**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

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

**Forthe quarterly period ended December 31, 2005**

**or**

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

**Forthe transition period from           to           **

**Commissionfile number 0-15071**

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**ADAPTEC, INC.**

(Exact name of registrantas specified in its charter)

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

 

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

**N/A**

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

Indicate by check markwhether the 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 o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act)

Yes x  No o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act)

Yes o  No x

Thenumber of shares of Adaptec’s common stock outstanding as of January 31,2006 was 114,036,179.

 

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**TABLE OF 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 |       |     | 27         |   |   |
| ** **    |       | Item 3.               |       | Quantitative  and Qualitative Disclosures About Market Risk                                 |       |     | 53         |   |   |
| ** **    |       | Item 4.               |       | Controls and  Procedures                                                                    |       |     | 53         |   |   |
| Part II. | ** ** | Other Information     |       |                                                                                        |       |     |       |
| ** **    |       | Item 6.               |       | Exhibits                                                                                    |       |     | 55         |   |   |
| ** **    | ** ** | Signature             |       |                                                                                        | 56         |     |       |

 

2

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**PART I.FINANCIAL INFORMATION**

**Item 1. Financial Statements**

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

| ** **                                                            | ** ** | **Three-Month Period Ended**                                | ** ** | **Nine-Month Period Ended** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                            | ** ** | **December 31, 2005**                                       | ** ** | **December 31, 2004**       | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| ** **                                                            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net revenues                                                          |       |                                                                  | $          | 77,831                                |       |   |   | $ | 93,473 |   |   |   | $ | 236,731 |   |   |   | $ | 292,299 |   |   |
| Cost of revenues                                                      |       |                                                                  | 48,857     |                                  |       |   | 59,577 |   |   |   | 156,442 |   |   |   | 164,912 |   |   |
| Gross profit                                                          |       |                                                                  | 28,974     |                                  |       |   | 33,896 |   |   |   | 80,289 |   |   |   | 127,387 |   |   |
| Operating expenses:                                                   |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and development                                              |       |                                                                  | 14,404     |                                  |       |   | 21,293 |   |   |   | 47,254 |   |   |   | 68,237 |   |   |
| Selling, marketing and  administrative                           |       |                                                                  | 15,739     |                                  |       |   | 17,785 |   |   |   | 49,717 |   |   |   | 55,044 |   |   |
| Amortization of  acquisition-related intangible assets                |       |                                                                  | 1,689      |                                  |       |   | 2,182 |   |   |   | 5,466 |   |   |   | 7,070 |   |   |
| Restructuring charges                                                 |       |                                                                  | 2,587      |                                  |       |   | 2,228 |   |   |   | 3,105 |   |   |   | 4,975 |   |   |
| Goodwill impairment                                                   |       |                                                                  | —     |                                  |       |   | — |   |   |   | 90,602 |   |   |   | — |   |   |
| Other charges (gains)                                                 |       |                                                                  | 1,472      |                                  |       |   | (2,755 | ) |   |   | 1,472 |   |   |   | (2,755 | ) |   |
| Total operating expenses                                              |       |                                                                  | 35,891     |                                  |       |   | 40,733 |   |   |   | 197,616 |   |   |   | 132,571 |   |   |
| Loss from continuing  operations                                      |       |                                                                  | (6,917     | )                                     |       |   | (6,837 | ) |   |   | (117,327 | ) |   |   | (5,184 | ) |   |
| Interest and other  income                                            |       |                                                                  | 4,479      |                                  |       |   | 3,097 |   |   |   | 12,610 |   |   |   | 8,599 |   |   |
| Interest expense                                                      |       |                                                                  | (758       | )                                     |       |   | (1,083 | ) |   |   | (2,598 | ) |   |   | (3,350 | ) |   |
| Income (loss) from  continuing operations before income taxes         |       |                                                                  | (3,196     | )                                     |       |   | (4,823 | ) |   |   | (107,315 | ) |   |   | 65 |   |   |
| Provision for (benefit  from) income taxes                            |       |                                                                  | (582       | )                                     |       |   | (21,788 | ) |   |   | 3,206 |   |   |   | (31,463 | ) |   |
| Income (loss) from  continuing operations                             |       |                                                                  | (2,614     | )                                     |       |   | 16,965 |   |   |   | (110,521 | ) |   |   | 31,528 |   |   |
| Discontinued operations, net of taxes (Note 4)                        |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from  discontinued operations, net of taxes             |       |                                                                  | (4,149     | )                                     |       |   | 5,524 |   |   |   | (31,045 | ) |   |   | (17,092 | ) |   |
| Income (loss) from  disposal of discontinued operations, net of taxes |       |                                                                  | 3,502      |                                  |       |   | — |   |   |   | (3,474 | ) |   |   | — |   |   |
| Income (loss) from  discontinued operations                           |       |                                                                  | (647       | )                                     |       |   | 5,524 |   |   |   | (34,519 | ) |   |   | (17,092 | ) |   |
| Net income (loss)                                                     |       |                                                                  | $          | (3,261                                | )          |   |   | $ | 22,489 |   |   |   | $ | (145,040 | ) |   |   | $ | 14,436 |   |   |
| Net income (loss) per share:                                          |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                 |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Continuing operations                                                 |       |                                                                  | $          | (0.02                                 | )          |   |   | $ | 0.15 |   |   |   | $ | (0.98 | ) |   |   | $ | 0.29 |   |   |
| Discontinued operations                                               |       |                                                                  | $          | (0.01                                 | )          |   |   | $ | 0.05 |   |   |   | $ | (0.31 | ) |   |   | $ | (0.15 | ) |   |
| Net income (loss)                                                     |       |                                                                  | $          | (0.03                                 | )          |   |   | $ | 0.20 |   |   |   | $ | (1.28 | ) |   |   | $ | 0.13 |   |   |
| Diluted                                                               |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Continuing operations                                                 |       |                                                                  | $          | (0.02                                 | )          |   |   | $ | 0.13 |   |   |   | $ | (0.98 | ) |   |   | $ | 0.25 |   |   |
| Discontinued operations                                               |       |                                                                  | $          | (0.01                                 | )          |   |   | $ | 0.04 |   |   |   | $ | (0.31 | ) |   |   | $ | (0.13 | ) |   |
| Net income (loss)                                                     |       |                                                                  | $          | (0.03                                 | )          |   |   | $ | 0.17 |   |   |   | $ | (1.28 | ) |   |   | $ | 0.12 |   |   |
| Shares used in computing net income (loss) per  share:                |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                 |       |                                                                  | 113,531    |                                  |       |   | 111,136 |   |   |   | 112,980 |   |   |   | 110,429 |   |   |
| Diluted                                                               |       |                                                                  | 113,531    |                                  |       |   | 134,517 |   |   |   | 112,980 |   |   |   | 131,607 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

3

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**ADAPTEC, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(unaudited)**

| ** **                                                   | ** ** | **December 31, 2005** | ** ** | **March 31, 2005** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                                   | ** ** | **(in thousands)**         | ** ** |
| **Assets**                                                   |       |                            |       |                         |       |   |   |   |   |
| Current assets:                                              |       |                            |       |                         |       |   |   |   |   |
| Cash and cash equivalents                                    |       |                            | $          | 107,688                      |       |   |   | $ | 441,588 |   |   |
| Marketable securities                                        |       |                            | 424,618    |                         |       |   | 84,968 |   |   |
| Restricted cash and marketable securities                    |       |                            | 1,647      |                         |       |   | 1,766 |   |   |
| Accounts receivable, net                                     |       |                            | 57,086     |                         |       |   | 70,159 |   |   |
| Inventories                                                  |       |                            | 22,441     |                         |       |   | 60,204 |   |   |
| Prepaid expenses and other current assets                    |       |                            | 14,384     |                         |       |   | 26,081 |   |   |
| Assets held for sale                                         |       |                            | 22,583     |                         |       |   | — |   |   |
| Current assets of discontinued operations                    |       |                            | 4,597      |                         |       |   | — |   |   |
| Total current assets                                         |       |                            | 655,044    |                         |       |   | 684,766 |   |   |
| Property and  equipment, net                                 |       |                            | 32,750     |                         |       |   | 56,180 |   |   |
| Restricted  marketable securities, less current portion      |       |                            | 3,084      |                         |       |   | 4,615 |   |   |
| Goodwill                                                     |       |                            | —     |                         |       |   | 91,486 |   |   |
| Other intangible  assets, net                                |       |                            | 21,739     |                         |       |   | 79,457 |   |   |
| Other long-term  assets                                      |       |                            | 9,867      |                         |       |   | 47,002 |   |   |
| Long-term  assets of discontinued operations                 |       |                            | 25,884     |                         |       |   | — |   |   |
| Total assets                                                 |       |                            | $          | 748,368                      |       |   |   | $ | 963,506 |   |   |
| **Liabilities  and Stockholders’ Equity**               |       |                            |       |                         |       |   |   |   |   |
| Current liabilities:                                         |       |                            |       |                         |       |   |   |   |   |
| Accounts payable                                             |       |                            | $          | 48,976                       |       |   |   | $ | 61,637 |   |   |
| Accrued liabilities                                          |       |                            | 86,067     |                         |       |   | 116,007 |   |   |
| Current liabilities of discontinued operations               |       |                            | 5,336      |                         |       |   | — |   |   |
| Total current liabilities                                    |       |                            | 140,379    |                         |       |   | 177,644 |   |   |
| 3⁄4% Convertible  Senior Subordinated Notes               |       |                            | 225,000    |                         |       |   | 225,000 |   |   |
| 3% Convertible  Subordinated Notes                           |       |                            | 11,992     |                         |       |   | 35,190 |   |   |
| Other long-term  liabilities                                 |       |                            | 3,656      |                         |       |   | 15,349 |   |   |
| Commitments and  contingencies (Note 13)                     |       |                            |       |                         |       |   |   |   |   |
| Stockholders’ equity:                                   |       |                            |       |                         |       |   |   |   |   |
| Common stock                                                 |       |                            | 114        |                         |       |   | 112 |   |   |
| Additional paid-in capital                                   |       |                            | 168,604    |                         |       |   | 165,707 |   |   |
| Deferred stock-based compensation                            |       |                            | (460       | )                            |       |   | (2,416 | ) |   |
| Accumulated other comprehensive income (loss), net  of taxes |       |                            | (2,091     | )                            |       |   | 706 |   |   |
| Retained earnings                                            |       |                            | 201,174    |                         |       |   | 346,214 |   |   |
| Total stockholders’ equity                              |       |                            | 367,341    |                         |       |   | 510,323 |   |   |
| Total liabilities and  stockholders’ equity             |       |                            | $          | 748,368                      |       |   |   | $ | 963,506 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

4

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

| ** **                                                                                                                   | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **December 31, 2005**       | ** ** | **December 31, 2004** | ** ** |
| ** **                                                                                                                   | ** ** | **(in thousands)**               | ** ** |
| **Cash Flows From Operating  Activities:**                                                                                   |       |                                  |       |   |   |   |   |   |   |
| Income (loss) from  continuing operations                                                                                    |       |                                  | $          | (110,521 | ) |   |   | $ | 31,528 |   |   |
| Adjustments to reconcile  income (loss) from continuing operations to net cash provided by (used for)  operating activities: |       |                                  |       |   |   |   |   |   |   |
| Non-cash restructuring charges                                                                                               |       |                                  | —     |   |   |   | 109 |   |   |
| Impairment of goodwill                                                                                                       |       |                                  | 90,602     |   |   |   | — |   |   |
| Stock-based compensation                                                                                                     |       |                                  | 284        |   |   |   | 2,348 |   |   |
| Non-cash effect of tax settlement                                                                                            |       |                                  | —     |   |   |   | (26,009 | ) |   |
| Loss on extinguishment of debt                                                                                               |       |                                  | 102        |   |   |   | — |   |   |
| Loss (gain) on sale of long-lived assets                                                                                     |       |                                  | 1,472      |   |   |   | (2,755 | ) |   |
| Depreciation and amortization                                                                                                |       |                                  | 19,398     |   |   |   | 28,359 |   |   |
| Deferred income taxes                                                                                                        |       |                                  | —     |   |   |   | (40 | ) |   |
| Other non-cash items                                                                                                         |       |                                  | 378        |   |   |   | (12 | ) |   |
| Changes in assets and liabilities (net of acquired  businesses)                                                              |       |                                  | (1,169     | ) |   |   | (21,498 | ) |   |
| **Net Cash  Provided by Operating Activities of Continuing Operations**                                                      |       |                                  | 546        |   |   |   | 12,030 |   |   |
| **Net Cash  Provided by (Used for) Operating Activities of Discontinued Operations**                                         |       |                                  | 7,876      |   |   |   | (27,980 | ) |   |
| **Net Cash  Provided by (Used for) Operating Activities**                                                                    |       |                                  | $          | 8,422 |   |   |   | $ | (15,950 | ) |   |
| **Cash Flows From Investing  Activities:**                                                                                   |       |                                  |       |   |   |   |   |   |   |
| Purchases of  certain net assets in connection with acquisitions, net of cash acquired                                       |       |                                  | —     |   |   |   | (65,380 | ) |   |
| Payment of  holdback in connection with acquisition of Eurologic                                                             |       |                                  | —     |   |   |   | (2,279 | ) |   |
| Proceeds from sale  of business                                                                                              |       |                                  | 24,126     |   |   |   | — |   |   |
| Maturities of  restricted marketable securities                                                                              |       |                                  | 1,688      |   |   |   | 2,213 |   |   |
| Purchases of  property and equipment                                                                                         |       |                                  | (6,452     | ) |   |   | (8,102 | ) |   |
| Proceeds from sale  of long-lived assets                                                                                     |       |                                  | —     |   |   |   | 9,577 |   |   |
| Proceeds from the  sale of property and equipment                                                                            |       |                                  | 2,684      |   |   |   | — |   |   |
| Purchases of  marketable securities                                                                                          |       |                                  | (495,893   | ) |   |   | (270,249 | ) |   |
| Sales of  marketable securities                                                                                              |       |                                  | 137,826    |   |   |   | 327,574 |   |   |
| Maturities of  marketable securities                                                                                         |       |                                  | 16,084     |   |   |   | 65,541 |   |   |
| **Net Cash  Provided by (Used for) Investing Activities of Continuing Operations**                                           |       |                                  | (319,937   | ) |   |   | 58,895 |   |   |
| **Net Cash  Used for Investing Activities of Discontinued Operations**                                                       |       |                                  | (1,655     | ) |   |   | (63,048 | ) |   |
| **Net Cash  Used for Investing Activities**                                                                                  |       |                                  | (321,592   | ) |   |   | (4,153 | ) |   |
| **Cash Flows From Financing  Activities:**                                                                                   |       |                                  |       |   |   |   |   |   |   |
| Repurchases and  redemption of long-term debt                                                                                |       |                                  | (22,988    | ) |   |   | — |   |   |
| Proceeds from  issuance of common stock                                                                                      |       |                                  | 3,329      |   |   |   | 5,446 |   |   |
| **Net Cash  Provided by (Used for) Financing Activities**                                                                    |       |                                  | (19,659    | ) |   |   | 5,446 |   |   |
| **Effect  of Foreign Currency Translation on Cash and Cash Equivalents**                                                     |       |                                  | (1,071     | ) |   |   | 822 |   |   |
| **Net  Decrease in Cash and Cash Equivalents**                                                                               |       |                                  | (333,900   | ) |   |   | (13,835 | ) |   |
| **Cash and  Cash Equivalents at Beginning of Period**                                                                        |       |                                  | 441,588    |   |   |   | 102,463 |   |   |
| **Cash and Cash Equivalents at  End of Period**                                                                              |       |                                  | $          | 107,688 |   |   |   | $ | 88,628 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

5

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

**1. Basis of 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, 2005 audited consolidated financial statements and include alladjustments, consisting of only normal recurring adjustments, necessary tofairly state the information set forth therein. The financial statements havebeen prepared in accordance with the regulations of the Securities and ExchangeCommission (“SEC”), and, therefore, omit certain information and footnotedisclosure necessary to present the statements in accordance with accountingprinciples generally accepted in the United States of America. These financialstatements should be read in conjunction with the audited consolidatedfinancial statements and notes thereto included in the Company’s Annual Reporton Form 10-K for the fiscal year ended March 31, 2005, whichwas filed with the SEC on June 14, 2005. The third quarters of fiscal 2006and 2005 ended on December 30, 2005 and December 31, 2004,respectively. For presentation purposes, the accompanying financial statementshave been shown as ending on December 31. The results of operations forthe third quarter and first nine months of fiscal 2006 are not necessarilyindicative of the results to be expected for the entire fiscal year.

Certain reclassifications have been made to priorperiod reported amounts to conform to the current period presentation,including reclassification of auction rate securities from cash and cashequivalents to marketable securities. Previously, such auction rate securitieswere classified as cash and cash equivalents. Accordingly, the Company hasrevised its presentation and made adjustments to the accompanying UnauditedCondensed Consolidated Statement of Cash Flows to reflect the gross purchases andsales of these auction rate securities as investing activities. This adjustmentresulted in a net increase in cash used for investing activities by$12.6 million in the first nine months of fiscal 2005. Thisreclassification had no impact on previously reported results of operations,operating cash flows or working capital of the Company.

In addition, as discussed in Note 4, on September 30,2005, the Company completed the sale to International Business Machines (“IBM”)of its IBM i/p Series RAID component business (“IBM i/p Series RAIDBusiness”) and on September 29, 2005 the Company’s Board of Directorsapproved management’s recommendation to divest its systems business. Both ofthese businesses have been accounted for as discontinued operations. Accordingly,the Company has reclassified the underlying Unaudited Condensed ConsolidatedStatements of Operations and Unaudited Condensed Consolidated Statements ofCash Flows and related disclosures for all periods presented to reflect the IBMi/p Series RAID Business and the systems business as discontinuedoperations. In the third quarter of fiscal 2006, in conjunction with therenegotiation of a customer supply contract, the Company decided to retain aproduct line that was previously classified within discontinued systemsbusiness. Accordingly, the Company has reclassified the underlying UnauditedCondensed Consolidated Statements of Operations and Unaudited CondensedConsolidated Statements of Cash Flows and related disclosures for all periodspresented to reflect that product line as part of continuing operations.

