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 December 31, 2004 or
¨	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from             to

 

Commission file number 0-15071

ADAPTEC, INC.

(Exact name of registrant as specified in its charter)

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

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 ¨

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

Yes x  No ¨

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

 

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

 

2

PART I.   FINANCIAL INFORMATION

Item 1.   Financial Statements

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

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

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

3

ADAPTEC, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)

		December 31,  2004					March 31, 2004
		(in thousands)
Assets
Current assets:
Cash and cash equivalents			$	92,728			$	119,113
Marketable securities			424,448				544,741
Restricted cash and marketable securities			2,283				2,815
Accounts receivable, net			87,488				51,562
Inventories			56,650				48,888
Deferred income taxes			58,355				55,678
Prepaid expenses			22,684				14,761
Other current assets			9,367				20,031
Total current assets			754,003				857,589
Property and equipment, net			61,036				58,435
Restricted marketable securities, less current portion			4,648				6,346
Goodwill			159,632				68,492
Other intangible assets, net			87,086				48,902
Other long-term assets			50,079				11,340
Total assets			$	1,116,484			$	1,051,104
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable			$	53,803			$	35,969
Accrued liabilities			111,149				106,392
Total current liabilities			164,952				142,361
¾% Convertible Senior Subordinated Notes			225,000				225,000
3% Convertible Subordinated Notes			35,190				35,190
Other long-term liabilities			16,059				3,662
Deferred tax liabilities			9,215				—
Commitments and contingencies (Note 16)
Stockholders’ equity:
Common stock			112				110
Additional paid-in capital			163,636				153,174
Deferred stock-based compensation			(3,517		)		(2,713		)
Accumulated other comprehensive income, net of taxes			81				3,000
Retained earnings			505,756				491,320
Total stockholders’ equity			666,068				644,891
Total liabilities and stockholders’ equity			$	1,116,484			$	1,051,104

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

4

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

		Nine-Month Period Ended
		December 31, 2004					December 31, 2003
		(in thousands)
Cash Flows From Operating Activities:
Net income			$	14,436				$	38,050
Adjustments to reconcile net income to net cash provided by operating activities:
Non-cash restructuring charges			109					105
Write-off of acquired in-process technology			5,200					3,649
Stock-based compensation			2,807					3,259
Non-cash effect of tax settlement			(26,009		)			—
Loss on extinguishment of debt			—					3,734
Non-cash portion of DPT settlement gain			—					(18,256		)
Gain on sale of long-lived assets			(2,755		)			—
Depreciation and amortization			34,987					40,431
Deferred income taxes			(40		)			(5,895		)
Other non-cash items			(12		)			551
Changes in operating assets and liabilities (net of acquired businesses):			(44,673		)			3,006
Net Cash Provided by (Used for) Operating Activities			$	(15,950	)			$	68,634
Cash Flows From Investing Activities:
Payment of general holdback in connection with acquisition of Platys			—					(195		)
Payment of holdback in connection with acquisition of Eurologic			(2,279		)			—
Purchases of businesses, net of cash acquired			(123,978		)			(29,884		)
Purchases of restricted marketable securities			—					(7,915		)
Maturities of restricted marketable securities			2,213					3,750
Purchases of property and equipment			(12,553		)			(5,859		)
Proceeds from sale of long-lived assets			9,577					—
Purchases of marketable securities			(252,649		)			(530,390		)
Sales of marketable securities			297,424					455,145
Maturities of marketable securities			65,541					78,918
Net Cash Used for Investing Activities			(16,704		)			(36,430		)
Cash Flows From Financing Activities:
Proceeds from the issuance of ¾% Convertible Senior Subordinated Notes, net of issuance costs of $6,750			—					218,250
Repurchases and redemption of long-term debt			—					(207,243		)
Purchase of convertible bond hedge			—					(64,140		)
Proceeds from issuance of warrant			—					30,390
Proceeds from issuance of common stock			5,446					4,130
Installment payment on acquisition of software licenses			—					(3,633		)
Net Cash Provided by (Used for) Financing Activities			5,446					(22,246		)
Effect of Foreign Currency Translation on Cash and Cash Equivalents			823					911
Net Increase (Decrease) in Cash and Cash Equivalents			(26,385		)			10,869
Cash and Cash Equivalents at Beginning of Period			119,113					149,373
Cash and Cash Equivalents at End of Period			$	92,728				$	160,242

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

5

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

1. 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, 2004 audited consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary to fairly present 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 for the year ended March 31, 2004, which were included in the Company’s Current Report on Form 8-K, which was filed with the SEC on December 7, 2004. The third quarters of fiscal 2005 and 2004 ended December 31, 2004 and December 26, 2003, respectively. For presentation purposes, the accompanying financial statements have been shown as ending on the last day of the calendar month. Certain amounts reported in previous periods have been reclassified to conform to the current period presentation. The results of operations for the third quarter and first nine months of fiscal 2005 are not necessarily indicative of the results to be expected for the entire fiscal year. In the first and second quarters of fiscal 2005, the Company reorganized its reportable segments, as described more fully in Note 18.

