Applied Micro Circuits (AMCC) 10-Q 2006 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal quarter ended December 31, 2005

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: 000-23193

APPLIED MICRO CIRCUITS CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	94-2586591
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
215 Moffett Park Drive, Sunnyvale, CA	94089
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (858) 450-9333

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, as amended (the “Exchange Act”), 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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨                Accelerated filer  x                Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of January 31, 2006, 294,309,814 shares of the registrant’s common stock were issued and outstanding.

APPLIED MICRO CIRCUITS CORPORATION

INDEX

		Page
Part I.	FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Balance Sheets at December 31, 2005 (unaudited) and March 31, 2005	3
	Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended December 31, 2005 and 2004	4
	Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended December 31, 2005 and 2004	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	43
Item 4.	Controls and Procedures	44
	OTHER INFORMATION
Item 1.	Legal Proceedings	45
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	45
Item 6.	Exhibits	45
Signatures		46

2

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

APPLIED MICRO CIRCUITS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par value)

	December 31, 2005			March 31, 2005
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	40,964		$	75,396
Short-term investments-available-for-sale		309,846			347,996
Accounts receivable, net		22,390			28,601
Inventories		20,648			18,014
Other current assets		14,999			51,448
Total current assets		408,847			521,455
Property and equipment, net		38,237			44,461
Goodwill and purchased intangibles, net		517,014			534,514
Other assets		8,269			1,965
Total assets	$	972,367		$	1,102,395
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	28,268		$	24,016
Accrued payroll and related expenses		8,525			10,101
Other accrued liabilities		21,289			87,107
Deferred revenue		3,358			3,939
Current portion of long-term debt and capital lease obligations		—			34
Total current liabilities		61,440			125,197
Stockholders’ equity:
Preferred stock, $0.01 par value:
Authorized shares - 2,000, none issued and outstanding		—			—
Common stock, $0.01 par value:
Authorized shares - 630,000 at December 31, 2005
Issued and outstanding shares - 293,284 at December 31, 2005 and 308,328 at March 31, 2005		2,933			3,083
Additional paid-in capital		5,881,795			5,939,640
Deferred compensation, net		(4,377	)		(9,101	)
Accumulated other comprehensive loss		(9,823	)		(6,867	)
Accumulated deficit		(4,959,601	)		(4,949,557	)
Total stockholders’ equity		910,927			977,198
Total liabilities and stockholders’ equity	$	972,367		$	1,102,395

See Accompanying Notes to Condensed Consolidated Financial Statements

3

APPLIED MICRO CIRCUITS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share data)

	Three Months Ended December 31,						Nine Months Ended December 31,
	2005			2004			2005			2004
Net revenues	$	65,243		$	61,081		$	194,851		$	189,552
Cost of revenues (1)		30,017			30,159			91,943			93,180
Gross profit		35,226			30,922			102,908			96,372
Operating expenses:
Research and development		22,775			31,411			68,910			94,103
Selling, general and administrative		14,239			15,887			44,133			45,563
Stock-based compensation:
Research and development		654			752			2,024			2,699
Selling, general and administrative		783			876			2,351			4,401
Acquired in-process research and development		—			—			—			13,400
Amortization of purchased intangibles		1,107			1,833			3,481			5,352
Impairment of purchased intangibles		—			27,330			—			27,330
Restructuring charges		1,339			8,079			4,898			8,389
Litigation settlement, net		—			28,900			—			28,900
Total operating expenses		40,897			115,068			125,797			230,137
Operating loss		(5,671	)		(84,146	)		(22,889	)		(133,765	)
Interest income, net		4,251			4,780			11,724			14,591
Other income (expense), net		689			—			157			—
Loss before income taxes		(731	)		(79,366	)		(11,008	)		(119,174	)
Income tax expense (benefit)		(1,315	)		2,526			(964	)		2,861
Net income (loss)	$	584		$	(81,892	)	$	(10,044	)	$	(122,035	)
Basic net income (loss) per share:
Net income (loss) per share:	$	0.00		$	(0.27	)	$	(0.03	)	$	(0.39	)
Shares used in calculating basic net income (loss) per share		297,119			307,729			302,974			309,792
Diluted net income (loss) per share:
Net income (loss) per share	$	0.00		$	(0.27	)	$	(0.03	)	$	(0.39	)
Shares used in calculating diluted net income (loss) per share		299,049			307,729			302,974			309,792
(1) Cost of revenuesincludes the following (in thousands):
Stock-based compensation	$	21		$	347		$	68		$	631
Amortization of developed technology		3,625			6,051			14,019			18,126
Amortization of purchased inventory fair value adjustment		—			—			—			2,204
	$	3,646		$	6,398		$	14,087		$	20,961

See Accompanying Notes to Condensed Consolidated Financial Statements

4

APPLIED MICRO CIRCUITS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

	Nine Months Ended December 31,
	2005			2004
Operating activities:
Net loss	$	(10,044	)	$	(122,035	)
Adjustments to reconcile net loss to net cash used for operating activities:
Depreciation and amortization		10,111			13,960
Amortization of purchased intangibles		17,500			23,478
Impairment of purchased intangibles		—			27,330
Acquired in-process research and development		—			13,400
Stock-based compensation expense		4,443			7,731
Non-cash restructuring charges		2,804			3,855
Net gains on disposals of property and equipment		(4	)		—
Changes in operating assets and liabilities:
Accounts receivables		6,211			2,605
Inventories		(2,634	)		(6,407	)
Other assets		33,452			(30,333	)
Accounts payable		4,252			(5,931	)
Accrued payroll and other accrued liabilities		(67,394	)		58,540
Deferred revenue		(581	)		(971	)
Net cash used for operating activities		(1,884	)		(14,778	)
Investing activities:
Proceeds from sales and maturities of short-term investments		923,685			2,507,877
Purchases of short-term investments		(888,231	)		(2,339,921	)
Purchase of strategic investment		(3,500	)		—
Purchase of property, equipment and other assets		(6,705	)		—
Proceeds from sale of property		101			(25,444	)
Net cash paid for acquisitions		—			(368,355	)
Net cash provided by (used for) investing activities		25,350			(225,843	)
Financing activities:
Proceeds from issuance of common stock		3,023			5,177
Repurchase of company stock		(9,947	)		(16,879	)
Funding of structured stock repurchase programs		(54,000	)		(50,000	)
Funds received from structured stock repurchase
programs including gains		3,210			22,343
Payments on capital lease obligations		(34	)		(132	)
Payment on long-term debt		—			(68	)
Other		(150	)		789
Net cash used for financing activities		(57,898	)		(38,770	)
Net decrease in cash and cash equivalents		(34,432	)		(279,391	)
Cash and cash equivalents at beginning of period		75,396			329,162
Cash and cash equivalents at end of period	$	40,964		$	49,771
Supplementary cash flow disclosure:
Cash paid for:
Interest	$	86		$	64
Income taxes	$	861		$	623

See Accompanying Notes to Condensed Consolidated Financial Statements

5

APPLIED MICRO CIRCUITS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements of Applied Micro Circuits Corporation (“AMCC” or the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying financial statements reflect all adjustments (consisting of normal recurring accruals), which are, in the opinion of management, considered necessary for a fair presentation of the results for the interim periods presented. Interim results are not necessarily indicative of results for a full year. The Company has experienced significant quarterly fluctuations in net revenues and operating results, and these fluctuations could continue.

