsic value of $2.2 million and a weighted average remainingcontractual term of 3.56 years.

As of June 30, 2006, the total unamortizedstock-based compensation expense related to non-vested stock options was$7.9 million, net of estimated forfeitures, and this expense is expectedto be recognized over a weighted-average period of 1.95 years.Compensation expenses for all stock-based awards granted are recognized usingthe straight-line amortization method.

***Restricted StockAwards and Restricted Stock Units:******  ***As of June 30, 2006,there were 517,080 shares of service-based restricted stock awards and 64,530of restricted stock units outstanding. Restrictions lapse 50% one year from thedate of grant and the remainder at the second anniversary.

Asummary of activity for restricted stock awards and restricted stock units asof June 30, 2006, and changes for the first quarter of 2006 is as follows:

| ** **                       | ** ** | **Shares  in thousands** | ** ** |
|----------------------------------|------------|-------------------------------|------------|
| Nonvested at  March 31,2006 |       |                          | —     |   |   |
| Granted                          |       |                          | 585,010    |   |   |
| Exercised                        |       |                          | —     |   |   |
| Forfeited or  expired            |       |                          | (3,400     | ) |   |
| Nonvested at  June 30, 2006 |       |                          | 581,610    |   |   |

 

The weighted average grant-date fair value ofrestricted stock awards granted during the first quarter of 2006 was $4.23. Theaggregate intrinsic value of restricted stock units that are expected to vest,net of estimated forfeitures, as of June 30, 2006 is $0.3 million. .

As of June 30, 2006, there was $1.7 million oftotal unrecognized compensation cost related to nonvested restricted stockawards and restricted stock units that is expected to vest, net of estimated ofestimated forfeitures. This cost is expected to be recognized over aweighted-average period of 1.96 years.

*Employee Stock Purchase Plan:*   TheCompany has authorized 10,600,000 shares of common stock for issuance under the1986 ESPP. Qualified employees may elect to have a certain percentage (not toexceed 10%) of their salary withheld pursuant to the ESPP. The salary withheldis then used to purchase shares of 

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the Company’s common stockat a price equal to 85% of the market value of the common stock at either thebeginning of the offering period or at the end of each applicable six monthpurchase period, whichever is lower. During fiscal 2001, the Company amendedthe ESPP to extend the offering period from six months to 24 months,beginning in August 2000. Purchases are made every six months. Duringfiscal 2004, an additional 5,000,000 shares were added to the ESPP, making atotal of 15,600,000 authorized shares under the 1986 ESPP.

We did not issue anyshares under our ESPP, for the three months ended June 30, 2006. As ofJune 30, 2006, there were 4.1 million shares reserved for grant underthis program.

*Stock-BasedCompensation*

OnApril 1, 2006, we adopted SFAS 123(R) using the modified prospectivetransition method. SFAS 123(R) requires the measurement and recognition ofcompensation expense for all stock-based awards made to our employees anddirectors including employee stock options, employee stock purchase plans, andother stock-based awards based on estimated fair values. Total compensationcost for the Company’s stock plans in the first quarter of 2006 was $2.5million, which consisted of $1.9 million from stock options, less than $0.1 millionfrom restricted stock awards and restricted stock units, and $0.6 million fromthe employee stock purchase plan. The following table summarizes the impact ofthe adoption of SFAS 123(R) on stock-based compensation costs foremployees on our Condensed Consolidated Statements of Operations for the threemonths ended June 30, 2006 (in thousands):

| ** **                                                    | ** ** | **Three Months Ended** | ** **              |
|---------------------------------------------------------------|------------|----------------------------------|-------------------------|
| ** **                                                    | ** ** | ** **                       | **June 30,  2006** | ** ** | ** ** |
| Employee stock-based  compensation in:                        |       |                             |                    |   |   |
| Cost of revenue                                               |       |                             | $                       | 188 |   |   |
| Total employee stock-based compensation in cost of  revenue   |       |                             | 188                     |   |   |
| Research and development expense                              |       |                             | 1,225                   |   |   |
| Selling, marketing and administrative expense                 |       |                             | 1,116                   |   |   |
| Total employee stock-based compensation in operating  expense |       |                             | 2,341                   |   |   |
| Total employee stock-based compensation                       |       |                             | 2,529                   |   |   |
| Total other stock-based compensation                          |       |                             | —                  |   |   |
| Total stock-based  compensation                               |       |                             | $                       | 2,529 |   |   |
|                                                               |            |                                  |                         |  |  |  |  |  |

 

9

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Throughfiscal 2006, the Company accounted for its stock plans using the intrinsicvalue method prescribed by APB No. 25. The following presents pro formaincome and per share data as if a fair value based method had been used toaccount for stock-based compensation for the first quarter of 2005(inthousands, except income per share amounts):

| ** **                                                                                                                 | ** ** | **Three Months Ended** | ** **              |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------------------|
| ** **                                                                                                                 | ** ** | ** **                       | **June 30,  2005** | ** ** | ** ** |
| ** **                                                                                                                 | ** ** | **(pro forma)**                  | ** **              |
| Net income,  before stock-based compensation for employees, prior period                                                   |       |                             | $                       | (35,973 | ) |   |
| Add: Stock-based compensation expense for employees  previously determined under intrinsic value method, net of tax effect |       |                             | 274                     |   |   |
| Less: Stock-based compensation expense for employees  determined under fair value based method, net of tax effect          |       |                             | (3,496                  | ) |   |
| Net income, after effect of stock-based compensation  for employees                                                        |       |                             | $                       | (39,195 | ) |   |
| Net income per  share:                                                                                                     |       |                             |                    |   |   |
| Basic—as reported for prior period                                                                                    |       |                             | $                       | (0.32 | ) |   |
| Basic—after effect of stock-based compensation for  employees                                                         |       |                             | $                       | (0.35 | ) |   |
| Diluted—as reported for prior period                                                                                  |       |                             | $                       | (0.32 | ) |   |
| Diluted—after  effect of stock-based compensation for employees                                                       |       |                             | $                       | (0.35 | ) |   |
|                                                                                                                            |            |                                  |                         |  |  |  |  |  |

 

Uponadoption of SFAS 123(R), we selected the Black-Scholes option pricing model asthe most appropriate model for determining the estimated fair value forstock-based awards. The use of the Black-Scholes model requires the use ofextensive actual employee exercise behavior data and the use of a number ofcomplex assumptions including expected volatility, risk-free interest rate, andexpected dividends. The assumptions used to value options granted are asfollows:

| ** **               | ** ** | **Three Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005** | ** ** |
| Risk free  interest rate |       |                             | 5.04       | % |   |   | 3.80 | % |   |
| Expected term            |       |                             | 4.22       |   |   |   | 2.35 |   |   |
| Dividend yield           |       |                             | 0.0        |   |   |   | 0.0 |   |   |
| Expected  volatility     |       |                             | 44         | % |   |   | 37 | % |   |

 

Beginning April 1, 2006, we estimated thevolatility of our stock using historical volatility as well as the impliedvolatility in market-traded options on our common stock in accordance withguidance in SFAS 123(R) and SAB 107. Management determined that ablend of implied volatility and historical volatility is more reflective ofmarket conditions and a better indicator of expected volatility than usingpurely historical volatility. We will continue to monitor these and otherrelevant factors used to measure expected volatility for future option grants.Prior to the adoption of SFAS 123(R), we had used our historical stock pricevolatility in accordance with SFAS 123 for purposes of pro forma informationdisclosed in the notes to our consolidated financial statements for priorperiods.

The risk-free interest rate assumption is based uponobserved interest rates appropriate for the term of our employee stock options.The dividend yield assumption is based on our history and expectation ofdividend payouts.

10

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The expected term ofemployee stock options represents the weighted-average period that the stockoptions are expected to remain outstanding. We derived the expected termassumption based on our historical settlement experience, while givingconsideration to options that have life cycles less than the contractual termsand vesting schedules in accordance with guidance in SFAS 123(R) andSAB 107 Prior to the adoption of SFAS 123(R), we used our historicalsettlement experience to derive the expected term for the purposes of pro formainformation under SFAS 123, as disclosed in the notes to our consolidatedfinancial statements for the related periods.

**4.   BusinessAcquisitions and Dispositions**

**IBM i/p Series RAID:****  **On June 29, 2004, the Company completed theacquisition of the IBM i/p Series RAID component business line.

On September 30, 2005, the Company entered into aseries of arrangements with IBM pursuant to which the Company sold its IBM i/p Series RAIDBusiness to IBM for approximately $22.0 million plus $1.3 million for certainfixed assets. In addition, IBM purchased certain related inventory at theCompany’s net book value of $0.8 million. Expenses incurred in the transactionprimarily included costs of approximately $0.5 million for legal and accountingfees. In addition, the Company accrued $0.3 million for lease obligations.Under the terms of the agreements, the Company granted IBM a nonexclusivelicense to certain intellectual property and sold to IBM substantially all ofthe assets dedicated to the engineering and manufacturing of RAID controllersand connectivity products for the IBM i/p Series RAID Business. Under theterms of the nonexclusive license, IBM has been paying royalties to the Companyfor the sale of its board-level products over the next five quarters, which arebeing recognized as contingent consideration in discontinued operations whenearned. In fiscal 2006, the Company received royalties of $5.6 million, whichthe Company recorded in “Income (loss) from disposal of discontinuedoperations, net of taxes,” in its Consolidated Statements of Operations. Additionalroyalties of $1.3 million were recorded in the first quarter of fiscal 2007. ThroughJune 30, 2006, the Company had incurred a cumulative loss of $1.0 millionon the disposal of the IBM i/p Series RAID Business.

**Snap Appliance:**   OnJuly 23, 2004, the Company completed the acquisition of Snap Appliance, aprovider of NAS products. Snap Appliance is included in the Company’s SSGsegment. (Note 14).

On September 29, 2005, the Company’s Board ofDirectors approved management’s recommendation to divest its systems business,including the Snap Appliance business. Accordingly, the Company had classifiedthe systems business as a discontinued operation in its consolidated financialstatements for the three year period ended March 31, 2006 and beganpursuing a sale of the systems business.

The Company had received offers from prospectivebuyers, however, management concluded that the potential value from retainingthe operations outweighed the offers received for the business. On July 6,2006, and effective for the end of the first quarter of fiscal 2007, theCompany’s Board of Directors decided to retain the Snap Systems portion of theserver business and management terminated its ongoing efforts to sell thisbusiness. As a result, results of operations for Snap Systems portion of theserver business business have now been reclassified as part of continuingoperations. For purposes of comparison, results from prior periods also reflectthis reclassification.

As a result of the decision to retain and operate theSnap Systems portion of the server business, the Company performed an analysisin accordance with SFAS No. 144 and determined that the carrying value ofthe business’ long-lived assets exceeded the Company’s estimate of the fairvalue of the long-lived asset group. The Company recognized an impairment lossof $13.2 million based on the excess of the carrying value over the fair valueof the long-lived asset group. The estimate of fair value of the assets wasbased on discounting estimated future cash flows using a discount ratecommensurate with the risks inherent in the current business model. Theestimation of the impairment involves numerous assumptions which require judgmentby the Company, including, but not limited to, future use of the assets by theCompany, 

11

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operations and futureselling prices for the Company’s products. The impairment loss, which wasrecorded as Impairment of intangible assets and other charges in the CondensedConsolidated Statement of Operations was due to the significant research anddevelopment expenditures necessary to grow Snap Systems portion of the serverbusiness revenue and the significant uncertainties associated with achieving the growth in revenue.

On January 31, 2006, the Company signed adefinitive agreement with Sanmina—SCI Corporation and its wholly ownedsubsidiary, Sanmina-SCI USA, Inc., for the sale of the Company’s OEMblock-based systems business for $14.5 million, of which $5.0 million will bereceived over the next two years. In addition, Sanmina-SCI USA agreed to paythe Company contingent consideration of up to an additional $12.0 million ifcertain revenue levels are achieved over a three-year period. The Companyrecorded a gain of $12.1 million on the disposal of the OEM block-based systemsbusiness in the fourth quarter of fiscal 2006.

***Acquisition-RelatedRestructuring:***   During the first quarter offiscal 2006, the Company finalized its Snap Appliance integration plan toeliminate certain duplicative resources, including severance and benefits inconnection with the involuntary termination of approximately 24 employees,exiting duplicative facilities and disposing of duplicative assets. Theacquisition-related restructuring liabilities were accounted for under EITF No. 95-3and therefore were included in the purchase price allocation. The Companyrecorded a total liability of $6.7 million for these activities, of which theoriginal estimate of $6.0 million was recorded in the second quarter offiscal 2005 and adjustments were recorded in each subsequent quarter throughthe first quarter of fiscal 2006 totaling $0.7 million. In the third quarter offiscal 2006, the Company recorded additional adjustments of $0.2 million due toadditional lease costs related to the estimated loss of facilities that theCompany subleased. As of June 30, 2006, the Company had utilized$4.4 million of these charges. The Company anticipates that the remainingrestructuring reserve balance of $2.5 million will be paid out by thethird quarter of fiscal 2012, primarily related to long-term facility leases.

**5.   Balance Sheets Details**

**Inventories:**

| ** **      | ** ** | **June 30, 2006** | ** ** | **March 31, 2006** | ** ** |
|-----------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **      | ** ** | **(in thousands)**     | ** ** |
| Raw materials   |       |                        | $          | 4,988                        |       |   |   | $ | 4,258 |   |   |
| Work-in-process |       |                        | 2,010      |                         |       |   | 4,732 |   |   |
| Finished goods  |       |                        | 28,151     |                         |       |   | 19,269 |   |   |
| Total           |       |                        | $          | 35,149                       |       |   |   | $ | 28,259 |   |   |

 

**Accrued Liabilities:**

| ** **                              | ** ** | **June 30, 2006** | ** ** | **March 31, 2006** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                              | ** ** | **(in thousands)**     | ** ** |
| Tax related                             |       |                        | $          | 48,549                       |       |   |   | $ | 46,704 |   |   |
| Acquisition related                     |       |                        | 3,594      |                         |       |   | 3,635 |   |   |
| Accrued compensation and  related taxes |       |                        | 14,670     |                         |       |   | 16,235 |   |   |
| Other                                   |       |                        | 16,181     |                         |       |   | 21,148 |   |   |
| Total                                   |       |                        | $          | 82,994                       |       |   |   | $ | 87,722 |   |   |

 

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**6.   Other Intangible Assets**

| ** **                                 | ** ** | **June 30, 2006**   | ** ** | **March 31, 2006** | ** ** |
|--------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| ** **                                 | ** ** | **Gross Carrying**Amount | ** ** | **Accumulated**Amortization  | ** ** | **Gross Carrying**Amount | ** ** | **Accumulated**Amortization | ** ** |
| ** **                                 | ** ** | **(in thousands)**       | ** ** |
| Acquisition-related intangible assets:     |       |                          |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Patents, core and existing  technologies   |       |                          | $          | 40,028                       |       |   |   | $ | (30,908 | ) |   |   | $ | 39,578 |   |   |   | $ | (29,426 | ) |   |
| Customer relationships                     |       |                          | 1,047      |                         |       |   | (838 | ) |   |   | 1,047 |   |   |   | (773 | ) |   |
| Trade name                                 |       |                          | 1,074      |                         |       |   | (674 | ) |   |   | 674 |   |   |   | (635 | ) |   |
| Subtotal                                   |       |                          | 42,149     |                         |       |   | (32,420 | ) |   |   | 41,299 |   |   |   | (30,834 | ) |   |
| Intellectual property  assets and warrants |       |                          | 41,623     |                         |       |   | (35,196 | ) |   |   | 41,623 |   |   |   | (33,617 | ) |   |
| Total                                      |       |                          | $          | 83,772                       |       |   |   | $ | (67,616 | ) |   |   | $ | 82,922 |   |   |   | $ | (64,451 | ) |   |

 

Amortization of otherintangible assets was $3.2 million and $12.9 million in the first quartersof fiscal 2007 and 2006, respectively. The intangible assets relating to theSnap Server portion of the systems business have been reclassified fromdiscontinuing operations and are included in the numbers above.