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

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 21.

2. Recent Accounting Pronouncements

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 awards that remain outstanding at the date of adoption. SFAS No. 123(R) will be effective for quarterly periods beginning after June 15, 2005, which is the Company’s second quarter of fiscal 2006. This statement will have a significant impact on the Company’s results of operations as the Company will be required to record compensation expense rather than disclose the impact on the Company’s results of operations within its footnotes (see Note 3 below).

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 to 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

6

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

2. Recent Accounting Pronouncements (Continued)

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.

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 following table illustrates the effect on net income (loss) and earnings 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										Nine-Month Period Ended
		December 31, 2004					December 31, 2003					December 31, 2004					December 31, 2003
		(in thousands, except per share amounts)
Net income (loss), as reported			$	22,489				$	(3,013	)			$	14,436				$	38,050
Add: Deferred stock-based compensation expense included in reported net income (loss)			775					892					2,453					2,991
Deduct: Total stock-based compensation expense determined under the fair value-based method, net of tax			(3,837		)			(6,025		)			(9,923		)			(21,186		)
Pro forma net income (loss)			$	19,427				$	(8,146	)			$	6,966				$	19,855
Basic net income (loss) per share:
As reported			$	0.20				$	(0.03	)			$	0.13				$	0.35
Pro forma			$	0.17				$	(0.07	)			$	0.06				$	0.18
Diluted net income (loss) per share:
As reported			$	0.17				$	(0.03	)			$	0.12				$	0.33
Pro forma			$	0.15				$	(0.07	)			$	0.06				$	0.18

 

SFAS No. 123 requires the use of option 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. Because the Company’s options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable measure of the fair value of options.

7

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

3. Stock-Based Compensation (Continued)

The fair value of options granted in the third quarter and first nine months of fiscal 2005 and 2004, as reported, were estimated at the date of grant using the Black-Scholes valuation model with the following weighted average assumptions:

		Three-Month Period Ended								Nine-Month Period Ended
		December 31, 2004				December 31, 2003				December 31, 2004				December 31, 2003
Employee Stock Option Plans:
Expected life (in years)			2.0				2.9				2.3				2.3 - 3.0
Risk-free interest rates			3.1	%			2.3	%			3.0	%			1.5% - 2.3	%
Expected volatility			39	%			61	%			44	%			61% -  66	%
Dividend yield			—				—				—				—
Director Option Plans:
Expected life (in years)			—				2.5				—				2.5
Risk-free interest rates			—				2.1	%			—				2.1	%
Expected volatility			—				62	%			—				62	%
Dividend yield			—				—				—				—
ESPP:
Expected life (in years)			1.4				0.5 - 2.0				1.4				0.5 - 2.0
Risk-free interest rates			2.1	%			1.1% - 1.8	%			2.1	%			1.1% - 1.8	%
Expected volatility			50	%			39% -  66	%			50	%			39% -  66	%
Dividend yield			—				—				—				—

 

4. Business Acquisitions

Snap Appliance:   On July 23, 2004, the Company completed the acquisition of Snap Appliance, Inc. (“Snap Appliance”), a provider of NAS solutions, 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 solutions from the workgroup to the data center. The total purchase price was $84.4 million, consisting of $77.4 million in cash and transaction fees and $7.0 million related to the fair value of assumed stock options to 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. Snap Appliance is included in the Company’s Channel segment (Note 18).

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.

The preliminary allocation of the Snap Appliance purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed is summarized below (in thousands). The preliminary allocation was based on an independent appraisal and management’s estimates of fair value. The allocation

8

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

4. Business Acquisitions (Continued)

of the purchase price may be subject to change based on final estimates of fair value; however, such changes are not expected to be material.

