**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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FORM 10-Q
| **(Mark One)** | ** **                                                                                              | ** ** |
|----------------|---------------------------------------------------------------------------------------------------------|------------|
| x              | **Quarterly  report pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |
| ** **     | **For the quarterly period ended June 30,  2005 or**                                               |
| o              | **Transition report pursuant to Section 13 or  15(d) of the Securities Exchange Act of 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’stelephone number, including area code **(408)945-8600**

**N/A**(Former name, former address and former fiscal year, ifchanged since last report)

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

Yes x  No o

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

Yes x  No o

The number of shares outstanding of Adaptec’s commonstock as of August 1, 2005 was 112,496,606.

 

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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 |       | 24       |
|                |       | Item 3.               |       | Quantitative  and Qualitative Disclosures About Market Risk                                 |       | 50       |
|                |       | Item 4.               |       | Controls and  Procedures                                                                    |       | 50       |
| Part II.  |       | Other Information     |       |                                                                                        |
|                |       | Item 6.               |       | Exhibits                                                                                    |       | 52       |
|                |       | Signatures            |       | 53                                                                                          |

 

2

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**PART I.   FINANCIAL INFORMATION**

**Item 1.   Financial Statements**

**ADAPTEC, INC.CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS(unaudited)**
| ** **                                             | ** ** | **Three-Month Period Ended**                            | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2005**                                       | ** ** | **June 30, 2004** | ** ** |
| ** **                                             | ** ** | **(in thousands, except per  share amounts)** | ** ** |
| Net revenues                                           |       |                                                              | $          | 98,398 |   |   |   | $ | 115,502 |   |   |
| Cost of revenues                                       |       |                                                              | 77,947     |   |   |   | 65,134 |   |   |
| Gross profit                                           |       |                                                              | 20,451     |   |   |   | 50,368 |   |   |
| Operating  expenses:                                   |       |                                                              |       |   |   |   |   |   |   |
| Research and development                               |       |                                                              | 25,779     |   |   |   | 25,388 |   |   |
| Selling, marketing and administrative                  |       |                                                              | 19,234     |   |   |   | 18,936 |   |   |
| Amortization of acquisition-related intangible  assets |       |                                                              | 4,892      |   |   |   | 2,929 |   |   |
| Write-off of acquired in-process  technology           |       |                                                              | —     |   |   |   | 3,000 |   |   |
| Restructuring charges                                  |       |                                                              | 40         |   |   |   | 819 |   |   |
| Other charges                                          |       |                                                              | 8,010      |   |   |   | — |   |   |
| Total operating expenses                               |       |                                                              | 57,955     |   |   |   | 51,072 |   |   |
| Loss from  operations                                  |       |                                                              | (37,504    | ) |   |   | (704 | ) |   |
| Interest and  other income                             |       |                                                              | 3,608      |   |   |   | 1,843 |   |   |
| Interest expense                                       |       |                                                              | (972       | ) |   |   | (1,122 | ) |   |
| Income (loss)  before income taxes                     |       |                                                              | (34,868    | ) |   |   | 17 |   |   |
| Provision for  income taxes                            |       |                                                              | 1,105      |   |   |   | 7 |   |   |
| Net income (loss)                                      |       |                                                              | $          | (35,973 | ) |   |   | $ | 10 |   |   |
| Net income (loss)  per share:                          |       |                                                              |       |   |   |   |   |   |   |
| Basic                                                  |       |                                                              | $          | (0.32 | ) |   |   | $ | 0.00 |   |   |
| Diluted                                                |       |                                                              | $          | (0.32 | ) |   |   | $ | 0.00 |   |   |
| Shares used in computing  net income (loss) per share: |       |                                                              |       |   |   |   |   |   |   |
| Basic                                                  |       |                                                              | 112,445    |   |   |   | 109,840 |   |   |
| Diluted                                                |       |                                                              | 112,445    |   |   |   | 111,536 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

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**ADAPTEC, INC.CONDENSED CONSOLIDATEDBALANCE SHEETS(unaudited)**
| ** **                                              | ** ** | **June 30, 2005** | ** ** | **March 31, 2005** | ** ** |
|---------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                              | ** ** | **(in thousands)**     | ** ** |
| **Assets**                                              |       |                        |       |                         |       |   |   |   |   |
| Current assets:                                         |       |                        |       |                         |       |   |   |   |   |
| Cash and cash equivalents                               |       |                        | $          | 77,176                       |       |   |   | $ | 441,588 |   |   |
| Marketable securities                                   |       |                        | 402,760    |                         |       |   | 84,968 |   |   |
| Restricted cash and marketable securities               |       |                        | 1,654      |                         |       |   | 1,766 |   |   |
| Accounts receivable, net                                |       |                        | 74,648     |                         |       |   | 70,159 |   |   |
| Inventories                                             |       |                        | 48,346     |                         |       |   | 60,204 |   |   |
| Prepaid expenses                                        |       |                        | 20,130     |                         |       |   | 21,822 |   |   |
| Other current assets                                    |       |                        | 5,739      |                         |       |   | 4,259 |   |   |
| Total current assets                                    |       |                        | 630,453    |                         |       |   | 684,766 |   |   |
| Property and  equipment, net                            |       |                        | 55,942     |                         |       |   | 56,180 |   |   |
| Restricted  marketable securities, less current portion |       |                        | 3,875      |                         |       |   | 4,615 |   |   |
| Goodwill                                                |       |                        | 90,602     |                         |       |   | 91,486 |   |   |
| Other intangible  assets, net                           |       |                        | 66,597     |                         |       |   | 79,457 |   |   |
| Other long-term  assets                                 |       |                        | 37,626     |                         |       |   | 47,002 |   |   |
| Total assets                                            |       |                        | $          | 885,095                      |       |   |   | $ | 963,506 |   |   |
| **Liabilities  and Stockholders' Equity**               |       |                        |       |                         |       |   |   |   |   |
| Current liabilities:                                    |       |                        |       |                         |       |   |   |   |   |
| Accounts payable                                        |       |                        | $          | 49,360                       |       |   |   | $ | 61,637 |   |   |
| Accrued liabilities                                     |       |                        | 106,320    |                         |       |   | 116,007 |   |   |
| Total current liabilities                               |       |                        | 155,680    |                         |       |   | 177,644 |   |   |
| 3⁄4% Convertible  Senior Subordinated Notes          |       |                        | 225,000    |                         |       |   | 225,000 |   |   |
| 3% Convertible  Subordinated Notes                      |       |                        | 15,368     |                         |       |   | 35,190 |   |   |
| Other long-term  liabilities                            |       |                        | 14,686     |                         |       |   | 15,349 |   |   |
| Commitments and  contingencies (Note 12)                |       |                        |       |                         |       |   |   |   |   |
| Stockholders' equity:                                   |       |                        |       |                         |       |   |   |   |   |
| Common stock                                            |       |                        | 112        |                         |       |   | 112 |   |   |
| Additional paid-in capital                              |       |                        | 165,438    |                         |       |   | 165,707 |   |   |
| Deferred stock-based compensation                       |       |                        | (1,752     | )                            |       |   | (2,416 | ) |   |
| Accumulated other comprehensive income, net of taxes    |       |                        | 322        |                         |       |   | 706 |   |   |
| Retained earnings                                       |       |                        | 310,241    |                         |       |   | 346,214 |   |   |
| Total stockholders' equity                              |       |                        | 474,361    |                         |       |   | 510,323 |   |   |
| Total liabilities and  stockholders' equity             |       |                        | $          | 885,095                      |       |   |   | $ | 963,506 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

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**ADAPTEC, INC.CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS(unaudited)**
| ** **                                                                                           | ** ** | **Three-Month Period Ended** | ** ** |                        |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|-----------------------------|
| ** **                                                                                           | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |   |
| ** **                                                                                           | ** ** | **(in thousands)**                | ** ** |                        |
| **Cash Flows From Operating  Activities:**                                                           |       |                                   |       |                        |   |   |   |   |   |
| Net income (loss)                                                                                    |       |                                   | $          | (35,973                     | ) |   |   | $ | 10 |   |   |
| Adjustments to reconcile  net income (loss) to net cash provided by (used for) operating activities: |       |                                   |       |                        |   |   |   |   |   |
| Non-cash restructuring charges                                                                       |       |                                   | —     |                        |   |   | 109 |   |   |
| Write-off of acquired in-process  technology                                                         |       |                                   | —     |                        |   |   | 3,000 |   |   |
| Impairment of intangible and long-lived assets                                                       |       |                                   | 15,520     |                        |   |   | — |   |   |
| Stock-based compensation                                                                             |       |                                   | 274        |                        |   |   | 805 |   |   |
| Loss on extinguishment of debt                                                                       |       |                                   | 86         |                        |   |   | — |   |   |
| Depreciation and amortization                                                                        |       |                                   | 14,606     |                        |   |   | 10,342 |   |   |
| Deferred income taxes                                                                                |       |                                   | —     |                        |   |   | (25 | ) |   |
| Other non-cash items                                                                                 |       |                                   | 133        |                        |   |   | — |   |   |
| Changes in assets and liabilities (net of acquired  businesses):                                     |       |                                   | (17,661    | )                           |   |   | (6,060 | ) |   |
| **Net  Cash Provided by (Used for) Operating Activities**                                            |       |                                   | $          | (23,015                     | ) |   |   | $ | 8,181 |   |   |
| **Cash  Flows From Investing Activities:**                                                           |       |                                   |       |                        |   |   |   |   |   |
| Purchases of  certain net assets in connection with acquisitions, net of cash acquired               |       |                                   | —     |                        |   |   | (47,475 | ) |   |
| Maturities of  restricted marketable securities                                                      |       |                                   | 844        |                        |   |   | 844 |   |   |
| Purchases of  property and equipment                                                                 |       |                                   | (5,101     | )                           |   |   | (2,216 | ) |   |
| Purchases of  marketable securities                                                                  |       |                                   | (364,679   | )                           |   |   | (136,444 | ) |   |
| Sales of  marketable securities                                                                      |       |                                   | 43,473     |                        |   |   | 193,450 |   |   |
| Maturities of  marketable securities                                                                 |       |                                   | 3,362      |                        |   |   | 25,990 |   |   |
| **Net  Cash Provided by (Used for) Investing Activities**                                            |       |                                   | (322,101   | )                           |   |   | 34,149 |   |   |
| **Cash  Flows From Financing Activities:**                                                           |       |                                   |       |                        |   |   |   |   |   |
| Repurchases and  redemption of long-term debt                                                        |       |                                   | (18,645    | )                           |   |   | — |   |   |
| Proceeds from  issuance of common stock                                                              |       |                                   | 121        |                        |   |   | 439 |   |   |
| **Net  Cash Provided by (Used for) Financing Activities**                                            |       |                                   | (18,524    | )                           |   |   | 439 |   |   |
| **Effect  of Foreign Currency Translation on Cash and Cash Equivalents**                             |       |                                   | (772       | )                           |   |   | (139 | ) |   |
| **Net  Increase (Decrease) in Cash and Cash Equivalents**                                            |       |                                   | (364,412   | )                           |   |   | 42,630 |   |   |
| **Cash  and Cash Equivalents at Beginning of Period**                                                |       |                                   | 441,588    |                        |   |   | 102,463 |   |   |
| **Cash and Cash Equivalents at  End of Period**                                                      |       |                                   | $          | 77,176                      |   |   |   | $ | 145,093 |   |   |

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

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

**1. Basis ofPresentation**

In the opinion of management, the accompanyingUnaudited Condensed Consolidated Interim Financial Statements (“financialstatements”) of Adaptec, Inc. and its wholly-owned subsidiaries(collectively, the “Company”) have been prepared on a consistent basis with theMarch 31, 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 SEC, and, therefore,omit certain information and footnote disclosure necessary to present thestatements in accordance with accounting principles generally accepted in theUnited States of America. These financial statements should be read inconjunction with the audited consolidated financial statements and notesthereto included in the Company’s Annual Report on Form 10-K for the yearended March 31, 2005, which was filed with the SEC on June 14, 2005.The first quarters of fiscal 2006 and 2005 ended July 1, 2005 and July 2,2004, respectively. For presentation purposes, the accompanying financialstatements have been shown as ending on the last day of the calendar month. Theresults of operations for the first quarter of fiscal 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, includingreclassification of auction rate securities from cash and cash equivalents tomarketable securities. Previously, such auction rate securities were classifiedas cash and cash equivalents. Accordingly, the Company has revised itspresentation and made adjustments to the accompanying Unaudited CondensedConsolidated Statement of Cash Flows to reflect the gross purchases and salesof these auction rate securities as investing activities. This adjustmentresulted in a net increase in cash used for investing activities by$4.0 million in the first quarter of fiscal 2005. This reclassificationhad no impact on previously reported results of operations, operating cashflows or working capital of the Company.

The glossary of acronymsand accounting rules and regulations referred to within this QuarterlyReport on Form 10-Q is listed in alphabetical order in Note 17.

**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 does not believe that theadoption of SFAS No. 154 will have a material effect on the Company’sUnaudited Condensed Consolidated Balance Sheet, Statement of Operations or CashFlows.

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 

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

**2. RecentAccounting Pronouncements (Continued)**

awards that remainoutstanding at the date of adoption. In April 2005, the SEC approved thatSFAS No. 123(R) will be effective for annual periods, as opposed tointerim periods as originally issued by the FASB, beginning after June 15,2005. The Company is currently evaluating the impact of adopting thisstatement; however, the Company expects that it will have a significant impacton the Company’s consolidated balance sheet and statement of operations. Theimpact on the Company’s consolidated financial statements will depend on thetransition method, the option-pricing model used to compute fair value and theinputs to that model such as volatility and expected life. 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 March 2005, the SEC issued SAB 107, whichoffers guidance on SFAS No. 123(R). SAB 107 was issued to assist preparersby simplifying some of the implementation challenges of SFAS No. 123(R) whileenhancing the information that investors receive. SAB 107 creates a frameworkthat is premised on two overarching themes: (a) considerable judgment willbe required by preparers to successfully implement FAS No. 123(R),specifically when valuing employee stock options; and (b) reasonableindividuals, acting in good faith, may conclude differently on the fair valueof employee stock options. Key topics covered by SAB 107 include valuationmodels, expected volatility and expected term. The Company will apply theprinciples of SAB 107 in conjunction with its adoption of SFAS No. 123(R).

