**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

----

FORM 10-Q
| (Mark One)                                                                                                                                                                                        | ** **                                                                                              |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                             | **Quarterly report pursuant to Section 13 or 15(d) of the  Securities Exchange Act of 1934**  |
| **For  the quarterly period ended December 31, 2004 or**                                                                                                                                     |
| ** ̈**                                                                                                                                                                                        | **Transition report pursuant to Section 13 or 15(d) of the  Securities Exchange Act of 1934** |
| **For  the transition period from             to             ** |

 

**Commissionfile number 0-15071**

----

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)                            |

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

**N/A**

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

 

----

Indicate by check mark whetherthe registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.

Yes x  No  ̈

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act)

Yes x  No  ̈

The number of shares outstanding of Adaptec’s commonstock as of January 31, 2005 was 111,577,536.

 

----

 

**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       |     | 32         |   |
|          | Item 3.               | Quantitative and Qualitative  Disclosures About Market Risk                                                                     |     | 62         |   |
|          | Item 4.               | Controls and Procedures                                                                                                         |     | 63         |   |
| Part II. | Other Information     |                                                                                                                            |     |       |
|          | Item 6.               | Exhibits                                                                                                                        |     | 64         |   |
|          | Signature             |                                                                                                                            | 65       |       |

 

2

----

**PART I**.   FINANCIAL INFORMATION

**Item1**.   FinancialStatements

**ADAPTEC, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(unaudited)**
| ** **                                             | ** ** | **Three-Month Period Ended**                                | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                             | ** ** | **December 31, 2004**                                       | ** ** | **December 31, 2003**       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| ** **                                             | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net revenues                                           |       |                                                                  | $          | 126,548                               |       |   |   | $ | 115,143 |   |   |   | $ | 363,750 |   |   |   | $ | 331,628 |   |   |
| Cost of revenues                                       |       |                                                                  | 83,657     |                                  |       |   | 68,575 |   |   |   | 217,065 |   |   |   | 192,849 |   |   |
| Gross profit                                           |       |                                                                  | 42,891     |                                  |       |   | 46,568 |   |   |   | 146,685 |   |   |   | 138,779 |   |   |
| Operating expenses:                                    |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and development                               |       |                                                                  | 29,970     |                                  |       |   | 25,103 |   |   |   | 87,374 |   |   |   | 76,487 |   |   |
| Selling, marketing and administrative                  |       |                                                                  | 21,260     |                                  |       |   | 19,745 |   |   |   | 63,325 |   |   |   | 59,583 |   |   |
| Amortization of acquisition-related intangible  assets |       |                                                                  | 5,095      |                                  |       |   | 4,530 |   |   |   | 13,205 |   |   |   | 14,067 |   |   |
| Write-off of acquired in-process technology            |       |                                                                  | —     |                                  |       |   | — |   |   |   | 5,200 |   |   |   | 3,649 |   |   |
| Restructuring charges                                  |       |                                                                  | 2,228      |                                  |       |   | 878 |   |   |   | 4,975 |   |   |   | 2,704 |   |   |
| Other charges                                          |       |                                                                  | (2,755     | )                                     |       |   | — |   |   |   | (2,755 | ) |   |   | — |   |   |
| Total operating expenses                               |       |                                                                  | 55,798     |                                  |       |   | 50,256 |   |   |   | 171,324 |   |   |   | 156,490 |   |   |
| Loss from  operations                                  |       |                                                                  | (12,907    | )                                     |       |   | (3,688 | ) |   |   | (24,639 | ) |   |   | (17,711 | ) |   |
| Interest and  other income                             |       |                                                                  | 3,097      |                                  |       |   | 3,369 |   |   |   | 8,599 |   |   |   | 64,491 |   |   |
| Interest expense                                       |       |                                                                  | (1,083     | )                                     |       |   | (2,322 | ) |   |   | (3,350 | ) |   |   | (8,010 | ) |   |
| Income (loss)  before income taxes                     |       |                                                                  | (10,893    | )                                     |       |   | (2,641 | ) |   |   | (19,390 | ) |   |   | 38,770 |   |   |
| Provision for  (benefit from) income taxes             |       |                                                                  | (33,382    | )                                     |       |   | 372 |   |   |   | (33,826 | ) |   |   | 720 |   |   |
| Net income (loss)                                      |       |                                                                  | $          | 22,489                                |       |   |   | $ | (3,013 | ) |   |   | $ | 14,436 |   |   |   | $ | 38,050 |   |   |
| Net income (loss)  per share:                          |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                  |       |                                                                  | $          | 0.20                                  |       |   |   | $ | (0.03 | ) |   |   | $ | 0.13 |   |   |   | $ | 0.35 |   |   |
| Diluted                                                |       |                                                                  | $          | 0.17                                  |       |   |   | $ | (0.03 | ) |   |   | $ | 0.12 |   |   |   | $ | 0.33 |   |   |
| Shares used in  computing net income (loss) per share: |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                  |       |                                                                  | 111,136    |                                  |       |   | 108,858 |   |   |   | 110,429 |   |   |   | 108,408 |   |   |
| Diluted                                                |       |                                                                  | 134,517    |                                  |       |   | 108,858 |   |   |   | 131,607 |   |   |   | 126,578 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

3

----

**ADAPTEC, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(unaudited)**
| ** **                                              | ** ** | ** December 31,   2004** | ** ** | **March 31,  2004** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------|------------|--------------------------|------------|
| ** **                                              | ** ** | **(in thousands)**                 | ** ** |
| **Assets**                                              |       |                                    |       |                     |       |   |   |
| Current assets:                                         |       |                                    |       |                     |       |   |   |
| Cash and cash equivalents                               |       |                                    | $          | 92,728                   |       |   | $ | 119,113 |   |
| Marketable securities                                   |       |                                    | 424,448    |                     |       | 544,741 |   |
| Restricted cash and marketable securities               |       |                                    | 2,283      |                     |       | 2,815 |   |
| Accounts receivable, net                                |       |                                    | 87,488     |                     |       | 51,562 |   |
| Inventories                                             |       |                                    | 56,650     |                     |       | 48,888 |   |
| Deferred income taxes                                   |       |                                    | 58,355     |                     |       | 55,678 |   |
| Prepaid expenses                                        |       |                                    | 22,684     |                     |       | 14,761 |   |
| Other current assets                                    |       |                                    | 9,367      |                     |       | 20,031 |   |
| Total current assets                                    |       |                                    | 754,003    |                     |       | 857,589 |   |
| Property and  equipment, net                            |       |                                    | 61,036     |                     |       | 58,435 |   |
| Restricted  marketable securities, less current portion |       |                                    | 4,648      |                     |       | 6,346 |   |
| Goodwill                                                |       |                                    | 159,632    |                     |       | 68,492 |   |
| Other intangible  assets, net                           |       |                                    | 87,086     |                     |       | 48,902 |   |
| Other long-term  assets                                 |       |                                    | 50,079     |                     |       | 11,340 |   |
| Total assets                                            |       |                                    | $          | 1,116,484                |       |   | $ | 1,051,104 |   |
| **Liabilities  and Stockholders’ Equity**          |       |                                    |       |                     |       |   |   |
| Current liabilities:                                    |       |                                    |       |                     |       |   |   |
| Accounts payable                                        |       |                                    | $          | 53,803                   |       |   | $ | 35,969 |   |
| Accrued liabilities                                     |       |                                    | 111,149    |                     |       | 106,392 |   |
| Total current liabilities                               |       |                                    | 164,952    |                     |       | 142,361 |   |
| 3⁄4% Convertible  Senior Subordinated Notes          |       |                                    | 225,000    |                     |       | 225,000 |   |
| 3% Convertible  Subordinated Notes                      |       |                                    | 35,190     |                     |       | 35,190 |   |
| Other long-term  liabilities                            |       |                                    | 16,059     |                     |       | 3,662 |   |
| Deferred tax  liabilities                               |       |                                    | 9,215      |                     |       | — |   |
| Commitments and  contingencies (Note 16)                |       |                                    |       |                     |       |   |   |
| Stockholders’ equity:                              |       |                                    |       |                     |       |   |   |
| Common stock                                            |       |                                    | 112        |                     |       | 110 |   |
| Additional paid-in capital                              |       |                                    | 163,636    |                     |       | 153,174 |   |
| Deferred stock-based compensation                       |       |                                    | (3,517     | )                        |       | (2,713 | ) |
| Accumulated other comprehensive income, net of taxes    |       |                                    | 81         |                     |       | 3,000 |   |
| Retained earnings                                       |       |                                    | 505,756    |                     |       | 491,320 |   |
| Total stockholders’ equity                         |       |                                    | 666,068    |                     |       | 644,891 |   |
| Total liabilities and  stockholders’ equity        |       |                                    | $          | 1,116,484                |       |   | $ | 1,051,104 |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

4

----

**ADAPTEC, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)**
| ** **                                                                                                     | ** ** | **Nine-Month Period Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                     | ** ** | **December 31, 2004**       | ** ** | **December 31, 2003** | ** ** |
| ** **                                                                                                     | ** ** | **(in thousands)**               | ** ** |
| **Cash Flows From Operating Activities:**                                                                      |       |                                  |       |   |   |   |   |   |   |
| Net income                                                                                                     |       |                                  | $          | 14,436 |   |   |   | $ | 38,050 |   |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:                             |       |                                  |       |   |   |   |   |   |   |
| Non-cash restructuring  charges                                                                                |       |                                  | 109        |   |   |   | 105 |   |   |
| Write-off of  acquired in-process technology                                                                   |       |                                  | 5,200      |   |   |   | 3,649 |   |   |
| Stock-based  compensation                                                                                      |       |                                  | 2,807      |   |   |   | 3,259 |   |   |
| Non-cash effect of tax  settlement                                                                             |       |                                  | (26,009    | ) |   |   | — |   |   |
| Loss on extinguishment  of debt                                                                                |       |                                  | —     |   |   |   | 3,734 |   |   |
| Non-cash portion  of DPT settlement gain                                                                       |       |                                  | —     |   |   |   | (18,256 | ) |   |
| Gain on sale of  long-lived assets                                                                             |       |                                  | (2,755     | ) |   |   | — |   |   |
| Depreciation and  amortization                                                                                 |       |                                  | 34,987     |   |   |   | 40,431 |   |   |
| Deferred income taxes                                                                                          |       |                                  | (40        | ) |   |   | (5,895 | ) |   |
| Other non-cash items                                                                                           |       |                                  | (12        | ) |   |   | 551 |   |   |
| Changes in operating  assets and liabilities (net of acquired businesses):                                     |       |                                  | (44,673    | ) |   |   | 3,006 |   |   |
| **Net Cash Provided by (Used for)  Operating Activities**                                                      |       |                                  | $          | (15,950 | ) |   |   | $ | 68,634 |   |   |
| **Cash Flows From Investing Activities:**                                                                      |       |                                  |       |   |   |   |   |   |   |
| Payment  of general holdback in connection with acquisition of Platys                                          |       |                                  | —     |   |   |   | (195 | ) |   |
| Payment of holdback in  connection with acquisition of Eurologic                                               |       |                                  | (2,279     | ) |   |   | — |   |   |
| Purchases of businesses,  net of cash acquired                                                                 |       |                                  | (123,978   | ) |   |   | (29,884 | ) |   |
| Purchases of restricted  marketable securities                                                                 |       |                                  | —     |   |   |   | (7,915 | ) |   |
| Maturities of restricted  marketable securities                                                                |       |                                  | 2,213      |   |   |   | 3,750 |   |   |
| Purchases of property  and equipment                                                                           |       |                                  | (12,553    | ) |   |   | (5,859 | ) |   |
| Proceeds from sale of  long-lived assets                                                                       |       |                                  | 9,577      |   |   |   | — |   |   |
| Purchases of marketable  securities                                                                            |       |                                  | (252,649   | ) |   |   | (530,390 | ) |   |
| Sales of marketable  securities                                                                                |       |                                  | 297,424    |   |   |   | 455,145 |   |   |
| Maturities of marketable  securities                                                                           |       |                                  | 65,541     |   |   |   | 78,918 |   |   |
| **Net Cash Used for Investing  Activities**                                                                    |       |                                  | (16,704    | ) |   |   | (36,430 | ) |   |
| **Cash Flows From Financing Activities:**                                                                      |       |                                  |       |   |   |   |   |   |   |
| Proceeds from the  issuance of 3⁄4% Convertible Senior Subordinated Notes, net of issuance costs  of $6,750 |       |                                  | —     |   |   |   | 218,250 |   |   |
| Repurchases and  redemption of long-term debt                                                                  |       |                                  | —     |   |   |   | (207,243 | ) |   |
| Purchase of convertible  bond hedge                                                                            |       |                                  | —     |   |   |   | (64,140 | ) |   |
| Proceeds from issuance  of warrant                                                                             |       |                                  | —     |   |   |   | 30,390 |   |   |
| Proceeds from issuance  of common stock                                                                        |       |                                  | 5,446      |   |   |   | 4,130 |   |   |
| Installment payment on  acquisition of software licenses                                                       |       |                                  | —     |   |   |   | (3,633 | ) |   |
| **Net Cash Provided by (Used for)  Financing Activities**                                                      |       |                                  | 5,446      |   |   |   | (22,246 | ) |   |
| **Effect of Foreign Currency  Translation on Cash and Cash Equivalents**                                       |       |                                  | 823        |   |   |   | 911 |   |   |
| **Net Increase (Decrease) in Cash  and Cash Equivalents**                                                      |       |                                  | (26,385    | ) |   |   | 10,869 |   |   |
| **Cash and Cash Equivalents at  Beginning of Period**                                                          |       |                                  | 119,113    |   |   |   | 149,373 |   |   |
| **Cash and Cash Equivalents at End of Period**                                                                 |       |                                  | $          | 92,728 |   |   |   | $ | 160,242 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

5

----

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

**1. Basisof Presentation**

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, 2004 audited consolidated financial statements and include alladjustments, consisting of only normal recurring adjustments, necessary tofairly present 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 for the year ended March 31, 2004, which were included in theCompany’s Current Report on Form 8-K, which was filed with the SEC on December 7,2004. The third quarters of fiscal 2005 and 2004 ended December 31, 2004and December 26, 2003, respectively. For presentation purposes, theaccompanying financial statements have been shown as ending on the last day ofthe calendar month. Certain amounts reported in previous periods have beenreclassified to conform to the current period presentation. The results ofoperations for the third quarter and first nine months of fiscal 2005 are notnecessarily indicative of the results to be expected for the entire fiscalyear. In the first and second quarters of fiscal 2005, the Company reorganizedits reportable segments, as described more fully in Note 18.

In the third quarter of fiscal 2005, the Companyadopted EITF 04-08 which required restatement of previously reported earningsper share as further discussed in Note13.

The glossary of acronymsand accounting rules and regulations referred to within this QuarterlyReport on Form 10-Q is listed in alphabetical order in Note 21.

**2. Recent AccountingPronouncements**

In December 2004, the FASB issued SFAS No. 123(R).This statement replaces SFAS No. 123, amends SFAS No. 95 andsupersedes APB Opinion No. 25. SFAS No. 123(R) requires companies toapply a fair-value based measurement method in accounting for share-basedpayment transactions with employees and to record compensation expense for allstock awards granted, and to awards modified, repurchased or cancelled afterthe required effective date. In addition, the Company is required to record compensationexpense (as previous awards continue to vest) for the unvested portion ofpreviously granted awards that remain outstanding at the date of adoption. SFASNo. 123(R) will be effective for quarterly periods beginning after June 15,2005, which is the Company’s second quarter of fiscal 2006. This statement willhave a significant impact on the Company’s results of operations as the Companywill be required to record compensation expense rather than disclose the impacton the Company’s results of operations within its footnotes (see Note 3 below).

At its March 2004meeting, the EITF reached a consensus on recognition and measurement guidancepreviously discussed under EITF 03-01. The consensus clarified the meaning ofother-than-temporary impairment and its application to investments classifiedas either available-for-sale or held-to-maturity under SFAS No. 115 and toinvestments accounted for under the cost method or the equity method. In September 2004,the FASB delayed the recognition and measurement guidance to be applied to 

6

----

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

**2. RecentAccounting Pronouncements (Continued)**

other-than-temporaryimpairment evaluations. The FASB expects to issue additional implementationguidance with respect to debt securities that are impaired solely due tointerest rates and/or sector spreads.

**3. Stock-BasedCompensation**

TheCompany accounts for stock-based compensation using the intrinsic-value-basedmethod, which is in accordance with APB Opinion No. 25 as interpreted byFIN 44, and complies with the disclosure provisions of SFAS No. 148, anamendment of SFAS No. 123. The following table illustrates the effect onnet income (loss) and earnings per share as if the Company had applied the fairvalue recognition provisions of SFAS No. 123 to employee and directorstock option plans, including shares issued under the Company’s ESPP,collectively called “options,” for all periods presented:
| ** **                                                                                                      | ** ** | **Three-Month Period Ended**                                | ** ** | **Nine-Month Period Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                      | ** ** | **December 31, 2004**                                       | ** ** | **December 31, 2003**       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| ** **                                                                                                      | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net income  (loss), as reported                                                                                 |       |                                                                  | $          | 22,489                                |       |   |   | $ | (3,013 | ) |   |   | $ | 14,436 |   |   |   | $ | 38,050 |   |   |
| Add: Deferred  stock-based compensation expense included in reported net income (loss)                          |       |                                                                  | 775        |                                  |       |   | 892 |   |   |   | 2,453 |   |   |   | 2,991 |   |   |
| Deduct: Total  stock-based compensation expense determined under the fair value-based  method, net of tax  |       |                                                                  | (3,837     | )                                     |       |   | (6,025 | ) |   |   | (9,923 | ) |   |   | (21,186 | ) |   |
| Pro forma net  income (loss)                                                                                    |       |                                                                  | $          | 19,427                                |       |   |   | $ | (8,146 | ) |   |   | $ | 6,966 |   |   |   | $ | 19,855 |   |   |
| Basic net income  (loss) per share:                                                                             |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                     |       |                                                                  | $          | 0.20                                  |       |   |   | $ | (0.03 | ) |   |   | $ | 0.13 |   |   |   | $ | 0.35 |   |   |
| Pro forma                                                                                                       |       |                                                                  | $          | 0.17                                  |       |   |   | $ | (0.07 | ) |   |   | $ | 0.06 |   |   |   | $ | 0.18 |   |   |
| Diluted net income  (loss) per share:                                                                           |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                     |       |                                                                  | $          | 0.17                                  |       |   |   | $ | (0.03 | ) |   |   | $ | 0.12 |   |   |   | $ | 0.33 |   |   |
| Pro forma                                                                                                       |       |                                                                  | $          | 0.15                                  |       |   |   | $ | (0.07 | ) |   |   | $ | 0.06 |   |   |   | $ | 0.18 |   |   |

 

SFAS No. 123 requires the use of option pricingmodels that were not developed for use in valuing employee stock options. TheBlack-Scholes option pricing model, used by the Company, was developed for usein estimating the fair value of short-lived exchange traded options that haveno vesting restrictions and are fully transferable. In addition, option pricingmodels require the input of highly subjective assumptions, including the option’sexpected life and the price volatility of the underlying stock. Because theCompany’s options have characteristics significantly different from those oftraded options, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in the opinion of management, the existingmodels do not necessarily provide a reliable measure of the fair value ofoptions.

7

----

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

**3.Stock-Based Compensation (Continued)**

The fair value of optionsgranted in the third quarter and first nine months of fiscal 2005 and 2004, asreported, were estimated at the date of grant using the Black-Scholes valuationmodel with the following weighted average assumptions:
| ** **                    | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|-------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **December 31, 2004**        | ** ** | **December 31, 2003**       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| Employee Stock  Option Plans: |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Expected life (in  years)     |       |                                   | 2.0        |                                  |       |   | 2.9 |   |   |   | 2.3 |   |   |   | 2.3 - 3.0 |   |   |
| Risk-free  interest rates     |       |                                   | 3.1        | %                                     |       |   | 2.3 | % |   |   | 3.0 | % |   |   | 1.5% - 2.3 | % |   |
| Expected  volatility          |       |                                   | 39         | %                                     |       |   | 61 | % |   |   | 44 | % |   |   | 61% -  66 | % |   |
| Dividend yield                |       |                                   | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Director Option  Plans:       |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Expected life (in  years)     |       |                                   | —     |                                  |       |   | 2.5 |   |   |   | — |   |   |   | 2.5 |   |   |
| Risk-free  interest rates     |       |                                   | —     |                                  |       |   | 2.1 | % |   |   | — |   |   |   | 2.1 | % |   |
| Expected  volatility          |       |                                   | —     |                                  |       |   | 62 | % |   |   | — |   |   |   | 62 | % |   |
| Dividend yield                |       |                                   | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |
| ESPP:                         |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Expected life (in  years)     |       |                                   | 1.4        |                                  |       |   | 0.5 - 2.0 |   |   |   | 1.4 |   |   |   | 0.5 - 2.0 |   |   |
| Risk-free  interest rates     |       |                                   | 2.1        | %                                     |       |   | 1.1% - 1.8 | % |   |   | 2.1 | % |   |   | 1.1% - 1.8 | % |   |
| Expected  volatility          |       |                                   | 50         | %                                     |       |   | 39% -  66 | % |   |   | 50 | % |   |   | 39% -  66 | % |   |
| Dividend yield                |       |                                   | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |

 

**4. Business Acquisitions**

**SnapAppliance:****  **On July 23,2004, the Company completed the acquisition of Snap Appliance, Inc. (“SnapAppliance”), a provider of NAS solutions, to expand its product offerings inthe external storage market and to deliver cost-effective, scalable andeasy-to-use DAS, NAS, Fibre Channel and IP-based SAN solutions from theworkgroup to the data center. The total purchase price was $84.4 million,consisting of $77.4 million in cash and transaction fees and$7.0 million related to the fair value of assumed stock options to purchase1.2 million shares of the Company’s common stock. The assumed stockoptions were valued using the Black-Scholes valuation model with the followingassumptions: volatility rate of 58%; a risk-free interest rate of 2.6%; and anestimated life of 2.25 years. Snap Appliance is included in the Company’sChannel segment (Note 18).