Unless otherwise indicated and other than balancesheet amounts as of March 31, 2005, the Notes to the Unaudited CondensedConsolidated Financial Statements relate to the discussion of the Company’scontinuing operations.

The glossary of keyacronyms used in the Company’s industry and accounting rules andregulations referred to within this Quarterly Report on Form 10-Q islisted in alphabetical order in Note 20.

6

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**2. Recent AccountingPronouncements**

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

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) requirescompanies to apply a fair-value based measurement method in accounting forshare-based payment transactions with employees and to record compensationexpense for all stock awards granted and to awards modified, repurchased orcancelled after the required effective date. In addition, the Company isrequired to record compensation expense (as previous awards continue to vest)for the unvested portion of previously granted awards that remain outstandingat the date of adoption. In April 2005, the SEC approved that SFAS No. 123(R) willbe effective for annual periods, as opposed to interim periods as originallyissued by the FASB, beginning after June 15, 2005. In March 2005, theSEC issued SAB 107, which offers guidance on SFAS No. 123(R). SAB 107 wasissued to assist preparers by simplifying some of the implementation challengesof SFAS No. 123(R) while enhancing the information that investorsreceive. The Company intends to use the modified prospective method, which willresult in a significant increase to expenses on the Company’s consolidatedfinancial statements beginning April 1, 2006. The Company cannot currentlyquantify the impact of the adoption of SFAS No. 123(R) and SAB107 as it will depend on the amount of share-based payments that the Companygrants in the future as well as other variables that affect the fair marketvalue estimates which cannot be forecasted at this time. The pro formadisclosures of the impact of SFAS No. 123 provided in Note 3 may notbe representative of the impact of adopting this statement.

In November 2004, theFASB issued SFAS No. 151, which clarifies the accounting for abnormalamounts of facility expense, freight, handling costs and wasted materials(spoilage) to require them to be recognized as current-period charges. Thisstatement is effective for inventory costs incurred during fiscal yearsbeginning after June 15, 2005. Earlier application is permitted. Theadoption of this standard is not expected to have a material impact on theCompany’s financial statements.

**3. Stock-BasedCompensation**

The Company accounts for stock-based compensationusing the intrinsic-value-based method, which is in accordance with APB OpinionNo. 25 as interpreted by FIN 44, and complies with the disclosureprovisions of SFAS No. 148, an amendment of SFAS No. 123. The Companyaccounts for equity instruments issued to non-employees in accordance with theprovisions of SFAS No. 123 and EITF No. 96-18, which requiresthat such equity instruments be recorded at their fair value on the measurementdate, which is typically the date of grant.

7

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Thefollowing table illustrates the effect on net income (loss) and net income(loss) per share as if the Company had applied the fair value recognitionprovisions of SFAS No. 123 to employee and director stock 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, 2005**                                       | ** ** | **December 31, 2004**       | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| ** **                                                                                                | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net income  (loss), as reported                                                                           |       |                                                                  | $          | (3,261                                | )          |   |   | $ | 22,489 |   |   |   | $ | (145,040 | ) |   |   | $ | 14,436 |   |   |
| Add: Deferred  stock-based compensation expense included in reported net income (loss)                    |       |                                                                  | 223        |                                  |       |   | 775 |   |   |   | 1,526 |   |   |   | 2,453 |   |   |
| Deduct: Total  stock-based compensation expense determined under the fair value-based  method, net of tax |       |                                                                  | (3,740     | )                                     |       |   | (3,837 | ) |   |   | (10,120 | ) |   |   | (9,923 | ) |   |
| Pro forma net  income (loss)                                                                              |       |                                                                  | $          | (6,778                                | )          |   |   | $ | 19,427 |   |   |   | $ | (153,634 | ) |   |   | $ | 6,966 |   |   |
| Basic net income (loss)  per share:                                                                       |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                               |       |                                                                  | $          | (0.03                                 | )          |   |   | $ | 0.20 |   |   |   | $ | (1.28 | ) |   |   | $ | 0.13 |   |   |
| Pro forma                                                                                                 |       |                                                                  | $          | (0.06                                 | )          |   |   | $ | 0.17 |   |   |   | $ | (1.36 | ) |   |   | $ | 0.06 |   |   |
| Diluted net income  (loss) per share:                                                                     |       |                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                               |       |                                                                  | $          | (0.03                                 | )          |   |   | $ | 0.17 |   |   |   | $ | (1.28 | ) |   |   | $ | 0.12 |   |   |
| Pro forma                                                                                                 |       |                                                                  | $          | (0.06                                 | )          |   |   | $ | 0.15 |   |   |   | $ | (1.36 | ) |   |   | $ | 0.06 |   |   |

 

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.

Thefair value of options granted in the third quarter and first nine months offiscal 2006 and 2005, as reported were estimated at the date of grant using theBlack-Scholes valuation model with the following weighted average assumptions:

| ** **                    | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|-------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **December 31, 2005**        | ** ** | **December 31, 2004**       | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| Employee Stock  Option Plans: |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Expected life (in  years)     |       |                                   | 4.3        |                                  |       |   | 2.0 |   |   |   | 2.5 |   |   |   | 2.3 |   |   |
| Risk-free  interest rates     |       |                                   | 4.4        | %                                     |       |   | 3.1 | % |   |   | 4.1 | % |   |   | 3.0 | % |   |
| Expected  volatility          |       |                                   | 52         | %                                     |       |   | 39 | % |   |   | 38 | % |   |   | 44 | % |   |
| Dividend yield                |       |                                   | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |
| ESPP:                         |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Expected life (in  years)     |       |                                   | 1.3        |                                  |       |   | 1.4 |   |   |   | 1.1 |   |   |   | 1.4 |   |   |
| Risk-free  interest rates     |       |                                   | 3.9        | %                                     |       |   | 2.1 | % |   |   | 3.8 | % |   |   | 2.1 | % |   |
| Expected  volatility          |       |                                   | 40         | %                                     |       |   | 50 | % |   |   | 39 | % |   |   | 50 | % |   |
| Dividend yield                |       |                                   | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |

 

8

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**4. Discontinued Operations**

**IBM i/p Series RAIDBusiness:**

On September 30, 2005, the Company entered into aseries of arrangements with IBM pursuant to which the Company sold its IBM i/p Series RAIDBusiness to IBM for approximately $22.0 million plus $1.3 million for certainfixed assets. In addition, IBM purchased certain related inventory at theCompany’s net book value of $0.8 million. Expenses incurred in the transactionprimarily included costs of approximately $0.5 million for legal and accountingfees. In addition, the Company accrued $0.3 million for lease obligations.Under the terms of the agreements, the Company granted IBM a nonexclusivelicense to certain intellectual property and sold to IBM substantially all ofthe assets dedicated to the engineering and manufacturing of RAID controllersand connectivity products for the IBM i/p Series RAID Business. Under theterms of the nonexclusive license, IBM will pay royalties to the Company forthe sale of its board-level products over the next six quarters, which will berecognized as contingent consideration in discontinued operations when earned.In the third quarter of fiscal 2006, the Company received royalties of $3.5million, which the Company recorded in “Income (loss) from disposal ofdiscontinued operations, net of taxes,” in the Unaudited Condensed ConsolidatedStatements of Operations.

Netrevenues and the components of income (loss) related to these discontinuedoperations, which were previously included in the Company’s DPS segment, wereas follows:

| ** **                                                     | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                     | ** ** | **December 31, 2005**        | ** ** | **December 31, 2004**       | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| ** **                                                     | ** ** | **(in thousands)**                | ** ** |
| Net revenues                                                   |       |                                   | $          | 237                                   |       |   |   | $ | 9,870 |   |   |   | $ | 20,046 |   |   |   | $ | 15,056 |   |   |
| Income (loss) from discontinued operations before income taxes |       |                                   | 424        |                                  |       |   | (3,341 | ) |   |   | (14,239 | ) |   |   | (8,945 | ) |   |
| Provision for  (benefit from) income taxes                     |       |                                   | 282        |                                  |       |   | (11,714 | ) |   |   | (360 | ) |   |   | (903 | ) |   |
| Income (loss) from  discontinued operations, net of taxes      |       |                                   | $          | 142                                   |       |   |   | $ | 8,373 |   |   |   | $ | (13,879 | ) |   |   | $ | (8,042 | ) |   |

 

Thecomponents of net assets, at the time of the sale of the IBM i/p Series RAIDBusiness, were as follows:

| ** **                             | ** ** | **September 30, 2005** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| ** **                             | ** ** | **(in thousands)**          | ** ** |
| Inventories                            |       |                             | $          | 838 |   |   |
| Prepaid expenses                       |       |                             | 11,139     |   |   |
| Property and equipment,  net           |       |                             | 3,326      |   |   |
| Other  intangibles, net                |       |                             | 10,958     |   |   |
| Other long-term  assets                |       |                             | 24,507     |   |   |
| Accrued  liabilities                   |       |                             | (10,051    | ) |   |
| Other long-term  liabilities           |       |                             | (10,625    | ) |   |
| Net assets of  discontinued operations |       |                             | $          | 30,092 |   |   |

 

Accounts receivablerelated to the IBM i/p Series RAID Business were not included indiscontinued operations as the Company will be retaining these assets.

9

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**Systems Business:**

On September 29, 2005, the Company’s Board ofDirectors approved management’s recommendation to divest its systems business,which includes substantially all of the operating assets and cash flows thatwere obtained through the Snap Appliance and Eurologic Systems acquisitions aswell as internally developed hardware and software. In connection with thisaction, the Company has classified the systems business as a discontinuedoperation in the financial statements. The Company has entered into anexclusive arrangement with an investment banker to sell this business andexpects to receive proceeds, less cost to sell, in excess of its carryingvalue.

In the third quarter of fiscal 2006, in conjunctionwith the renegotiation of a customer supply contract, the Company decided toretain a product line that was previously classified within discontinuedsystems business. Accordingly, the Company has reclassified the underlyingUnaudited Condensed Consolidated Statements of Operations and UnauditedCondensed Consolidated Statements of Cash Flows and related disclosures for allperiods presented to reflect that product line as part of continuingoperations.

Netrevenues and the components of net loss related to the discontinued operations,were as follows:

| ** **                                                          | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                          | ** ** | **December 31, 2005**        | ** ** | **December 31, 2004**       | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| ** **                                                          | ** ** | **(in thousands)**                | ** ** |
| Net revenues                                                        |       |                                   | $          | 18,958                                |       |   |   | $ | 23,205 |   |   |   | $ | 53,704 |   |   |   | $ | 56,395 |   |   |
| Loss from discontinued operations before provision for income taxes |       |                                   | (3,501     | )                                     |       |   | (2,729 | ) |   |   | (16,651 | ) |   |   | (10,510 | ) |   |
| Provision for  (benefit from) income taxes                          |       |                                   | 790        |                                  |       |   | 120 |   |   |   | 515 |   |   |   | (1,460 | ) |   |
| Loss from discontinued  operations, net of taxes                    |       |                                   | $          | (4,291                                | )          |   |   | $ | (2,849 | ) |   |   | $ | (17,166 | ) |   |   | $ | (9,050 | ) |   |

 

Thecomponents of net assets related to the discontinued operations were asfollows:

| ** **                                      | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **(in thousands)**         | ** ** |
| Inventories                                     |       |                            | $          | 4,522 |   |   |
| Prepaid expenses                                |       |                            | 75         |   |   |
| Current assets of discontinued operations       |       |                            | 4,597      |   |   |
| Property and  equipment, net                    |       |                            | 1,145      |   |   |
| Other  intangibles, net                         |       |                            | 24,730     |   |   |
| Other long-term  assets                         |       |                            | 9          |   |   |
| Total assets of discontinued operations         |       |                            | 30,481     |   |   |
| Accrued  liabilities                            |       |                            | (5,336     | ) |   |
| Current  liabilities of discontinued operations |       |                            | (5,336     | ) |   |
| Net assets of  discontinued operations          |       |                            | $          | 25,145 |   |   |

 

Accounts receivable related tothe systems business were not included in discontinued operations as theCompany intends to retain these assets.

10

----

**5. Balance Sheet Details**

**Inventories:**

| ** **      | ** ** | **December 31, 2005** | ** ** | **March 31, 2005** | ** ** |
|-----------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **      | ** ** | **(in thousands)**         | ** ** |
| Raw materials   |       |                            | $          | 10,775                       |       |   |   | $ | 15,914 |   |   |
| Work-in-process |       |                            | 6,334      |                         |       |   | 7,435 |   |   |
| Finished goods  |       |                            | 5,332      |                         |       |   | 36,855 |   |   |
| Total           |       |                            | $          | 22,441                       |       |   |   | $ | 60,204 |   |   |

 

**Accrued Liabilities:**

| ** **                              | ** ** | **December 31, 2005** | ** ** | **March 31, 2005** | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                              | ** ** | **(in thousands)**         | ** ** |
| Tax related                             |       |                            | $          | 46,632                       |       |   |   | $ | 57,538 |   |   |
| Acquisition  related                    |       |                            | 3,604      |                         |       |   | 6,748 |   |   |
| Accrued  compensation and related taxes |       |                            | 19,676     |                         |       |   | 18,304 |   |   |
| IBM distribution  agreement             |       |                            | —     |                         |       |   | 11,575 |   |   |
| Other                                   |       |                            | 16,155     |                         |       |   | 21,842 |   |   |
| Total                                   |       |                            | $          | 86,067                       |       |   |   | $ | 116,007 |   |   |

 

**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 2006 was as follows:

| ** **                         | ** ** | **OEM**                 | ** ** | **Channel** | ** ** | **Total** | ** ** |
|------------------------------------|------------|-------------------------|------------|-------------|------------|-----------|------------|
| ** **                         | ** ** | **(in thousands)** | ** ** |
| Balance at  March 31, 2005    |       | $                       | 48,783     |        | $          | 42,703    |       | $ | 91,486 |   |
| Goodwill  adjustments              |       | (166                    | )          | (718        | )          | (884      | )          |
| Goodwill  impairment               |       | (48,617                 | )          | (41,985     | )          | (90,602   | )          |
| Balance at  December 31, 2005 |       | $                       | —     |        | $          | —    |       | $ | — |   |

 

In the first quarter offiscal 2006, adjustments were made to goodwill for changes to theacquisition-related restructuring reserves and other purchase price adjustmentsfor the IBM i/p Series RAID business and Snap Appliance. As a result ofthe segment reorganization, discussed in Note 15, an assessment of therecoverability of goodwill was performed. Impairment of goodwill is tested atthe Company’s operating segment level by comparing each segment’s carryingamount, including goodwill, to the fair value of that segment. To determinefair value, the Company’s review process uses the income, or discounted cashflows, approach and the market approach. In performing its analysis, theCompany uses the best information available under the circumstances, includingreasonable and supportable assumptions and projections. If the carrying amountof the operating segment exceeds its implied fair value, goodwill is consideredimpaired and a second step is performed to measure the amount of impairmentloss, if any. As a result of this review, the Company wrote-off its entirebalance of goodwill of $90.6 million in the second quarter of fiscal 2006. Factorsthat led to this conclusion were industry technology changes such as the shiftfrom parallel to serial technology and the migration of core functionality toserver chipsets; required increased investments that eventually led the Companyto sell the IBM i/p Series RAID Business and the proposed sale of thesystems business; continued losses associated with sales of systems to IBM; andgeneral market conditions.

11

----

**Other IntangibleAssets:**

| ** **                                 | ** ** | **December 31, 2005** | ** ** | **March 31, 2005**  | ** ** |
|--------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                 | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **                                 | ** ** | **(in thousands)**         | ** ** |
| Acquisition-related  intangible assets:    |       |                            |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Patents, core and existing technologies    |       |                            | $          | 39,578                        |       |   |   | $ | (27,861 | ) |   |   | $ | 74,009 |   |   |   | $ | (26,265 | ) |   |
| Supply agreement                           |       |                            | —     |                          |       |   | — |   |   |   | 7,600 |   |   |   | (1,140 | ) |   |
| Customer relationships                     |       |                            | 1,047      |                          |       |   | (708 | ) |   |   | 1,290 |   |   |   | (631 | ) |   |
| Trade names                                |       |                            | 674        |                          |       |   | (577 | ) |   |   | 10,930 |   |   |   | (1,523 | ) |   |
| Foundry agreement                          |       |                            | —     |                          |       |   | — |   |   |   | 600 |   |   |   | (90 | ) |   |
| Subtotal                                   |       |                            | 41,299     |                          |       |   | (29,146 | ) |   |   | 94,429 |   |   |   | (29,649 | ) |   |
| Intellectual  property assets and warrants |       |                            | 41,623     |                          |       |   | (32,037 | ) |   |   | 41,942 |   |   |   | (27,265 | ) |   |
| Total                                      |       |                            | $          | 82,922                        |       |   |   | $ | (61,183 | ) |   |   | $ | 136,371 |   |   |   | $ | (56,914 | ) |   |

 

Amortization of other intangible assets was $3.3million and $4.1 million in the third quarter of fiscal 2006 and 2005,respectively. Amortization of other intangible assets was $10.5 million and$12.5 million in the first nine months of fiscal 2006 and 2005,respectively.