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 be recognizedas current-period charges. This statement is effective for inventory costsincurred during fiscal years beginning after June 15, 2005. Earlierapplication is permitted. The adoption of this standard is not expected to havea material impact on the Company’s Unaudited Condensed Consolidated BalanceSheet or Statement of Operations.

At its March 2004meeting, the EITF reached a consensus on recognition and measurement guidancepreviously discussed under EITF 03-01. The consensus clarified the meaning ofother-than-temporary impairment and its application to investments classifiedas either available-for-sale or held-to-maturity under SFAS No. 115 andinvestments accounted for under the cost method or the equity method. In September 2004,the FASB delayed the recognition and measurement guidance to be applied toother-than-temporary impairment evaluations. The FASB expects to issueadditional implementation guidance with respect to debt securities that areimpaired solely due to interest rates and/or sector spreads. If this additionalimplementation guidance is issued as currently written, the Company may have torecognize unrealized losses on investments in the Statement of Operations. Ifthere is a material decline in the fair value of investments, the Company’sfinancial statements could be adversely affected.

**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 andEITF No. 96-18, which requires that such equity instruments be recorded attheir fair value on the measurement date, which is typically the date of grant.

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

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

The following tableillustrates the effect on net income (loss) and net income (loss) per share asif the Company had applied the fair value recognition provisions of SFAS No. 123to employee and director stock option plans, including shares issued under theCompany’s ESPP, collectively called “options” for all periods presented:
| ** **                                                                                                | ** ** | **Three-Month Period Ended**                                | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                                | ** ** | **June 30, 2005**                                           | ** ** | **June 30, 2004** | ** ** |
| ** **                                                                                                | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net income  (loss), as reported                                                                           |       |                                                                  | $          | (35,973 | ) |   |   | $ | 10 |   |   |
| Add: Deferred  stock-based compensation expense included in reported net income (loss)                    |       |                                                                  | 274        |   |   |   | 805 |   |   |
| Deduct: Total  stock-based compensation expense determined under the fair value-based  method, net of tax |       |                                                                  | (3,496     | ) |   |   | (3,497 | ) |   |
| Pro forma net  loss                                                                                       |       |                                                                  | $          | (39,195 | ) |   |   | $ | (2,682 | ) |   |
| Basic net income  (loss) per share:                                                                       |       |                                                                  |       |   |   |   |   |   |   |
| As reported                                                                                               |       |                                                                  | $          | (0.32 | ) |   |   | $ | 0.00 |   |   |
| Pro forma                                                                                                 |       |                                                                  | $          | (0.35 | ) |   |   | $ | (0.02 | ) |   |
| Diluted net income  (loss) per share:                                                                     |       |                                                                  |       |   |   |   |   |   |   |
| As reported                                                                                               |       |                                                                  | $          | (0.32 | ) |   |   | $ | 0.00 |   |   |
| Pro forma                                                                                                 |       |                                                                  | $          | (0.35 | ) |   |   | $ | (0.02 | ) |   |

 

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 first quarters of fiscal 2006 and 2005, asreported were estimated at the date of grant using the Black-Scholes valuationmodel with the following weighted average assumptions:
| ** **                | ** ** | **Employees’ Stock Option Plans** | ** ** |
|---------------------------|------------|-------------------------------------------------------|------------|
| ** **                | ** ** | **Three-Month Period Ended**                | ** ** |
| ** **                | ** ** | **June 30, 2005**                           | ** ** | **June 30, 2004** | ** ** |
| Expected life (in  years) |       |                                                  | 2.35       |   |   |   | 3.00 |   |   |
| Risk-free  interest rate  |       |                                                  | 3.8        | % |   |   | 3.0 | % |   |
| Expected  volatility      |       |                                                  | 37         | % |   |   | 58 | % |   |
| Dividend yield            |       |                                                  | —     |   |   |   | — |   |   |

 

**4. BusinessAcquisitions**

**IBM i/p Series RAID:  **OnJune 29, 2004, the Company completed the acquisition of the IBM i/p Series RAIDcomponent business line consisting of certain purchased RAID data protectionintellectual 

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

**4.Business Acquisitions (Continued)**

property, semiconductordesigns and assets, and licensed from IBM related RAID intellectual property.The licensing agreement grants the Company the right to use IBM’s RAIDtechnology and embedded Power PC technology for the Company’s internal andexternal RAID products to be sold to IBM and other customers. In conjunctionwith the acquisition, the Company also entered into a three-year exclusiveproduct supply agreement under which the Company will 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 consist primarily of legal, valuation and other fees. The IBMi/p Series RAID business is included in the Company’s OEM segment(Note 14).

**Snap Appliance:  **OnJuly 23, 2004, the Company completed the acquisition of Snap Appliance, aprovider of NAS products, to expand its product offerings in the externalstorage market and to deliver cost-effective, scalable and easy-to-use DAS,NAS, Fibre Channel and IP-based SAN products from the workgroup to the datacenter. The total purchase price was $83.7 million, consisting of$76.7 million in cash and transaction fees and $7.0 million relatedto the fair value of assumed stock options to purchase 1.2 million shares ofthe Company’s common stock. The assumed stock options were valued using theBlack-Scholes valuation model with the following assumptions: volatility rateof 58%; a risk-free interest rate of 2.6%; and an estimated life of2.25 years. In the first quarter of fiscal 2006, adjustments of $0.7 weremade to both goodwill and the acquisition costs. Snap Appliance is included inthe Company’s Channel segment. (Note 14).

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 the first quarter of fiscal 2006, the Companyrecorded a reduction of $0.1 million of deferred stock-based compensationrelated to cancellations of Snap Unvested Options. In the first quarter offiscal 2006, the Unaudited Condensed Consolidated Statement of Operationsincluded stock-based compensation expense with respect to Snap Unvested Optionsof $0.3 million.

In addition, a management incentive program wasestablished to pay former employees of Snap Appliance cash payments totaling$13.8 million, which is being paid, contingent upon their employment withthe Company, over a two-year period through the second quarter of fiscal 2007.Payments under the management incentive program will be expensed as employeesmeet their employment obligations or are recorded as part of the Snap Applianceacquisition-related restructuring for involuntarily terminations by 

9

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

**4.Business Acquisitions (Continued)**

the Company. In the firstquarter of fiscal 2006, the Unaudited Condensed Consolidated Statements ofOperations included compensation expense related to the management incentiveprogram of $1.3 million.

***Acquisition-RelatedRestructuring:  ***In the third and fourth quarter offiscal 2005, the Company refined its Snap Appliance integration plan toeliminate certain duplicative resources, including severance and benefits inconnection with the involuntary termination of approximately 24 employees,exiting duplicative facilities and disposing of duplicative assets. Theacquisition-related restructuring liabilities were accounted for under EITF95-3 and therefore were included in the purchase price allocation. The Companyrecorded a preliminary estimate of $6.0 million in the second quarter offiscal 2005 for these activities. In the third and fourth quarters of fiscal2005, the Company recorded a $0.8 million increase to the accruedrestructuring charges with a corresponding change to goodwill as its plans werefurther refined. In the first quarter of fiscal 2006, the Company recordedadditional adjustments of $0.1 million as a decrease to the accruedrestructuring charges with a corresponding change to goodwill, as actualresults for benefits were lower than anticipated. The Company expects toexecute the integration plan as currently designed; however, actual results andcosts may differ as the plan is executed.

Any further changes to the Company’s estimate willresult in an increase or decrease to the accrued restructuring charges and acorresponding increase or decrease to goodwill. As of June 30, 2005, theCompany had utilized $3.9 million of these charges. The Companyanticipates that the remaining restructuring reserve balance of$2.8 million will be paid out by the third quarter of fiscal 2012,primarily related to long-term facility leases.

Theactivity in the accrued restructuring reserve related to the Snap Applianceacquisition-related restructuring plan was as follows for the first quarter offiscal 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        | )                      |       |       | —     |   |   | (49 | ) |
| Cash paid                                                   |       |                    | (1         | )                      |       |       | (255       | ) |   | (256 | ) |
| Reserve balance at  June 30, 2005                      |       |                    | $          | 105                    |       |       |       | $ | 2,646 |   |   | $ | 2,751 |   |
|                                                             |            |                         |            |                        |            |            |            |  |  |  |  |  |  |  |

 

**In-process Technology**

As part of the purchaseagreements of the IBM i/p Series RAID business and Snap Appliance, certainamounts of the purchase prices were allocated to acquired in-process technologywhich were determined through established valuation techniques in thehigh-technology computer industry and written off in the first and secondquarter of fiscal 2005, respectively, because technological feasibility had notbeen established and no alternative future uses existed. The values weredetermined by estimating the net cash 

10

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

**4.Business Acquisitions (Continued)**

flows and discounting the estimated net cash flows totheir present values. A summary 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      |   |   |

----

(1)          Thein-process projects were related to designing semiconductors and related boardsand enhancements to RAID and firmware code.

(2)          Theidentified in-process projects were related to operating system enhancementsand system functionality improvements.

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

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

The percentage of completion was determined usingcosts incurred by the IBM i/p Series RAID business and Snap Applianceprior to their respective acquisition dates compared to the estimated remainingresearch and development to be completed to bring the projects to technologicalfeasibility. The Company estimated, as of the respective acquisition dates forthe IBM i/p Series RAID business and Snap Appliance, that the projectswere approximately 50% complete and 25% complete, respectively. The Companyexpects remaining costs of approximately $8.7 million and $0.2 millionrelated to the IBM i/p Series RAID business and Snap Appliance, respectively,to bring the planned in-process projects to completion.

11

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

**4.Business Acquisitions (Continued)**

During the first quarter of fiscal 2006, the Companyrecorded an impairment charge of $15.5 million on the long-lived assetsassociated with the IBM i/p Series RAID business. The Company is currentlyin negotiations with IBM regarding their current research and developmentrequirements and the profitability of this business. There can be no assuranceof a positive outcome to these negotiations and they otherwise could lead toadditional impairment charges, a reduction of this business and/or litigationbetween the parties.

**ProForma Results:  **The following unaudited pro formafinancial information for the first quarter of fiscal 2005 presents thecombined results of the Company and the IBM i/p Series RAID business andSnap Appliance as if the acquisitions had occurred at the beginning of theperiod presented. Certain adjustments have been made to the combined results ofoperations, including amortization of acquired other intangible assets;however, charges for purchased in-process technology were excluded as theseitems were non-recurring. The pro forma financial results for the first quarterof fiscal 2005 were as follows:
| ** **           | ** ** | **Three-Month Period Ended**                                | ** ** |
|----------------------|------------|-----------------------------------------------------------------------|------------|
| ** **           | ** ** | **June 30, 2004**                                           | ** ** |
| ** **           | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net revenues         |       |                                                                  | $          | 128,667 |   |   |
| Net loss             |       |                                                                  | (5,961     | ) |   |
| Net loss per  share: |       |                                                                  |       |   |   |
| Basic                |       |                                                                  | $          | (0.05 | ) |   |
| Diluted              |       |                                                                  | $          | (0.05 | ) |   |

 

**5. Balance SheetsDetails**

**Inventories:**
| ** **      | ** ** | **June 30, 2005** | ** ** | **March 31, 2005** | ** ** |
|-----------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **      | ** ** | **(in thousands)**     | ** ** |
| Raw materials   |       |                        | $          | 13,007                       |       |   |   | $ | 15,914 |   |   |
| Work-in-process |       |                        | 6,608      |                         |       |   | 7,435 |   |   |
| Finished goods  |       |                        | 28,731     |                         |       |   | 36,855 |   |   |
| Total           |       |                        | $          | 48,346                       |       |   |   | $ | 60,204 |   |   |

 

In the first quarter offiscal 2006, the Company recorded an excess inventory adjustment of $4.3million related to the transition of its products to comply with the EuropeanRestriction on Use of Hazardous Substances Directive.

12

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

**5. Balance Sheets Details(Continued)**

**Accrued Liabilities:**
| ** **                              | ** ** | **June 30, 2005** | ** ** | **March 31, 2005** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                              | ** ** | **(in thousands)**     | ** ** |
| Tax related                             |       |                        | $          | 47,046                       |       |   |   | $ | 57,538 |   |   |
| Acquisition  related                    |       |                        | 6,359      |                         |       |   | 6,748 |   |   |
| Accrued  compensation and related taxes |       |                        | 17,198     |                         |       |   | 18,304 |   |   |
| IBM distribution  agreement             |       |                        | 8,550      |                         |       |   | 11,575 |   |   |
| Other                                   |       |                        | 27,167     |                         |       |   | 21,842 |   |   |
| Total                                   |       |                        | $          | 106,320                      |       |   |   | $ | 116,007 |   |   |

 

**6. Goodwill and Other Intangible Assets**

**Goodwill:**

Goodwillallocated to the Company’s reportable segments and changes in the carryingamount of goodwill for the first quarter 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      | )          |
| Balance at June 30,  2005  |       | $                       | 48,617     |        | $          | 41,985    |       | $ | 90,602 |   |

 

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.

**Other IntangibleAssets:**
| ** **                                           | ** ** | **June 30, 2005** | ** ** | **March 31, 2005** | ** ** |
|------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                           | ** ** | **Gross Carrying**     | ** ** | **Accumulated**              | ** ** | **Gross Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                                           | ** ** | **Amount**                  | ** ** | **Amortization**             | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| ** **                                           | ** ** | **(in thousands)**     | ** ** |
| **Acquisition-related intangible assets:** |       |                        |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Patents, core and existing technologies              |       |                        | $          | 74,009                       |       |   |   | $ | (34,517 | ) |   |   | $ | 74,009 |   |   |   | $ | (26,265 | ) |   |
| Supply agreement                                     |       |                        | 7,600      |                         |       |   | (3,343 | ) |   |   | 7,600 |   |   |   | (1,140 | ) |   |
| Customer relationships                               |       |                        | 1,290      |                         |       |   | (711 | ) |   |   | 1,290 |   |   |   | (631 | ) |   |
| Trade name                                           |       |                        | 10,930     |                         |       |   | (1,953 | ) |   |   | 10,930 |   |   |   | (1,523 | ) |   |
| Foundry agreement                                    |       |                        | 600        |                         |       |   | (264 | ) |   |   | 600 |   |   |   | (90 | ) |   |
| Subtotal                                             |       |                        | 94,429     |                         |       |   | (40,788 | ) |   |   | 94,429 |   |   |   | (29,649 | ) |   |
| Intellectual  property assets and warrants           |       |                        | 41,942     |                         |       |   | (28,986 | ) |   |   | 41,942 |   |   |   | (27,265 | ) |   |
| Total                                                |       |                        | $          | 136,371                      |       |   |   | $ | (69,774 | ) |   |   | $ | 136,371 |   |   |   | $ | (56,914 | ) |   |

 

13

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

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

Amortization of other intangible assets was $12.9million and $4.7 million in the first quarters of fiscal 2006 and 2005,respectively.