Of the total assumed stock options, stock options topurchase approximately 0.7 million shares of the Company’s common stock,with exercise prices ranging between $1.42 and $5.66 per share, were unvested(the “Snap Unvested Options”). The Snap Unvested Options have a ten-year termand vest primarily over four years from the date of grant. The intrinsic valueof the Snap Unvested Options of $3.6 million was accounted for as deferredstock-based compensation and is being recognized as compensation expense overthe related vesting periods.

The preliminary allocationof the Snap Appliance purchase price to the tangible and identifiableintangible assets acquired and liabilities assumed is summarized below (inthousands). The preliminary allocation was based on an independent appraisaland management’s estimates of fair value. The allocation 

8

----

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

**4.Business Acquisitions (Continued)**

of thepurchase price may be subject to change based on final estimates of fair value;however, such changes are not expected to be material.
| Cash                               |   | $       | 60      |   |
|------------------------------------|--------|---------|---------|--------|
| Accounts  receivable               |   | 5,752   |    |
| Inventory                          |   | 3,316   |    |
| Prepaid expenses                   |   | 438     |    |
| Property and  equipment            |   | 1,379   |    |
| Other long-term  assets            |   | 163     |    |
| Total assets  acquired             |   | 11,108  |    |
| Accounts payable                   |   | (4,254  | )       |
| Current  liabilities               |   | (16,180 | )       |
| Other long-term  liabilities       |   | (2,325  | )       |
| Total liabilities  assumed         |   | (22,759 | )       |
| Net tangible liabilities  acquired |   | $       | (11,651 | )      |

 

The allocationof the purchase price to the tangible and intangible assets acquired andliabilities assumed is as follows (in thousands):
| Net tangible  liabilities acquired    |   | $       | (11,651 | )      |
|---------------------------------------|--------|---------|---------|--------|
| Acquired in-process  technology       |   | 2,200   |    |
| Deferred  stock-based compensation    |   | 3,610   |    |
| Deferred income  tax liabilities      |   | (11,640 | )       |
| Goodwill                              |   | 72,830  |    |
| Other intangible  assets:             |   |    |    |
| Core and existing technologies        |   | 19,000  |    |
| Trade name                            |   | 10,100  |    |
|                                  |   | 29,100  |    |
| Net assets acquired  (purchase price) |   | $       | 84,449  |   |

 

The values allocated to the core and existingtechnologies and trade name created as a result of the acquisition of SnapAppliance are being amortized over an estimated weighted average useful life of7 years. No residual value has been estimated for the intangible assets.In accordance with SFAS No. 142, the Company will not amortize thegoodwill, but will evaluate it at least annually for impairment.

In addition, a management incentive program wasestablished to pay former employees of Snap Appliance cash payments totaling$13.8 million, which will be paid, contingent upon their employment withthe Company, over a two-year period through the second quarter of fiscal 2007.Payments under the management incentive program will be expensed as employeesmeet their employment obligations or are recorded as part of the Snap Applianceacquisition-related restructuring for involuntarily terminations from theCompany. In the third quarter of fiscal 2005, the Unaudited CondensedConsolidated Statements of Operations included compensation expense related tothe management incentive program of 

9

----

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

**4.Business Acquisitions (Continued)**

$1.4 million and anadditional $1.4 million was originally accrued in the Snap Applianceacquisition-related restructuring. In the first nine months of fiscal 2005, theUnaudited Condensed Consolidated Statements of Operations included compensationexpense related to the management incentive program of $4.3 million and anadditional $1.4 million was originally accrued in the Snap Applianceacquisition-related restructuring.

A portion of the Snap Appliance acquisition pricetotaling $5.4 million was held back, and in connection with the managementincentive program, $1.3 million was held back for a total of $6.7 million (the “SnapAppliance Holdback”) for unknown liabilities that may have existed as of theacquisition date. The Snap Appliance Holdback will be paid in the secondquarter of fiscal 2006, except for funds necessary to provide for any pendingclaims.

***Acquisition-RelatedRestructuring:******  ***Inthe third quarter of fiscal 2005, the Company refined its plan to integrate theSnap Appliance operations related to integrating certain duplicative resourcesfor both severance and benefits in connection with the involuntary terminationof approximately 24 employees, exiting facilities and the disposal ofduplicative assets. The acquisition-related restructuring liabilities wereaccounted for under EITF 95-3 and therefore were included in the purchaseprice allocation of the cost to acquire Snap Appliance. The Company recorded apreliminary estimate of $6.0 million in the second quarter of fiscal 2005 forthese activities. In the third quarter of fiscal 2005, the Company recorded a$0.8 million increase to the accrued restructuring charges with a correspondingchange to goodwill as its plans were further refined. The Company expects toexecute the integration plan as currently designed; however, actual results andcosts may differ as the plan is executed. Any further changes to the Company’sestimate will result in an increase or decrease to the accrued restructuringcharges and a corresponding increase or decrease to goodwill. As of December 31,2004, the Company had utilized $1.4 million of these charges. The Companyanticipates that the remaining restructuring reserve balance of $5.4 millionwill be paid out by third quarter of fiscal 2012, primarily related tolong-term facility leases.

Theactivity in the accrued restructuring reserve related to the Snap Applianceacquisition-related restructuring plan was as follows for the first nine monthsof fiscal 2005;
| ** **                                                  | ** ** | **Severance And**  | ** ** | ** **             | ** ** | ** ** | ** ** |
|-------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                  | ** ** | **Benefits**            | ** ** | **Other Charges** | ** ** | **Total**  | ** ** |
| ** **                                                  | ** ** | **(in thousands)** | ** ** |
| **Snap  Appliance Acquisition-Related Restructuring Plan:** |       |                    |       |                   |       |       |       |   |   |   |   |
| Restructuring Provision                                     |       |                    | $          | 1,967                  |       |       |       | $ | 3,999 |   |   | $ | 5,966 |   |
| Adjustments                                                 |       |                    | 689        |                   |       |       | 109        |   |   | 798 |   |
| Cash paid                                                   |       |                    | (349       | )                      |       |       | (186       | ) |   | (535 | ) |
| Non-cash charges                                            |       |                    | (334       | )                      |       |       | (468       | ) |   | (802 | ) |
| Reserve balance  at December 31, 2004                  |       |                    | $          | 1,973                  |       |       |       | $ | 3,454 |   |   | $ | 5,427 |   |

 

**IBMi/p Series****RAID:**    OnJune 29, 2004, the Company completed the acquisition of InternationalBusiness Machines Corporation’s (“IBM”) i/p Series RAID component businessline consisting of certain purchased RAID data protection intellectualproperty, semiconductor designs and assets, and licensed from IBM related RAIDintellectual property (the “IBM i/p Series RAID” business). The licensing 

10

----

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

**4.Business Acquisitions (Continued)**

agreement grants theCompany the right to use IBM’s RAID technology and embedded Power PC technologyfor the Company’s internal and external RAID products to be sold to IBM andother customers. In conjunction with the acquisition, the Company also enteredinto a three-year exclusive product supply agreement under which the Companywill supply RAID software, firmware and hardware to IBM for use in IBM’s iSeries andpSeries servers. The Company also entered into an agreement for IBM toprovide silicon wafer manufacturing processing services to the Company for theterm of the supply agreement at agreed upon rates.

The total purchase price is estimated at$49.5 million, which consists of a cash payment to IBM of$47.5 million, warrants valued at $1.1 million, net of registrationcosts, and transactions costs of $0.9 million. In connection with theacquisition, the Company issued a warrant to IBM to purchase 250,000 shares ofthe Company’s common stock at an exercise price of $8.13 per share. The warranthas a term of 5 years from the date of issuance and is immediatelyexercisable. The warrant was valued using the Black-Scholes valuation modelusing a volatility rate of 62%, a risk-free interest rate of 3.9% and anestimated life of 5 years. The transaction costs consist primarily oflegal, valuation and other fees. The IBM i/p Series RAID business isincluded in the Company’s OEM segment (Note 18).

The Company also entered into a service agreement forIBM to provide certain research and development services and to provide accessto IBM’s semiconductor design tools. The semiconductor design tools licenseagreement is for two years at a total cost of $9.9 million and is payablein quarterly installments; however, the agreement can be cancelled by theCompany in any quarter, which termination would relieve any obligations for theCompany to make future quarterly installment payments to IBM.

TheIBM i/p Series RAID business was accounted for as a purchase businesscombination with the allocation of the purchase price to the tangible andintangible assets acquired summarized below (in thousands). The allocation wasbased on management’s estimates of fair value, which included an independentappraisal.
| Net property and  equipment           |   | $      | 635    |   |
|---------------------------------------|--------|--------|--------|--------|
| Acquired in-process  technology       |   | 3,000  |   |
| Goodwill                              |   | 18,915 |   |
| Other intangible  assets:             |   |   |   |
| Supply agreement                      |   | 7,600  |   |
| Patents and core technology           |   | 18,700 |   |
| Foundry agreement                     |   | 600    |   |
|                                  |   | 26,900 |   |
| Net assets acquired  (purchase price) |   | $      | 49,450 |   |

 

The values allocated to the supply agreement, patentsand core technology and foundry agreement are being amortized over estimateduseful lives of 3 to 5 years. The estimated weighted average useful lifeof other intangible assets, created as a result of the acquisition of the IBMi/p Series RAID business, is approximately 5 years. No residual valuehas been estimated for the intangible assets. In accordance with SFAS No. 142,the Company will not amortize the goodwill, but will evaluate it at leastannually for impairment.

11

----

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

**4.Business Acquisitions (Continued)**

**Eurologic:****  **On April 2, 2003, the Company completed theacquisition of Eurologic Systems Group Limited (“Eurologic”), a provider ofexternal and networked storage solutions. The Company acquired Eurologic tofurther enhance its direct-attached and fibre-attached server storagecapabilities by allowing it to provide end-to-end block- and file-basednetworked storage solutions. As consideration for the acquisition of all of theoutstanding capital stock of Eurologic, the Company paid $25.6 million incash, subject to a Holdback as described below, and assumed stock options topurchase 0.5 million shares of the Company’s common stock, with a fairvalue of $1.6 million. The Company also incurred $1.1 million intransaction fees, including legal, valuation and accounting fees. The assumedstock options were valued using the Black-Scholes valuation model with thefollowing assumptions: volatility rate ranging from 57% to 81%; a risk-freeinterest rate ranging from 1.1% to 2.5%; and an estimated life ranging from0.08 to 4 years. As part of the Eurologic purchase agreement,$3.8 million of the cash payment was held back (the “Holdback”) forunknown liabilities that may have existed as of the acquisition date. TheHoldback, which was included as part of the purchase price, was included in “Accruedliabilities” in the Unaudited Condensed Consolidated Balance Sheet as of December 31,2004 and was to have been paid to the former Eurologic stockholders18 months after the acquisition closing date, except for funds necessaryto provide for any pending claims. The Company has paid $2.3 million of theHoldback as of December 31, 2004 and has asserted claims against theremaining amount for liabilities of which it became aware following theconsummation of the transaction. The former Eurologic stockholders havedisputed these claims. The Company also agreed to pay the stockholders ofEurologic contingent consideration of up to $10.0 million in cash ifcertain revenue levels were achieved by the acquired Eurologic business in theperiod from July 1, 2003 through June 30, 2004. The milestone toachieve the contingent consideration was not attained as of June 30, 2004.As a result, no additional payments were made to the former stockholders ofEurologic. Eurologic’s goodwill and amortizable intangible assets wereallocated based on the relative fair values of the two segments, OEM andChannel (Note 18).

***Acquisition-RelatedRestructuring:******  ***Duringthe fourth quarter of fiscal 2004, the Company finalized its plans to integratethe Eurologic operations. The integration plan included the involuntarytermination or relocation of approximately 110 employees, exiting duplicativefacilities and the transition of all manufacturing operations from Dublin,Ireland to the Company’s manufacturing facility in Singapore. The consolidationof the manufacturing operations as well as involuntary employee terminationswas completed in the fourth quarter of fiscal 2004. The acquisition-relatedrestructuring liabilities were accounted for under EITF 95-3 and thereforewere included in the purchase price allocation of the cost to acquireEurologic. The Company recorded a liability of $3.3 million in fiscal 2004for these activities. As of December 31, 2004, the Company utilizedapproximately all of these charges and the plan is materially complete.

**ICPvortex:****  **On June 5,2003, the Company completed the acquisition of ICP vortex Computersysteme GmbH(“ICP vortex”). ICP vortex was a wholly-owned subsidiary of Intel Corporationand provided a broad range of hardware and software RAID data protectionsolutions, including SCSI, Serial ATA and fibre channel products. The finalpurchase price was $14.5 million in cash, which included $0.3 millionin transaction fees, consisting of legal, valuation and accounting fees. Thispurchase price included a final adjustment of $0.1 million in the firstquarter of fiscal 2005 to both goodwill and 

12

----

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

**4.Business Acquisitions (Continued)**

acquisitions costs. ICPvortex’s goodwill and amortizable intangible assets were allocated based on therelative fair values of the two segments, OEM and Channel (Note 18).

During the first quarter of fiscal 2005, the Companyfinalized its plans to integrate the ICP vortex operations. The integrationplan included the involuntary termination of 19 employees, the transfer ofmanufacturing operations to Singapore and the integration of certainduplicative resources. The acquisition-related restructuring liabilities wereaccounted for under EITF 95-3 and therefore were included in the purchaseprice allocation of the cost to acquire ICP vortex. In fiscal 2004, the Companyrecorded a liability of $0.4 million for severance and benefits, of which$0.3 million of these charges were utilized and $0.1 million wasrecorded as a reduction to the restructuring liability with a correspondingdecrease to goodwill in the first quarter of fiscal 2005.

**Elipsan:****  **On February 13, 2004, the Company completed theacquisition of Elipsan Limited (“Elipsan”), a provider of networked storageinfrastructure software. Elipsan’s storage virtualization technology willenable the Company to make storage more cost-effective, easier to scale andincrease performance across multiple RAID subsystems. The total purchase pricewas $19.4 million in cash to acquire Elipsan, which included$0.7 million in transaction fees, consisting of legal, valuation andaccounting fees. In the first nine months of fiscal 2005, adjustments were madeto both goodwill and the acquisition costs, primarily related to the reversalof the acquisition-related restructuring reserves of approximately $0.6million. Elipsan’s goodwill and amortizable intangible assets were allocatedbased on the relative fair values of the two segments, OEM and Channel (Note18).

***Acquisition-Related Restructuring:******  ***During the third quarter offiscal 2005, the Company further refined its plans to integrate of the Elipsanoperations. The initial plan included the integration of certain duplicativeresources related to both severance and benefits in connection with theinvoluntary termination of employees and, accordingly, the Company recorded a$0.8 million reserve as of March 31, 2004. In the third quarter of fiscal2005, the Company recorded an adjustment of $0.6 million as a reduction to theliability with a corresponding decrease to goodwill as the Company intends toretain these employees. The acquisition-related restructuring liabilities wereaccounted for under EITF 95-3 and therefore were included in the purchaseprice allocation of the cost to acquire Elipsan. As of December 31, 2004,the Company made payments of approximately $25,000 under the plan. The Companyanticipates that the remaining restructuring reserve balance of $0.2 millionwill be paid out by the second quarter of fiscal 2006.

13

----

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

**4.Business Acquisitions (Continued)**

**In-processTechnology**

As part of the purchaseagreements of Snap Appliance, the IBM i/p Series RAID business, Eurologicand Elipsan, certain amounts of the purchase prices were allocated to acquiredin-process technology which were determined through established valuationtechniques in the high-technology computer industry and written off in thesecond quarter of fiscal 2005, first quarter of fiscal 2005, first quarter offiscal 2004 and fourth quarter of fiscal 2004, respectively, becausetechnological feasibility had not been established and no alternative futureuses existed. The values were determined by estimating the net cash flows anddiscounting the estimated net cash flows to their present values. A summary ofthe amounts written off were as follows:
| ** **                            | ** ** | **Acquired**                   | ** ** |
|---------------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **In-Process Technology** | ** ** |
| ** **                            | ** ** | **(in thousands)**        | ** ** |
| Snap Appliance(1)                     |       |                           | $          | 2,200 |   |   |
| IBM i/p  Series RAID business(2) |       |                           | 3,000      |   |   |
| Eurologic(3)                          |       |                           | 3,649      |   |   |
| Elipsan(4)                            |       |                           | 4,000      |   |   |

----

(1)          The identifiedin-process projects were related to operating system enhancements and systemfunctionality improvements.

(2)          The in-process projectswere related to designing semiconductors and related boards and enhancements toRAID and firmware code.

(3)          The Company acquiredvarious external and networked storage products that enable organizations toinstall, manage and scale multiterabyte storage solutions. The identifiedprojects focus on increasing performance while reducing the storage controllerform factor.

(4)          The in-process projectswere related to the development of software modules to add additionalfunctionality to the existing storage virtualization software as well asaddress specific customer needs.

The net cash flows from the identified projects werebased on estimates of revenues, cost of revenues, research and development expenses,including costs to complete the projects, selling, marketing and administrativeexpenses, royalty expenses and income taxes from the projects. The Companybelieves the assumptions used in the valuations were reasonable at the time ofthe acquisitions. The estimated net revenues and gross margins were based onmanagement’s projections of the projects and were in line with industryaverages. Estimated total net revenues from the projects of Snap Appliance, theIBM i/p Series RAID business, Eurologic and Elipsan were expected to growthrough fiscal 2009, fiscal 2009, fiscal 2008 and fiscal 2007, respectively,and decline thereafter as other new products are expected to become available.Estimated operating expenses included research and development expenses andselling, marketing and administrative expenses based upon historical andexpected direct expense levels and general industry metrics. Estimated researchand development expenses include costs to bring the projects to technologicalfeasibility and costs associated with activities undertaken to correct errorsor keep products updated with current information (also referred to as “maintenance”research and development) 

14

----

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

**4.Business Acquisitions (Continued)**

after a product isavailable for general release to customers. These activities range from 0% to5% of net revenues for the in-process technologies.

The effective tax rate utilized in the analysis of thein-process technologies reflects a combined historical industry specificaverage for the United States Federal and state statutory income tax rates. Thecost of capital reflects the estimated time to complete the projects and thelevel of risk involved. The following discount rates were used in computing thepresent value of net cash flows for the acquired companies: approximately 24%for Snap Appliance, between 23% and 28% for the IBM i/p Series RAIDbusiness, approximately 27% for Eurologic and approximately 63% for Elipsan.

The percentage of completion was determined usingcosts incurred by Snap Appliance, the IBM i/p Series RAID business,Eurologic and Elipsan prior to their respective acquisition dates compared tothe estimated remaining research and development to be completed to bring theprojects to technological feasibility. The Company estimated, as of theacquisition date for Snap Appliance, the IBM i/p Series RAID business,Eurologic and Elipsan, that the projects were approximately 25% complete, 50%complete, 60% complete and 28% complete, respectively. All projects outstandingas of the acquisition date for Eurologic and Elipsan were completed as of March 31,2004 and December 31, 2004, respectively. The Company expects remainingcosts of approximately $0.5 million and $18.4 million related to SnapAppliance and the IBM i/p Series RAID business, respectively, to bring theplanned in-process projects to completion.

**ProForma Results:****  **Thefollowing unaudited pro forma financial information for the third quarter offiscal 2004 and first nine months of fiscal 2005 and 2004, presents thecombined results of the Company and Snap Appliance, the IBM i/p Series RAIDbusiness, ICP vortex and Elipsan, as if the acquisitions had occurred at thebeginning of the periods presented. Eurologic was not included in thecalculation as the results of Eurologic have been included in the Company’sfinancial statements from April 2, 2003. Certain adjustments have beenmade to the combined results of operations, including amortization of acquiredother intangible assets; however, charges for purchased in-process technologywere excluded as these items were non-recurring. The pro forma financialresults for the third quarter of fiscal 2004 and first nine months of fiscal2005 and 2004 were as follows:
| ** **                    | ** ** | **Three-Month Period Ended**                                | ** ** | **Nine-Month Period Ended** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **December 31, 2003**                                       | ** ** | **December 31, 2004**       | ** ** | **December 31, 2003** | ** ** |
| ** **                    | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net revenues                  |       |                                                                  | $          | 142,208                               |       |   |   | $ | 377,931 |   |   |   | $ | 405,550 |   |   |
| Net income (loss)             |       |                                                                  | (6,885     | )                                     |       |   | 7,088 |   |   |   | 20,051 |   |   |
| Net income (loss)  per share: |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Basic                         |       |                                                                  | $          | (0.06                                 | )          |   |   | $ | 0.06 |   |   |   | $ | 0.18 |   |   |
| Diluted                       |       |                                                                  | $          | (0.06                                 | )          |   |   | $ | 0.06 |   |   |   | $ | 0.18 |   |   |

 

15

----

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

**5. Balance Sheets Details**

**Inventories:**
| ** **      | ** ** | **December 31, 2004** | ** ** | **March 31, 2004** | ** ** |
|-----------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **      | ** ** | **(in thousands)**         | ** ** |
| Raw materials   |       |                            | $          | 17,817                       |       |   |   | $ | 16,244 |   |   |
| Work-in-process |       |                            | 7,122      |                         |       |   | 6,210 |   |   |
| Finished goods  |       |                            | 31,711     |                         |       |   | 26,434 |   |   |
| Total           |       |                            | $          | 56,650                       |       |   |   | $ | 48,888 |   |   |

 

**Accrued Liabilities:**
| ** **                              | ** ** | **December 31, 2004** | ** ** | **March 31, 2004** | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                              | ** ** | **(in thousands)**         | ** ** |
| Tax related                             |       |                            | $          | 37,613                       |       |   |   | $ | 65,812 |   |   |
| Acquisition  related                    |       |                            | 10,289     |                         |       |   | 8,200 |   |   |
| Accrued  compensation and related taxes |       |                            | 26,239     |                         |       |   | 19,336 |   |   |
| IBM distribution  agreement             |       |                            | 14,600     |                         |       |   | — |   |   |
| Other*                                  |       |                            | 22,408     |                         |       |   | 13,044 |   |   |
| Total                                   |       |                            | $          | 111,149                      |       |   |   | $ | 106,392 |   |   |

----

*                    Included$5.3million and $0.3 million ofmargin related to  deferred revenue inthe channel at December 31, 2004 andMarch 31, 2004, respectively.