The financial statements and related disclosures have been prepared with the presumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financial statements should be read in conjunction with the audited financial statements and the related notes thereto contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission for the fiscal year ended March 31, 2005.

Changes to Previously Announce Fiscal 2006 Third Quarter Results

On January 25, 2006, the Company announced its fiscal 2006 third quarter results. Subsequent to the announcement, the Company received information from the Investment Center in Israel, which removed a substantial portion of a tax contingency the Company had previously recorded to account for certain exposures related to the tax holiday status of its subsidiary. As a result, the Company has increased the income tax benefit it previously reported in the third quarter by $1.1 million and is revising the previously reported net loss of $(534,000) to net income of $584,000. The previously reported basic and diluted earnings or loss per share of $0.00 for the three months ended December 31, 2005 remained unchanged by this adjustment. In addition, the previously reported net loss of $(11.2) million or $(0.04) per share for the nine months ended December 31, 2005 was revised to reflect a net loss of $(10.0) million or $(0.03) per share.

Use of Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses in the reporting period. The Company regularly evaluates estimates and assumptions related to inventory valuation and warranty liabilities, which affects our cost of sales and gross margin; the valuation of purchased intangibles and goodwill, which affects our amortization and impairments of goodwill and other intangibles; the valuation of restructuring liabilities, which affects the amount and timing of restructuring charges; and the valuation of deferred income taxes, which affects our income tax expense and benefit. The Company bases its estimates and assumptions on historical experience and on various other factors that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The actual results experienced by the Company may differ materially and adversely from management’s estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected.

Stock-Based Compensation

The Company has in effect several stock option plans under which non-qualified and incentive stock options have been granted to employees and non-employee directors. The Company also has in effect an employee stock

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purchase plan. The Company accounts for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and the related Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation—An Interpretation of APB Opinion No. 25”. The Company has adopted the disclosure-only alternative of SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS 148”).

In accordance with the requirements of the disclosure-only alternative of SFAS 123, set forth below are the assumptions used and a pro forma illustration of the effect on net income (loss) and net income (loss) per share if the Company had valued stock-based awards to employees using the Black-Scholes option pricing model instead of applying the guidelines provided by APB 25. In arriving at an option valuation, the Black-Scholes model considers, among other factors, the expected life of the option and the expected volatility of the Company’s stock price.

The per share fair value of options granted in connection with stock option plans and rights granted in connection with the employee stock purchase plans reported below has been estimated at the date of grant with the following weighted average assumptions:

	Employee Stock Options												Employee Stock Purchase Plan
	Three Months Ended December 31,						Nine Months Ended December 31,						Three Months Ended December 31,						Nine Months Ended December 31,
	2005			2004			2005			2004			2005			2004			2005			2004
Expected life (years)		4.0			4.0			3.1			4.0			1.4			1.4			1.33			1.4
Volatility		0.49			0.93			0.52			0.95			0.61			0.97			0.64			0.98
Risk-free interest rate		4.4	%		3.3	%		4.0	%		3.8	%		3.1	%		1.8	%		2.9	%		1.7	%
Dividend yield		0	%		0	%		0	%		0	%		0	%		0	%		0	%		0	%
Weighted average fair value per share	$	1.09		$	2.42		$	1.12		$	2.64		$	1.48		$	2.16		$	1.50		$	2.19

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The Company’s pro forma information under SFAS 123 and SFAS 148 was as follows (in thousands, except for per share data):

	Three Months Ended December 31,						Nine Months Ended December 31,
	2005			2004			2005			2004
Net income (loss)—as reported	$	584		$	(81,892	)	$	(10,044	)	$	(122,035	)
Plus: Reported stock-based compensation		1,458			1,975			4,443			7,731
Less: Fair value stock-based compensation		(8,661	)		(22,834	)		(23,380	)		(86,310	)
Net loss—pro forma	$	(6,619	)	$	(102,751	)	$	(28,981	)	$	(200,614	)
Reported basic net income (loss) per share	$	0.00		$	(0.27	)	$	(0.03	)	$	(0.39	)
Reported diluted net income (loss) per share	$	0.00		$	(0.27	)	$	(0.03	)	$	(0.39	)
Pro forma basic and diluted net loss per share	$	(0.02	)	$	(0.33	)	$	(0.10	)	$	(0.65	)

The Company evaluates the assumptions used to value stock awards under SFAS 123 on a quarterly basis. Based on guidance provided in SFAS No. 123 (revised 2004),Share-Based Payment(“SFAS 123R”), and SAB No. 107,Share-Based Payment, in the three months ended December 31, 2005, the Company refined its volatility assumption from 0.53% to 0.49% based on historical data over the estimated life of the options. The Company believes that its current assumptions generate a more representative estimate of fair value.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123R, which is a revision of SFAS 123. SFAS 123R requires all share-based payments to employees, including grants of employee

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stock options, to be recognized in the financial statements based on their fair values and does not allow the previously permitted pro forma disclosure as an alternative to financial statement recognition. SFAS 123R supersedes APB 25 and related interpretations and amends SFAS No. 95,Statement of Cash Flows.The Company will be required to adopt SFAS 123R in the first quarter of fiscal 2007. SFAS 123R allows for either prospective recognition of compensation expense or retroactive recognition, which may date back to the original issuance of SFAS 123 or only to interim periods in the year of adoption. The Company is currently evaluating these transition methods.

The adoption of the SFAS 123R fair value method will have a significant impact on the Company’s reported results of operations, although it will have no impact on the Company’s overall financial position. The impact of adoption of SFAS 123R cannot be predicted at this time because that will depend on the fair value and number of share-based payments granted in the future. However, had the Company adopted SFAS 123R in prior periods, the magnitude of the impact of that standard would have approximated the impact of SFAS 123 assuming the application of the Black-Scholes model as illustrated in the table above.

Derivative Financial Instruments

The Company has used foreign exchange forward contracts to hedge expense commitments that are denominated in currencies other than the U.S. dollar. The purpose of the Company’s foreign currency hedging activities is to fix the dollar value of specific commitments and payments to foreign vendors. At December 31, 2005, the Company did not have any open foreign exchange contracts. The Company accounts for derivatives pursuant to SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, as amended. This standard requires that all derivative instruments be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them. The classification of gains and losses resulting from changes in the fair values of derivatives is dependent on the intended use of the derivative and its resulting designation. The change in fair value of the ineffective portion of a hedge, and changes in fair values of derivatives that are not considered highly effective hedges are immediately recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive income and are subsequently recognized in earnings when the hedged item affects earnings.

