UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-Q

(Mark One)

 

 

x

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended June 30, 2005 or

o

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from             to             

Commission file number 0-15071


ADAPTEC, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

94-2748530

(State or other jurisdiction of
incorporation or organization)

(I.R.S. Employer
Identification No.)

691 S. MILPITAS BLVD., MILPITAS, CALIFORNIA

95035

(Address of principal executive offices)

(Zip Code)

 

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

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


Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x  No o

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

Yes x  No o

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

 




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




PART I.   FINANCIAL INFORMATION

Item 1.   Financial Statements

ADAPTEC, INC.
CONDENSED CONSOLIDATED STATEMENTS 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.

3




ADAPTEC, INC.
CONDENSED CONSOLIDATED BALANCE 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

 

 

¾% 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.

4




ADAPTEC, INC.
CONDENSED CONSOLIDATED STATEMENTS 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.

5




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

1. Basis of Presentation

In the opinion of management, the accompanying Unaudited Condensed Consolidated Interim Financial Statements (“financial statements”) of Adaptec, Inc. and its wholly-owned subsidiaries (collectively, the “Company”) have been prepared on a consistent basis with the March 31, 2005 audited consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary to fairly state the information set forth therein. The financial statements have been prepared in accordance with the regulations of the SEC, and, therefore, omit certain information and footnote disclosure necessary to present the statements in accordance with accounting principles generally accepted in the United States of America. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended 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 financial statements have been shown as ending on the last day of the calendar month. The results of operations for the first quarter of fiscal 2006 are not necessarily indicative of the results to be expected for the entire fiscal year.

Certain reclassifications have been made to prior period reported amounts to conform to the current period presentation, including reclassification of auction rate securities from cash and cash equivalents to marketable securities. Previously, such auction rate securities were classified as cash and cash equivalents. Accordingly, the Company has revised its presentation and made adjustments to the accompanying Unaudited Condensed Consolidated Statement of Cash Flows to reflect the gross purchases and sales of these auction rate securities as investing activities. This adjustment resulted in a net increase in cash used for investing activities by $4.0 million in the first quarter of fiscal 2005. This reclassification had no impact on previously reported results of operations, operating cash flows or working capital of the Company.

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

2. Recent Accounting Pronouncements

In June 2005, the FASB issued SFAS No. 154, which changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. The Company does not believe that the adoption of SFAS No. 154 will have a material effect on the Company’s Unaudited Condensed Consolidated 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 and supersedes APB Opinion No. 25. SFAS No. 123(R) requires companies to apply a fair-value based measurement method in accounting for share-based payment transactions with employees and to record compensation expense for all stock awards granted and to awards modified, repurchased or cancelled after the required effective date. In addition, the Company is required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted

6




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

2. Recent Accounting Pronouncements (Continued)

awards that remain outstanding at the date of adoption. In April 2005, the SEC approved that SFAS No. 123(R) will be effective for annual periods, as opposed to interim periods as originally issued by the FASB, beginning after June 15, 2005. The Company is currently evaluating the impact of adopting this statement; however, the Company expects that it will have a significant impact on the Company’s consolidated balance sheet and statement of operations. The impact on the Company’s consolidated financial statements will depend on the transition method, the option-pricing model used to compute fair value and the inputs to that model such as volatility and expected life. The pro forma disclosures of the impact of SFAS No. 123 provided in Note 3 may not be representative of the impact of adopting this statement.

In March 2005, the SEC issued SAB 107, which offers guidance on SFAS No. 123(R). SAB 107 was issued to assist preparers by simplifying some of the implementation challenges of SFAS No. 123(R) while enhancing the information that investors receive. SAB 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required by preparers to successfully implement FAS No. 123(R), specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may conclude differently on the fair value of employee stock options. Key topics covered by SAB 107 include valuation models, expected volatility and expected term. The Company will apply the principles 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 recognized as current-period charges. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted. The adoption of this standard is not expected to have a material impact on the Company’s Unaudited Condensed Consolidated Balance Sheet or Statement of Operations.

At its March 2004 meeting, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01. The consensus clarified the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under SFAS No. 115 and 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 to other-than-temporary impairment evaluations. The FASB expects to issue additional implementation guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads. If this additional implementation guidance is issued as currently written, the Company may have to recognize unrealized losses on investments in the Statement of Operations. If there is a material decline in the fair value of investments, the Company’s financial statements could be adversely affected.

3. Stock-Based Compensation

The Company accounts for stock-based compensation using the intrinsic-value-based method, which is in accordance with APB Opinion No. 25 as interpreted by FIN 44 and complies with the disclosure provisions of SFAS No. 148, an amendment of SFAS No. 123. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and
EITF No. 96-18, which requires that such equity instruments be recorded at their fair value on the measurement date, which is typically the date of grant.

7




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

3. Stock-Based Compensation (Continued)

The following table illustrates the effect on net income (loss) and net income (loss) per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to employee and director stock option plans, including shares issued under the Company’s ESPP, collectively called “options” for all periods presented:

 

 

Three-Month Period Ended

 

 

 

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 pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option pricing model, used by the Company, was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock.