**6. Goodwill and OtherIntangible Assets**

**Goodwill:**

Goodwillallocated to the Company’s reportable segments and changes in the carryingamount of goodwill for the first nine months of fiscal 2005 was as follows:
| ** **                           | ** ** | **SSG**                 | ** ** | **SNG** | ** ** | **OEM** | ** ** | **Channel** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-------------------------|------------|---------|------------|---------|------------|-------------|------------|-----------|------------|
| ** **                           | ** ** | **(in thousands)** | ** ** |
| Balance at  March 31, 2004      |       | $                       | 22,825     |    | $          | 45,667  |       | $           | —     |      | $          | — |   | $ | 68,492 |   |
| Reallocation (See  Note 18)          |       | (22,825                 | )          | (45,667 | )          | 30,326  |       | 38,166      |       | —    |       |
| Goodwill acquired  (See Note 4) |       | —                  |       | —  |       | 18,915  |       | 72,830      |       | 91,745    |       |
| Goodwill  adjustments                |       | —                  |       | —  |       | (400    | )          | (205        | )          | (605      | )          |
| Balance at  December 31, 2004   |       | $                       | —     |    | $          | —  |       | $           | 48,841     |      | $          | 110,791 |   | $ | 159,632 |   |

 

The goodwill reallocationshown in the table above relates to the reorganization of certain of theCompany’s reportable segments discussed in Note 18. The goodwill formerlyincluded in the SSG and SNG segments was allocated between the OEM and Channelsegments based on a relative fair value approach using an independent appraisaland management estimates of fair value of the segment. No impairment wasrecorded as a result of the change in segments. In the first nine months offiscal 2005, adjustments 

16

----

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

**6.Goodwill and Other Intangible Assets (Continued)**

weremade to goodwill for changes to the acquisition-related restructuring reservesand other purchase price adjustments for ICP vortex and Elipsan.

**Other Intangible Assets:**
| ** **                                  | ** ** | **December 31, 2004** | ** ** | **March 31, 2004**  | ** ** |
|---------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                  | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **                                  | ** ** | **(in thousands)**         | ** ** |
| Acquisition-related  intangible assets:     |       |                            |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Patents, core and existing technologies     |       |                            | $          | 112,630                       |       |   |   | $ | (60,915 | ) |   |   | $ | 74,930 |   |   |   | $ | (50,898 | ) |   |
| Supply agreement                            |       |                            | 7,600      |                          |       |   | (760 | ) |   |   | — |   |   |   | — |   |   |
| Covenants-not-to-compete                    |       |                            | 4,818      |                          |       |   | (4,799 | ) |   |   | 4,818 |   |   |   | (4,095 | ) |   |
| Customer relationships                      |       |                            | 1,290      |                          |       |   | (550 | ) |   |   | 1,290 |   |   |   | (308 | ) |   |
| Trade names                                 |       |                            | 12,406     |                          |       |   | (2,385 | ) |   |   | 2,306 |   |   |   | (963 | ) |   |
| Foundry agreement                           |       |                            | 600        |                          |       |   | (60 | ) |   |   | — |   |   |   | — |   |   |
| Backlog and royalties                       |       |                            | 455        |                          |       |   | (455 | ) |   |   | 455 |   |   |   | (455 | ) |   |
| Subtotal                                    |       |                            | 139,799    |                          |       |   | (69,924 | ) |   |   | 83,799 |   |   |   | (56,719 | ) |   |
| Intellectual  property assets and  warrants |       |                            | 44,868     |                          |       |   | (27,657 | ) |   |   | 43,892 |   |   |   | (22,070 | ) |   |
| Total                                       |       |                            | $          | 184,667                       |       |   |   | $ | (97,581 | ) |   |   | $ | 127,691 |   |   |   | $ | (78,789 | ) |   |

 

In August 2004, the Company entered into anagreement to sell external storage products to IBM. In connection with theagreement, the Company issued IBM a warrant to purchase 250,000 shares of theCompany’s common stock at an exercise price of $6.94 per share. The warrant hasa term of five years from the date of issuance and was immediately exercisable.The warrant was valued at $1.0 million using the Black-Scholes valuationmodel using a volatility rate of 62%, a risk-free interest rate of 4.0% and anestimated life of 5 years. The value of the warrant will be amortized against“Net revenues” over a two and a half year period reflecting the pattern inwhich the economic benefits of the assets are expected to be realized and isincluded as part of “Intellectual property assets and warrants” in the tableabove. Other intangible assets increased by approximately $57.0 million inthe first nine months of fiscal 2005 as a result of the Company’s acquisitionsof Snap Appliance and the IBM i/p Series RAID business and the warrantsissued to IBM.

Amortization of other intangible assets was $7.0 millionand $6.4 million in the third quarters of fiscal 2005 and 2004,respectively. Amortization of other intangible assets was $18.8 million and$19.5 million in the first nine months of fiscal 2005 and 2004,respectively.

17

----

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

**6.Goodwill and Other Intangible Assets (Continued)**

The annual amortization expense of the otherintangible assets that existed as of December 31, 2004 is expected to beas follows:
| ** **                     | ** ** | **Estimated Amortization Expense**    | ** ** |
|--------------------------------|------------|-------------------------------------------------|------------|
| ** **                     | ** ** | **Acquisition-related  intangible assets** | ** ** | **Intellectual  property assets** | ** ** |
| ** **                     | ** ** | **(in thousands)**                         | ** ** |
| Fiscal Years:                  |       |                                            |       |   |   |   |   |   |   |
| 2005 (remaining  three months) |       |                                            | $          | 5,095 |   |   |   | $ | 1,818 |   |   |
| 2006                           |       |                                            | 17,374     |   |   |   | 7,061 |   |   |
| 2007                           |       |                                            | 14,591     |   |   |   | 6,641 |   |   |
| 2008                           |       |                                            | 11,476     |   |   |   | 1,691 |   |   |
| 2009 and  thereafter           |       |                                            | 21,339     |   |   |   | — |   |   |
| Total                          |       |                                            | $          | 69,875 |   |   |   | $ | 17,211 |   |   |

 

**7. IBM DistributionAgreement**

In December 2004, the Company entered into adistribution agreement on its RAID controllers and connectivity products soldfor IBM’s iSeries and pSeries servers. The agreement was made throughan amendment to the Company’s existing i/p Series RAID supply andintellectual property agreement entered into in June 2004 (See Note 4). Thedistribution agreement is accounted for as a standalone transaction as it wasnot contemplated at the time the Company entered into the original IBM i/p Series RAIDtransaction.

Under the amended intellectual property agreement, theCompany is required to make fixed and variable royalty-based payments to IBM. Thefixed payments potentially due under the arrangement total $52.1 million, ofwhich $25.0 million was paid in December 2004 and the remainder is duequarterly, in varied installments, through December 2008. A portion of the$52.1 million in total payments is contingent upon IBM purchasing certain levelsof the Company’s products. The Company has recorded the full remaining amountpayable to IBM of $27.1 million as a liability to “Accrued Liabilities” of$14.6 million and to “Other Long-Term Liabilities” of $12.5 million as theCompany considers payment of the full amount to be probable.

The fixed considerationfor the distribution agreement of $52.1 million was recorded as an asset to “Prepaidexpenses” and “Other long-term assets” in the Unaudited Condensed ConsolidatedBalance Sheets and the amortization will be included in “Net revenues” in theUnaudited Condensed Consolidated Statements of Operations over a four-yearperiod reflecting the pattern in which the economic benefits of the assetsexpected to be  realized. Theroyalty-based fee per unit is calculated using the average net sales price forunits sold within the quarter and baseline royalty rates subject to certainadjustment factors. The royalty-based payments will be recorded as a reductionto revenue in the period the units are sold.

**8. Line of Credit**

In connection with theacquisition of Snap Appliance, the Company acquired an available revolving lineof credit of up to $7.5 million that bears interest at the greater ofprime rate or 4.25% per annum. At December 31, 2004, the Company had noborrowings against this line. Borrowings are collateralized by 

18

----

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

**8. Lineof Credit (Continued)**

certainaccounts receivable balances. Under the amended terms of the line of credit,all financial covenants are waived through the term of the line of credit on April 23,2005.

**9. Stock Plans**

*2004 EquityIncentive Plan*

During the second quarterof fiscal 2005, the Company’s Board of Directors and its stockholders approvedthe Company’s 2004 Equity Incentive Plan and reserved for issuance thereunder10,000,000 shares of the Company’s common stock plus shares reserved but notissued under the Company’s 1999 Stock Option Plan and 2000 Nonstatutory StockOption Plan. The 2004 Equity Incentive Plan provides for granting ofnonstatutory stock options, restricted stock, stock awards, restricted stockunits and stock appreciation rights to employees, employee directors andconsultants. Incentive stock options may also be granted to the Company’semployees under the 2004 Equity Incentive Plan.

*Snap ApplianceStock Option Plan*

In connection with theacquisition of Snap Appliance in the second quarter of fiscal 2005(Note 4), outstanding stock options under the Snap Appliance Stock OptionPlan were converted into options to purchase 1,232,489 shares of the Company’scommon stock. No further options may be granted under the Snap Appliance StockOption Plan.

**10. Interest and OtherIncome**

Thecomponents of interest and other income for the third quarter and first ninemonths of fiscal 2005 and 2004 were as follows:
| ** **                                       | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **December 31, 2004**        | ** ** | **December 31, 2003**       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                | ** ** |
| Interest income                                  |       |                                   | $          | 2,833                                 |       |   |   | $ | 4,010 |   |   |   | $ | 8,593 |   |   |   | $ | 14,689 |   |   |
| Gain on  settlement with former president of DPT |       |                                   | —     |                                  |       |   | — |   |   |   | — |   |   |   | 49,256 |   |   |
| Payment of  license fee with NSE                 |       |                                   | (442       | )                                     |       |   | — |   |   |   | (1,692 | ) |   |   | — |   |   |
| Loss on  redemption of debt                      |       |                                   | —     |                                  |       |   | (2,944 | ) |   |   | — |   |   |   | (3,734 | ) |   |
| Foreign currency  transaction gains              |       |                                   | 461        |                                  |       |   | 877 |   |   |   | 800 |   |   |   | 1,719 |   |   |
| Interest on  Federal and State tax refunds       |       |                                   | —     |                                  |       |   | 1,094 |   |   |   | — |   |   |   | 1,094 |   |   |
| Other                                            |       |                                   | 245        |                                  |       |   | 332 |   |   |   | 898 |   |   |   | 1,467 |   |   |
| Total                                            |       |                                   | $          | 3,097                                 |       |   |   | $ | 3,369 |   |   |   | $ | 8,599 |   |   |   | $ | 64,491 |   |   |

 

In June 2004, the Company, Nevada SCSIEnterprises, Inc. and Thomas A. Gafford (jointly, “NSE”) entered into alicense and release agreement, pursuant to which the Company paid NSE$1.3 million as a one-time, fully paid-up license fee to settle NSE’sclaims that some of the Company’s products infringed 

19

----

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

**10.Interest and Other Income (Continued)**

certain patents. Thelicense and release agreement expressly excluded any sales of products made byEurologic prior to the Company’s April 2003 acquisition. In November 2004,the Company exercised its option to secure a license and release with respectto such Eurologic sales by payment to NSE of a royalty fee of $0.4 million. TheCompany has filed a claim against the Eurologic acquisition Holdback for the$0.4 million royalty it paid with respect to Eurologic’s pre-acquisition sales.The Eurologic shareholders are disputing the Company’s right to withhold the$0.4 million from the Holdback.

In December 1999, the Company purchasedDistributed Processing Technology Corporation (“DPT”). As part of the purchaseagreement, $18.5 million of the purchase price was held back (“HoldbackAmount”) from former DPT stockholders for unknown liabilities that may haveexisted as of the acquisition date. Subsequent to the date of purchase, theCompany determined that certain representations and warranties made by the DPTstockholders were incomplete or inaccurate, which caused the Company to loserevenues and incur additional expenses. This caused the Company to file courtproceedings against Steven Goldman, the principal shareholder and formerpresident of DPT, alleging causes of action for, amongst others, fraud,fraudulent inducement, and negligent misrepresentation. In May 2003, theCompany entered into a written settlement and a mutual general releaseagreement with Steven Goldman, on his own and on behalf of all the sellingshareholders of DPT, pursuant to which it was agreed that the Company wouldretain the Holdback Amount and additionally, Steven Goldman would pay theCompany $31.0 million. The Company received the $31.0 million paymentin May 2003 and recorded a gain of approximately $49.3 million in thefirst quarter of fiscal 2004. The cash received from the DPT settlement of$31.0 million was included in cash provided by operating activities in theUnaudited Condensed Consolidated Statements of Cash Flows.

In the first quarter offiscal 2004, the Company redeemed the outstanding $82.4 million balance ofits 4 3⁄4% Convertible Subordinated Notes (“4 3⁄4% Notes”) for an aggregate priceof $83.0 million resulting in a loss on extinguishment of debt of$0.8 million (including unamortized debt issuance costs of$0.2 million). In the third quarter of fiscal 2004, the Company utilized$124.2 million of the net proceeds from the issuance of the 3⁄4% Convertible Senior Subordinated Notes  (“3⁄4% Notes”) and repurchased $124.2 millionin aggregate principal amount of the 3%Convertible Subordinated Notes (“3% Notes”) resulting in a loss onextinguishment of debt of $2.9 million (including unamortized debt issuancecosts of $2.9 million). The loss on extinguishment of debt has been included in“Interest and other income” in the Company’s Unaudited Condensed ConsolidatedStatements of Operations.

**11. Restructuring Charges**

The Company recorded restructuring charges of$2.2 million and $0.9 million for the third quarters of fiscal 2005and 2004, respectively. The Company recorded restructuring charges of$5.0 million and $2.7 million for the first nine months of fiscal2005 and 2004, respectively. The restructuring plans entered into in the firstnine months of fiscal 2005 are discussed in detail below. For a completediscussion of all restructuring actions that were implemented prior to fiscal2004, please refer to the Notes to Consolidated Financial Statements includedin the Company’s Current Report on Form 8-K filed on December 7, 2004.Restructuring charges are not allocated to segments but rather managed at thecorporate level.

20

----

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

**11.Restructuring Charges (Continued)**

**ThirdQuarter of Fiscal 2005 Restructuring Plan:****  **In the third quarter of fiscal 2005, the Companyinitiated certain actions to simplify the Company’s structure by streamliningthe corporate organization and reducing operating costs. This resulted in arestructuring charge of $2.4 million, which related to the involuntarytermination of 46 employees in all functions of the organization and costspertaining to estimated future obligations for non-cancelable lease paymentsfor an excess facility in Germany. The expenses associated with thisrestructuring plan were included in “Restructuring charges” in the UnauditedCondensed Consolidated Statements of Operations. The Company does not expect toincur any further charges in connection with this restructuring plan.

**SecondQuarter of Fiscal 2005 Restructuring Plan:****  **In the second quarter of fiscal 2005, the Companyinitiated certain actions to consolidate duplicative resources in connectionwith the acquisition of Snap Appliance, primarily in selling, marketing andadministrative functions, and recorded a restructuring charge of$0.7 million. The expenses associated with this restructuring plan wereincluded in “Restructuring charges” in the Unaudited Condensed ConsolidatedStatements of Operations. The Company does not expect to incur any furthercharges in connection with this restructuring plan. For the acquisition-relatedrestructuring plan associated with the Snap Appliance acquisition, please seeNote 4 for further details.

**FirstQuarter of Fiscal 2005 Restructuring Plan:****  **In the first quarter of fiscal 2005, the Companyinitiated certain actions to consolidate certain development and administrativefunctions in the United States and Europe, which were completed in the firsthalf of fiscal 2005. The Company recorded a restructuring charge of$0.8 million in the first quarter of fiscal 2005 related to theinvoluntary termination of employees and the costs pertaining to estimatedfuture obligations for non-cancelable lease payments for an excess facility inthe United Kingdom. Additional charges of $1.4 million related to thisplan associated with severance and benefits for employees primarily in the areaof research and development were taken in the second quarter of fiscal 2005. Inthe third quarter of fiscal 2005, a provision adjustment of $0.1 million wasmade related to the fiscal 2004 restructuring plan as severance and benefitswere lower than originally anticipated. Restructuring charges related to thefirst quarter restructuring plan total $2.1 million. The Company does notexpect to incur any further charges in connection with this restructuring plan.

The activity in the accrued restructuring reservesrelated to all of the plans was as follows for the first nine months of fiscal2005:
| ** **                                 | ** ** | **Severance And  Benefits** | ** ** | **Other Charges** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                 | ** ** | **(in thousands)**          | ** ** |
| Reserve balance  at March 31, 2004    |       |                             | $          | 987                    |       |      |       | $ | 1,773 |   |   | $ | 2,760 |   |
| Q1’05  Restructuring Plan             |       |                             | 1,657      |                   |       |      | 540        |   |   | 2,197 |   |
| Q2’05  Restructuring Plan             |       |                             | 700        |                   |       |      | —     |   |   | 700 |   |
| Q3’05  Restructuring Plan             |       |                             | 2,286      |                   |       |      | 102        |   |   | 2,388 |   |
| Provision adjustment                       |       |                             | (305       | )                      |       |      | (5         | ) |   | (310 | ) |
| Cash paid                                  |       |                             | (3,015     | )                      |       |      | (605       | ) |   | (3,620 | ) |
| Non-cash charges                           |       |                             | —     |                   |       |      | (141       | ) |   | (141 | ) |
| Reserve balance  at December 31, 2004 |       |                             | $          | 2,310                  |       |      |       | $ | 1,664 |   |   | $ | 3,974 |   |

 

21

----

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

**11.Restructuring Charges (Continued)**

Theprovision adjustment of $0.3 million relatedto the first quarter of fiscal 2005 and the fiscal 2004 restructuring plans, ofwhich $0.2 million related to the fiscal 2004 restructuring plan, asseverance and benefits and lease costs were lower than originally anticipated. The Company anticipates that the remainingrestructuring reserve balance of $4.0million will be substantially paid out by the first quarter of fiscal 2009,primarily attributable to longer term lease obligations.  The remaining restructuring reserve balance isreflected both in “Accrued liabilities” and “Other long-term liabilities” inthe Unaudited Condensed Consolidated Balance Sheet.

**12. Other Charges**

In fiscal 2004, theCompany recorded an impairment charge of $5.0 million to reduce thecarrying value of certain properties classified as assets held for sale to fairvalue less cost to sell. The Company decided to consolidate its properties inMilpitas, California to better align its business needs with existing operationsand to provide more efficient use of its facilities. As a result, two ownedbuildings, including associated building improvements and property, plant andequipment, were classified as assets held for sale and were included in “Othercurrent assets” in the Consolidated Balance Sheet at March 31, 2004 attheir expected fair value less expected cost to sell. In October 2004, theCompany completed the sale of these properties that were previously classifiedas held for sale. Net proceeds from the sale of the properties aggregated $9.6million, which exceeded the Company’s final revised fair value of$6.8 million. As a result, a gain on the sale of the properties of $2.8million was recorded in the third quarter of fiscal 2005 as a credit to “OtherCharges” in the Unaudited Condensed Consolidated Statements of Operations.

**13. Net Income (Loss) PerShare**

Basic net income (loss) per share is computed bydividing net income (loss) by the weighted average number of common sharesoutstanding during the period. Diluted net income per share gives effect to allpotentially dilutive common shares outstanding during the period, which includecertain stock options and warrants, calculated using the treasury stock method,and convertible notes which are potentially dilutive at certain earningslevels, and are computed using the if-converted method.

22

----

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

**13. Net Income (Loss) Per Share (Continued)**

A reconciliation of thenumerator and denominator of the basic and diluted net income (loss) per sharecomputations are as follows:
| ** **                                                                               | ** ** | **Three-Month Period Ended**                                | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                               | ** ** | **December 31, 2004**                                       | ** ** | **December 31, 2003**       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| ** **                                                                               | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Numerators:                                                                              |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                                        |       |                                                                  | $          | 22,489                                |       |   |   | $ | (3,013 | ) |   |   | $ | 14,436 |   |   |   | $ | 38,050 |   |   |
| Adjustment for  interest expense on 3⁄4% Notes, net of taxes                     |       |                                                                  | 454        |                                  |       |   | — |   |   |   | 1,371 |   |   |   | — |   |   |
| Adjustment for interest expense on 3% Notes,  net of taxes                          |       |                                                                  | 196        |                                  |       |   | — |   |   |   | — |   |   |   | 4,120 |   |   |
| Adjusted net income (loss)                                                               |       |                                                                  | $          | 23,139                                |       |   |   | $ | (3,013 | ) |   |   | $ | 15,807 |   |   |   | $ | 42,170 |   |   |
| Denominators:                                                                            |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding—basic                                           |       |                                                                  | 111,136    |                                  |       |   | 108,858 |   |   |   | 110,429 |   |   |   | 108,408 |   |   |
| Effect of  dilutive securities:                                                          |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Employee stock options                                                                   |       |                                                                  | 1,859      |                                  |       |   | — |   |   |   | 1,954 |   |   |   | 1,992 |   |   |
| 3⁄4% Notes                                                                            |       |                                                                  | 19,224     |                                  |       |   | — |   |   |   | 19,224 |   |   |   | — |   |   |
| 3% Notes                                                                                 |       |                                                                  | 2,298      |                                  |       |   | — |   |   |   | — |   |   |   | 16,178 |   |   |
| Weighted average shares and potentially dilutive  common shares outstanding—diluted |       |                                                                  | 134,517    |                                  |       |   | 108,858 |   |   |   | 131,607 |   |   |   | 126,578 |   |   |
| Net income (loss)  per share:                                                            |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                    |       |                                                                  | $          | 0.20                                  |       |   |   | $ | (0.03 | ) |   |   | $ | 0.13 |   |   |   | $ | 0.35 |   |   |
| Diluted                                                                                  |       |                                                                  | $          | 0.17                                  |       |   |   | $ | (0.03 | ) |   |   | $ | 0.12 |   |   |   | $ | 0.33 |   |   |

 

23

----

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

**13. NetIncome (Loss) Per Share (Continued)**

Diluted loss per share forthe third quarter of fiscal 2004 was based only on the weighted-average numberof shares outstanding during this period, as the inclusion of any common stockequivalents would have been anti-dilutive. In addition, certain potentialcommon shares were excluded from the diluted computation for the third quarterof fiscal 2005 and the first nine months of fiscal 2004 and 2005 because theirinclusion would have been anti-dilutive. The items excluded for the thirdquarter and first nine months of fiscal 2005 and 2004 were as follows:
| ** **                                | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **December 31, 2004**        | ** ** | **December 31, 2003**       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| ** **                                | ** ** | **(in thousands)**                | ** ** |
| Outstanding  employee stock options  |       |                                   | 13,971     |                                  |       |   | 13,188 |   |   |   | 14,478 |   |   |   | 14,264 |   |   |
| Warrants(1)                               |       |                                   | 19,624     |                                  |       |   | 20,534 |   |   |   | 19,624 |   |   |   | 20,534 |   |   |
| 43⁄4% Notes                            |       |                                   | —     |                                  |       |   | — |   |   |   | — |   |   |   | 549 |   |   |
| 3% Notes                                  |       |                                   | —     |                                  |       |   | 15,881 |   |   |   | 2,298 |   |   |   | — |   |   |
| 3⁄4% Notes                             |       |                                   | —     |                                  |       |   | 19,224 |   |   |   | — |   |   |   | 19,224 |   |   |

----

(1)   Inconnection with the issuance of its 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.