2. CERTAIN FINANCIAL STATEMENT INFORMATION

Accounts receivable (in thousands):

	December 31, 2005			March 31, 2005
Accounts receivable	$	24,174		$	30,385
Less: allowance for bad debts		(1,784	)		(1,784	)
	$	22,390		$	28,601

Inventories (in thousands):

	December 31, 2005		March 31, 2005
Finished goods	$	12,015	$	9,754
Work in process		5,300		7,095
Raw materials		3,333		1,165
	$	20,648	$	18,014

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Other current assets (in thousands):

	December 31, 2005		March 31, 2005
Litigation insurance receivable	$	—	$	32,947
Deposits		1,099		2,366
Prepaid expenses		11,507		13,689
Other		2,393		2,446
	$	14,999	$	51,448

Property and equipment (in thousands):

	Useful Life	December 31, 2005			March 31, 2005
	(in years)
Machinery and equipment	5-7	$	40,499		$	42,906
Leasehold improvements	1-15		11,289			11,676
Computers, office furniture and equipment	3-7		76,917			80,353
Buildings	31.5		5,954			5,860
Land	N/A		12,202			12,202
			146,861			152,997
Less accumulated depreciation and amortization			(108,624	)		(108,536	)
		$	38,237		$	44,461

Goodwill and purchased intangibles:

Goodwill and other acquisition-related intangibles were as follows (in thousands):

	December 31, 2005							March 31, 2005
	Gross		Accumulated Amortization and Impairments			Net		Gross		Accumulated Amortization and Impairments			Net
Goodwill	$	4,401,662	$	(3,974,186	)	$	427,476	$	4,401,662	$	(3,974,186	)	$	427,476
Developed technology		413,500		(345,050	)		68,450		413,500		(331,031	)		82,469
Backlog/customer relationships		3,600		(3,470	)		130		3,600		(3,282	)		318
Patents/core technology rights/tradename		59,200		(38,242	)		20,958		59,200		(34,949	)		24,251
	$	4,877,962	$	(4,360,948	)	$	517,014	$	4,877,962	$	(4,343,448	)	$	534,514

As of December 31, 2005, the estimated future amortization expense of purchased intangible assets to be charged to cost of sales and operating expenses was as follows (in thousands):

	Cost of Sales		Operating Expenses		Total
Fiscal year 2006	$	3,625	$	1,108	$	4,733
Fiscal year 2007		14,500		4,430		18,930
Fiscal year 2008		14,500		4,430		18,930
Fiscal year 2009		13,950		4,429		18,379
Fiscal year 2010		10,500		3,169		13,669
Thereafter		11,375		3,522		14,897
Total	$	68,450	$	21,088	$	89,538

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Other accrued liabilities (in thousands):

	December 31, 2005		March 31, 2005
Accrued warranty and excess purchase commitments	$	6,256	$	6,828
Current tax liabilities		872		2,697
Restructuring liabilities		2,062		2,699
Excess lease liability		—		4,769
Litigation settlement liability		—		60,000
Other		12,099		10,114
	$	21,289	$	87,107

Interest income, net (in thousands):

	Three Months Ended December 31,						Nine Months Ended December 31,
	2005			2004			2005			2004
Interest income	$	4,190		$	4,284		$	12,499		$	12,592
Net realized gains (losses) from short-term investments		101			508			(689	)		2,063
Interest expense		(40	)		(12	)		(86	)		(64	)
	$	4,251		$	4,780		$	11,724		$	14,591

Other income (expense), net (in thousands):

	Three Months Ended December 31,					Nine Months Ended December 31,
	2005			2004		2005			2004
Net gains on disposals of property and equipment	$	—		$	—	$	4		$	—
Sublease income		25			—		25			—
Gain from the sale of strategic investment		671			—		671			—
Foreign currency loss		(7	)		—		(543	)		—
	$	689		$	—	$	157		$	—

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Net income (loss) per share:

Shares used in basic net income (loss) per share are computed using the weighted average number of common shares outstanding during each period. Shares used in diluted net income (loss) per share include the dilutive effect of common shares potentially issuable upon the exercise of stock options. The reconciliation of shares used to calculate basic and diluted net income (loss) per share consists of the following (in thousands, except per share data):

	Three Months Ended December 31,					Nine Months Ended December 31,
	2005		2004			2005			2004
Net income (loss)	$	584	$	(81,892	)	$	(10,044	)	$	(122,035	)
Shares used in net income (loss) per share computation:
Weighted average common shares outstanding		297,119		307,729			302,974			309,792
Net effect of dilutive common share equivalents based on treasury stock method		1,930		—			—			—
Shares used in diluted net income (loss) per share computations		299,049		307,729			302,974			309,792
Basic net income (loss) per share	$	0.00	$	(0.27	)	$	(0.03	)	$	(0.39	)
Diluted net income (loss) per share	$	0.00	$	(0.27	)	$	(0.03	)	$	(0.39	)

Because the Company incurred losses for the nine months ended December 31, 2005 and for the three and nine months ended December 31, 2004, the effect of dilutive securities totaling 1.5 million equivalent shares for the nine months ended December 31, 2005, respectively, and 3.1 million and 4.0 million equivalent shares for the three and nine months ended December 31, 2004, respectively, have been excluded from the net loss per share computations as their impact would be antidilutive.

3. RESTRUCTURING CHARGES

Over the last several years, the Company has undertaken significant restructuring activities in an effort to reduce operating costs. The Company has initiated several restructuring programs. A combined summary of the restructuring programs is as follows (in thousands):

	Workforce Reduction			Facilities Consolidation and Operating Lease Commitments			Property and Equipment Impairments			Total
Liability, March 31, 2005	$	697		$	2,002		$	—		$	2,699
Charge to expense		1,450			974			2,611			5,035
Cash payments		(1,803	)		(928	)		—			(2,731	)
Noncash write-off		—			—			(2,804	)		(2,804	)
Adjustments		(8	)		(322	)		193			(137	)
Liability, December 31, 2005	$	336		$	1,726		$	—		$	2,062

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The following tables provide detailed activity related to the three most recent restructuring programs during the nine months ended December 31, 2005 (in thousands):

	Workforce Reduction			Facilities Consolidation and Operating Lease Commitments			Property and Equipment Impairments			Total
April 2003 Restructuring Program
Liability, March 31, 2005	$	—		$	1,801		$	—		$	1,801
Cash payments		—			(566	)		—			(566	)
Adjustments		—			(383	)		—			(383	)
Liability, December 31, 2005	$	—		$	852		$	—		$	852
November 2004 Restructuring Program
Liability, March 31, 2005	$	697		$	201		$	—		$	898
Cash payments		(311	)		(262	)		—			(573	)
Noncash write-off		—			—			(193	)		(193	)
Adjustments		(50	)		61			193			204
Liability, December 31, 2005	$	336		$	—		$	—		$	336
July 2005 Restructuring Program
Charge to expense	$	1,450		$	974		$	2,611		$	5,035
Cash payments		(1,492	)		(100	)		—			(1,592	)
Noncash write-off		—			—			(2,611	)		(2,611	)
Adjustments		42			—			—			42
Liability, December 31, 2005	$	—		$	874		$	—		$	874

In April 2003, the Company announced a restructuring program. The April 2003 restructuring program consisted of a workforce reduction of 185 employees, consolidation of excess facilities and fixed asset disposals. In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities”, requiring that costs associated with exit or disposal activities be recognized when they are incurred rather than at the date of a commitment to an exit or disposal plan. Accordingly, approximately $281,000 was charged for severance packages communicated to employees in March 2003. The remaining restructuring costs of $23.5 million were recognized in the first quarter of fiscal 2004 and consisted of approximately $5.4 million for employee severances, $7.2 million representing the discounted cash flow of lease payments on exited facilities, $3.4 million for the disposal of certain software licenses, and $7.5 million for the write off of leasehold improvements and property and equipment. This restructuring charge was offset by a $2.6 million restructuring benefit, in November 2003, related to the reoccupation of a portion of the 58,000 square foot building in San Diego and an adjustment for overestimated severance to be paid.