The Company regularly performs reviews to determine iffacts or circumstances are present, either internal or external, which wouldindicate that the carrying values of its long-lived assets may not berecoverable. If such circumstances are determined to exist, an estimate ofundiscounted future cash flows produced by the long-lived asset, or theappropriate grouping of assets, is compared to the carrying value to determinewhether an impairment exists. If an asset is determined to be impaired, theloss is measured based on the difference between the asset’s fair value and itscarrying value. The estimate of fair value of the assets is based ondiscounting estimated future cash flows using a discount rate commensurate withthe risks inherent in its current business model. The estimation of theimpairment involves numerous assumptions which require judgment by the Company,including, but not limited to, future use of the assets for Company operationsversus sale or disposal of the assets and future selling prices for the Company’sproducts. During the first quarter of fiscal 2006, as a result of increasedresearch and development costs necessary to meet IBM’s current expectations,the Company performed an impairment analysis that indicated that the carryingamount of the long-lived assets associated with the IBM i/p Series RAIDbusiness, which is part of the Company’s OEM segment, exceeded their estimatedfair value, resulting in an impairment of $15.5 million in the UnauditedCondensed Consolidated Statements of Operations. Of the resulting impairment of$15.5 million, $7.5 million related to theIBM distribution agreement prepaid and other assets and was recorded as areduction to “Net revenues,” $6.2 million related to intangible assetsand was recorded against “Other charges” and $1.8 million related to fixedassets and was recorded against “Other charges.” The Company is currently innegotiations with IBM regarding their current research and developmentrequirements and the profitability of this business. There can be no assuranceof a positive outcome to these negotiations and they otherwise could lead toadditional impairment charges, a reduction of this business and/or litigationbetween the parties.

Theannual amortization expense of the other intangible assets that existed as of June 30,2005 is expected to be as follows:
| ** **                    | ** ** | **Estimated Amortization Expense**    | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|
| ** **                    | ** ** | **Acquisition-related  intangible assets** | ** ** | **Intellectual  property assets** | ** ** |
| ** **                    | ** ** | **(in thousands)**                         | ** ** |
| Fiscal Years:                 |       |                                            |       |   |   |   |   |   |   |
| 2006 (remaining  nine months) |       |                                            | $          | 11,120 |   |   |   | $ | 4,949 |   |   |
| 2007                          |       |                                            | 12,774     |   |   |   | 6,316 |   |   |
| 2008                          |       |                                            | 10,042     |   |   |   | 1,691 |   |   |
| 2009                          |       |                                            | 9,415      |   |   |   | — |   |   |
| 2010 and  thereafter          |       |                                            | 10,290     |   |   |   | — |   |   |
| Total                         |       |                                            | $          | 53,641 |   |   |   | $ | 12,956 |   |   |

 

14

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

**7. Interest and OtherIncome**

Thecomponents of interest and other income for the first quarters of fiscal 2006and 2005, were as follows:
| ** **                                   | ** ** | **Three-Month Period Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                | ** ** |
| Interest income                              |       |                                   | $          | 3,574 |   |   |   | $ | 2,726 |   |   |
| Payment of  license fee with NSE             |       |                                   | —     |   |   |   | (1,250 | ) |   |
| Loss on  redemption of debt                  |       |                                   | (86        | ) |   |   | — |   |   |
| Foreign currency  transaction gains (losses) |       |                                   | (317       | ) |   |   | 44 |   |   |
| Other                                        |       |                                   | 437        |   |   |   | 323 |   |   |
| Total                                        |       |                                   | $          | 3,608 |   |   |   | $ | 1,843 |   |   |

 

In the first quarter of fiscal 2006, the Companyrepurchased $19.8 million of its 3% Convertible Subordinated Notes (“3%Notes”) on the open market for an aggregate price of $19.6 million, ofwhich $1.0 million will be paid in the second quarter of fiscal 2006, resultingin a loss on extinguishment of debt of $0.1 million (including unamortizeddebt issuance costs of $0.3 million). The loss on extinguishment of debthas been included in “Interest and other income” in the Company’s UnauditedCondensed Consolidated Statement of Operations.

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 fee to settleNSE’s claims that some of the Company’s products infringed certain patents. Thelicense and release agreement expressly excluded any sales of products made byEurologic Systems Group Limited (“Eurologic”) prior to the Company’s April 2003acquisition of Eurologic. In November 2004, the Company exercised itsoption to secure a license and release with respect to such Eurologic sales bypayment to NSE of a royalty fee of $0.4 million. The Company has filed aclaim against the Eurologic acquisition Holdback for the $0.4 millionroyalty it paid with respect to Eurologic’s pre-acquisition sales. TheEurologic shareholders are disputing the Company’s right to withhold the$0.4 million from the Holdback. See Note 12 for further discussion of theEurologic Holdback.

**8. RestructuringCharges**

The Company recorded restructuring charges of $0.04million and $0.8 million for the first quarters of fiscal 2006 and 2005,respectively. 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 rather managed at the corporate level. For a complete discussionof all restructuring actions that were implemented prior to fiscal 2006, pleaserefer to the Notes to Consolidated Financial Statements included in the Company’sAnnual Report onForm 10-K for the year ended March 31, 2005. In the first quarter offiscal 2006, the Company recorded provision adjustments of $0.04 millionrelated to severance and benefits as actual costs were lower than anticipatedand additional lease costs related to the estimated loss of facilities that theCompany subleased in California through April 2008, the end of the leaseterm. This restructuring charge pertained to the 

15

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

**8.Restructuring Charges (Continued)**

Company’s first, second,third and fourth quarters of fiscal 2005, fiscal 2004 and fiscal 2001restructuring plans. The fiscal 2004 restructuring plan was completed in thefirst quarter of fiscal 2006.

Theactivity in the accrued restructuring reserves related to all of the plans wasas follows for the first quarter of fiscal 2006:
| ** **                              | ** ** | **Severance And**  | ** ** | ** **             | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|------------------------|------------|------------|------------|
| ** **                              | ** ** | **Benefits**            | ** ** | **Other Charges** | ** ** | **Total**  | ** ** |
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Reserve balance  at March 31, 2005 |       |                    | $          | 896                    |       |       |       | $ | 1,627 |   |   | $ | 2,523 |   |
| Provision  adjustments                  |       |                    | (198       | )                      |       |       | 238        |   |   | 40 |   |
| Cash paid                               |       |                    | (548       | )                      |       |       | (300       | ) |   | (848 | ) |
| Reserve balance  at June 30, 2005  |       |                    | $          | 150                    |       |       |       | $ | 1,565 |   |   | $ | 1,715 |   |

 

The Company anticipatesthat the remaining restructuring reserve balance of $1.7 million will besubstantially paid out by the first quarter of fiscal 2009, primarilyattributable to longer term lease obligations.  The remaining restructuring reserve balance isreflected both in “Accrued liabilities” and “Other long-term liabilities” inthe Unaudited Condensed Consolidated Balance Sheet.

**9. 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.

A reconciliation of the numeratorand denominator of the basic and diluted net income (loss) per sharecomputations were as follows:
| ** **                                                                               | ** ** | **Three-Month Period Ended**                                | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **June 30, 2005**                                           | ** ** | **June 30, 2004** | ** ** |
| ** **                                                                               | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Numerators:                                                                              |       |                                                                  |       |   |   |   |   |   |   |
| Net income (loss)                                                                        |       |                                                                  | $          | (35,973 | ) |   |   | $ | 10 |   |   |
| Adjusted net income (loss)                                                               |       |                                                                  | $          | (35,973 | ) |   |   | $ | 10 |   |   |
| Denominators:                                                                            |       |                                                                  |       |   |   |   |   |   |   |
| Weighted average shares outstanding—basic                                           |       |                                                                  | 112,445    |   |   |   | 109,840 |   |   |
| Effect of  dilutive securities:                                                          |       |                                                                  |       |   |   |   |   |   |   |
| Employee stock options                                                                   |       |                                                                  | —     |   |   |   | 1,696 |   |   |
| Weighted average shares and potentially dilutive  common shares outstanding—diluted |       |                                                                  | 112,445    |   |   |   | 111,536 |   |   |
| Net income (loss)  per share:                                                            |       |                                                                  |       |   |   |   |   |   |   |
| Basic                                                                                    |       |                                                                  | $          | (0.32 | ) |   |   | $ | 0.00 |   |   |
| Diluted                                                                                  |       |                                                                  | $          | (0.32 | ) |   |   | $ | 0.00 |   |   |

** **

16

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

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

 

Dilutedloss per share for the first quarter 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 for the first quarter of fiscal 2005 because their inclusion wouldhave been anti-dilutive. The items excluded for the first quarters of fiscal2006 and 2005 were as follows:
| ** **                          | ** ** | **Three-Month Period Ended** | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |
| ** **                          | ** ** | **(in thousands)**                | ** ** |
| Outstanding  employee stock options |       |                                   | 19,730     |   |   |   | 14,812 |   |   |
| Warrants(1)                         |       |                                   | 19,874     |   |   |   | 19,374 |   |   |
| 3% Notes                            |       |                                   | 1,427      |   |   |   | 2,298 |   |   |
| 3⁄4% Notes                       |       |                                   | 19,224     |   |   |   | 19,224 |   |   |

----

(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 our AnnualReport on Form 10-K for the year ended March 31, 2005.

**10. ComprehensiveIncome (Loss)**

TheCompany’s comprehensive loss, which consisted of net loss and the changes innet unrealized gains (losses) on marketable securities, net of taxes, andforeign currency translation adjustments, net of taxes, were as follows:
| ** **                                                            | ** ** | **Three-Month Period Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                            | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |
| ** **                                                            | ** ** | **(in thousands)**                | ** ** |
| Net income (loss)                                                     |       |                                   | $          | (35,973 | ) |   |   | $ | 10 |   |   |
| Net unrealized  gains (losses) on marketable securities, net of taxes |       |                                   | 421        |   |   |   | (3,094 | ) |   |
| Foreign currency  translation adjustment, net of taxes                |       |                                   | (805       | ) |   |   | (154 | ) |   |
| Comprehensive loss                                                    |       |                                   | $          | (36,357 | ) |   |   | $ | (3,238 | ) |   |

 

Thecomponents of accumulated other comprehensive income, net of taxes, were asfollows:
| ** **                                                                                               | ** ** | **June 30, 2005** | ** ** | **March 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                               | ** ** | **(in thousands)**     | ** ** |
| Unrealized losses  on marketable securities                                                              |       |                        | $          | (125                         | )          |   |   | $ | (546 | ) |   |
| Foreign currency  translation, net of tax of $298 at June 30, 2005 and $834 at  March 31, 2005 |       |                        | 447        |                         |       |   | 1,252 |   |   |
| Total                                                                                                    |       |                        | $          | 322                          |       |   |   | $ | 706 |   |   |

 

17

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

**11. IncomeTaxes**

Income tax provisions forinterim periods are based on the Company’s estimated annual income tax rate. Inthe first quarter of fiscal 2006, the Company recorded an income tax provisionof $1.1 million on a pre-tax loss of $34.9 million. In the first quarter offiscal 2005, the Company recorded an income tax provision of $7,000 on pre-taxincome of $17,000. The estimated annual tax rate differs from the combinedUnited States Federal and state statutory income tax rate of 40% primarily dueto the valuation allowance recorded on all of the U.S. net deferred tax assets,foreign taxes related to the Company’s foreign subsidiaries and certainacquisition related intangible assets, excluding goodwill, that are not fullydeductible for tax purposes and interest accrued on prior years’ tax disputes.The Company is in ongoing negotiations with the IRS with regard to its varioustax disputes that may result in settlement of certain issues. The Company’s taxrate for the period in which a settlement is reached will be impacted if thesettlement materially differs from the amounts previously accrued.

**12. Commitmentsand Contingencies**

The Company has been, oris, subject to IRS audits for its fiscal years 1994 through 2003. The fiscal1994 through fiscal 1996 cycle, which is docketed in the United States TaxCourt, was resolved in December 2001. The outcome did not have a materialadverse effect on the Company’s financial position or results of operations, assufficient tax provisions had been made. The final Tax Court stipulation willbe filed when the subsequent audit cycles are completed. Tax credits that weregenerated but not used in subsequent years may be carried back to the fiscal1994 to 1996 audit cycle.

On December 15, 2000,the Company received a statutory notice of deficiency from the IRS with respectto its Federal income tax return for fiscal 1997. The Company filed a Petitionwith the United States Tax Court on March 14, 2001, contesting theasserted deficiencies. Settlement agreements have been filed with the UnitedStates Tax Court on all but one issue. The Company believes that the finaloutcome of all issues will not have a material adverse impact on its financialposition or results of operations, as the Company believes that it hasmeritorious defenses against the asserted deficiencies and any proposedadjustments and that it has made sufficient tax provisions. However, theCompany cannot predict with certainty how these matters will be resolved andwhether it will be required to make additional payments.

In addition, the IRS iscurrently auditing the Company’s Federal income tax returns for fiscal 1998through fiscal 2003. In the third quarter of fiscal 2005, the Company resolvedall issues for fiscal 1998 through fiscal 2001, other than the rollover impactof any potential resolution on the remaining fiscal 1997 issue and tax creditsthat were generated but not used in subsequent years that may be carried back.The Company believes that it has provided sufficient tax provisions for theseyears and the ultimate outcome of the IRS audits will not have a materialadverse impact on its financial position or results of operations in futureperiods. However, the Company cannot predict with certainty how these matterswill be resolved and whether it will be required to make additional taxpayments.

The Company is a party toother litigation matters and claims, including those related to intellectualproperty, which are normal in the course of its operations, and while theresults of such litigation matters and claims cannot be predicted withcertainty, the Company believes that the final outcome of such matters will nothave a material adverse impact on its financial position or results ofoperations. However, because of the nature and inherent uncertainties oflitigation, should the outcome of these actions be unfavorable, the Company’sbusiness, financial condition, results of operations and cash flows could bematerially and adversely affected.