TheCompany adopted EITF 04-08 in its third quarter of fiscal 2005, which requiredthe inclusion of shares related to contingently convertible debt instrumentsfor computing diluted earnings per share using the if-converted method, regardlessof whether the market price contingency has been met.  As a result of applying EITF 04-08 to thefourth quarter of fiscal 2004 and fiscal 2004, diluted earnings per share havebeen changed to $0.19 and $0.53, respectively, rather than $0.22 and $0.54 aspreviously reported. There would have been no impact to diluted earnings pershare for the first quarter, second quarter and first half of fiscal 2005.

**14. Comprehensive Income(Loss)**

TheCompany’s comprehensive income (loss), which consisted of net income and thechanges in net unrealized losses on marketable securities, net of taxes andforeign currency translation adjustments, net of taxes, were as follows:
| ** **                                                    | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                    | ** ** | **December 31, 2004**        | ** ** | **December 31, 2003**       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                | ** ** |
| Net income (loss)                                             |       |                                   | $          | 22,489                                |       |   |   | $ | (3,013 | ) |   |   | $ | 14,436 |   |   |   | $ | 38,050 |   |   |
| Net unrealized  losses on marketable securities, net of taxes |       |                                   | (921       | )                                     |       |   | (1,820 | ) |   |   | (3,955 | ) |   |   | (1,883 | ) |   |
| Foreign currency  translation adjustment, net of taxes        |       |                                   | 1,089      |                                  |       |   | 859 |   |   |   | 1,036 |   |   |   | 911 |   |   |
| Comprehensive income  (loss)                                  |       |                                   | $          | 22,657                                |       |   |   | $ | (3,974 | ) |   |   | $ | 11,517 |   |   |   | $ | 37,078 |   |   |

 

24

----

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

**14.Comprehensive Income (Loss) (Continued)**

The components of accumulated other comprehensiveincome (loss), net of income taxes, were as follows:
| ** **                                                                                                                                                          | ** ** | **December 31, 2004** | ** ** | **March 31, 2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                          | ** ** | **(in thousands)**         | ** ** |
| Unrealized gains  (losses) on marketable securities, net of income tax provision (benefit) of  $(1,179) at December 31, 2004 and $1,443 at March 31, 2004 |       |                            | $          | (1,769                       | )          |   |   | $ | 2,186 |   |   |
| Foreign currency  translation, net of income tax provision of $1,233 at December 31, 2004  and $543 at March 31, 2004                                     |       |                            | 1,850      |                         |       |   | 814 |   |   |
| Total                                                                                                                                                               |       |                            | $          | 81                           |       |   |   | $ | 3,000 |   |   |

 

**15. Income Taxes**

Income tax provisions for interim periods are based onthe Company’s estimated annual income tax rate. In the third quarter and firstnine months of fiscal 2005, the Company recorded an income tax benefit of$33.4 million and $33.8 million, respectively, on a pre-tax loss of$10.9 million and $19.4 million, respectively. The estimated annual taxrate differs from the combined United States Federal and state statutory incometax rate of 40% primarily due to changes in the Company’s tax reserves andcertain acquisition related intangible assets, excluding goodwill, that are notfully deductible for tax purposes. The Company is in ongoing negotiations withthe IRS with regard to its various tax disputes that may result in settlementof certain issues. The Company’s tax rate for the period in which a settlementis reached will be impacted if the settlement materially differs from theamounts previously accrued. The tax rates for the third quarter and the firstnine months of fiscal 2005 differ from the combined United States Federal andstate statutory income tax rate of 40% primarily due to tax benefits of $21.9million and $31.9 million respectively from discrete events relating tothe method and amount of settled tax controversies. As a result of thesettlements, $21.9 million previously recorded as a tax provision was reversedduring the third quarter of fiscal 2005. In addition, $4.1 millionpreviously recorded as a tax provision was reclassified as a reduction toadditional paid-in capital, $1.8 million previously recorded as a taxprovision was reversed and a $4.0 million tax benefit associated with arefund claim was recognized during the second quarter of fiscal 2005. The taxrate for the third quarter and first nine months of 2004 differed from thecombined United States Federal and state statutory rate of 40% primarily due tothe gain on settlement with the former president of DPT of $49.3 millionwhich is treated as an adjustment to the tax basis in the acquired DPT commonstock and does not result in taxable income.

On October 22, 2004,the American Jobs Creation Act of 2004 (the “Act”), was signed into law. TheAct creates a temporary incentive for U.S. companies to repatriate accumulatedforeign earnings by providing a one-time deduction of 85% for certain dividendsfrom controlled foreign corporations. The deduction is subject to certainlimitations and numerous provisions of the Act contain uncertainties thatrequire interpretation and evaluation. As a result, the Company is currentlyevaluating whether, and to what extent, to repatriate foreign earnings thathave not yet been remitted to the U.S. Until such evaluation is complete, theCompany has not accrued income taxes on the accumulated undistributed earningsof the Company’s Singapore subsidiary, as these earnings are currently expectedto be reinvested indefinitely. Based on its analysis to date, it is reasonablypossible that the Company may repatriate an 

25

----

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

**15.Income Taxes (Continued)**

amountbetween $0 and $650 million, with the respective tax liability ranging from $0and $59 million. The Company expects to be in a position to finalize itsassessment and record any resulting tax liability in its quarter ending by March 2005.

**16. Commitments andContingencies**

On June 27, 2000, the Company received astatutory notice of deficiency from the IRS with respect to its Federal incometax returns for fiscal 1994 to 1996. The Company filed a Petition with theUnited States Tax Court on September 25, 2000, contesting the asserteddeficiencies. In December 2001, settlement agreements were filed with theUnited States Tax Court reflecting a total of $9.0 million of adjustmentsand an allowance of $0.5 million in additional tax credits. The outcomedid not have a material adverse effect on the Company’s financial position orresults of operations, as sufficient tax provisions had been made. The finalTax Court stipulation will be filed when the subsequent audit cycles arecompleted. Tax credits that were generated but not used in subsequent years maybe 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 defense against theasserted deficiencies and any proposed adjustments and that it has madesufficient tax provisions. However, the Company cannot predict with certaintyhow these 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 2001. In the thirdquarter of fiscal 2005, the Company has resolved all issues other than therollover impact of any potential resolution on the remaining fiscal 1997 issueand tax credits that were generated but not used in subsequent years that maybe carried back. As a result of the resolutions, $21.9 million and $31.9million previously recorded as a tax provision was reversed during the thirdquarter and first nine months of fiscal 2005, respectively. The Companybelieves that it has provided sufficient tax provisions for these years and theultimate outcome of the IRS audits will not have a material adverse impact onits financial position or results of operations in future periods. However, theCompany cannot predict with certainty how these matters will be resolved andwhether it will be required to make additional tax payments.

The Company is a party toother litigation matters and claims, including those related to intellectualproperty, which are normal in the course of its operations, and while theresults of such litigation matters and claims cannot be predicted with certainty,the Company believes that the final outcome of such matters will not have amaterial adverse impact on its financial position or results of operations.However, because of the nature and inherent uncertainties of litigation, theCompany’s business, financial condition, results of operations and cash flowscould be materially and adversely affected by the outcome of these actions.

26

----

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

**17.Guarantees**

*Intellectual Property 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 thirdparties for certain payments made by it under these agreements. It is notpossible to make a reasonable estimate of the maximum potential amount offuture payments under these or similar agreements due to the conditional natureof the Company’s obligations and the unique facts and circumstances involved ineach particular agreement. Historically, the Company has not incurredsignificant costs to defend lawsuits or settle claims related to suchagreements and no amount has been accrued in the accompanying financialstatements with respect to these indemnification guarantees.

*Letters of Credit*

In connection with theacquisition of Snap Appliance, the Company maintained an irrevocable standbyletter of credit for $500,000 with an approved financial institution under anoffice lease term, which guaranteed its performance to the landlord. On December 31,2004, the letter of credit was cancelled.

*Product Warranty*

TheCompany provides an accrual for estimated future warranty costs based upon thehistorical relationship of warranty costs to sales. The estimated futurewarranty obligations related to product sales are recorded in the period inwhich the related revenue is recognized. The estimated future warrantyobligations are affected by product failure rates, material usage andreplacement costs incurred in correcting a product failure. If actual productfailure rates, material usage or replacement costs differ from the Company’sestimates, revisions to the estimated warranty obligations would be required;however the Company made no adjustments to pre-existing warranty accruals inthe first nine months of fiscal 2005. The Company has received communicationsfrom a customer alleging that the Company is in breach of certain contractualobligations that it assumed in conjunction with its acquisition of DPT. TheCompany recorded $0.4 million of warranty costs in the third quarter offiscal 2004 associated with these claims.
| ** **                      | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|
| ** **                      | ** ** | **December 31, 2004**       | ** ** | **December 31, 2003** | ** ** |
| ** **                      | ** ** | **(in thousands)**               | ** ** |
| Balance at beginning of  period |       |                                  | $          | 1,598 |   |   |   | $ | 1,343 |   |   |
| Warranties assumed              |       |                                  | 2,562      |   |   |   | 120 |   |   |
| Warranties provided             |       |                                  | 3,932      |   |   |   | 3,244 |   |   |
| Actual costs incurred           |       |                                  | (4,188     | ) |   |   | (3,051 | ) |   |
| Balance at end of period        |       |                                  | $          | 3,904 |   |   |   | $ | 1,656 |   |   |

 

27

----

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

**18. Segment Reporting**

In thesecond quarter of fiscal 2005 and in response to the Snap Appliance acquisitionin July 2004 (Note 4), the Company refined its internalorganizational structure to operate in three reportable segments: OEM, Channeland DSG. Where historically the Company’s former SSG and SNG segment eachoffered distinct products across its entire customer base, the new OEM andChannel segments offer an integrated set of products to customers that are specificto the segment. The Company believes that reorganizing its business in acustomer-focused manner will enable it to concentrate on addressing thespecific business needs of its customers and better coordinate productplanning. A description of the types of customers or products and servicesprovided by each reportable segment is as follows:

·       OEMincludes all OEM customers to which the Company sells a wide variety of itsproducts.

·       Channelincludes the distribution channel customers and VARs that buy a wide variety ofproducts.

·       DSGprovides high-performance I/O connectivity and digital media solutions forpersonal computing platforms, including notebook and desktop PCs, sold toconsumers and small and midsize businesses.

In thethird quarter of fiscal 2005, the Company further refined its internalorganizational structure such that certain operating expenses previouslyallocated to segments will now be separately managed at the corporate level.These unallocated corporate income and expenses, which are in the “Other”category, include restructuring charges, other charges, interest and otherincome, interest expense, and all administrative, research and development andselling and marketing expenses. Summarized financial information on the Company’sreportable segments, under the new organizational structure, is shown in thefollowing table. The segment financial data for the third quarter and firstnine months of fiscal 2004 has been restated to reflect this change. There wereno inter-segment revenues for the periods shown below. The Company does notseparately track all tangible assets or depreciation by operating segments norare the segments evaluated under these criteria. Segment financial informationis summarized as follows for the third quarters and first nine months of fiscal2005 and 2004:
| ** **                                        | ** ** | **OEM**                 | ** ** | **Channel** | ** ** | **DSG** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-------------|------------|---------|------------|-----------|------------|-----------|------------|
| ** **                                        | ** ** | **(in thousands)** | ** ** |
| Three-Month Period Ended  December 31, 2004: |       |                    |       |        |       |    |       |      |       |      |       |
| Net revenues                                      |       | $                       | 81,693     |        | $          | 36,270  |       | $         | 8,585      |      | $          | — |   | $ | 126,548 |   |
| Segment income (loss)                             |       | 23,320                  |       | 18,841      |       | 663     |       | (53,717   | )          | (10,893   | )          |
| Three-Month Period Ended  December 31, 2003: |       |                    |       |        |       |    |       |      |       |      |       |
| Net revenues                                      |       | $                       | 74,132     |        | $          | 30,090  |       | $         | 10,921     |      | $          | — |   | $ | 115,143 |   |
| Segment income                                    |       | 24,055                  |       | 18,217      |       | 4,293   |       | (49,206   | )          | (2,641    | )          |
| Nine-Month Period Ended December 31, 2004:   |       |                    |       |        |       |    |       |      |       |      |       |
| Net revenues                                      |       | $                       | 224,318    |        | $          | 110,889 |       | $         | 28,543     |      | $          | — |   | $ | 363,750 |   |
| Segment income (loss)                             |       | 75,606                  |       | 63,114      |       | 8,411   |       | (166,521  | )          | (19,390   | )          |
| Nine-Month Period Ended December 31, 2003:   |       |                    |       |        |       |    |       |      |       |      |       |
| Net revenues                                      |       | $                       | 210,093    |        | $          | 89,094  |       | $         | 32,441     |      | $          | — |   | $ | 331,628 |   |
| Segment income (loss)                             |       | 72,963                  |       | 54,213      |       | 11,601  |       | (100,007  | )          | 38,770    |       |

 

28

----

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

**18.Segment Reporting (Continued)**

The following tablepresents the details of unallocated corporate income and expenses for the thirdquarters and first nine months of fiscal 2005 and 2004: 
| ** **                                | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **December 31, 2004**        | ** ** | **December 31, 2003**       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| ** **                                | ** ** | **(in thousands)**                | ** ** |
| Unallocated  corporate expenses, net |       |                                   | $          | (56,258                               | )          |   |   | $ | (49,375 | ) |   |   | $ | (164,350 | ) |   |   | $ | (150,135 | ) |   |
| Acquired  in-process technology           |       |                                   | —     |                                  |       |   | — |   |   |   | (5,200 | ) |   |   | (3,649 | ) |   |
| Restructuring  charges                    |       |                                   | (2,228     | )                                     |       |   | (878 | ) |   |   | (4,975 | ) |   |   | (2,704 | ) |   |
| Other charges                             |       |                                   | 2,755      |                                  |       |   | — |   |   |   | 2,755 |   |   |   | — |   |   |
| Interest and  other income                |       |                                   | 3,097      |                                  |       |   | 3,369 |   |   |   | 8,599 |   |   |   | 64,491 |   |   |
| Interest expense                          |       |                                   | (1,083     | )                                     |       |   | (2,322 | ) |   |   | (3,350 | ) |   |   | (8,010 | ) |   |
| Total                                     |       |                                   | $          | (53,717                               | )          |   |   | $ | (49,206 | ) |   |   | $ | (166,521 | ) |   |   | $ | (100,007 | ) |   |

 

**19.Supplemental Disclosure of Cash Flows**
| ** **                                              | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                              | ** ** | **December 31, 2004**       | ** ** | **December 31, 2003** | ** ** |
| ** **                                              | ** ** | **(in thousands)**               | ** ** |
| Non-cash  investing and financial activities:           |       |                                  |       |   |   |   |   |   |   |
| Deferred stock-based  compensation                      |       |                                  | $          | 7,060 |   |   |   | $ | 1,582 |   |   |
| Adjustment for  deferred stock-based compensation  |       |                                  | 116        |   |   |   | 1,323 |   |   |
| Unrealized loss  on available-for-sale securities       |       |                                  | (3,955     | ) |   |   | (1,883 | ) |   |
| Restricted Stock                                        |       |                                  | 118        |  |   |   | — |   |   |
|                                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

**20. Subsequent Events**

On January 26, 2005,the Company entered into a strategic alliance with Vitesse SemiconductorCorporation to develop and market next generation SAS products. Under the termsof the alliance, Vitesse will employ up to 48 of the Company’s engineering andmarketing employees and license certain SAS technology and assets related tothe Company’s development of SAS ROC products. The Company expects to incur acharge in the range of $0.7 million to $1.1 million in severance andbenefits associated with these employees. Consideration for the licensedtechnology and assets totaled $1.3 million.

**21.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.

·       **ATA:** Advanced Technology Attachment

·       **DAS:** Direct-Attached Storage

·       **DSG:** Desktop Solutions Group

29

----

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

**21. Glossary (Continued)**

·       **ESPP:** Employee Stock Purchase Plan

·       **IC:** Integrated Circuit

·       **I/O:** Input/Output

·       **IP:** Internet Protocol

·       **IRS:** Internal Revenue Service

·       **IPsec:** IP Security Protocol

·       **iSCSI:** Internet Protocol SCSI

·       **NAS:** Network Attached Storage

·       **OEM:** Original Equipment Manufacturer

·       **PC:** Personal Computer

·       **PCI:** Peripheral Component Interconnect

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

·       **SAN:** Storage Area Networks

·       **SAS:**  Serial AttachedSCSI

·       **SAS ROC:**  SAS RAID onChip

·       **SCSI:** Small Computer System Interface

·       **Serial ATA:** Serial Advanced TechnologyAttachment

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

·       **SNG:** Storage Networking Group

·       **SSG:** Storage Solutions 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 are listed inalphabetical order.

·       **APB:** Accounting Principles Board

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

·       **EITF:** Emerging Issues Task Force

30

----

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

**21. Glossary (Continued)**

·       **EITF 95-3**—Recognition of Liabilities inConnection with Purchase Business Combinations

·       **EITF 00-19**—Accounting for DerivativeFinancial Instruments Indexed To, and Potentially Settled In a Company’s OwnStock

·       **EITF 03-01**—The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments

·       **EITF 04-08**—Accounting Issues Related toCertain Features of Contingently Convertible Debt and the Effect on DilutedEarnings per Share

·       **FASB:** Financial Accounting Standards Board

·       **FIN:** FASB Interpretation Number

·       **FIN 44**—Accounting for Certain TransactionsInvolving Stock Compensation

·       **SEC:** Securities Exchange Commission

·       **SFAS:** Statement of Financial AccountingStandards

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

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

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

·       **SFAS No. 123R**—Share-Based Payment

·       **SFAS No. 142**—Goodwill and OtherIntangible Assets

·       **SFAS No. 148**—Accounting forStock-Based Compensation—Transition and Disclosure—an amendment of SFAS No. 123

31

----

**Item2**.   Management’s Discussion and Analysis ofFinancial 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, the level ofour expenditures and savings for various expense items and our liquidity infuture periods. We may identify these statements by the use of words such as “anticipate,”“believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,”“plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and othersimilar expressions. All forward-looking statements included in this documentare based on information available to us on the date hereof, and we assume noobligation to update any such forward-looking statements, except as mayotherwise 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 Current Report on Form 8-K filed on December 7,2004. In the first and second quarters of fiscal 2005, we reorganized ourreportable segments, which are described more fully in Note 18 to Notes to theUnaudited Condensed Consolidated Financial Statements.

For your convenience, we have included, in Note 21 tothe Notes to the Unaudited Condensed Consolidated Financial Statements, aGlossary that contains a list of (1) key acronyms commonly used in ourindustry that are used in this Quarterly Report and (2) accounting rules andregulations that are also referred to herein. These acronyms and accounting rules andregulations are listed in alphabetical order.

Our critical accountingpolicies have not changed from our year ended March 31, 2004. For acomplete discussion of our critical accounting policies, please refer to ourCurrent Report on Form 8-K filed on December 7, 2004.

**Results ofOperations**

**Overview**

In the third quarter of fiscal 2005, our revenues grew10% as compared to the third quarter of fiscal 2004 primarily as a result ofour recent acquisitions increasing both systems and component products salesand to a lesser extent new component technologies. Despite our overall revenuegrowth, we deferred revenues from the distribution channel, as the market sharefor non-branded servers has shifted from distributors to certain Tier 1 OEMsdue to lower pricing advantages.  Weexpect the transition to SAS to provide an opportunity for non-branded serversuppliers to compete more effectively. Gross margins declined in the thirdquarter of fiscal 2005 as compared to the third quarter of fiscal 2004 due to adecline of products sold to channel customers, which generally have highergross margins. Operating expenses increased in the third quarter of fiscal 2005as compared to the third quarter of fiscal 2004, primarily as a result ofadditional costs related to our acquisitions.

32

----

We have continuedin our efforts to grow and strengthen our business and expand our productofferings by streamlining the corporate organization, entering into strategicalliances and making selective acquisitions.

·       OnJanuary 26, 2005, we entered into a strategic alliance with VitesseSemiconductor Corporation to develop and market the next generation SASproducts. Under the terms of the alliance, Vitesse will employ up to 48 of ourengineering and marketing employees and license certain SAS technology andassets related to our development of SAS ROC products.  Working together, Vitesse will combine its6Gb/s mixed signal and expander technology and expertise with our RAID, RAID 6and I/O technology and expertise to jointly develop advanced SAS products. Weexpect to incur a charge in the range of $0.7 million to $1.1 million in severance andbenefits associated with these employees. Consideration for the licensedtechnology and assets totaled $1.3 million.

·       OnDecember 30, 2004, we further expanded our relationship with IBM todeliver Adaptec-branded RAID controllers and connectivity products for IBM’seServer iSeries and pSeries servers directly through the IBM channel(“IBM Distribution Agreement”). This arrangement furthers our position ofproviding IBM customers with scalable storage solutions for the IBM eServerfamily.