Cash		$	60
Accounts receivable		5,752
Inventory		3,316
Prepaid expenses		438
Property and equipment		1,379
Other long-term assets		163
Total assets acquired		11,108
Accounts payable		(4,254		)
Current liabilities		(16,180		)
Other long-term liabilities		(2,325		)
Total liabilities assumed		(22,759		)
Net tangible liabilities acquired		$	(11,651	)

 

The allocation of the purchase price to the tangible and intangible assets acquired and liabilities assumed is as follows (in thousands):

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

 

The values allocated to the core and existing technologies and trade name created as a result of the acquisition of Snap Appliance are being amortized over an estimated weighted average useful life of 7 years. No residual value has been estimated for the intangible assets. In accordance with SFAS No. 142, the Company will not amortize the goodwill, but will evaluate it at least annually for impairment.

In addition, a management incentive program was established to pay former employees of Snap Appliance cash payments totaling $13.8 million, which will be 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 from the Company. In the third quarter of fiscal 2005, the Unaudited Condensed Consolidated Statements of Operations included compensation expense related to the management incentive program of

9

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

4. Business Acquisitions (Continued)

$1.4 million and an additional $1.4 million was originally accrued in the Snap Appliance acquisition-related restructuring. In the first nine months of fiscal 2005, the Unaudited Condensed Consolidated Statements of Operations included compensation expense related to the management incentive program of $4.3 million and an additional $1.4 million was originally accrued in the Snap Appliance acquisition-related restructuring.

A portion of the Snap Appliance acquisition price totaling $5.4 million was held back, and in connection with the management incentive program, $1.3 million was held back for a total of $6.7 million (the “Snap Appliance Holdback”) for unknown liabilities that may have existed as of the acquisition date. The Snap Appliance Holdback will be paid in the second quarter of fiscal 2006, except for funds necessary to provide for any pending claims.

Acquisition-Related Restructuring:   In the third quarter of fiscal 2005, the Company refined its plan to integrate the Snap Appliance operations related to integrating certain duplicative resources for both severance and benefits in connection with the involuntary termination of approximately 24 employees, exiting facilities and the disposal of duplicative assets. The acquisition-related restructuring liabilities were accounted for under EITF 95-3 and therefore were included in the purchase price allocation of the cost to acquire Snap Appliance. The Company recorded a preliminary estimate of $6.0 million in the second quarter of fiscal 2005 for these activities. In the third quarter 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. 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 December 31, 2004, the Company had utilized $1.4 million of these charges. The Company anticipates that the remaining restructuring reserve balance of $5.4 million will be paid out by 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 nine months of fiscal 2005;

		Severance And
		Benefits					Other Charges					Total
		(in thousands)
Snap Appliance Acquisition-Related Restructuring Plan:
Restructuring Provision			$	1,967				$	3,999			$	5,966
Adjustments			689					109				798
Cash paid			(349		)			(186		)		(535		)
Non-cash charges			(334		)			(468		)		(802		)
Reserve balance at December 31, 2004			$	1,973				$	3,454			$	5,427

 

IBM i/p Series RAID:    On June 29, 2004, the Company completed the acquisition of International Business Machines Corporation’s (“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 “IBM i/p Series RAID” business). The licensing

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

4. Business Acquisitions (Continued)

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 total purchase price is estimated at $49.5 million, which consists of a cash payment to IBM of $47.5 million, warrants valued at $1.1 million, net of registration costs, and transactions costs of $0.9 million. 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 18).

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

The IBM i/p Series RAID business was accounted for as a purchase business combination with the allocation of the purchase price to the tangible and intangible assets acquired summarized below (in thousands). The allocation was based on management’s estimates of fair value, which included an independent appraisal.

Net property and equipment		$	635
Acquired in-process technology		3,000
Goodwill		18,915
Other intangible assets:
Supply agreement		7,600
Patents and core technology		18,700
Foundry agreement		600
		26,900
Net assets acquired (purchase price)		$	49,450

 