In November 2004, the Company implemented another workforce reduction and realignment. The November 2004 workforce reduction was implemented as a means to reduce ongoing operating expenses by restructuring the Company’s operations, consolidating its facilities and reducing its workforce. The restructuring consisted of the elimination of approximately 150 employees, or 20% of the workforce, the closure of the Israel facility and consolidating other locations. As a result of the November 2004 restructuring, the Company recorded a charge of approximately $9.1 million, consisting of $4.4 million for employee severances, $4.2 million for property and equipment write-offs, and $500,000 for the closure of the Israel facility and abandonment of certain leased property.

In July 2005, the Company implemented another restructuring program. The July 2005 restructuring program was implemented to reduce job redundancies and reduce ongoing operating expenses. The restructuring program consisted of the elimination of approximately 40 employees, or 5% of the workforce, the disposal of idle fixed assets, and the consolidation of San Diego facilities. As a result of the July 2005 restructuring, the

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Company recorded a charge of approximately $5.0 million, consisting of $1.4 million for employee severances, $2.6 million for property and equipment write-offs and $1.0 million representing expenses relating to the consolidation of San Diego facilities. The Company anticipates saving approximately $4.0 million annually, as a result of this restructuring program.

4. COMPREHENSIVE INCOME OR LOSS

The components of comprehensive income or loss, net of tax, are as follows (in thousands):

	Three Months Ended December 31,						Nine Months Ended December 31,
	2005			2004			2005			2004
Net income (loss)	$	584		$	(81,892	)	$	(10,044	)	$	(122,035	)
Change in net unrealized loss on short-term investments		(3,608	)		(1,931	)		(2,696	)		(7,724	)
Foreign currency translation adjustment		(59	)		693			(260	)		789
Comprehensive loss	$	(3,083	)	$	(83,130	)	$	(13,000	)	$	(128,970	)

5. STOCKHOLDERS’ EQUITY

On August 12, 2004, the Company’s board of directors authorized a stock repurchase program for the repurchase of up to $200.0 million of its common stock. Under the program, the Company is authorized to make purchases in the open market or enter into structured agreements. During the three months ended December 31, 2005, the Company repurchased 4.0 million shares of its common stock for approximately $9.9 million on the open market. These shares were retired upon delivery to the Company.

The Company also utilizes structured stock repurchase agreements to buy back shares which are prepaid written put options on the Company’s common stock. The Company pays a fixed sum of cash upon execution of each agreement in exchange for the right to receive either a pre-determined amount of cash or stock depending on the closing market price of the Company’s common stock on the expiration date of the agreement. Upon expiration of each agreement, if the closing market price of the Company’s common stock is above the pre-determined price, the Company will have its investment returned with a premium. If the closing market price is at or below the pre-determined price, the Company will receive the number of shares specified at the agreement inception. Any cash received, including the premium, is treated as an increase to additional paid in capital on the balance sheet in accordance with the guidance issued in EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”

During the three months ended December 31, 2005, the Company purchased a total of 9.5 million shares of its common stock from it open market transactions and its structure stock repurchase program. These shares were retired upon delivery to the Company.

During the three months ended December 31, 2005, five structured stock repurchase agreements settled with the Company receiving $3.2 million in cash and 5.5 million shares of its common stock at an effective purchase price of $2.52 per share. At December 31, 2005, two open agreements mature in January in which the Company could receive up to $8.9 million in cash or the delivery of up to 3.2 million of its common stock, or a combination of cash and shares.

In addition, during the three months ended December 31, 2005, the Company entered into five structured stock repurchase agreements totaling $17.5 million that have varying maturities through May 2006. Under these new agreements, the Company could receive up to $19.4 million in cash or the delivery of up to 7.2 million shares of its common stock, or a combination of cash and shares.

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6. CONTINGENCIES

Since 1993, the Company has been named as a potentially responsible party, or PRP, along with a large number of other companies that used Omega Chemical Corporation in Whittier, California to handle and dispose of certain hazardous waste material. The Company is a member of a large group of PRPs that has agreed to fund certain remediation efforts at the Omega Chemical site, for which the Company has accrued approximately $100,000. In September 2000, the Company entered into a consent decree with the Environmental Protection Agency, pursuant to which the Company agreed to fund its proportionate share of the initial remediation efforts at the Omega Chemical site. The Company believes the amounts accrued are adequate to cover its proportionate share.

In September 2003, Silvaco Data Systems filed a complaint against the Company in the Superior Court of the State of California in the County of Santa Clara, Silvaco Data Systems v. Applied Micro Circuits Corporation, case no. 103CV005696. In its complaint, Silvaco claims that the Company misappropriated trade secrets and engaged in unfair business practices by using software licensed to the Company by Circuit Symantics, Inc. The Company filed an answer denying Silvaco’s allegations. The court has ordered the parties to mediate the dispute, and a mediation is now set for March 6, 2006. The court has not set a trial date. The Company believes that the allegations in this lawsuit are without merit and intends to defend against the lawsuit vigorously.

In April 2005, Cicada Semiconductor Corporation, a Delaware corporation and now a wholly owned subsidiary of Vitesse Semiconductor Corporation, filed a complaint against the Company and other unknown defendants in the Superior Court of the State of California in the County of San Diego.Cicada Semiconductor Corporation v. Applied Micro Circuits Corporation, case no. GIC 845887. In its complaint, Cicada alleges that the Company breached a contract to purchase assets from Cicada by failing to make installment payments due under the contract. Cicada’s complaint seeks $2 million in damages plus interest and its attorneys’ fees and costs. In June 2005, the Company filed a cross-complaint against both Cicada and Vitesse. The cross-complaint states claims for breach of contract, breach of the implied covenant of good faith and fair dealing and rescission against Cicada, based on allegations that Cicada failed to perform its obligations under the contract and further breached the contract by assigning its rights and obligations under the contract to Vitesse. The cross-complaint states claims for intentional interference with contract and breach of contract against Vitesse based on allegations that Vitesse interfered with the Company’s contract with Cicada and, separately, failed to pay for certain products ordered from and delivered by the Company. Preliminary settlement negotiations were unsuccessful. The Company’s claims against Vitesse arising from Vitesse’s nonpayment are scheduled for trial in April 2006. The court has ordered the parties to engage in arbitration to resolve certain disputes relating to the Company’s disputes with Cicada. That arbitration is scheduled for June 2006. Subsequent to the arbitration, remaining issues will remain to be litigated before the court; however, no date has been set for the trial of those remaining issues. Discovery has commenced and is ongoing.