·       OnNovember 30, 2004, we internally announced our intent to simplify ourstructure by streamlining our corporate organization and reducing operatingcosts. As a result, we implemented a restructuring plan and recorded arestructuring charge of $2.4 million in the third quarter of fiscal 2005. Thischarge was utilized to cover the cash payments associated with the involuntarytermination of 46 employees and the vacating of certain operating buildingleases. The plan of action is expected to reduce annual operating expenses byapproximately $12 million due to this reduction in workforce, the continuedintegration of Snap Appliance and the reduction in the usage of contractors andconsultants.

·       OnJuly 23, 2004, we acquired Snap Appliance, Inc., or Snap Appliance, aprovider of NAS solutions. The acquisition of Snap Appliance allows us toexpand our external-storage product portfolio by including network storagesystems and to build upon our systems channel business. Results for fiscal 2005include the full operations of Snap Appliance subsequent to the acquisition.

·       OnJune 29, 2004, we extended our strategic relationship with IBM toencompass RAID technology for IBM’s eServer product line. We completed theacquisition of IBM’s i/p Series RAID component business line consisting ofcertain purchased RAID data protection intellectual property, semiconductordesigns and assets, and licensed from IBM related RAID intellectual property.This acquisition enables us to use IBM’s eServer RAID technology for ourinternal and external RAID products. Additionally, it allows us to use IBM’stechnology to extend the features and performance of our RAID products to bedelivered to both IBM and other customers. In conjunction with the acquisition,we also entered into a product supply agreement under which we will supply RAIDsoftware, firmware and hardware to IBM for use in IBM’s iSeries and pSeries servers.These agreements build upon our existing relationship with IBM that focuses ondata protection for IBM’s xSeries servers. We began recognizing revenueand expenses from this transaction in the second quarter of fiscal 2005.

Our growth and future revenue remains largelydependent on the success of our external and networked storage solutions and,to a lesser extent, on our products addressing new technologies (i.e., SerialAttached SCSI, Serial ATA and iSCSI). We continue to invest in research anddevelopment to support key customer design wins for both component level andexternal storage related products. OEM design wins, channel acceptance of ourproducts and overall profitability are key indicators management uses toevaluate the status of the business.

33

----

Thefollowing table sets forth the items in the Unaudited Condensed ConsolidatedStatements of Operations as a percentage of net revenues:
| ** **                                            | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                            | ** ** | **December 31, 2004(2)**     | ** ** | **December 31, 2003(2)**    | ** ** | **December 31, 2004(3)** | ** ** | **December 31, 2003(3)** | ** ** |
| Net revenues                                          |       |                                   | 100        | %                                     |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |
| Cost of revenues(1)                                   |       |                                   | 66         |                                  |       |   | 60 |   |   |   | 60 |   |   |   | 58 |   |   |
| Gross margin                                          |       |                                   | 34         |                                  |       |   | 40 |   |   |   | 40 |   |   |   | 42 |   |   |
| Operating expenses:                                   |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and development(1)                           |       |                                   | 23         |                                  |       |   | 22 |   |   |   | 24 |   |   |   | 23 |   |   |
| Selling, marketing and administrative(1)              |       |                                   | 17         |                                  |       |   | 17 |   |   |   | 17 |   |   |   | 18 |   |   |
| Amortization of acquisition-related intangible assets |       |                                   | 4          |                                  |       |   | 4 |   |   |   | 4 |   |   |   | 4 |   |   |
| Write-off of acquired in-process technology           |       |                                   | —     |                                  |       |   | — |   |   |   | 2 |   |   |   | 1 |   |   |
| Restructuring charges                                 |       |                                   | 2          |                                  |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Other charges                                         |       |                                   | (2         | )                                     |       |   | — |   |   |   | (1 | ) |   |   | — |   |   |
| Total operating expenses                              |       |                                   | 44         |                                  |       |   | 44 |   |   |   | 47 |   |   |   | 47 |   |   |
| Loss from operations                                  |       |                                   | (10        | )                                     |       |   | (4 | ) |   |   | (7 | ) |   |   | (5 | ) |   |
| Interest and other income(1)                          |       |                                   | 2          |                                  |       |   | 3 |   |   |   | 3 |   |   |   | 19 |   |   |
| Interest expense                                      |       |                                   | (1         | )                                     |       |   | (2 | ) |   |   | (1 | ) |   |   | (2 | ) |   |
| Income (loss) before income taxes                     |       |                                   | (9         | )                                     |       |   | (3 | ) |   |   | (5 | ) |   |   | 12 |   |   |
| Provision for (benefit from) income taxes             |       |                                   | (27        | )                                     |       |   | 0 |   |   |   | (9 | ) |   |   | 0 |   |   |
| Net income (loss)                                     |       |                                   | 18         | %                                     |       |   | (3 | )% |   |   | 4 | % |   |   | 12 | % |   |

----

(1)    Prior period financial statements have beenreclassified to conform to current period presentation.

(2)    In thethird quarter of fiscal 2005, we implemented a restructuring plan (Note 11),made acquisition related cash payments to former employees of Snap Appliance(Note 4), recorded a gain of $2.8 million on the sale of certain properties(Note 12), made a payment of $0.4 million to Nevada SCSI Enterprises, Inc.,or NSE, in the form of a license fee (Note 10) and received a tax benefit fromthe settlements of disputes with the IRS. In the third quarter of fiscal 2004,we implemented a restructuring plan to consolidate our research and developmentresources. These transactions affect the comparability of this data.

(3)    In the first nine months of fiscal 2005, we purchasedSnap Appliance and the IBM i/p Series RAID component business line(Note 4), implemented restructuring plans in the first, second and thirdquarter of fiscal 2005 (Note 11), made acquisition related cash payments toformer employees of Snap Appliance (Note 4), recorded a gain of $2.8 million onthe sale of certain properties (Note 12), made a payment of $1.7 millionto NSE in the form of a license fee (Note 10) and received a tax benefit fromthe settlements of disputes with the IRS. In the first nine months of fiscal2004, we purchased Eurologic Systems Group Limited, or Eurologic, and ICPvortex Computersysteme GmbH, or ICP vortex (Note 4), implementedrestructuring plans to consolidate our research and development resources andrecorded a gain of $49.3 million related to the settlement with the formerpresident of Distributed Processing Technology Corporation, or DPT (Note 10).These transactions affect the comparability of this data.

34

----

**Net Revenues.**
| ** **                 | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **                 | ** ** | **(in millions, except percentages)** | ** ** |
| **Segment  Net Revenues:** |       |                                                 |       |                                  |       |   |   |   |   |   |   | ** ** |   |   |   |   |   |   |   |   |   |   |   | ** ** |   |
| OEM                        |       |                                                 | $          | 81.7                                  |       |   |   | $ | 74.1 |   |   |   | 10 | % |   |   | $ | 224.3 |   |   |   | $ | 210.1 |   |   |   | 7 | % |   |
| Channel                    |       |                                                 | 36.3       |                                  |       |   | 30.1 |   |   |   | 21 | % |   |   | 110.9 |   |   |   | 89.1 |   |   |   | 24 | % |   |
| DSG                        |       |                                                 | 8.5        |                                  |       |   | 10.9 |   | ** ** | ** ** | (21 | )% |   |   | 28.5 |   |   |   | 32.4 |   | ** ** | ** ** | (12 | )% |   |
| **Total  Net Revenues**    |       |                                                 | 126.5      |                                  |       |   | 115.1 |   | ** ** | ** ** | **10** | % |   |   | 363.7 |   |   |   | 331.6 |   | ** ** | ** ** | **10** | % |   |
|                            |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Net revenues from our OEM segment increased by $7.6million and $14.2 million in the third quarter and first nine months offiscal 2005, respectively, as compared to the corresponding periods of fiscal2004. The increase was primarily a result of our component products, whichincluded revenue of $10.0 million and $15.2 million in the third quarterand first nine months of fiscal 2005, respectively, from our acquisition of theIBM i/p Series RAID business, as well as increased sales from productsbased on next generation Serial ATA technology and external storage systems.This was partially offset by a decline in sales volumes of our SCSI productsprimarily attributable to the transition from our Ultra 160 products to Ultra320 products in which we have a lower market share.

Net revenues from our Channel segment increased by$6.2 million and $21.8 million in the third quarter and first nine monthsof fiscal 2005, respectively, as compared to the corresponding periods offiscal 2004. This was primarily due to sales of our systems products, whichincluded revenues of $8.4 million and $11.5 million in the third quarter andfirst nine months of fiscal 2005, respectively, from our acquisition of SnapAppliance and sales from products based on next generation Serial ATA technology,partially offset by a decrease in our other components products. Net revenuesfrom our Channel segment excluded approximately $4.6 million of products thatwere shipped prior to December 31, 2004 but for which related revenue wasdeferred because of the uncertainty regarding levels of stock rotation andprice concessions that we would be required to grant to our channel partnerswith respect to these products. This uncertainty arose based on our evaluationof channel inventory levels and historical channel sell-through data.

Netrevenues from our DSG segment decreased by $2.4 million and$3.9 million in the third quarter and first nine months of fiscal 2005,respectively, as compared to the corresponding periods of fiscal 2004. This wasdue to a decline in sales volumes of our SCSI-based desktop computer solutionsand our digital media products, offset partially by increased sales of non-SCSIbased connectivity products. We expect revenues from our SCSI-based desktopcomputer solutions to continue to decline as OEMs are incorporatingconnectivity technologies directly into their products.
| ** **                   | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                   | ** ** | **December 31,  2004**            | ** ** | **December 31,  2003**           | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
| **Geographical  Revenues:**  | ** ** |                                   | ** ** | ** **                            |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| North America                |       |                                   | 38         | %                                     |       |   | 39 | % |   |   | 40 | % |   |   | 42 | % |   |
| Europe                       |       |                                   | 35         | %                                     |       |   | 34 | % |   |   | 32 | % |   |   | 31 | % |   |
| Pacific Rim                  |       |                                   | 27         | %                                     |       |   | 27 | % |   |   | 28 | % |   |   | 27 | % |   |
| Total  Geographical Revenues |       |                                   | 100        | %                                     |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

 

Our international revenues remained relatively flat asa percentage of our total gross revenues in the third quarter of fiscal 2005 ascompared to the third quarter of fiscal 2004 primarily as a result of foreigncurrency fluctuations, which resulted in increased revenues and margins inEurope. Our international revenues grew as a percentage of our total grossrevenues in the first nine months of fiscal 2005 as 

35

----

compared to the first ninemonths of fiscal 2004 primarily as a result of increased sales of our systemsproducts in the Pacific Rim.

A small number of our customersaccount for a substantial portion of our net revenues, and we expect that alimited number of customers will continue to represent a substantial portion ofour net revenues for the foreseeable future. IBM and Dell accounted for 29% and10% of our total net revenues, respectively, in the third quarter of fiscal2005. IBM accounted for 21% of our total net revenues in the third quarter offiscal 2004. IBM and Dell accounted for 23% and 11% of our total net revenues,respectively, in the first nine months of fiscal 2005, and accounted for 18%and 11% of our total net revenues, respectively, in the first nine months offiscal 2004. We expect IBM to represent a larger percentage of our total netrevenues in future periods as a result of the distribution agreement we enteredinto with IBM in the third quarter of fiscal 2005 and our acquisition of theIBM i/p Series RAID business.

**Gross Margin.**
| ** **   | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **   | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **   | ** ** | **(in millions, except percentages)** | ** ** |
| Gross Profit |       |                                                 | $          | 42.9                                  |       |   |   | $ | 46.6 |   |   |   | (8 | )% |   |   | $ | 146.7 |   |   |   | $ | 138.8 |   |   |   | 6 | % |   |
| Gross Margin |       |                                                 | 34         | %                                     |       |   | 40 | % |   |   |   |   |   |   | 40 | % |   |   | 42 | % |   |   |   |   |   |

 

The decline in grossmargin in the third quarter of fiscal 2005 compared to the third quarter offiscal 2004 was primarily due to changes in our customer mix between OEM andchannel customers, increased costs associated with our new external storageproducts sold to IBM and, to a lesser extent, changes in our product mix fromhigher margin to lower margin products. Although both OEM revenue and channelrevenue increased from the third quarter of fiscal 2005 compared to the thirdquarter of fiscal 2004, the overall increase in OEM revenue was greater thanthe increase in channel revenue by $1.4 million. Gross margins are generallylower from OEM revenue as compared to channel revenue. We believe the channelsell-through shortfall was primarily due to a combination of end users buyingfrom Tier 1 OEM’s and VAR’s configuring Serial ATA based servers rather thenSCSI. Costs associated with our new external storage products sold to IBM werehigher as a result of increased costs for initial components purchases fromsuppliers, start-up production costs, high overhead costs associated with lowervolumes and the cost of expediting components from suppliers and products toIBM. In addition, the decrease in gross margins was attributable to thedecrease in channel revenue related to component products and an increase inthe sale of OEM system products. The decrease in gross margin in the first ninemonths of fiscal 2005 compared to the first nine months of fiscal 2004 wasprimarily due to lower gross margins incurred in the third quarter of fiscal2005. Our gross margins will be significantly impacted in the future by the mixof OEM and channel revenue, the mix of component and system revenue and ourability to manage OEM external storage product costs.

**Research and Development Expense.**
| ** **                | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **                | ** ** | **(in millions, except percentages)** | ** ** |
| Research and  Development |       |                                                 | $          | 30.0                                  |       |   |   | $ | 25.1 |   |   |   | 19 | % |   |   | $ | 87.4 |   |   |   | $ | 76.5 |   |   |   | 14 | % |   |
|                           |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in research and development expense inthe third quarter and first nine months of fiscal 2005 compared to thecorresponding periods of fiscal 2004 was primarily a result of increasedheadcount from the acquisitions of Snap Appliance and the IBM i/p Series RAIDbusiness and compensation of $0.4 million and $1.2 million in the third quarterand first nine months of fiscal 2005, respectively, related to a 

36

----

management incentiveprogram established for former Snap Appliance employees pursuant to the SnapAppliance acquisition agreement. This was offset by decreased infrastructurespending and reduced headcount as a result of restructuring programsimplemented in fiscal 2004 and the first and third quarters of fiscal 2005 anddecreased deferred compensation charges of $0.5 million and $1.5 millionin the third quarter and first nine months of fiscal 2005, respectively,compared to the corresponding periods of fiscal 2004. Deferred compensationcharges represented the vesting of restricted stock, unvested cash and assumedstock options in connection with our Platys Communications, Inc., orPlatys, acquisition and assumed stock options in connection with our SnapAppliance acquisition.

Our investment in researchand development primarily focuses on developing new products for the externalstorage, IP storage, server storage and networking markets. A portion of ourresearch and development expense fluctuates depending on the timing of majorproject costs such as prototype costs. As a result of the decrease in headcountassociated with the Vitesse alliance, we expect to reduce research anddevelopment expenses by approximately $1 million per month. We invest inresearch and development of new technologies, including iSCSI, Serial ATA andSerial Attached SCSI.

**Selling, Marketing and Administrative Expense.**
| ** **                             | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **                             | ** ** | **(in millions, except percentages)** | ** ** |
| Selling,  Marketing and Administrative |       |                                                 | $          | 21.3                                  |       |   |   | $ | 19.7 |   |   |   | 8 | % |   |   | $ | 63.3 |   |   |   | $ | 59.6 |   |   |   | 6 | % |   |
|                                        |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in selling, marketing and administrativeexpense in the third quarter and first nine months of fiscal 2005 compared tothe corresponding periods of fiscal 2004 was primarily a result of increasedheadcount from the acquisition of Snap Appliance, compensation of $0.8 millionand $2.9 million in the third quarter and first nine months of fiscal 2005,respectively, related to a management incentive program established for formerSnap Appliance employees pursuant to the Snap Appliance acquisition agreementand increased deferred compensation charges. This was partially offset bydecreased spending due to reductions of our workforce and infrastructurespending as a result of the restructuring plans implemented in fiscal 2004 andthe first, second and third quarters of fiscal 2005, and the integration andconsolidation of Eurologic’s operations, which was completed in the fourthquarter of fiscal 2004. Deferred compensation charges representing the vestingof assumed stock options in connection with our Platys and Snap Applianceacquisitions increased $0.3 million and $0.4 million in the third quarter andfirst nine months of fiscal 2005, respectively, compared to the corresponding periods of fiscal 2004.

As our selling, marketingand administrative expense consist primarily of salaries, includingcommissions, our selling, marketing and administrative expense may fluctuatebased on changes to our revenue levels. We will focus on controlling ourselling, marketing and administrative spending in a way that allows ourrevenues to rise faster than our expenses.

**Amortization of Acquisition-Related IntangibleAssets.**
| ** **                                             | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                             | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **                                             | ** ** | **(in millions, except percentages)** | ** ** |
| Amortization of  Acquisition-Related Intangible Assets |       |                                                 | $          | 5.1                                   |       |   |   | $ | 4.5 |   |   |   | 12 | % |   |   | $ | 13.2 |   |   |   | $ | 14.1 |   |   |   | (6 | )% |   |
|                                                        |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

37

----

Acquisition-related intangible assets include patents,core and existing technologies, covenants-not-to-compete, supply agreement,foundry agreement, customer relationships, trade names, backlog and royalties.We amortize the acquisition-related intangible assets over periods whichreflect the pattern in which the economic benefits of the assets are expectedto be realized, which is primarily using the straight-line method over theirestimated useful lives, ranging from three months to seven years.

The increase in amortization of acquisition-relatedintangible assets in the third quarter of fiscal 2005 compared to the thirdquarter of fiscal 2004 was due to the amortization of $3.2 million ofpurchased intangible assets related to the acquisitions of Elipsan Limited, orElipsan, in February 2004, the IBM i/p Series RAID business in June 2004and Snap Appliance in July 2004. This was partially offset byacquisition-related intangible assets that became fully amortized in December 2003associated with our DPT acquisition.

The decrease inamortization of acquisition-related intangible assets in the first nine monthsof fiscal 2005 compared to the first nine months of fiscal 2004 was due to theacquisition-related intangible assets that became fully amortized in December 2003associated with our DPT acquisition and certain acquisition-related intangibleassets that became fully amortized associated with our Platys and Eurologicacquisitions. This was partially offset by amortization of purchased intangibleassets related to the acquisitions of Elipsan, the IBM i/p Series RAIDbusiness and Snap Appliance.

**Write-off of Acquired In-Process Technology.**
| ** **                         | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **December 31,  2004**            | ** ** | **December 31,  2003**           | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
| ** **                         | ** ** | **(in millions)**                 | ** ** |
| Snap Appliance                     |       |                                   | $          | —                                |       |   |   | $ | — |   |   |   | $ | 2.2 |   |   |   | $ | — |   |   |
| IBM i/p  Series RAID business |       |                                   | —     |                                  |       |   | — |   |   |   | 3.0 |   |   |   | — |   |   |
| Eurologic                          |       |                                   | —     |                                  |       |   | — |   |   |   | — |   |   |   | 3.6 |   |   |

 

Projects that qualify as acquired in-processtechnology represent those in which technological feasibility had not beenestablished and no alternative future uses existed. The amounts allocated toacquired in-process technology were determined throughestablished valuation techniques in the high-technology computer industry.

The net cash flows from the identified projects werebased on estimates of revenues, cost of revenues, research and developmentexpenses, including costs to complete the projects, selling, marketing andadministrative expenses, royalty expenses and income taxes from the projects.We believe the assumptions used in the valuations were reasonable at the timeof the acquisitions. The estimated net revenues and gross margins were based onmanagement’s projections of the projects and were in line with industryaverages. Estimated total net revenues from the projects of Snap Appliance, theIBM i/p Series RAID business, Eurologic and Elipsan were expected to growthrough fiscal 2009, fiscal 2009, fiscal 2008 and fiscal 2007, respectively,and decline thereafter as other new products are expected to become available.Estimated operating expenses included research and development expenses andselling, marketing and administrative expenses based upon historical andexpected direct expense levels and general industry metrics. Estimated researchand development expenses include costs to bring the projects to technologicalfeasibility and costs associated with activities undertaken to correct errorsor keep products updated with current information (also referred to as “maintenance”research and development) after a product is available for general release tocustomers. These activities range from 0% to 5% of net revenues for the in-process technologies.

The effective tax rate utilized in the analysis of thein-process technologies reflects a combined historical industry specificaverage for the United States Federal and state statutory income tax rates. The

38

----

cost of capital reflectsthe estimated time to complete the projects and the level of risk involved. Thefollowing discount rates were used in computing the present value of net cashflows from the acquired companies: approximately 24% for Snap Appliance,between 23% and 28% for the IBM i/p Series RAID business, approximately27% for Eurologic and approximately 63% for Elipsan.

The percentage ofcompletion was determined using costs incurred by Snap Appliance, the IBM i/p Series RAIDbusiness, Eurologic and Elipsan prior to their respective acquisition datescompared to the estimated remaining research and development to be completed tobring the projects to technological feasibility. We estimated, as of theacquisition dates for Snap Appliance, the IBM i/p Series RAID business,Eurologic and Elipsan, that the projects were approximately 25% complete, 50%complete, 60% complete and 28% complete, respectively. All projects outstandingas of the acquisition dates for Eurologic and Elipsan were completed as of March 31,2004 and December 31, 2004, respectively. We expect remaining costs ofapproximately $0.5 million and $18.4 million related to SnapAppliance and the IBM i/p Series RAID business, respectively, to bring theplanned in-process projects to completion.

**Restructuring Charges.**
| ** **             | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage   Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **             | ** ** | **(in millions, except percentages)** | ** ** |
| Restructuring  Charges |       |                                                 | $          | 2.2                                   |       |   |   | $ | 0.9 |   |   |   | 154 | % |   |   | $ | 5.0 |   |   |   | $ | 2.7 |   |   |   | 84 | % |   |
|                        |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The restructuring plans entered into in the first ninemonths of fiscal 2005 are discussed in detail below. For a complete discussionof all restructuring actions that were implemented prior to fiscal 2004, pleaserefer to the Notes to Consolidated Financial Statements included in our CurrentReport on Form 8-K filed on December 7, 2004. Restructuringcharges are not allocated to segments but rather managed at the corporatelevel.