The fair value of options granted in the first quarters of fiscal 2006 and 2005, as reported were estimated at the date of grant using the Black-Scholes valuation model 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. Business Acquisitions

IBM i/p Series RAID:   On June 29, 2004, the Company completed the acquisition of the IBM i/p Series RAID component business line consisting of certain purchased RAID data protection intellectual

8




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

4. Business Acquisitions (Continued)

property, semiconductor designs and assets, and licensed from IBM related RAID intellectual property. The licensing agreement grants the Company the right to use IBM’s RAID technology and embedded Power PC technology for the Company’s internal and external RAID products to be sold to IBM and other customers. In conjunction with the acquisition, the Company also entered into a three-year exclusive product 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 wafer manufacturing processing services to the Company for the term of the supply agreement at agreed upon rates.

The final purchase price was $49.3 million, which consisted 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 and acquisitions costs. In connection with the acquisition, the Company issued a warrant to IBM to purchase 250,000 shares of the Company’s common stock at an exercise price of $8.13 per share. The warrant has a term of 5 years from the date of issuance and is immediately exercisable. The warrant was valued using the Black- Scholes valuation model using a volatility rate of 62%, a risk-free interest rate of 3.9% and an estimated life of 5 years. The transaction costs consist primarily of legal, valuation and other fees. The IBM i/p Series RAID business is included in the Company’s OEM segment (Note 14).

Snap Appliance:   On July 23, 2004, the Company completed the acquisition of Snap Appliance, a provider of NAS products, to expand its product offerings in the external storage market and to deliver cost-effective, scalable and easy-to-use DAS, NAS, Fibre Channel and IP-based SAN products from the workgroup to the data center. The total purchase price was $83.7 million, consisting of $76.7 million in cash and transaction fees and $7.0 million related to the fair value of assumed stock options to purchase 1.2 million shares of the Company’s common stock. The assumed stock options were valued using the Black-Scholes valuation model with the following assumptions: volatility rate of 58%; a risk-free interest rate of 2.6%; and an estimated life of 2.25 years. In the first quarter of fiscal 2006, adjustments of $0.7 were made to both goodwill and the acquisition costs. Snap Appliance is included in the Company’s Channel segment. (Note 14).

Of the total assumed stock options, stock options to purchase 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 term and vest primarily over four years from the date of grant. The intrinsic value of the Snap Unvested Options of $3.6 million was accounted for as deferred stock-based compensation and is being recognized as compensation expense over the related vesting periods. In the first quarter of fiscal 2006, the Company recorded a reduction of $0.1 million of deferred stock-based compensation related to cancellations of Snap Unvested Options. In the first quarter of fiscal 2006, the Unaudited Condensed Consolidated Statement of Operations included stock-based compensation expense with respect to Snap Unvested Options of $0.3 million.

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

9




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

4. Business Acquisitions (Continued)

the Company. In the first quarter of fiscal 2006, the Unaudited Condensed Consolidated Statements of Operations included compensation expense related to the management incentive program of $1.3 million.

Acquisition-Related Restructuring:   In the third and fourth quarter of fiscal 2005, the Company refined its Snap Appliance integration plan to eliminate certain duplicative resources, including severance and benefits in connection with the involuntary termination of approximately 24 employees, exiting duplicative facilities and disposing of duplicative assets. The acquisition-related restructuring liabilities were accounted for under EITF 95-3 and therefore were included in the purchase price allocation. The Company recorded a preliminary estimate of $6.0 million in the second quarter of fiscal 2005 for these activities. In the third and fourth quarters of fiscal 2005, the Company recorded a $0.8 million increase to the accrued restructuring charges with a corresponding change to goodwill as its plans were further refined. In the first quarter of fiscal 2006, the Company recorded additional adjustments of $0.1 million as a decrease to the accrued restructuring charges with a corresponding change to goodwill, as actual results for benefits were lower than anticipated. The Company expects to execute the integration plan as currently designed; however, actual results and costs may differ as the plan is executed.

Any further changes to the Company’s estimate will result in an increase or decrease to the accrued restructuring charges and a corresponding increase or decrease to goodwill. As of June 30, 2005, the Company had utilized $3.9 million of these charges. The Company anticipates 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.

The activity in the accrued restructuring reserve related to the Snap Appliance acquisition-related restructuring plan was as follows for the first quarter of fiscal 2006:

 

 

Severance And

 

 

 

 

 

 

 

Benefits

 

Other Charges

 

Total

 

 

 

(in thousands)

 

Snap Appliance Acquisition-Related Restructuring Plan:

 

 

 

 

 

 

 

 

 

 

 

Reserve balance at March 31, 2005

 

 

155

 

 

 

2,901

 

 

3,056

 

Adjustments

 

 

(49

)

 

 

 

 

(49

)

Cash paid

 

 

(1

)

 

 

(255

)

 

(256

)

Reserve balance at June 30, 2005

 

 

$

105

 

 

 

$

2,646

 

 

$

2,751

 

 

In-process Technology

As part of the purchase agreements of the IBM i/p Series RAID business and Snap Appliance, certain amounts of the purchase prices were allocated to acquired in-process technology which were determined through established valuation techniques in the high-technology computer industry and written off in the first and second quarter of fiscal 2005, respectively, because technological feasibility had not been established and no alternative future uses existed. The values were determined by estimating the net cash

10




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

4. Business Acquisitions (Continued)

flows and discounting the estimated net cash flows to their 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)          The in-process projects were related to designing semiconductors and related boards and enhancements to RAID and firmware code.