18

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

**12. Commitments &Contingencies (Continued)**

In connection with theCompany’s acquisitions of Snap Appliance, Eurologic and Elipsan Limited (“Elipsan”),a portion of the purchase price and other future payments totaling $6.7million, $3.8 million and $2.0 million, respectively, were held back (the “Holdbacks”)for unknown liabilities that may have existed as of the acquisition dates. TheCompany has asserted claims against the Snap Appliance and Eurologic Holdbackstotaling $3.5 million and $1.5 million, respectively. The Elipsan Holdback willbe paid in the second quarter of fiscal 2006, except for funds necessary toprovide for any pending claims.

**13. Guarantees**

*IntellectualProperty Indemnification Obligations*

The Company has enteredinto agreements with customers and suppliers that include intellectual propertyindemnification obligations. These indemnification obligations generallyrequire the Company to compensate the other party for certain damages and costsincurred as a result of third party intellectual property claims arising fromthese transactions. In each of these circumstances, payment by the Company isconditional on the other party making a claim pursuant to the proceduresspecified in the particular contract, which procedures typically allow theCompany to challenge the other party’s claims. Further, the Company’sobligations under these agreements may be limited in terms of time and/oramount, and in some instances, the Company may have recourse against 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 quarters of fiscal 2006 and 2005.

19

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

**13.Guarantees (Continued)**

A reconciliation of thechanges to the Company’s warranty accrual for the first quarters of fiscal 2006and 2005 was as follows:
| ** **                      | ** ** | **Three-Month Period Ended** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|
| ** **                      | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |
| ** **                      | ** ** | **(in thousands)**                | ** ** |
| Balance at  beginning of period |       |                                   | $          | 2,084 |   |   |   | $ | 1,598 |   |   |
| Warranties  provided            |       |                                   | 1,383      |   |   |   | 1,708 |   |   |
| Actual costs  incurred          |       |                                   | (1,520     | ) |   |   | (1,493 | ) |   |
| Balance at end of period        |       |                                   | $          | 1,947 |   |   |   | $ | 1,813 |   |   |

 

**14. Segment Reporting**

The Company is in the process of reorganizing itsinternal organization structure related to its OEM and Channel segments. Wherehistorically the Company’s former OEM and Channel segments each offered anintegrated set of customer-focused products, the new organization will bemanaged at the product level. The Company will begin to report its  financial information based upon this newstructure in the second quarter of fiscal 2006.

For the periodended June 30, 2005, the Company operated in three reportable segments:OEM, Channel and DSG. A description of the types of customers or products andservices provided by each reportable segment is as follows:

·       OEMprovides storage products directly to OEMs or to ODMs that supplyOEMs, enabling them to resell next-generation storage products built on theCompany’s intellectual property. OEM customers are characterized by long salesand design cycles involving close collaboration between the Company’s and OEMs’engineering teams. The Company currently sells all of its storage technologies,except DSG products, in various form factors, such as storage arrays,board-level products, ASICs and stand-alone software, to its OEM customers.

·       Channelprovides storage products to VARs and end users through its network of distributionand reseller customers. Channel customers are characterized by shorter salescycles than OEM customers and Channel customers purchase standard products. TheCompany currently sells many of the technologies it provides to its OEMcustomers to its Channel customers generally in storage array or board-levelform factors.

·       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, acquired in-process technology, restructuring charges, othercharges, interest and other income, interest expense, and all administrative,research and development and selling and marketing expenses.

There were nointer-segment revenues for the periods shown below. The Company does notseparately track all tangible assets or depreciation by operating segments norare the segments evaluated 

20

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

**14.Segment Reporting (Continued)**

under these criteria. Segment financial information issummarized as follows for the first quarters of fiscal 2006 and 2005:
| ** **                                    | ** ** | **OEM**                 | ** ** | **Channel** | ** ** | **DSG** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|-------------|------------|---------|------------|-----------|------------|-----------|------------|
| ** **                                    | ** ** | **(in thousands)** | ** ** |
| Three-Month  Period Ended June 30, 2005: |       |                    |       |        |       |    |       |      |       |      |       |
| Net revenues                                  |       | $                       | 63,591     |        | $          | 26,015  |       | $         | 8,792      |      | $          | — |   | $ | 98,398 |   |
| Segment income (loss)                         |       | 11,885                  |       | 8,213       |       | 285     |       | (55,251   | )          | (34,868   | )          |
| Three-Month  Period Ended June 30, 2004: |       |                    |       |        |       |    |       |      |       |      |       |
| Net revenues                                  |       | $                       | 67,065     |        | $          | 37,833  |       | $         | 10,604     |      | $          | — |   | $ | 115,502 |   |
| Segment income                                |       | 24,015                  |       | 23,412      |       | 3,914   |       | (51,324   | )          | 17        |       |

 

Thefollowing table presents the details of unallocated corporate income andexpenses for the first quarters of fiscal 2006 and 2005:
| ** **                           | ** ** | **Three-Month Period Ended** | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|
| ** **                           | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |
| ** **                           | ** ** | **(in thousands)**                | ** ** |
| Unallocated  corporate expenses, net |       |                                   | $          | (49,837 | ) |   |   | $ | (48,226 | ) |   |
| Acquired  in-process technology      |       |                                   | —     |   |   |   | (3,000 | ) |   |
| Restructuring  charges               |       |                                   | (40        | ) |   |   | (819 | ) |   |
| Other charges                        |       |                                   | (8,010     | ) |   |   | — |   |   |
| Interest and  other income           |       |                                   | 3,608      |   |   |   | 1,843 |   |   |
| Interest expense                     |       |                                   | (972       | ) |   |   | (1,122 | ) |   |
| Total                                |       |                                   | $          | (55,251 | ) |   |   | $ | (51,324 | ) |   |

 

**15.Supplemental Disclosure of Cash Flows**
| ** **                                        | ** ** | **Three-Month Period Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                        | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                | ** ** |
| Non-cash  investing and financial activities:     |       |                                   |       |   |   |   |   |   |   |
| Adjustment for  deferred stock-based compensation |       |                                   | $          | 390 |   |   |   | $ | 4 |   |   |
| Unrealized loss on  available-for-sale securities |       |                                   | 421        |   |   |   | (3,094 | ) |   |
|                                                   |            |                                        |            |  |  |  |  |  |  |  |  |

 

**16. Subsequent Events**

On July 29, 2005, theCompany completed the sale of certain properties in Milpitas, California, whichwere previously included in “Property and equipment, net” in the UnauditedCondensed Consolidated Balance Sheet as of June 30, 2005. Net proceeds forthe sale of the properties aggregated approximately $2.7 million. A gain on thesale will be recorded in the second quarter of fiscal 2006 approximating $0.3million.

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

**17. Glossary**

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

·       **ASIC:** Application Specific IntegratedCircuit

·       **ATA:** Advanced Technology Attachment

·       **DAS:** Direct-Attached Storage

·       **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

22

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

**17.Glossary (Continued)**

The following is a list of accounting rules andregulations and related regulatory bodies referred to within this QuarterlyReport on Form 10-Q. They are listed in alphabetical order.

·       **APB:** Accounting Principles Board

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

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

·       **ARB:**Accounting Research Bulletin

·       **EITF:** Emerging Issues Task Force

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

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

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

·       **FASB:** Financial Accounting Standards Board

·       **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. 115:**Accounting for CertainInvestments in Debt and Equity Securities

·       **SFAS No. 123:**Accounting for Stock-BasedCompensation

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

·       **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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**Item2.   Management’s Discussion and Analysis of Financial Condition andResults 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, revenues fromour SCSI-based desktop products, impairment charges that may occur inconnection with our IBM relationship and our liquidity in future periods. Wemay identify these statements by the use of words such as “anticipate,” “believe,”“continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,”“predict,” “project,” “should,” “will,” “would” and other similar expressions.All forward-looking statements included in this document are based oninformation available to us on the date hereof, and we assume no obligation toupdate any such forward-looking statements, except as may otherwise be requiredby law.

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

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

For your convenience, wehave included, in Note 17 to the Notes to the Unaudited Condensed ConsolidatedFinancial Statements, a Glossary that contains a list of (1) key acronymscommonly used in our industry that are used in this Quarterly Report and (2) accountingrules and regulations that are also referred to herein. These key acronymsand accounting rules and regulations are listed in alphabetical order.

**Results ofOperations**

**Overview**

In the first quarter of fiscal 2006, our revenuesdecreased 15% as compared to the first quarter of fiscal 2005 primarily as aresult of the transition from our Ultra 160 products to Ultra 320 products anddecreased demand from our Channel customers relative to our OEM customers forour component products in which we have a lower market share, and lower averageselling prices of our component products as demand shifts to lower-costsolutions. This decrease in revenue was partially offset by our fiscal 2005acquisitions which increased revenue by $11.5 million, net of theimpairment charge related to the IBM i/p Series RAID business of which$7.5 million was recorded as a reduction to “Net revenues.” In the firstquarter of fiscal 2006, IBM and Dell accounted for 23% (28% prior to theimpairment charge of $7.5 million) and 12% of our total net revenues,respectively. The decline in gross margin in the first quarter of fiscal 2006compared to the first quarter of fiscal 2005 was primarily due to theimpairment charge of $7.5 million related to the IBM i/p Series RAIDbusiness, an excess inventory adjustment of $4.3 million related to thetransition of our products to comply with the European Restriction on Use ofHazardous Substances Directive, or RoHS Directive, fixed costs associated withour manufacturing facilities that were distributed over lower revenue levelsand changes in our product and customer mix. Operating expenses increased inthe first quarter of fiscal 2006 as compared to the first quarter of fiscal2005, primarily as a result of the impairment charge related to the IBM i/p Series RAIDbusiness.

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Our new managementteam is in the process of performing a thorough analysis of our operations andmaking a detailed plan of our corporate strategy. This analysis will include areview of all aspects of our business, including our product portfolio, ourrelationships with IBM and our other strategic partners and our research anddevelopment focus. The actions that we are considering could adverselyaffect our business and financial results in the short term, may not have thelong-term beneficial results that we intend and could result in the following:

·       Lossof customers:

·       Reducedrevenue base:

·       Impairmentof our assets:

·       Increasedoperating costs: and

·       Materialrestructuring charges.

During the first quarter of fiscal 2006, we recordedan impairment charge of $15.5 million for long-lived assets associated with theIBM i/p Series RAID business. We are currently in negotiations with IBMregarding their current research and development requirements and theprofitability of this business. There can be no assurance of a positive outcometo these negotiations and they otherwise could lead to additional impairmentcharges, a reduction of this business and/or litigation between the parties.

Our future revenue growth remains largely dependent onthe success of our external and networked storage solutions, new OEM designwins and, to a lesser extent, on our products addressing new technologies (i.e.,SAS, SATA and iSCSI).

We are in the process of reorganizing our internalorganization structure related to our OEM and Channel segments. Wherehistorically our former OEM and Channel segments each offered an integrated setof customer-focused products, the new organization will be managed at theproduct level. We will begin to report our financial information based uponthis new structure in the second quarter of fiscal 2006.

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The following table sets forth the items in the Unaudited Condensed Consolidated Statementsof Operations as a percentage of net revenues:
| ** **                                             | ** ** | **Three-Month Period Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2005(1)**         | ** ** | **June 30, 2004(1)** | ** ** |
| Net revenues                                           |       |                                   | 100        | % |   |   | 100 | % |   |
| Cost of revenues                                       |       |                                   | 79         |   |   |   | 56 |   |   |
| Gross margin                                           |       |                                   | 21         |   |   |   | 44 |   |   |
| Operating expenses:                                    |       |                                   |       |   |   |   |   |   |   |
| Research and development                               |       |                                   | 26         |   |   |   | 22 |   |   |
| Selling, marketing and  administrative                 |       |                                   | 20         |   |   |   | 16 |   |   |
| Amortization of  acquisition-related intangible assets |       |                                   | 5          |   |   |   | 3 |   |   |
| Write-off of  acquired in-process technology           |       |                                   | —     |   |   |   | 3 |   |   |
| Restructuring charges                                  |       |                                   | 0          |   |   |   | 1 |   |   |
| Other charges                                          |       |                                   | 8          |   |   |   | — |   |   |
| Total operating expenses                               |       |                                   | 59         |   |   |   | 45 |   |   |
| Loss from operations                                   |       |                                   | (38        | ) |   |   | (1 | ) |   |
| Interest and other  income                             |       |                                   | 4          |   |   |   | 2 |   |   |
| Interest expense                                       |       |                                   | (1         | ) |   |   | (1 | ) |   |
| Income (loss) from  operations before income taxes     |       |                                   | (35        | ) |   |   | 0 |   |   |
| Provision for income  taxes                            |       |                                   | 1          |   |   |   | 0 |   |   |
| Net income (loss)                                      |       |                                   | (36        | )% |   |   | 0 | % |   |

----

 

(1)          Inthe first quarter of fiscal 2006, we recorded an impairment charge of $15.5million related to the IBM i/p Series RAID business, of which $7.5 millionwas recorded as a reduction to “Net revenues” and $8.0 million was recorded to “Othercharges” (Note 6). In the first quarter of fiscal 2005, we purchased the IBM i/p Series RAID business (Note4), made a payment of $1.3 million to Nevada SCSI Enterprises, Inc., orNSE, in the form of a license fee (Note 7) and implemented a restructuring planto consolidate certain development andadministrative functions in the United States and Europe. Thesetransactions affect the comparability of this data.

**Net Revenues.**
| ** **                 | ** ** | **Three-Month Period Ended**               | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|
| ** **                 | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                 | ** ** | **(in millions, except percentages)** | ** ** |
| **Segment  Net Revenues:** | ** ** |                                                 | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| OEM                        |       |                                                 | $          | 63.6 | ** ** |   |   | $ | 67.1 | ** ** |   |   | (5 | **)%** |   |
| Channel                    |       |                                                 | 26.0       | ** ** |   |   | 37.8 | ** ** |   |   | (31 | **)%** |   |
| DSG                        |       |                                                 | 8.8        | ** ** |   |   | 10.6 | ** ** |   |   | (17 | **)%** |   |
| **Total  Net Revenues**    |       |                                                 | 98.4       | ** ** |   |   | 115.5 | ** ** |   |   | **(15** | **)%** |   |
|                            |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Net revenues from our OEM segment decreased by$3.5 million in the first quarter of fiscal 2006 as compared to the firstquarter of fiscal 2005, reflecting a decline in sales volumes of our SCSIproducts primarily attributable to the transition from our Ultra 160 productsto Ultra 320 products in which we have a lower market share. This decrease inrevenue was partially offset by sales of $4.4 million in connection with theIBM i/p Series RAID business acquisition, net of the impairment chargerelated to the IBM i/p Series RAID business of which $7.5 million wasrecorded as a reduction to “Net revenues,” as well as increased sales fromproducts based on next generation SATA technology. For further discussion onthe impairment of the IBM i/p Series RAID business, please refer to “Othercharges” discussed below.