The Company regularly performs reviews to determine iffacts or circumstances are present, either internal or external, which wouldindicate that the carrying values of its long-lived assets may not berecoverable. If such circumstances are determined to exist, an estimate ofundiscounted future cash flows produced by the long-lived asset, or theappropriate grouping of assets, is compared to the carrying value to determinewhether an impairment exists. If an asset is determined to be impaired, theloss is measured based on the difference between the asset’s fair value and itscarrying value. The estimate of fair value of the assets is based ondiscounting estimated future cash flows using a discount rate commensurate withthe risks inherent in the Company’s current business model. The estimation ofthe impairment involves numerous assumptions which require judgment by theCompany, including, but not limited to, future use of the assets for Companyoperations versus sale or disposal of the assets and future selling prices forthe Company’s products. During the first quarter of fiscal 2007, as a result ofretaining the Snap Systems portion of the server business the company performedan impairment analysis that indicated that the carrying amount of thelong-lived assets associated with the business exceeded their estimated fairvalue resulting in an impairment of $13.2 million in the Unaudited ConsolidatedStatement of Operations. Of the resulting impairment $5.6 million related toexisting technology, $3.1 million was recorded as a reduction of coretechnology, and $4.5 million related to trademarks.

The annual amortization expense of the otherintangible assets that existed as of June 30, 2006 is expected to be asfollows:

| ** **                    | ** ** | **Estimated Amortization Expense**  | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|
| ** **                    | ** ** | **Acquisition-related**intangible assets | ** ** | **Intellectual**property assets | ** ** |
| ** **                    | ** ** | **(in thousands)**                       | ** ** |
| Fiscal years:                 |       |                                          |       |   |   |   |   |   |   |
| 2007 (remaining nine  months) |       |                                          | $          | 4,231 |   |   |   | $ | 4,737 |   |   |
| 2008                          |       |                                          | 2,655      |   |   |   | 1,691 |   |   |
| 2009                          |       |                                          | 2,327      |   |   |   | — |   |   |
| 2010                          |       |                                          | 121        |   |   |   | — |   |   |
| 2011 and thereafter           |       |                                          | 395        |   |   |   | — |   |   |
| Total                         |       |                                          | $          | 9,729 |   |   |   | $ | 6,428 |   |   |

 

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**7.   Interest and Other Income**

Thecomponents of interest and other income for the first quarters of fiscal 2007and 2006, were as follows:

| ** **                                   | ** ** | **Three-Month Period Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **June 30, 2006**            | ** ** | **June 30, 2005** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                | ** ** |
| Interest income                              |       |                                   | $          | 5,693 |   |   |   | $ | 3,574 |   |   |
| Loss on redemption of  debt                  |       |                                   | —     |   |   |   | (86 | ) |   |
| Foreign currency  transaction gains (losses) |       |                                   | 179        |   |   |   | (317 | ) |   |
| Other                                        |       |                                   | 31         |   |   |   | 437 |   |   |
| Total                                        |       |                                   | $          | 5,903 |   |   |   | $ | 3,608 |   |   |

 

**8.   Restructuring Charges**

In the first quarter of fiscal 2007, managementapproved and initiated a plan to restructure the operations of the Company bysimplifying its infrastructure. The restructuring plan eliminated certainduplicative resources in all functions of the organization worldwide. Thisresulted in a restructuring charge of $3.0 million for the first quarter offiscal 2007. The Company recorded restructuring charges of $0.04 millionfor the first quarter of fiscal 2006. All expenses, including adjustments,associated with the Company’s restructuring plans are included in“Restructuring charges” in the Unaudited Condensed Consolidated Statements ofOperations and are not allocated to segments but rather managed at thecorporate level. For a complete discussion of all restructuring actions thatwere implemented prior to fiscal 2007, please refer to the Notes toConsolidated Financial Statements included in the Company’s Annual Report onForm 10-K for the year ended March 31, 2006.

Theactivity in the accrued restructuring reserves related, excludingacquisition-related restructuring, was as follows for the first quarter offiscal 2007:

| ** **                                | ** ** | **Severance And  Benefits** | ** ** | **Other Charges** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                | ** ** | **(in thousands)**          | ** ** |
| Reserve balance  at March 31, 2006   |       |                             | $          | 1,185                  |       |      |       | $ | 1,586 |   |   | $ | 2,771 |   |
| First quarter of  2007 restructuring plan |       |                             | 3,011      |                   |       |      | —     |   |   | 3,011 |   |
| Provision  adjustments                    |       |                             | (246       | )                      |       |      | (3         | ) |   | (249 | ) |
| Cash paid                                 |       |                             | (1,819     | )                      |       |      | (237       | ) |   | (2,056 | ) |
| Reserve balance  at June 30, 2006    |       |                             | $          | 2,131                  |       |      |       | $ | 1,346 |   |   | $ | 3,477 |   |

 

The Company anticipatesthat the remaining restructuring severance and benefits balance of $2.2 millionwill be substantially paid out by the third quarter of fiscal 2007. Othercharges will be paid out through fiscal 2009. The remaining restructuringreserve balance is reflected both in “Accrued liabilities” and “Other long-termliabilities” in the Unaudited Condensed Consolidated Balance Sheets.

**9.   Net Loss Per Share**

Basic net loss per shareis computed by dividing net income (loss) by the weighted average number ofcommon shares outstanding during the period. Diluted net loss per share giveseffect to all potentially dilutive common shares outstanding during the period,which include certain stock options and warrants, calculated using the treasurystock method, and convertible notes which are potentially dilutive at certainearnings levels, and are computed using the if-converted method.

14

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Areconciliation of the numerator and denominator of the basic and diluted netloss per share computations were as follows:

| ** **                                                                               | ** ** | **Three-Month Period Ended**                                                  | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **     June 30, 2006     ** | ** ** | **     June 30, 2005     ** | ** ** |
| ** **                                                                               | ** ** | **(in thousands, except per share amounts)**                   | ** ** |
| Numerators:                                                                              |       |                                                                                    |       |   |   |   |   |   |   |
| Loss from continuing  operations                                                         |       |                                                                                    | $          | (24,824 | ) |   |   | $ | (14,060 | ) |   |
| Income (loss) from  discontinued operations                                              |       |                                                                                    | $          | 1,554 |   |   |   | $ | (21,913 | ) |   |
| Adjusted net loss                                                                        |       |                                                                                    | $          | (23,270 | ) |   |   | $ | (35,973 | ) |   |
| Denominators:                                                                            |       |                                                                                    |       |   |   |   |   |   |   |
| Weighted average shares  outstanding—basic                                          |       |                                                                                    | 115,609    |   |   |   | 112,445 |   |   |
| Effect of dilutive securities:                                                           |       |                                                                                    |       |   |   |   |   |   |   |
| Employee stock options                                                                   |       |                                                                                    | —     |   |   |   | — |   |   |
| Weighted average shares  and potentially dilutive common shares outstanding—diluted |       |                                                                                    | 115,609    |   |   |   | 112,445 |   |   |
| Net loss per share:                                                                      |       |                                                                                    |       |   |   |   |   |   |   |
| Basic                                                                                    |       |                                                                                    |       |   |   |   |   |   |   |
| Continuing Operations                                                                    |       |                                                                                    | $          | (0.21 | ) |   |   | $ | (0.13 | ) |   |
| Discontinued Operations                                                                  |       |                                                                                    | $          | 0.01 |   |   |   | $ | (0.19 | ) |   |
| Net Loss                                                                                 |       |                                                                                    | $          | (0.20 | ) |   |   | $ | (0.32 | ) |   |
| Diluted                                                                                  |       |                                                                                    |       |   |   |   |   |   |   |
| Continuing Operations                                                                    |       |                                                                                    | $          | (0.21 | ) |   |   | $ | (0.13 | ) |   |
| Discontinued Operations                                                                  |       |                                                                                    | $          | 0.01 |   |   |   | $ | (0.19 | ) |   |
| Net Loss                                                                                 |       |                                                                                    | $          | (0.20 | ) |   |   | $ | (0.32 | ) |   |

 

Dilutedloss per share for the first quarters of fiscal 2007 and 2006 were based onlyon the weighted-average number of shares outstanding during these periods, asthe inclusion of any common stock equivalents would have been anti-dilutive.The items excluded for the first quarters of fiscal 2007 and 2006 were asfollows:

| ** **                          | ** ** | **Three-Month Period Ended** | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **June 30, 2006**            | ** ** | **June 30, 2005** | ** ** |
| ** **                          | ** ** | **(in thousands)**                | ** ** |
| Outstanding employee  stock options |       |                                   | 17,571     |   |   |   | 19,730 |   |   |
| Warrants(1)                         |       |                                   | 19,874     |   |   |   | 19,874 |   |   |
| 3% Notes                            |       |                                   | 695        |   |   |   | 1,427 |   |   |
| 3⁄4% Notes                       |       |                                   | 19,224     |   |   |   | 19,224 |   |   |

----

       (1) In connection with the issuance of its 3⁄4% Convertible Senior Notes due 2023 (the “3⁄4% Notes”), the Company entered into aderivative financial instrument to repurchase up to 19,224,000 shares of itscommon stock, at the Company’s option, at specified prices in the future tomitigate any potential dilution as a result of the conversion of the 3⁄4% Notes. For further discussion on thisderivative financial instrument, please refer to Note 6 of the Notes toConsolidated Financial Statements in the Company’s Annual Report on Form 10-Kfor the year ended March 31, 2006.

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**10.   ComprehensiveLoss**

TheCompany’s comprehensive loss, which consisted of net loss and the changes innet unrealized gains on marketable securities and foreign currency translationadjustments were as follows:

| ** **                                     | ** ** | **Three-Month Period Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                     | ** ** | **June 30, 2006**            | ** ** | **June 30, 2005** | ** ** |
| ** **                                     | ** ** | **(in thousands)**                | ** ** |
| Net loss                                       |       |                                   | $          | (23,270 | ) |   |   | $ | (35,973 | ) |   |
| Net unrealized  gains on marketable securities |       |                                   | 653        |   |   |   | 421 |   |   |
| Foreign currency  translation adjustment       |       |                                   | (867       | ) |   |   | (805 | ) |   |
| Comprehensive  loss                            |       |                                   | $          | (23,484 | ) |   |   | $ | (36,357 | ) |   |

 

Thecomponents of accumulated other comprehensive income were as follows:

| ** **                                  | ** ** | **June 30, 2006** | ** ** | **March 31, 2006** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | **(in thousands)**     | ** ** |
| Unrealized losses  on marketable securities |       |                        | $          | (3,891                       | )          |   |   | $ | (3,233 | ) |   |
| Foreign currency  translation               |       |                        | 1,314      |                         |       |   | 452 |   |   |
| Total                                       |       |                        | $          | (2,577                       | )          |   |   | $ | (2,781 | ) |   |

 

**11.   IncomeTaxes**

Income tax provisions forinterim periods are based on the Company’s estimated annual income tax rate. Inthe first quarter of fiscal 2007, the Company recorded an income tax provisionof $0.9 million on a pre-tax loss from continuing operations of $23.9 million.In the first quarter of fiscal 2006, the Company recorded an income taxprovision of $0.8 million on a pre-tax loss from continuing operations of $13.2 million.The estimated annual tax rate differs from the combined United States Federaland state statutory income tax rate of 40% primarily due to the valuationallowance recorded on all of the U.S. net deferred tax assets, foreign taxesrelated to the Company’s foreign subsidiaries the amortization of certainacquisition related intangible assets, excluding goodwill, that are not fullydeductible for tax purposes and interest accrued on prior years’ tax disputes.The Company is in ongoing negotiations with the IRS with regard to its varioustax disputes that may result in settlement of certain issues. The Company’s taxrate for the period in which a settlement is reached will be impacted if thesettlement materially differs from the amounts previously accrued.

**12.   Commitmentsand Contingencies**

The Company has been, or is, subject to IRS audits forits fiscal years 1994 through 2003. The fiscal 1994 through fiscal 1996 cycle,which is docketed in the United States Tax Court, was resolved in December 2001.The outcome did not have a material adverse effect on the Company’s financialposition or results of operations, as sufficient tax provisions had been made.The final Tax Court stipulation will be filed when the subsequent audit cyclesare completed. Tax credits that were generated but not used in subsequent yearsmay be carried back to the fiscal 1994 to 1996 audit cycle.

On December 15, 2000, the Company received astatutory notice of deficiency from the IRS with respect to its Federal incometax return for fiscal 1997. The Company filed a Petition with the United StatesTax Court on March 14, 2001, contesting the asserted deficiencies.Settlement agreements have been filed with the United States Tax Court on allbut one issue. The Company believes that the final outcome of all issues willnot have a material adverse impact on its financial position or results ofoperations, as the Company believes that it has meritorious defenses againstthe asserted deficiencies and any proposed adjustments and that it has made sufficienttax provisions. However, the Company cannot 

16

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predict with certainty howthese matters will be resolved and whether it will be required to makeadditional payments.

In addition, the IRS is currently auditing the Company’sFederal income tax returns for fiscal 1998 through fiscal 2003. In the thirdquarter of fiscal 2005, the Company resolved all issues for fiscal 1998 throughfiscal 2001, other than the rollover impact of any potential resolution on theremaining fiscal 1997 issue and tax credits that were generated but not used insubsequent years that may be carried back. The Company believes that it hasprovided sufficient tax provisions for these years and the ultimate outcome ofthe IRS audits will not have a material adverse impact on its financialposition or results of operations in future periods. However, the Companycannot predict with certainty how these matters will be resolved and whether itwill be required to make additional tax payments.