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

11

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

4. Business Acquisitions (Continued)

Eurologic:   On April 2, 2003, the Company completed the acquisition of Eurologic Systems Group Limited (“Eurologic”), a provider of external and networked storage solutions. The Company acquired Eurologic to further enhance its direct-attached and fibre-attached server storage capabilities by allowing it to provide end-to-end block- and file-based networked storage solutions. As consideration for the acquisition of all of the outstanding capital stock of Eurologic, the Company paid $25.6 million in cash, subject to a Holdback as described below, and assumed stock options to purchase 0.5 million shares of the Company’s common stock, with a fair value of $1.6 million. The Company also incurred $1.1 million in transaction fees, including legal, valuation and accounting fees. The assumed stock options were valued using the Black-Scholes valuation model with the following assumptions: volatility rate ranging from 57% to 81%; a risk-free interest rate ranging from 1.1% to 2.5%; and an estimated life ranging from 0.08 to 4 years. As part of the Eurologic purchase agreement, $3.8 million of the cash payment was held back (the “Holdback”) for unknown liabilities that may have existed as of the acquisition date. The Holdback, which was included as part of the purchase price, was included in “Accrued liabilities” in the Unaudited Condensed Consolidated Balance Sheet as of December 31, 2004 and was to have been paid to the former Eurologic stockholders 18 months after the acquisition closing date, except for funds necessary to provide for any pending claims. The Company has paid $2.3 million of the Holdback as of December 31, 2004 and has asserted claims against the remaining amount for liabilities of which it became aware following the consummation of the transaction. The former Eurologic stockholders have disputed these claims. The Company also agreed to pay the stockholders of Eurologic contingent consideration of up to $10.0 million in cash if certain revenue levels were achieved by the acquired Eurologic business in the period from July 1, 2003 through June 30, 2004. The milestone to achieve the contingent consideration was not attained as of June 30, 2004. As a result, no additional payments were made to the former stockholders of Eurologic. Eurologic’s goodwill and amortizable intangible assets were allocated based on the relative fair values of the two segments, OEM and Channel (Note 18).

Acquisition-Related Restructuring:   During the fourth quarter of fiscal 2004, the Company finalized its plans to integrate the Eurologic operations. The integration plan included the involuntary termination or relocation of approximately 110 employees, exiting duplicative facilities and the transition of all manufacturing operations from Dublin, Ireland to the Company’s manufacturing facility in Singapore. The consolidation of the manufacturing operations as well as involuntary employee terminations was completed in the fourth quarter of fiscal 2004. The acquisition-related restructuring liabilities were accounted for under EITF 95-3 and therefore were included in the purchase price allocation of the cost to acquire Eurologic. The Company recorded a liability of $3.3 million in fiscal 2004 for these activities. As of December 31, 2004, the Company utilized approximately all of these charges and the plan is materially complete.

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

12

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

4. Business Acquisitions (Continued)

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

During the first quarter of fiscal 2005, the Company finalized its plans to integrate the ICP vortex operations. The integration plan included the involuntary termination of 19 employees, the transfer of manufacturing operations to Singapore and the integration of certain duplicative resources. The acquisition-related restructuring liabilities were accounted for under EITF 95-3 and therefore were included in the purchase price allocation of the cost to acquire ICP vortex. In fiscal 2004, the Company recorded a liability of $0.4 million for severance and benefits, of which $0.3 million of these charges were utilized and $0.1 million was recorded as a reduction to the restructuring liability with a corresponding decrease to goodwill in the first quarter of fiscal 2005.

Elipsan:   On February 13, 2004, the Company completed the acquisition of Elipsan Limited (“Elipsan”), a provider of networked storage infrastructure software. Elipsan’s storage virtualization technology will enable the Company to make storage more cost-effective, easier to scale and increase performance across multiple RAID subsystems. The total purchase price was $19.4 million in cash to acquire Elipsan, which included $0.7 million in transaction fees, consisting of legal, valuation and accounting fees. In the first nine months of fiscal 2005, adjustments were made to both goodwill and the acquisition costs, primarily related to the reversal of the acquisition-related restructuring reserves of approximately $0.6 million. Elipsan’s goodwill and amortizable intangible assets were allocated based on the relative fair values of the two segments, OEM and Channel (Note 18).

Acquisition-Related Restructuring:   During the third quarter of fiscal 2005, the Company further refined its plans to integrate of the Elipsan operations. The initial plan included the integration of certain duplicative resources related to both severance and benefits in connection with the involuntary termination of employees and, accordingly, the Company recorded a $0.8 million reserve as of March 31, 2004. In the third quarter of fiscal 2005, the Company recorded an adjustment of $0.6 million as a reduction to the liability with a corresponding decrease to goodwill as the Company intends to retain these employees. The acquisition-related restructuring liabilities were accounted for under EITF 95-3 and therefore were included in the purchase price allocation of the cost to acquire Elipsan. As of December 31, 2004, the Company made payments of approximately $25,000 under the plan. The Company anticipates that the remaining restructuring reserve balance of $0.2 million will be paid out by the second quarter of fiscal 2006.