Net revenues from our Channel segment decreased by$11.8 million in the first quarter of fiscal 2006 as compared to the firstquarter of fiscal 2005, reflecting a shift to lower cost SATA solutions and 

26

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motherboards that containbuilt-in SCSI I/O functionality, thus reducing our average selling price. Inaddition, we intentionally reduced inventory in the channel and experienced anoverall decrease in sales of our component products due to lower demand fromour Channel customers relative to our OEM customers. This was partially offsetby sales of our NAS system products of $7.1 million that were acquired throughthe Snap Appliance acquisition in the second quarter of fiscal 2005.

Net revenues fromour DSG segment decreased by $1.8 million in the first quarter of fiscal2006 as compared to the first quarter of fiscal 2005 as a result of the declinein sales volumes of our SCSI-based desktop computer products, partially offsetby sales of storage products that were introduced in the fourth quarter offiscal 2005 and increased sales of our digital media products. We expectrevenues from our SCSI-based desktop computer products to continue to declineas OEMs are incorporating connectivity technologies directly into theirproducts.
| ** **                   | ** ** | **Three-Month Period Ended** | ** ** |
|------------------------------|------------|----------------------------------------|------------|
| ** **                   | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |
| **Geographical  Revenues:**  | ** ** |                                   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| North America                |       |                                   | 45         | **%** |   |   | 40 | **%** |   |
| Europe                       |       |                                   | 33         | **%** |   |   | 31 | **%** |   |
| Pacific Rim                  |       |                                   | 22         | **%** |   |   | 29 | **%** |   |
| Total Geographical  Revenues |       |                                   | 100        | **%** |   |   | 100 | **%** |   |

 

Our overall internationalrevenues declined as a percentage of our total gross revenues in thefirst quarter of fiscal 2006 as compared to the first quarter of fiscal 2005primarily as a result of increased sales to IBM, which are sold primarily inNorth America, and foreign currency fluctuations in the European countries. Includedin European revenues for the first quarter of fiscal 2006 was $5 million of a$10 million last time customer order. The remaining $5 million is expected tobe recognized in the second quarter of fiscal 2006.

A small number of our customers account for asubstantial portion of our net revenues, and we expect that a limited number ofcustomers will continue to represent a substantial portion of our net revenuesfor the foreseeable future. In the first quarter of fiscal 2006, IBM and Dellaccounted for 23% (28% prior to the impairment charge of $7.5 million) and 12%of our total net revenues, respectively. In the first quarter of fiscal 2005, IBM,Dell and Synnex accounted for 16%, 12% and 12% of our total net revenues,respectively.

**Gross Margin.**
| ** **   | ** ** | **Three-Month Period Ended**               | ** ** |
|--------------|------------|------------------------------------------------------|------------|
| ** **   | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **   | ** ** | **(in millions, except percentages)** | ** ** |
| Gross Profit |       |                                                 | $          | 20.5 |   |   |   | $ | 50.4 |   |   |   | (59 | )% |   |
| Gross Margin |       |                                                 | 21         | % |   |   | 44 | % |   |   |   |   |   |

 

The decline in grossmargin in the first quarter of fiscal 2006 compared to the first quarter offiscal 2005 was primarily due to the impairment charge related to the IBM i/p Series RAIDbusiness which decreased gross margin by six percentage points, an excessinventory adjustment of $4.3 million related to the transition of our productsto comply with the European RoHS Directive, fixed costs associated with ourmanufacturing facilities that were distributed over lower revenue levels,  and changes in our product mix and to alesser extent, changes in our customer mix between OEM and Channel customers.Gross margins were also impacted due to increased sales of our lower-marginsystem products and decreased sales of our higher-margin component productssold to Channel customers. Our gross margins will be significantly impacted inthe future by the mix of OEM and channel revenue.

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**Research andDevelopment Expense.**
| ** **                | ** ** | **Three-Month Period Ended**               | ** ** |
|---------------------------|------------|------------------------------------------------------|------------|
| ** **                | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                | ** ** | **(in millions, except percentages)** | ** ** |
| Research and  Development |       |                                                 | $          | 25.8 |   |   |   | $ | 25.4 |   |   |   | 2 | % |   |
|                           |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in researchand development expense in the first quarter of fiscal 2006 as compared to thefirst quarter of fiscal 2005 was primarily a result of increased headcount fromour acquisitions of the IBM i/p Series RAID business and Snap Appliance,costs associated with the development of the IBM DS300 and DS400 products andcompensation of $0.4 million in the first quarter of fiscal 2006 relatedto a management incentive program established for former Snap Applianceemployees pursuant to the Snap Appliance acquisition agreement. This waspartially offset by decreased infrastructure spending and reduced headcount asa result of restructuring programs implemented in fiscal 2005, the reducedheadcount as a result of the ServerEngines and Vitesse strategic alliances weentered into in the fourth quarter of fiscal 2005 and decreased deferredcompensation charges of $0.7 million in the first quarter of fiscal 2006compared to the first quarter of fiscal 2005. Deferred compensation chargesrepresented the vesting of assumed stock options in connection with our PlatysCommunications, Inc., or Platys, and Snap Appliance acquisitions.

**Selling, Marketing and Administrative Expense.**
| ** **                             | ** ** | **Three-Month Period Ended**               | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                             | ** ** | **(in millions, except percentages)** | ** ** |
| Selling,  Marketing and Administrative |       |                                                 | $          | 19.2 |   |   |   | $ | 18.9 |   |   |   | 2 | % |   |
|                                        |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in selling,marketing and administrative expense in the first quarter of fiscal 2006 ascompared to the first quarter of fiscal 2005 was primarily a result ofincreased headcount, compensation of $1.2 million in relation to retirementcosts of our former CEO, compensation of $0.7 million in the first quarterof fiscal 2006 related to a management incentive program established for formerSnap Appliance employees pursuant to the Snap Appliance acquisition agreementand increased deferred compensation charges of $0.2 million representingthe vesting of assumed stock options in connection with our Platys and SnapAppliance acquisitions. This was partially offset by decreased spending due toreductions of our workforce and infrastructure spending as a result of therestructuring plans we implemented in fiscal 2005.

**Amortization of Acquisition-Related IntangibleAssets.**
| ** **                                             | ** ** | **Three-Month Period Ended**               | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                                             | ** ** | **(in millions, except percentages)** | ** ** |
| Amortization of  Acquisition-Related Intangible Assets |       |                                                 | $          | 4.9 |   |   |   | $ | 2.9 |   |   |   | 67 | % |   |
|                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

The increase inamortization of acquisition-related intangible assets in the first quarter offiscal 2006 compared to the first quarter of fiscal 2005 was due to theamortization of $2.6 million of purchased intangible assets related to theacquisitions of the IBM i/p Series RAID business in June 2004 and ofSnap Appliance in July 2004. This was partially offset by certainEurologic Systems Group Limited and Platys acquisition-related intangibleassets that became fully amortized.

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**Write-off of Acquired In-Process Technology.**
| ** **                | ** ** | **Three-Month Period Ended** | ** ** |
|---------------------------|------------|----------------------------------------|------------|
| ** **                | ** ** | **June 30, 2005**            | ** ** | **June 30, 2004** | ** ** |
| IBM i/p  Series RAID |       |                                   | $          | — |   |   |   | $ | 3.0 |   |   |
|                           |            |                                        |            |  |  |  |  |  |  |  |  |

 

Projects that qualify as acquired in-processtechnology represent those in which technological feasibility had not been establishedand no alternative future uses existed. The amounts allocated to acquiredin-process technology were determined through established valuation techniquesin the high-technology computer industry.

The net cash flows from the identified projects were basedon estimates of revenues, cost of revenues, research and development expenses,including costs to complete the projects, selling, marketing and administrativeexpenses, royalty expenses and income taxes from the projects. We believe theassumptions used in the valuation were reasonable at the time of theacquisition. The estimated net revenues and gross margins were based onmanagement’s projections of the projects and were in line with industryaverages. Estimated total net revenues from the projects of the IBM i/p Series RAIDbusiness were expected to grow through fiscal 2009 and decline thereafter asother new products are expected to become available. Estimated operatingexpenses included research and development expenses and selling, marketing andadministrative expenses based upon historical and expected direct expenselevels and general industry metrics. Estimated research and developmentexpenses included costs to bring the projects to technological feasibility andcosts associated with activities undertaken to correct errors or keep productsupdated with current information (also referred to as “maintenance” researchand development) after a product is available for general release to customers.These activities range from 0% to 5% of net revenues for the in-processtechnologies.

The effective tax rate used in the analysis of thein-process technologies reflects a combined historical industry specificaverage for the United States Federal and state statutory income tax rates. Thecost of capital reflects the estimated time to complete the projects and thelevel of risk involved. The discount rate used in computing the present valueof net cash flows from the IBM i/p Series RAID business acquisition wasbetween 23% and 28%.

The percentage of completion was determined usingcosts incurred by the IBM i/p Series RAID business prior to theacquisition date compared to the estimated remaining research and developmentto be completed to bring the projects to technological feasibility. Weestimated, as of the acquisition date for the IBM i/p Series RAIDbusiness, that the projects were approximately 50% complete. We expectremaining costs of approximately $8.7 million related to the IBM i/p Series RAIDbusiness to bring the planned in-process projects to completion.

During the first quarterof fiscal 2006, we recorded an impairment charge of $15.5 million on thelong-lived assets associated with the IBM i/p Series RAID business. We arecurrently in negotiations with IBM regarding their current research and developmentrequirements and the profitability of this business. There can be no assuranceof a positive outcome to these negotiations and they otherwise could lead toadditional impairment charges, a reduction of this business and/or litigationbetween the parties.

**Restructuring Charges.**
| ** **             | ** ** | **Three-Month Period Ended**               | ** ** |
|------------------------|------------|------------------------------------------------------|------------|
| ** **             | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **             | ** ** | **(in millions, except percentages)** | ** ** |
| Restructuring  Charges |       |                                                 | $          | 0.04 |   |   |   | $ | 0.8 |   |   |   | (95 | )% |   |
|                        |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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All expenses, includingadjustments, associated with our restructuring plans are included in “Restructuringcharges” in the Unaudited Condensed Consolidated Statements of Operations andare not allocated to segments but rather managed at the corporate level. For acomplete discussion of all restructuring actions that were implemented prior tofiscal 2006, please refer to the Notes to Consolidated Financial Statementsincluded in our Annual Report on Form 10-K for the year ended March 31,2005. In the first quarter of fiscal 2006, we recorded provision adjustments of$0.04 million related to severance and benefits as actual costs were lower thananticipated and additional lease costs related to the estimated loss offacilities that we subleased in California through April 2008, the end ofthe lease term. This restructuring charge pertained to our first, second, thirdand fourth quarters of fiscal 2005, fiscal 2004 and fiscal 2001 restructuringplans. The fiscal 2004 restructuring plan was completed in the first quarter offiscal 2006.

**Other Charges.**
| ** **    | ** ** | **Three-Month Period Ended**               | ** ** |
|---------------|------------|------------------------------------------------------|------------|
| ** **    | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **    | ** ** | **(in millions, except percentages)** | ** ** |
| Other Charges |       |                                                 | $          | 8.0 |   |   |   | $ | — |   |   |   | 100 | % |   |
|               |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

We regularly performreviews to determine if facts or circumstances are present, either internal orexternal, which would indicate that the carrying values of our long-livedassets may not be recoverable. If such circumstances are determined to exist,an estimate of undiscounted future cash flows produced by the long-lived asset,or the appropriate grouping of assets, is compared to the carrying value todetermine whether an impairment exists. If an asset is determined to beimpaired, the loss is measured based on the difference between the asset’s fairvalue and its carrying value. The estimate of fair value of the assets is basedon discounting estimated future cash flows using a discount rate commensuratewith the risks inherent in its current business model. The estimation of theimpairment involves numerous assumptions which require judgment by us, including,but not limited to, future use of the assets for our operations versus sale ordisposal of the assets and future selling prices for our products. During thefirst quarter of fiscal 2006, as a result of increased research and developmentcosts necessary to meet IBM’s current expectations, we performed an impairmentanalysis that indicated that the carrying amount of the long-lived assetsassociated with the IBM i/p Series RAID business, which is part of our OEMsegment, exceeded their estimated fair value, resulting in an impairment of$15.5 million in the Unaudited Condensed Consolidated Statements of Operations.Of the resulting impairment of $15.5 million,$7.5 million related to the IBM distribution agreement’s prepaid and otherassets and was recorded as a reduction to “Net revenues,” $6.2 millionrelated to intangible assets and was recorded against “Other charges” and $1.8million related to fixed assets and was recorded against “Other charges.” Weare currently in negotiations with IBM regarding their current research anddevelopment requirements and the profitability of this business. There can beno assurance of a positive outcome to these negotiations and they otherwisecould lead to additional impairment charges, a reduction of this business and/orlitigation between the parties.

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**Interest and OtherIncome.**
| ** **                          | ** ** | **Three-Month Period Ended**               | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|
| ** **                          | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                          | ** ** | **(in millions, except percentages)** | ** ** |
| **Interest  and Other Income:**     | ** ** |                                                 | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Interest income                     |       |                                                 | $          | 3.6 | ** ** |   |   | $ | 2.7 | ** ** |   |   | 31 | **%** |   |
| Payment of  license fee with NSE    |       |                                                 | —     | ** ** |   |   | (1.3 | **)** |   |   | 100 | **%** |   |
| Loss on  redemption of debt         |       |                                                 | (0.1       | **)** |   |   | — | ** ** |   |   | (100 | **)%** |   |
| Other                               |       |                                                 | 0.1        | ** ** |   |   | 0.4 | ** ** |   |   | (67 | **)%** |   |
| **Total Interest and Other Income** |       |                                                 | 3.6        | ** ** |   |   | 1.8 | ** ** |   |   | **96** | **%** |   |
|                                     |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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% Notes.

The increase in interestand other income in the first quarter of fiscal 2006 as compared to the firstquarter of fiscal 2005 was primarily due to higher interest income earned onour cash, cash equivalents and marketable securities and a one-time fullypaid-up license fee of $1.3 million to NSE, which was recorded in thefirst quarter of fiscal 2005, primarily for historical products thatincorporated certain technology. This was offset by foreign currencyfluctuations primarily related to the Euro and a loss of $0.1 million on therepurchase of our 3% Notes. For further discussion on the settlement with NSE,please refer to Note 7 to the Notes to Unaudited Condensed ConsolidatedFinancial Statements.