***Third Quarter ofFiscal 2005 Restructuring Plan:******  ***In the third quarter offiscal 2005, we initiated certain actions to simplify our structure bystreamlining the corporate organization and reducing operating costs. Thisresulted in a restructuring charge of $2.4 million, which related to theinvoluntary termination of 46 employees in all functions of the organizationand costs pertaining to estimated future obligations for non-cancelable leasepayments for an excess facility in Germany. The expenses associated with thisrestructuring plan were included in “Restructuring charges” in the UnauditedCondensed Consolidated Statements of Operations. We do not expect to incur anyfurther charges in connection with this restructuring plan.

As a result of our third quarter of fiscal 2005restructuring plan, we expect to reduce our annual infrastructure spending byapproximately $6.0 million, of which approximately 7%, 37% and 56%will be reflected as a reduction in cost of revenues, research and developmentand selling, marketing and administrative expense, respectively.

***Second Quarter ofFiscal 2005 Restructuring Plan:******  ***In the second quarter offiscal 2005, we initiated certain actions to consolidate duplicative resourcesin connection with the acquisition of Snap Appliance, primarily in selling,marketing and administrative functions and recorded a restructuring charge of$0.7 million. The expenses associated with this restructuring plan areincluded in “Restructuring charges” in the Unaudited Consolidated Statements ofOperations. We do not expect to incur any further charges in connection withthis restructuring plan. For the acquisition-related restructuring planassociated with the Snap Appliance acquisition, please see Note 4 forfurther details.

As a result of our second quarter of fiscal 2005restructuring plan, we expect to reduce our annual infrastructure spending byapproximately $2 million, of which approximately 19% and 81% will bereflected as a reduction in cost of revenues and selling, marketing andadministrative expense, respectively.

39

----

***First Quarter ofFiscal 2005 Restructuring Plan:******  ***In the first quarter offiscal 2005, we initiated certain actions to consolidate certain developmentand administrative functions in the United States and Europe, which werecompleted in the first half of fiscal 2005. We recorded a restructuring chargeof $0.8 million in the first quarter of fiscal 2005 related to theinvoluntary termination of employees and the costs pertaining to estimatedfuture obligations for non-cancelable lease payments for an excess facility inthe United Kingdom. Additional charges of $1.4 million related to thisplan associated with severance and benefits for employees primarily in the areaof research and development were taken in the second quarter of fiscal 2005. Inthe third quarter of fiscal 2005, a provision adjustment of $0.1 million wasmade related to the fiscal 2004 restructuring plan as severance and benefitswere lower than originally anticipated. Restructuring charges related to thefirst quarter restructuring plan total $2.1 million. We do not expect toincur any further charges in connection with this restructuring plan.

As a result of our first quarter of fiscal 2005restructuring plan, we expect to reduce our annual infrastructure spending byapproximately $5 million, of which approximately 78% and 22% will bereflected as a reduction in research and development expense and selling,marketing and administrative expense, respectively.

Additionally, in the firstnine months of fiscal 2005, we recorded a net reduction of $0.3 million tothe first quarter of fiscal 2005 and the fiscal 2004 restructuring plans asseverance and benefits and lease costs were lower than originally anticipated.

**Other Charges.**
| ** **    | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **    | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **    | ** ** | **(in millions, except percentages)** | ** ** |
| Other Charges |       |                                                 | $          | (2.8                                  | )          |   |   | $ | — |   |   |   | 100 | % |   |   | $ | (2.8 | ) |   |   | $ | — |   |   |   | 100 | % |   |
|               |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In fiscal 2004, werecorded an impairment charge of $5.0 million to reduce the carrying valueof certain properties classified as assets held for sale to fair value lesscost to sell. We decided to consolidate our properties in Milpitas, Californiato better align our business needs with existing operations and to provide moreefficient use of our facilities. As a result, two owned buildings, includingassociated building improvements and property, plant and equipment, wereclassified as assets held for sale and were included in “Other current assets”in the Consolidated Balance Sheet at March 31, 2004 at their expected fairvalue less expected cost to sell. In October 2004, we completed the saleof these properties that were previously classified as held for sale. Netproceeds from the sale of the properties aggregated $9.6 million, whichexceeded our final revised fair value of $6.8 million. As a result, a gainon the sale of the properties of $2.8 million was recorded in the third quarterand first nine months of fiscal 2005 as a credit to “Other Charges” in theUnaudited Condensed Consolidated Statements of Operations.

40

----

**Interest and Other Income.**
| ** **                                       | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **                                       | ** ** | **(in millions, except percentages)** | ** ** |
| **Interest and Other Income:**         |       |                                                 |       |                                  |       |   |   |   |   |   |   | ** ** |   |   |   |   |   |   |   |   |   |   |   | ** ** |   |
| Interest income                                  |       |                                                 | $          | 2.8                                   |       |   |   | $ | 4.0 |   |   |   | (29 | )% |   |   | $ | 8.6 |   |   |   | $ | 14.7 |   |   |   | (42 | )% |   |
| Gain on  settlement with former president of DPT |       |                                                 | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 49.3 |   |   |   | (100 | )% |   |
| Payment of  license fee with NSE                 |       |                                                 | (0.4       | )                                     |       |   | — |   |   |   | 100 | % |   |   | (1.7 | ) |   |   | — |   |   |   | 100 | % |   |
| Loss on  redemption of debt                      |       |                                                 | —     |                                  |       |   | (2.9 | ) |   |   | (100 | )% |   |   | — |   |   |   | (3.7 | ) |   |   | (100 | )% |   |
| Interest on  Federal and State Taxes             |       |                                                 | —     |                                  |       |   | 1.1 |   |   |   | (100 | )% |   |   | — |   |   |   | 1.1 |   |   |   | (100 | )% |   |
| Other                                            |       |                                                 | 0.7        |                                  |       |   | 1.2 |   |   |   | (42 | )% |   |   | 1.7 |   |   |   | 3.1 |   |   |   | (47 | )% |   |
| **Total  Interest and Other Income**             |       |                                                 | 3.1        |                                  |       |   | 3.4 |   | ** ** | ** ** | **(8** | **)%** |   |   | 8.6 |   |   |   | 64.5 |   | ** ** | ** ** | **(87** | **)%** |   |
|                                                  |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest and other income is primarily attributable tointerest income earned on our cash, cash equivalents and marketable securities,loss from the repurchase of our 3% Convertible Subordinated Notes, or 3% Notes,loss from the redemption of our 4 3⁄4% Subordinated Convertible Notes, or 4 3⁄4%Notes, fluctuations in foreign currency gains or losses and lease incomereceived from third parties.

The decrease in interest and other income in the thirdquarter of fiscal 2005 compared to the third quarter of fiscal 2004 wasprimarily due to lower interest income earned on our cash, cash equivalents andmarketable securities related to lower average cash balances, slightly offsetby increased interest rates. The decrease in interest and other income in thefirst nine months of fiscal 2005 compared to the first nine months of fiscal2004 was primarily due to a gain recorded in the first nine months of fiscal2004 of $49.3 million in relation to a settlement with the formerpresident of DPT, as well as to lower interest income earned on our cash, cashequivalents and marketable securities related to lower average cash balances,realized losses on our cash, cash equivalents and marketable securities, aone-time fully paid-up license fee of $1.7 million to NSE, which wasrecorded in the first nine months of fiscal 2005, primarily for historicalproducts that incorporated certain technology, a loss of $2.9 million relatedto the repurchase of $124.2 million in principal amount of our 3% Notes, and aloss of $0.8 million on the redemption of $82.4 million in principalamount of our 4 3⁄4% Notes. For further discussion on the settlement with former presidentof DPT and NSE, please refer to Note 10 to the Notes to Unaudited CondensedConsolidated Financial Statements.

In January 2005, theState Board of Equalization informed us that we will receive a refund for priorqualifying sales and use tax payments totaling approximately $0.7 million thatwe will record as other income in the fourth quarter of fiscal 2005.

**Interest Expense.**
| ** **       | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **       | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **       | ** ** | **(in millions, except percentages)** | ** ** |
| Interest Expense |       |                                                 | $          | (1.1                                  | )          |   |   | $ | (2.3 | ) |   |   | (53 | )% |   |   | $ | (3.4 | ) |   |   | $ | (8.0 | ) |   |   | (58 | )% |   |
|                  |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

41

----

Interest expense isprimarily associated with our 3⁄4% Convertible Senior Subordinated Notes, or 3⁄4%Notes, and 3% Notes, issued in December 2003 and March 2002,respectively. The decrease in interest expense for the third quarter of fiscal2005 compared to the third quarter of fiscal 2004 was primarily due to thereduction in the outstanding balances of the 3% Notes, partially offset byinterest expense related to our 3⁄4% Notes. The decrease in interest expense forthe first nine months of fiscal 2005 compared to the first nine months offiscal 2004 was primarily due to the reduction in the outstanding balances ofthe 3% Notes and 4 3⁄4% Notes, partially offset by interest expense related toour 3⁄4% Notes. We expect future interest expense to remain relatively constantwith the third quarter of fiscal 2005 based upon our outstanding debtobligations of $260.2 million at December 31, 2004.

**Income Taxes.**
| ** **                                 | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                 | ** ** | **December 31,  2004**                          | ** ** | **December 31,  2003**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** | **Percentage  Change** | ** ** |
| ** **                                 | ** ** | **(in millions, except percentages)** | ** ** |
| Provision for  (Benefit from) Income Taxes |       |                                                 | $          | (33.4                                 | )          |   |   | $ | 0.4 |   |   |   | (9,074 | )% |   |   | $ | (33.8 | ) |   |   | $ | 0.7 |   |   |   | (4,798 | )% |   |
|                                            |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Income tax provisions for interim periods are based onour estimated annual income tax rate. The estimated annual tax rate for thethird quarter and first nine months of 2005 differs from the combined UnitedStates Federal and state statutory income tax rate of 40% primarily due tochanges to our tax reserves and certain acquisition related intangible assets,excluding goodwill, that are not fully deductible for tax purposes. We are inongoing negotiations with the IRS with regard to various tax disputes that mayresult in settlement of certain issues. Our tax rate for the period in which asettlement is reached will be impacted if the settlement materially differsfrom the amounts previously accrued. The tax rates for the third quarter andthe first nine months of fiscal 2005 differ from the combined United StatesFederal and state statutory income tax rate of 40% primarily due to tax benefitsof $21.9 million and $31.9 million respectively from discrete eventsrelating to the method and amount of settled tax controversies. As a result ofthe settlements, $21.9 million previously recorded as a tax provision wasreversed during the third quarter of fiscal 2005. In addition, $4.1 million previouslyrecorded as a tax provision was reclassified as a reduction to additionalpaid-in capital, $1.8 million previously recorded as a tax provision wasreversed, and a $4.0 million tax benefit associated with a refund claimwas recognized during the second quarter of fiscal 2005. The tax rate for thethird quarter and first nine months of 2004 differed from the combined UnitedStates Federal and state statutory rate of 40% primarily due to the gain on settlementwith the former president of DPT of $49.3 million which is treated as anadjustment to the tax basis in the acquired DPT common stock and does notresult in taxable income.

On October 22, 2004,the American Jobs Creation Act of 2004, also referred to as the Act, was signedinto law. The Act creates a temporary incentive for U.S. companies torepatriate accumulated foreign earnings by providing a one-time deduction of85% for certain dividends from controlled foreign corporations. The deductionis subject to certain limitations and numerous provisions of the Act containuncertainties that require interpretation and evaluation. As a result, we arecurrently evaluating whether, and to what extent, to repatriate foreignearnings that have not yet been remitted to the U.S. Until such evaluation iscomplete, we have not accrued income taxes on the accumulated undistributedearnings of our Singapore subsidiary, as these earnings are currently expectedto be reinvested indefinitely. Based on our analysis to date, however, it isreasonably possible that we may repatriate an amount between $0 and $650million, with the respective tax liability ranging from $0 and $59 million. Weexpect to be in a position to finalize our assessment and record any resultingtax liability in its quarter ending by March 2005.

42

----

**Liquidity andCapital Resources**

**Key Components ofCash Flows**

Cash used for operations was $16.0 million in thefirst nine months of fiscal 2005 as compared to cash provided by operations of$68.6 million in the first nine months of fiscal 2004 primarily driven bya decrease in net income from $38.1 million in the first nine months offiscal 2004 to net income of $14.4 million in the first nine months offiscal 2005 and a cash payment of $25.0 million related to the distributionagreement we entered into with IBM in the third quarter of fiscal 2005.Operating cash flow for the first nine months of fiscal 2005 were also impactedunfavorably by an increase in accounts receivable offset by the benefit ofnon-cash items included in operating results. Non-cash items primarilyconsisted of depreciation and amortization of intangible assets and propertyand equipment of $35.0 million, write-off of acquired in processtechnology of $5.2 million and amortization of deferred stock-basedcompensation of $2.8 million, offset by the non-cash effect on taxsettlement of $26.0 million and gain on the sale of long-lived assets of $2.8million. Operating cash for the first nine months of fiscal 2004 resultedprimarily from our net income of $38.1 million, offset by non-cash items of$27.6 million and changes to working capital assets and liabilities,excluding the impact of balances acquired from Eurologic and ICP vortex, of$3.0 million. Non-cash items primarily consisted of the non-cash portionof the gain on settlement with the former president of DPT of$18.3 million, offset by depreciation and amortization of intangibleassets and property and equipment of $40.4 million and write-off ofacquired in process technology of $3.6 million.

Days sales outstanding increased to 63 at December 31,2004 as compared to 41 at March 31, 2004 due to the deferral of $4.6million of revenue and the timing of our shipments in the third quarter offiscal 2005 and the integration of Snap Appliance and the IBM i/p Series RAIDbusiness; the increase was not due to changes in the credit quality of ourcustomers. Annualized inventory turns decreased to 5.5 at December 31,2004 as compared to 5.7 at March 31, 2004. Overall inventory levels werehigher at the end of December 31, 2004 compared to March 31, 2004 dueto our beginning to manufacture certain products that were previouslyoutsourced to subcontractors, our Snap Appliance acquisition and increasedinventory levels related to new system products.

Cash used for investing activities was$16.7 million in the first nine months of fiscal 2005, which was primarilyrelated to our acquisitions of Snap Appliance and the IBM i/p Series RAIDbusiness of $124.0 million, offset by sales and maturities of restrictedmarketable securities and marketable securities, net of purchases, of$112.5 million. Cash used for investing activities of $36.4 millionin the first nine months of fiscal 2004 primarily related to our acquisitionsof Eurologic and ICP vortex of $29.9 million and purchases of restrictedmarketable securities and marketable securities, net of sales and maturities,of $0.5 million.

Cash provided by financingactivities was $5.4 million in the first nine months of fiscal 2005, whichrelated to net proceeds received from our issuance of common stock inconnection with purchases made under our employee stock purchase plan and theexercise of stock options. Cash used for financing activities of$22.2 million in the first nine months of fiscal 2004 was primarily drivenby the repurchase of our 3% Notes and 4 3⁄4% Notes for $207.2 million,offset by net proceeds from the issuance of our 3⁄4% Notes.

**Liquidity.**

At December 31, 2004, we had $517.2 millionin cash, cash equivalents and marketable securities of which approximately$424.2 million was held by our Singapore subsidiary. In consideration ofthe American Jobs Creation Act of 2004, we are currently evaluating whether,and to what extent, to repatriate foreign earnings that have not yet beenremitted to the United States. Based on our analysis to date, however, it isreasonably possible that we may repatriate an amount between $0 and $650million, with the 

43

----

respective tax liabilityranging from $0 and $59 million. If the amount repatriated does not qualify forthe Act’s one-time deduction of 85% for certain dividends from controlledforeign corporations, we could incur additional income taxes up to the combinedUnited States Federal and state statutory rate of approximately 40%.

We also acquired an available revolving line of creditof up to $7.5 million through the acquisition of Snap Appliance, of whichno borrowings were drawn against the line at December 31, 2004. Under theamended terms of the line of credit, all financial covenants are waived throughthe term of the line of credit on April 23, 2005.

At December 31, 2004, we had $260.2 millionof aggregate principal amount of convertible notes outstanding, consisting of$35.2 million in aggregate principal amount of our 3% Notes that are duein March 2007 and $225.0 million in aggregate principal amount of our3⁄4% Notes that are due in December 2023.

We are required to maintain restricted cash orinvestments to serve as collateral for the first six scheduled interestpayments and the first ten scheduled interest payments on our 3% Notes and 3⁄4%Notes, respectively. As of December 31, 2004, we had $6.9 million ofrestricted cash and restricted marketable securities, consisting of UnitedStates government securities, of which $2.3 million was classified asshort-term and $4.6 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 2001. 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 2000 and 2001 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.

We invest in technology companies through two venturecapital funds, Pacven Walden Venture V Funds and APV Technology Partners II,L.P. At December 31, 2004, the carrying value of such investmentsaggregated $3.3 million. We have also committed to provide additionalfunding of up to $0.5 million.

We believe that liquidity provided by our existingworking capital, together with expected cash flows from operations andavailable sources of bank, equity and equipment financing, will be sufficientto support our operations through at least the next twelve months. However,should prevailing economic conditions and/or financial, business and otherfactors beyond our control adversely affect our estimates of our future cash requirements, we would be requiredto fund our cash requirements by alternative financing. There can be noassurance that additional financing, if needed, would be available on termsacceptable to us or at all.

As of December 31, 2004, we did not have anymaterial changes to our contractual obligations, other than our acquisition ofSnap Appliance, which increased our operating lease commitments by$8.6 million primarily through October 2011 related to leasedfacilities and the distribution agreement we entered into with IBM in the thirdquarter of fiscal 2005, which increased our fixed payment obligations by$27.1 million through December 2008.

In connection with theacquisition of Snap Appliance, we maintained an irrevocable standby letter ofcredit for $500,000 with an approved financial institution under an officelease term, which guarantees our performance to the landlord. On December 31,2004, the letter of credit was cancelled.

44

----

**Recent AccountingPronouncements**

In December 2004, the FASB issued SFAS No. 123(R).This statement replaces SFAS No. 123, amends SFAS No. 95 andsupersedes APB Opinion No. 25. SFAS No. 123(R) requires companies toapply a fair-value based measurement method in accounting for share-basedpayment transactions with employees and to record compensation expense for allstock awards granted and to awards modified, repurchased or cancelled after therequired effective date. In addition, we are required to record compensationexpense (as previous awards continue to vest) for the unvested portion ofpreviously granted awards that remain outstanding at the date of adoption. SFASNo. 123(R) will be effective for quarterly periods beginning after June 15,2005, which is our second quarter of fiscal 2006. This statement will have asignificant impact on our results of operations as we will be required torecord compensation expense rather than disclose the impact on our results ofoperations within our footnotes (see Note 3).

At its March 2004meeting, the EITF reached a consensus on recognition and measurement guidancepreviously discussed under EITF 03-01. The consensus clarified themeaning of other-than-temporary impairment and its application to investmentsclassified as either available-for-sale or held-to-maturity under SFAS No. 115and investments accounted for under the cost method or the equity method. In September 2004,the FASB delayed the recognition and measurement guidance to be applied toother-than-temporary impairment evaluations. The FASB expects to issueadditional implementation guidance with respect to debt securities that areimpaired solely due to interest rates and/or sector spreads.

**IBM DistributionAgreement**

In December 2004, we entered into a distributionagreement on our RAID controllers and connectivity products sold for IBM’s iSeries andpSeries servers. The agreement was made through an amendment to ourexisting i/p Series RAID supply and intellectual property agreemententered into in June 2004 (See Note 4). The distribution agreement isaccounted for as a standalone transaction as it was not contemplated at thetime we entered into the original IBM i/p Series RAID transaction.

Under the amended intellectual property agreement, weare required to make fixed and royalty-based payments to IBM. The fixedpayments potentially due under the arrangement total $52.1 million, of which$25.0 million was paid in December 2004 and the remainder is duequarterly, in varied installments, through December 2008. A portion of the$52.1 million in total payments is contingent upon IBM purchasing certainlevels of our products. We have recorded the full remaining amount payable toIBM of $27.1 million as a liability to “Accrued Liabilities” of $14.6 millionand to “Other Long-Term Liabilities” of $12.5 million as we considers paymentof the full amount to be probable.

The fixed considerationfor the distribution agreement of $52.1 million was recorded as an asset to “Prepaidexpenses” and “Other long-term assets” in the Unaudited Condensed ConsolidatedBalance Sheets and the amortization will be included in “Net revenues” in theUnaudited Condensed Consolidated Statements of Operations over a four-yearperiod reflecting the pattern in which the economic benefits of the assets areexpected to be realized. The royalty-based fee per unit is calculated using theaverage net sales price for units sold within the quarter and baseline royaltyrates subject to certain adjustment factors. The royalty-based payments will berecorded as a reduction to revenue in the period the units are sold.

**Acquisitions**

**SnapAppliance:****  **On July 23,2004, we completed the acquisition of Snap Appliance, a provider of NASsolutions, to expand our product offerings in the external storage market andto deliver cost-effective, scalable and easy-to-use DAS, NAS, Fibre Channel andIP-based SAN solutions from the workgroup to the data center. The totalpurchase price was $84.4 million, consisting of $77.4 million in cashand transaction fees and $7.0 million related to the fair value of assumedstock options to purchase 1.2 million shares of our common stock. Theassumed stock options were valued using the Black-Scholes valuation 

45

----

model with the followingassumptions: volatility rate of 58%; a risk-free interest rate of 2.6%; and anestimated life of 2.25 years. Snap Appliance is included in our Channelsegment (Note 18).

Of the total assumed stock options, stock options topurchase approximately 0.7 million shares of our common stock, withexercise prices ranging between $1.42 and $5.66 per share, were unvested, whichis also known as the Snap Unvested Options. The Snap Unvested Options have aten-year term and vest primarily over four years from the date of grant. Theintrinsic value of the Snap Unvested Options of $3.6 million was accountedfor as deferred stock-based compensation and is being recognized ascompensation expense over the related vesting periods.

In addition, a management incentive program wasestablished to pay former employees of Snap Appliance cash payments totaling$13.8 million, which will be paid, contingent upon their employment withus, over a two-year period through the second quarter of fiscal 2007. Paymentsunder the management incentive program will be expensed as employees meet theiremployment obligations or are recorded as part of the Snap Applianceacquisition-related restructuring for involuntarily terminations by us. In thethird quarter of fiscal 2005, the Unaudited Condensed Consolidated Statementsof Operations included compensation expense related to the management incentiveprogram of $1.4 million and an additional $1.4 million was originally accruedin the Snap Appliance acquisition-related restructuring. In the first ninemonths of fiscal 2005, the Unaudited Condensed Consolidated Statements ofOperations included compensation expense related to the management incentiveprogram of $4.3 million and an additional $1.4 million was originally accruedin the Snap Appliance acquisition-related restructuring.