The Company is a party to other litigation matters andclaims, including those related to intellectual property, which are normal inthe course of its operations, and while the results of such litigation mattersand claims cannot be predicted with certainty, the Company believes that thefinal outcome of such matters will not have a material adverse impact on itsfinancial position or results of operations. However, because of the nature andinherent uncertainties of litigation, should the outcome of these actions beunfavorable, the Company’s business, financial condition, results of operationsand cash flows could be materially and adversely affected.

In connection with theCompany’s acquisitions of Snap Appliance, Eurologic and Elipsan Limited (“Elipsan”),portions of the purchase price and other future payments totaling $6.7 million,$3.8 million and $2.0 million, respectively, were held back (the “Holdbacks”)for unknown liabilities that may have existed as of the acquisition dates. TheCompany has asserted claims against the Snap Appliance and Eurologic Holdbackstotaling $3.0 million and $1.5 million, respectively. The Elipsan Holdback willbe paid in fiscal 2007, except for funds necessary to provide for any pendingclaims.

**13.   Guarantees**

*IntellectualProperty Indemnification Obligations*

The Company has enteredinto agreements with customers and suppliers that include intellectual propertyindemnification obligations. These indemnification obligations generallyrequire the Company to compensate the other party for certain damages and costsincurred as a result of third party intellectual property claims arising fromthese transactions. In each of these circumstances, payment by the Company isconditional on the other party making a claim pursuant to the proceduresspecified in the particular contract, which procedures typically allow theCompany to challenge the other party’s claims. Further, the Company’sobligations under these agreements may be limited in terms of time and/oramount, and in some instances, the Company may have recourse against third partiesfor certain payments made by it under these agreements. It is not possible tomake a reasonable estimate of the maximum potential amount of future paymentsunder these or similar agreements due to the conditional nature of the Company’sobligations and the unique facts and circumstances involved in each particularagreement. Historically, the Company has not incurred significant costs todefend lawsuits or settle claims related to such agreements and no amount hasbeen accrued in the accompanying financial statements with respect to theseindemnification guarantees.

*Product Warranty*

The Company provides an accrual for estimated futurewarranty costs based upon the historical relationship of warranty costs tosales. The estimated future warranty obligations related to product sales arerecorded in the period in which the related revenue is recognized. Theestimated future warranty obligations are affected by product failure rates,material usage and replacement costs incurred in correcting a product failure.If actual product failure rates, material usage or replacement costs differfrom 

17

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the Company’s estimates,revisions to the estimated warranty obligations would be required; however, theCompany made no adjustments to pre-existing warranty accruals in the firstquarters of fiscal 2007 and 2006.

Areconciliation of the changes to the Company’s warranty accrual for the firstquarters of fiscal 2007 and 2006 was as follows:

| ** **                      | ** ** | **Three-Month Period Ended** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|
| ** **                      | ** ** | **June 30, 2006**            | ** ** | **June 30, 2005** | ** ** |
| ** **                      | ** ** | **(in thousands)**                | ** ** |
| Balance at  beginning of period |       |                                   | $          | 1,819 |   |   |   | $ | 2,084 |   |   |
| Warranties provided             |       |                                   | 1,240      |   |   |   | 1,383 |   |   |
| Actual costs  incurred          |       |                                   | (1,409     | ) |   |   | (1,520 | ) |   |
| Balance at end of period        |       |                                   | $          | 1,650 |   |   |   | $ | 1,947 |   |   |

 

**14.   SegmentReporting**

For the three monthperiod ended June 30, 2006, the Company operated in three reportablesegments: DPS, DSG and SSG. A description of the types of customers or productsand services provided by each reportable segment is as follows:

·       DPSprovides storage products and currently sells all of its storage technologiesin various form factors, such as board-level products, ASICs and stand-alonesoftware. The Company sells these products directly to OEMs, ODMs thatsupply OEMs, VARs and end users through its network of distribution andreseller customers.

·       DSGprovides high-performance I/O connectivity and digital media products forpersonal computing platforms, including notebook and desktop PCs. The Companysells these products to retailers, OEMs and distributors.

·       SSGprimarily provides Snap Server products, including NAS hardware and relatedsoftware. The Company sells these products to VARs and end users through itsnetwork of distribution and reseller channels.

The unallocated corporate income and expenses, whichare in the “Other” category, include amortization of acquisition-relatedintangible assets, restructuring charges, goodwill impairment, other charges,interest and other income, interest expense, all administrative expenses and certainresearch and development, selling and marketing expenses.

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Summarizedfinancial information on the Company’s reportable segments is shown in thefollowing table. There were no inter-segment revenues for the periods shownbelow. The Company does not separately track all tangible assets ordepreciation by operating segments nor are the segments evaluated under thesecriteria. Segment financial information is summarized as follows for the firstquarters of fiscal 2007 and 2006:

| ** **                                    | ** ** | **DPS**                 | ** ** | **DSG** | ** ** | **SSG** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|---------|------------|---------|------------|-----------|------------|-----------|------------|
| ** **                                    | ** ** | **(in thousands)** | ** ** |
| Three-Month Period Ended  June 30, 2006: |       |                    |       |    |       |    |       |      |       |      |       |
| Net revenues                                  |       | $                       | 56,108     |    | $          | 5,203   |       | $         | 7,760      |      | $          | — |   | $ | 69,071 |   |
| Segment income (loss)                         |       | 7,270                   |       | 919     |       | (1,094  | )          | (31,025   | )          | (23,930   | )          |
| Three-Month Period Ended  June 30, 2005: |       |                    |       |    |       |    |       |      |       |      |       |
| Net revenues                                  |       | $                       | 65,171     |    | $          | 8,792   |       | $         | 9,850      |      | $          | — |   | $ | 83,813 |   |
| Segment income  (loss)                        |       | 9,264                   |       | (381    | )          | (486    | )          | (21,611   | )          | (13,214   | )          |

 

Thefollowing table presents the details of unallocated corporate income andexpenses for the first quarters of fiscal 2007 and 2006:

| ** **                                   | ** ** | **Three-Month Period Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **June 30, 2006**            | ** ** | **June 30, 2005** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                | ** ** |
| Unallocated  corporate expenses, net         |       |                                   | $          | (19,099 | ) |   |   | $ | (24,207 | ) |   |
| Restructuring  charges                       |       |                                   | (3,011     | ) |   |   | (40 | ) |   |
| Impairment of  intangibles and other charges |       |                                   | (13,942    | ) |   |   | — |   |   |
| Interest and  other income                   |       |                                   | 5,903      |   |   |   | 3,608 |   |   |
| Interest expense                             |       |                                   | (876       | ) |   |   | (972 | ) |   |
| Total                                        |       |                                   | $          | (31,025 | ) |   |   | $ | (21,611 | ) |   |

 

**15.   Supplemental Disclosure of Cash Flows**

| ** **                                        | ** ** | **Three-Month Period Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                        | ** ** | **June 30, 2006**            | ** ** | **June 30, 2005** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                | ** ** |
| Non-cash investing and  financial activities:     |       |                                   |       |   |   |   |   |   |   |
| Adjustment for  deferred stock-based compensation |       |                                   | $          | 319 |   |   |   | $ | 390 |   |   |
| Unrealized loss on  available-for-sale securities |       |                                   | 653        |   |   |   | 421 |   |   |
|                                                   |            |                                        |            |  |  |  |  |  |  |  |  |

 

**16.   Glossary**

The following is alist of business related acronyms that are contained within this QuarterlyReport on Form 10-Q. They are listed in alphabetical order.

·       **ASIC:** Application Specific IntegratedCircuit

·       **ATA:** Advanced Technology Attachment

·       **DAS:** Direct-Attached Storage

·       **DPS:** Data Protection Solutions

·       **DSG:** Desktop Solutions Group

·       **ESPP:** Employee Stock Purchase Plan

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·       **I/O:** Input/Output

·       **IP:** Internet Protocol

·       **IPsec:** Internet Protocol Security

·       **IRS:******InternalRevenue Service

·       **iSCSI:** Internet Protocol SCSI

·       **NAS:** Network Attached Storage

·       **ODM:** Original Design Manufacturer

·       **OEM:** Original Equipment Manufacturer

·       **PC:** Personal Computer

·       **PCI:** Peripheral Component Interconnect

·       **RAID:** Redundant Array of Independent Disks

·       **ROC:** RAID on a Chip

·       **SAN:** Storage Area Networks

·       **SAS:** Serial Attached SCSI

·       **SATA:** Serial Advanced Technology Attachment

·       **SCSI:** Small Computer System Interface

·       **SMI-S:** Storage Management InitiativeSpecification

·       **SSG:** Snap Server Group

·       **Ultra DMA:** Ultra Direct Memory Access

·       **USB:** Universal Serial Bus

·       **VAR:** Value Added Reseller

The following is alist of accounting rules and regulations and related regulatory bodiesreferred to within this Quarterly Report on Form 10-Q. They arelisted in alphabetical order.

·       **APB:** Accounting Principles Board

·       **APB Opinion No. 20:** Accounting Changes

·       **APB Opinion No. 25:**Accounting forStock Issued to Employees

·       **ARB:**Accounting Research Bulletin

·       **EITF:** Emerging Issues Task Force

·       **EITF No. 95-3:**Recognition ofLiabilities in Connection with Purchase Business Combinations

·       **EITF No. 96-18:**Accounting forEquity Instruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods or Services

·       **EITF No. 03-01:**The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments

·       **FASB:** Financial Accounting Standards Board

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·       **FIN:** FASB Interpretation Number

·       **FIN No. 47:**Accounting for ConditionalAsset Retirement Obligations—an interpretation of FASB Statement No. 143

·       **FIN No. 48:**Accounting for Uncertaintyin Income Taxes

·       **FSP:** FASB Staff Position

·       **FSP 115-1 and FAS 124-1:**The Menaing of Other-Than-Temporary Impairment and Its Application to CertainInvestments

·       **SAB:**Staff Accounting Bulletin

·       **SAB 107:**Share Based Payment

·       **SEC:** Securities Exchange Commission

·       **SFAS:** Statement of Financial AccountingStandards

·       **SFAS No. 3:**Reporting AccountingChanges in Interim Financial Statements

·       **SFAS No. 95:**Statement of Cash Flows

·       **SFAS No. 109:**Accounting for IncomeTaxes

·       **SFAS No. 115:**Accounting for CertainInvestments in Debt and Equity Securities

·       **SFAS No. 123:**Accounting forStock-Based Compensation

·       **SFAS No. 123(R):**Share Based Payment

·       **SFAS No. 143:**Accounting for AssetRetirement Obligations

·       **SFAS No. 144:**Accounting for theImpairment or Disposal of Long-Lived Assets

·       **SFAS No. 151:**Inventory Costs—anamendment of ARB No. 43, Chapter 4

·       **SFAS No. 154:**Accounting Changes andError Corrections, a replacement of APB Opinion No. 20 and SFAS No. 3

 

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**Item 2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q containsforward-looking statements that involve risks and uncertainties. The statementscontained in this document that are not purely historical are forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934, including, withoutlimitation, statements regarding our expectations, beliefs, intentions orstrategies regarding our business, including, but not limited to, our intentionto sell a portion of our systems business, expected revenues from our DSGsegment, and our liquidity in future periods. We may identify these statementsby the use of words such as “anticipate,” “believe,” “continue,” “could,” “estimate,”“expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “project,” “should,”“will,” “would” and other similar expressions. All forward-looking statementsincluded in this document are based on information available to us on the datehereof, and we assume no obligation to update any such forward-lookingstatements, except as may otherwise be required by law.

Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of certain factors,including those set forth in the “Risk Factors” section and elsewhere in thisdocument. In evaluating our business, current and prospective investors shouldconsider carefully these factors in addition to the other information set forthin this document.

While management believes that the discussion andanalysis in this report is adequate for a fair presentation of the informationpresented, we recommend that you read this discussion and analysis inconjunction with our Annual Report on Form 10-K for the year ended March 31,2006.

For your convenience, wehave included, in Note 16 to the Notes to the Unaudited Condensed ConsolidatedFinancial Statements, a Glossary that contains a list of (1) key acronymscommonly used in our industry that are used in this Quarterly Report and (2) accountingrules and regulations that are also referred to herein. These key acronymsand accounting rules and regulations are listed in alphabetical order.

**Recent Developments**

On September 29, 2005, our Board of Directorsapproved management’s recommendation to divest our systems business, whichincludes substantially all of the operating assets and cash flows that wereobtained through our acquisitions of Snap Appliance and Eurologic Systems infiscal 2004, as well as internally developed hardware and software. Inconnection with this action, we classified the systems business as adiscontinued operation in our consolidated financial statements in September 2005,and sold the block-based portion of the systems business in January 2006.

On July 6, 2006, ourBoard of Directors decided to retain the Snap Server portion of the systemsbusiness, and management terminated its ongoing efforts to sell this business. Asa result of the decision to retain the Snap Systems portion of the serverbusiness, we reorganized our segments in the first quarter of 2007, adding theSSG segment to our previous DPS and DSG segments. Our SSG segment primarilyprovides Snap Server products, including NAS hardware and related software. Wesell these products to VARs and end users through our network of distributionand reseller channels.”

**Results ofOperations**

**Overview**

In the first quarter of fiscal 2007, our revenues decreased 18% ascompared to the first quarter of fiscal 2006 due primarily to slower adoptionof our newer generation of serial products as compared to the declining revenuebase of our parallel products. In the first quarter of fiscal 2007, IBM andDell accounted for 34% and 17% of revenues, respectively, compared with 23% and14%, respectively for IBM and Dell in the first quarter of fiscal 2006.  The increase in gross margin in the firstquarter of fiscal 2007 compared to 

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the first quarter of fiscal 2006 wasprimarily due to cost reductions taken throughout fiscal 2006 that we began torealize in the first quarter of 2007, coupled with favorable pricingnegotiations with certain of our customers. Operating expenses also decreasedin the first quarter of fiscal 2007 as compared to the first quarter of fiscal2006 as a result of cost reductions and restructuring efforts.

Our future revenue growth remains largely dependent onthe success of our new products addressing serial technologies (i.e., SAS, SATAand iSCSI), new OEM design wins and channel growth.