Theannual amortization expense of the other intangible assets that existed as of December 31,2005 is expected to be as follows:

| ** **                     | ** ** | **Estimated Amortization Expense**    | ** ** |
|--------------------------------|------------|-------------------------------------------------|------------|
| ** **                     | ** ** | **Acquisition-related  Intangible Assets** | ** ** | **Intellectual  Property Assets** | ** ** |
| ** **                     | ** ** | **(in thousands)**                         | ** ** |
| Fiscal Years:                  |       |                                            |       |   |   |   |   |   |   |
| 2006 (remaining  three months) |       |                                            | $          | 1,688 |   |   |   | $ | 1,579 |   |   |
| 2007                           |       |                                            | 5,726      |   |   |   | 6,316 |   |   |
| 2008                           |       |                                            | 2,534      |   |   |   | 1,691 |   |   |
| 2009                           |       |                                            | 2,205      |   |   |   | — |   |   |
| 2010 and  thereafter           |       |                                            | —     |   |   |   | — |   |   |
| Total                          |       |                                            | $          | 12,153 |   |   |   | $ | 9,586 |   |   |

 

**7. Interest and OtherIncome**

Thecomponents of interest and other income for the third quarter and first ninemonths of fiscal 2006 and 2005, were as follows:

| ** **                                   | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **December 31, 2005**        | ** ** | **December 31, 2004**       | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                | ** ** |
| Interest income                              |       |                                   | $          | 4,450                                 |       |   |   | $ | 2,833 |   |   |   | $ | 11,993 |   |   |   | $ | 8,593 |   |   |
| Payment of  license fee with NSE        |       |                                   | —     |                                  |       |   | (442 | ) |   |   | — |   |   |   | (1,692 | ) |   |
| Loss on  redemption of debt                  |       |                                   | —     |                                  |       |   | — |   |   |   | (102 | ) |   |   | — |   |   |
| Foreign currency  transaction gains (losses) |       |                                   | (241       | )                                     |       |   | 461 |   |   |   | (621 | ) |   |   | 800 |   |   |
| Other                                        |       |                                   | 270        |                                  |       |   | 245 |   |   |   | 1,340 |   |   |   | 898 |   |   |
| Total                                        |       |                                   | $          | 4,479                                 |       |   |   | $ | 3,097 |   |   |   | $ | 12,610 |   |   |   | $ | 8,599 |   |   |

 

12

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In the first nine months of fiscal 2006, the Companyrepurchased $23.2 million in aggregate principal amount of its 3% ConvertibleSubordinated Notes (“3% Notes”) on the open market for an aggregate price of$23.1 million, resulting in an immaterial loss. The loss on extinguishmentof debt has been included in “Interest and other income” in the Company’sUnaudited Condensed Consolidated Statement of Operations. Subsequent to thethird quarter of fiscal 2006, the Company repurchased $1.4 million of the 3%Notes on the open market for $1.3 million, resulting in an immaterial gain. Thegain on extinguishment of debt will be included in “Interest and other income”in the Company’s Consolidated Statement of Operations in the fourth quarter offiscal 2006.

In June 2004, theCompany, Nevada SCSI Enterprises, Inc. and Thomas A. Gafford (jointly, “NSE”)entered into a license and release agreement, pursuant to which the Companypaid NSE $1.3 million as a one-time, fully paid-up license payment fee tosettle NSE’s claims that some of the Company’s products infringed certainpatents. The license and release agreement expressly excluded any sales ofproducts made by Eurologic prior to the Company’s April 2003 acquisitionof Eurologic. In November 2004, the Company exercised its option to securea license and release with respect to such Eurologic sales by payment to NSE ofa royalty fee of $0.4 million. The Company has filed a claim against theEurologic acquisition Holdback for the $0.4 million royalty it paid withrespect to Eurologic’s pre-acquisition sales. The Eurologic shareholders aredisputing the Company’s right to withhold the $0.4 million from theHoldback. See Note 13 for further discussion of the Eurologic Holdback.

**8. Restructuring Charges**

In the third quarter of fiscal 2006, managementapproved and initiated a plan to restructure the operations of the Company bysimplifying its infrastructure. The third quarter of fiscal 2006 restructuringplan eliminated certain duplicative resources in all functions of theorganization worldwide, due in part, to the discontinued operations and vacatedredundant facilities in order to reduce the combined cost structure of theCompany. This resulted in a restructuring charge of $2.4 million for the thirdquarter of fiscal 2006.

The Company recorded provision adjustments of $0.2million and $0.7 million in the third quarter of fiscal 2006 and first ninemonths of fiscal 2006, respectively, related to severance and benefits asactual costs were lower than anticipated and additional lease costs related tothe estimated loss on facilities that the Company subleased. The provisionadjustments also include additional lease costs related to the estimated losson facilities that the Company subleased in connection with Snap Applianceacquisition (Note 18). These provision adjustments pertained to therestructuring plans that the Company implemented in each quarter of fiscal2005, and restructuring plans that it implemented in fiscal 2004, fiscal 2003,fiscal 2002 and fiscal 2001. The fiscal 2004 restructuring plan was completedin the first quarter of fiscal 2006. The third quarter of fiscal 2005restructuring plan and fourth quarter of fiscal 2005 restructuring plan werecompleted in the third quarter of fiscal 2006. For a complete discussion of allrestructuring actions that were implemented prior to fiscal 2006, please referto the Notes to Consolidated Financial Statements included in the Company’sAnnual Report on Form 10-K for the fiscal year ended March 31,2005. All expenses, including adjustments, associated with the Company’srestructuring plans are included in “Restructuring charges” in the UnauditedCondensed Consolidated Statements of Operations and are not allocated tosegments, but are managed at the corporate level.

13

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Theactivity in the accrued restructuring reserves related to all of the plans wasas follows for the first nine months of fiscal 2006:

| ** **                                 | ** ** | **Severance And  Benefits** | ** ** | **Other Charges** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                 | ** ** | **(in thousands)**          | ** ** |
| Reserve balance  at March 31, 2005    |       |                             | $          | 896                    |       |      |       | $ | 1,627 |   |   | $ | 2,523 |   |
| Q3’06  Restructuring Plan             |       |                             | 1,738      |                   |       |      | 695        |   |   | 2,433 |   |
| Provision  adjustments                     |       |                             | (288       | )                      |       |      | 716        |   |   | 428 |   |
| Cash paid                                  |       |                             | (1,886     | )                      |       |      | (1,037     | ) |   | (2,923 | ) |
| Reserve balance  at December 31, 2005 |       |                             | $          | 460                    |       |      |       | $ | 2,001 |   |   | $ | 2,461 |   |

 

The Company anticipatesthat the remaining restructuring reserve balance of $2.5 million will besubstantially paid out by the first quarter of fiscal 2009, primarilyattributable to longer term lease obligations. The remaining restructuring reserve balance is reflected both in “Accruedliabilities” and “Other long-term liabilities” in the Unaudited CondensedConsolidated Balance Sheet.

**9. Other Charges (Gains)**

In January 2006, the Company entered into athree-year contract manufacturing agreement with Sanmina-SCI whereby Sanmina-SCIhas assumed manufacturing operations of Adaptec products. In addition, theCompany sold certain manufacturing assets, buildings and improvements andinventory located in Singapore to Sanmina-SCI. In connection with thisagreement, the Company recorded a loss on disposal of assets of $1.5 millionthat was recorded in the third quarter of fiscal 2006 in “Other charges(gains)” on the Unaudited Condensed Consolidated Statements of Operations.Please refer to Note 17 for further details.

In October 2004, the Company completed the saleof certain properties in Milpitas, California that were previously classifiedas held for sale. Net proceeds from the sale of the properties aggregated$9.6 million, 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 $2.8 million wasrecorded in the third quarter of fiscal 2005 as a credit to “Other charges(gains)” in the Unaudited Condensed ConsolidatedStatements of Operations.

**10. Net Income (Loss) Per Share**

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 (loss) per share gives effectto all potentially dilutive common shares outstanding during the period, whichinclude certain stock options and warrants, calculated using the treasury stockmethod, and convertible notes which are potentially dilutive at certainearnings levels, and are computed using the if-converted method.

14

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Areconciliation of the numerator and denominator of the basic and diluted income(loss) per share computations for continuing operations, discontinuedoperations and net income (loss) were as follows:

| ** **                                                                               | ** ** | **Three-Month Period Ended**                                | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **Continuing Operations**                                        | ** ** | **Discontinued Operations** | ** ** | **Net Income (Loss)** | ** ** |
| ** **                                                                               | ** ** | **December 31,  2005**                                           | ** ** | **December 31,  2004** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| ** **                                                                               | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Numerators:                                                                              |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss)                                                                            |       |                                                                  | $          | (2,614 | ) |   |   | $ | 16,965 |   |   |   | $ | (647 | ) |   |   | $ | 5,524 |   |   |   | $ | (3,261 | ) |   |   | $ | 22,489 |   |   |
| Adjustment for interest expense on 3⁄4% Notes, net of  taxes                          |       |                                                                  | —     |   |   |   | 454 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 454 |   |   |
| Adjustment for interest expense on 3% Notes, net of  taxes                               |       |                                                                  | —     |   |   |   | 196 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 196 |   |   |
| Adjusted income (loss)                                                                   |       |                                                                  | $          | (2,614 | ) |   |   | $ | 17,615 |   |   |   | $ | (647 | ) |   |   | $ | 5,524 |   |   |   | $ | (3,261 | ) |   |   | $ | 23,139 |   |   |
| Denominators:                                                                            |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding—basic                                           |       |                                                                  | 113,531    |   |   |   | 111,136 |   |   |   | 113,531 |   |   |   | 111,136 |   |   |   | 113,531 |   |   |   | 111,136 |   |   |
| Effect of  dilutive securities:                                                          |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Employee stock options and other                                                         |       |                                                                  | —     |   |   |   | 1,859 |   |   |   | — |   |   |   | 1,859 |   |   |   | — |   |   |   | 1,859 |   |   |
| 3⁄4% Notes                                                                            |       |                                                                  | —     |   |   |   | 19,224 |   |   |   | — |   |   |   | 19,224 |   |   |   | — |   |   |   | 19,224 |   |   |
| 3% Notes                                                                                 |       |                                                                  | —     |   |   |   | 2,298 |   |   |   | — |   |   |   | 2,298 |   |   |   | — |   |   |   | 2,298 |   |   |
| Weighted average shares and potentially dilutive  common shares outstanding—diluted |       |                                                                  | 113,531    |   |   |   | 134,517 |   |   |   | 113,531 |   |   |   | 134,517 |   |   |   | 113,531 |   |   |   | 134,517 |   |   |
| Income (loss) per  share:                                                                |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                    |       |                                                                  | $          | (0.02 | ) |   |   | $ | 0.15 |   |   |   | $ | (0.01 | ) |   |   | $ | 0.05 |   |   |   | $ | (0.03 | ) |   |   | $ | 0.20 |   |   |
| Diluted                                                                                  |       |                                                                  | $          | (0.02 | ) |   |   | $ | 0.13 |   |   |   | $ | (0.01 | ) |   |   | $ | 0.04 |   |   |   | $ | (0.03 | ) |   |   | $ | 0.17 |   |   |

 

15

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| ** **                                                                               | ** ** | **Nine-Month Period Ended**                                 | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **Continuing Operations**                                        | ** ** | **Discontinued Operations** | ** ** | **Net Income (Loss)** | ** ** |
| ** **                                                                               | ** ** | **December 31,  2005**                                           | ** ** | **December 31,  2004** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| ** **                                                                               | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Numerators:                                                                              |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss)                                                                            |       |                                                                  | $          | (110,521 | ) |   |   | $ | 31,528 |   |   |   | $ | (34,519 | ) |   |   | $ | (17,092 | ) |   |   | $ | (145,040 | ) |   |   | $ | 14,436 |   |   |
| Adjustment for interest expense on 3⁄4% Notes, net of  taxes                          |       |                                                                  | —     |   |   |   | 1,371 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,371 |   |   |
| Adjustment for interest expense on 3% Notes, net of  taxes                               |       |                                                                  | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Adjusted income (loss)                                                                   |       |                                                                  | $          | (110,521 | ) |   |   | $ | 32,899 |   |   |   | $ | (34,519 | ) |   |   | $ | (17,092 | ) |   |   | $ | (145,040 | ) |   |   | $ | 15,807 |   |   |
| Denominators:                                                                            |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding—basic                                           |       |                                                                  | 112, 980   |   |   |   | 110,429 |   |   |   | 112,980 |   |   |   | 110,429 |   |   |   | 112,980 |   |   |   | 110,429 |   |   |
| Effect of  dilutive securities:                                                          |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Employee stock options and other                                                         |       |                                                                  | —     |   |   |   | 1,954 |   |   |   | — |   |   |   | 1,954 |   |   |   | — |   |   |   | 1,954 |   |   |
| 3⁄4% Notes                                                                            |       |                                                                  | —     |   |   |   | 19,224 |   |   |   | — |   |   |   | 19,224 |   |   |   | — |   |   |   | 19,224 |   |   |
| 3% Notes                                                                                 |       |                                                                  | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Weighted average shares and potentially dilutive  common shares outstanding—diluted |       |                                                                  | 112,980    |   |   |   | 131,607 |   |   |   | 112,980 |   |   |   | 131,607 |   |   |   | 112,980 |   |   |   | 131,607 |   |   |
| Income (loss) per  share:                                                                |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                    |       |                                                                  | $          | (0.98 | ) |   |   | $ | 0.29 |   |   |   | $ | (0.31 | ) |   |   | $ | (0.15 | ) |   |   | $ | (1.28 | ) |   |   | $ | 0.13 |   |   |
| Diluted                                                                                  |       |                                                                  | $          | (0.98 | ) |   |   | $ | 0.25 |   |   |   | $ | (0.31 | ) |   |   | $ | (0.13 | ) |   |   | $ | (1.28 | ) |   |   | $ | 0.12 |   |   |

 

16

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Diluted loss per sharefrom continuing operations, discontinued operations and net loss for the thirdquarter and first nine months of fiscal 2006 was based only on theweighted-average number of shares outstanding during the period, as theinclusion of any common stock equivalents would have been anti-dilutive. Inaddition, certain potential common shares were excluded from the dilutedcomputation from continuing operations, discontinued operations and net incomefor the third quarter and first nine months of fiscal 2005 because theirinclusion would have been anti-dilutive. The items excluded for the thirdquarters and first nine months of fiscal 2006 and 2005 from continuingoperations, discontinued operations and net income (loss) were as follows:

| ** **                          | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **December 31,  2005**            | ** ** | **December 31,  2004**           | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| ** **                          | ** ** | **(in thousands)**                | ** ** |
| Outstanding employee  stock options |       |                                   | 23,549     |                                  |       |   | 13,971 |   |   |   | 22,939 |   |   |   | 14,478 |   |   |
| Warrants(1)                         |       |                                   | 19,874     |                                  |       |   | 19,624 |   |   |   | 19,874 |   |   |   | 19,624 |   |   |
| 3⁄4% Notes                       |       |                                   | 19,224     |                                  |       |   | — |   |   |   | 19,224 |   |   |   | — |   |   |
| 3% Notes                            |       |                                   | 783        |                                  |       |   | — |   |   |   | 1,030 |   |   |   | 2,298 |   |   |

----

(1)          Inconnection with the issuance of its 3⁄4%Notes, the Company entered into a derivative financial instrument to repurchaseup to 19,224,000 shares of its common stock, at the Company’s option, atspecified prices in the future to mitigate any potential dilution as a resultof the conversion of the 3⁄4% Notes.For further discussion on this derivative financial instrument, please refer toNote 6 of the Notes to Consolidated Financial Statements in the Company’sAnnual Report on Form 10-K for the fiscal year ended March 31,2005.

**11. Comprehensive Income (Loss)**

TheCompany’s comprehensive income (loss), which consisted of net loss and thechanges in net unrealized gains (losses) on marketable securities, net oftaxes, and foreign currency translation adjustments, net of taxes, were asfollows:

| ** **                                                    | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                    | ** ** | **December 31,  2005**            | ** ** | **December 31,  2004**           | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                | ** ** |
| Net income (loss)                                             |       |                                   | $          | (3,261                                | )          |   |   | $ | 22,489 |   |   |   | $ | (145,040 | ) |   |   | $ | 14,436 |   |   |
| Net unrealized  losses on marketable securities, net of taxes |       |                                   | (739       | )                                     |       |   | (921 | ) |   |   | (1,549 | ) |   |   | (3,955 | ) |   |
| Foreign currency  translation adjustment, net of taxes        |       |                                   | (286       | )                                     |       |   | 1,089 |   |   |   | (1,248 | ) |   |   | 1,036 |   |   |
| Comprehensive income  (loss)                                  |       |                                   | $          | (4,286                                | )          |   |   | $ | 22,657 |   |   |   | $ | (147,837 | ) |   |   | $ | 11,517 |   |   |

 

Thecomponents of accumulated other comprehensive income (loss), net of taxes, wereas follows:

| ** **                                                                                                 | ** ** | **December 31, 2005** | ** ** | **March 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                                                                                 | ** ** | **(in thousands)**         | ** ** |
| Unrealized losses  on marketable securities                                                                |       |                            | $          | (2,095                       | )          |   |   | $ | (546 | ) |   |
| Foreign currency  translation, net of tax of $3 at December 31, 2005 and $834 at  March 31, 2005 |       |                            | 4          |                         |       |   | 1,252 |   |   |
| Total                                                                                                      |       |                            | $          | (2,091                       | )          |   |   | $ | 706 |   |   |

 

17

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**12. Income Taxes**

Income tax provisions forinterim periods are based on the Company’s estimated annual income tax. Theestimated annual tax for fiscal 2006 primarily consists of foreign taxesrelated to the Company’s foreign subsidiaries and interest accrued on prioryears’ tax disputes. The Company currently has a full valuation allowance onits net U.S. deferred tax assets. 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 rate for the third quarter and the firstnine months of fiscal 2005 also differed from the combined United StatesFederal and state statutory income tax rate of 40% due to tax benefits of$21.9 million and $31.9 million respectively from discrete events relatingto the method and amount of settled controversies. As a result of thesettlements, $21.9 million previously recorded as a tax provision wasreversed during 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 has been reversed, and a $4.0 million tax benefit associatedwith a refund claim has been recognized during the second quarter of fiscal2005.

**13. Commitments and Contingencies**

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

On December 15, 2000, the Company received astatutory notice of deficiency from the IRS with respect to its Federal incometax return for fiscal 1997. The Company filed a Petition with the United StatesTax Court on March 14, 2001, contesting the asserted deficiencies.Settlement agreements have been filed with the United States Tax Court on allbut one issue. The Company believes that the final outcome of all issues willnot have a material adverse impact on its financial position or results ofoperations, as the Company believes that it has meritorious defenses againstthe asserted deficiencies and any proposed adjustments and that it has 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 2003. In the thirdquarter of fiscal 2005, the Company resolved all issues for fiscal 1998 throughfiscal 2001, other than the rollover impact of any potential resolution on theremaining fiscal 1997 issue and tax credits that were generated but not used insubsequent years that may be carried back. The Company believes that it hasprovided sufficient tax provisions for these years and the ultimate outcome ofthe IRS audits will not have a material adverse impact on its financialposition or results of operations in future periods. However, the Company cannotpredict with certainty how these matters will be resolved and whether it willbe required to make additional tax payments.