(2)          The identified in-process projects were related to operating system enhancements and system functionality improvements.

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

The effective tax rate used in the analysis of the in-process technologies reflects a combined historical industry specific average for the United States Federal and state statutory income tax rates. The cost of capital reflects the estimated time to complete the projects and the level of risk involved. The following discount rates were used in computing the present 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 Snap Appliance.

The percentage of completion was determined using costs incurred by the IBM i/p Series RAID business and Snap Appliance prior to their respective acquisition dates compared to the estimated remaining research and development to be completed to bring the projects to technological feasibility. The Company estimated, as of the respective acquisition dates for the IBM i/p Series RAID business and Snap Appliance, that the projects were approximately 50% complete and 25% complete, respectively. The Company expects remaining costs of approximately $8.7 million and $0.2 million related to the IBM i/p Series RAID business and Snap Appliance, respectively, to bring the planned in-process projects to completion.

11




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

4. Business Acquisitions (Continued)

During the first quarter of fiscal 2006, the Company recorded an impairment charge of $15.5 million on the long-lived assets associated with the IBM i/p Series RAID business. The Company is currently in negotiations with IBM regarding their current research and development requirements and the profitability of this business. There can be no assurance of a positive outcome to these negotiations and they otherwise could lead to additional impairment charges, a reduction of this business and/or litigation between the parties.

Pro Forma Results:   The following unaudited pro forma financial information for the first quarter of fiscal 2005 presents the combined results of the Company and the IBM i/p Series RAID business and Snap Appliance as if the acquisitions had occurred at the beginning of the period presented. Certain adjustments have been made to the combined results of operations, including amortization of acquired other intangible assets; however, charges for purchased in-process technology were excluded as these items were non-recurring. The pro forma financial results for the first quarter of 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 Sheets Details

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 of fiscal 2006, the Company recorded an excess inventory adjustment of $4.3 million related to the transition of its products to comply with the European Restriction on Use of Hazardous Substances Directive.

12




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:

Goodwill allocated to the Company’s reportable segments and changes in the carrying amount 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 of fiscal 2006, adjustments were made to goodwill for changes to the acquisition-related restructuring reserves and other purchase price adjustments for the IBM i/p Series RAID business and Snap Appliance.

Other Intangible Assets:

 

 

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




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

6. Goodwill and Other Intangible Assets (Continued)

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

The Company regularly performs reviews to determine if facts or circumstances are present, either internal or external, which would indicate that the carrying values of its long-lived assets 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 to determine whether an impairment exists. If an asset is determined to be impaired, the loss is measured based on the difference between the asset’s fair value and its carrying value. The estimate of fair value of the assets is based on discounting estimated future cash flows using a discount rate commensurate with the risks inherent in its current business model. The estimation of the impairment involves numerous assumptions which require judgment by the Company, including, but not limited to, future use of the assets for Company operations versus sale or disposal of the assets and future selling prices for the Company’s products. During the first quarter of fiscal 2006, as a result of increased research and development costs necessary to meet IBM’s current expectations, the Company performed an impairment analysis that indicated that the carrying amount of the long-lived assets associated with the IBM i/p Series RAID business, which is part of the Company’s OEM segment, 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 prepaid and other assets and was recorded as a reduction to “Net revenues,” $6.2 million related to intangible assets and was recorded against “Other charges” and $1.8 million related to fixed assets and was recorded against “Other charges.” The Company is currently in negotiations with IBM regarding their current research and development requirements and the profitability of this business. There can be no assurance of a positive outcome to these negotiations and they otherwise could lead to additional impairment charges, a reduction of this business and/or litigation between the parties.

The annual 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




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

7. Interest and Other Income

The components of interest and other income for the first quarters of fiscal 2006 and 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 Company repurchased $19.8 million of its 3% Convertible Subordinated Notes (“3% Notes”) on the open market for an aggregate price of $19.6 million, of which $1.0 million will be paid in the second quarter of fiscal 2006, resulting in a loss on extinguishment of debt of $0.1 million (including unamortized debt issuance costs of $0.3 million). The loss on extinguishment of debt has been included in “Interest and other income” in the Company’s Unaudited Condensed Consolidated Statement of Operations.