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

4. Business Acquisitions (Continued)

In-process Technology

As part of the purchase agreements of Snap Appliance, the IBM i/p Series RAID business, Eurologic and Elipsan, 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 second quarter of fiscal 2005, first quarter of fiscal 2005, first quarter of fiscal 2004 and fourth quarter of fiscal 2004, respectively, because technological feasibility had not been established and no alternative future uses existed. The values were determined by estimating the net cash 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)
Snap Appliance(1)			$	2,200
IBM i/p Series RAID business(2)			3,000
Eurologic(3)			3,649
Elipsan(4)			4,000

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

(2)          The in-process projects were related to designing semiconductors and related boards and enhancements to RAID and firmware code.

(3)          The Company acquired various external and networked storage products that enable organizations to install, manage and scale multiterabyte storage solutions. The identified projects focus on increasing performance while reducing the storage controller form factor.

(4)          The in-process projects were related to the development of software modules to add additional functionality to the existing storage virtualization software as well as address specific customer needs.

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 Snap Appliance, the IBM i/p Series RAID business, Eurologic and Elipsan were expected to grow through fiscal 2009, fiscal 2009, fiscal 2008 and fiscal 2007, respectively, and decline thereafter as other new products are expected to become available. Estimated operating expenses included research and development expenses and selling, marketing and administrative expenses based upon historical and expected direct expense levels and general industry metrics. Estimated research and development expenses include 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)

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

4. Business Acquisitions (Continued)

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 utilized 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: approximately 24% for Snap Appliance, between 23% and 28% for the IBM i/p Series RAID business, approximately 27% for Eurologic and approximately 63% for Elipsan.

The percentage of completion was determined using costs incurred by Snap Appliance, the IBM i/p Series RAID business, Eurologic and Elipsan 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 acquisition date for Snap Appliance, the IBM i/p Series RAID business, Eurologic and Elipsan, that the projects were approximately 25% complete, 50% complete, 60% complete and 28% complete, respectively. All projects outstanding as of the acquisition date for Eurologic and Elipsan were completed as of March 31, 2004 and December 31, 2004, respectively. The Company expects remaining costs of approximately $0.5 million and $18.4 million related to Snap Appliance and the IBM i/p Series RAID business, respectively, to bring the planned in-process projects to completion.

Pro Forma Results:   The following unaudited pro forma financial information for the third quarter of fiscal 2004 and first nine months of fiscal 2005 and 2004, presents the combined results of the Company and Snap Appliance, the IBM i/p Series RAID business, ICP vortex and Elipsan, as if the acquisitions had occurred at the beginning of the periods presented. Eurologic was not included in the calculation as the results of Eurologic have been included in the Company’s financial statements from April 2, 2003. 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 third quarter of fiscal 2004 and first nine months of fiscal 2005 and 2004 were as follows:

		Three-Month Period Ended					Nine-Month Period Ended
		December 31, 2003					December 31, 2004					December 31, 2003
		(in thousands, except per share amounts)
Net revenues			$	142,208				$	377,931				$	405,550
Net income (loss)			(6,885		)			7,088					20,051
Net income (loss) per share:
Basic			$	(0.06	)			$	0.06				$	0.18
Diluted			$	(0.06	)			$	0.06				$	0.18

 

15

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

5. Balance Sheets Details

Inventories:

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

 

Accrued Liabilities:

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

*                    Included $5.3 million and $0.3 million of margin related to  deferred revenue in the channel at December 31, 2004 and March 31, 2004, respectively.

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 nine months of fiscal 2005 was as follows:

		SSG			SNG			OEM			Channel			Total
		(in thousands)
Balance at March 31, 2004		$	22,825		$	45,667		$	—		$	—		$	68,492
Reallocation (See Note 18)		(22,825		)	(45,667		)	30,326			38,166			—
Goodwill acquired (See Note 4)		—			—			18,915			72,830			91,745
Goodwill adjustments		—			—			(400		)	(205		)	(605		)
Balance at December 31, 2004		$	—		$	—		$	48,841		$	110,791		$	159,632

 

The goodwill reallocation shown in the table above relates to the reorganization of certain of the Company’s reportable segments discussed in Note 18. The goodwill formerly included in the SSG and SNG segments was allocated between the OEM and Channel segments based on a relative fair value approach using an independent appraisal and management estimates of fair value of the segment. No impairment was recorded as a result of the change in segments. In the first nine months of fiscal 2005, adjustments

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

6. Goodwill and Other Intangible Assets (Continued)

were made to goodwill for changes to the acquisition-related restructuring reserves and other purchase price adjustments for ICP vortex and Elipsan.