Thefollowing table sets forth the items in the UnauditedCondensed Consolidated Statements of Operations as a percentage of netrevenues (references to notes in the footnotes to this table are to the Notesto Unaudited Condensed Consolidated Financial Statements appearing in thisreport):

| ** **                                                     | ** ** | **Three-Month Period Ended(1)** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **June 30, 2006**               | ** ** | **June 30, 2005** | ** ** |
| Net revenues                                                   |       |                                      | 100        | % |   |   | 100 | % |   |
| Cost of revenues                                               |       |                                      | 68         |   |   |   | 71 |   |   |
| Gross margin                                                   |       |                                      | 32         |   |   |   | 29 |   |   |
| Operating expenses:                                            |       |                                      |       |   |   |   |   |   |   |
| Research and development                                       |       |                                      | 25         |   |   |   | 22 |   |   |
| Selling, marketing and administrative                          |       |                                      | 22         |   |   |   | 22 |   |   |
| Amortization of acquisition-related intangible  assets         |       |                                      | 2          |   |   |   | 4 |   |   |
| Restructuring charges                                          |       |                                      | 5          |   |   |   | 0 |   |   |
| Impairment of intangible assets and other charges  (gains)     |       |                                      | 20         |   |   |   | (0 | ) |   |
| Total operating expenses                                       |       |                                      | 74         |   |   |   | 48 |   |   |
| Loss from  continuing operations                               |       |                                      | (42        | ) |   |   | (19 | ) |   |
| Interest and  other income                                     |       |                                      | 8          |   |   |   | 4 |   |   |
| Interest expense                                               |       |                                      | (1         | ) |   |   | (1 | ) |   |
| Loss from  continuing operations before income taxes           |       |                                      | (35        | ) |   |   | (16 | ) |   |
| Provision for  income taxes                                    |       |                                      | (1         | ) |   |   | (1 | ) |   |
| Provision from  continuing operations                          |       |                                      | (36        | ) |   |   | (17 | ) |   |
| Discontinued operations,  net of taxes (Note 4)                |       |                                      |       |   |   |   |   |   |   |
| Loss from  discontinued operations, net of taxes               |       |                                      | (0         | ) |   |   | (26 | ) |   |
| Income from  disposal of discontinued operations, net of taxes |       |                                      | 2          |   |   |   | — |   |   |
| Income (loss)  from discontinued operations                    |       |                                      | 2          |   |   |   | (26 | ) |   |
| Net loss                                                       |       |                                      | (34        | )% |   |   | (43 | )% |   |

 

In the first quarter offiscal 2007, we recorded an impairment charge of $13.2 million related to theSnap Systems server  business, for whichthe entire amount was recorded to Impairment of intangible assets and othercharges. In the first quarter of fiscal 2006, we recorded an impairment chargeof $15.5 million related to our IBM i/p Series RAID component business(the “IBM i/p Series RAID business”), which we subsequently sold to IBM inSeptember 2005, of which $7.5 million was recorded as a reduction to “Netrevenues” and $8.0 million was recorded to Impairment of intangible assets andother charges.

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**Net Revenues.**

| ** **                          | ** ** | **Three-Month Period Ended**               | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|
| ** **                          | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **                          | ** ** | **(in millions, except percentages)** | ** ** |
| **Segment Net Revenues:** |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| DPS                                 |       |                                                 | $          | 56.1 |   |   |   | $ | 65.2 |   |   |   | (14 | )% |   |
| DSG                                 |       |                                                 | 5.2        |   |   |   | 8.8 |   |   |   | (41 | )% |   |
| SSG                                 |       |                                                 | 7.8        |   |   |   | 9.8 |   |   |   | (20 | )% |   |
| **Total  Net Revenues**             |       |                                                 | $          | 69.1 |   |   |   | $ | 83.8 |   | ** ** | ** ** | **(18** | **)%** | ** ** |

 

Revenues from our DPS segment decreased by $9.1 million in the firstquarter of fiscal 2007 as compared to the first quarter of fiscal 2006,reflecting a decline in sales volumes and average selling prices of ourparallel SCSI products, which was partially offset by increased sales of ourserial products and benefits associated with the renegotiation of a customersupply contract. The decline in sales volumes of our SCSI products wasprimarily attributable to the transition from parallel to serial products inwhich we have a lower market share and a shift to lower-priced SATA solutionsin which there is a more competitive market. The DPS segment performance wasalso hindered during the first quarter of fiscal 2007 due to supply issues thatresulted from the transition of manufacturing operations to a contractmanufacturer. During the quarter, our contract manufacturer was challenged withmaterial shortages and systems transitions that impacted their ability to meetdelivery commitments on a consistent basis, which consequently prevented usfrom completing certain product shipments during the quarter. These shortagesare expected to continue through August 2006.

Revenues from our DSG segment decreased by $3.6 million in the firstquarter of fiscal 2007 as compared to the first quarter of fiscal 2006primarily due to the decline in sales volumes of our digital media products andSCSI-based desktop computer products. We expect revenues from our DSG productsto continue to decline as OEMs are incorporating other connectivity technologiesdirectly into their products.

Revenues fromour SSG segment decreased by $2.0 million in the first quarter of fiscal 2007as compared to the first quarter of fiscal 2006 primarily as a result ofdecreased sales resources focusing on the Snap Systems portion of the serverbusiness while it was available for sale, combined with customer concerns overthe future of the product lines.

| ** **                   | ** ** | **Three-Month Period Ended** | ** ** |
|------------------------------|------------|----------------------------------------|------------|
| ** **                   | ** ** | **June 30, 2006**            | ** ** | **June 30, 2005** | ** ** |
| **Geographical Revenues:**   | ** ** |                                   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| North America                |       |                                   | 45         | % |   |   | 45 | % |   |
| Europe                       |       |                                   | 26         | % |   |   | 33 | % |   |
| Pacific Rim                  |       |                                   | 29         | % |   |   | 22 | % |   |
| Total  Geographical Revenues |       |                                   | 100        | % |   |   | 100 | % |   |

 

Our overall international revenues remained flat as a percentage ofour total revenues in the first quarter of fiscal 2007 as compared to the firstquarter of fiscal 2006. Included in European revenues for the first quarter offiscal 2006 was a $5 million customer order that we do not expect to berepeated. Notwithstanding our supply and manufacturing constraints, we wereable to deliver many RoHS compliant products to the European markets in thefirst quarter of fiscal 2007. The increase in the Pacific Rim market is due tothe movement of some of our customer’s production to this region.

A small number of ourcustomers account for a substantial portion of our net revenues, and we expectthat a limited number of customers will continue to represent a substantialportion of our net revenues for 

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theforeseeable future. In the first quarter of fiscal 2007, IBM and Dell accountedfor 34% and 17% of our total revenues, respectively. In the first quarter offiscal 2006, IBM and Dell accounted for 23% and 14% of our total revenues,respectively.

**Gross Margin.**

| ** **   | ** ** | **Three-Month Period Ended**               | ** ** |
|--------------|------------|------------------------------------------------------|------------|
| ** **   | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **   | ** ** | **(in millions, except percentages)** | ** ** |
| Gross Profit |       |                                                 | $          | 22.3 |   |   |   | $ | 24.1 |   |   |   | (8 | )% |   |
| Gross Margin |       |                                                 | 32         | % |   |   | 29 | % |   |   | 3 | % |   |

 

The increase in grossmargin in the first quarter of fiscal 2007 compared to the first quarter offiscal 2006 was primarily due to an excess inventory adjustment of $4.3 millionin the first quarter of fiscal 2006 related to the transition of our productsto comply with the European RoHS Directive and to the benefits associated withrenegotiated supply contracts in the December quarter of fiscal 2006. Wehave also been able to successfully lower our expenses through cost-controlmeasures; however, the favorable impact was reduced due to the decrease inrevenue from the first quarter of fiscal 2006. Cost of sales for the firstquarter of fiscal 2007 included $0.2 million of charges related to the adoptionof SFAS 123(R).

**Research and Development Expense.**

| ** **                | ** ** | **Three-Month Period Ended**               | ** ** |
|---------------------------|------------|------------------------------------------------------|------------|
| ** **                | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **                | ** ** | **(in millions, except percentages)** | ** ** |
| Research and  Development |       |                                                 | $          | 17.3 |   |   |   | $ | 18.4 |   |   |   | (6 | )% |   |
|                           |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in research anddevelopment expense in the first quarter of fiscal 2007 as compared to thefirst quarter of fiscal 2006 was primarily due to reduced headcount as a resultof restructuring programs implemented in fiscal 2006 and decreasedinfrastructure spending. Research and Development expense for the first quarterof fiscal 2007 included $1.2 million of charges related to the adoption of SFAS 123(R).

**Selling, Marketing and Administrative Expense.**

| ** **                             | ** ** | **Three-Month Period Ended**               | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **                             | ** ** | **(in millions, except percentages)** | ** ** |
| Selling,  Marketing and Administrative |       |                                                 | $          | 15.4 |   |   |   | $ | 18.5 |   |   |   | (17 | )% |   |
|                                        |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in selling, marketingand administrative expense in the first quarter of fiscal 2007 as compared tothe first quarter of fiscal 2006 was primarily a result of compensation expenserecorded in the first quarter of fiscal 2006 of $1.2 million in relation toretirement costs of our former CEO and reductions of our workforce andinfrastructure spending as a result of the restructuring plans we implementedin fiscal 2006. Selling, Marketing and Administrative expense for the firstquarter of fiscal 2007 included $1.1 million of charges related to the adoptionof SFAS 123(R).

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**Amortization of Acquisition-Related IntangibleAssets.**

| ** **                                             | ** ** | **Three-Month Period Ended**               | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **                                             | ** ** | **(in millions, except percentages)** | ** ** |
| Amortization of  Acquisition-Related Intangible Assets |       |                                                 | $          | 1.6 |   |   |   | $ | 3.1 |   |   |   | (48 | )% |   |
|                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Acquisition-related intangible assets include patents,core and existing technologies, covenants-not-to-compete, supply agreement,foundry agreement, customer relationships and trade names. We amortize theacquisition-related intangible assets over periods which reflect the pattern inwhich the economic benefits of the assets are expected to be realized, which isprimarily using the straight-line method over their estimated useful lives,ranging from three months to seven years.

The decrease inamortization of acquisition-related intangible assets in the first quarter offiscal 2007 compared to the first quarter of fiscal 2006 was due to the absenceof amortization of $2.6 million of purchased intangible assets related tothe disposition of the IBM i/p Series RAID business in September 2005and lower amortization related to Snap Appliance intangible assets which werewritten down through charges recorded in March 2006 and June 2006.

**Restructuring Charges.**

| ** **             | ** ** | **Three-Month Period Ended**               | ** ** |
|------------------------|------------|------------------------------------------------------|------------|
| ** **             | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **             | ** ** | **(in millions, except percentages)** | ** ** |
| Restructuring  Charges |       |                                                 | $          | 3.0 |   |   |   | $ | 0.04 |   |   |   | 7,428 | % |   |
|                        |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

All expenses, includingadjustments, associated with our restructuring plans are included in “Restructuringcharges” in the Unaudited Condensed Consolidated Statements of Operations andare not allocated to segments but rather managed at the corporate level. For acomplete discussion of all restructuring actions that were implemented prior tofiscal 2007, please refer to the Notes to Consolidated Financial Statementsincluded in our Annual Report on Form 10-K for the year ended March 31,2006. In the first quarter of fiscal 2007, we recorded a provision of $3.0million related to severance and benefits related to the first quarter offiscal 2007 restructuring plan.

**Amortization of Intangibles and Other Charges.**

| ** **                                     | ** ** | **Three-Month Period Ended**               | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                     | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **                                     | ** ** | **(in millions, except percentages)** | ** ** |
| Amortization of  Intangibles and Other Charges |       |                                                 | $          | 13.9 |   |   |   | $ | — |   |   |   | 100 | % |   |
|                                                |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

We regularly perform reviews to determine if facts orcircumstances are present, either internal or external, which would indicatethat the carrying values of our long-lived assets may not be recoverable. Ifsuch circumstances are determined to exist, an estimate of undiscounted futurecash flows produced by the long-lived asset, or the appropriate grouping ofassets, is compared to the carrying value to determine whether an impairmentexists. If an asset is determined to be impaired, the loss is measured based onthe difference between the asset’s fair value and its carrying value. Theestimate of fair value of the assets is based on discounting estimated futurecash flows using a discount rate commensurate with the risks inherent in itscurrent business model. The estimation of the impairment involves numerousassumptions which require judgment by us, including, but not limited to, futureuse of the assets for our operations versus sale or disposal of the assets andfuture selling prices for our products.

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At the end of the first quarter of fiscal 2007, adecision was made to retain the Snap Server portion of the systems business,and management terminated its ongoing efforts to sell this business. We hadclassified the entire systems business as a discontinued operation in September 2005,and sold the block-based portion of the systems business in January 2006. Inthe fourth quarter of fiscal 2006, we recorded an impairment charge of $10.0million on the long-lived assets held for sale to adjust the carrying value ofthese assets to fair value, which was aligned to the offers being negotiated.  With the decision at the end of the secondquarter of fiscal 2007 to retain the Snap Server portion of the systemsbusiness, amounts which had previously classified as discontinued operationshave been reclassified as part of continuing operations. For purposes ofcomparison, results from prior periods also reflect this reclassification.

As a result of the decision to retain and operate theSnap Systems portion of the server business, we performed an impairmentanalysis of this business. Due to the limited cash flows and a number ofuncertainties, the analysis indicated that the carrying amount of theintangible assets associated with Snap Systems server business exceeded theirestimated fair value, resulting in a required impairment of $13.2 million,which was recorded against Impairment of intangibles and other charges.

The remaining amount inOther Charges include legal and consulting fees incurred in connection with theeffort that had been undertaken to sell the Snap Systems portion of the serverbusiness.

**Interest and Other Income.**

| ** **                                    | ** ** | **Three-Month Period Ended**               | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                    | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **                                    | ** ** | **(in millions, except percentages)** | ** ** |
| **Interest and Other Income:** |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                               |       |                                                 | $          | 5.7 |   |   |   | $ | 3.6 |   |   |   | 59 | % |   |
| Loss on  redemption of debt                   |       |                                                 | —     |   |   |   | (0.1 | ) |   |   | 100 | % |   |
| Translation gain  (loss)                      |       |                                                 | 0.2        |   |   |   | (0.3 | ) |   |   | 167 | % |   |
| Other                                         |       |                                                 | —     |   |   |   | 0.4 |   |   |   | 100 | % |   |
| **Total  Interest and Other Income**          |       |                                                 | $          | 5.9 |   |   |   | $ | 3.6 |   | ** ** | ** ** | **64** | **%** | ** ** |

 

Interest and other income isprimarily attributable to interest income earned on our cash, cash equivalentsand marketable securities, fluctuations in foreign currency gains or losses,realized gains and losses on marketable securities, sublease income receivedfrom third parties and loss from the repurchase of our 3% ConvertibleSubordinated Notes due 2007 (the “3% Notes”). The increase in interest andother income in the first quarter of fiscal 2007 as compared to the firstquarter of fiscal 2006 was primarily due to higher interest rates, whichresulted in additional income earned on our cash, cash equivalents andmarketable securities. Other income in the first quarter of fiscal 2006 was aresult of sublease income, which was minimal in the first quarter of fiscal2007.