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

18

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In connection with theCompany’s acquisitions of Snap Appliance, Eurologic, Elipsan Limited (“Elipsan”),and Platys Communications, Inc. (“Platys”), a portion of the purchaseprice and other future payments totaling $6.7 million, $3.8 million, $2.0million and $15.0 million, respectively, were held back (the “Holdbacks”) forunknown liabilities that may have existed as of the acquisition dates. TheCompany has asserted claims against the Snap Appliance, Eurologic and PlatysHoldbacks totaling $3.0 million, $1.5 million and $0.7 million, respectively. TheElipsan Holdback of $2.0 million was paid in the second quarter of fiscal 2006.

**14. Guarantees**

*IntellectualProperty Indemnification Obligations*

The Company has enteredinto agreements with customers and suppliers that include intellectual propertyindemnification obligations. These indemnification obligations generallyrequire the Company to compensate the other party for certain damages and costsincurred as a result of third party intellectual property claims arising fromthese transactions. In each of these circumstances, payment by the Company isconditional on the other party making a claim pursuant to the proceduresspecified in the particular contract, which procedures typically allow theCompany to challenge the other party’s claims. Further, the Company’sobligations under these agreements may be limited in terms of time and/oramount, and in some instances, the Company may have recourse against 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.

*Product Warranty*

The Company provides an accrual for estimated futurewarranty costs based upon the historical relationship of warranty costs tosales. The estimated future warranty obligations related to product sales arerecorded in the period in which the related revenue is recognized. Theestimated future warranty obligations are affected by product failure rates,material usage and replacement costs incurred in correcting a product failure.If actual product failure rates, material usage or replacement costs differfrom the Company’s estimates, revisions to the estimated warranty obligationswould be required; however, the Company made no adjustments to pre-existingwarranty accruals in the first nine months of fiscal 2006 and 2005.

Areconciliation of the changes to the Company’s warranty accrual for the firstnine months of fiscal 2006 and 2005 was as follows:

| ** **                                                                                  | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                  | ** ** | **December 31, 2005**       | ** ** | **December 31, 2004** | ** ** |
| ** **                                                                                  | ** ** | **(in thousands)**               | ** ** |
| Balance at  beginning of period                                                             |       |                                  | $          | 2,084 |   |   |   | $ | 1,598 |   |   |
| Warranties  assumed                                                                         |       |                                  | —     |   |   |   | 2,562 |   |   |
| Warranties  provided                                                                        |       |                                  | 3,958      |   |   |   | 3,932 |   |   |
| Actual costs  incurred                                                                      |       |                                  | (4,053     | ) |   |   | (4,188 | ) |   |
| Warranties  classified as current liabilities of discontinued operations (Note 4) |       |                                  | (359       | ) |   |   | — |   |   |
| Balance at end of period                                                                    |       |                                  | $          | 1,630 |   |   |   | $ | 3,904 |   |   |

 

19

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**15. Segment Reporting**

In the second quarter of fiscal 2006, the Companyreorganized its internal organization structure related to its OEM and Channelsegments. Where previously the Company’s former OEM and Channel segments eachoffered an integrated set of customer-focused products, the new organization ismanaged at the product level.

Following the reorganization, the Company operated intwo reportable segments: DPS and DSG. A description of the types of customersor products and services provided by each reportable segment is as follows:

·       DPSprovides storage products and currently sells all of its storage technologiesin various form factors, such as board-level products, ASICs, RAID enclosuresand stand-alone software. The Company sells these products directly to OEMs,ODMs that supply OEMs, VARs and end users through its network ofdistribution and reseller customers.

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

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

Summarizedfinancial information on the Company’s reportable segments, under the neworganizational structure, is shown in the following table. The segmentfinancial data for the third quarter of fiscal 2005 and first nine months offiscal 2005 and fiscal 2006 has been restated to reflect this change. Therewere no inter-segment revenues for the periods shown below. The Company doesnot separately track all tangible assets or depreciation by operating segmentsnor are the segments evaluated under these criteria. Segment financialinformation is summarized as follows for the third quarters and first ninemonths of fiscal 2006 and 2005:

| ** **                                        | ** ** | **DPS**                 | ** ** | **DSG** | ** ** | **Other** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|---------|------------|-----------|------------|------------------|------------|
| ** **                                        | ** ** | **(in thousands)** | ** ** |
| Three-Month Period  Ended December 31, 2005: |       |                    |       |    |       |      |       |             |       |   |   |
| Net revenues                                      |       | $                       | 69,130     |    | $          | 8,701     |       | $                | —     |   |   | $ | 77,831 |   |   |
| Segment income (loss)                             |       | 16,778                  |       | (403    | )          | (19,571   | )          |             | (3,196     | ) |   |
| Three-Month Period  Ended December 31, 2004: |       |                    |       |    |       |      |       |             |       |   |   |
| Net revenues                                      |       | $                       | 84,888     |    | $          | 8,585     |       | $                | —     |   |   | $ | 93,473 |   |   |
| Segment income (loss)                             |       | 16,034                  |       | (402    | )          | (20,455   | )          |             | (4,823     | ) |   |
| Nine-Month Period  Ended December 31, 2005:  |       |                    |       |    |       |      |       |             |       |   |   |
| Net revenues                                      |       | $                       | 208,114    |    | $          | 28,617    |       | $                | —     |   |   | $ | 236,731 |   |   |
| Segment income (loss)                             |       | 42,794                  |       | (1,875  | )          | (148,234  | )          |             | (107,315   | ) |   |
| Nine-Month Period  Ended December 31, 2004:  |       |                    |       |    |       |      |       |             |       |   |   |
| Net revenues                                      |       | $                       | 263,756    |    | $          | 28,543    |       | $                | —     |   |   | $ | 292,299 |   |   |
| Segment income  (loss)                            |       | 62,917                  |       | 5,558   |       | (68,410   | )          |             | 65         |   |   |

 

20

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Thefollowing table presents the details of unallocated corporate income andexpenses for the third quarters and first nine months of fiscal 2006 and 2005:

| ** **                           | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **December 31, 2005**        | ** ** | **December 31, 2004**       | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| ** **                           | ** ** | **(in thousands)**                | ** ** |
| Unallocated  corporate expenses, net |       |                                   | $          | (19,233                               | )          |   |   | $ | (22,996 | ) |   |   | $ | (63,067 | ) |   |   | $ | (71,439 | ) |   |
| Restructuring  charges               |       |                                   | (2,587     | )                                     |       |   | (2,228 | ) |   |   | (3,105 | ) |   |   | (4,975 | ) |   |
| Other charges  (gains)               |       |                                   | (1,472     | )                                     |       |   | 2,755 |   |   |   | (1,472 | ) |   |   | 2,755 |   |   |
| Goodwill  impairment                 |       |                                   | —     |                                  |       |   | — |   |   |   | (90,602 | ) |   |   | — |   |   |
| Interest and  other income      |       |                                   | 4,479      |                                  |       |   | 3,097 |   |   |   | 12,610 |   |   |   | 8,599 |   |   |
| Interest expense                     |       |                                   | (758       | )                                     |       |   | (1,083 | ) |   |   | (2,598 | ) |   |   | (3,350 | ) |   |
| Total                                |       |                                   | $          | (19,571                               | )          |   |   | $ | (20,455 | ) |   |   | $ | (148,234 | ) |   |   | $ | (68,410 | ) |   |

 

**16.Supplemental Disclosure of Cash Flows**

| ** **                                        | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | **December 31, 2005**       | ** ** | **December 31, 2004** | ** ** |
| ** **                                        | ** ** | **(in thousands)**               | ** ** |
| Non-cash investing  and financial activities:     |       |                                  |       |   |   |   |   |   |   |
| Deferred stock-based  compensation                |       |                                  | $          | — |   |   |   | $ | 7,060 |   |   |
| Adjustment for  deferred stock-based compensation |       |                                  | 430        |   |   |   | 116 |   |   |
| Unrealized loss  on available-for-sale securities |       |                                  | (1,549     | ) |   |   | (3,955 | ) |   |
| Restricted stock                                  |       |                                  | —     |   |   |   | 118 |   |   |
|                                                   |            |                                       |            |  |  |  |  |  |  |  |  |

 

**17. Assets Held for Sale**

The Company entered intoon December 23, 2005 and subsequently closed on January 9, 2006 athree-year contract manufacturing agreement with Sanmina—SCI whereby Sanmina—SCIhas assumed manufacturing operations of Adaptec products. In addition, theCompany sold certain manufacturing assets , buildings and improvements andinventory located in Singapore with respect to printed circuit board assembliesand storage system manufacturing operations to Sanmina—SCI for the Company’snet book value of approximately $27.0 million, subject to final closing adjustmentsfor $25.5 million (net of closing costs of $0.5 million) resulting in a loss ondisposal of assets of $1.5 million that was recorded in the third quarter offiscal 2006 in “Other charges (gains)” on the Unaudited Condensed ConsolidatedStatements of Operations. Those assets have been reclassified to “Assets heldfor sale” on the Unaudited Condensed Consolidated Balance Sheets.

**18. Business Acquisitions**

The acquisitions described below were previouslyaccounted for as purchase transactions and, accordingly, the results ofoperations and financial position of the acquired businesses were included inthe Company’s financial statements as of the respective effective dates of theacquisitions. However, as a result of the sale of the IBM i/p Series RAIDBusiness and the Company’s plan to divest its systems business, the assetsexpected to be sold have been reclassified as Assets and Liabilities ofDiscontinued Operations on the Unaudited Condensed Consolidated Balance Sheetat December 31, 2005 and the related operations have been reclassified to “Income(loss) from discontinued operations, net of taxes” on the Unaudited CondensedConsolidated Statements of Operations, as discussed in Note 4.

**IBM i/p Series RAID:** On June 29, 2004, the Company completedthe acquisition of the IBM i/p Series RAID component business lineconsisting of certain purchased RAID data protection intellectual property,semiconductor designs and assets, and licensed from IBM related RAIDintellectual property. 

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**Thelicensing agreement granted the Company the right to use IBM’s RAID technologyand embedded Power PC technology for the Company’s internal and external RAIDproducts to be sold to IBM and other customers. In conjunction with theacquisition, the Company also entered into a three-year exclusive productsupply agreement under which the Company agreed to supply RAID software,firmware and hardware to IBM for use in IBM’s iSeries and pSeries servers.The Company also entered into an agreement for IBM to provide silicon wafermanufacturing processing services to the Company for the term of the supplyagreement at agreed upon rates.**

The final purchase price was $49.3 million, whichconsisted of a cash payment to IBM of $47.5 million, warrants valued at$1.1 million, net of registration costs, and transaction costs of$0.7 million. This purchase price included a final adjustment of$0.2 million in the first quarter of fiscal 2006 to both goodwill andacquisitions costs. In connection with the acquisition, the Company issued awarrant to IBM to purchase 250,000 shares of the Company’s common stock at anexercise price of $8.13 per share. The warrant has a term of 5 years fromthe date of issuance and is immediately exercisable. The warrant was valuedusing the Black- Scholes valuation model using a volatility rate of 62%, arisk-free interest rate of 3.9% and an estimated life of 5 years. Thetransaction costs consisted primarily of legal, valuation and other fees. TheIBM i/p Series RAID business was included in the Company’s DPS segment.

**Snap Appliance:** On July 23, 2004, the Company completedthe acquisition of Snap Appliance, a provider of NAS products, to expand itsproduct offerings in the external storage market and to deliver cost-effective,scalable and easy-to-use DAS, NAS, Fibre Channel and IP-based SAN products fromthe workgroup to the data center. The final purchase price was $83.7 million,consisting of $76.7 million in cash and transaction fees and$7.0 million related to the fair value of assumed stock options topurchase 1.2 million shares of the Company’s common stock. This purchaseprice included a final adjustment of $0.7 million in the first half offiscal 2006 to both goodwill and acquisitions costs. The assumed stock optionswere 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. In the first quarter of fiscal 2006,adjustments of $0.7 were made to both goodwill and the acquisition costs.

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.

In addition, a managementincentive program was established to pay former employees of Snap Appliancecash payments totaling $13.8 million, which is being paid, contingent upontheir employment with the Company, over a two-year period through the secondquarter of fiscal 2007. Payments under the management incentive program will beexpensed as employees meet their employment obligations or are recorded as partof the Snap Appliance acquisition-related restructuring for involuntary terminationsby the Company.  Any amounts outstandingas of the completion of the sale of the systems business will be accelerated.

***Acquisition-Related Restructuring:***

During the first quarter of fiscal 2006, the Companyfinalized its Snap Appliance integration plan to eliminate certain duplicativeresources, including severance and benefits in connection with the involuntarytermination of approximately 24 employees, exiting duplicative facilities anddisposing of duplicative assets. The acquisition-related restructuringliabilities were accounted for under EITF No. 95-3 and thereforewere included in the purchase price allocation. The Company recorded a totalliability of $6.7 million for these activities, of which the original estimateof $6.0 million was recorded in the second 

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quarter of fiscal 2005 andadjustments were recorded in each subsequent quarter through the first quarterof fiscal 2006 totaling $0.7 million. Any further changes to the Company’sfinalized plan will be accounted for under SFAS No. 146 and will berecorded in “Restructuring charges” in the Unaudited Condensed ConsolidatedStatements of Operations. In the third quarter of fiscal 2006, the Companyrecorded additional adjustments of $0.2 million due to additional lease costsrelated to the estimated loss of facilities that the Company subleased, whichwas recorded in “Restructuring charges” in the Unaudited Condensed ConsolidatedStatements of Operations (Note 8). As of December 31, 2005, the Companyhad utilized $4.2 million of these charges. The Company anticipates thatthe remaining restructuring reserve balance of $2.7 million will be paidout by the third quarter of fiscal 2012, primarily related to long-termfacility leases.

Theactivity in the accrued restructuring reserve related to the Snap Applianceacquisition-related restructuring plan was as follows for the first nine monthsof fiscal 2006:

| ** **                                                  | ** ** | **Severance And  Benefits** | ** ** | **Other Charges** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                                  | ** ** | **(in thousands)**          | ** ** |
| **Snap Appliance  Acquisition-Related Restructuring Plan:** |       |                             |       |                   |       |      |       |   |   |   |   |
| Reserve balance  at March 31, 2005                     |       |                             | $          | 155                    |       |      |       | $ | 2,901 |   |   | $ | 3,056 |   |
| Adjustments                                                 |       |                             | (49        | )                      |       |      | 244        |   |   | 195 |   |
| Cash paid                                                   |       |                             | (60        | )                      |       |      | (538       | ) |   | (598 | ) |
| Reserve balance at  December 31, 2005                  |       |                             | $          | 46                     |       |      |       | $ | 2,607 |   |   | $ | 2,653 |   |

 

**In-process Technology**

As part of the purchase agreements of the IBM i/p Series RAIDbusiness and Snap Appliance, certain amounts of the purchase prices wereallocated to acquired in-process technology which were determined throughestablished valuation techniques in the high-technology computer industry andwritten off in the first and second quarter of fiscal 2005, respectively,because technological feasibility had not been established and no alternativefuture uses existed. The values were determined by estimating the net cashflows and discounting the estimated net cash flows to their present values. Asummary of the amounts written off were as follows: 

| ** **                            | ** ** | **Acquired**                   | ** ** |
|---------------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **In-Process Technology** | ** ** |
| ** **                            | ** ** | **(in thousands)**        | ** ** |
| IBM i/p  Series RAID business(1) |       |                           | $          | 3,000 |   |   |
| Snap Appliance(2)                     |       |                           | 2,200      |   |   |

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

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

The net cash flows fromthe identified projects were based on estimates of revenues, cost of revenues,research and development expenses, including costs to complete the projects,selling, marketing and administrative expenses, royalty expenses and incometaxes from the projects. The Company believes the assumptions used in thevaluations were reasonable at the time of the acquisitions. The estimated netrevenues and gross margins were based on management’s projections of theprojects and were in line with industry averages. Estimated total net revenuesfrom the projects of the IBM i/p Series RAID business and Snap Appliancewere expected to grow through fiscal 2009 and decline thereafter as other newproducts were expected to become available. Estimated operating expenses includedresearch and development expenses and selling, marketing and administrativeexpenses based upon historical and expected direct expense levels and generalindustry metrics. Estimated research and development expenses included costs 

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to bringthe projects to technological feasibility and costs associated with activitiesundertaken to correct errors or keep products updated with current information(also referred to as “maintenance” research and development) 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 rateused in the analysis of the in-process technologies reflects a combinedhistorical industry specific average for the United States Federal and statestatutory income tax rates. The cost of capital reflects the estimated time tocomplete the projects and the level of risk involved. The following discountrates were used in computing the present value of net cash flows for theacquired companies: between 23% and 28% for the IBM i/p Series RAIDbusiness and approximately 24% for Snap Appliance.

The percentage ofcompletion was determined using costs incurred by the IBM i/p Series RAIDbusiness and Snap Appliance prior to their respective acquisition datescompared to the estimated remaining research and development to be completed tobring the projects to technological feasibility. The Company estimated, as ofthe respective acquisition dates for the IBM i/p Series RAID business andSnap Appliance, that the projects were approximately 50% complete and 25%complete, respectively. All projects outstanding as of the acquisition date forthe IBM i/p Series RAID business ceased as of September 30, 2005 withthe sale of the business. All projects outstanding as of the acquisition datefor Snap Appliance were completed as of September 30, 2005.

Pro forma financialinformation for the first nine months of fiscal 2005 has not been disclosed asthe acquisitions of the IBM i/p Series RAID business and Snap Appliancewere included as part of discontinued operations.

**19. SubsequentEvents**

On January 31, 2006,the Company and one of its wholly owned subsidiaries signed a definitiveagreement with Sanmina—SCI Corporation and its wholly owned subsidiary, Sanmina-SCIUSA, Inc. (the”Definitive Agreement”), for the sale of the Company’s OEMblock-based systems business for $14.6 million, of which $5.0 million will bereceived over the next two years. In addition, Sanmina-SCI USA agreed to paythe Company contingent consideration of up to an additional $12.0 million ifcertain revenue levels are achieved over the next three years. Sanmina intendsto operate the Company’s OEM block-based business within Sanmina-SCI’s ODMsubsidiary, Newisys.