Other Intangible Assets:

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

 

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

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

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

6. Goodwill and Other Intangible Assets (Continued)

The annual amortization expense of the other intangible assets that existed as of December 31, 2004 is expected to be as follows:

		Estimated Amortization Expense
		Acquisition-related intangible assets					Intellectual property assets
		(in thousands)
Fiscal Years:
2005 (remaining three months)			$	5,095				$	1,818
2006			17,374					7,061
2007			14,591					6,641
2008			11,476					1,691
2009 and thereafter			21,339					—
Total			$	69,875				$	17,211

 

7. IBM Distribution Agreement

In December 2004, the Company entered into a distribution agreement on its RAID controllers and connectivity products sold for IBM’s iSeries and pSeries servers. The agreement was made through an amendment to the Company’s existing i/p Series RAID supply and intellectual property agreement entered into in June 2004 (See Note 4). The distribution agreement is accounted for as a standalone transaction as it was not contemplated at the time the Company entered into the original IBM i/p Series RAID transaction.

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

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

8. Line of Credit

In connection with the acquisition of Snap Appliance, the Company acquired an available revolving line of credit of up to $7.5 million that bears interest at the greater of prime rate or 4.25% per annum. At December 31, 2004, the Company had no borrowings against this line. Borrowings are collateralized by

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

8. Line of Credit (Continued)

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

9. Stock Plans

2004 Equity Incentive Plan

During the second quarter of fiscal 2005, the Company’s Board of Directors and its stockholders approved the Company’s 2004 Equity Incentive Plan and reserved for issuance thereunder 10,000,000 shares of the Company’s common stock plus shares reserved but not issued under the Company’s 1999 Stock Option Plan and 2000 Nonstatutory Stock Option Plan. The 2004 Equity Incentive Plan provides for granting of nonstatutory stock options, restricted stock, stock awards, restricted stock units and stock appreciation rights to employees, employee directors and consultants. Incentive stock options may also be granted to the Company’s employees under the 2004 Equity Incentive Plan.

Snap Appliance Stock Option Plan

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

10. Interest and Other Income

The components of interest and other income for the third quarter and first nine months of fiscal 2005 and 2004 were as follows:

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

 

In June 2004, the Company, Nevada 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

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

10. Interest and Other Income (Continued)

certain patents. The license and release agreement expressly excluded any sales of products made by Eurologic prior to the Company’s April 2003 acquisition. 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.

In December 1999, the Company purchased Distributed Processing Technology Corporation (“DPT”). As part of the purchase agreement, $18.5 million of the purchase price was held back (“Holdback Amount”) from former DPT stockholders for unknown liabilities that may have existed as of the acquisition date. Subsequent to the date of purchase, the Company determined that certain representations and warranties made by the DPT stockholders were incomplete or inaccurate, which caused the Company to lose revenues and incur additional expenses. This caused the Company to file court proceedings against Steven Goldman, the principal shareholder and former president of DPT, alleging causes of action for, amongst others, fraud, fraudulent inducement, and negligent misrepresentation. In May 2003, the Company entered into a written settlement and a mutual general release agreement with Steven Goldman, on his own and on behalf of all the selling shareholders of DPT, pursuant to which it was agreed that the Company would retain the Holdback Amount and additionally, Steven Goldman would pay the Company $31.0 million. The Company received the $31.0 million payment in May 2003 and recorded a gain of approximately $49.3 million in the first quarter of fiscal 2004. The cash received from the DPT settlement of $31.0 million was included in cash provided by operating activities in the Unaudited Condensed Consolidated Statements of Cash Flows.

In the first quarter of fiscal 2004, the Company redeemed the outstanding $82.4 million balance of its 4 ¾% Convertible Subordinated Notes (“4 ¾% Notes”) for an aggregate price of $83.0 million resulting in a loss on extinguishment of debt of $0.8 million (including unamortized debt issuance costs of $0.2 million). In the third quarter of fiscal 2004, the Company utilized $124.2 million of the net proceeds from the issuance of the ¾% Convertible Senior Subordinated Notes  (“¾% Notes”) and repurchased $124.2 million in aggregate principal amount of the 3% Convertible Subordinated Notes (“3% Notes”) resulting in a loss on extinguishment of debt of $2.9 million (including unamortized debt issuance costs of $2.9 million). The loss on extinguishment of debt has been included in “Interest and other income” in the Company’s Unaudited Condensed Consolidated Statements of Operations.