**Interest Expense.**

| ** **       | ** ** | **Three-Month Period Ended**               | ** ** |
|------------------|------------|------------------------------------------------------|------------|
| ** **       | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **       | ** ** | **(in millions, except percentages)** | ** ** |
| Interest Expense |       |                                                 | $          | (0.9 | ) |   |   | $ | (1.0 | ) |   |   | (10 | )% |   |
|                  |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest expense isprimarily associated with our 3¤4% ConvertibleSenior Notes due 2023 (the “3⁄4% Notes”)and 3% Notes, issued in December 2003 and March 2002, respectively.The slight decrease in interest expense for the first quarter of fiscal 2007compared to the first quarter of fiscal 2006 was primarily due to the reductionin the outstanding balances of the 3% Notes.

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**Income Taxes.**

| ** **                  | ** ** | **Three-Month Period Ended**               | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|
| ** **                  | ** ** | **June 30, 2006**                          | ** ** | **June 30, 2005** | ** ** | **Percentage**Change | ** ** |
| ** **                  | ** ** | **(in millions, except percentages)** | ** ** |
| Provision for  Income Taxes |       |                                                 | $          | 0.9 |   |   |   | $ | 0.8 |   |   |   | 6 | % |   |
|                             |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Income tax provisions forinterim periods are based on our estimated annual effective income tax rate.Our estimate of our taxes for the first quarters of fiscal 2007 and fiscal 2006represent interest accrued on prior year’s tax disputes and foreign taxesrelated to our foreign subsidiaries. These tax rates for the first quarters offiscal 2007 and fiscal 2006 differed from the combined United States Federaland state statutory income tax rate of 40% primarily due to the valuationallowance recorded on all of our U.S. net deferred tax assets, foreign taxesrelated to our foreign subsidiaries, certain acquisition-related intangibleassets, excluding goodwill, that are not fully deductible for tax purposes andinterest accrued on prior years’ tax disputes. We are in ongoing negotiationswith the IRS with regard to various tax disputes that may result in settlementof certain issues. Our tax rate for the period in which a settlement is reachedwill be impacted if the settlement materially differs from the amountspreviously accrued.

**Discontinued Operations.**

| ** **                                  | ** ** | **Three-Month Period Ended**               | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                  | ** ** | **June 30,  2006**                              | ** ** | **June 30,  2005** | ** ** | **Percentage  Change** | ** ** |
| ** **                                  | ** ** | **(in millions, except percentages)** | ** ** |
| Income (loss) from  discontinued operations |       |                                                 | $          | 1.6 |   |   |   | $ | (21.9 | ) |   |   | — |   |   |
|                                             |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The change in discontinuedoperations in the first quarter of fiscal 2007 as compared to the first quarterof fiscal 2006 was primarily driven by reduced operating expenses due to thedivestiture of the IBM i/p Series RAID Business on September 30, 2005and the divestiture of the OEM block-based systems business on January 31,2006. The contribution from discontinued operations in the first quarter offiscal 2007 is a combination of some residual royalty revenue related to theIBM i/p Series RAID Business and the contribution margin from one customerthat remained with the Company after the divestiture of the OEM block-basedsystems business.

**Liquidity andCapital Resources**

**Key Components ofCash Flows**

Cash used for continuing operations was$4.6 million in the first quarter of fiscal 2007 as compared to cash usedfor continuing operations of $19.1 million in the first quarter of fiscal2006. Cash used in the first quarter of fiscal 2007 resulted primarily from ournet loss of $24.8 million. This was partially offset by the benefit of non-cashitems included in operating results, which primarily consisted of an impairmentcharge of $13.2 million related to the SNAP Server intangible assets, thenon-cash effect of the SFAS 123R expenses of $2.5 million, and depreciation andamortization of intangible assets and property and equipment of$5.0 million. Cash used in the first quarter of fiscal 2006 resultedprimarily from our net loss of $14.1 million. This was partially offset by thebenefit of non-cash items included in operating results, which primarilyconsisted of depreciation and amortization of intangible assets and propertyand equipment of $7.6 million. Additional factors included changes toworking capital assets and liabilities that decreased cash provided byoperating activities by $0.5 million in the first quarter of fiscal 2007compared with $13.0 million in the first quarter of fiscal 2006, which was primarilythe result of accounts payable increasing by $12.3 million.

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Cash used for investing activities was$28.8 million in the first quarter of fiscal 2007, which was primarily dueto net purchases, net of sales and maturities, of restricted marketablesecurities and marketable securities of $28.0 million and purchases of propertyand equipment from continuing operations of $0.8 million. Cash used forinvesting activities was $320.9 million in the first quarter of fiscal2006, which was primarily due to net purchases, net of sales and maturities, ofrestricted marketable securities and marketable securities of $317.0 millionand purchases of property and equipment of $3.9 million.

Cash provided by financing activities of $1.6 millionin the first quarter of fiscal 2006 was driven by the issuance of common stockin connection with purchases made under our employee stock purchase plan andstock option exercises. Cash used for financing activities of$18.5 million in the first quarter of fiscal 2006 was primarily driven bythe repurchase of $19.8 million in aggregate principal amount of our 3% Notesfor $18.6 million.

**Liquidity.  **At June 30, 2006, we had $555.7 million incash, cash equivalents and marketable securities, of which approximately$93.2 million was held by our Singapore subsidiary. In the fourth quarterof fiscal 2005, we repatriated $360.6 million of undistributed earningsfrom Singapore to the United States and incurred a tax liability of$17.6 million. The repatriated amounts will be used to fund a qualifiedDomestic Reinvestment Plan, as required by the American Jobs Creation Act of2004. If we do not spend the repatriated funds in accordance with ourreinvestment plan, we may incur additional tax liabilities. We have notprovided for U.S. deferred income taxes or foreign withholding taxes on theremaining undistributed earnings since these earnings totaling approximately$257.2 million are intended to be reinvested internationally indefinitely.Although we do not have any current plans to repatriate the remainingundistributed earnings from our Singapore subsidiary to our United Statesparent company, if we were to do so, additional income taxes at the combinedUnited States Federal and state statutory rate of approximately 40% could beincurred from the repatriation.

At June 30, 2006, we had $235.6 million ofaggregate principal amount in convertible notes outstanding, consisting of$10.6 million in aggregate principal amount of our 3% Notes that are due in March 2007and $225.0 million in aggregate principal amount of our 3⁄4% Notes that are duein December 2023.

We are required to maintain restricted cash orinvestments to serve as collateral for the first ten scheduled interestpayments on our 3⁄4% Notes. As of June 30, 2006, we had $4.0 million ofrestricted cash and restricted marketable securities, consisting of UnitedStates government securities, of which $1.7 million was classified asshort-term and $2.3 million was long-term.

The IRS is currently auditing our income tax returnsfor fiscal 1997 and final settlement agreements have been filed with the UnitedStates Tax Court on all but one issue. In addition, the IRS is auditing ourFederal income tax returns for fiscal 1998 through fiscal 2003. We haveresolved all issues for fiscal 1998 through fiscal 2001 other than the rolloverimpact of any potential resolution on the remaining fiscal 1997 issue and taxcredits that were generated but not used in subsequent years that may becarried back. The fiscal 2002 and 2003 audit is ongoing. We believe that wehave sufficient tax provisions for these years. We believe the final outcome ofthe IRS audits will not have a material adverse impact on our liquidity.  However, we cannot predict with certainty howthese matters will be resolved and whether we will be required to makeadditional payments.

As of June 30, 2006, we did not have any materialchanges to our contractual obligations that were disclosed in the Liquiditysection of our Form 10-K for the fiscal year ended March 31,2006. However, as part of the three-yearcontract manufacturing agreement entered into with Sanmina-SCI on January 9,2006, we are committed to purchasing a majority of our products fromSanmina-SCI. In addition, as part of the agreement, we entered into a putagreement which entitles Sanmina-SCI to return any equipment not used 

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withinsix months of the close of the transaction. We have a reserve for thispotential liability as of June 30, 2006.

We believe that liquidityprovided by our existing working capital, together with expected cash flowsfrom operations and available sources of equity and equipment financing, willbe sufficient to support our operations through at least the next twelvemonths. However, should prevailing economic conditions and/or financial,business and other factors beyond our control adversely affect our estimates ofour future cash requirements, we would be required to fund our cashrequirements by alternative financing. There can be no assurance thatadditional financing, if needed, would be available on terms acceptable to usor at all.

**Recent AccountingPronouncements**

In June 2005, the FASB issued SFAS No. 154,which changes the requirements for the accounting for, and reporting of, achange in accounting principle. Previously, most voluntary changes inaccounting principles were required to be recognized by way of a cumulativeeffect adjustment within net income during the period of the change. SFAS No. 154requires retrospective application to prior periods’ financial statements,unless it is impracticable to determine either the period-specific effects orthe cumulative effect of the change. SFAS No. 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005;however, the statement does not change the transition provisions of anyexisting accounting pronouncements. Our results of operations and financialcondition will only be impacted following the adoption of SFAS No. 154 ifit implements changes in accounting principles that are addressed by thestandard or corrects accounting errors in future periods.

In June 2005, the FASB issued FSP 143-1,which provides guidance in accounting for obligations associated with Directive2002/96/EC (the “Directive”) on Waste Electrical and Electronic Equipmentadopted by the European Union. FSP 143-1 is required to be applied to thelater of the first period ending after June 6, 2005 or the date of theDirective’s adoption into law by the applicable EU member countries in which wehave significant operations. The Directive distinguishes between “new” and “historical”waste. New waste relates to products put on the market after August 13,2005. FSP 143-1 directs commercial users to apply the provisions of SFAS No. 143and the related FIN No. 47 for the measurement and recognition of theliability and asset retirement obligation associated with the historical wastemanagement requirements of the Directive. Additionally, FSP 143-1provides guidance for the accounting by producers for the financing of theobligations of historical waste held by private households. The Company iscontinuing to analyze the impact of the Directive and FSP 143-1 on itsfinancial position and results of operations and once it is completed expectsto adopt FSP143-1 sometime in fiscal 2007.

In November 2005, the FASB issued FSP 115-1and FAS 124-1, which clarifies when an investment is considered impaired,whether the impairment is other than temporary, and the measurement of animpairment loss. It also includes accounting considerations subsequent to therecognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. FSP 115-1 and FAS 124-1 areeffective for all reporting periods beginning after December 15, 2005. At June 30,2006, none of our unrealized investment losses were recognized asother-than-temporary impairments in our available-for-securities. The adoptionof FSP 115-1 and FAS 124-1 did not have a material effect onour consolidated financial position, results of operations or cash flow.

In June 2006, theFASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”),which clarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with SFAS No. 109. FINNo. 48 prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. This interpretation also providesguidance on derecognition, 

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classification,interest and penalties, accounting in interim periods, disclosure, andtransition. FIN 48 is effective beginning with the Company’s fiscal year2008. The Company is currently assessing the impact, if any, of FIN No. 48on its financial position and results of operations.

**Critical AccountingPolicies**

For a complete description of what we believe to bethe critical accounting policies that affect our more significant judgments andestimates used in the preparation of our condensed consolidated financialstatements, refer to our Annual Report on Form 10-K for the yearended March 31, 2006. The following was added as a critical accountingpolicy during the first fiscal quarter ended June 30, 2006.

**Stock-based compensation:****  **In fiscal 2007, the Company adopted SFAS No.123(R) using the modified prospective application method and began accountingfor its stock-based compensation using a fair-valued based recognition method.Under the provisions of SFAS No. 123(R), stock-based compensation cost isestimated at the grant date based on the fair-value of the award and isrecognized as expense ratably over the requisite service period of the award.Determining the appropriate fair-value model and calculating the fair value ofstock-based awards at the grant date requires considerable judgment, includingestimating stock price volatility, expected option life and forfeiture rates.The Company develops its estimates based on historical data and marketinformation which can change significantly over time. A small change in theestimates used can have a relatively large change in the estimated valuation.

The Company uses the Black-Scholes option valuationmodel to value employee stock awards. The Company estimates stock pricevolatility based on an average of its historical volatility and the impliedvolatility derived from traded options on the Company’s stock. Estimated optionlife and forfeiture rate assumptions are derived from historical data. Forstock based compensation awards with graded vesting that were granted afterfiscal 2006, the Company recognizes compensation expense using thestraight-line amortization method.

There have been no otherchanges in our critical accounting policies since March 31, 2006.

**Acquisitions &Dispositions**

**IBM********i/p Series RAID:**   On June 29,2004, the Company completed the acquisition of the IBM i/p Series RAIDcomponent business line.

On September 30, 2005, the Company entered into aseries of arrangements with IBM pursuant to which the Company sold its IBM i/p Series RAIDBusiness to IBM for approximately $22.0 million plus $1.3 million for certainfixed assets. In addition, IBM purchased certain related inventory at theCompany’s net book value of $0.8 million. Expenses incurred in the transactionprimarily included costs of approximately $0.5 million for legal and accountingfees. In addition, the Company accrued $0.3 million for lease obligations.Under the terms of the agreements, the Company granted IBM a nonexclusivelicense to certain intellectual property and sold to IBM substantially all ofthe assets dedicated to the engineering and manufacturing of RAID controllersand connectivity products for the IBM i/p Series RAID Business. Under theterms of the nonexclusive license, IBM has been paying royalties to the Companyfor the sale of its board-level products over the next five quarters, which arebeing recognized as contingent consideration in discontinued operations whenearned. In fiscal 2006, the Company received royalties of $5.6 million, whichthe Company recorded in “Income (loss) from disposal of discontinuedoperations, net of taxes,” in our Consolidated Statements of Operations. Additionalroyalties of $1.3 million were recorded in the first quarter of fiscal2007. Through June 30, 2006, the Company had incurred a loss of $1.0million on the disposal of the IBM i/p Series RAID Business.

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**Snap Server:****  **On July23, 2004, the Company completed the acquisition of Snap Appliance, a providerof NAS products. Snap Appliance is included in the Company’s SSG segment. (Note4).

On September 29, 2005, the Company’s Board ofDirectors approved management’s recommendation to divest its systems business,including the Snap Appliance business. Accordingly, the Company had classifiedthe systems business as a discontinued operation in its consolidated financialstatements and was pursuing a sale of the systems business.

The Company had received offers from prospectivebuyes, however, management concluded that the potential value from retainingthe operations outweighed the offers received for the business. On July 6,2006, and effective for the end of the first quarter of fiscal 2007, our Boardof Directors decided  that we shouldretain the Snap Server portion of the systems business, and managementterminated its ongoing efforts to sell this business. As a result, results ofoperations for Snap Applicance business have now been reclassified as part ofcontinuing operations.  For purposes ofcomparison, results from prior periods also reflect this reclassification.

As a result of the decision to retain and operate theSnap Systems portion of the server business, the Company performed an ananalysis in accordance with SFAS No. 144 and determined that the carryingvalue of the business’ long-lived assets exceeded the Company’s estimate of thefair value of the long-lived asset group. The Company recognized an impairmentloss of $13.2 million based on the excess of the carrying value over the fairvalue of the long-lived asset group. The estimate of fair value of the assetswas based on discounting estimated future cash flows using a discount ratecommensurate with the risks inherent in the current business model. Theestimation of the impairment involves numerous assumptions which requirejudgment by the Company, including, but not limited to, future use of theassets by the Company operations and future selling prices for the Company’sproducts. The impairment loss, which was recorded as Impairment of intangiblesand other charges in the Condensed Consolidated Statement of Operations was dueto the significant research and development expenditures necessary to grow SnapServer systems business revenue and  thesignificant  uncertainties associated withachieving the growth in revenue.