In June 2004, the Company, Nevada SCSI Enterprises, Inc. and Thomas A. Gafford (jointly, “NSE”) entered into a license and release agreement, pursuant to which the Company paid NSE $1.3 million as a one-time, fully paid-up license fee to settle NSE’s claims that some of the Company’s products infringed certain patents. The license and release agreement expressly excluded any sales of products made by Eurologic Systems Group Limited (“Eurologic”) prior to the Company’s April 2003 acquisition of Eurologic. In November 2004, the Company exercised its option to secure a license and release with respect to such Eurologic sales by payment to NSE of a royalty fee of $0.4 million. The Company has filed a claim against the Eurologic acquisition Holdback for the $0.4 million royalty it paid with respect to Eurologic’s pre-acquisition sales. The Eurologic shareholders are disputing the Company’s right to withhold the $0.4 million from the Holdback. See Note 12 for further discussion of the Eurologic Holdback.

8. Restructuring Charges

The Company recorded restructuring charges of $0.04 million and $0.8 million for the first quarters of fiscal 2006 and 2005, respectively. All expenses, including adjustments, associated with the Company’s restructuring plans are included in “Restructuring charges” in the Unaudited Condensed Consolidated Statements of Operations and are not allocated to segments but rather managed at the corporate level. For a complete discussion of all restructuring actions that were implemented prior to fiscal 2006, please refer to the Notes to Consolidated Financial Statements included in the Company’s Annual Report on
Form 10-K for the year ended March 31, 2005. In the first quarter of fiscal 2006, the Company recorded provision adjustments of $0.04 million related to severance and benefits as actual costs were lower than anticipated and additional lease costs related to the estimated loss of facilities that the Company subleased in California through April 2008, the end of the lease term. This restructuring charge pertained to the

15




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 2001 restructuring plans. The fiscal 2004 restructuring plan was completed in the first quarter of fiscal 2006.

The activity in the accrued restructuring reserves related to all of the plans was as 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 anticipates that the remaining restructuring reserve balance of $1.7 million will be substantially paid out by the first quarter of fiscal 2009, primarily attributable to longer term lease obligations.  The remaining restructuring reserve balance is reflected both in “Accrued liabilities” and “Other long-term liabilities” in the Unaudited Condensed Consolidated Balance Sheet.

9. Net Income (Loss) Per Share

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

A reconciliation of the numerator and denominator of the basic and diluted net income (loss) per share computations 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




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

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

 

Diluted loss per share for the first quarter of fiscal 2006 was based only on the weighted-average number of shares outstanding during the period, as the inclusion of any common stock equivalents would have been anti-dilutive. In addition, certain potential common shares were excluded from the diluted computation for the first quarter of fiscal 2005 because their inclusion would have been anti-dilutive. The items excluded for the first quarters of fiscal 2006 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

 

 

¾% Notes

 

 

19,224

 

 

 

19,224

 

 


(1)          In connection with the issuance of its ¾% Notes, the Company entered into a derivative financial instrument to repurchase up to 19,224,000 shares of its common stock, at the Company’s option, at specified prices in the future to mitigate any potential dilution as a result of the conversion of the ¾% Notes. For further discussion on this derivative financial instrument, please refer to Note 6 of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended March 31, 2005.

10. Comprehensive Income (Loss)

The Company’s comprehensive loss, which consisted of net loss and the changes in net unrealized gains (losses) on marketable securities, net of taxes, and foreign 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

)

 

 

The components of accumulated other comprehensive income, net of taxes, were as follows:

 

 

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




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

11. Income Taxes

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

12. Commitments and Contingencies

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

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

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

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

18




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

12. Commitments & Contingencies (Continued)

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

13. Guarantees

Intellectual Property Indemnification Obligations

The Company has entered into agreements with customers and suppliers that include intellectual property indemnification obligations. These indemnification obligations generally require the Company to compensate the other party for certain damages and costs incurred as a result of third party intellectual property claims arising from these transactions. In each of these circumstances, payment by the Company is conditional on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by it under these agreements. It is not possible to make a reasonable estimate of the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved in each particular agreement. Historically, the Company has not incurred significant costs to defend lawsuits or settle claims related to such agreements and no amount has been accrued in the accompanying financial statements with respect to these indemnification guarantees.

Product Warranty

The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The estimated 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 differ from the Company’s estimates, revisions to the estimated warranty obligations would be required; however, the Company made no adjustments to pre-existing warranty accruals in the first quarters of fiscal 2006 and 2005.

19




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

13. Guarantees (Continued)

A reconciliation of the changes to the Company’s warranty accrual for the first quarters of fiscal 2006 and 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 its internal organization structure related to its OEM and Channel segments. Where historically the Company’s former OEM and Channel segments each offered an integrated set of customer-focused products, the new organization will be managed at the product level. The Company will begin to report its  financial information based upon this new structure in the second quarter of fiscal 2006.

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

·       OEM provides storage products directly to OEMs or to ODMs that supply OEMs, enabling them to resell next-generation storage products built on the Company’s intellectual property. OEM customers are characterized by long sales and 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.