11. Restructuring Charges

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

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

11. Restructuring Charges (Continued)

Third Quarter of Fiscal 2005 Restructuring Plan:   In the third quarter of fiscal 2005, the Company initiated certain actions to simplify the Company’s structure by streamlining the corporate organization and reducing operating costs. This resulted in a restructuring charge of $2.4 million, which related to the involuntary termination of 46 employees in all functions of the organization and costs pertaining to estimated future obligations for non-cancelable lease payments for an excess facility in Germany. The expenses associated with this restructuring plan were included in “Restructuring charges” in the Unaudited Condensed Consolidated Statements of Operations. The Company does not expect to incur any further charges in connection with this restructuring plan.

Second Quarter of Fiscal 2005 Restructuring Plan:   In the second quarter of fiscal 2005, the Company initiated certain actions to consolidate duplicative resources in connection with the acquisition of Snap Appliance, primarily in selling, marketing and administrative functions, and recorded a restructuring charge of $0.7 million. The expenses associated with this restructuring plan were included in “Restructuring charges” in the Unaudited Condensed Consolidated Statements of Operations. The Company does not expect to incur any further charges in connection with this restructuring plan. For the acquisition-related restructuring plan associated with the Snap Appliance acquisition, please see Note 4 for further details.

First Quarter of Fiscal 2005 Restructuring Plan:   In the first quarter of fiscal 2005, the Company initiated certain actions to consolidate certain development and administrative functions in the United States and Europe, which were completed in the first half of fiscal 2005. The Company recorded a restructuring charge of $0.8 million in the first quarter of fiscal 2005 related to the involuntary termination of employees and the costs pertaining to estimated future obligations for non-cancelable lease payments for an excess facility in the United Kingdom. Additional charges of $1.4 million related to this plan associated with severance and benefits for employees primarily in the area of research and development were taken in the second quarter of fiscal 2005. In the third quarter of fiscal 2005, a provision adjustment of $0.1 million was made related to the fiscal 2004 restructuring plan as severance and benefits were lower than originally anticipated. Restructuring charges related to the first quarter restructuring plan total $2.1 million. The Company does not expect to incur any further charges in connection with this restructuring plan.

The activity in the accrued restructuring reserves related to all of the plans was as follows for the first nine months of fiscal 2005:

		Severance And Benefits					Other Charges					Total
		(in thousands)
Reserve balance at March 31, 2004			$	987				$	1,773			$	2,760
Q1’05 Restructuring Plan			1,657					540				2,197
Q2’05 Restructuring Plan			700					—				700
Q3’05 Restructuring Plan			2,286					102				2,388
Provision adjustment			(305		)			(5		)		(310		)
Cash paid			(3,015		)			(605		)		(3,620		)
Non-cash charges			—					(141		)		(141		)
Reserve balance at December 31, 2004			$	2,310				$	1,664			$	3,974

 

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

11. Restructuring Charges (Continued)

The provision adjustment of $0.3 million related to the first quarter of fiscal 2005 and the fiscal 2004 restructuring plans, of which $0.2 million related to the fiscal 2004 restructuring plan, as severance and benefits and lease costs were lower than originally anticipated. The Company anticipates that the remaining restructuring reserve balance of $4.0 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.

12. Other Charges

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

13. 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 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.

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

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

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

		Three-Month Period Ended										Nine-Month Period Ended
		December 31, 2004					December 31, 2003					December 31, 2004					December 31, 2003
		(in thousands, except per share amounts)
Numerators:
Net income (loss)			$	22,489				$	(3,013	)			$	14,436				$	38,050
Adjustment for interest expense on ¾% Notes, net of taxes			454					—					1,371					—
Adjustment for interest expense on 3% Notes, net of taxes			196					—					—					4,120
Adjusted net income (loss)			$	23,139				$	(3,013	)			$	15,807				$	42,170
Denominators:
Weighted average shares outstanding—basic			111,136					108,858					110,429					108,408
Effect of dilutive securities:
Employee stock options			1,859					—					1,954					1,992
¾% Notes			19,224					—					19,224					—
3% Notes			2,298					—					—					16,178
Weighted average shares and potentially dilutive common shares outstanding—diluted			134,517					108,858					131,607					126,578
Net income (loss) per share:
Basic			$	0.20				$	(0.03	)			$	0.13				$	0.35
Diluted			$	0.17				$	(0.03	)			$	0.12				$	0.33