On January 31, 2006, the Companysigned a definitive agreement with Sanmina—SCI Corporation and its wholly ownedsubsidiary, Sanmina-SCI USA, Inc., for the sale of the Company’s OEMblock-based systems business for $14.5 million, of which $5.0 million will bereceived over the next two years. In addition, Sanmina-SCI USA agreed to paythe Company contingent consideration of up to an additional $12.0 million ifcertain revenue levels are achieved over a three-year period. The Companyrecorded a gain of $12.1 million on the disposal of the OEM block-based systemsbusiness in the fourth quarter of fiscal 2006.

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk

For financial market risksrelated to changes in interest rates, equity price and foreign currencyexchange rates, reference is made to Item 7A “Quantitative and QualitativeDisclosures About Market Risk” contained in Part II of our Annual Reporton Form 10-K for the year ended March 31, 2006. Our exposure tomarket risk has not changed materially since March 31, 2006.

**Item 4.**                        Controlsand Procedures

**Evaluation ofDisclosure Controls and Procedures**

Under the supervision andwith the participation of our management, including our Chief Executive Officer(CEO) and our Chief Financial Officer (CFO), we conducted an evaluation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934 (Exchange Act)), as of the end of theperiod covered by this Quarterly Report on Form 10-Q. 

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Basedupon that evaluation, our CEO and our CFO have concluded that the design andoperation of our disclosure controls and procedures were effective to ensurethat information required to be disclosed by us in reports that we file orsubmit under the Exchange Act (i) is recorded, processed, summarized andreported within the time periods specified in Securities and ExchangeCommission rules and forms and (ii) is accumulated and communicatedto our management, including our CEO and CFO, as appropriate to allow timelydecisions regarding required disclosure.

**Changes in InternalControl Over Financial Reporting**

There has been no changein our internal control over financial reporting that occurred during theperiod covered by this Quarterly Report on Form 10-Q that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

**InherentLimitations on Effectiveness of Controls**

Our management, including the CEO and CFO, does notexpect that our disclosure controls and procedures or our internal control overfinancial reporting will prevent or detect all error and all fraud. A controlsystem, no matter how well designed and operated, can provide only reasonable,not absolute, assurance that the control system’s objectives will be met. Thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Further, because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that misstatements due toerror or fraud will not occur or that all control issues and instances offraud, if any, within the company have been detected. These inherentlimitations include the realities that judgments in decision-making can befaulty and that breakdowns can occur because of simple error or mistake.Controls can also be circumvented by the individual acts of some persons, bycollusion of two or more people, or by management override of the controls. Thedesign of any system of controls is based in part on certain assumptions aboutthe likelihood of future events, and there can be no assurance that any designwill succeed in achieving its stated goals under all potential future conditions.Projections of any evaluation of controls effectiveness to future periods aresubject to risks. Over time, controls may become inadequate because of changesin conditions or deterioration in the degree of compliance with policies orprocedures.

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**PART II. OTHER INFORMATION**

**Item 1A.,**             RiskFactors

Our business faces significant risks. The risksdescribed below may not be the only risks we face. Additional risks that we donot yet know of or that we currently think are immaterial may also impair our businessoperations. If any of the events or circumstances described in the followingrisks actually occurs, our business, financial condition or results ofoperations could suffer, and the trading price of our common stock coulddecline.

***The impact of ongoing contractnegotiations with our large OEM customers, industry technology transitions andmarket acceptance of our new products could cause our quarterly revenues tocontinue to decline.  ***Our quarterly revenues havedeclined in each of the last two quarters and may continue to decline.******We depend on a small number oflarge OEM customers for a significant portion of our revenues, and we areengaged in ongoing contract negotiations concerning product specifications andprice. These negotiations may prove to be unfavorable. In addition, we are inthe midst of an industry transition from parallel to serial connectivity, andthe revenue we generate from sales of our serial products may not grow at afast enough rate to offset declines in sales of our parallel products. Inaddition, the new products and technologies to replace our legacy products andtechnologies we are developing may not gain sufficient market acceptance orcontribute significantly to revenue. These factors, individually or in theaggregate, could cause our quarterly revenues to continue to decline.

***We depend on contractmanufacturers and subcontractors, and if they fail to meet our manufacturingneeds, it could delay shipments of our products and result in the loss ofcustomers.  ***We rely on contract manufacturers formanufacturing of our products and subcontractors for the assembly and packagingof the integrated circuits included in our products. On December 23, 2005,we entered into a three-year contract manufacturing agreement with Sanmina-SCIwhereby Sanmina-SCI upon the closing of the transaction on January 9,2006, assumed manufacturing operations of a majority of our products. Thetransition of the manufacturing facilities has not gone as well as expected, asSanmina-SCI was challenged with material shortages that impacted their abilityto meet delivery commitments on a consistent basis, which negatively impactedour revenues and operating results in the first quarter of fiscal 2007. IfSanmina-SCI is unable to meet our supply needs, we could lose customers oradditional revenue, which would have an adverse effect on our results. We haveno long-term agreements with our assembly and packaging subcontractors. We alsoemploy Amkor Technology and Advanced Semiconductor Engineering for our finalassembly and test operations related to our ASIC products. We cannot assure youthese subcontractors will continue to be able and willing to meet ourrequirements for these components or services. Any significant disruption insupplies from or degradation in the quality of components or services suppliedby, these contract manufacturers and subcontractors could delay shipments andresult in the loss of customers or revenues, which could have an adverse effecton our financial results.

***Actions that we have taken andthe actions that we are considering could adversely affect our business andfinancial results in the short-term, and may not have the long-term beneficialresults that we intend.  ***Our new management team iscontinuing to perform a thorough analysis of our operations, which it initiatedin the first quarter of fiscal 2006, and has begun making a detailed plan tosupport our corporate strategy. This analysis of our operations includes areview of all aspects of our business, including our product portfolio, ourrelationships with strategic partners and our research and development focus.

The actions that wehave taken and the actions that we are considering could adversely affect our businessand financial results in the short-term, may not have the long-term beneficialresults that we intend and could result in the following:

·       lossof customers;

·       lossof employees;

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·       increaseddependency on suppliers;

·       supplyissues;

·       reducedrevenue base;

·       impairmentof our assets;

·       increasedoperating costs; and

·       materialrestructuring charges.

***If we are unable to successfullycomplete the divestiture of our systems business it could result in an adverseeffect on our business and financial results.  ***Completingthe divestiture of our systems business (which includes substantially all ofthe operating assets that were obtained through the Eurologic Systemsacquisitions) could cause significant diversions of management time andresources. In addition, if the net proceeds of any such sale, prove to be lessthan we anticipate, it could lead to an additional impairment charge againstour assets. Additionally, customers for our systems products could be reluctantto continue to buy from us due to the uncertainty caused by the planneddivestiture. We may not be successful in selling the systems business on termsthat are acceptable to us or might not be able to find a buyer for the business.We may not be successful in overcoming these risks or any other problemsencountered in connection with this divesture which may adversely affect ourbusiness, financial position and operating results.

***Our operating results havefluctuated in the past, and are likely to continue to fluctuate, and if ourfuture results are below the expectations of investors or securities analysts,the market price of our common stock would likely decline significantly.  ***Ourquarterly operating results have fluctuated in the past, and are likely to varysignificantly in the future, based on a number of factors related to ourindustry and the markets for our products. Factors that are likely to cause ouroperating results to fluctuate include those discussed in this Risk Factorssection. In the first quarter of fiscal 2007, our operating results werematerially impacted by an impairment charge of intangibles for $13.2 million.

Our operating expenses are largely based on anticipatedrevenues, and a large portion of our expenses, including facility costs andsalaries, are fixed in the short term. As a result, lower than anticipatedrevenues for any reason could cause significant variations in our operatingresults from quarter to quarter.

Due to the factors summarized above, and the otherrisks described in this section, we believe that you should not rely onperiod-to-period comparisons of our financial results as an indication of ourfuture performance. In the event that our operating results fall below theexpectations of market analysts or investors, the market price of our commonstock could decline substantially.

***Ouroperating results may be adversely affected by unfavorable economic and marketconditions and the uncertain geopolitical environment.  ***Adverseeconomic conditions in some markets may impact our business, which could resultin:

·       Reduceddemand for our products as a result of a decrease in capital spending by ourcustomers;

·       Increasedprice competition for our products;

·       Increasedrisk of excess and obsolete inventories;

·       Excessfacilities and manufacturing capacity; and

·       Higheroverhead costs as a percentage of revenues.

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Demand for our products would likely be negativelyaffected if demand in the server and network storage markets declines. Forexample, demand in the server market declined slightly in fiscal 2002 andfiscal 2003, which contributed to a decline in our net revenues. It isdifficult to predict future server sales growth, if any. In addition, othertechnologies may replace the technologies used in our existing products and theacceptance of our products using new technologies in the market may not bewidespread, which could adversely affect our revenues.

***Because our sales are made bymeans of standard purchase orders rather than long-term contracts, if demandfor our customers’ products declines or if our customers do not control theirinventories effectively, they may cancel or reschedule shipments previouslyordered from us or reduce their levels of purchases from us.  ***Thevolume and timing of orders received during a quarter are difficult toforecast. Our customers generally order based on their forecasts and theyfrequently encounter uncertain and changing demand for their products. Ifdemand falls below such forecasts or if our customers do not control theirinventories effectively, they may cancel or reschedule shipments previouslyordered from us. Our customers have from time to time in the past canceled orrescheduled shipments previously ordered from us, and we cannot assure you thatthey will not do so in the future. In addition, because our sales are made bymeans of standard purchase orders rather than long-term contracts, we cannotassure you that these customers will continue to purchase quantities of ourproducts at current levels, or at all. Historically, we have set our operatingbudget based on forecasts of future revenues because we do not have significantbacklog. Because much of our operating budget is relatively fixed in the short-term,if revenues do not meet our expectations, then our financial results will beadversely affected.

***We depend on a fewkey customers and the loss of any of them could significantly reduce ourrevenues.  ***Historically, a small number of ourcustomers has accounted for a significant portion of our revenues, and weexpect that a limited number of customers will continue to represent asubstantial portion of our net revenues for the foreseeable future. In addition,our largest customers have begun accounting for an increasingly greaterpercentage of our net revenues, which could magnify the effects if one of thesecustomers elected to reduce or eliminate their purchases from us. For example,in the first quarter of fiscal 2007, IBM and Dell accounted for 34% and 17% ofour total net revenues, respectively, whereas in the first quarter of fiscal2006, IBM, and Dell accounted for 23% and 14% of our total net revenues,respectively. We believe that our major customers continually evaluate whetheror not to purchase products from alternate or additional sources. Additionally,customers’ economic and market conditions frequently change. Accordingly, wecannot assure you that a major customer will not reduce, delay or eliminate itspurchases from us, which would likely cause our revenues to decline. Inaddition, we do not carry credit insurance on our accounts receivables and anydifficulty in collecting outstanding amounts due from our customers,particularly customers that place larger orders or experience financialdifficulties, could adversely affect our revenues and our net income. Becauseour sales are made by means of standard purchase orders rather than long-termcontracts, we cannot assure you that these customers will continue to purchasequantities of our products at current levels, or at all.

***If there is ashortage of components used in our customers’ products, our sales may decline,which could adversely affect our results of operations and financial position.  ***Ifour customers are unable to purchase certain components which are embedded intotheir products, their demand for our products may decline. In addition, we orour customers may be impacted by component shortages if components that complywith the RoHS Directive are not available. Similar shortages of components usedin our products or our customers’ products could adversely affect our netrevenues and financial results in future periods.

***We may be subjectto a higher effective tax rate that could negatively affect our results ofoperations and financial position.  ***Historically oureffective tax rate was benefited by a Singapore tax holiday relating to certainof our products. As a result of the contract manufacturing agreement that weentered into with Sanmina-SCI, we will no longer qualify for this holiday. Ifthe alternative plans we have developed to 

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reduce our effective taxrate are not successful, our effective tax rate could increase, which wouldadversely affect our financial results.

We held approximately $93.2 million of cash, cashequivalents and marketable securities at our subsidiary in Singapore at June 30,2006. During the fourth quarter of fiscal 2005, we repatriated$360.6 million of cash from Singapore to the United States in connectionwith the American Jobs Creation Act of 2004 which provides a one-time deductionof 85% for certain dividends from controlled foreign corporations. If theamount repatriated does not qualify for the one-time deduction, we could incuradditional income taxes at up to the United States Federal statutory rate of35%, which would negatively affect our results of operations and financialcondition.

***Our dependence on new products may cause our net revenues tofluctuate or decline.  ***Our future successsignificantly depends upon our completing and introducing enhanced and newproducts at competitive prices and performance levels in a timely manner. Thesuccess of new product introductions depends on several factors, including thefollowing:

·       Designingproducts to meet customer needs;

·       Productcosts;

·       Timelycompletion and introduction of new product designs;

·       Qualityof new products;

·       Differentiationof new products from those of our competitors; and

·       Marketacceptance of our products.

Our product life cycles in each of our segments may beas brief as 12 months. As a result, we believe that we will continue toincur significant expenditures for research and development in the future. Wemay fail to identify new product opportunities and may not develop and bringnew products to market in a timely manner. In addition, products ortechnologies developed by others may render our products or technologiesobsolete or noncompetitive, or our targeted customers may not select ourproducts for design or integration into their products. The failure of any ofour new product development efforts could have an adverse effect on ourbusiness and financial results.

We have introduced RAID-enabled products based on thenext generation SATA technology and delivered our products based on SerialAttached SCSI technology to certain major OEMs for testing andintegration. We will not succeed in generating significant revenues from ournew SATA and Serial Attached SCSI technology products if the market does notadapt to these new technologies, which would, over time, adversely affect ournet revenues and operating results.

***Our reliance on industrystandards and technological changes in the marketplace may cause our netrevenues to fluctuate or decline.  ***The computerindustry is characterized by various, evolving standards and protocols. Wedesign our products to conform to certain industry standards and protocols suchas the following:

*Technologies:*

·       ATA

·       Fibrechannel

·       FireWire/1394

·       IPsec

·       iSCSI

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·       PCI

·       PCI-Express

·       PCI-X

·       RAID

·       SerialAttached SCSI

·       SATA

·       SCSI

·       SMI-S

·       UltraDMA

·       USB

*Operating Systems:*

·       Linux

·       Macintosh

·       Netware

·       OS/2

·       UNIX

·       Windows

If user acceptance ofthese standards declines, or if new standards emerge, and if we do notanticipate these changes and develop new products, these changes couldadversely affect our business and financial results.