Several litigation matters are discussed below involving JNI Corporation, which became a wholly owned subsidiary of the Company in October 2003.

In April 2001, a series of similar federal complaints were filed against JNI and certain of its officers and directors. These complaints were consolidated into a single proceeding in U.S. District Court for the Southern District of California. Osher v. JNI, lead case no. 01 cv 0557 J (NLS). The first consolidated and amended complaint contained allegations that between July 13, 2000 and March 28, 2001 JNI and the individual defendants made false statements about JNI’s business and operating results in violation of the Securities Exchange Act of 1934, and also included allegations that defendants made false statements in JNI’s public offering of common stock in October 2000. In March 2003, the court dismissed the action with prejudice. In April 2004, plaintiffs filed a notice of appeal. The appeal has been fully briefed and the case was orally argued on December 7, 2005.

In October 2001, a shareholder derivative lawsuit was filed against JNI and certain of its former officers and directors in the Superior Court of the State of California in the County of San Diego, case no. GIC 775153. The

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complaint alleged that between October 16, 2000 and January 24, 2001, the defendants breached their fiduciary duty by failing to adequately oversee the activities of management and that JNI allegedly made false statements about its business and results causing its stock to trade at artificially inflated levels. The court sustained JNI’s demurrers to each of the plaintiff’s complaints and dismissed the complaint in June 2002. In June 2002, the court granted Sik-Lin Huang’s motion to intervene. Huang filed a complaint in intervention in July 2002. In September 2002, JNI’s board of directors appointed a special litigation committee to investigate the allegations. In February 2003, the special litigation committee issued a report of its investigation, which concluded that it was not in JNI’s best interests to pursue the litigation. In November 2003, the court dismissed the complaint with prejudice. In January 2004, the plaintiff filed a notice of appeal. A motion to dismiss the appeal was filed by the defendants on the grounds that the plaintiff had lost standing because he no longer owned JNI shares. On October 20, 2005, the court dismissed the appeal, finding the plaintiff had no standing to maintain the lawsuit. The California Supreme Court granted review of the Court of Appeal’s decision on January 4, 2006. Plaintiff’s opening brief was due on February 2, 2006. They have requested an additional 60 days to file, but that request has not been acted on by the Court.

In November 2001, a class action lawsuit was filed against JNI and the underwriters of its initial and secondary public offerings of common stock in the U.S. District Court for the Southern District of New York, case no. 01 Civ 10740 (SAS). The complaint alleges that defendants violated the Securities Exchange Act of 1934 in connection with JNI’s public offerings. This lawsuit is among more than 300 class action lawsuits pending in this court that have come to be known as the “IPO laddering cases.” In June 2003, a proposed partial global settlement, subsequently approved by JNI’s board of directors, was announced between the issuer defendants and the plaintiffs that would guarantee at least $1 billion to investors who are class members from the insurers of the issuers. The proposed settlement, if approved by the court and by the issuers, would be funded by insurers of the issuers, and would not result in any payment by JNI or the Company. The Court has granted its preliminary approval of settlement subject to defendants’ agreement to modify certain provisions of the settlement agreements regarding contractual indemnification. JNI has accepted the Court’s proposed modifications. The court has set a hearing for final approval of the settlement for April 24, 2006.

The Company cannot predict the likely outcome of these lawsuits, and an adverse result in any of these lawsuits could have a material adverse effect on the Company.

The Company is also party to various claims and legal actions arising in the normal course of business, including employee disputes and notification of possible infringement on the intellectual property rights of third parties.

7. RELATED PARTY TRANSACTIONS

From time to time the Company chartered an aircraft for business travel from an aircraft charter company, which managed an aircraft owned by a company that AMCC’s former chief executive officer controlled. The Company expensed a total of $0 in the three and nine months ended December 31, 2005 and $200,000 and $600,000 in the three and nine months ended December 31, 2004. These amounts were within the limits on such expenses approved by the board of directors. The board of directors discontinued this practice during the fourth quarter of fiscal year 2005.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s discussion and analysis of financial condition and results of operations, or MD&A, is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of our financial condition, changes in our financial condition and results of our operations. The MD&A is organized as follows:

• Caution concerning forward-looking statements. This section discusses how forward-looking statements made by us in the MD&A and elsewhere in this report are based on management’s present expectations about future events and are inherently susceptible to uncertainty and changes in circumstances.

• Overview. This section provides an introductory overview and context for the discussion and analysis that follows in the MD&A.

• Critical accounting policies. This section discusses those accounting policies that are both considered important to our financial condition and operating results and require significant judgment and estimates on the part of management in their application.

• Results of operations. This section provides an analysis of our results of operations for the three and nine months ended December 31, 2005 and 2004. A brief description is provided of transactions and events that impact the comparability of the results being analyzed.

• Financial condition and liquidity. This section provides an analysis of our cash position and cash flows, as well as a discussion of our financing arrangements and financial commitments.

• Risk factors. This section provides a description of risk factors that could adversely affect our business, results of operations, or financial condition.

CAUTION CONCERNING FORWARD-LOOKING STATEMENTS

This section should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended March 31, 2005. This discussion contains forward-looking statements. These forward-looking statements are made as of the date of this report. Any statement that refers to an expectation, projection or other characterization of future events or circumstances, including the underlying assumptions, is a forward-looking statement. We use certain words and their derivatives such as “anticipate”, “believe”, “plan”, “expect”, “estimate”, “predict”, “intend”, “may”, “will”, “should”, “could”, “future”, “potential”, and similar expressions in many of the forward-looking statements. The forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs, and other assumptions made by us. These statements and the expectations, estimates, projections, beliefs and other assumptions on which they are based are subject to many risks and uncertainties and are inherently subject to change. We describe many of the risks and uncertainties that we face in the “Risk Factors” section of MD&A. We update our descriptions of the risks and uncertainties facing us in our periodic reports filed with the SEC in which we report our financial condition and results for the quarter and fiscal year-to-date. Our actual results and actual events could differ materially from those anticipated in any forward-looking statement. Readers should not place undue reliance on any forward-looking statement.

OVERVIEW

AMCC provides semiconductor and board level products that are the essential building blocks for processing, transporting and storing digital information worldwide. The company blends systems and software expertise with high-performance, high-bandwidth silicon integration to deliver silicon, hardware and software solutions for global wide area networks (WAN), embedded applications such as PowerPC and programmable system on a chip architectures, storage area networks (SAN), and high-growth storage markets such as Serial ATA (SATA) RAID. AMCC’s corporate headquarters are located in Sunnyvale, California. Sales and engineering offices are located throughout the world.