A portion of the Snap Appliance acquisition pricetotaling $5.4 million was held back, and in connection with the managementincentive program, $1.3 million will be held back for a total of $6.7 million,also referred to as the Snap Appliance Holdback, for unknown liabilities thatmay have existed as of the acquisition date. The Snap Appliance Holdback willbe paid in the second quarter of fiscal 2006, except for funds necessary toprovide for any pending claims.

***Acquisition-RelatedRestructuring:******  ***Inthe third quarter of fiscal 2005, we refined our plan to integrate the SnapAppliance operations related to integrating certain duplicative resources forboth severance and benefits in connection with the involuntary termination of24 employees, exiting duplicative facilities and the disposal of duplicativeassets. The acquisition-related restructuring liabilities were accounted forunder EITF 95-3 and therefore were included in the purchase priceallocation of the cost to acquire Snap Appliance. We recorded a preliminaryestimate of $6.0 million in the second quarter of fiscal 2005 for theseactivities. In the third quarter of fiscal 2005, we recorded a $0.8 millionincrease to the accrued restructuring charges with a corresponding change togoodwill as our plans were further refined. We expect to execute theintegration plan as currently designed; however, actual results and costs maydiffer as the plan is executed.  Anyfurther changes to our estimate will result in an increase or decrease to theaccrued restructuring charges and a corresponding increase or decrease togoodwill. As of December 31, 2004, we had utilized $1.4 million of thesecharges. We anticipate that the remaining restructuring reserve balance of $5.4million will be paid out by third quarter of fiscal 2012, primarily related tolong-term facility leases.

The acquisition of Snap Appliance is being accountedfor as a purchase business combination with the allocation of the purchaseprice to the tangible and intangible assets acquired. The allocation was basedon an independent appraisal and management’s estimates of fair value.Approximately $2.2 million of the purchase price was allocated to acquiredin-process technology and was written off in the second quarter of fiscal 2005.The in-process projects were related to operating system enhancements andsystem functionality improvements.

**IBMi/p Series****RAID:  **On June 29,2004, we completed the acquisition of IBM’s i/p Series RAID componentbusiness line consisting of certain purchased RAID data protection intellectualproperty, semiconductor designs and assets, and licensed from IBM related RAIDintellectual property. The 

46

----

licensing agreement grantsus the right to use IBM’s RAID technology and embedded Power PC technology forour internal and external RAID products to be sold to IBM and other customers.In conjunction with the acquisition, we also entered into a three-yearexclusive product supply agreement under which we will supply RAID software,firmware and hardware to IBM for use in IBM’s iSeries and pSeries servers.We also entered into an agreement for IBM to provide silicon wafermanufacturing processing services to us for the term of the supply agreement atagreed upon rates.

The total purchase price is estimated at$49.5 million, which consists of a cash payment to IBM of$47.5 million, warrants valued at $1.1 million, net of registrationcosts, and transactions costs of $0.9 million. In connection with theacquisition, we issued to IBM a warrant to purchase 250,000 shares of ourcommon stock at an exercise price of $8.13 per share. The warrant has a term of5 years from the date of issuance and is immediately exercisable. Thewarrant was valued using the Black-Scholes valuation model using a volatilityrate of 62%, a risk-free interest rate of 3.9% and an estimated life of5 years. The transaction costs consist primarily of legal, valuation andother fees. The IBM i/p Series RAID business is included in our OEMsegment (Note 18).

We also entered into a service agreement for IBM toprovide certain research and development services and to provide access to IBM’ssemiconductor design tools. The semiconductor design tools license agreement isfor two years at a total cost of $9.9 million and is payable in quarterlyinstallments; however, the agreement can be cancelled by us in any quarter,which termination would relieve any obligations for us to make future quarterlyinstallment payments to IBM.

**Eurologic:  **OnApril 2, 2003, we completed the acquisition of Eurologic, a provider ofexternal and networked storage solutions. We acquired Eurologic to furtherenhance our direct-attached and fibre-attached server storage capabilities byallowing us to provide end-to-end block- and file-based networked storagesolutions. As consideration for the acquisition of all of the outstandingcapital stock of Eurologic, we paid $25.6 million in cash, subject to aHoldback as described below, and assumed stock options to purchase0.5 million shares of our common stock, with a fair value of$1.6 million. We also incurred $1.1 million in transaction fees,including legal, valuation and accounting fees. The assumed stock options were valuedusing the Black-Scholes valuation model with the following assumptions:volatility rate ranging from 57% to 81%; a risk-free interest rate ranging from1.1% to 2.5%; and an estimated life ranging from 0.08 to 4 years. As partof the Eurologic purchase agreement, $3.8 million of the cash payment washeld back, also known as the Holdback, for unknown liabilities that may haveexisted as of the acquisition date. The Holdback, which was included as part ofthe purchase price, was included in “Accrued liabilities” in the UnauditedCondensed Consolidated Balance Sheet as of December 31, 2004 and was tohave been paid to the former Eurologic stockholders 18 months after theacquisition closing date, except for funds necessary to provide for any pendingclaims. We paid $2.3 million of the Holdback as of December 31, 2004 andhave asserted claims against the remaining amount for liabilities of which webecame aware following the consummation of the transaction. The formerEurologic stockholders have disputed these claims. We also agreed to pay thestockholders of Eurologic contingent consideration of up to $10.0 millionin cash if certain revenue levels were achieved by the acquired Eurologicbusiness in the period from July 1, 2003 through June 30, 2004. Themilestone to achieve the contingent consideration was not attained as of June 30,2004. As a result, no additional payments were made to former stockholders ofEurologic. Eurologic’s goodwill and amortizable intangible assets wereallocated based on the relative fair values of our two segments, OEM andChannel (Note 18).

***Acquisition-RelatedRestructuring:******  ***Duringthe fourth quarter of fiscal 2004, we finalized our plans to integrate theEurologic operations. The integration plan included the involuntary terminationor relocation of approximately 110 employees, exiting duplicative facilitiesand the transition of all manufacturing operations from Dublin, Ireland to ourmanufacturing facility in Singapore. The consolidation of the manufacturingoperations as well as involuntary employee terminations was completed in thefourth quarter of fiscal 2004. The acquisition-related restructuringliabilities were accounted for under 

47

----

EITF No. 95-3and therefore were included in the purchase price allocation of the cost to acquireEurologic. We recorded a liability of $3.3 million in fiscal 2004 forthese activities. As of December 31, 2004, we utilized approximatelyall of these charges and the plan is materially complete.

**ICPvortex:  **On June 5, 2003, we completed theacquisition of ICP vortex. ICP vortex was a wholly-owned subsidiary of IntelCorporation and provided a broad range of hardware and software RAID dataprotection solutions, including SCSI, Serial ATA and fibre channel products.The final purchase price was $14.5 million in cash, which included$0.3 million in transaction fees, consisting of legal, valuation andaccounting fees. This purchase price included a final adjustment of$0.1 million in the first quarter of fiscal 2005 to both goodwill andacquisitions costs. ICP vortex’s goodwill and amortizable intangible assetswere allocated based on the relative fair values of our two segments, OEM andChannel (Note 18).

During the first quarter of fiscal 2005, we finalizedour plans to integrate the ICP vortex operations. The integration plan includedthe involuntary termination of 19 employees, the transfer of manufacturingoperations to Singapore and the integration of certain duplicative resources.The acquisition-related restructuring liabilities were accounted for underEITF 95-3 and therefore were included in the purchase priceallocation of the cost to acquire ICP vortex. In fiscal 2004, we recorded aliability of $0.4 million for severance and benefits, of which$0.3 million of these charges were utilized and $0.1 million wasrecorded as a reduction to the restructuring liability with a correspondingdecrease to goodwill in the first quarter of fiscal 2005.

**Elipsan:  **OnFebruary 13, 2004, we completed the acquisition of Elipsan, a provider ofnetworked storage infrastructure software. Elipsan’s storage virtualizationtechnology will enable us to make storage more cost-effective, easier to scale,and increase performance across multiple RAID subsystems. The total purchaseprice was $19.4 million in cash to acquire Elipsan, which included$0.7 million in transaction fees, consisting of legal, valuation andaccounting fees. In the first nine months of fiscal 2005, adjustments were madeto both goodwill and the acquisition costs, primarily related to the reversalof the acquisition-related restructuring reserves of approximately $0.6million. Elipsan’s goodwill and amortizable intangible assets were allocatedbased on the relative fair values of our two segments, OEM and Channel segment(Note 18).

***In-processTechnology:******  ***Aspart of the Elipsan purchase agreement, $4.0 million was allocated toacquired in-process technology and written off in the fourth quarter of fiscal2004 because technological feasibility had not been established and noalternative future uses existed. The in-process projects were related to thedevelopment of software modules to add additional functionality to the existingstorage virtualization software as well as address specific customer needs. Thevalue for the identifiable intangible were determined by estimating the netcash flows and discounting the estimated net cash flows to their present value.

The percentage of completion of the acquired projectswas determined using costs incurred by Elipsan prior to the acquisition datecompared to the estimated remaining research and development to be completed tobring the projects to technological feasibility. We estimated, as of theacquisition date, the projects were approximately 28% complete. All projectsoutstanding as of the acquisition date for Elipsan were completed as of December 31,2004.

***Acquisition-Related Restructuring:******  ***During the third quarter offiscal 2005, we further refined our plans related to integrate of the Elipsanoperations. The initial plan included the integration of certain duplicativeresources, related to both severance and benefits in connection with theinvoluntary termination of employees and, accordingly, recorded a $0.8 millionreserve as of March 31, 2004. In the third quarter of fiscal 2005, werecorded an adjustment of $0.6 million as a reduction to the liability with acorresponding decrease to goodwill as we now intend to retain these employees. Theacquisition-related restructuring liabilities were accounted for underEITF 95-3 and therefore were included in the purchase priceallocation of the cost to acquire Elipsan. As of December 31, 2004, wemade payments of 

48

----

approximately$25,000 under the plan. We anticipate that the remaining restructuring reservebalance of $0.2 million will be paid out by the second quarter of fiscal 2006.

**RISK FACTORS**

Our business faces significant risks. The risks describedbelow may not be the only risks we face. Additional risks that we do not yetknow 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 occur, our business, financial condition or results ofoperations could suffer, and the trading price of our common stock coulddecline.

**Our operating results have fluctuated in the past, andare likely to continue to fluctuate, and if our future results are below theexpectations of investors or securities analysts, the market price of ourcommon stock would likely decline significantly.**

Our quarterly operating results have fluctuated in thepast, and are likely to vary significantly in the future, based on a number offactors related to our industry and the markets for our products. Factors thatare likely to cause our operating results to fluctuate include those discussedin the risk factors below. In addition, in the first nine months of fiscal2005, our operating results were materially affected by unusual charges,including the write-off of acquired in-process technology from the acquisitionsof the i/p Series RAID business from IBM and Snap Appliance.

Our operating expenses are largely based on anticipatedrevenues, and a large portion of our expenses, including those related to rentand salaries, 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.

**Our operating results may be adversely affected byunfavorable economic and market conditions and the uncertain geopoliticalenvironment.**

Adverse economicconditions in some markets have contributed to the slowdown in the informationtechnology industry and may continue to 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.

Demand for our products would likely be negativelyaffected if demand in the server and network storage markets declines. Ourbusiness or operating results would be adversely affected by a decline indemand for our products. For example, demand in the server market declinedslightly in fiscal 2002 and fiscal 2003, which contributed to a decline in ournet revenues. It is difficult to predict future server sales growth, if any. Inaddition, other technologies may replace the technologies used in our existing productsand the acceptance of our products using new technologies in the market may notbe widespread, which could adversely affect our revenues.

49

----

Political turmoil in many parts of the world,including terrorist and military actions, may continue to put pressure onglobal economic conditions. If conditions do not improve in affected markets,or if conditions deteriorate further, our business, operating results andfinancial condition may be adversely affected. We do not expect the trend oflower capital spending among our customers to reverse itself in the near term.

**Because our salesare made by means of standard purchase orders rather than long-term contracts,if demand for our customers’ products declines or if our customers do notcontrol their inventories effectively, they may cancel or reschedule shipmentspreviously ordered from us or reduce their levels of purchases from us.**

The volume and timing of orders received during aquarter are difficult to forecast. Our customers generally order based on theirforecasts and they frequently encounter uncertain and changing demand for theirproducts. If demand falls below such forecasts or if our customers do notcontrol their inventories effectively, they may cancel or reschedule shipmentspreviously ordered from us. Our customers have from time to time in the pastcanceled or rescheduled shipments previously ordered from us, and we cannotassure you that they will not do so in the future. In addition, because oursales 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. Historically, we haveset our operating budget based on forecasts of future revenues because we donot have significant backlog. Because much of our operating budget isrelatively fixed in the short-term, if revenues do not meet our expectations,then our financial results will be adversely affected.

**We expect that theproducts we are developing for the network storage marketplace will be animportant component of our anticipated future growth, and these products maynot be accepted by the market or reach the market in a timely fashion.**

We believe that developing products for the networkstorage marketplace will be an important component of our anticipated futuregrowth, and we have attempted to accelerate such product development effortsthrough acquisitions. For example, in July 2004, we acquired SnapAppliance, Inc., a provider of NAS solutions, in February 2004, weacquired Elipsan, a network storage software provider, and in April 2003,we acquired Eurologic, a provider of external and networked storage solutions.The marketplace for advanced storage products is highly competitive. While weare focusing on solutions employing iSCSI technology for this market, othercompanies are also focusing on network storage solutions based on identifiedtechnologies that include, but are not limited to, iSCSI. As a result, ourtechnology may never be broadly adopted. Even if iSCSI technology achievesbroad market acceptance, our early technological advantage in this field maynot afford us the advantages we had anticipated if such acceptance continues tobe delayed. In addition, there are substantial risks that known and unknownchallenges to successful deployment of our products, and of productsincorporating our products, will cause delays in their reaching the market. IfiSCSI technology and our network storage products, and our customers’ productsusing our technology, do not achieve a broad level of market acceptance, or ifwe encounter substantial delays in entering the market, our growth will likelybe impaired.

**If we do notprovide adequate support during our customers’ design and development stage, orif we are unable to provide such support in a timely manner, we may loserevenues to our competitors.**

Certain of our products are designed to meet ourcustomers’ specifications and, to the extent we are not able to meet theseexpectations in a timely manner or provide adequate support during ourcustomers’ 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.

50

----

**Our reliance on industry standards and technologicalchanges in the marketplace may cause our net revenues to fluctuate or decline.**

The computer industry is characterized by various,evolving standards and protocols. We design our products to conform to certainindustry standards and protocols such as the following:

Technologies:

·       ATA

·       SerialATA

·       Fibrechannel

·       FireWire/1394

·       IPsec

·       iSCSI

·       PCI

·       PCI-X

·       PCI-Express

·       RAID

·       SCSI

·       SerialAttached SCSI

·       SMI-S

·       UltraDMA

·       USB

Operating Systems:

·       Linux

·       Macintosh

·       Netware

·       OS/2

·       UNIX

·       Windows

If consumer acceptance of these standards declines, orif new standards emerge, and if we do not anticipate these changes and developnew products, these changes could adversely affect our business and financialresults.

**If we lose thecooperation of other hardware and software producers whose products areintegral to ours, our ability to sustain or grow our revenues could beadversely affected.**

We must design ourproducts to operate effectively with a variety of hardware and softwareproducts supplied by other manufacturers, including the following:

·       Microprocessors;

51

----

·       Peripherals;and

·       Operatingsystem software.

We depend on significant cooperation from thesemanufacturers to achieve our design objectives and develop products thatoperate successfully with their products. These companies could, from time totime, elect to make it more difficult for us to design our products forsuccessful operability with their products. For example, if one or more ofthese companies were to determine that as a result of competition or otherfactors our technology or products would not be broadly accepted by the marketswe target, these companies may no longer work with us to plan for new productsand new generations of our products, which would make it more difficult tointroduce products on a timely basis or at all. Further, some of thesecompanies might decide not to continue to offer products that are compatiblewith our technology and our markets could contract. If any of these events wereto occur, our revenue could be adversely affected.

**Our dependence onnew products may cause our net revenues to fluctuate 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 Serial ATA technology and delivered our products based onSerial Attached SCSI technology to certain major OEMs for testing andintegration. We will not succeed in generating significant revenues from ournew Serial ATA and Serial Attached SCSI technology products if the market doesnot adapt to these new technologies, which would, over time, adversely affectour net revenues and operating results.

**We entered into astrategic alliance with Vitesse for the development of our SAS ROC product andif they fail to develop and bring new products to market in a timely manner itcould result in an adverse effect on our business and financial results.**

In January 2005, we entered into a strategicalliance with Vitesse for it to develop and market the next generation of ourSAS products. Accordingly, we are at risk that Vitesse may encounter challengesin fulfilling its responsibilities under this alliance, such as timelycompleting and introducing new product designs, maintaining the quality of newproducts, minimizing product costs, differentiating new products from those ofour competitors and achieving market acceptance of our products. The failure ofthis new product development effort could have an adverse effect on ourbusiness and financial results.

52

----

**If we are unable to compete effectively, our netrevenues could be adversely affected.**

Themarkets for all of our products are intensely competitive and are characterizedby the following:

·       Rapidtechnological advances;

·       Frequentnew product introductions;

·       Evolvingindustry standards; and

·       Priceerosion.

Consequently, we mustcontinue to enhance our products on a timely basis to keep pace with marketdemands. If we do not do so, or if our competition is more effective indeveloping products that meet the needs of our existing and potential customers,we may lose market share and not participate in the future growth of our targetmarkets. For example, intense competition in the transition from productsemploying Ultra 160 technology to solutions employing Ultra 320 technology hasadversely affected revenues from our SCSI products. Our future success willdepend on the level of acceptance of our external storage products and productsbased on the next generation Serial ATA and Serial Attached SCSI technologiesby new and existing customers. In addition, we expect that our future successwill depend significantly on our ability to participate in the ongoingdevelopment of the network storage market in which we face intense competitionfrom other companies that are also focusing on networked storage solutions.

Wecannot assure you that we will have sufficient resources to accomplish all ofthe 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.

**Costs associated with acquisitions or strategicalliances may adversely affect our results of operations, which could beexacerbated if we are unable to integrate the acquired companies, products ortechnologies.**

In thefirst quarter of fiscal 2005, we acquired the i/p Series RAID businessfrom IBM, and in the second quarter of fiscal 2005, we acquired Snap Appliance,a provider of NAS solutions. In fiscal 2004, we acquired Elipsan, a networkstorage software provider, ICP vortex, a provider of a broad range of hardwareand software RAID data protection solutions, and Eurologic, a provider ofexternal and networked storage solutions. In addition, we enter into strategicalliances from time to time with other companies. For example, we entered intoa technology licensing agreement with IBM in fiscal 2002. As part of ouroverall strategy, we may continue to 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 are timely, relative to existing business opportunities;

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

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

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

·       Retainthe key employees of the acquired operation; and

·       Developthe capabilities necessary to exploit newly acquired technologies.

53

----

The benefits of acquisitions or strategic alliancesmay prove to be less than anticipated and may not outweigh the costs reportedin our financial statements. 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,recognize significant charges for impairment of goodwill, other intangibleassets or other losses. If we consummate any potential future acquisitions inwhich the consideration consists of stock or other securities, our existingstockholders’ ownership may be significantly diluted. If we proceed with anypotential future acquisitions in which the consideration is cash, we may berequired to use a substantial portion of our available cash. In addition, wemay be required to invest significant resources in order to perform under a strategicalliance or to complete an acquisition, which could adversely affect ourresults of operations, at least in the short-term, even if we believe thestrategic alliance or acquisition will benefit us in the long-term. We may notbe successful in overcoming these risks or any other problems encountered inconnection with these or other business combinations, investments or strategicalliances. These transactions may adversely affect our business, financialposition and operating results.

**Product qualityproblems could lead to reduced revenues and gross margins.**

We produce highly complex products that incorporateleading-edge technologies, including both hardware and software. Software oftencontains “bugs” which can interfere with expected operations. We cannot assureyou that our pre-shipment testing programs will be adequate to detect alldefects which might interfere with customer satisfaction, reduce salesopportunities, or affect our gross margins if the cost of remedying theproblems exceed reserves established for that purpose. An inability to cure aproduct defect could result in the failure of a product line, and withdrawal,at least temporarily, from a product or market segment, damage to ourreputation, inventory costs, product reengineering expenses, and a materialimpact on revenues and gross margins.

**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.**

If our customers are unable to purchase certaincomponents which are embedded into their products, their demand for ourproducts may decline. For example, beginning in the fourth quarter of fiscal2000, we experienced the impact of other companies’ chip supply shortages,which reduced the demand for certain of our products. This negatively affectedour revenues in the first half of fiscal 2001. Similar shortages of componentsused in our customers’ products could adversely affect our net revenues andfinancial results in future periods.

**The manufacture andintroduction of our products is highly complex.**

We confrontchallenges in the manufacturing process that require us to:

·       Maintaina competitive manufacturing cost structure;

·       Implementthe latest process technologies required to manufacture new products;

·       Exercisestringent quality control measures to ensure high yields;

·       Effectivelymanage inventory levels;

·       Effectivelymanage the subcontractors engaged in the wafer fabrication, test and assemblyof products; and

·       Updateequipment and facilities as required for leading-edge production capabilities.

54

----

We cannot assure you that problems with ourmanufacturing process may not occur in the future. If any such problems withour manufacturing process were to occur, we might not be able to meet thedemands of our customers, which could harm our reputation, result in the lossof customers and adversely affect our net revenues and financial results infuture periods.