***If we lose the cooperation of otherhardware and software producers whose products are integral to ours, ourability to sustain or grow our revenues could be adversely affected.  ***Wemust design our products to operate effectively with a variety of hardware andsoftware products supplied by other manufacturers, including the following:

·       Microprocessors;

·       Peripherals;and

·       Operatingsystem software.

We depend on significantcooperation from these manufacturers to achieve our design objectives anddevelop products that operate successfully with their products. These companiescould, from time to time, elect to make it more difficult for us to design ourproducts for successful operability with their products. For example, if one ormore of these companies were to determine that as a result of competition orother factors our technology or products would not be broadly accepted by themarkets we target, these companies may no longer work with us to plan for newproducts and new generations of our products, which would make it moredifficult to introduce products on a timely basis or at all. Further, some ofthese companies might decide not to continue to offer products that arecompatible with our technology and our markets could contract. If any of theseevents were to occur, our revenue and financial results could be adverselyaffected.

***We are subject tovarious environmental laws and regulations that could impose substantial costsupon us and may adversely affect our business.  ***TheEuropean Parliament has enacted the RoHS Directive, which 

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restricts the sale of newelectrical and electronic equipment containing certain hazardous substances,including lead that is currently used in some of our products. We are workingto eliminate lead from our products in accordance with the timelinesestablished in the RoHS Directive. The costs associated with compliance maynegatively impact our operating results and competitive position. For example,in fiscal 2006, we had an excess inventory expense of $1.9 million related tothe transition of our products to comply with the RoHS Directive. We are alsoworking with our suppliers to redesign or reformulate their componentscontaining lead to reduce or eliminate lead in our products. If we are unableto comply with the RoHS Directive, we may suffer a loss of revenue, be unableto sell affected products in certain markets or countries and be at a competitivedisadvantage.

The European Parliament has also finalized the WasteElectrical and Electronic Equipment Directive, or WEEE Directive, which makesproducers of electrical and electronic equipment financially responsible forspecified collection, recycling, treatment and disposal of past and futurecovered products. We may incur financial responsibility for the collection,recycling, treatment or disposal of products covered under the WEEE Directive.Because the EU member states have not fully implemented the WEEE Directive, thenature and extent of the costs to comply and fees or penalties associated withnon-compliance are unknown at this time. Costs to comply with the WEEEDirective and similar future legislation, if applicable, may also include legaland regulatory costs and insurance costs. We may also be required to takereserves for costs associated with compliance with these regulations.

***We entered into strategicalliances with Vitesse for the development of our Serial Attached SCSI ROCproduct and with ServerEngines to advance our development of iSCSI products,and if these companies fail to develop and bring new products to market in atimely manner, it could result in an adverse effect on our business andfinancial results.  ***In January 2005, we enteredinto a strategic alliance with Vitesse for it to develop and market the nextgeneration of our Serial Attached SCSI products. In March 2005, we enteredinto a strategic alliance with ServerEngines to develop and market the nextgeneration of our IP storage products, such as 10Gb iSCSI. Accordingly, we areat risk that Vitesse and ServerEngines may encounter challenges in fulfillingtheir responsibilities under these alliances, such as timely completing andintroducing new product designs, maintaining the quality of new products,minimizing product costs, differentiating new products from those of ourcompetitors and achieving market acceptance of our products. Vitesse becamesubject to investigation by the SEC and the U.S. Attorney’s office in New Yorkregarding its historical practices with respect to the granting of stockoptions, which resulted in Vitesse terminating certain of their executives. Tothe extent that these investigations cause disruptions in Vitesse’s operations,or if we otherwise encounter issues with respect to our strategic alliances, itcould have an adverse effect on our business and financial results.

***If we do not provide adequatesupport during our customers’ design and development stage, or if we are unableto provide such support in a timely manner, we may lose revenues to ourcompetitors.  ***Certain of our products are designedto meet our customers’ specifications and, to the extent we are not able tomeet these expectations in a timely manner or provide adequate support duringour customers’ design and development stage, our customers may choose to buysimilar products from another company. If this were to occur we may loserevenues and market share to our competitors.

***If we are unable to compete effectively, our net revenuescould be adversely affected.  ***The markets for all ofour products are intensely competitive and are characterized by the following:

·       Rapidtechnological advances;

·       Frequentnew product introductions;

·       Evolvingindustry standards; and

·       Priceerosion.

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Consequently, we must continue to enhance our productson a timely basis to keep pace with market demands. If we do not do so, or ifour competition is more effective in developing products that meet the needs ofour existing and potential customers, we may lose market share and not participatein the future growth of our target markets. For example, intense competition inthe transition from products employing Ultra 160 technology to productsemploying Ultra 320 technology has adversely affected revenues from our SCSIproducts. Our future success will depend on the level of acceptance of our RAIDproducts and products based on the next generation SATA and Serial AttachedSCSI technologies by new and existing customers. In addition, we expect thatour future success will depend significantly on our ability to participate inthe ongoing development of the network storage market in which we face intensecompetition from other companies that are also focusing on networked storageproducts.

We cannot assureyou that we will have sufficient resources to accomplish all of the following:

·       Satisfyany growth in demand for our products;

·       Maketimely introductions of new products;

·       Competesuccessfully in the future against existing or potential competitors;

·       ProvideOEMs with design specifications in a timely manner; and

·       Preventprice competition from eroding margins.

***Aspart of our overall strategy we may make acquisitions and enter into strategicalliances. Costs associated with these acquisitions or strategic alliances mayadversely affect our results of operations, which could be exacerbated if weare unable to integrate the acquired companies, products or technologies.  ***Aspart of our overall strategy we may acquire or invest in complementarycompanies, products or technologies and enter into strategic alliances withother companies. In order to be successful in these activities, we must:

·       Conductacquisitions that enhance our time to market with new products;

·       Successfullyprevail over competing bidders for target acquisitions at an acceptable price;

·       Investin companies and technologies that contribute to the growth of our business;

·       Integrateacquired operations into our business and maintain uniform standards, controlsand procedures;

·       Retainthe key employees of the acquired operations; and

·       Developthe capabilities necessary to exploit newly acquired technologies.

The benefits of acquisitions or strategic alliancesmay prove to be less than anticipated and may not outweigh the costs reportedin our financial statements. For example, during fiscal 2006, we sold the IBM i/pSeries RAID business for a loss of $2.3 million.

Completing any potential future acquisitions orstrategic alliances could cause significant diversions of management time andresources. If we acquire new businesses, products or technologies in thefuture, we may be required to assume warranty claims or other contingentliabilities, including liabilities unknown at the time of acquisition, andamortize significant amounts of other intangible assets and, over time, recognizesignificant charges for impairment of goodwill, other intangible assets orother losses. If we consummate any potential future acquisitions in which theconsideration consists of stock or other securities, our existing stockholders’ownership may be significantly diluted. If we proceed with any potential futureacquisitions in which the consideration is cash, we may be required to use asubstantial portion of our available cash. In addition, we may be required toinvest significant resources in order to perform under a strategic alliance orto complete an acquisition, which could adversely affect our results ofoperations, at least in the short-term, even if we believe the strategicalliance or acquisition will benefit us 

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in the long-term. We maynot be successful in overcoming these risks or any other problems encounteredin connection with these or other business combinations, investments orstrategic alliances. These transactions may adversely affect our business,financial position and operating results.

***Product qualityproblems could lead to reduced revenues and gross margins.  ***Weproduce highly complex products that incorporate leading-edge technologies,including both hardware and software. Software often contains “bugs” which caninterfere with expected operations. We cannot assure you that our pre-shipmenttesting programs will be adequate to detect all defects which might interferewith customer satisfaction, reduce sales opportunities, or affect our grossmargins if the costs of remedying the problems exceed reserves established forthat purpose. An inability to cure a product defect could result in the failureof a product line, and withdrawal, at least temporarily, from a product ormarket segment, damage to our reputation, inventory costs, productreengineering expenses, and a material impact on revenues and gross margins.

***Wecurrently purchase all of the finished production silicon wafers used in ourproducts from wafer suppliers, and if they fail to meet our manufacturingneeds, it would delay our production and our product shipments to customers andnegatively affect our operations.  ***Independentfoundries manufacture to our specifications all of the finished silicon wafersused for our products. We currently purchase finished production silicon wafersused in our products from Taiwan Semiconductor Manufacturing Company, or TSMC,and IBM. The manufacture of semiconductor devices is sensitive to a widevariety of factors, including the following:

·       Theavailability of raw materials;

·       Theavailability of manufacturing capacity;

·       Transitionto smaller geometries of semiconductor devices;

·       Thelevel of contaminants in the manufacturing environment;

·       Impuritiesin the materials used; and

·       Theperformance of personnel and equipment.

We cannot assure you that manufacturing problems maynot occur in the future. A shortage of raw materials or production capacitycould lead our wafer suppliers to allocate available capacity to othercustomers. Any prolonged inability to obtain wafers with competitiveperformance and cost attributes, adequate yields or timely deliveries woulddelay our production and our product shipments, and could have an adverseeffect on our business and financial results. We expect that our wafersuppliers will continually seek to convert their processes for manufacturingwafers to more advanced process technologies. Such conversions entail inherenttechnological risks that can affect yields and delivery times. If for anyreason the wafer suppliers we use are unable or unwilling to satisfy our waferneeds, we will be required to identify and qualify additional suppliers. Additionalwafer suppliers may be unavailable, may take significant amounts of time toqualify or may be unable to satisfy our requirements on a timely basis.

***We depend on the efforts of ourdistributors, which if reduced, could result in a loss of sales of our productsin favor of competitive offerings.  ***We derivedapproximately 38% of our revenues for fiscal 2006 from independent distributorand reseller channels. Our financial results could be adversely affected if ourrelationships with these distributors or resellers were to deteriorate or ifthe financial condition of these distributors or resellers were to decline.

Our distributors generally offer a diverse array ofproducts from several different manufacturers. Accordingly, we are at risk thatthese distributors may give higher priority to selling products from othersuppliers. A reduction in sales efforts by our current distributors couldadversely affect our business and financial results. For example, some of ourdistributors have threatened to stop selling our products or 

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make pricing of ourproducts non-competitive if we do not agree to absorb their costs to complywith the RoHS and WEEE Directives with respect to our products. Ourdistributors build inventories in anticipation of future sales, and if suchsales do not occur as rapidly as they anticipate, our distributors willdecrease the size of their product orders. If we decrease our price protectionor distributor-incentive programs, our distributors may also decrease theirorders from us. In addition, we have from time to time taken actions to reducelevels of products at distributors and may do so in the future. These actionsmay affect our net revenues and negatively affect our financial results.

***If we do not meetour restructuring objectives, we may have to implement additional plans inorder to reduce our operating costs and may, as a result, incur additionalmaterial restructuring charges.  ***We have implementedseveral restructuring plans to reduce our operating costs in the first quarterof fiscal 2007, fiscal 2006, fiscal 2005 and fiscal 2004, and recorded relatedrestructuring charges of $3,0 million, $10.4 million, $5.9 million and $4.3 million,respectively. The plans included primarily the reduction of our workforce andthe consolidation of our manufacturing operations in Singapore. The goals ofthese plans were to support future growth opportunities, focus on investmentsthat grow revenues and increase operating margins. If we do not meet ourrestructuring objectives, we may have to implement additional restructuringplans to reduce our operating costs, which could cause us to incur materialrestructuring charges. Further, these restructuring plans may not achieve theoriginal goals we had in implementing them due to such factors as significantcosts or restrictions on workforce reductions that may be imposed in someinternational locales and a potential adverse effect on employee capabilitiesthat could harm our efficiency and our ability to act quickly and effectivelyin the rapidly changing technology markets in which we sell our products.

***Some of ourproducts contain “open source” software, and any failure to comply with theterms of one or more of these open source licenses could negatively affect ourbusiness.  ***Some of our products are distributed withsoftware licensed by its authors or other third parties under so-called “opensource” licenses, including, for example, the GNU General Public License, orGPL, GNU Lesser General Public License, or LGPL, the Mozilla Public License,the BSD License, and the Apache License. Some of those licenses may require asa condition of the license that we make available source code for modificationsor derivative works we create based upon, incorporating, or using the opensource software, that we provide notices with our products, and/or that welicense such modifications or derivative works under the terms of a particularopen source license or other license granting third parties certain rights offurther use. If an author or other third party that distributes such opensource software were to allege that we had not complied with the conditions ofone or more of those open source licenses, we could be required to incur legalexpenses in defending against such allegations, and if our defenses were notsuccessful we could be enjoined from distribution of the products thatcontained the open source software and required to either make the source code forthe open source software available, to grant third parties certain rights offurther use of our software, or to remove the open source software from ourproducts, which could disrupt our distribution and sale of some of ourproducts. In addition, if we combine our proprietary software with open sourcesoftware in a certain manner, we could under some of the open source licenses,be required to release the source code of our proprietary software. If anauthor or other third party that distributes open source software were toobtain a judgment against us based on allegations that we had not complied withthe terms of any such open source licenses, we could also be subject toliability for copyright infringement damages and breach of contract for ourpast distribution of such open source software.

***Our operationsdepend on key personnel, the loss of whom could affect the growth and successof our business.  ***In order to be successful, we mustretain and motivate our executives, our principal engineers and other keyemployees, including those in managerial, technical, marketing and informationtechnology support positions. In particular, our product generation effortsdepend on hiring and retaining qualified engineers. Competition for experiencedmanagement, technical, marketing and support personnel remains intense. Forexample, we transitioned certain research and development efforts to NorthCarolina, where 

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we have experiencedsignificant competition in our efforts to attract and retain qualified softwareengineers. The loss of any of these key employees could have a significantimpact on our operations. We also must continue to motivate employees and keep themfocused on our strategies and goals, which may be particularly difficult due tomorale challenges posed by workforce reductions and general uncertainty.

***Our internationaloperations involve risks, and may be subject to political or other non-economicbarriers to our being able to sell our products in certain countries, localeconomic conditions that reduce demand for our products among our targetmarkets and potential disruption in the supply of necessary components.  ***Manyof our subcontractors are primarily located in Asia and we have sales officesand customers located throughout Europe, Japan and other countries. Ourinternational operations and sales are subject to political and economic risks,including political instability, currency controls, changes in import/exportregulations, tariffs and freight rates. In addition, because our primary wafersupplier, TSMC, is located in Taiwan, we may be subject to certain risksresulting from political instability in Taiwan, including conflicts betweenTaiwan and the People’s Republic of China. These and other international riskscould result in the creation of political or other non-economic barriers to ourbeing able to sell our products in certain countries, create local economicconditions that reduce demand for our products among our target market orexpose us to potential disruption in the supply of necessary components orotherwise adversely affect our ability to generate revenue and operateeffectively.