·       Channel provides storage products to VARs and end users through its network of distribution and reseller customers. Channel customers are characterized by shorter sales cycles than OEM customers and Channel customers purchase standard products. The Company currently sells many of the technologies it provides to its OEM customers to its Channel customers generally in storage array or board-level form factors.

·       DSG provides high-performance I/O connectivity and digital media products for personal computing platforms, including notebook and desktop PCs. The Company sells these products to retailers, OEMs and distributors.

The unallocated corporate income and expenses, which are in the “Other” category, include amortization of acquisition-related intangible assets, acquired in-process technology, restructuring charges, other charges, interest and other income, interest expense, and all administrative, research and development and selling and marketing expenses.

There were no inter-segment revenues for the periods shown below. The Company does not separately track all tangible assets or depreciation by operating segments nor are the segments evaluated

20




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

14. Segment Reporting (Continued)

under these criteria. Segment financial information is summarized 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

 

 

The following table presents the details of unallocated corporate income and expenses 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, the Company completed the sale of certain properties in Milpitas, California, which were previously included in “Property and equipment, net” in the Unaudited Condensed Consolidated Balance Sheet as of June 30, 2005. Net proceeds for the sale of the properties aggregated approximately $2.7 million. A gain on the sale will be recorded in the second quarter of fiscal 2006 approximating $0.3 million.

21




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

17. Glossary

The following is a list of business related acronyms that are contained within this Quarterly Report on Form 10-Q. They are listed in alphabetical order.

·       ASIC: Application Specific Integrated Circuit

·       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: Internal Revenue 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 Initiative Specification

·       Ultra DMA: Ultra Direct Memory Access

·       USB: Universal Serial Bus

·       VARs: Value Added Reseller

22




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

17. Glossary (Continued)

The following is a list of accounting rules and regulations and related regulatory bodies referred to within this Quarterly Report 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 for Stock Issued to Employees

·       ARB: Accounting Research Bulletin

·       EITF: Emerging Issues Task Force

·       EITF No. 95-3: Recognition of Liabilities in Connection with Purchase Business Combinations

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

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

·       FASB: Financial Accounting Standards Board

·       FIN: FASB Interpretation Number

·       FIN 44: Accounting for Certain Transactions Involving Stock Compensation

·       SAB: Staff Accounting Bulletin

·       SAB 107: Share Based Payment

·       SEC: Securities Exchange Commission

·       SFAS: Statement of Financial Accounting Standards

·       SFAS No. 3: Reporting Accounting Changes in Interim Financial Statements

·       SFAS No. 95: Statement of Cash Flows

·       SFAS No. 115: Accounting for Certain Investments in Debt and Equity Securities

·       SFAS No. 123: Accounting for Stock-Based Compensation

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

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

·       SFAS No. 151: Inventory Costs—an amendment of ARB No. 43, Chapter 4

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

23




Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this document that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding our business, including, but not limited to, revenues from our SCSI-based desktop products, impairment charges that may occur in connection with our IBM relationship and our liquidity in future periods. We may identify these statements by the use of words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and other similar expressions. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements, except as may otherwise be required by law.

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

While management believes that the discussion and analysis in this report is adequate for a fair presentation of the information presented, we recommend that you read this discussion and analysis in conjunction 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, please refer to our Annual Report on Form 10-K for the year ended March 31, 2005.

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

Results of Operations

Overview

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

24




Our new management team is in the process of performing a thorough analysis of our operations and making a detailed plan of our corporate strategy. This analysis will include a review of all aspects of our business, including our product portfolio, our relationships with IBM and our other strategic partners and our research and development focus. The actions that we are considering could adversely affect our business and financial results in the short term, may not have the long-term beneficial results that we intend and could result in the following:

·       Loss of customers:

·       Reduced revenue base:

·       Impairment of our assets:

·       Increased operating costs: and

·       Material restructuring charges.

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

Our future revenue growth remains largely dependent on the success of our external and networked storage solutions, new OEM design wins 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 internal organization structure related to our OEM and Channel segments. Where historically our former OEM and Channel segments each offered an integrated set of customer-focused products, the new organization will be managed at the product level. We will begin to report our financial information based upon this new structure in the second quarter of fiscal 2006.

25




The following table sets forth the items in the Unaudited Condensed Consolidated Statements of 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)          In the first quarter of fiscal 2006, we recorded an impairment charge of $15.5 million related to the IBM i/p Series RAID business, of which $7.5 million was recorded as a reduction to “Net revenues” and $8.0 million was recorded to “Other charges” (Note 6). In the first quarter of fiscal 2005, we purchased the IBM i/p Series RAID business (Note 4), made a payment of $1.3 million to Nevada SCSI Enterprises, Inc., or NSE, in the form of a license fee (Note 7) and implemented a restructuring plan to consolidate certain development and administrative functions in the United States and Europe. These transactions 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 first quarter of fiscal 2005, reflecting a decline in sales volumes of our SCSI products primarily attributable to the transition from our Ultra 160 products to Ultra 320 products in which we have a lower market share. This decrease in revenue was partially offset by sales of $4.4 million in connection with the IBM i/p Series RAID business acquisition, net of the impairment charge related to the IBM i/p Series RAID business of which $7.5 million was recorded as a reduction to “Net revenues,” as well as increased sales from products based on next generation SATA technology. For further discussion on the impairment of the IBM i/p Series RAID business, please refer to “Other charges” discussed below.