Under the terms of theDefinitive Agreement, Sanmina-SCI USA will assume most OEM contracts for itsblock-based systems customers. The sale of the OEM block-based systemsbusiness, in terms of future expected revenues, represents approximately halfof the planned divestiture of the systems business that was included indiscontinued operations as of December 31, 2005. In return, Sanmina-SCIUSA will supply the Company with block-based system products for the continuedsale through the channel. This arrangement will cease upon identifying a buyerfor the remainder of the Company’s systems business, which represents block-and file-based systems, including Snap-branded solutions. At that time, the newbuyer would assume the supply agreement and channel distribution of allproducts of the systems business.

The Company expects torecord a gain of approximately $13.0 million, subject to final closingadjustments, on the sale of the OEM block-based systems business in the fourthquarter of fiscal 2006, which will be recorded in “Income (loss) from disposalof discontinued operations, net of taxes,” in the Consolidated Statements ofOperations.

**20. Glossary**

Thefollowing is a list of business related acronyms that are contained within thisQuarterly Report on Form 10-Q. They are listed in alphabeticalorder.

·       **ASIC:** Application Specific IntegratedCircuit

·       **ATA:** Advanced Technology Attachment

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·       **DAS:** Direct-Attached Storage

·       **DPS:** Data Protection Solutions

·       **DSG:** Desktop Solutions Group

·       **ESPP:** Employee Stock Purchase Plan

·       **I/O:** Input/Output

·       **IP:** Internet Protocol

·       **IPsec:** Internet Protocol Security

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

·       **iSCSI:** Internet Protocol SCSI

·       **NAS:** Network Attached Storage

·       **ODM:** Original Design Manufacturer

·       **OEM:** Original Equipment Manufacturer

·       **PC:** Personal Computer

·       **PCI:** Peripheral Component Interconnect

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

·       **ROC:** RAID on a Chip

·       **SAN:** Storage Area Networks

·       **SAS:**Serial Attached SCSI

·       **SATA:** Serial Advanced Technology Attachment

·       **SCSI:** Small Computer System Interface

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

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

·       **USB:** Universal Serial Bus

·       **VARs:** Value Added Reseller

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

·       **APB:** Accounting Principles Board

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

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

·       **ARB:**Accounting Research Bulletin

·       **EITF:** Emerging Issues Task Force

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

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

·       **FASB:** Financial Accounting Standards Board

·       **FIN:** FASB Interpretation Number

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

·       **SAB:**Staff Accounting Bulletin

·       **SAB 107:**Share Based Payment

·       **SEC:** Securities Exchange Commission

·       **SFAS:** Statement of Financial AccountingStandards

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

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

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

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

·       **SFAS No. 146:**Accounting for CostsAssociated with Exit or Disposal Activities

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

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

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

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

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

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

While management believes that the discussion andanalysis in this report is adequate for a fair presentation of the informationpresented, we recommend that you read this discussion and analysis inconjunction with our Annual Report on Form 10-K for the fiscal yearended March 31, 2005. Our critical accounting policies have not changedfrom our fiscal year ended March 31, 2005. For a complete discussion ofour critical accounting policies, please refer to our Annual Report on Form 10-Kfor the fiscal year ended March 31, 2005.

As discussed below, on September 30, 2005, wecompleted the sale to International Business Machines, or IBM, of our IBM i/p Series RAIDcomponent business, or IBM i/p Series RAID Business, and on September 29,2005, our Board of Directors approvedmanagement’s recommendation to divest our systems business. Both of thesebusinesses have been accounted for as discontinued operations. Accordingly, we have reclassified the underlyingUnaudited Condensed ConsolidatedStatements of Operations and Unaudited CondensedConsolidated Statements of Cash Flows and related disclosures for all periodspresented to reflect the IBM i/p Series RAID Business and systems businessas discontinued operations. In the third quarter of fiscal 2006, in conjunctionwith the renegotiation of a customer supply contract, we decided to retain aproduct line that was previously classified within discontinued systemsbusiness. Accordingly, we have reclassified the underlying Unaudited CondensedConsolidated Statements of Operations and Unaudited Condensed Consolidated Statements of Cash Flowsand related disclosures for all periods presented to reflect that product lineas part of continuing operations.

Unless otherwise indicated and other than balancesheet amounts as of March 31, 2005, the following discussion pertains onlyto our continuing operations.

For your convenience, wehave included, in Note 20 to the Notes to the Unaudited CondensedConsolidated Financial Statements, a Glossary that contains a list of (1) keyacronyms commonly used in our industry that are used in this Quarterly Reportand (2) accounting rules and regulations that are also referred toherein. These key acronyms and accounting rules and regulations are listedin alphabetical order.

**Results of Operations**

**Overview**

Our new managementteam is continuing to perform a thorough analysis of our operations, which itinitiated in the first quarter of fiscal 2006, and has begun making a detailedplan of our corporate strategy. 

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Thisanalysis of our operations includes a review of all aspects of our business,including our product portfolio, our relationships with strategic partners andour research and development focus. To date, we have implemented the followingsteps:

·       OnJanuary 31, 2006, we and one of its wholly owned subsidiaries signed adefinitive agreement with Sanmina-SCI Corporation and its wholly ownedsubsidiary, Sanmina-SCI USA, Inc., or the Definitive Agreement, for thesale of our OEM block-based systems business for $14.6 million, of which $5.0million will be received over the next two years. In addition, Sanmina-SCI USAagreed to pay us contingent consideration of up to an additional $12.0 millionif certain revenue levels are achieved over the next three years. Sanminaintends to operate our OEM block-based business within Sanmina-SCI’s ODMsubsidiary, Newisys. We expect to record a gain of approximately $13.0 million,subject to final closing adjustments, on the sale of the OEM block-basedsystems business in the fourth quarter of fiscal 2006.

·       Weentered into on December 23, 2005 and subsequently closed on January 9,2006 a three-year contract manufacturing agreement with Sanmina-SCI wherebySanmina-SCI has assumed manufacturing operations of Adaptec products. Inaddition, we sold certain manufacturing assets, buildings and improvements andinventory located in Singapore with respect to printed circuit board assembliesand storage system manufacturing operations to Sanmina-SCI for our net bookvalue of approximately $27.0 million, subject to final closing adjustments for$25.5 million (net of closing costs of $0.5million) resulting in a loss on disposal of assets of $1.5 millionthat  was recorded in the third quarterof fiscal 2006 in “Other charges (gains)” on the Unaudited CondensedConsolidated Statements of Operations. Those assets have been reclassified to “Assetsheld for sale” on the Unaudited Condensed Consolidated Balance Sheets.

·       OnSeptember 30, 2005, we sold our IBM i/p Series RAID Business to IBMfor approximately $22.0 million plus $1.3 million for certain fixed assets.In addition, IBM purchased certain related inventory at our net book value of$0.8 million. We also granted IBM a nonexclusive license to certain intellectualproperty and sold to IBM substantially all of the assets dedicated to theengineering and manufacturing of RAID controllers and connectivity products forthe IBM i/p Series RAID Business. Under the terms of the nonexclusivelicense, IBM will pay us royalties for the sale of our board-level productsover the next six quarters, which will be recognized as contingentconsideration in discontinued operations when earned. In the third quarter offiscal 2006, we received royalties of $3.5 million, which we recorded in “Income(loss) from disposal of discontinued operations, net of taxes,” in theUnaudited Condensed Consolidated Statements of Operations.

·       OnSeptember 29, 2005, our Board of Directors approved management’srecommendation to divest our systems business, which includes substantially allof the operating assets and cash flows that were obtained through the SnapAppliance and Eurologic Systems acquisitions as well as internally developedhardware and software. In connection with this action, we have classified thesystems business as a discontinued operation in the financial statements. Weexpect to receive proceeds, less cost to sell, in excess of our carrying value.In the third quarter of fiscal 2006, inconjunction with the renegotiation of a customer supply contract, we decided toretain a product line that was previously classified within discontinuedsystems business. Accordingly, we have reclassified the underlying UnauditedCondensed Consolidated Statements of Operations and Unaudited CondensedConsolidated Statements of Cash Flows andrelated disclosures for all periods presented to reflect that product line aspart of continuing operations.

·       Wereorganized our internal organization structure related to our OEM and Channelsegments in the second quarter of fiscal 2006. Where previously our former OEMand Channel segments each offered an integrated set of customer-focusedproducts, the new organization is managed at the 

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product level. Ourreportable segments currently are DPS and DSG. As a result of the segmentreorganization, an assessment of the recoverability of goodwill was performedand we wrote-off our entire balance of goodwill of $90.6 million in the secondquarter of fiscal 2006. All prior periods have been restated to reflect our newsegments.

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

·       Lossof customers;

·       Lossof employees;

·       Increaseddependency on suppliers;

·       Supplyissues;

·       Reducedrevenue base;

·       Impairmentof our assets;

·       Increasedoperating costs; and

·       Materialrestructuring charges.

Our future revenue growth remains largely dependent onthe success of our  data protectionsolutions, new OEM design wins and our products addressing new technologies(i.e., Serial Attached SCSI, SATA and iSCSI).

In the third quarter of fiscal 2006, our revenuesdecreased 17% as compared to the third quarter of fiscal 2005 primarilyreflecting a decline in sales volumes and the average selling prices of ourparallel SCSI products, which was partially offset by sales of our serialproducts primarily sold to OEMs and one-timebenefits associated with the renegotiation of a customer supply contractrelated to our systems products. The improvement in gross margin in thethird quarter of fiscal 2006 compared to the third quarter of fiscal 2005 wasprimarily due to decreased component costs and one-time benefits associated with the renegotiation of a customer supplycontract related to our systems products, which was partially offset bychanges in our product mix, which led to lower average margins. Operatingexpenses decreased in the third quarter of fiscal 2006 as compared to the thirdquarter of fiscal 2005, primarily as a result of reduced headcount related tothe ServerEngines and Vitesse strategic alliances we entered into in the fourthquarter of fiscal 2005 and decreased infrastructure spending and reducedheadcount as a result of restructuring programs implemented in fiscal 2005 andthe third quarter of fiscal 2006.

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

| ** **                                                            | ** ** | **Three-Month Period  Ended(1)** | ** ** | **Nine-Month Period  Ended(2)** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                            | ** ** | **December 31,  2005**           | ** ** | **December 31,  2004**          | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| Net revenues                                                          |       |                                  | 100        | %                                    |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |
| Cost of revenues                                                      |       |                                  | 63         |                                 |       |   | 64 |   |   |   | 66 |   |   |   | 56 |   |   |
| Gross margin                                                          |       |                                  | 37         |                                 |       |   | 36 |   |   |   | 34 |   |   |   | 44 |   |   |
| Operating expenses:                                                   |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and development                                              |       |                                  | 19         |                                 |       |   | 23 |   |   |   | 20 |   |   |   | 23 |   |   |
| Selling, marketing and administrative                                 |       |                                  | 20         |                                 |       |   | 19 |   |   |   | 21 |   |   |   | 19 |   |   |
| Amortization of acquisition-related intangible  assets                |       |                                  | 2          |                                 |       |   | 2 |   |   |   | 2 |   |   |   | 3 |   |   |
| Restructuring charges                                                 |       |                                  | 3          |                                 |       |   | 2 |   |   |   | 1 |   |   |   | 2 |   |   |
| Goodwill impairment                                                   |       |                                  | —     |                                 |       |   | — |   |   |   | 38 |   |   |   | — |   |   |
| Other charges (gains)                                                 |       |                                  | 2          |                                 |       |   | (3 | ) |   |   | 1 |   |   |   | (1 | ) |   |
| Total operating expenses                                              |       |                                  | 46         |                                 |       |   | 43 |   |   |   | 83 |   |   |   | 46 |   |   |
| Loss from  continuing operations                                      |       |                                  | (9         | )                                    |       |   | (7 | ) |   |   | (49 | ) |   |   | (2 | ) |   |
| Interest and  other income                                            |       |                                  | 6          |                                 |       |   | 3 |   |   |   | 5 |   |   |   | 3 |   |   |
| Interest expense                                                      |       |                                  | (1         | )                                    |       |   | (1 | ) |   |   | (1 | ) |   |   | (1 | ) |   |
| Income (loss)  from continuing operations before income taxes         |       |                                  | (4         | )                                    |       |   | (5 | ) |   |   | (45 | ) |   |   | 0 |   |   |
| Provision for  (benefit from) income taxes                            |       |                                  | (1         | )                                    |       |   | (23 | ) |   |   | 2 |   |   |   | (11 | ) |   |
| Income (loss)  from continuing operations                             |       |                                  | (3         | )                                    |       |   | 18 |   |   |   | (47 | ) |   |   | 11 |   |   |
| Discontinued operations,  net of taxes (Note 4)                  |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss)  from discontinued operations, net of taxes             |       |                                  | (5         | )                                    |       |   | 6 |   |   |   | (13 | ) |   |   | (6 | ) |   |
| Income (loss)  from disposal of discontinued operations, net of taxes |       |                                  | 4          |                                 |       |   | — |   |   |   | (1 | ) |   |   | — |   |   |
| Income (loss)  from discontinued operations                           |       |                                  | (1         | )                                    |       |   | 6 |   |   |   | (14 | ) |   |   | (6 | ) |   |
| Net income (loss)                                                     |       |                                  | (4         | )%                                   |       |   | 24 | % |   |   | (61 | )% |   |   | 5 | % |   |

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(1)          In the third quarter offiscal 2006, we implemented a restructuring plan (Note 8) and recorded aloss on disposal of assets of $1.5 million (Note 17). In the third quarterof fiscal 2005, we implemented a restructuring plan, recorded a gain of $2.8million on the sale of certain properties (Note 9), made a payment of $0.4million to Nevada SCSI Enterprises, Inc., or NSE, in the form of a licensefee (Note 7) and received a tax benefit from the settlements of disputeswith the IRS. These transactions affect the comparability of this data.

(2)          Inthe first nine months of fiscal 2006, we recorded a goodwill impairment chargeof $90.6 million (Note 6), implemented a restructuring plan in thethird quarter of fiscal 2006 (Note 8) and recorded a loss on disposal ofassets of $1.5 million (Note 17). In the first nine months of fiscal 2005,we recorded a gain of $2.8 million on the sale of certain properties (Note 9),made a payment of $1.7 million to NSE in the form of a license fee(Note 7) and implemented restructuring plans in the first, second andthird quarters of fiscal 2005. These transactions affect the comparability ofthis data.

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**Net Revenues.**

| ** **                          | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                          | ** ** | **(in millions, except percentages)** | ** ** |
| **Segment Net Revenues:** |       |                                                 |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| DPS                                 |       |                                                 | $          | 69.1                                  |       |   |   | $ | 84.9 |   |   |   | (19 | )% |   |   | $ | 208.1 |   |   |   | $ | 263.7 |   |   |   | (21 | )% |   |
| DSG                                 |       |                                                 | 8.7        |                                  |       |   | 8.6 |   |   |   | 1 | % |   |   | 28.6 |   |   |   | 28.6 |   |   |   | 0 | % |   |
| **Total  Net Revenues**             |       |                                                 | 77.8       |                                  |       |   | 93.5 |   | ** ** | ** ** | **(17** | **)%** |   |   | 236.7 |   |   |   | 292.3 |   | ** ** | ** ** | **(19** | **)%** | ** ** |
|                                     |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Net revenues from our DPS segment decreased by$15.8 million and $55.6 million in the third quarter and first nine monthsof fiscal 2006, respectively, as compared to the corresponding periods offiscal 2005, reflecting a decline in sales volumes and average selling pricesof our parallel SCSI products, which was partially offset by sales of ourserial products primarily to OEMs and one-timebenefits associated with the renegotiation of a customer supply contractrelated to our systems products. The decline in sales volumes of ourSCSI products was primarily attributable to the transition from ourUltra 160 products to Ultra 320 products in which we have a lowermarket share, a shift to lower cost SATA solutions in which we have a lowermarket share and motherboards that contain built-in SCSI I/O functionality,thus reducing our average selling price.

Netrevenues from our DSG segment increased by $0.1 million in the thirdquarter compared to the third quarter of fiscal 2005 as a result of increasedsales of our digital media products and sales of storage products that wereintroduced in the fourth quarter of fiscal 2005, partially offset by thedecline in sales volumes of our SCSI-based desktop computer products. We expectrevenues from our SCSI-based desktop computer products to continue to declineas OEMs are incorporating other connectivity technologies directly into theirproducts. Net revenues from our DSG segment remained relatively flat in thefirst nine months of fiscal 2006 compared to the first nine months of fiscal2005.

| ** **                   | ** ** | **Three-Month Period Ended** | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                   | ** ** | **December 31,  2005**            | ** ** | **December 31,  2004**           | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| **Geographical Revenues:**   | ** ** |                                   | ** ** | ** **                            |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| North America                |       |                                   | 37         | %                                     |       |   | 26 | % |   |   | 36 | % |   |   | 34 | % |   |
| Europe                       |       |                                   | 31         | %                                     |       |   | 39 | % |   |   | 31 | % |   |   | 33 | % |   |
| Pacific Rim                  |       |                                   | 32         | %                                     |       |   | 35 | % |   |   | 33 | % |   |   | 33 | % |   |
| Total  Geographical Revenues |       |                                   | 100        | %                                     |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

 

Our North America revenuesincreased as a percentage of our total gross revenues in the thirdquarter and first nine months of fiscal 2006 as compared to the correspondingperiods of fiscal 2005 primarily as a result of one-time benefits associated with the renegotiation of a customer supplycontract related to our systems products and increased sales related to a NorthAmerica OEM, partially offset by a decline in channel sales in NorthAmerica. Included in European revenues for the third quarter and first ninemonths of fiscal 2006 was $1.0 million and $11.7 million, respectively, of alast time buy customer order.

A small number of ourcustomers account for a substantial portion of our net revenues, and we expectthat a limited number of customers will continue to represent a substantialportion of our net revenues for the foreseeable future. IBM and Dell accountedfor 34% and 17% of our total net revenues, respectively, in the third quarter offiscal 2006. IBM and Dell accounted for 38% and 14% of our total net revenues,respectively, in the third quarter of fiscal 2005. IBM and Dell accounted for30% and 16% of our total net revenues, respectively, in the first nine monthsof fiscal 2006. IBM, Dell and Synnex accounted for 26%, 14% and 11% of ourtotal net revenues, respectively, in the first nine months of fiscal 2005.