**Interest Expense.**
| ** **       | ** ** | **Three-Month Period Ended**               | ** ** |
|------------------|------------|------------------------------------------------------|------------|
| ** **       | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **       | ** ** | **(in millions, except percentages)** | ** ** |
| Interest Expense |       |                                                 | $          | (1.0 | ) |   |   | $ | (1.1 | ) |   |   | (13 | )% |   |
|                  |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest expense isprimarily associated with our 3/4% Notes and 3% Notes, issued in December 2003and March 2002, respectively. The decrease in interest expense for thefirst quarter of fiscal 2006 compared to the first quarter of fiscal 2005 wasprimarily due to the reduction in the outstanding balances of the 3% Notes.

**Income Taxes.**
| ** **                  | ** ** | **Three-Month Period Ended**               | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|
| ** **                  | ** ** | **June 30, 2005**                          | ** ** | **June 30, 2004** | ** ** | **Percentage  Change** | ** ** |
| ** **                  | ** ** | **(in millions, except percentages)** | ** ** |
| Provision for  Income Taxes |       |                                                 | $          | 1.1 |   |   |   | $ | 0 |   |   |   | n/a |   |   |
|                             |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Income tax provisions for interim periods are based onour estimated annual effective income tax rate. Our estimate of our fiscal 2006taxes represents interest accrued on prior year’s tax disputes and foreigntaxes related to our foreign subsidiaries including tax on certain Singaporeincome that is not subject to our Singapore tax holiday. The tax rate for thefirst quarter of fiscal 2006 differed from the combined United States Federaland state statutory income tax rate of 40% primarily due to the valuationallowance recorded on all of the U.S. net deferred tax assets, foreign taxesrelated to our foreign subsidiaries, certain acquisition related intangibleassets, excluding goodwill, that are not fully deductible for tax purposes andinterest accrued on prior years’ tax disputes. The tax rate for the firstquarter of fiscal 2005 differed from the combined United States Federal andstate statutory income tax rate of 40% primarily due to certain 

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acquisitionrelated intangible assets, excluding goodwill, that are not fully deductiblefor tax purposes and interest accrued on prior years’ tax disputes. We are inongoing negotiations with the IRS with regard to various tax disputes that mayresult in settlement of certain issues. Our tax rate for the period in which asettlement is reached will be impacted if the settlement materially differsfrom the amounts previously accrued.

**Liquidity and Capital Resources**

**Key Components of Cash Flows**

Cash used for operationswas $23.0 million in the first quarter of fiscal 2006 as compared to cashprovided by operations of $8.2 million in the first quarter of fiscal 2005.Cash used in the first quarter of fiscal 2006 resulted primarily from our netloss of $36.0 million. This was partially offset by the benefit of non-cashitems included in operating results, which primarily consisted of an impairmentcharge of $15.5 million related to the IBM i/p Series RAID business anddepreciation and amortization of marketable securities, intangible assets andproperty and equipment of $14.6 million. Additional factors includedchanges to working capital assets and liabilities that decreased cash providedby operating activities by $17.7 million. Operating cash for the first quarterof fiscal 2005 resulted primarily from the benefit of non-cash items includedin operating results and the growth in accounts payable offset by the growth inaccounts receivable and inventory. Non-cash items primarily consisted ofdepreciation and amortization of marketable securities, intangible assets andproperty and equipment of $10.3 million, write-off of acquired in processtechnology of $3.0 million and amortization of deferred stock-basedcompensation of $0.8 million.

Days sales outstanding deteriorated to 70 at June 30,2005 as compared to 57 at March 31, 2005 due to linearity of shipmentswithin the quarter and lower revenue levels in the first quarter of fiscal 2006due to the impairment of the IBM i/p Series RAID business with nocorresponding decrease to accounts receivable. The increase was not due tochanges in the credit quality of our customers. Annualized inventory turnsincreased to 5.7 at June 30, 2005 as compared to 5.2 at March 31,2005 primarily due to decreased inventory levels.

Cash used for investing activities was$322.1 million in the first quarter of fiscal 2006, which was primarilydue to net sales and maturities of restricted marketable securities andmarketable securities, net of purchases, of $317.0 million and purchases ofproperty and equipment of $5.1 million. Cash provided by investingactivities was $34.1 million in the first quarter of fiscal 2005, whichwas primarily due to net sales and maturities of restricted marketablesecurities and marketable securities, net of purchases, of $83.8 million,offset by our use of $47.5 million of cash to acquire the IBM i/p Series RAIDbusiness.

Cash used for financing activities of $18.5 millionin the first quarter of fiscal 2006 was primarily driven by the repurchaseof  $19.8 million in aggregate principalamount of our 3% Notes for $18.6 million (an additional $1.0 million willbe paid in the second quarter of fiscal 2006). Cash provided by financingactivities was $0.4 million in the first quarter of fiscal 2005, whichrelated to net proceeds received from our issuance of common stock inconnection with stock option exercises.

**Liquidity**.   At June 30,2005, we had $479.9 million in cash, cash equivalents and marketablesecurities, of which approximately $53.5 million was held by our Singaporesubsidiary. In the fourth quarter of fiscal 2005, we repatriated $360.6 millionof undistributed earnings from Singapore to the United States and incurred atax liability of $17.6 million. The repatriated amounts will be used tofund a qualified Domestic Reinvestment Plan, as required by the American JobsCreation Act of 2004. If we do not spend the repatriated funds in accordancewith our reinvestment plan, we may incur additional tax liabilities. We havenot provided for U.S. deferred income taxes of foreign withholding taxes on theremaining undistributed earnings since these earnings totaling approximately$255.6 million are intended to be reinvested indefinitely. Although we donot have any current plans to repatriate the remaining undistributed earningsfrom our Singapore subsidiary to our United States parent company, if we wereto 

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do so, additional incometaxes at the combined United States Federal and state statutory rate ofapproximately 40% could be incurred from the repatriation.

At June 30, 2005, we had $240.4 million ofaggregate principal amount in convertible notes outstanding, consisting of$15.4 million in aggregate principal amount of our 3% Notes that are due in March 2007and $225.0 million in aggregate principal amount of our 3⁄4% Notes that are duein December 2023.

We are required to maintain restricted cash orinvestments to serve as collateral for the first ten scheduled interestpayments on our 3⁄4% Notes, respectively. As of June 30, 2005, we had$5.5 million of restricted cash and restricted marketable securities,consisting of United States government securities, of which $1.6 millionwas classified as short-term and $3.9 million was long-term.

The IRS is currentlyauditing our income tax returns for fiscal 1997 and final settlement agreementshave been filed with the United States Tax Court on all but one issue. Inaddition, the IRS is auditing our Federal income tax returns for fiscal 1998through fiscal 2003. We have resolved all issues for fiscal 1998 through fiscal2001 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 fiscal 2002 and 2003 audit isongoing. We believe that we have sufficient tax provisions for these years. Webelieve the final outcome of the IRS audits will not have a material adverseimpact on our liquidity.  However, wecannot predict with certainty how these matters will be resolved and whether wewill be required to make additional payments.

We invest in technology companies through two venturecapital funds, Pacven Walden Venture V Funds and APV Technology Partners II,L.P. At June 30, 2005, the carrying value of such investments aggregated$3.4 million. We have also committed to provide additional funding of up to$0.4 million.

As of June 30, 2005,we did not have any material changes to our contractual obligations.

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 twelve months.However, should prevailing economic conditions and/or financial, business andother factors beyond our control adversely affect our estimates of our futurecash requirements, we would be required to fund our cash requirements byalternative financing. There can be no assurance that additional financing, ifneeded, would be available on terms acceptable to us or at all.

**Recent Accounting Pronouncements**

In June 2005, theFASB issued SFAS No. 154, which changes the requirements for theaccounting for, and reporting of, a change in accounting principle. Previously,most voluntary changes in accounting principles were required to be recognizedby way of a cumulative effect adjustment within net income during the period ofthe change. SFAS No. 154 requires retrospective application to priorperiods’ financial statements, unless it is impracticable to determine eitherthe period-specific effects or the cumulative effect of the change. SFAS No. 154is effective for accounting changes made in fiscal years beginning after December 15,2005; however, the Statement does not change the transition provisions of anyexisting accounting pronouncements. We do not believe that the adoption ofSFAS No. 154 will have a material effect on our Unaudited CondensedConsolidated Balance Sheet, Statement of Operations or Cash Flows.

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 

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compensationexpense (as previous awards continue to vest) for the unvested portion ofpreviously granted awards that remain outstanding at the date of adoption. In April 2005,the SEC approved that SFAS No. 123(R) will be effective for annualperiods, as opposed to interim periods as originally issued by the FASB,beginning after June 15, 2005. We are currently evaluating the impact ofadopting this statement; however, we expect that it will have a significantimpact on our consolidated balance sheet and statement of operations. Theimpact on our consolidated financial statements will depend on the transitionmethod, the option-pricing model used to compute fair value and the inputs tothat model such as volatility and expected life. The pro forma disclosures ofthe impact of SFAS No. 123 provided in Note 3 of the Notes to theUnaudited Condensed Consolidated Financial Statements may not be representativeof the impact of adopting this statement.

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. SAB 107 creates a framework that is premised on two overarchingthemes: (a) considerable judgment will be required by preparers tosuccessfully implement SFAS No. 123(R), specifically when valuing employeestock options; and (b) reasonable individuals, acting in good faith, mayconclude differently on the fair value of employee stock options. Key topicscovered by SAB 107 include valuation models, expected volatility and expectedterm. We will apply the principles of SAB 107 in conjunction with our adoptionof SFAS No. 123(R).

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 ourUnaudited Condensed Consolidated Balance Sheet or Statement of Operations.

At its March 2004meeting, the EITF reached a consensus on recognition and measurement guidancepreviously discussed under EITF 03-01. The consensus clarified themeaning of other-than-temporary impairment and its application to investmentsclassified as either available-for-sale or held-to-maturity under SFAS No. 115and investments accounted for under the cost method or the equity method. In September 2004,the FASB delayed the recognition and measurement guidance to be applied toother-than-temporary impairment evaluations. The FASB expects to issueadditional implementation guidance with respect to debt securities that areimpaired solely due to interest rates and/or sector spreads. If this additionalimplementation guidance is issued as currently written, we may have torecognize unrealized losses on investments in the Statement of Operations. Ifthere is a material decline in the fair value of investments, our financialstatements could be adversely affected.

**Acquisitions**

**IBM i/p Series RAID:**On June 29,2004, we completed the acquisition of the IBM i/p Series RAID componentbusiness line consisting of certain purchased RAID data protection intellectualproperty, semiconductor designs and assets, and licensed from IBM related RAIDintellectual property. The licensing agreement grants us the right to use IBM’sRAID technology and embedded Power PC technology for our internal and externalRAID products to be sold to IBM and other customers. In conjunction with theacquisition, we also entered into a three-year exclusive product supplyagreement under which we will supply RAID software, firmware and hardware toIBM for use in IBM’s iSeries and pSeries servers. We also enteredinto an agreement for IBM to provide silicon wafer manufacturing processingservices to us for the term of the supply agreement 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 

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andacquisitions costs. In connection with the acquisition, we issued a warrant toIBM to purchase 250,000 shares of our common stock at an exercise price of$8.13 per share. The warrant has a term of 5 years from the date ofissuance and is immediately exercisable. The warrant was valued using theBlack- Scholes valuation model using a volatility rate of 62%, a risk-freeinterest rate of 3.9% and an estimated life of 5 years. The transactioncosts consist primarily of legal, valuation and other fees. The IBM i/p Series RAIDbusiness is included in our OEM segment (Note 14).

**SnapAppliance:**    On July 23, 2004, wecompleted the acquisition of Snap Appliance, a provider of NAS products, toexpand our product offerings in the external storage market and to delivercost-effective, scalable and easy-to-use DAS, NAS, Fibre Channel and IP-basedSAN products from the workgroup to the data center. The total purchase pricewas $83.7 million, consisting of $76.7 million in cash andtransaction fees and $7.0 million related to the fair value of assumedstock options to purchase 1.2 million shares of our common stock. Theassumed stock options were valued using the Black-Scholes valuation model withthe following assumptions: volatility rate of 58%; a risk-free interest rate of2.6%; and an estimated life of 2.25 years. In the first quarter of fiscal2006, adjustments of $0.7 were made to both goodwill and the acquisition costs.Snap Appliance is included in the our Channel segment. (Note 14).

Of the total assumed stockoptions, stock options to purchase approximately 0.7 million shares of ourcommon stock, with exercise prices ranging between $1.42 and $5.66 per share,were unvested (the “Snap Unvested Options”). The Snap Unvested Options have aten-year term and vest primarily over four years from the date of grant. Theintrinsic value of the Snap Unvested Options of $3.6 million was accountedfor as deferred stock-based compensation and is being recognized ascompensation expense over the related vesting periods. In the first quarter offiscal 2006, we recorded a reduction of $0.1 million of deferredstock-based compensation related to cancellations of Snap Unvested Options. Inthe first quarter of fiscal 2006, the Unaudited Condensed ConsolidatedStatement of Operations included stock-based compensation expense with respectto Snap Unvested Options of $0.3 million.

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 us, over a two-year period through the second quarter offiscal 2007. Payments under the management incentive program will be expensedas employees meet their employment obligations or are recorded as part of theSnap Appliance acquisition-related restructuring for involuntarily terminationsby us. In the first quarter of fiscal 2006, the Unaudited CondensedConsolidated Statements of Operations included compensation expense related tothe management incentive program of $1.3 million.

***Acquisition-Related Restructuring:***    Inthe third and fourth quarter of fiscal 2005, we refined our Snap Applianceintegration plan to eliminate certain duplicative resources, includingseverance and benefits in connection with the involuntary termination ofapproximately 24 employees, exiting duplicative facilities and disposing ofduplicative assets. The acquisition-related restructuring liabilities wereaccounted for under EITF 95-3 and therefore were included in the purchaseprice allocation. We recorded a preliminary estimate of $6.0 million inthe second quarter of fiscal 2005 for these activities. In the third and fourthquarters of fiscal 2005, we recorded a $0.8 million increase to theaccrued restructuring charges with a corresponding change to goodwill as ourplans were further refined. In the first quarter of fiscal 2006, we recordedadditional adjustments of $0.1 million as a decrease to the accruedrestructuring charges with a corresponding change to goodwill, as actualresults for benefits were lower than anticipated. We expect to execute theintegration plan as currently designed; however, actual results and costs maydiffer as the plan is executed. Any further changes to our estimate will resultin an increase or decrease to the accrued restructuring charges and acorresponding increase or decrease to goodwill. As of June 30, 2005, wehad utilized $3.9 million of these charges. We anticipate that theremaining restructuring reserve balance of $2.8 million will be paid outby the third quarter of fiscal 2012, primarily related to long-term facilityleases.