**We currentlypurchase all of the finished production silicon wafers used in our productsfrom wafer suppliers, and if they fail to meet our manufacturing needs, itwould 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 adverse effecton our business and financial results. We expect that our wafer suppliers willcontinually seek to convert their processes for manufacturing wafers to moreadvanced process technologies. Such conversions entail inherent technologicalrisks that can affect yields and delivery times. If for any reason the wafersuppliers we use are unable or unwilling to satisfy our wafer needs, we will berequired to identify and qualify additional suppliers. Additional wafersuppliers may be unavailable, may take significant amounts of time to qualifyor may be unable to satisfy our requirements on a timely basis.

**We have enteredinto an expanded relationship with IBM and if the revenue streams are less thananticipated we may incur an impairment of our asset.**

In the third quarter of fiscal 2005, we entered intoan expanded relationship with IBM that enables us to sell certainAdaptec-branded RAID controllers and connectivity products for IBM’s eServer iSeries andpSeries servers directly through the IBM channel. As part of thisagreement, we committed to payments totaling $52.1 million. If, in the future,the revenue we expect to generate from this agreement is less than we currentlyanticipate, we could incur an impairment of this asset which could adverselyaffect our financial results.

**We have enteredinto an expanded relationship with IBM and if we do not fulfill ourresponsibilities under this agreement, it could result in a loss of revenues.**

In the first quarter of fiscal 2005, we entered intoan expanded relationship with IBM to supply external storage products andfurther expanded this relationship during the third quarter of fiscal 2005. Wemay encounter challenges in fulfilling our responsibilities under this expandedrelationship such as, timely completion and introduction of product designs tomeet the specifications of IBM, quality of new products introduced, productcosts, sales forecasting, material planning and inventory management to meetits demand forecast. If we do not fulfill our responsibilities under thisagreement, product shipments could be 

55

----

affected , which couldresult in delayed or lost revenues and customer dissatisfaction. In addition,if we are not successful in achieving our targeted costs and pricingassumptions we could incur losses from the sale of our products.

**If ourmanufacturing demand for silicon wafers falls below our projections, we may notbe able to fully utilize our prepayments to TSMC, which could adversely affectour results of operations and financial position.**

From time to time, we have entered into “take or pay”contracts that have committed us to purchase specific wafer quantities overextended periods based on our projected needs. In addition, we have madeadvance payments to TSMC in order to secure guaranteed wafer capacity. If ourdemand for wafer units falls below our projections, we may not be able to fullyutilize our advance payments. The unused portion of the advance payments may beimpaired and written off as an asset impairment charge, which would adverselyaffect our financial results.

**We depend onsubcontractors, and if they fail to meet our manufacturing needs, it coulddelay shipments of our products and result in the loss of customers.**

We rely on subcontractors for the assembly andpackaging of the integrated circuits included in our products and for theassembly and manufacturing of a portion of our systems products. We have nolong-term agreements with our assembly and packaging subcontractors. We have,from time to time, used board subcontractors to better balance production runsand capacity. For example, we employ Quanta Computer, Inc. and Sanmina-SCICorporation to manufacture certain products related to the acquisition of SnapAppliance. We also employ Celestica, Inc. and Jabil Circuit, Inc. tomanufacture products related to the IBM i/p Series RAID business. Wecannot assure you these subcontractors will continue to be able and willing tomeet our requirements for these components or services. For example, in thethird quarter of fiscal 2005, Quanta Computer, Inc. could not meet ourmanufacturing needs and as a result initial product delivery dates committed tocustomers was not met. Any significant disruption in supplies from, ordegradation in the quality of components or services supplied by, thesesubcontractors could delay shipments and result in the loss of customers orrevenues, which could have an adverse effect on our financial results.

**We depend on the effortsof our distributors, which if reduced, could result in a loss of sales of ourproducts in favor of competitive offerings.**

We derived approximately 40% of our gross revenues forthe first nine months of fiscal 2005 from independent distributor and resellerchannels. 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. Our distributors buildinventories in anticipation of future sales, and if such sales do not occur asrapidly as they anticipate, our distributors will decrease the size of theirproduct orders. If we decrease our price protection or distributor-incentiveprograms, our distributors may also decrease their orders from us. In addition,we have from time to time taken actions to reduce levels of products atdistributors and may do so in the future. These actions may affect our netrevenues and negatively affect our financial results.

**We depend on a fewkey customers and the loss of any of them could significantly reduce ourrevenues.**

Historically, a small number of our customers hasaccounted for a significant portion of our revenues. During the first ninemonths of fiscal 2005, sales to the ten customers from which we received thegreatest 

56

----

revenues accounted forapproximately 73% of our total gross revenues. In addition, IBM and Dellrepresented 23% and 11%, respectively, of our total net revenues in the firstnine months of fiscal 2005. We expect IBM to represent an even largerpercentage of our total net revenues in future periods as a result of ouracquisition of the IBM i/p Series RAID business and our recently announcedsupply agreement with IBM. We believe that our major customers continuallyevaluate whether or not to purchase products from alternate or additionalsources. Additionally, customers’ economic and market conditions frequentlychange. Accordingly, we cannot assure you that a major customer will notreduce, delay or eliminate its purchases from us, which would likely cause ourrevenues to decline. In addition, we do not carry credit insurance on ouraccounts receivables and any difficulty in collecting outstanding amounts duefrom our customers, particularly customers that place larger orders or experiencefinancial difficulties, could adversely affect our revenues and our net income.Because our sales are made by means of standard purchase orders rather thanlong-term contracts, we cannot assure you that these customers will continue topurchase quantities of our products at current levels, or at all.

**We reorganized ourbusiness segments to be focused on customers and have planned significantsystem enhancements and improvements and these changes could adversely impactour business if not adequately managed and controlled.**

In the second quarter of fiscal 2005 and in responseto the Snap Appliance acquisition in July 2004, we refined our internalorganizational structure to operate in three reportable segments: OEM, Channeland DSG. Whereas historically our former SSG and SNG segments each offereddistinct products across our entire customer base, the new OEM and Channelsegments offer an integrated set of products to customers that are specific tothe segment. The reorganization has placed demands on our management,operational and financial infrastructure. In addition, management is in theprocess of enhancing certain systems and processes, such as in the supply chainarea. These system enhancements and improvements require expenditures andallocation of management resources. If these improvements are not implementedsuccessfully, our ability to manage our new organization could be impaired. Inaddition, we may be required to incur additional expenditures to address theseissues, which could harm our financial position.

**If we do not meet ourrestructuring objectives, we may have to implement additional plans in order toreduce our operating costs and may, as a result, incur additional materialrestructuring charges.**

We have implemented several restructuring plans toreduce our operating costs, including in the first, second and third quartersof fiscal 2005, and in fiscal 2004 and fiscal 2003, and recorded relatedrestructuring charges of $5.0 million, $4.3 million and$14.3 million in the first nine months of fiscal 2005, fiscal 2004 and2003, respectively. The plans included primarily the reduction of our workforceand the consolidation of our manufacturing operations in Singapore. The goalsof these plans were to support future growth opportunities, focus oninvestments that grow revenues and increase operating margins. If we do notmeet our restructuring objectives, we may have to implement additionalrestructuring plans to reduce our operating costs, which could cause us toincur material restructuring charges. Further, these restructuring plans maynot achieve the goals we had in implementing them due to such factors assignificant costs or restrictions that may be imposed in some internationallocales on workforce reductions and a potential adverse effect on employeemorale that could harm our efficiency and our ability to act quickly andeffectively in the rapidly changing technology markets in which we sell ourproducts.

**Our operationsdepend on key personnel, the loss of whom could affect the growth and successof our business.**

In order to be successful, we must retain and motivateour executives, the general managers of our business segments, our principalengineers and other key employees, including those in managerial, technical,marketing and information technology support positions. In particular, ourproduct generation efforts depend on hiring and retaining qualified engineers.Competition for experienced management, technical, marketing and supportpersonnel remains intense. For example, we transitioned certain research 

57

----

and development efforts toIndia, where we have experienced significant competition in our efforts toattract and retain qualified engineers. In addition, with the exception of afew employees with whom we entered into employment agreements in connectionwith acquisition transactions, we do not have employment contracts with our keyemployees, including any of our executive officers. The loss of any of thesekey employees could have a significant impact on our operations. We also mustcontinue to motivate employees and keep them focused on our strategies andgoals, which may be particularly difficult due to morale challenges posed byworkforce 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.**

Many of our subcontractors are primarily located inAsia and we have sales offices and customers located throughout Europe, Japanand other countries. Our international operations and sales are subject topolitical and economic risks, including political instability, currencycontrols, changes in import/export regulations, tariffs and freight rates. Inaddition, because our primary wafer supplier, TSMC, is located in Taiwan, wemay be subject to certain risks resulting from political instability in Taiwan,including conflicts between Taiwan and the People’s Republic of China. Theseand other international risks could result in the creation of political orother non-economic barriers to our being able to sell our products in certaincountries, create local economic conditions that reduce demand for our productsamong our target market or expose us to potential disruption in the supply ofnecessary components or otherwise adversely affect our ability to generaterevenue and operate effectively.

**We depend on thirdparties to transport our products.**

We rely on independent freight forwarders to move ourproducts between manufacturing plants and our customers. Any transport ordelivery problems because of their errors, or because of unforeseen interruptionsin their activities due to factors such as strikes, political instability,terrorism, natural disasters and accidents, could adversely affect ourbusiness, financial condition and results of operations and ultimately impactour relationship with our customers.

**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 or changes in circumstances wouldrequire us to assess the recoverability of the carrying amount of ourlong-lived assets. In fiscal 2004, we recorded an impairment charge of$5.0 million related to certain properties classified as held-for sale anda charge of $1.0 million relating to the decline in value of a minorityinvestment. In fiscal 2003, we recorded an impairment charge of$1.5 million relating to the decline in value of minority investments. Infiscal 2002, we recorded impairment charges of $77.6 million relating totechnology acquired in a prior acquisition and the decline in value of minorityinvestments. We will continue to evaluate the recoverability of the carryingamount of our long-lived assets, and we may incur substantial impairmentcharges which could adversely affect our financial results.

**If actual results orevents differ materially from those contemplated by us in making estimates andassumptions, our reported financial condition and results of operations forfuture periods could be materially affected.**

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the amountsreported in the consolidated financial statements and accompanying notes.Actual results could differ from those estimates. Note 1 of the Notes toConsolidated Financial Statements in our Current Report on Form 8-Kfiled on December 7, 2004 describes the significant accounting policiesessential to preparing our consolidated financial statements. The preparationof these financial statements requires 

58

----

estimates and assumptionsthat affect the reported amounts and disclosures. Although we believe that ourjudgments and estimates are appropriate and correct, actual future results maydiffer materially from our estimates.

**If we are unable toprotect and enforce our intellectual property rights, we may be unable tocompete effectively.**

Although we actively maintain and defend ourintellectual property rights, we may be unable to adequately protect ourproprietary rights. In addition, the laws of certain territories in which ourproducts are or may be developed, manufactured or sold, including Asia andEurope, may not protect our products and intellectual property rights to thesame extent as the laws of the United States. Because we conduct a substantialportion of our operations in Singapore and other locations outside of theUnited States and sell to a worldwide customer base, we are more dependent onour ability to protect our intellectual property in international environmentsthan would be the case if a larger 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 mayassert infringement claims against us, which may be expensive to defend andcould divert our resources.**

From time to time, third parties assert exclusivepatent, copyright and other intellectual property rights to our keytechnologies, and we expect to continue to receive such claims in the future.For example, we entered into a patent cross-license agreement with IBM in May 2000.Under this agreement, which was amended in March 2002, we received arelease from infringement claims prior to January 1, 2000 and received theright to use certain of IBM’s patents through June 30, 2007. Inconsideration, we are paying, in annual installments, an aggregate patent feeof $13.3 million, and we granted IBM a license to use all of our patentsfor the same period. The risks of our receiving additional claims from thirdparties may be enhanced in periods such as the one that we are currently enteringwhere we are beginning to offer product lines employing new technologiesrelative 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 subjectto a higher effective tax rate that could negatively affect our results ofoperations and financial position.**

Our effective tax rate is benefited by a Singapore taxholiday relating to certain of our products. The tax holiday package, which iseffective until fiscal 2010, provides that profits derived from certainproducts will be exempt from tax, subject to certain conditions. If we do notmeet the conditions and requirements of the tax holiday in Singapore, oureffective tax rate will increase, which would adversely affect our financialresults. Additionally, we held $424.2 million of cash, cash equivalents andmarketable securities at our subsidiary in Singapore at December 31, 2004.From time to time we may need to repatriate our cash from Singapore to theUnited States. If the amount repatriated does not qualify for the American Jobs

59

----

Creation Act of 2004’sone-time deduction of 85% for certain dividends from controlled foreigncorporations, we could incur additional income taxes at up to the combinedUnited States Federal and state statutory rate of approximately 40%, whichwould negatively affect our results of operations and financial condition.

**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 statutorynotice of deficiency from the IRS with respect to our Federal income tax returnfor fiscal 1997. We filed a Petition with the United States Tax Court on March 14,2001 contesting the asserted deficiencies and settlement agreements have beenfiled with the United States Tax Court on all but one issue. In addition, theIRS is currently auditing our Federal income tax returns for fiscal 1998through fiscal 2001. We have resolved all issues other than the rollover impactof any potential resolution on the remaining fiscal 1997 issue and tax creditsthat were generated but not used in subsequent years that may be carried back. Whilewe believe we have meritorious defenses against the asserted deficiencies andany proposed adjustments, and that sufficient taxes have been provided, we cannotpredict the final outcome of these matters, and the final resolution couldadversely affect our results of operations 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.**

From time to time we are subject to litigation orclaims that could negatively affect our business operations and financialposition. Such disputes could cause us to incur unforeseen expenses, could occupya significant amount of our management’s time and attention, and couldnegatively affect our business operations and financial position.

**We finance ourcapital expenditure needs from operating cash flows and capital marketfinancing, and if we need to seek additional financing, it may not be availableon favorable terms.**

In order to finance strategic acquisitions, capitalasset acquisitions and other general corporate needs, we rely, in part, onoperating cash flows and the capital markets. Historically, we have been ableto access capital markets, but this does not necessarily guarantee that we willbe able to access these markets in the future or at terms that are acceptableto us. The availability of capital in these markets is affected by several factors,including geopolitical risk, the interest rate environment and the condition ofthe economy as a whole. In addition, our own operating performance, capitalstructure and expected future performance impacts our ability to raise capital.We believe that our current cash, cash equivalents, short-term investments andfuture cash provided by operations will be sufficient to fund our needs for atleast the next twelve months. However, if our operating performance falls belowexpectations, we may need additional funds, which may not be available onfavorable terms, if at all.

**We are exposed tofluctuations in foreign currency exchange rates.**

Because a significant portion of our business isconducted outside the United States, we face exposure to adverse movements innon-United States currency exchange rates. These exposures may change over timeas business practices evolve and could have an adverse impact on our financialresults and cash flows. Historically, our exposures have related tonon-dollar-denominated operating expenses in Europe and Asia. We beganEuro-denominated sales to our distribution customers in the European Union inthe fourth quarter of fiscal 2003. Additionally, we purchase a substantialportion of our raw materials and manufacturing equipment from foreignsuppliers, and incur labor and other operating costs in foreign currencies,particularly in our Singapore manufacturing facility. An increase in the valueof the dollar could increase the real cost to our customers of our products inmarkets outside the United States where we sell in dollars, and a weakeneddollar could increase the cost of local operating expenses and procurement ofraw materials to the extent we must purchase components in foreign currencies.

60

----

**We hold minorityinterests in privately held venture funds, and if these venture funds facefinancial difficulties in their operations, our investments could be impaired.**

We continue to hold minority interests in privatelyheld venture funds. These investments are inherently risky because theseventure funds invest in companies that may still be in the development stage ordepend on third parties for financing to support their ongoing operations. Inaddition, the markets for the technologies or products of these companies aretypically in the early stages and may never develop. If these companies do nothave adequate cash funding to support their operations, or if they encounterdifficulties developing their technologies or products, the venture funds’investment in these companies may be impaired, which in turn, could result inimpairment of our investment in these venture funds.

**Our spin-off ofRoxio may have potential subsequent tax liabilities that could negativelyaffect our results of operations.**

Pursuant to our distribution of the Roxio, Inc.common stock, we received an opinion from PricewaterhouseCoopers LLP, or PwC,regarding the tax-free nature of the transaction to us and to our stockholdersunder Section 355 of the Internal Revenue Code. The validity of the PwCopinion relating to the qualification of the distribution as a tax-freetransaction is subject to factual representations and assumptions. We are notaware of any facts or circumstances that would cause such representations andassumptions to be untrue. In addition, the opinion of PwC is not binding on theIRS. If Roxio or we fail to conform to the requirements set forth in the IRSregulations, it could cause the distribution to be taxable to us and to ourstockholders, and our financial results could be adversely affected.

**We may havepotential business conflicts of interest with Roxio with respect to our pastand ongoing relationships, and we may not resolve these conflicts on termsfavorable to us.**

Conflicts ofinterest may arise between Roxio and us in areas relating to our past andongoing relationship, including:

·       Tax,indemnification and other matters arising from the separation; and

·       Intellectual propertymatters.

These and other business conflicts could adverselyaffect the growth of our business in the future.

**Recently enactedchanges in securities laws and regulations have increased and may continue toincrease our costs.**

Recently enacted 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 expect to incur additional administrativeexpense as we implement Section 404 of the Sarbanes-Oxley Act, whichrequires management to report on, and our Independent Registered PublicAccounting Firm to attest to, our internal control over financial reporting. Weare in the process of completing the documentation of our controls and testingtheir effectiveness and expect that our management will be able to provide afavorable assessment. However, this evaluation and attestation process is new andneither our independent registered public accounting firm nor we havesignificant experience with it, and we cannot be assured that our independentregistered public accounting firm and we will reach a favorable conclusionunder Section 404. If we fail to do so on a timely basis, investorconfidence in us could be adversely affected and our results of operationscould be adversely affected as we seek to address any shortcomings, and as aresult our stock price could decline.

In addition, The Nasdaq National Market, on which ourcommon stock is listed, has also adopted comprehensive rules andregulations relating to corporate governance. These laws, rules andregulations 

61

----

have increased and willcontinue to increase the scope, complexity and cost of our corporategovernance, reporting and disclosure practices. We also expect thesedevelopments to make it more difficult and more expensive for us to obtaindirector and officer liability insurance in the future, and we may be requiredto accept reduced coverage or incur substantially higher costs to obtaincoverage. 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.

**We may encounternatural disasters, which could cause disruption to our employees or interruptthe manufacturing process for our products.**

Our operations could be subject to natural disastersand other business disruptions, which could seriously harm our revenues andfinancial condition and increase our costs and expenses. Our corporateheadquarters are located in California, near major earthquake faults.Additionally, our primary wafer supplier, TSMC, is located in Taiwan, which hasexperienced significant earthquakes in the past. A severe earthquake couldcause disruption to our employees or interrupt the manufacturing process, whichcould affect TSMC’s ability to supply wafers to us, which would negativelyaffect our business and financial results. The ultimate impact on us and ourgeneral infrastructure of being located near major earthquake faults isunknown, but our net revenues and financial condition and our costs andexpenses could be significantly impacted in 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 network securitymeasures, our servers are vulnerable to computer viruses, break-ins, andsimilar disruptions from unauthorized tampering with our computer systems. Anysuch event could have an adverse effect on our business, operating results, andfinancial condition. In addition, the effects of war or acts of terrorism couldhave an adverse effect on our business, operating results, and financialcondition. In addition, as a multi-national company with headquarters andsignificant operations located in the United States, we may be impacted byactions against the United States. We are predominantly uninsured for lossesand interruptions caused by terrorist acts and acts of war.

**We may experiencesignificant fluctuations in our stock price, which may, in turn, significantlyaffect the trading price of our convertible 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 stockmarket has experienced price and volume fluctuations that have affected themarket price of many technology companies, in particular, and that have oftenbeen unrelated 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.

**Item3**.   Quantitative and Qualitative Disclosures AboutMarket 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, 2004. Our exposure tomarket risk has not changed materially since March 31, 2004.

62

----

**Item4**.   Controls and Procedures

Under the supervision and with the participation ofour management, including our Chief Executive Officer (CEO) and our ChiefFinancial Officer (CFO), we conducted an evaluation of our disclosure controlsand 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. Based uponthat evaluation, our CEO and our CFO have concluded that the design and operationof our disclosure controls and procedures were effective to ensure thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commission rules andforms.

There has been no change in our internal control overfinancial reporting that occurred during the period covered by this QuarterlyReport on Form 10-Q that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

While we believe our disclosure controls andprocedures and our internal control over financial reporting are adequate, nosystem of controls can prevent all error and all fraud. A control system, nomatter how well designed and operated, can provide only reasonable, notabsolute, assurance that the control system’s objectives will be met. Further,the design of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within our company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and that breakdowns can occur because of simple error. Controlscan also be circumvented by the individual acts of some persons, by collusionof two or more people, or by management override of the controls. The design ofany system of controls is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions.Over time, controls may become inadequate because of changes in conditions ordeterioration in the degree of compliance with its policies or procedures.Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

63

----

 

**PART II**.OTHER INFORMATION

**Item 6**.   Exhibits
| Exhibit Number | ** ** | ** **                                                                                                                             | ** ** | **Description** |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| Exhibit 10.1   |       | Amended Adaptec  Incentive Plan.                                                                                                       |
| 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. |

----

*                    Thesecertifications are not deemed filed by the SEC and are not to be incorporatedby reference in any filing we make under the Securities Act of 1933 or theSecurities Exchange Act of 1934, irrespective of any general incorporationlanguage in any filings.

64

----

 

**SIGNATURE**

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/  MARSHALL L. MOHR                           |   |
|              | Marshall L. Mohr                                |   |
|              | *Vice  President and Chief Financial Officer*   |   |
|              | *(principal  financial and accounting officer)* | Date: February 7, 2005 |

 

65

----

 

**EXHIBITINDEX**
| Exhibit Number | ** ** | ** **                                                                                                                             | ** ** | **Description** |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| Exhibit 10.1   |       | Amended Adaptec Incentive Plan.                                                                                                        |
| 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. |

----

*       Thesecertifications are not deemed filed by the SEC and are not to be incorporatedby reference in any filing of the Registrant under the Securities Act of 1933or the Securities Exchange Act of 1934, irrespective of any general incorporationlanguage in any filings.

66

----