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**Gross Margin.**

| ** **   | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **   | ** ** | **December 31  2005**                           | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **   | ** ** | **(in millions, except percentages)** | ** ** |
| Gross Profit |       |                                                 | $          | 29.0                                  |       |   |   | $ | 33.9 |   |   |   | (15 | )% |   |   | $ | 80.3 |   |   |   | $ | 127.4 |   |   |   | (37 | )% |   |
| Gross Margin |       |                                                 | 37         | %                                     |       |   | 36 | % |   |   |   |   |   |   | 34 | % |   |   | 44 | % |   |   |   |   |   |

 

The improvement in gross margin in the third quarterof fiscal 2006 compared to the third quarter of fiscal 2005 was primarily dueto decreased component costs and one-timebenefits associated with the renegotiation of a customer supply contractrelated to our systems products, which was partially offset by changesin our product mix, which led to lower average margins.

The decline in gross margin in the first nine monthsof fiscal 2006 compared to the first nine months of fiscal 2005 was primarilydue to changes in our product and customer mix, which led to lower average margins,fixed costs associated with our manufacturing facilities that were distributedover lower revenue levels and an excess inventory adjustment of $1.9 millionrecorded in the first nine months of fiscal 2006 related to the transition ofour products to comply with the European Union Restriction on Use of HazardousSubstances Directive, or RoHS  Directive.This was partially offset by decreased component costs and one-time benefits associated with therenegotiation of a customer supply contract related to our systems products. Ourgross margins will be significantly impacted in the future by the mix of OEMand channel revenue.

**Researchand Development Expense.**

| ** **                | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                | ** ** | **(in millions, except percentages)** | ** ** |
| Research and  Development |       |                                                 | $          | 14.4                                  |       |   |   | $ | 21.3 |   |   |   | (32 | )% |   |   | $ | 47.3 |   |   |   | $ | 68.2 |   |   |   | (31 | )% |   |
|                           |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in research and development expense inthe third quarter and first nine months of fiscal 2006 as compared to thecorresponding periods of fiscal 2005 was primarily a result of reducedheadcount achieved as a result of the ServerEngines and Vitesse strategicalliances we entered into in the fourth quarter of fiscal 2005, decreasedinfrastructure spending and reduced headcount as a result of restructuringprograms implemented in fiscal 2005 and decreased deferred compensation chargesof $0.3 million and $1.7 million in the third quarter and first ninemonths of fiscal 2006, respectively compared to the corresponding periods of fiscal2005. Deferred compensation charges represented the vesting of assumed stockoptions in connection with our acquisition of Platys Communications, Inc.,or Platys, in August 2001. Deferred compensation charges associated withthe Platys acquisition ceased in the first quarter of fiscal 2006.

**Selling, Marketing and Administrative Expense.**

| ** **                             | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,   2005** | ** ** | **December 31    2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                             | ** ** | **(in millions, except percentages)** | ** ** |
| Selling,  Marketing and Administrative |       |                                                 | $          | 15.7                                  |       |   |   | $ | 17.8 |   |   |   | (12 | )% |   |   | $ | 49.7 |   |   |   | $ | 55.0 |   |   |   | (10 | )% |   |
|                                        |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in selling, marketing and administrativeexpense in the third quarter and first nine months of fiscal 2006 as comparedto the corresponding periods of fiscal 2005 was primarily a result of 

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decreased spending due toreductions of our workforce and infrastructure spending as a result of therestructuring plans we implemented in fiscal 2005 and the third quarter offiscal 2006. This was partially offset by compensation of $1.2 million recordedin the first quarter of fiscal 2006 related to retirement costs of our formerChief Executive Officer.

**Amortization of Acquisition-Related IntangibleAssets.**

| ** **                                             | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                             | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                                             | ** ** | **(in millions, except percentages)** | ** ** |
| Amortization of  Acquisition-Related Intangible Assets |       |                                                 | $          | 1.7                                   |       |   |   | $ | 2.2 |   |   |   | (23 | )% |   |   | $ | 5.5 |   |   |   | $ | 7.1 |   |   |   | (23 | )% |   |
|                                                        |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Acquisition-related intangible assets include patents,core and existing technologies, covenants-not-to-compete, customerrelationships and trade names. We amortize the acquisition-related intangibleassets over periods which reflect the pattern in which the economic benefits ofthe assets are expected to be realized, which is primarily using thestraight-line method over their estimated useful lives, ranging from threemonths to five years.

The decrease in amortization of acquisition-relatedintangible assets in the third quarter and first nine months of fiscal 2006compared to the corresponding periods of fiscal 2005 was due to intangibleassets that became fully amortized in August 2005 associated with ourPlatys acquisition and certain intangible assets that became fully amortized infiscal 2005 associated with our acquisition of Eurologic Systems Group Limitedin April 2003.

**Restructuring Charges.**

| ** **             | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **             | ** ** | **(in millions, except percentages)** | ** ** |
| Restructuring  Charges |       |                                                 | $          | 2.6                                   |       |   |   | $ | 2.2 |   |   |   | 16 | % |   |   | $ | 3.1 |   |   |   | $ | 5.0 |   |   |   | (38 | )% |   |
|                        |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In the third quarter of fiscal 2006, managementapproved and initiated a plan to restructure our operations by simplifying ourinfrastructure. The third quarter of fiscal 2006 restructuring plan eliminatedcertain duplicative resources in all functions of the organization worldwide,due in part, to the discontinued operations and vacated redundant facilities inorder to reduce our combined cost structure. This resulted in a restructuringcharge of $2.4 million for the third quarter of fiscal 2006.

As a result of our third quarter of fiscal 2006restructuring plan, we expect to reduce our annual infrastructure spending byapproximately $3 million, of which 24%, 34% and 42% will be reflected as areduction in cost of revenues, research and development and selling, marketingand administrative expense, respectively.

We recorded provision adjustments of $0.2 million and$0.7 million in the third quarter of fiscal 2006 and first nine months offiscal 2006, respectively, related to severance and benefits as actual costswere lower than anticipated and additional lease costs related to the estimatedloss on facilities that we subleased. The provision adjustments also includeadditional lease costs related to the estimated loss on facilities that wesubleased in connection with the Snap Appliance acquisition (Note 18). Theseprovision adjustments pertained to restructuring plans that we implemented ineach quarter of fiscal 2005, and restructuring plans that we implemented infiscal 2004, fiscal 2003, fiscal 2002 and fiscal 2001. The fiscal 2004restructuring plan was completed in the first quarter of fiscal 2006. The thirdquarter of fiscal 2005 restructuring plan and fourth quarter of fiscal 2005restructuring plan were completed in the third quarter 

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of fiscal 2006. For acomplete discussion of all restructuring actions that were implemented prior tofiscal 2006, please refer to the Notes to Consolidated Financial Statementsincluded in our Annual Report on Form 10-K for the fiscal year endedMarch 31, 2005. All expenses, including adjustments, associated with ourrestructuring plans are included in “Restructuring charges” in the UnauditedCondensed Consolidated Statements of Operations and are not allocated tosegments, but are managed at the corporate level.

In conjunction with the agreements entered into withSanmina—SCI on December 23, 2005 related to the transaction thatsubsequently closed on January 9, 2006, management approved and initiateda plan to restructure our work force in our Singapore operations. To the extentthat the employees are not be hired by Sanmina—SCI, the employees will beterminated by us over approximately the next two quarters. We estimate that wewill incur future severance costs in the range of $5 million and $6 million.

**Goodwill Impairment.**

| ** **           | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|----------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **           | ** ** | **(in millions, except percentages)** | ** ** |
| Goodwill  Impairment |       |                                                 | $          | —                                |       |   |   | $ | — |   |   |   | — |   |   |   | $ | 90.6 |   |   |   | $ | — |   |   |   | 100 | % |   |
|                      |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Goodwill is not amortized, but instead is reviewedannually and whenever events or circumstances occur which indicate thatgoodwill might be impaired. As a result of the segment reorganization discussedabove and in Note 15 to the Notes to Unaudited Condensed Consolidated FinancialStatements, an assessment of the recoverability of goodwill was performed. Impairmentof goodwill is tested at our operating segment level by comparing each segment’scarrying amount, including goodwill, to the fair value of that segment. Todetermine fair value, our review process uses the income, or discounted cashflows, approach and the market approach. In performing our analysis, we use thebest information available under the circumstances, including reasonable andsupportable assumptions and projections. If the carrying amount of theoperating segment exceeds its implied fair value, goodwill is consideredimpaired and a second step is performed to measure the amount of impairmentloss, if any. As a result of this review, we wrote-off our entire balance ofgoodwill of $90.6 million in the second quarter of 2006. Factors that led tothis conclusion were industry technology changes such as the shift fromparallel to serial technology and the migration of core functionality to serverchipsets; required increased investments that eventually led us to sell the IBMi/p Series RAID Business and the proposed sale of the systems business;continued losses associated with sales of systems to IBM; and general marketconditions.

**OtherCharges (Gains).**

| ** **             | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **             | ** ** | **(in millions, except percentages)** | ** ** |
| Other Charges  (Gains) |       |                                                 | $          | 1.5                                   |       |   |   | $ | (2.8 | ) |   |   | (153 | )% |   |   | $ | 1.5 |   |   |   | $ | (2.8 | ) |   |   | (153 | )% |   |
|                        |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We entered into on December 23, 2005 andsubsequently closed on January 9, 2006 a three-year contract manufacturingagreement with Sanmina—SCI whereby Sanmina—SCI has assumed manufacturingoperations of Adaptec products. In addition, we sold certain manufacturingassets, buildings and improvements and inventory located in Singapore withrespect to printed circuit board assemblies and storage system manufacturingoperations to Sanmina—SCI for our net book value of approximately $27.0million, subject to final closing adjustments for $25.5 million (net of closing costs of $0.5 million) resultingin a loss on disposal of assets of $1.5 million that was recorded in the thirdquarter of fiscal 2006 in “Other charges (gains)” on the Unaudited CondensedConsolidated Statements of Operations. Those assets have been reclassified to “Assetsheld for sale” on the Unaudited Condensed Consolidated Balance Sheets.

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In October 2004, we completed the sale of certainproperties in Milpitas, California that were previously classified as held forsale. Net proceeds from the sale of the properties aggregated$9.6 million, which exceeded our final revised fair value of$6.8 million. As a result, a gain on the sale of the properties of$2.8 million was recorded in the third quarter of fiscal 2005 as a creditto “Other charges (gains)” in the UnauditedCondensed Consolidated Statements of Operations.

**Interest and Other Income.**

| ** **                           | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                           | ** ** | **(in millions, except percentages)** | ** ** |
| **Interest and Other Income:**       |       |                                                 |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                      |       |                                                 | $          | 4.5                                   |       |   |   | $ | 2.8 |   |   |   | 57 | % |   |   | $ | 12.0 |   |   |   | $ | 8.6 |   |   |   | 40 | % |   |
| Payment of  license fee with NSE     |       |                                                 | —     |                                  |       |   | (0.4 | ) |   |   | 100 | % |   |   | — |   |   |   | (1.7 | ) |   |   | 100 | % |   |
| Loss on  redemption of debt          |       |                                                 | —     |                                  |       |   | — |   |   |   | — |   |   |   | (0.1 | ) |   |   | — |   |   |   | (100 | )% |   |
| Other                                |       |                                                 | 0.0        |                                  |       |   | 0.7 |   |   |   | (96 | )% |   |   | 0.7 |   |   |   | 1.7 |   |   |   | (58 | )% |   |
| **Total  Interest and Other Income** |       |                                                 | 4.5        |                                  |       |   | 3.1 |   | ** ** | ** ** | **45** | **%** |   |   | 12.6 |   |   |   | 8.6 |   | ** ** | ** ** | **47** | **%** | ** ** |
|                                      |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest and other income is primarily attributable tointerest income earned on our cash, cash equivalents and marketable securities,fluctuations in foreign currency gains or losses, realized gains and losses onmarketable securities, sublease income received from third parties and lossfrom the repurchase of our 3% Convertible Subordianted Notes, or 3% Notes.

The increase in interest and other income in the thirdquarter and first nine months of fiscal 2006 as compared to the correspondingperiods of fiscal 2005 was primarily due to higher interest rates earned on ourcash, cash equivalents and marketable securities in the first nine months offiscal 2006 and a one-time fully paid-up license payment fee of $1.7 millionto NSE, which was recorded in the first nine months of fiscal 2005, primarilyfor historical products that incorporated certain technology. This waspartially offset by foreign currency fluctuations primarily related to the Euroand a loss of $0.1 million on the repurchase of our 3% Notes for the first ninemonths of fiscal 2006. For further discussion on the settlement with NSE andgain on the sale of the property, please refer to Note 7 to the Notes toUnaudited Condensed Consolidated Financial Statements.

**Interest Expense.**

| ** **       | ** ** | **Three-Month Period Ended**               | ** ** | **Nine-Month Period Ended** | ** ** |
|------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **       | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004**           | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **       | ** ** | **(in millions, except percentages)** | ** ** |
| Interest Expense |       |                                                 | $          | (0.8                                  | )          |   |   | $ | (1.1 | ) |   |   | (30 | )% |   |   | $ | (2.6 | ) |   |   | $ | (3.4 | ) |   |   | (22 | )% |   |
|                  |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest expense is primarily associated with our 3⁄4%Convertible Senior Subordinated Notes, or 3⁄4% Notes, and 3% Notes issued in December 2003and March 2002, respectively. The decrease in interest expense for thethird quarter and first nine months of fiscal 2006 compared to thecorresponding periods of fiscal 2005 was primarily due to the reduction in theoutstanding balances of the 3% Notes, as we repurchased $23.2 million inaggregate principal amount of our 3% Notes during the first nine months offiscal 2006.

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**Income Taxes.**

| ** **                                  | ** ** | **Three-Month Period Ended**                         | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                                  | ** ** | **(in millions, except percentages)** | ** ** |
| Provision for   (Benefit from) Income Taxes |       |                                                 | $          | (0.6                        | )          |   |   | $ | (21.8 | ) |   |   | (97 | )% |   |   | $ | 3.2 |   |   |   | $ | (31.5 | ) |   |   | (110 | )% |   |
|                                             |            |                                                      |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Income tax provisions for interim periods are based onour estimated annual effective income tax. The estimated annual tax for fiscal2006 primarily consists of foreign taxes related to our foreign subsidiariesand interest accrued on prior years’ tax disputes. We currently have a fullvaluation allowance on our net U.S. deferred tax assets. We are engaged 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 rate for the third quarter andfirst nine months of fiscal 2005 differed from the combined United StatesFederal and state statutory income tax rate of 40% primarily due to certainacquisition-related intangible assets, excluding goodwill, that are not fullydeductible for tax purposes and interest accrued on prior years’ tax disputes.The tax rate for the third quarter and the first nine months of fiscal 2005also differed from the combined United States Federal and state statutoryincome tax rate of 40% due to tax benefits of $21.9 million and $31.9 millionrespectively from discrete events relating to the method and amount of settledcontroversies. As a result of the settlements, $21.9 million previouslyrecorded as a tax provision was reversed during the third quarter of fiscal2005. In addition, $4.1 million previously recorded as a tax provision wasreclassified as a reduction to additional paid-in capital, $1.8 millionpreviously recorded as a tax provision has been reversed, and a$4.0 million tax benefit associated with a refund claim has been recognizedduring the second quarter of fiscal 2005.

Historically our effectivetax rate was benefited by a Singapore tax holiday relating to certain of ourproducts. The contract manufacturing agreement entered into with Sanmina-SCIcould jeopardize this holiday which may cause our effective tax rate toincrease. We currently have alternative plans to reduce our effective tax rate;however, if these plans are not successful, our effective tax rate couldincrease, which would adversely affect our financial results.

**Income(Loss) From Discontinued Operations.**

| ** **                                  | ** ** | **Three-Month Period Ended**                         | ** ** | **Nine-Month Period Ended** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **December 31,  2005**                          | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                                  | ** ** | **(in millions, except percentages)** | ** ** |
| Income (Loss)  From Discontinued Operations |       |                                                 | $          | (0.6                        | )          |   |   | $ | 5.5 |   |   |   | (112 | )% |   |   | $ | (34.5 | ) |   |   | $ | (17.1 | ) |   |   | 102 | % |   |
|                                             |            |                                                      |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**IBMi/p Series RAID Business:****  **OnSeptember 30, 2005, we entered into a series of arrangements with IBMpursuant to which we sold our IBM i/p Series RAID Business to IBM forapproximately $22.0 million plus $1.3 million for certain fixedassets. In addition, IBM purchased certain related inventory at our net bookvalue of $0.8 million. Expenses incurred in the transaction primarilyincluded costs of approximately $0.5 million for legal and accounting fees.In addition, we accrued $0.3 million for lease obligations. Under theterms of the agreements, we granted IBM a nonexclusive license to certainintellectual property and sold to IBM substantially all of the assets dedicatedto the engineering and manufacturing of RAID controllers and connectivityproducts for the IBM i/p Series RAID Business. Under the terms of thenonexclusive license, IBM will pay us royalties for the sale of our board-level

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products over the next sixquarters, which will be recognized as contingent consideration in discontinuedoperations when earned. In the third quarter of fiscal 2006, we receivedroyalties of $3.5 million, which we recorded in “Income (loss) fromdisposal of discontinued operations, net of taxes,” in the Unaudited CondensedConsolidated Statements of Operations.

**SystemsBusiness:****  **On September 29,2005, our Board of Directors approved management’s recommendation to divest oursystems business, which includes substantially all of the operating assets andcash flows that were obtained through the Snap Appliance and Eurologic Systems acquisitionsas well as internally developed hardware and software. In connection with thisaction, we have classified the systems business as a discontinued operation inthe financial statements. We have entered into an exclusive arrangement with aninvestment banker to sell this business and expect to receive proceeds, lesscost to sell, in excess of our carrying value.