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Over the last several years, we have undertaken significant restructuring activities in an effort to reduce operating costs and focus the activity of the company on profitable growth opportunities. In addition, in an effort to diversify our customer base and markets that we serve, we have also made several acquisitions. In September 2003 and January 2004, we purchased assets and licensed intellectual property associated with IBM’s PowerPRS Switch Fabric product line, or the PRS Business, for approximately $51 million in cash to complement our existing communications products portfolio. In October 2003, we completed the acquisition of all outstanding shares of JNI Corporation, a provider of Fibre Channel hardware and software products that are critical elements of storage networks, for approximately $196.4 million in cash. In April 2004, we completed the acquisition of 3ware, Inc., a provider of high-performance, high-capacity SATA storage solutions, for a purchase price of approximately $145 million in cash. In May 2004 and December 2004, we acquired intellectual property and a portfolio of assets associated with IBM’s 400 series of embedded PowerPC^® standard products, or the Embedded Products Business, for approximately $232 million in cash. The PowerPC 400 series product line targets Internet, communication, data storage, consumer and imaging applications.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses in the reporting period. We regularly evaluate our estimates and assumptions related to inventory valuation and warranty liabilities, which affects our cost of sales and gross margin; the valuation of purchased intangibles and goodwill, which affects our amortization and impairments of goodwill and other intangibles; the valuation of restructuring liabilities, which affects the amount and timing of restructuring charges; and the valuation of deferred income taxes, which affects our income tax expense and benefit. We also have other key accounting policies, such as our policies for revenue recognition, including the deferral of a portion of revenues on sales to distributors, and allowance for bad debts. The methods, estimates and judgments we use in applying these most critical accounting policies have a significant impact on the results we report in our financial statements. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected.

We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our consolidated financial statements.

Inventory Valuation and Warranty Liabilities

Our policy is to value inventories at the lower of cost or market on a part-by-part basis. This policy requires us to make estimates regarding the market value of our inventories, including an assessment of excess or obsolete inventories. We determine excess and obsolete inventories based on an estimate of the future demand for our products within a specified time horizon, generally 12 months. The estimates we use for future demand are also used for near-term capacity planning and inventory purchasing and are consistent with our revenue forecasts. If our demand forecast is greater than our actual demand we may be required to take additional excess inventory charges, which would decrease gross margin and net operating results in the future. Our products typically carry a one to three year warranty. We establish reserves for estimated product warranty costs at the time revenue is recognized. Although we engage in extensive product quality programs and processes, our warranty obligation is affected by product failure rates, use of materials and service delivery costs incurred in correcting any product failure. Should actual product failure rates, use of materials or service delivery costs differ from our estimates, additional warranty reserves could be required, which could reduce our gross margins.

Goodwill and Intangible Asset Valuation

The purchase method of accounting for acquisitions requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair value of the net tangible and intangible assets acquired,

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including in-process research and development, or IPR&D. Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment tests. The amounts and useful lives assigned to other intangible assets impact future amortization, and the amount assigned to IPR&D is expensed immediately. Determining the fair values and useful lives of intangible assets especially requires the use of estimates and the exercise of judgment. While there are a number of different generally accepted valuation methods to estimate the value of intangible assets acquired, we primarily use the discounted cash flow method and the market comparison approach. These methods require significant management judgment to forecast the future operating results used in the analysis. In addition, other significant estimates are required such as residual growth rates and discount factors. The estimates we use to value and amortize intangible assets are consistent with the plans and estimates that we use to manage our business and are based on available historical information and industry estimates and averages. These judgments can significantly affect our net operating results.

We are required to assess goodwill impairment annually using the methodology prescribed by Statement of Financial Accounting Standards, or SFAS, No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 requires that goodwill be tested for impairment at the reporting unit level on an annual basis or more frequently if we believe indicators of impairment exist. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units and determining the fair value of each reporting unit. The goodwill impairment test compares the implied fair value of the reporting unit with the carrying value of the reporting unit. The implied fair value of goodwill is determined in the same manner as in a business combination. Determining the fair value of the implied goodwill is judgmental in nature and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the magnitude of any such charge. Estimates of fair value are primarily determined using discounted cash flows and market comparisons. These approaches use significant estimates and assumptions, including projection and timing of future cash flows, discount rates reflecting the risk inherent in future cash flows, perpetual growth rates, determination of appropriate market comparables, and determination of whether a premium or discount should be applied to comparables. It is reasonably possible that the plans and estimates used to value these assets may be incorrect. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur additional impairment charges.

Restructuring Charges

Over the last four years we have undertaken significant restructuring initiatives, which have required us to develop formalized plans for exiting certain business activities and reducing spending levels. We have had to record estimated expenses for employee severance, long-term asset write downs, lease cancellations, facilities consolidation costs, and other restructuring costs. Given the significance, and the timing of the execution, of such activities, this process is complex and involves periodic reassessments of estimates made at the time the original decisions were made. Prior to 2003, the liability for certain exit costs was recognized on the date that management committed to a plan. In 2003, new accounting guidance was issued requiring us to recognize costs associated with our exit and disposal activities at fair value when a liability is incurred. In calculating the charges for our excess facilities, we have to estimate the timing of exiting certain facilities and then estimate the future lease and operating costs to be paid until the lease is terminated and the amount of any sublease income. To form our estimates for these costs, we performed an assessment of the affected facilities and considered the current market conditions for each site. Our assumptions for the operating costs until termination or the offsetting sublease revenues may turn out to be incorrect, and our actual costs may be materially different from our estimates, which could result in the need to record additional costs or to reverse previously recorded liabilities. Our policies require us to periodically evaluate, at least semiannually, the adequacy of the remaining liabilities under our restructuring initiatives.

Valuation of Deferred Income Taxes

We record valuation allowances to reduce our deferred tax assets to an amount that we believe is more likely than not to be realized. We consider estimated future taxable income and ongoing prudent and feasible tax

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planning strategies, including reversals of deferred tax liabilities, in assessing the need for a valuation allowance. If we were to determine that we will not realize all or part of our deferred tax assets in the future, we would make an adjustment to the carrying value of the deferred tax asset, which would be reflected as income tax expense. Conversely, if we were to determine that we will realize a deferred tax asset, which currently has a valuation allowance, we would reverse the valuation allowance which would be reflected as an income tax benefit or as an adjustment to stockholders’ equity, for tax assets related to stock options, or goodwill, for tax assets related to acquired businesses.

Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements”, or SAB 101 as well as SAB 104, “Revenue Recognition”. These pronouncements require that four basic criteria be met before revenue can be recognized: 1) there is evidence that an arrangement exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4) collectibility is reasonably assured. We recognize revenue upon determination that all criteria for revenue recognition have been met. In addition, we do not recognize revenue until all customers’ acceptance criteria have been met. The criteria are usually met at the time of product shipment, except for shipments to distributors with rights of return. Revenue from shipments to distributors subject to rights of return is deferred until all return or cancellation privileges lapse. Revenue from shipments to distributors without return rights is recognized upon shipment. In addition, we record reductions to revenue for estimated allowances such as returns, competitive pricing programs and rebates. These estimates are based on our experience with product returns and the contractual terms of the competitive pricing and rebate programs. Shipping terms are generally FCA shipping point. If actual returns or pricing adjustments exceed our estimates, additional reductions to revenue would result.

Allowance for Bad Debt

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Our allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts, the aging of accounts receivable, our history of bad debts, and the general condition of the industry. If a major customer’s credit worthiness deteriorates, or our customers’ actual defaults exceed our historical experience, our estimates could change and impact our reported results.