 

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

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

Diluted loss per share for the third quarter of fiscal 2004 was based only on the weighted-average number of shares outstanding during this 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 third quarter of fiscal 2005 and the first nine months of fiscal 2004 and 2005 because their inclusion would have been anti-dilutive. The items excluded for the third quarter and first nine months of fiscal 2005 and 2004 were as follows:

		Three-Month Period Ended								Nine-Month Period Ended
		December 31, 2004				December 31, 2003				December 31, 2004				December 31, 2003
		(in thousands)
Outstanding employee stock options			13,971				13,188				14,478				14,264
Warrants(1)			19,624				20,534				19,624				20,534
4¾% Notes			—				—				—				549
3% Notes			—				15,881				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.

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

14. Comprehensive Income (Loss)

The Company’s comprehensive income (loss), which consisted of net income and the changes in net unrealized losses on marketable securities, net of taxes and foreign currency translation adjustments, net of taxes, were as follows:

		Three-Month Period Ended										Nine-Month Period Ended
		December 31, 2004					December 31, 2003					December 31, 2004					December 31, 2003
		(in thousands)
Net income (loss)			$	22,489				$	(3,013	)			$	14,436				$	38,050
Net unrealized losses on marketable securities, net of taxes			(921		)			(1,820		)			(3,955		)			(1,883		)
Foreign currency translation adjustment, net of taxes			1,089					859					1,036					911
Comprehensive income (loss)			$	22,657				$	(3,974	)			$	11,517				$	37,078

 

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

14. Comprehensive Income (Loss) (Continued)

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

		December 31, 2004					March 31, 2004
		(in thousands)
Unrealized gains (losses) on marketable securities, net of income tax provision (benefit) of $(1,179) at December 31, 2004 and $1,443 at March 31, 2004			$	(1,769	)			$	2,186
Foreign currency translation, net of income tax provision of $1,233 at December 31, 2004 and $543 at March 31, 2004			1,850					814
Total			$	81				$	3,000

 

15. Income Taxes

Income tax provisions for interim periods are based on the Company’s estimated annual income tax rate. In the third quarter and first nine months of fiscal 2005, the Company recorded an income tax benefit of $33.4 million and $33.8 million, respectively, on a pre-tax loss of $10.9 million and $19.4 million, respectively. The estimated annual tax rate differs from the combined United States Federal and state statutory income tax rate of 40% primarily due to changes in the Company’s tax reserves and certain acquisition related intangible assets, excluding goodwill, that are not fully deductible for tax purposes. 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. The tax rates for the third quarter and the first nine months of fiscal 2005 differ from the combined United States Federal and state statutory income tax rate of 40% primarily due to tax benefits of $21.9 million and $31.9 million respectively from discrete events relating to the method and amount of settled tax controversies. As a result of the settlements, $21.9 million previously recorded as a tax provision was reversed during the third quarter of fiscal 2005. In addition, $4.1 million previously recorded as a tax provision was reclassified as a reduction to additional paid-in capital, $1.8 million previously recorded as a tax provision was reversed and a $4.0 million tax benefit associated with a refund claim was recognized during the second quarter of fiscal 2005. The tax rate for the third quarter and first nine months of 2004 differed from the combined United States Federal and state statutory rate of 40% primarily due to the gain on settlement with the former president of DPT of $49.3 million which is treated as an adjustment to the tax basis in the acquired DPT common stock and does not result in taxable income.

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

25

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

15. Income Taxes (Continued)

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

16. Commitments and Contingencies

On June 27, 2000, the Company received a statutory notice of deficiency from the IRS with respect to its Federal income tax returns for fiscal 1994 to 1996. The Company filed a Petition with the United States Tax Court on September 25, 2000, contesting the asserted deficiencies. In December 2001, settlement agreements were filed with the United States Tax Court reflecting a total of $9.0 million of adjustments and an allowance of $0.5 million in additional tax credits. 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 defense 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 2001. In the third quarter of fiscal 2005, the Company has resolved all issues 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. As a result of the resolutions, $21.9 million and $31.9 million previously recorded as a tax provision was reversed during the third quarter and first nine months of fiscal 2005, respectively. 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, the Company’s business, financial condition, results of operations and cash flows could be materially and adversely affected by the outcome of these actions.

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