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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.

***Our new management team isperforming a thorough analysis of all aspects of our businesses and developinga corporate strategy. The actions taken by our management may not have thebeneficial results that we intend and our business and financial results may beadversely impacted by these decisions.*** Our new managementteam is in the process of performing a thorough analysis of our operations andmaking a detailed plan of our corporate strategy. This analysis will include areview of all aspects of our business, including our product portfolio, ourrelationship with IBM and our other strategic partners and our research anddevelopment focus. The actions that we are considering could adverselyaffect our business and financial results in the short term and may not havethe long term beneficial results that we intend and could result in thefollowing:

·       Lossof customers

·       Reducedrevenue base

·       Impairmentof our assets

·       Increasedoperating costs

·       Materialrestructuring charges

***Our operating results havefluctuated in the past, and are likely to continue to fluctuate, and if ourfuture results are below the expectations of investors or securities analysts,the market price of our common stock would likely decline significantly.***  Our quarterly operating results have fluctuated in the past, andare likely to vary significantly in the future, based on a number of factorsrelated to our industry and the markets for our products. Factors that arelikely to cause our operating results to fluctuate include those discussed inthe risk factors below. In the first quarter of fiscal 2006, our operatingresults were materially affected by unusual charges, including an impairmentcharge of $15.5 million related to the IBM i/p Series RAID business and anexcess inventory adjustment of $4.3 million related to the transition of our productsto 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.

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

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

·       Increasedprice competition for our products;

·       Increasedrisk of excess and obsolete inventories;

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·       Excessfacilities and manufacturing capacity; and

·       Higheroverhead costs as a percentage of revenues.

Demand for our products would likely be negativelyaffected if demand in the server and network storage markets declines. 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 be widespread,which could adversely affect our revenues.

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

***We depend on a fewkey customers and the loss of any of them could significantly reduce ourrevenues.***   Historically, a small numberof our customers has accounted for a significant portion of our revenues.During the first quarters of fiscal 2006 and 2005, sales to the ten customersfrom which we received the greatest revenues accounted for approximately 79%and 72% of our total gross revenues, respectively. In addition, IBM represented23% (28% prior to the impairment charge of $7.5 million) and 16%, respectively,of our total net revenues in the first quarters of fiscal 2006 and 2005, andDell represented 12% of our total net revenues in both the first quarters offiscal 2006 and 2005. We believe that our major customers continually evaluatewhether or not to purchase products from alternate or additional sources.Additionally, customers’ economic and market conditions frequently change.Accordingly, we cannot assure you that a major customer will not reduce, delayor eliminate its purchases from us, which would likely cause our revenues todecline. In addition, we do not carry credit insurance on our accountsreceivables and any difficulty in collecting outstanding amounts due from ourcustomers, particularly customers that place larger orders or experiencefinancial difficulties, could adversely affect our revenues and our net income.Because our sales are made by means of standard purchase orders rather thanlong-term contracts, we cannot assure you that these customers will continue topurchase quantities of our products at current levels, or at all.

***We expect that the products weare developing for the network storage marketplace will be an importantcomponent of our anticipated future growth, and these products may not beaccepted by the market or reach the market in a timely fashion.***  Webelieve that developing products for the network storage marketplace will be animportant component of our anticipated future growth, and we have attempted toaccelerate such product development efforts through acquisitions. For example,in July 2004, we acquired Snap Appliance, a provider of NAS products; in February 2004,we acquired Elipsan, a provider of networked storage infrastructure software;and in April 2003, we acquired Eurologic, a provider of external andnetworked storage products. The marketplace for advanced storage products ishighly competitive. While we are focusing on products employing iSCSItechnology for this market, other companies are also focusing on 

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network storage productsbased on identified technologies that include, but are not limited to, iSCSI. Asa result, our technology may never be broadly adopted. Even if iSCSI technologyachieves broad market acceptance, our early technological advantage in thisfield may not afford us the advantages we had anticipated if such acceptancecontinues to be delayed. In addition, there are substantial risks that knownand unknown challenges to successful deployment of our products, and ofproducts incorporating our products, will cause delays in their reaching themarket. If iSCSI technology and our network storage products, and our customers’products using our technology, do not achieve a broad level of marketacceptance, or if we encounter substantial delays in entering the market, ourgrowth will likely be impaired.

***Our dependence onnew products may cause our net revenues to fluctuate or decline.***  Ourfuture success significantly depends upon our completing and introducingenhanced and new products at competitive prices and performance levels in atimely manner. The success of new product introductions depends on severalfactors, including the following:

·       Designingproducts to meet customer needs;

·       Productcosts;

·       Timelycompletion and introduction of new product designs;

·       Qualityof new products;

·       Differentiationof new products from those of our competitors; and

·       Marketacceptance of our products.

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

We have introducedRAID-enabled products based on the next generation SATA technology anddelivered our products based on SAS technology to certain major OEMs fortesting and integration. We will not succeed in generating significant revenuesfrom our new SATA and SAS technology products if the market does not adapt tothese new technologies, which would, over time, adversely affect our netrevenues and operating results.

***Ourreliance on industry standards and technological changes in the marketplace maycause our net 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

·       Fibrechannel

·       FireWire/1394

·       IPsec

·       iSCSI

·       PCI

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·       PCI-Express

·       PCI-X

·       RAID

·       SAS

·       SATA

·       SCSI

·       SMI-S

·       UltraDMA

·       USB

*Operating Systems:*

·       Linux

·       Macintosh

·       Netware

·       OS/2

·       UNIX

·       Windows

If user acceptance ofthese standards declines, or if new standards emerge, and if we do not anticipatethese changes and develop new products, these changes could adversely affectour business and financial results.

***If welose the cooperation of other hardware and software producers whose productsare integral to ours, our ability to sustain or grow our revenues could beadversely affected.***  We must design ourproducts to operate effectively with a variety of hardware and softwareproducts supplied by other manufacturers, including the following:

·       Microprocessors;

·       Peripherals;and

·       Operatingsystem software.

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

***We are subject to variousenvironmental laws and regulations that could impose substantial costs upon usand may adversely affect our business.***   TheEuropean Parliament has enacted the Restriction on Use of Hazardous SubstancesDirective, or RoHS Directive, which restricts the sale of new electrical andelectronic equipment containing certain hazardous substances, including leadthat is currently used in 

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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  RoHS Directive. This may require us to makeadditional capital expenditures. In addition the costs associated withcompliance may negatively impact our operating results and competitiveposition. For example, in the first quarter of fiscal 2006, we had an excessinventory adjustment of $4.3 million related to the transition of our productsto comply with the RoHS Directive. We are also working with our suppliers toredesign or reformulate their components containing lead to reduce or eliminatelead in our products. If we are unable to comply with this Directive, we maysuffer a loss of revenue, be unable to sell affected products in certainmarkets or countries and be at a competitive disadvantage.

The European Parliament has also recently finalizedthe Waste Electrical and Electronic Equipment Directive, or WEEE Directive,which makes producers of electrical and electronic equipment financiallyresponsible for specified collection, recycling, treatment and disposal of pastand future covered products. We may incur financial responsibility for thecollection, recycling, treatment or disposal of products covered under the WEEEDirective. Because the EU member states have not fully implemented the WEEEDirective, the nature and extent of the costs to comply and fees or penaltiesassociated with non-compliance are unknown at this time. Costs to comply withthe WEEE Directive and similar future legislation, if applicable, may alsoinclude legal and regulatory costs and insurance costs. We may also be requiredto take reserves for costs associated with compliance with these regulations.

***Weentered into strategic alliances with Vitesse for the development of our SASROC 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 SAS products. In March 2005, we entered into astrategic alliance with ServerEngines to develop and market the next generationof our IP storage products, such as 10Gb iSCSI. Accordingly, we are at riskthat Vitesse and ServerEngines may encounter challenges in fulfilling theirresponsibilities under these alliances, such as timely completing andintroducing new product designs, maintaining the quality of new products,minimizing product costs, differentiating new products from those of our competitorsand achieving market acceptance of our products. The failure of this newproduct development effort could have an adverse effect on our business andfinancial results.

***If wedo not provide adequate support during our customers’ design and developmentstage, or if we are unable to provide such support in a timely manner, we maylose revenues to our competitors.***  Certain ofour products are designed to meet our customers’ specifications and, to theextent we 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 net revenues could be adversely affected.***  Themarkets for all of our products are intensely competitive and are characterizedby the following:

·       Rapidtechnological advances;

·       Frequentnew product introductions;

·       Evolvingindustry standards; and

·       Priceerosion.

Consequently, we mustcontinue to enhance our products on a timely basis to keep pace with marketdemands. If we do not do so, or if our competition is more effective indeveloping products that meet the needs of our existing and potentialcustomers, we may lose market share and not participate in the future growth ofour target markets. For example, intense competition in the transition fromproducts employing Ultra 160 technology to products employing Ultra 320technology has adversely affected revenues from 

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our SCSIproducts. Our future success will depend on the level of acceptance of ourexternal storage products and products based on the next generation SATA andSAS technologies by new and existing customers. In addition, we expect that ourfuture success will depend significantly on our ability to participate in theongoing development of the network storage market in which we face intensecompetition from other companies that are also focusing on networked storageproducts.

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

·       Satisfyany growth in demand for our products;

·       Maketimely introductions of new products;

·       Competesuccessfully in the future against existing or potential competitors;

·       ProvideOEMs with design specifications in a timely manner; and

·       Preventprice competition from eroding margins.

***Costsassociated with acquisitions or strategic alliances may adversely affect ourresults of operations, which could be exacerbated if we are unable to integratethe acquired companies, products or technologies.***   Infiscal 2005, we acquired the i/p Series RAID business from IBM and SnapAppliance. In fiscal 2004, we acquired Elipsan, ICP vortex, a provider of abroad range of hardware and software RAID data protection products, andEurologic, a provider of external and networked storage products. In addition,we enter into strategic alliances from time to time with other companies. Forexample, we entered into strategic alliances with Vitesse and ServerEngines in January andMarch 2005, respectively. As part of our overall strategy, we may continueto acquire or invest in complementary companies, products or technologies andenter into strategic alliances with other companies. In order to be successfulin these activities, we must:

·       Conductacquisitions that are timely, relative to existing business opportunities;

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

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

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

·       Retainthe key employees of the acquired 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 quarter of fiscal2006, we recorded an impairment charge of $15.5 million on the long-livedassets associated with the IBM i/p Series RAID business. We are currentlyin negotiations with IBM regarding their current research and developmentrequirements and the profitability of this business. There can be no assuranceof a positive outcome to these negotiations and they otherwise could lead toadditional impairment charges, a reduction of this business and/or litigationbetween the parties.

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 

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perform under a strategicalliance or to complete an acquisition, which could adversely affect ourresults of operations, at least in the short-term, even if we believe thestrategic alliance or acquisition will benefit us in the long-term. We may notbe successful in overcoming these risks or any other problems encountered inconnection with these or other business combinations, investments or strategicalliances. These transactions may adversely affect our business, financialposition and operating results.

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

***If there is a shortage ofcomponents used in our customers’ products, our sales may decline, which couldadversely 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. Similar shortagesof components used in our customers’ products could adversely affect our netrevenues and financial results in future periods.

***The manufacture and introduction of our products is highlycomplex.***  We confront challenges in themanufacturing process that require us to:

·       Maintaina competitive manufacturing cost structure;

·       Implementthe latest process technologies required to manufacture new products;

·       Exercisestringent quality control measures to ensure high yields;

·       Effectivelymanage inventory levels;

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

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

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

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

·       Theavailability of raw materials;

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·       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.Additional wafer suppliers may be unavailable, may take significant amounts oftime to qualify or may be unable to satisfy our requirements on a timely basis.

***We have entered into an expandedrelationship with IBM and if the revenue streams are less than anticipated wemay incur an impairment of our asset.  *** In December 2004,we entered into an expanded relationship with IBM that enables us to sellcertain Adaptec-branded RAID controllers and connectivity products, which werepreviously branded as IBM, for IBM’s i/p Series directly through IBM’ssales channel. As part of this agreement, we committed to payments totaling upto $52.1 million. During the first quarter of fiscal 2006 we recorded animpairment charge related to the IBM i/p Series RAID business of $15.5million, of which $7.5 million related to these assets. We are currently innegotiations with IBM regarding their current research and developmentrequirements and the profitability of this business. There can be no assuranceof a positive outcome to these negotiations and they otherwise could lead toadditional impairment charges, a reduction of this business and/or litigationbetween the parties.

***We have entered into an expandedrelationship with IBM and if we do not fulfill our responsibilities under thisagreement, it could result in a loss of revenues or reduced gross margins.***  InJune 2004, we entered into an expanded relationship with IBM to supplyexternal storage products and further expanded this relationship in December 2004.We may encounter challenges in fulfilling our responsibilities under thisexpanded relationship such as, timely completion and introduction of productdesigns to meet the specifications of IBM, quality of new products introduced,product costs, sales forecasting, material planning and inventory management tomeet its demand forecast. If we do not fulfill our responsibilities under thisagreement, product shipments could be affected, which could result in delayedor lost revenues and customer dissatisfaction. In addition, if we are notsuccessful in achieving our targeted costs and pricing assumptions, we couldcontinue to incur losses from the sale of our products or reduced grossmargins. For example, in fiscal 2005, gross margins were adversely impacted dueto negative margins obtained from our new external storage products sold toIBM. Costs associated with our new external storage products sold to IBM werehigher as a result of increased costs for initial components purchases fromsuppliers, start-up production costs, high overhead costs associated with lowervolumes and the cost of expediting components from suppliers and products toIBM.