RESULTS OF OPERATIONS

Net Revenues. Net revenues for the three and nine months ended December 31, 2005 were approximately $65.2 million and $194.9 million, respectively, representing increases of 6.8% and 2.8% from net revenues of approximately $61.1 million and $189.6 million for the three and nine months ended December 31, 2004, respectively. We classify our revenues into categories based on markets that the underlying products serve. The categories are Communications, Storage and Embedded. We use this information to analyze the performance and success in these markets.The increases in total net revenues were primarily attributable to increases in our communications and embedded products revenues offset by a decrease in our storage revenues and other revenues. See the following tables (dollars in thousands):

	Three Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Communications	$	31,768	48.7	%	$	30,534	50.0	%	$	1,234		4.0	%
Storage		11,714	18.0	%		12,886	21.1	%		(1,172	)	(9.1	)%
Embedded Products		21,125	32.4	%		16,847	27.6	%		4,278		25.4	%
Other		636	1.0	%		814	1.3	%		(178	)	(21.9	)%
	$	65,243	100.0	%	$	61,081	100.0	%	$	4,162		6.8	%

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	Nine Months Ended December 31, 2005
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Communications	$	99,028	50.8	%	$	95,712	50.5	%	$	3,316		3.5	%
Storage		38,372	19.7	%		38,691	20.4	%		(319	)	(0.8	)%
Embedded Products		52,721	27.1	%		47,432	25.0	%		5,289		11.2	%
Other		4,730	2.4	%		7,717	4.1	%		(2,987	)	(38.7	)%
	$	194,851	100.0	%	$	189,552	100.0	%	$	5,299		2.8	%

The communication revenue increased largely due to an increase in the volume of our communication products and the embedded products revenue increased primarily due to an increase in average price of the products sold and to the introduction of new products. Storage revenue decreased due to the phase out of the FibreChannel host bus adaptor products offset by an increase in volume of our RAID products. In fiscal 2005, we discontinued our FibreChannel host bus adaptor products. These products accounted for a significant portion of our storage revenues in fiscal 2005 and though we continue to ship these products, the revenue from sales of these products has declined significantly.

As a result of our efforts to reduce ongoing operating expenses, we have focused our product development efforts on higher growth opportunities (“focus” products) and defocused our product development efforts away from certain legacy product (“nonfocus” products). Product areas we have focused on are products that process, transport and store information. Our process technology products focus on utilizing our sixth generation of Network Processor cores and our PPC portfolio to meet the needs of the converged IP/Ethernet network while the transport technology products focus on Metro Ethernet, Triple Play access technologies and Error Correction solutions. The storage technology products address the needs of mass storage based on high performance sequential I/O. The nonfocus product areas are our legacy switching products, ASICS, Fibre Channel HBAs, SAN IC’s, Pointer Processors, and legacy framers. We expect the revenues from our nonfocus products to continue to decline in the future. The following table illustrates revenue from our focus and nonfocus areas (dollars in thousands):

	Three Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Focus	$	52,877	81.0	%	$	45,514	74.5	%	$	7,363		16.2	%
Nonfocus		12,366	19.0	%		15,567	25.5	%		(3,201	)	(20.6	)%
	$	65,243	100.0	%	$	61,081	100.0	%	$	4,162		6.8	%
	Nine Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Focus	$	151,260	77.6	%	$	136,322	71.9	%	$	14,938		11.0	%
Nonfocus		43,591	22.4	%		53,230	28.1	%		(9,639	)	(18.1	)%
	$	194,851	100.0	%	$	189,552	100.0	%	$	5,299		2.8	%

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Based on direct shipments, net revenues to customers that exceeded 10% of total net revenues in the three and nine months ended December 31, 2005 and 2004 were as follows:

	Three Months Ended December 31,				Nine Months Ended December 31,
	2005		2004		2005		2004
Avnet	24	%	21	%	19	%	19	%
Sanmina	14	%	*		11	%	*

On July 5, 2005, Avnet acquired Insight Electronics. For purposes of the table above, the shipments to Insight Electronics and Avnet were retroactively combined for all periods presented.

Looking through product shipments to distributors and subcontractors to the end customers, net revenues to end customers that exceeded 10% of total net revenues in the three and nine months ended December 31, 2005 and 2004 were as follows:

	Three Months Ended December 31,				Nine Months Ended December 31,
	2005		2004		2005		2004
Nortel Networks Corporation	13	%	11	%	12	%	10	%

* Less than 10% of total net revenues for period indicated.

Revenues based on direct shipments outside the United States of America accounted for 58% and 55% of net revenues for the three and nine months ended December 31, 2005, compared to 48% and 50% for the three and nine months ended December 31, 2004.

Gross Profit. The following tables present net revenues, cost of revenues and gross profit for the three and nine months ended December 31, 2005 and 2004 (dollars in thousands):

	Three Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Net revenues	$	65,243	100.0	%	$	61,081	100.0	%	$	4,162		6.8	%
Cost of revenues		30,017	46.0	%		30,159	49.4	%		(142	)	(0.5	)%
Gross profit	$	35,226	54.0	%	$	30,922	50.6	%	$	4,304		13.9	%

	Nine Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Net revenues	$	194,851	100.0	%	$	189,552	100.0	%	$	5,299		2.8	%
Cost of revenues		91,943	47.2	%		93,180	49.2	%		(1,237	)	(1.3	)%
Gross profit	$	102,908	52.8	%	$	96,372	50.8	%	$	6,536		6.8	%

The increase in gross profit for the three and nine months ended December 31, 2005 was primarily attributable to the increase in net revenues for those periods and to the decrease of $2.4 million and $6.3 million, respectively, of amortization in purchased intangibles included in our cost of revenues partially offset by an unfavorable change in the mix of our products sold.

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The standard gross margin of our storage and embedded products are lower on average than the standard gross margin of our communications products on average. We expect the storage and embedded products to become a higher percentage of the overall revenue. This anticipated change in the mix of our revenue will have an unfavorable impact on the gross margin.

The amortization of purchased intangible assets included in cost of revenues during the three and nine months ended December 31, 2005 was $3.6 million and $14.0 million, respectively, compared to $6.1 million and $20.3 million, respectively, for the three and nine months ended December 31, 2004. Based on the amount of capitalized purchased intangible assets on the balance sheet as of December 31, 2005, we expect amortization expense for purchased intangibles charged to cost of revenues to be $17.6 million in fiscal 2006, $14.5 million in fiscal 2007, and $50.3 million for fiscal periods thereafter. Future acquisitions of businesses may result in substantial additional charges which would impact the gross margin in future periods.