***We depend on thirdparties to transport our products.  ***We rely onindependent freight forwarders to move our products between manufacturingplants and our customers. Any transport or delivery problems because of theirerrors, or because of unforeseen interruptions in their activities due tofactors such as strikes, political instability, terrorism, natural disastersand accidents, could adversely affect our business, financial condition andresults of operations and ultimately impact our relationship with ourcustomers.

***If the carryingvalue of our long-lived assets is not recoverable, an impairment loss must berecognized which would adversely affect our financial results.  ***Certain events orchanges in circumstances would require us to assess the recoverability of thecarrying amount of our long-lived assets. For example, in the first quarter offiscal 2007, we recorded an impairment charge of $13.2 million onintangible assets related to our decision to retain and operate the SnapSystems portion of the server business. Of the resulting impairment $5.6million related to existing technology, $3.1 million was recorded as areduction of core technology, and $4.5 million related to trademarks. In fiscal2006, we recorded a goodwill impairment charge of $90.6 million related to ourDPS segment. In fiscal 2005, we recorded a goodwill impairment charge of$52.3 million related to our former Channel segment. In fiscal 2004, werecorded an impairment charge of $5.0 million related to certainproperties classified as held-for sale and a charge of $1.0 millionrelating to the decline in value of a minority investment. We will continue toevaluate the recoverability of the carrying amount of our long-lived assets,and we may incur substantial impairment charges which could adversely affectour financial results.

***If actual results or eventsdiffer materially from those contemplated by us in making estimates and assumptions,our reported financial condition and results of operations for future periodscould be materially affected.******  ***Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes. For example, we have identifiedkey accounting estimates in our Critical Accounting Policies in our Annual Reporton Form 10 K for the fiscal year ended March 31, 2006, which include revenuerecognition, inventory, goodwill, stock compensation expense and income taxes.In addition, we have included a new Critical Accounting Policy in this Form 10Q related to stock based compensation. Furthermore, Note 1 of the Notes toConsolidated Financial Statements in our Annual Report on Form 10 K for thefiscal year ended March 31, 2006 describes the significant accounting policiesessential to preparing our consolidated financial statements. The preparationof these financial statements requires estimates and assumptions 

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that affect the reportedamounts and disclosures. Although we believe that our judgments and estimatesare appropriate and correct, actual future results may differ materially fromour estimates.

***If we are unable toprotect and enforce our intellectual property rights, we may be unable tocompete effectively.  ***Although we actively maintainand defend our intellectual property rights, we may be unable to adequatelyprotect our proprietary rights. In addition, the laws of certain territories inwhich our products are or may be developed, manufactured or sold, includingAsia and Europe, may not protect our products and intellectual property rightsto the same extent as the laws of the United States. Because we conduct asubstantial portion of our operations outside of the United States and sell toa worldwide customer base, we are more dependent on our ability to protect ourintellectual property in international environments than would be the case if alarger portion of our operations were domestic.

Despite our efforts, we may be unable to prevent thirdparties from infringing upon or misappropriating our intellectual property,which could harm our business and ability to compete effectively. We have fromtime to time discovered counterfeit copies of our products being manufacturedor sold by others. Although we have programs to detect and deter thecounterfeiting of our products, significant availability of counterfeitproducts could reduce our revenues and damage our reputation and goodwill withcustomers.

***Third parties may assertinfringement claims against us, which may be expensive to defend and coulddivert our resources.  ***From time to time, thirdparties assert exclusive patent, copyright and other intellectual propertyrights to our key technologies, and we expect to continue to receive suchclaims in the future. For example, in fiscal 2005, we, Nevada SCSI Enterprises, Inc.and Thomas A. Gafford (jointly, “NSE”) entered into a license and releaseagreement, pursuant to which we paid NSE $1.7 million as a one-time, fullypaid-up license fee to settle NSE’s claims that some of our products infringedcertain patents. In addition, we entered into a patent cross-license agreementwith IBM in May 2000. Under this agreement, which was amended in March 2002,we received a release from infringement claims prior to January 1, 2000and received the right to use certain of IBM’s patents through June 30,2007. In consideration, we paid, in annual installments, an aggregate patentfee of $13.3 million through June 30, 2004. The risks of ourreceiving additional claims from third parties may be increased in periods suchas the one that we are currently entering where we are beginning to offerproduct lines employing new technologies relative to our existing products.

We cannot assure you that third parties will notassert other infringement claims against us, directly or indirectly, in thefuture, that assertions by third parties will not result in costly litigationor that we would prevail in such litigation or be able to license any valid andinfringed intellectual property from third parties on commercially reasonableterms. These claims may be asserted in respect of intellectual property that weown or that we license from others. In addition to claims brought against us bythird parties, we may also bring litigation against others to protect ourrights. Intellectual property litigation, regardless of the outcome, couldresult in substantial costs to us and diversion of our resources, and couldadversely affect our business and financial results.

***We may be requiredto pay additional federal income taxes which could negatively affect ourresults of operations and financial position.  ***On December 15,2000, we received a statutory notice of deficiency from the IRS with respect toour Federal income tax return for fiscal 1997. We filed a Petition with theUnited States Tax Court on March 14, 2001, contesting the asserteddeficiencies and settlement agreements have been filed with the United StatesTax Court on all but one issue. In addition, the IRS is currently auditing ourFederal income tax returns for fiscal 1998 through fiscal 2003. We haveresolved all issues for fiscal 1998 through fiscal 2001 other than the rolloverimpact of any potential resolution on the remaining fiscal 1997 issue and taxcredits that were generated but not used in subsequent years that may becarried back. While we believe we have meritorious defenses against theasserted deficiencies and any proposed 

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adjustments, and thatsufficient taxes have been provided, we cannot predict the final outcome ofthese matters, and the final resolution could adversely affect our results ofoperations and financial position.

***We may be engagedin legal proceedings that could cause us to incur unforeseen expenses and couldoccupy a significant amount of our management’s time and attention.  ***Fromtime to time we are subject to litigation or claims that could negativelyaffect our business operations and financial position. Such disputes couldcause us to incur unforeseen expenses, could occupy a significant amount of ourmanagement’s time and attention, and could negatively affect our businessoperations and financial position.

***We have in the pastfinanced a portion of our capital expenditure needs from capital marketfinancing, and if we need to seek additional financing, it may not be availableon favorable terms.  ***In order to finance strategicacquisitions, capital asset acquisitions and other general corporate needs, wehave in the past relied, in part, on the capital markets. Historically, we havebeen able to access capital markets, but this does not necessarily guaranteethat we will be able to access these markets in the future or at terms that areacceptable to us. The availability of capital in these markets is affected byseveral factors, including geopolitical risk, the interest rate environment andthe condition of the economy as a whole. In addition, our own operatingperformance, capital structure and expected future performance impacts ourability to raise capital. For example, in the third quarter of fiscal 2006,Standard and Poor’s Ratings Services downgraded our subordinated debt ratingfrom B- to CCC+. We believe that our current cash, cash equivalents, short-terminvestments and future cash provided by operations will be sufficient to fundour needs for at least the next twelve months. However, if our operatingperformance falls below expectations, we may need additional funds, which maynot be available on favorable terms, if at all.

***We are exposed tofluctuations in foreign currency exchange rates.  ***Becausea significant portion of our business is conducted outside the United States,we face exposure to adverse movements in non-United States currency exchangerates. These exposures may change over time as business practices evolve andcould have an adverse impact on our financial results and cash flows.Historically, our exposures have related to non-dollar-denominated operatingexpenses in Europe and Asia. We began Euro-denominated sales to ourdistribution customers in the European Union in the fourth quarter of fiscal2003. An increase in the value of the dollar could increase the real cost toour customers of our products in markets outside the United States where wesell in dollars, and a weakened dollar could increase the cost of localoperating expenses and procurement.

***We hold minorityinterests in privately held venture funds, and if these venture funds facefinancial difficulties in their operations, our investments could be impaired.  ***Wecontinue to hold minority interests in privately held venture funds. At June 30,2007, the carrying value of such investments aggregated $2.3 million. Wehave also committed to provide additional funding of up to $0.2 million.These investments are inherently risky because these venture funds invest incompanies that may still be in the development stage or depend on third partiesfor financing to support their ongoing operations. In addition, the markets forthe technologies or products of these companies are typically in the earlystages and may never develop. If these companies do not have adequate cashfunding to support their operations, or if they encounter difficultiesdeveloping their technologies or products, the venture funds’ investments inthese companies may be impaired, which in turn, could result in impairment ofour investment in these venture funds.

***Our spin-off ofRoxio Inc., which is now known as Napster Inc., may have potentialsubsequent tax liabilities that could negatively affect our results ofoperations.  ***Pursuant to our distribution of theRoxio, Inc. common stock, we received an opinion fromPricewaterhouseCoopers LLP, or PwC, regarding the tax-free nature of thetransaction to us and to our stockholders under Section 355 of theInternal Revenue Code. The validity of the PwC opinion relating to thequalification of the distribution as a tax-free transaction is subject tofactual representations and assumptions. We are not aware of any facts orcircumstances that would cause such representations and assumptions to beuntrue. In addition, the opinion of PwC is not binding on the 

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IRS. If Napster or we failto conform to the requirements set forth in the IRS regulations, it could causethe distribution to be taxable to us and to our stockholders, and our financialresults could be adversely affected.

***Changes insecurities laws and regulations have increased and may continue to increase ourcosts.  ***Changes in the laws and regulationsaffecting public companies, including the provisions of the Sarbanes-Oxley Actof 2002 and rules promulgated by the Securities and Exchange Commission,have increased and may continue to increase our expenses as we evaluate theimplications of these rules and devote resources to respond to theirrequirements. In particular, we incurred additional administrative expense toimplement Section 404 of the Sarbanes-Oxley Act, which requires managementto report on, and our independent registered public accounting firm to attestto, our internal control over financial reporting.

In addition, the NASDAQ Global Market, on which ourcommon stock is listed, has also adopted comprehensive rules andregulations relating to corporate governance. These laws, rules andregulations have increased and will continue to increase the scope, complexityand cost of our corporate governance, reporting and disclosure practices. Wealso expect these developments to make it more difficult and more expensive forus to obtain director and officer liability insurance in the future, and we maybe required to accept reduced coverage or incur substantially higher costs toobtain coverage. Further, our board members, Chief Executive Officer and ChiefFinancial Officer could face an increased risk of personal liability inconnection with the performance of their duties. As a result, we may havedifficultly attracting and retaining qualified board members and executiveofficers, which would adversely affect our business.

***Internal controldeficiencies or weaknesses that are not yet identified could emerge.  ***Overtime we may identify and correct deficiencies or weaknesses in our internalcontrol over financial reporting and, where and when appropriate, report on theidentification and correction of these deficiencies or weaknesses. However, theinternal control procedures can provide only reasonable, and not absolute,assurance that deficiencies or weaknesses are identified. Deficiencies orweaknesses that are not yet identified could emerge, and the identification andcorrections of these deficiencies or weaknesses could have a material impact onour results of operations.

***Internal controlissues that appear minor now may later become material weaknesses.  ***Weare required to publicly report on deficiencies or weaknesses in our internalcontrol over financial reporting that meet a materiality standard as requiredby law and related regulations and interpretations. Management may, at a pointin time, accurately categorize a deficiency or weakness as immaterial or minorand therefore not be required to publicly report such deficiency or weakness.Such determination, however, does not preclude a change in circumstances suchthat the deficiency or weakness could, at a later time, become a materialweakness that could have a material impact on our results of operations.

***We may encounternatural disasters, which could cause disruption to our employees or interruptthe manufacturing process for our products.  ***Ouroperations could be subject to natural disasters and other businessdisruptions, which could seriously harm our revenues and financial conditionand increase our costs and expenses. Our corporate headquarters are located inCalifornia, near major earthquake faults. Additionally, our primary wafersupplier, TSMC, is located in Taiwan, which has experienced significantearthquakes in the past. A severe earthquake could cause disruption to ouremployees or interrupt the manufacturing process, which could affect TSMC’sability to supply wafers to us, which would negatively affect our business andfinancial results. The ultimate impact on us and our general infrastructure ofbeing located near major earthquake faults is unknown, but our net revenues andfinancial condition and our costs and expenses could be significantly impactedin the event of a major earthquake.

***Manmade problemssuch as computer viruses or terrorism may disrupt our operations and harm ouroperating results.  ***Despite our implementation of networksecurity measures, our servers are vulnerable to computer viruses, break-insand similar disruptions from unauthorized tampering with our computer systems.Any such event could have an adverse effect on our business, operating results,and financial 

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condition. In addition,the effects of war or acts of terrorism could have an adverse effect on ourbusiness, operating results, and financial condition. In addition, as a companywith headquarters and significant operations located in the United States, wemay be impacted by actions against the United States. We are predominantlyuninsured for losses and interruptions caused by terrorist acts and acts ofwar.

***We may experience significant fluctuations in our stockprice, which may, in turn, significantly affect the trading price of ourconvertible notes.  ***Our stock has experiencedsubstantial price volatility, particularly as a result of quarterly variationsin our operating results, the published expectations of analysts and as aresult of announcements by our competitors and us. In addition, the stock markethas experienced price and volume fluctuations that have affected the marketprice of many technology companies, in particular, and that have often beenunrelated to the operating performance of such companies. In addition, theprice of our securities may also be affected by general global, economic andmarket conditions and the cost of operations in one or more of our productmarkets. While we cannot predict the individual effect that these factors mayhave on the price or our securities, these factors, either individually or inthe aggregate, could result in significant variations in the price of ourcommon stock during any given period of time. These fluctuations in our stockprice also impact the price of our outstanding convertible securities and thelikelihood of the convertible securities being converted into our common stock.

**Item6.**                        Exhibits
| Exhibit Number | ** ** | ** **                                                                                                                             | **Description** |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|-----------------|
| Exhibit 31.1   |       | Certification of Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                              |
| Exhibit 31.2   |       | Certification of Chief Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                              |
| Exhibit 32.1   |       | Certification of Chief Executive Officer and Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned hereuntoduly authorized.
| **ADAPTEC, INC.** |                                                                         |
|-------------------|------------------------------------------------------------------------------|
| By:               | /s/  CHRISTOPHER G. O’MEARA                                             |   |   |
|              | Christopher G.  O’Meara                                                 |   |   |
|              | *Vice  President and Chief Financial Officer  (principal financial officer)* |   | Date:  August 8, 2006 |
| By:               | /s/  JOHN M. WESTFIELD                                                       |   |   |
|              | John M. Westfield                                                            |   |   |
|              | *Vice  President and Corporate Controller  (principal accounting officer)*   |   | Date:  August 8, 2006 |

 

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**EXHIBITINDEX**
| Exhibit Number | ** ** | ** **                                                                                                                             | ** ** | **Description** |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| Exhibit 31.1   |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                             |
| Exhibit 31.2   |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                             |
| Exhibit 32.1   |       | Certification of Chief Executive Officer and Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |

 

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