***We depend on subcontractors, andif they fail to meet our manufacturing needs, it could delay shipments of ourproducts and result in the loss of customers.  *** Werely on subcontractors for the assembly and packaging of the integratedcircuits included in our products and for the assembly and manufacturing of aportion of our systems products. We have no long-term agreements with ourassembly and packaging subcontractors. We have, from time to time, used boardsubcontractors to better balance production runs and capacity. For example, weemploy Quanta Computer, Inc. and Sanmina-SCI Corporation to manufacturecertain 

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products related to theacquisition of Snap Appliance. We also employ Celestica, Inc. and JabilCircuit, Inc. to manufacture products related to the IBM i/p Series RAIDbusiness. We cannot assure you these subcontractors will continue to be ableand willing to meet our requirements for these components or services. Forexample, in the third quarter of fiscal 2005, Quanta Computer, Inc. couldnot meet our manufacturing needs and as a result initial product delivery datescommitted to customers were not met. Any significant disruption in suppliesfrom or degradation in the quality of components or services supplied by, thesesubcontractors could delay shipments and result in the loss of customers orrevenues, which could have an adverse effect on our financial results.

***We depend on the efforts of ourdistributors, which if reduced, could result in a loss of sales of our productsin favor of competitive offerings.***   We derivedapproximately 31% of our gross revenues for the first quarter of fiscal 2006from independent distributor and reseller channels. Our financial results couldbe adversely affected if our relationships with these distributors or resellerswere to deteriorate or if the financial condition of these distributors orresellers 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.

***We are in the process ofreorganizing our business segments and have planned significant systemenhancements and improvements, and these changes could adversely impact ourbusiness if not adequately managed and controlled.***  Weare in the process of reorganizing our internal organization structure relatedto our OEM and Channel segments. Where historically our former OEM and Channelsegments each offered an integrated set of customer-focused products, the neworganization will be managed at the product level. The reorganization hasplaced 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 meet ourrestructuring objectives, we may have to implement additional plans in order toreduce our operating costs and may, as a result, incur additional materialrestructuring charges.***   We have implementedseveral restructuring plans to reduce our operating costs in fiscal 2005,fiscal 2004 and fiscal 2003, and recorded related restructuring charges of$5.9 million, $4.3 million and $14.3 million, respectively. Theplans included primarily the reduction of our workforce and the consolidationof our manufacturing operations in Singapore. The goals of these plans were tosupport future growth opportunities, focus on investments that grow revenuesand increase operating margins. If we do not meet our restructuring objectives,we may 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.

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***Some of our products contain“open source” software, and any failure to comply with the terms of one or moreof these open source licenses could negatively affect our business.***  Someof our products are distributed with software licensed by its authors or otherthird parties under so-called “open source” licenses, including, for example,the GNU General Public License, or GPL, GNU Lesser General Public License, orLGPL, the Mozilla Public License, the BSD License, and the Apache License. Someof those licenses may require as a condition of the license that we makeavailable source code for modifications or derivative works we create basedupon, incorporating, or using the open source software, that we provide noticeswith our products, and/or that we license such modifications or derivativeworks under the terms of a particular open source license or other licensegranting third parties certain rights of further use. If an author or other thirdparty that distributes such open source software were to allege that we had notcomplied with the conditions of one or more of those open source licenses, wecould be required to incur legal expenses in defending against suchallegations, and if our defenses were not successful we could be enjoined fromdistribution of the products that contained the open source software andrequired to either make the source code for the open source software available,to grant third parties certain rights of further use of our software, or toremove the open source software from our products, which could disrupt ourdistribution and sale of some of our products. In addition, if we combine ourproprietary software with open source software in a certain manner, we could undersome of the open source licenses, be required to release the source code of ourproprietary software. If an author or other third party that distributes opensource software were to obtain a judgment against us based on allegations thatwe had not complied with the terms of any such open source licenses, we couldalso be subject to liability for copyright infringement damages and breach ofcontract for our past distribution of such open source software.

***Our operationsdepend on key personnel, the loss of whom could affect the growth and successof our business.***  In order to be successful,we must retain and motivate our executives, the general managers of ourbusiness segments, our principal engineers and other key employees, includingthose in managerial, technical, marketing and information technology supportpositions. In particular, our product generation efforts depend on hiring andretaining qualified engineers. Competition for experienced management,technical, marketing and support personnel remains intense. For example, wetransitioned certain research and development efforts to North Carolina, wherewe have experienced significant competition in our efforts to attract andretain qualified software engineers. In addition, with the exception of a fewemployees with whom we entered into employment agreements in connection withacquisition transactions, we do not have employment contracts with our keyemployees, including any of our executive officers. The loss of any of thesekey employees could have a significant impact on our operations. We also mustcontinue to motivate employees and keep them focused on our strategies andgoals, which may be particularly difficult due to morale challenges posed byworkforce reductions and general uncertainty.

***Our international operationsinvolve risks, and may be subject to political or other non-economic barriersto our being able to sell our products in certain countries, local economicconditions that reduce demand for our products among our target markets andpotential 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.

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***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 carrying value of ourlong-lived assets is not recoverable, an impairment loss must be recognizedwhich 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 firstquarter of fiscal 2006, we recorded an impairment charge of $15.5 millionrelated to the IBM i/p Series RAID business. In fiscal 2005, we recorded agoodwill impairment charge of $52.3 million related to our Channelsegment. In fiscal 2004, we recorded an impairment charge of $5.0 millionrelated to certain properties classified as held-for sale and a charge of$1.0 million relating to the decline in value of a minority investment. Infiscal 2003, we recorded an impairment charge of $1.5 million relating tothe decline in value of minority investments. In fiscal 2002, we recordedimpairment charges of $77.6 million relating to technology acquired in aprior acquisition and the decline in value of minority investments. We willcontinue to evaluate the recoverability of the carrying amount of ourlong-lived assets, and we may incur substantial impairment charges which couldadversely affect our financial results.

***If actual results or eventsdiffer materially from those contemplated by us in making estimates andassumptions, 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 year ended March 31, 2005, whichinclude revenue, inventory, goodwill and income taxes. In addition, Note 1of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-Kfor the year ended March 31, 2005 describes the significant accountingpolicies essential to preparing our consolidated financial statements. Thepreparation of these financial statements requires estimates and assumptionsthat affect the reported amounts and disclosures. Although we believe that ourjudgments and estimates are appropriate and correct, actual future results maydiffer materially from our estimates.

***If we are unable to protect andenforce our intellectual property rights, we may be unable to competeeffectively.  ***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 may assert infringementclaims against us, which may be expensive to defend and could divert ourresources.***  From time to time, third partiesassert exclusive patent, copyright and other intellectual 

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property rights to our keytechnologies, and we expect to continue to receive such claims in the future.For example, in June 2004, we, Nevada SCSI Enterprises, Inc. andThomas A. Gafford (jointly, “NSE”) entered into a license and releaseagreement, pursuant to which we paid NSE $1.3 million as a one-time, fullypaid-up license fee to settle NSE’s claims that some of our products infringedcertain patents. In addition, we entered into a patent cross-license agreementwith IBM in May 2000. Under this agreement, which was amended in March 2002,we received a release from infringement claims prior to January 1, 2000and received the right to use certain of IBM’s patents through June 30,2007. In consideration, we paid, in annual installments, an aggregate patentfee of $13.3 million through June 30, 2004. The risks of our receivingadditional claims from third parties may be enhanced in periods such as the onethat we are currently entering where we are beginning to offer product linesemploying new technologies relative to our existing products.

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

***We may be subject to a highereffective tax rate that could negatively affect our results of operations andfinancial position.***  Our effective tax rate isbenefited by a Singapore tax holiday relating to certain of our products. Thetax holiday package, which is effective until fiscal 2010, provides thatprofits derived from certain products may be exempt from tax, subject tocertain conditions. If we do not meet the conditions and requirements of thetax holiday in Singapore, our effective tax rate may increase, which wouldadversely affect our financial results. We held approximately$53.5 million of cash, cash equivalents and marketable securities at oursubsidiary in Singapore at June 30, 2005. During the fourth quarter offiscal 2005, we repatriated $360.6 million of cash from Singapore to theUnited States in connection with the American Jobs Creation Act of 2004 whichprovides a one-time deduction of 85% for certain dividends from controlledforeign corporations. If the amount repatriated does not qualify for theone-time deduction, we could incur additional income taxes at up to the UnitedStates Federal statutory rate of 35%, which would negatively affect our resultsof operations and financial condition. Further, if our subsidiary in Singaporeincurs losses in excess of their liquidity we may need to loan our subsidiaryin Singapore money that could result in unfavorable tax consequences.

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

***We may be engaged in legalproceedings that could cause us to incur unforeseen expenses and could occupy asignificant 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 could 

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cause us to incurunforeseen expenses, could occupy a significant amount of our management’s timeand attention, and could negatively affect our business operations andfinancial position.

***We have in the past financed aportion of our capital expenditure needs from capital market financing, and ifwe need to seek additional financing, it may not be available on favorableterms.***  In order to finance strategic acquisitions,capital asset acquisitions and other general corporate needs, we have in thepast relied, in part, on the capital markets. Historically, we have been ableto access capital markets, but this does not necessarily guarantee that we willbe able to access these markets in the future or at terms that are acceptableto us. The availability of capital in these markets is affected by severalfactors, including geopolitical risk, the interest rate environment and thecondition of the economy as a whole. In addition, our own operatingperformance, capital structure and expected future performance impacts ourability to raise capital. We believe that our current cash, cash equivalents,short-term investments and future cash provided by operations will be sufficientto fund our needs for at least the next twelve months. However, if ouroperating performance falls below expectations, we may need additional funds,which may not be available on favorable terms, if at all.

***We are exposed tofluctuations in foreign currency exchange rates.***  Becausea significant portion of our business is conducted outside the United States,we face exposure to adverse movements in non-United States currency exchangerates. These exposures may change over time as business practices evolve andcould have an adverse impact on our financial results and cash flows.Historically, our exposures have related to non-dollar-denominated operatingexpenses in Europe and Asia. We began Euro-denominated sales to ourdistribution customers in the European Union in the fourth quarter of fiscal2003. 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 minority interests inprivately held venture funds, and if these venture funds face financialdifficulties in their operations, our investments could be impaired.***  Wecontinue to hold minority interests in privately held venture funds. At June 30,2005, the carrying value of such investments aggregated $3.4 million. Wehave also committed to provide additional funding of up to $0.4 million.These investments are inherently risky because these venture funds invest incompanies that may still be in the development stage or depend on third partiesfor financing to support their ongoing operations. In addition, the markets forthe technologies or products of these companies are typically in the earlystages and may never develop. If these companies do not have adequate cashfunding to support their operations, or if they encounter difficultiesdeveloping their technologies or products, the venture funds’ investments inthese companies may be impaired, which in turn, could result in impairment ofour investment in these venture funds.

***Our spin-off of Roxio Inc.,which is now known as Napster Inc., may have potential subsequent taxliabilities that could negatively affect our results of operations.***  Pursuantto our distribution of the Roxio, Inc. common stock, we received anopinion from PricewaterhouseCoopers LLP, or PwC, regarding the tax-free natureof the transaction 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.

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***We may have potential businessconflicts of interest with Roxio, which is now known as Napster, with respectto our past and ongoing relationships, and we may not resolve these conflictson terms favorable to us.  *** Conflicts ofinterest 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, Interim Chief Executive Officerand Chief Financial Officer could face an increased risk of personal liabilityin connection with the performance of their duties. As a result, we may havedifficultly attracting and retaining qualified board members and executiveofficers, which would adversely affect our business.

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

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

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

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***Manmade problemssuch as computer viruses or terrorism may disrupt our operations and harm ouroperating results.  ***Despite our implementation ofnetwork security measures, our servers are vulnerable to computer viruses,break-ins and similar disruptions from unauthorized tampering with our computersystems. Any such event could have an adverse effect on our business, operatingresults, and financial condition. In addition, the effects of war or acts ofterrorism could have an adverse effect on our business, operating results, andfinancial condition. In addition, as a company with headquarters andsignificant operations located in the United States, we may be impacted byactions against the United States. We are predominantly uninsured for lossesand interruptions caused by terrorist acts and acts of war.

***We may experience significantfluctuations in our stock price, which may, in turn, significantly affect thetrading price of our convertible notes.***  Ourstock has experienced substantial price volatility, particularly as a result ofquarterly variations in our operating results, the published expectations ofanalysts and as a result of announcements by our competitors and us. Inaddition, the stock market has experienced price and volume fluctuations thathave affected the market price of many technology companies, in particular, andthat have often been unrelated to the operating performance of such companies.In addition, the price of our securities may also be affected by generalglobal, economic and market conditions and the cost of operations in one ormore of our product markets. While we cannot predict the individual effect thatthese factors may have on the price or our securities, these factors, eitherindividually or in the aggregate, could result in significant variations in theprice of our common stock during any given period of time. These fluctuationsin our stock price also impact the price of our outstanding convertiblesecurities and the likelihood of the convertible securities being convertedinto our common stock.

**Item3. Quantitative and Qualitative Disclosures About Market Risk**

For financial market risksrelated to changes in interest rates, equity price and foreign currencyexchange rates, reference is made to Item 7A “Quantitative and QualitativeDisclosures About Market Risk” contained in Part II of our Annual Reporton Form 10-K for the year ended March 31, 2005. Our exposure tomarket risk has not changed materially since March 31, 2005.

**Item 4. Controls and Procedures**

**Evaluationof Disclosure Controls and Procedures**

Under the supervision andwith the participation of our management, including our Interim Chief ExecutiveOfficer (CEO) and our Chief Financial Officer (CFO), we conducted an evaluationof our disclosure 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 Interim CEO and our CFO have concluded that thedesign and operation of our disclosure controls and procedures were effectiveto ensure that information required to be disclosed by us in reports that wefile or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in Securities and ExchangeCommission rules and forms.

**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 the Interim CEO and CFO,does not expect that our disclosure controls and procedures or our internalcontrol over financial reporting will prevent or detect all error and all 

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fraud. A control system,no matter how well designed and operated, can provide only reasonable, notabsolute, 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 31.1   |       | Certification of Interim 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 Interim Chief Executive Officer and  Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned hereuntoduly authorized.
| **ADAPTEC, INC.** |                                            |
|-------------------|-------------------------------------------------|
| By:               | /s/  MARSHALL L. MOHR                           |   |   |
|              | Marshall L. Mohr                                |   |   |
|              | *Vice  President and Chief Financial Officer*   |   |   |
|              | *(principal  financial and accounting officer)* |   | Date: August 8, 2005 |

 

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**EXHIBIT INDEX**
| Exhibit Number | ** ** | **Description**                                                                                                                                |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 31.1   |       | Certification of Interim 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 Interim Chief Executive Officer and  Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |

 

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