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

26




motherboards that contain built-in SCSI I/O functionality, thus reducing our average selling price. In addition, we intentionally reduced inventory in the channel and experienced an overall decrease in sales of our component products due to lower demand from our Channel customers relative to our OEM customers. This was partially offset by sales of our NAS system products of $7.1 million that were acquired through the Snap Appliance acquisition in the second quarter of fiscal 2005.

Net revenues from our DSG segment decreased by $1.8 million in the first quarter of fiscal 2006 as compared to the first quarter of fiscal 2005 as a result of the decline in sales volumes of our SCSI-based desktop computer products, partially offset by sales of storage products that were introduced in the fourth quarter of fiscal 2005 and increased sales of our digital media products. We expect revenues from our SCSI-based desktop computer products to continue to decline as OEMs are incorporating connectivity technologies directly into their products.

 

 

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 international revenues declined as a percentage of our total gross revenues in the first quarter of fiscal 2006 as compared to the first quarter of fiscal 2005 primarily as a result of increased sales to IBM, which are sold primarily in North America, and foreign currency fluctuations in the European countries. Included in 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 to be recognized in the second quarter of fiscal 2006.

A small number of our customers account for a substantial portion of our net revenues, and we expect that a limited number of customers will continue to represent a substantial portion of our net revenues for the foreseeable future. In the first quarter of fiscal 2006, IBM and Dell accounted 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 gross margin in the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005 was primarily due to the impairment charge related to the IBM i/p Series RAID business which decreased gross margin by six percentage points, an excess inventory adjustment of $4.3 million related to the transition of our products to comply with the European RoHS Directive, fixed costs associated with our manufacturing facilities that were distributed over lower revenue levels,  and changes in our product mix and to a lesser extent, changes in our customer mix between OEM and Channel customers. Gross margins were also impacted due to increased sales of our lower-margin system products and decreased sales of our higher-margin component products sold to Channel customers. Our gross margins will be significantly impacted in the future by the mix of OEM and channel revenue.

27




Research and Development 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 research and development expense in the first quarter of fiscal 2006 as compared to the first quarter of fiscal 2005 was primarily a result of increased headcount from our acquisitions of the IBM i/p Series RAID business and Snap Appliance, costs associated with the development of the IBM DS300 and DS400 products and compensation of $0.4 million in the first quarter of fiscal 2006 related to a management incentive program established for former Snap Appliance employees pursuant to the Snap Appliance acquisition agreement. This was partially offset by decreased infrastructure spending and reduced headcount as a result of restructuring programs implemented in fiscal 2005, the reduced headcount as a result of the ServerEngines and Vitesse strategic alliances we entered into in the fourth quarter of fiscal 2005 and decreased deferred compensation charges of $0.7 million in the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005. Deferred compensation charges represented the vesting of assumed stock options in connection with our Platys Communications, 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 as compared to the first quarter of fiscal 2005 was primarily a result of increased headcount, compensation of $1.2 million in relation to retirement costs of our former CEO, compensation of $0.7 million in the first quarter of fiscal 2006 related to a management incentive program established for former Snap Appliance employees pursuant to the Snap Appliance acquisition agreement and increased deferred compensation charges of $0.2 million representing the vesting of assumed stock options in connection with our Platys and Snap Appliance acquisitions. This was partially offset by decreased spending due to reductions of our workforce and infrastructure spending as a result of the restructuring plans we implemented in fiscal 2005.

Amortization of Acquisition-Related Intangible Assets.

 

 

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 the acquisition-related intangible assets over periods which reflect the pattern in which the economic benefits of the assets are expected to be realized, which is primarily using the straight-line method over their estimated useful lives, ranging from three months to seven years.

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

28




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-process technology represent those in which technological feasibility had not been established and no alternative future uses existed. The amounts allocated to acquired in-process technology were determined through established valuation techniques in the high-technology computer industry.

The net cash flows from the identified projects were based on estimates of revenues, cost of revenues, research and development expenses, including costs to complete the projects, selling, marketing and administrative expenses, royalty expenses and income taxes from the projects. We believe the assumptions used in the valuation were reasonable at the time of the acquisition. The estimated net revenues and gross margins were based on management’s projections of the projects and were in line with industry averages. Estimated total net revenues from the projects of the IBM i/p Series RAID business were expected to grow through fiscal 2009 and decline thereafter as other new products are expected to become available. Estimated operating expenses included research and development expenses and selling, marketing and administrative expenses based upon historical and expected direct expense levels and general industry metrics. Estimated research and development expenses included costs to bring the projects to technological feasibility and costs associated with activities undertaken to correct errors or keep products updated with current information (also referred to as “maintenance” research and development) after a product is available for general release to customers. These activities range from 0% to 5% of net revenues for the in-process technologies.

