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

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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

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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

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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

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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

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

4. Business Acquisitions (Continued)

flows and discounting the estimated net cash flows 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

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

4. Business Acquisitions (Continued)

During the first quarter of fiscal 2006, the 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

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

5. Balance Sheets Details (Continued)

Accrued Liabilities:

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

 

6. Goodwill and Other Intangible Assets

Goodwill:

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

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

6. Goodwill and Other Intangible Assets (Continued)

Amortization of other intangible assets was $12.9 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

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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

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

8. Restructuring Charges (Continued)

Company’s first, second, third and fourth quarters of fiscal 2005, fiscal 2004 and fiscal 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

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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

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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

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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

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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

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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

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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