In the third quarter offiscal 2006, in conjunction with the renegotiation of a customer supplycontract, we decided to retain a product line that was previously classifiedwithin discontinued systems business. Accordingly, we have reclassified theunderlying Unaudited Condensed Consolidated Statements of Operations andUnaudited Condensed Consolidated Statements of Cash Flows and related disclosuresfor all periods presented to reflect that product line as part of continuingoperations.

**Liquidity and Capital Resources**

**Key Components of Cash Flows**

Cash provided by operations was $8.4 million inthe first nine months of fiscal 2006 as compared to cash used for operations of$16.0 million in the first nine months of fiscal 2005. Cash provided byoperations for the first nine months of fiscal 2006 resulted primarily from thebenefit of non-cash items included in operating results, which primarilyconsisted of an impairment of goodwill of $90.6 million and depreciationand amortization of $19.4 million. This was partially offset by our loss from continuingoperations of $110.5 million. Additional factors included changes toworking capital assets and liabilities that decreased cash provided byoperating activities of continuing operations by $1.2 million andincreased cash provided by operating activities of discontinued operations of$7.9 million. Cash used for the first nine months of fiscal 2005 resultedprimarily from changes to working capitalassets and liabilities that decreased cash used for operating activities ofcontinuing operations and discontinued operations by $21.5 million and$28.0 million, respectively, and non-cash effect on tax settlement of$26.0 million. This was partially offset by our income fromcontinuing operations of $31.5 million and depreciation and amortizationof $28.4 million.

Cash used for investing activities was$321.6 million in the first nine months of fiscal 2006, which wasprimarily due to net sales and maturities of restricted marketable securitiesand marketable securities, net of purchases, of $340.3 million and purchases ofproperty and equipment from continuing operations of $6.5 million, partiallyoffset by proceeds from the sale of the IBM i/p Series RAID Business of$24.1 million. Cash used for investing activities was $4.2 million in thefirst nine months of fiscal 2005, which was primarily due to cash used toacquire Snap Appliance and the IBM i/p Series RAID business of$65.4 million, purchases of property and equipment from continuingoperations of $8.1 million and cash used in investing activities ofdiscontinued operations of $63.0 million. This was offset by net purchases ofrestricted marketable securities and marketable securities, net of sales andmaturities, of $125.1 million and proceeds from the sale of long-livedassets of $9.6 million

Cash used for financing activities of$19.7 million in the first nine months of fiscal 2006 was primarily drivenby the repurchase of $23.2 million in aggregate principal amount of our 3%Notes for $23.0 million. Cash provided by financing activities was$5.4 million in the first nine months of fiscal 2005, which related to netproceeds received from our issuance of common stock in connection withpurchases made under our employee stock purchase plan and stock optionexercises.

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**Liquidity.****  **At December 31,2005, we had $532.3 million in cash, cash equivalents and marketablesecurities, of which approximately $91.1 million was held by our Singaporesubsidiary. In the fourth quarter of fiscal 2005, we repatriated$360.6 million of undistributed earnings from Singapore to the UnitedStates and incurred a tax liability of $17.6 million. The repatriatedamounts will be used to fund a qualified Domestic Reinvestment Plan, asrequired by the American Jobs Creation Act of 2004. If we do not spend therepatriated funds in accordance with our reinvestment plan, we may incuradditional tax liabilities. We have not provided for U.S. deferred income taxesor foreign withholding taxes on the remaining undistributed earnings sincethese earnings totaling approximately $255.6 million are intended to bereinvested internationally indefinitely. Although we do not have any currentplans to repatriate the remaining undistributed earnings from our Singaporesubsidiary to our United States parent company, if we were to do so, additionalincome taxes at the combined United States Federal and state statutory rate ofapproximately 40% could be incurred from the repatriation.

At December 31, 2005, we had $237.0 millionof aggregate principal amount in convertible notes outstanding, consisting of$12.0 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 ten scheduled interestpayments on our 3⁄4% Notes. As of December 31, 2005, we had$4.7 million of restricted cash and restricted marketable securities,consisting of United States government securities, of which $1.6 millionwas classified as short-term and $3.1 million was long-term.

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

As of December 31, 2005, we did not have anymaterial changes to our contractual obligations that were disclosed in theLiquidity section of our Form 10-K for the fiscal year ended March 31,2005. However, as part of the three-yearcontract manufacturing agreement entered into with Sanmina-SCI on January 9,2006, we are committed to purchasing majority of our products from Sanmina-SCI.In addition, as part of the agreement, we entered into a put agreement whichentitles Sanmina-SCI to return any equipment not used within six months of theclose of the transaction. We reserved for this potential liability as of December 31,2005.

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

**Recent Accounting Pronouncements**

In June 2005, the FASB issued SFAS No. 154,which changes the requirements for the accounting for, and reporting of, achange in accounting principle. Previously, most voluntary changes inaccounting 

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principles were requiredto be recognized by way of a cumulative effect adjustment within net incomeduring the period of the change. SFAS No. 154 requires retrospectiveapplication to prior periods’ financial statements, unless it is impracticableto determine either the period-specific effects or the cumulative effect of thechange. SFAS No. 154 is effective for accounting changes made infiscal years beginning after December 15, 2005; however, the Statementdoes not change the transition provisions of any existing accountingpronouncements. Our results of operations and financial condition will only beimpacted following the adoption of SFAS No. 154 if it implements changesin accounting principles that are addressed by the standard or correctsaccounting errors in future periods.

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) requirescompanies to apply a fair-value based measurement method in accounting forshare-based payment transactions with employees and to record compensationexpense for all stock awards granted and to awards modified, repurchased orcancelled after the required effective date. In addition, we are required torecord compensation expense (as previous awards continue to vest) for theunvested portion of previously granted awards that remain outstanding at thedate of adoption. In April 2005, the SEC approved that SFAS No. 123(R) willbe effective for annual periods, as opposed to interim periods as originallyissued by the FASB, beginning after June 15, 2005. In March 2005, theSEC issued SAB 107, which offers guidance on SFAS No. 123(R). SAB 107 wasissued to assist preparers by simplifying some of the implementation challengesof SFAS No. 123(R) while enhancing the information that investorsreceive. We intend to use the modified prospective method, which will result ina significant increase to expenses on our consolidated financial statementsbeginning April 1, 2006. We cannot currently quantify the impact of theadoption of SFAS No. 123(R) and SAB 107 as it will depend on theamount of share-based payments that we grant in the future as well as othervariables that affect the fair market value estimates which cannot beforecasted at this time. The pro forma disclosures of the impact of SFAS No. 123provided in Note 3 of the Notes to the Unaudited Condensed ConsolidatedFinancial Statements may not be representative of the impact of adopting thisstatement.

In November 2004, the FASB issued SFAS No. 151,which clarifies the accounting for abnormal amounts of facility expense,freight, handling costs and wasted materials (spoilage) to require them to berecognized as current-period charges. This statement is effective for inventorycosts incurred during fiscal years beginning after June 15, 2005. Earlierapplication is permitted. The adoption of this standard is not expected to havea material impact on our financial statements.

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**RISK FACTORS**

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

***We depend oncontract manufacturers and subcontractors, and if they fail to meet ourmanufacturing needs, it could delay shipments of our products and result in theloss of customers.***   We rely on contractmanufacturers for manufacturing of our products and subcontractors for theassembly and packaging of the integrated circuits included in our products andfor the assembly. On January 9, 2006 we entered into a three-year contractmanufacturing agreement with Sanmina-SCI whereby Sanmina-SCI has assumedmanufacturing operations of Adaptec products. If the transition of themanufacturing facilities does not go as expected it could result in loss ofcustomers or revenue, which would have an adverse effect on our financialresults. We have no long-term agreements with our assembly and packagingsubcontractors. For example, we employ Quanta Computer, Inc. tomanufacture certain products related to the acquisition of Snap Appliance. Wealso employ Amkor Technology and Advanced Semiconductor Engineering for ourfinal assembly and test operations related to our ASIC products. We cannotassure you these subcontractors will continue to be able and willing to meetour requirements for these components or services. For example, in the thirdquarter of fiscal 2005, Quanta Computer, Inc. could not meet ourmanufacturing needs and as a result initial product delivery dates committed tocustomers were not met. Any significant disruption in supplies from ordegradation in the quality of components or services supplied by, thesecontract manufacturers and subcontractors could delay shipments and result inthe loss of customers or revenues, which could have an adverse effect on ourfinancial results.

***Actions that wehave taken and the actions that we are considering could adversely affect ourbusiness and financial results in the short-term, and may not have thelong-term beneficial results that we intend.***   Ournew management team is continuing to perform a thorough analysis of ouroperations, which it initiated in the first quarter of fiscal 2006, and hasbegun making a detailed plan of our corporate strategy. This analysis of ouroperations includes a review of all aspects of our business, including ourproduct portfolio, our relationships with strategic partners and our researchand development focus. To date we have implemented the following stepsdescribed in “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Results of Operations—Overview.”

The actions that we have taken and the actions that weare considering could adversely affect our business and financial results inthe short-term, may not have the long-term beneficial results that we intendand could result in the following:

• Loss of customers;

• Loss of employees;

• Increased dependency on suppliers;

• Supply issues;

• Reduced revenue base;

• Impairment of our assets;

• Increased operating costs; and

• Material restructuring charges.

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***If we are unable tosuccessfully complete the divestiture of our systems business it could resultin an adverse effect on our business and financial results.***   Completingthe systems divestiture could cause significant diversions of management timeand resources. In addition, if the anticipated proceeds, less cost to sell,prove to be less than anticipated, it could lead to an impairment of our assets.Additionally, customers for our systems products could be reluctant to continueto buy from us. We may not be successful in selling the systems business onterms that are acceptable to us or might not be able to find a buyer for thebusiness. We may not be successful in overcoming these risks or any otherproblems encountered in connection with this divesture which may adverselyaffect our business, financial position and operating results.

***Our operatingresults have fluctuated in the past, and are likely to continue to fluctuate,and if our future results are below the expectations of investors or securitiesanalysts, the market price of our common stock would likely declinesignificantly.***   Our quarterly operatingresults have fluctuated in the past, and are likely to vary significantly inthe future, based on a number of factors related to our industry and themarkets for our products. Factors that are likely to cause our operatingresults to fluctuate include those discussed in this Risk Factors section. Inthe first nine months of fiscal 2006, our operating results were materiallyaffected by unusual charges, including a goodwill impairment charge of $90.6million and an excess inventory adjustment of $1.9 million related to thetransition of our products to comply with the RoHS Directive.

Our operating expenses are largely based onanticipated revenues, and a large portion of our expenses, including facilitycosts and salaries, are fixed in the short term. As a result, lower thananticipated revenues for any reason could cause significant variations in ouroperating results 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 operatingresults may be adversely affected by unfavorable economic and market conditionsand the uncertain geopolitical environment.***   Adverseeconomic conditions in some markets may impact our business, which could resultin:

• Reduced demand for our products as a result of adecrease in capital spending by our customers;

• Increased price competition for our products;

• Increased risk of excess and obsolete inventories;

• Excess facilities and manufacturing capacity; and

• Higher overhead costs as a percentage of revenues.

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

***Because our 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.***   Thevolume and timing of orders received during a quarter are difficult toforecast. Our customers generally order based on their forecasts and theyfrequently encounter uncertain and changing demand for their 

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products. If demand fallsbelow such forecasts or if our customers do not control their inventorieseffectively, they may cancel or reschedule shipments previously ordered fromus. Our customers have from time to time in the past canceled or rescheduledshipments previously ordered from us, and we cannot assure you that they willnot do so in the future. In addition, because our sales are made by means ofstandard purchase orders rather than long-term contracts, we cannot assure youthat these customers will continue to purchase quantities of our products atcurrent levels, or at all. Historically, we have set our operating budget basedon forecasts of future revenues because we do not have significant backlog.Because much of our operating budget is relatively fixed in the short-term, ifrevenues do not meet our expectations, then our financial results will beadversely affected.

***We depend on a fewkey customers and the loss of any of them could significantly reduce ourrevenues.******  ***Historically, a small number of ourcustomers has accounted for a significant portion of our revenues. During thefirst nine months of fiscal 2006, sales to the ten customers from which wereceived the greatest revenues accounted for approximately 93% of our totalgross revenues. In addition, IBM and Dell represented 30% and 16%,respectively, of our total net revenues in the first nine months of fiscal2006. We believe that our major customers continually evaluate whether or notto purchase products from alternate or additional sources. Additionally,customers’ economic and market conditions frequently change. Accordingly, wecannot assure you that a major customer will not reduce, delay or eliminate itspurchases from us, which would likely cause our revenues to decline. Inaddition, we do not carry credit insurance on our accounts receivables and anydifficulty in collecting outstanding amounts due from our customers,particularly customers that place larger orders or experience financialdifficulties, could adversely affect our revenues and our net income. Becauseour sales are made by means of standard purchase orders rather than long-termcontracts, we cannot assure you that these customers will continue to purchasequantities of our products at current levels, or at all.

***If there is ashortage of components used in our customers’ products, our sales may decline,which could adversely affect our results of operations and financial position.***   Ifour customers are unable to purchase certain components which are embedded intotheir products, their demand for our products may decline. For example,beginning in the fourth quarter of fiscal 2005, we experienced the impact ofother companies’ enterprise drive shortages, which reduced the demand for ourSCSI-related products from our OEM and Channel customers. This negativelyaffected our revenues in the fourth quarter of fiscal 2005. In addition, ourcustomers may be impacted by component shortages if components are notavailable that comply with the RoHS Directive. Similar shortages of componentsused in our customers’ products could adversely affect our net revenues andfinancial results in future periods.

***We may be subjectto a higher effective tax rate that could negatively affect our results ofoperations and financial position.***   Oureffective tax rate is benefited by a Singapore tax holiday relating to certainof our products. The tax holiday package, which is effective until fiscal 2010,provides that profits derived from certain products may be exempt from tax,subject to certain conditions. If we do not meet the conditions andrequirements of the tax holiday in Singapore, our effective tax rate mayincrease, which would adversely affect our financial results. The contractmanufacturing agreement entered into with Sanmina-SCI could jeopardize thisholiday. We currently have alternative plans to reduce our effective tax rate;however, if these plans are not successful, our effective tax rate could increase,which would adversely affect our financial results.

We held approximately $91.1 million of cash, cashequivalents and marketable securities at our subsidiary in Singapore at December 31,2005. During the fourth quarter of fiscal 2005, we repatriated$360.6 million of cash from Singapore to the United States in connectionwith the American Jobs Creation Act of 2004 which provides a one-time deductionof 85% for certain dividends from controlled foreign corporations. If theamount repatriated does not qualify for the one-time deduction, we could incuradditional income taxes at up to the United States Federal statutory rate of35%, which would negatively affect our results of operations and financialcondition.

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***Our dependence onnew products may cause our net revenues to fluctuate or decline.******  ***Our futuresuccess significantly depends upon our completing and introducing enhanced andnew products at competitive prices and performance levels in a timely manner.The success of new product introductions depends on several factors, includingthe following:

• Designing products to meet customer needs;

• Product costs;

• Timely completion and introduction of new productdesigns;

• Quality of new products;

• Differentiation of new products from those of ourcompetitors; and

• Market acceptance of our products.

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

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

***Our reliance onindustry standards and technological changes in the marketplace may cause ournet revenues to fluctuate or decline.***   Thecomputer industry is characterized by various, evolving standards andprotocols. We design our products to conform to certain industry standards andprotocols such as the following:

*Technologies:*

• ATA

• Fibre channel

• FireWire/1394

• IPsec

• iSCSI

• PCI

• PCI-Express

• PCI-X

• RAID

• Serial Attached SCSI

• SATA

• SCSI

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• SMI-S

• Ultra DMA

• USB

*Operating Systems:*

• Linux

• Macintosh

• Netware

• OS/2

• UNIX

• Windows

If user acceptance of these standards declines, or ifnew standards emerge, and if we do not anticipate these changes and develop newproducts, 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 our products tooperate effectively with a variety of hardware and software products suppliedby other manufacturers, including the following:

• Microprocessors;

• Peripherals; and

• Operating system 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.

***We are subject tovarious environmental laws and regulations that could impose substantial costsupon us and may adversely affect our business.***   TheEuropean Parliament has enacted the RoHS Directive, which restricts the sale ofnew electrical and electronic equipment containing certain hazardoussubstances, including lead that is currently used in some of the products wemanufacture. We are working to modify our manufacturing processes to eliminatelead from our products in accordance with the timelines established in the RoHSDirective. This may require us to make additional capital expenditures. Inaddition, the costs associated with compliance may negatively impact ouroperating results and competitive position. For example, in the first ninemonths of fiscal 2006, we had an excess inventory adjustment of $1.9 million relatedto the transition of our products to comply with the RoHS Directive. We arealso working with our suppliers to redesign or reformulate their componentscontaining lead to reduce or eliminate lead in our products. If we are unableto comply with the RoHS Directive, we may suffer a loss of revenue, be unableto sell affected products in certain markets or countries and be at acompetitive disadvantage.

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

***We entered intostrategic alliances with Vitesse for the development of our Serial AttachedSCSI ROC product and with ServerEngines to advance our development of iSCSIproducts, and if these companies fail to develop and bring new products tomarket in a timely manner it could result in an adverse effect on our businessand financial results.***   In January 2005,we entered into a strategic alliance with Vitesse for it to develop and marketthe next generation of our Serial Attached SCSI products. In March 2005,we entered into a strategic alliance with ServerEngines to develop and marketthe next generation of our IP storage products, such as 10Gb iSCSI.Accordingly, we are at risk that Vitesse and ServerEngines may encounterchallenges in fulfilling their responsibilities under these alliances, such astimely completing and introducing new product designs, maintaining the qualityof new products, minimizing product costs, differentiating new products fromthose of our competitors and achieving market acceptance of our products. Thefailure of this new product development effort could have an adverse effect onour business and financial results.

***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 ourproducts are designed to meet our customers’ specifications and, to the extentwe are not able to meet these expectations in a timely manner or provideadequate support during our customers’ design and development stage, ourcustomers may choose to buy similar products from another company. If this wereto occur we may lose revenues and market share to our competitors.

***If we are unable to compete effectively, our netrevenues could be adversely affected.******  ***The marketsfor all of our products are intensely competitive and are characterized by thefollowing:

·       Rapidtechnological advances;

·       Frequentnew product introductions;

·       Evolvingindustry standards; and

·       Priceerosion.