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

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

During the first quarter of fiscal 2006, we recorded an impairment charge of $15.5 million on the long-lived assets associated with the IBM i/p Series RAID business. We are currently in negotiations with IBM regarding their current research and development requirements and the profitability of this business. There can be no assurance of a positive outcome to these negotiations and they otherwise could lead to additional impairment charges, a reduction of this business and/or litigation between 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

)%

 

 

29




All expenses, including adjustments, associated with our restructuring plans are included in “Restructuring charges” in the Unaudited Condensed Consolidated Statements of Operations and are not allocated to segments but rather managed at the corporate level. For a complete discussion of all restructuring actions that were implemented prior to fiscal 2006, please refer to the Notes to Consolidated Financial Statements included 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 than anticipated and additional lease costs related to the estimated loss of facilities that we subleased in California through April 2008, the end of the lease term. This restructuring charge pertained to our first, second, third and fourth quarters of fiscal 2005, fiscal 2004 and fiscal 2001 restructuring plans. The fiscal 2004 restructuring plan was completed in the first quarter of fiscal 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 perform reviews to determine if facts or circumstances are present, either internal or external, which would indicate that the carrying values of our long-lived assets 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 to determine whether an impairment exists. If an asset is determined to be impaired, the loss is measured based on the difference between the asset’s fair value and its carrying value. The estimate of fair value of the assets is based on discounting estimated future cash flows using a discount rate commensurate with the risks inherent in its current business model. The estimation of the impairment involves numerous assumptions which require judgment by us, including, but not limited to, future use of the assets for our operations versus sale or disposal of the assets and future selling prices for our products. During the first quarter of fiscal 2006, as a result of increased research and development costs necessary to meet IBM’s current expectations, we performed an impairment analysis that indicated that the carrying amount of the long-lived assets associated with the IBM i/p Series RAID business, which is part of our OEM segment, 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 other assets and was recorded as a reduction to “Net revenues,” $6.2 million related to intangible assets and was recorded against “Other charges” and $1.8 million related to fixed assets and was recorded against “Other charges.” We are currently in negotiations with IBM regarding their current research and development requirements and the profitability of this business. There can be no assurance of a positive outcome to these negotiations and they otherwise could lead to additional impairment charges, a reduction of this business and/or litigation between the parties.

30




Interest and Other Income.

 

 

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 to interest income earned on our cash, cash equivalents and marketable securities, fluctuations in foreign currency gains or losses, realized gains and losses on marketable securities, sublease income received from third parties and loss from the repurchase of our 3% Notes.

The increase in interest and other income in the first quarter of fiscal 2006 as compared to the first quarter of fiscal 2005 was primarily due to higher interest income earned on our cash, cash equivalents and marketable securities and a one-time fully paid-up license fee of $1.3 million to NSE, which was recorded in the first quarter of fiscal 2005, primarily for historical products that incorporated certain technology. This was offset by foreign currency fluctuations primarily related to the Euro and a loss of $0.1 million on the repurchase of our 3% Notes. For further discussion on the settlement with NSE, please refer to Note 7 to the Notes to Unaudited Condensed Consolidated Financial 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 is primarily associated with our 3/4% Notes and 3% Notes, issued in December 2003 and March 2002, respectively. The decrease in interest expense for the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005 was primarily 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 on our estimated annual effective income tax rate. Our estimate of our fiscal 2006 taxes represents interest accrued on prior year’s tax disputes and foreign taxes related to our foreign subsidiaries including tax on certain Singapore income that is not subject to our Singapore tax holiday. The tax rate for the first quarter of fiscal 2006 differed from the combined United States Federal and state statutory income tax rate of 40% primarily due to the valuation allowance recorded on all of the U.S. net deferred tax assets, foreign taxes related to our foreign subsidiaries, certain acquisition related intangible assets, excluding goodwill, that are not fully deductible for tax purposes and interest accrued on prior years’ tax disputes. The tax rate for the first quarter of fiscal 2005 differed from the combined United States Federal and state statutory income tax rate of 40% primarily due to certain

31




acquisition related intangible assets, excluding goodwill, that are not fully deductible for tax purposes and interest accrued on prior years’ tax disputes. We are in ongoing negotiations with the IRS with regard to various tax disputes that may result in settlement of certain issues. Our tax rate for the period in which a settlement is reached will be impacted if the settlement materially differs from the amounts previously accrued.

Liquidity and Capital Resources

Key Components of Cash Flows

Cash used for operations was $23.0 million in the first quarter of fiscal 2006 as compared to cash provided 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 net loss of $36.0 million. This was partially offset by the benefit of non-cash items included in operating results, which primarily consisted of an impairment charge of $15.5 million related to the IBM i/p Series RAID business and depreciation and amortization of marketable securities, intangible assets and property and equipment of $14.6 million. Additional factors included changes to working capital assets and liabilities that decreased cash provided by operating activities by $17.7 million. Operating cash for the first quarter of fiscal 2005 resulted primarily from the benefit of non-cash items included in operating results and the growth in accounts payable offset by the growth in accounts receivable and inventory. Non-cash items primarily consisted of depreciation and amortization of marketable securities, intangible assets and property and equipment of $10.3 million, write-off of acquired in process technology of $3.0 million and amortization of deferred stock-based compensation 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 shipments within the quarter and lower revenue levels in the first quarter of fiscal 2006 due to the impairment of the IBM i/p Series RAID business with no corresponding decrease to accounts receivable. The increase was not due to changes in the credit quality of our customers. Annualized inventory turns increased 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 primarily due to net sales and maturities of restricted marketable securities and marketable securities, net of purchases, of $317.0 million and purchases of property and equipment of $5.1 million. Cash provided by investing activities was $34.1 million in the first quarter of fiscal 2005, which was primarily due to net sales and maturities of restricted marketable securities 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 RAID business.

Cash used for financing activities of $18.5 million in the first quarter of fiscal 2006 was primarily driven by the repurchase of  $19.8 million in aggregate principal amount of our 3% Notes for $18.6 million (an additional $1.0 million will be paid in the second quarter of fiscal 2006). Cash provided by financing activities was $0.4 million in the first quarter of fiscal 2005, which related to net proceeds received from our issuance of common stock in connection with stock option exercises.

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

32




do so, additional income taxes at the combined United States Federal and state statutory rate of approximately 40% could be incurred from the repatriation.

At June 30, 2005, we had $240.4 million of aggregate principal amount in convertible notes outstanding, consisting of $15.4 million in aggregate principal amount of our 3% Notes that are due in March 2007 and $225.0 million in aggregate principal amount of our ¾% Notes that are due in December 2023.

We are required to maintain restricted cash or investments to serve as collateral for the first ten scheduled interest payments on our ¾% 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 million was classified as short-term and $3.9 million was long-term.

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

We invest in technology companies through two venture capital 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 liquidity provided by our existing working capital, together with expected cash flows from operations and available sources of equity and equipment financing, will be sufficient to support our operations through at least the next twelve months. However, should prevailing economic conditions and/or financial, business and other factors beyond our control adversely affect our estimates of our future cash requirements, we would be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all.

Recent Accounting Pronouncements

In June 2005, the FASB issued SFAS No. 154, which changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. We do not believe that the adoption of SFAS No. 154 will have a material effect on our Unaudited Condensed Consolidated 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 and supersedes APB Opinion No. 25. SFAS No. 123(R) requires companies to apply a fair-value based measurement method in accounting for share-based payment transactions with employees and to record compensation expense for all stock awards granted and to awards modified, repurchased or cancelled after the required effective date. In addition, we are required to record

33




compensation expense (as previous awards continue to vest) for the unvested portion of previously 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 annual periods, as opposed to interim periods as originally issued by the FASB, beginning after June 15, 2005. We are currently evaluating the impact of adopting this statement; however, we expect that it will have a significant impact on our consolidated balance sheet and statement of operations. The impact on our consolidated financial statements will depend on the transition method, the option-pricing model used to compute fair value and the inputs to that model such as volatility and expected life. The pro forma disclosures of the impact of SFAS No. 123 provided in Note 3 of the Notes to the Unaudited Condensed Consolidated Financial Statements may not be representative of the impact of adopting this statement.

In March 2005, the SEC issued SAB 107, which offers guidance on SFAS No. 123(R). SAB 107 was issued to assist preparers by simplifying some of the implementation challenges of SFAS No. 123(R) while enhancing the information that investors receive. SAB 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required by preparers to successfully implement SFAS No. 123(R), specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may conclude differently on the fair value of employee stock options. Key topics covered by SAB 107 include valuation models, expected volatility and expected term. We will apply the principles of SAB 107 in conjunction with our 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 recognized as current-period charges. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted. The adoption of this standard is not expected to have a material impact on our Unaudited Condensed Consolidated Balance Sheet or Statement of Operations.

At its March 2004 meeting, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01. The consensus clarified the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under SFAS No. 115 and 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 to other-than-temporary impairment evaluations. The FASB expects to issue additional implementation guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads. If this additional implementation guidance is issued as currently written, we may have to recognize unrealized losses on investments in the Statement of Operations. If there is a material decline in the fair value of investments, our financial statements 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 component business line consisting of certain purchased RAID data protection intellectual property, semiconductor designs and assets, and licensed from IBM related RAID intellectual property. The licensing agreement grants us the right to use IBM’s RAID technology and embedded Power PC technology for our internal and external RAID products to be sold to IBM and other customers. In conjunction with the acquisition, we also entered into a three-year exclusive product supply agreement under which we will supply RAID software, firmware and hardware to IBM for use in IBM’s iSeries and pSeries servers. We also entered into an agreement for IBM to provide silicon wafer manufacturing processing services to us for the term of the supply agreement at agreed upon rates.

The final purchase price was $49.3 million, which consisted of a cash payment to IBM of $47.5 million, warrants valued at $1.1 million, net of registration costs