Consequently, we must continue to enhance our productson a timely basis to keep pace with market demands. If we do not do so, or ifour competition is more effective in developing products that meet the needs ofour existing and potential customers, we may lose market share and notparticipate in the future growth of our target markets. For example, intensecompetition in the transition from products employing Ultra 160 technology toproducts employing Ultra 320 technology has adversely affected revenues fromour SCSI products. Our future success will depend on the level of acceptance ofour external storage products and products based on the next generation SATAand Serial Attached SCSI technologies by new and existing customers. Inaddition, we expect that our future success will depend significantly on ourability to participate in the ongoing development of the network storage marketin which we face intense competition from other companies that are alsofocusing on networked storage products.

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

·       Satisfyany growth in demand for our products;

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·       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 fiscal 2005, we acquiredSnap Appliance and the i/p Series RAID business from IBM. In fiscal 2004,we acquired Elipsan, ICP vortex, a provider of a broad range of hardware andsoftware RAID data protection products, and Eurologic, a provider of externaland networked storage products. In addition, we enter into strategic alliancesfrom time to time with other companies. For example, we entered into strategicalliances with Vitesse and ServerEngines in January and March 2005,respectively. As part of our overall strategy, we may continue to acquire orinvest in complementary companies, products or technologies and enter intostrategic alliances with other companies. In order to be successful in theseactivities, 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 operations; and

·       Developthe capabilities necessary to exploit newly acquired technologies.

The benefits of acquisitions or strategic alliancesmay prove to be less than anticipated and may not outweigh the costs reportedin our financial statements. For example, during the first nine months offiscal 2006, we sold the IBM i/p Series RAID Business for a loss of $3.5million and plan to divest our systems business, which includes certain assetswe obtained through the Snap Appliance and Eurologic Systems acquisitions.

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 astrategic alliance or to complete an acquisition, which could adversely affectour results 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 producehighly complex products that incorporate leading-edge technologies, includingboth hardware and software. Software often contains “bugs” which can interferewith expected operations. We cannot assure you that our pre-shipment testingprograms will be adequate to detect all defects which might interfere withcustomer 

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satisfaction, reduce salesopportunities, or affect our gross margins if the costs 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.

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

·       Theavailability of raw materials;

·       Theavailability of manufacturing capacity;

·       Transitionto smaller geometries of semiconductor devices;

·       Thelevel of contaminants in the manufacturing environment;

·       Impuritiesin the materials used; and

·       Theperformance of personnel and equipment.

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

***We depend on theefforts of our distributors, which if reduced, could result in a loss of salesof our products in favor of competitive offerings.***   Wederived approximately 38% of our gross revenues for the first nine months offiscal 2006 from independent distributor and reseller channels. Our financialresults could be adversely affected if our relationships with thesedistributors or resellers were to deteriorate or if the financial condition ofthese distributors or resellers were to decline.

Our distributors generally offer a diverse array ofproducts from several different manufacturers. Accordingly, we are at risk thatthese distributors may give higher priority to selling products from othersuppliers. A reduction in sales efforts by our current distributors couldadversely affect our business and financial results. For example, some of ourdistributors have threatened to stop selling our products or make pricing ofour products non-competitive if we do not agree to absorb their costs to complywith the RoHS and WEEE Directives with respect to our products. Ourdistributors build inventories in anticipation of future sales, and if suchsales do not occur as rapidly as they anticipate, our distributors willdecrease the size of their product orders. If we decrease our price protectionor distributor-incentive programs, our distributors may also decrease theirorders from us. In addition, we have from time to time taken actions to reducelevels of products at distributors and may do so in the future. These actionsmay affect our net revenues and negatively affect our financial results.

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***We reorganized ourbusiness segments and have planned significant system enhancements andimprovements, and these changes could adversely impact our business if notadequately managed and controlled.***   Inthe second quarter of fiscal 2006, we reorganized our internal organizationstructure related to our OEM and Channel segments. Where previously our formerOEM and Channel segments each offered an integrated set of customer-focusedproducts, the new organization is managed at the product level. The reorganizationhas placed demands on our management and our operational and financialinfrastructure. In addition, management is in the process of enhancing oursupply-chain systems and processes. These system enhancements and improvementsrequire expenditures and allocation of management resources. If theseimprovements are not implemented successfully, our ability to manage our neworganization could be impaired. In addition, we may be required to incuradditional expenditures to address these issues, which could harm our financialposition.

***If we do not meetour restructuring objectives, we may have to implement additional plans inorder to reduce our operating costs and may, as a result, incur additionalmaterial restructuring charges.***   Wehave implemented several restructuring plans to reduce our operating costs inthe third quarter of fiscal 2006, fiscal 2005, fiscal 2004 and fiscal 2003, andrecorded related restructuring charges of $2.6 million, $5.9 million,$4.3 million and $14.3 million, respectively. The plans includedprimarily the reduction of our workforce and the consolidation of ourmanufacturing operations in Singapore. The goals of these plans were to supportfuture growth opportunities, focus on investments that grow revenues andincrease operating margins. If we do not meet our restructuring objectives, wemay have to implement additional restructuring plans to reduce our operatingcosts, which could cause us to incur material restructuring charges. Further,these restructuring plans may not achieve the goals we had in implementing themdue to such factors as significant costs or restrictions on workforcereductions that may be imposed in some international locales and a potentialadverse effect on employee morale that could harm our efficiency and ourability to act quickly and effectively in the rapidly changing technologymarkets in which we sell our products.

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

***Our operationsdepend on key personnel, the loss of whom could affect the growth and successof our business.******  ***In order to be successful, wemust retain and motivate our executives, the general managers of 

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our business segments, ourprincipal engineers and other key employees, including those in managerial,technical, marketing and information technology support positions. Inparticular, our product generation efforts depend on hiring and retainingqualified engineers. Competition for experienced management, technical,marketing and support personnel remains intense. For example, we transitionedcertain research and development efforts to North Carolina, where we haveexperienced significant competition in our efforts to attract and retainqualified software engineers. The loss of any of these key employees could havea significant impact on our operations. We also must continue to motivateemployees and keep them focused on our strategies and goals, which may beparticularly difficult due to morale challenges posed by workforce reductions,the announcement of the divestiture of the systems business 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 target marketsand potential disruption in the supply of necessary components.***   Manyof our subcontractors are primarily located in Asia and we have sales officesand customers located throughout Europe, Japan and other countries. Ourinternational operations and sales are subject to political and economic risks,including political instability, currency controls, changes in import/exportregulations, tariffs and freight rates. In addition, because our primary wafersupplier, TSMC, is located in Taiwan, we may be subject to certain risksresulting from political instability in Taiwan, including conflicts betweenTaiwan and the People’s Republic of China. These and other international riskscould result in the creation of political or other non-economic barriers to ourbeing able to sell our products in certain countries, create local economicconditions that reduce demand for our products among our target market orexpose us to potential disruption in the supply of necessary components orotherwise adversely affect our ability to generate revenue and operateeffectively.

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

***If the carryingvalue of our long-lived assets is not recoverable, an impairment loss must berecognized which would adversely affect our financial results.***   Certainevents or changes in circumstances would require us to assess therecoverability of the carrying amount of our long-lived assets. In the firstnine months of fiscal 2006, we recorded a goodwill impairment charge of $90.6million related to our DPS segment. In fiscal 2005, we recorded a goodwillimpairment charge of $52.3 million related to our Channel segment. Infiscal 2004, we recorded an impairment charge of $5.0 million related tocertain properties classified as held-for sale and a charge of $1.0 millionrelating to the decline in value of a minority investment. In fiscal 2003, werecorded an impairment charge of $1.5 million relating to the decline invalue of minority investments. In fiscal 2002, we recorded impairment chargesof $77.6 million relating to technology acquired in a prior acquisitionand the decline in value of minority investments. We will continue to evaluatethe recoverability of the carrying amount of our long-lived assets, and we mayincur substantial impairment charges which could adversely affect our financialresults.

***If actual resultsor events differ materially from those contemplated by us in making estimatesand assumptions, our reported financial condition and results of operations forfuture periods could be materially affected.***   Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes. For example, we have identifiedkey accounting estimates in our Critical Accounting Policies in our AnnualReport on Form 10-K for the fiscal year ended March 31, 2005,which includes revenue, inventory, goodwill and income taxes. In addition,Note 1 of the Notes to Consolidated Financial Statements in our 

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Annual Report onForm 10-K for the fiscal year ended March 31, 2005 describesthe significant accounting policies essential to preparing our consolidatedfinancial statements. The preparation of these financial statements requiresestimates and assumptions that affect the reported amounts and disclosures.Although we believe that our judgments and estimates are appropriate andcorrect, actual future results may differ 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 anddefend our intellectual property rights, we may be unable to adequately protectour proprietary rights. In addition, the laws of certain territories in whichour products 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 manufactured orsold 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.******  ***Fromtime to time, third parties assert exclusive patent, copyright and otherintellectual property rights to our key technologies, and we expect to continueto receive such claims in the future. For example, in fiscal 2005, we, NevadaSCSI Enterprises, Inc. and Thomas A. Gafford (jointly, “NSE”) entered intoa license and release agreement, pursuant to which we paid NSE$1.7 million as a one-time, fully paid-up license fee to settle NSE’sclaims that some of our products infringed certain patents. In addition, weentered into a patent cross-license agreement with IBM in May 2000. Underthis agreement, which was amended in March 2002, we received a releasefrom infringement claims prior to January 1, 2000 and received the rightto use certain of IBM’s patents through June 30, 2007. In consideration,we paid, in annual installments, an aggregate patent fee of $13.3 millionthrough June 30, 2004. The risks of our receiving additional claims fromthird parties may be enhanced in periods such as the one that we are currentlyentering where we are beginning to offer product lines employing newtechnologies relative to our existing products.

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

***We may be requiredto pay additional federal income taxes which could negatively affect ourresults of operations and financial position.***   On December 15,2000, we received a statutory notice of deficiency from the IRS with respect toour Federal income tax return for fiscal 1997. We filed a Petition with theUnited States Tax Court on March 14, 2001, contesting the asserteddeficiencies and settlement agreements have been filed with the United StatesTax Court on all but one issue. In addition, the IRS is currently auditing ourFederal income tax returns for fiscal 1998 through fiscal 2003. We haveresolved all issues for fiscal 

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1998 through fiscal 2001other than the rollover impact of any potential resolution on the remainingfiscal 1997 issue and tax credits that were generated but not used insubsequent years that may be carried back. While we believe we have meritoriousdefenses against the asserted deficiencies and any proposed adjustments, andthat sufficient taxes have been provided, we cannot predict the final outcomeof these matters, and the final resolution could adversely affect our resultsof 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.***   Fromtime to time we are subject to litigation or claims that could negativelyaffect our business operations and financial position. Such disputes couldcause us to incur unforeseen expenses, could occupy a significant amount of ourmanagement’s time and attention, and could negatively affect our businessoperations and financial position.

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

***We are exposed tofluctuations in foreign currency exchange rates.******  ***Because asignificant portion of our business is conducted outside the United States, weface exposure to adverse movements in non-United States currency exchangerates. These exposures may change over time as business practices evolve andcould have an adverse impact on our financial results and cash flows.Historically, our exposures have related to non-dollar-denominated operatingexpenses in Europe and Asia. We began Euro-denominated sales to ourdistribution customers in the European Union in the fourth quarter of fiscal2003. Additionally, we purchase a substantial portion of our raw materials andmanufacturing equipment from foreign suppliers, and incur labor and otheroperating costs in foreign currencies, particularly in our Singaporemanufacturing facility. An increase in the value of the dollar could increasethe real cost to our customers of our products in markets outside the UnitedStates where we sell in dollars, and a weakened dollar could increase the costof local operating expenses and procurement of raw materials to the extent wemust purchase components in foreign currencies.

***We hold minorityinterests in privately held venture funds, and if these venture funds facefinancial difficulties in their operations, our investments could be impaired.***   Wecontinue to hold minority interests in privately held venture funds. At December 31,2005, the carrying value of such investments aggregated $3.5 million. Wehave also committed to provide additional funding of up to $0.3 million.These investments are inherently risky because these venture funds invest incompanies that may still be in the development stage or depend on third partiesfor financing to support their ongoing operations. In addition, the markets forthe technologies or products of these companies are typically in the earlystages and may never develop. If these companies do not have adequate cashfunding to support their operations, or if they encounter difficultiesdeveloping their technologies or products, the venture funds’ investments inthese companies may be impaired, which in turn, could result in impairment ofour investment in these venture funds.

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

***We may havepotential business conflicts of interest with Roxio, which is now known asNapster, with respect to our past and ongoing relationships, and we may notresolve these conflicts on terms favorable to us.***   Conflictsof interest may arise between Napster and us in areas relating to our past andongoing relationship, including tax, indemnification and other matters arisingfrom the separation. These and other business conflicts could adversely affectthe growth of our business in the future.

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

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

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

***Internal controlissues that appear minor now may later become material weaknesses.******  ***We arerequired to publicly report on deficiencies or weaknesses in our internalcontrol over financial reporting that meet a materiality standard as requiredby law. Management may, at a point in time, accurately categorize a deficiencyor weakness as immaterial or minor and therefore not be required to publiclyreport such deficiency or weakness. Such determination, however, does notpreclude a change in circumstances such that the deficiency or weakness could,at a later time, become a material weakness that could have a material impacton our results of operations.

***We may encounternatural disasters, which could cause disruption to our employees or interruptthe manufacturing process for our products.***   Ouroperations could be subject to natural disasters and other 

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business disruptions,which could seriously harm our revenues and financial condition and increaseour costs and expenses. Our corporate headquarters are located in California,near major earthquake faults. Additionally, our primary wafer supplier, TSMC,is located in Taiwan, which has experienced significant earthquakes in thepast. A severe earthquake could cause disruption to our employees or interruptthe manufacturing process, which could affect TSMC’s ability to supply wafersto us, which would negatively affect our business and financial results. Theultimate impact on us and our general infrastructure of being located nearmajor earthquake faults is unknown, but our net revenues and financialcondition and our costs and expenses could be significantly impacted in theevent of a major earthquake.

***Manmade problemssuch as computer viruses or terrorism may disrupt our operations and harm ouroperating results.******  ***Despite our implementation of networksecurity measures, our servers are vulnerable to computer viruses, break-insand similar disruptions from unauthorized tampering with our computer systems.Any such event could have an adverse effect on our business, operating results,and financial condition. In addition, the effects of war or acts of terrorismcould have an adverse effect on our business, operating results, and financialcondition. In addition, as a company with headquarters and significantoperations located in the United States, we may be impacted by actions againstthe United States. We are predominantly uninsured for losses and interruptionscaused by terrorist acts and acts of war.

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

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

Forfinancial market risks related to changes in interest rates, equity price andforeign currency exchange rates, reference is made to Item 7A “Quantitative andQualitative Disclosures About Market Risk” contained in Part II of ourAnnual Report on Form 10-K for the fiscal year ended March 31,2005. Our exposure to market risk has not changed materially since March 31,2005.

**Item 4.**                        Controlsand Procedures

**Evaluationof Disclosure Controls and Procedures**

Under the supervision andwith the participation of our management, including our Chief Executive Officer(CEO) and our Chief Financial Officer (CFO), we conducted an evaluation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (Exchange Act),as of the end of the period covered by this Quarterly Report on Form 10-Q.Based upon that evaluation, our CEO and our CFO have concluded that the designand operation of our disclosure controls and procedures were effective toensure that information required to be disclosed by us in reports that we fileor submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in Securities and ExchangeCommission rules and forms.

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**Changesin Internal Control Over Financial Reporting**

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

**InherentLimitations on Effectiveness of Controls**

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

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**PART II. OTHER INFORMATION**

**Item 6.**                        Exhibits

| Exhibit Number | ** **        | **Description** | ** ** |
|---------------------|-------------------|-----------------|------------|
|                | Exhibit 10.1 |            |       | Manufacturing  Services and Supply Agreement by and between Adaptec, Inc. and Sanmina-SCI  Corporation* |   |
|                | Exhibit 10.2 |            |       | Asset  Purchase and Sale Agreement, dated as of December 23, 2005, by and among  Adaptec Manufacturing (s) Pte. Ltd., Sanmina-SCI Corporation and Sanmina-SCI  Systems Singapore Pte. Ltd. |   |
|                | Exhibit 10.3 |            |       | Amendment  to Manufacturing Services and Supply Agreement by and between Adaptec, Inc.  and Sanmina-SCI Corporation* |   |
|                | Exhibit 31.1 |            |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |   |
|                | Exhibit 31.2 |            |       | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |   |
|                | Exhibit 32.1 |            |       | Certification of Chief  Executive Officer and Chief Financial Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |   |

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*                    Confidentialtreatment has been requested for portions of this exhibit pursuant to anapplication for confidential treatment sent to the Securities and ExchangeCommission. Such portions are omitted from this filing and are filed separatelywith the Securities and Exchange Commission.

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**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,  2006 |

 

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**EXHIBIT INDEX**

| Exhibit Number | ** ** | **Description**                                                                                                                                                                                     |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 10.1   |       | Manufacturing Services and Supply Agreement by and  between Adaptec, Inc. and Sanmina-SCI Corporation*                                                                                              |
| Exhibit 10.2   |       | Asset Purchase and Sale Agreement, dated as of  December 23, 2005, by and among Adaptec Manufacturing (s) Pte. Ltd.,  Sanmina-SCI Corporation and Sanmina-SCI Systems Singapore Pte. Ltd. |
| Exhibit 10.3   |       | Amendment to Manufacturing Services and Supply  Agreement by and between Adaptec, Inc. and Sanmina-SCI Corporation*                                                                                 |
| Exhibit 31.1   |       | Certification of Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                           |
| Exhibit 31.2   |       | Certification of Chief Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                           |
| Exhibit 32.1   |       | Certification of Chief Executive Officer and Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                              |

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*                    Confidentialtreatment has been requested for portions of this exhibit pursuant to anapplication for confidential treatment sent to the Securities and ExchangeCommission. Such portions are omitted from this filing and are filed separatelywith the Securities and Exchange Commission.

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