Research and Development and Selling, General and Administrative Expenses. The following tables present research and development and selling, general and administrative expenses for the three and nine months ended December 31, 2005 and 2004 (dollars in thousands):

	Three Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Decrease			Change
Research and development	$	22,775	34.9	%	$	31,411	51.4	%	$	(8,636	)	(27.5	)%
Selling, general and administrative	$	14,239	21.8	%	$	15,887	26.0	%	$	(1,648	)	(10.4	)%
	Nine Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Decrease			Change
Research and development	$	68,910	35.4	%	$	94,103	49.6	%	$	(25,193	)	(26.8	)%
Selling, general and administrative	$	44,133	22.6	%	$	45,563	24.0	%	$	(1,430	)	(3.1	)%

Research and Development. Research and development, or R&D, expenses consist primarily of salaries and related costs of employees engaged in research, design and development activities, costs related to engineering design tools, subcontracting costs and facilities expenses. The decrease in R&D expenses of 27.5% and 26.8%, respectively, for the three and nine months ended December 31, 2005 compared to the three and nine months ended December 31, 2004, was primarily due to lower payroll and related benefits expense of $3.7 million and $9.9 million, respectively, resulting from our workforce reductions and lower design costs, software and equipment depreciation costs, and subcontracting costs of approximately $4.9 million and $15.3 million, respectively, resulting from our restructuring initiatives. We believe that a continued commitment to R&D is vital to our goal of maintaining a leadership position with innovative communications, storage and embedded products. Currently, R&D expenses are focused on the development of communications, storage, and embedded products and we expect to continue this focus. Future acquisitions of businesses may result in substantial additional on-going costs.

Since the start of fiscal 2003, we have invested a total of approximately $432 million in the research and development of new products, including higher-speed, lower-power and lower-cost products, products that combine the functions of multiple existing products into single highly integrated products, and other products to complete our portfolio of communications, storage and embedded products. For most products developed by us, due to their complexity and the complexity of our customers’ equipment and software qualification efforts, it often takes several years to complete development and deployment of our products. We have not yet generated significant revenues from many of these new products for two additional reasons. First, the downturn in the telecommunications market severely impacted many customers and resulted in significantly less demand for the

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quantity of these products than expected when some of the developments commenced. Second, as a result of restructuring activities, we have discontinued development of several products and slowed down development of other new products as we realized that demand for these products would not materialize as originally anticipated.

Selling, General and Administrative. Selling, general and administrative, or SG&A, expenses consist primarily of personnel-related expenses, professional and legal fees, corporate branding and facilities expenses. The decrease in SG&A expenses of 10.4% and 3.1%, respectively, for the three and nine months ended December 31, 2005 compared to the three and nine months ended December 31, 2004, were primarily due to lower personnel-related expense of approximately $900,000 and $400,000, respectively, and lower facilities rents, equipment, outside services and travel of $750,000 and $1.0 million, respectively. The future acquisitions of businesses may result in substantial additional on-going costs.

Stock-Based Compensation. The following tables present stock-based compensation expense for employees engaged in research and development and selling, general and administrative activities for the three and nine months ended December 31, 2005 and 2004, all of which wereexcludedfrom those operating expenses (dollars in thousands):

	Three Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Decrease				Change
Research and development	$	654	1.0	%	$	752	1.2	%	$	(98	)		(13.0	)%
Selling, general and administrative		783	1.2	%		876	1.4	%		(93	)		(10.6	)%
	$	1,437	2.2	%	$	1,628	2.7	%	$	(191	)		(11.7	)%
	Nine Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Decrease				Change
Research and development	$	2,024	1.0	%	$	2,699	1.4	%	$	(675	)		(25.0	)%
Selling, general and administrative		2,351	1.2	%		4,401	2.3	%		(2,050	)		(46.6	)%
												��
	$	4,375	2.2	%	$	7,100	3.7	%	$	(2,725	)		(38.4	)%

Stock-based compensation expense represents the amortization of deferred compensation related to acquisitions. Deferred compensation is the difference between the fair value of our common stock at the date of each acquisition and the exercise price of the unvested stock options assumed in the acquisition. Stock-based compensation charges, including amounts charged to cost of revenues, were $1.5 million and $4.4 million for the three and nine months ended December 31, 2005, respectively, compared to $2.0 million and $7.7 million for the three and nine months ended December 31, 2004, respectively. We currently expect to record amortization of deferred compensation with respect to these assumed options of approximately $1.4 million in the remaining three months ending March 31, 2006, $2.8 million in fiscal 2007, and $152,000 in fiscal 2008. These charges could be reduced as a result of employee turnover and could change upon adoption of SFAS 123(R). Acquisitions of businesses may result in substantial additional on-going costs. Such charges may cause fluctuations in our interim or annual operating results.

Acquired In-process Research and Development. For the nine months ended December 31, 2004, we recorded $13.4 million of IPR&D resulting from the acquisition of 3ware and the Embedded Products Business. These amounts were expensed on the acquisition dates because the acquired technology had not yet reached technological feasibility and had no future alternative uses. The IPR&D charge related to the 3ware acquisition was made up of two projects that were 42% and 25% complete at the date of acquisition. The estimated aggregate cost to complete these projects was $3.0 million, and the discount rate applied to calculate the IPR&D

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charge was 30% and 35%, respectively. The IPR&D charge related to the Embedded Products Business acquisition was made up of three projects, which were between 42% and 69% complete at the date of acquisition. The estimated aggregate cost to complete these projects was $9.1 million. The discount rate applied to calculate the IPR&D charge ranged from 25% to 30%. There can be no assurance that acquisitions of businesses, products or technologies by us in the future will not result in substantial charges for acquired IPR&D that may cause fluctuations in our interim or annual operating results.

Restructuring Charges. The following tables present restructuring charges for the three and nine months ended December 31, 2005 and 2004 (dollars in thousands):

	Three Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Decrease			Change
Restructuring Charges	$	1,339	2.1	%	$	8,079	13.2	%	$	(6,740	)	(83.4	)%

	Nine Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Decrease			Change
Restructuring Charges	$	4,898	2.5	%	$	8,389	4.4	%	$	(3,491	)	(41.6	)%

In July 2005, we implemented a restructuring program. The July 2005 restructuring program was implemented to reduce job redundancies and reduce ongoing operating expenses. The restructuring program consisted of the elimination of approximately 40 employees, or 5% of the workforce, the disposal of idle fixed assets, and the consolidation of San Diego facilities. As a result of the July 2005 restructuring, during the nine months ending December 31, 2005, we recorded a charge of approximately $5.0 million, consisting of $1.4 million for employee severances, $2.6 million for property and equipment write-offs and $1.0 million representing expenses relating to the consolidation of San Diego facilities. We anticipate saving approximately $4.0 million annually, as a result of this restructuring program.

In November 2004, we implemented another restructuring program. The November 2004 restructuring program was implemented as a means to reduce ongoing operating expenses by restructuring our operations, consolidating our facilities and reducing our workforce. The restructuring consisted of the elimination of approximately 150 employees, or 20 percent of our workforce, the closure of our Israel facilities and consolidating other locations. As a result of the November restructuring, we recorded a charge of approximately $9.1 million, consisting of $4.4 million for employee severances, $4.2 million for property and equipment write-offs, and $500,000 for the closure of our Israel facility and abandonment of certain leased property.

Interest and Other Income (Expense), net. The following tables present interest and other income (expense), net for the three and nine months ended December 31, 2005 and 2004 (dollars in thousands):

	Three Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Interest income, net	$	4,251	6.5	%	$	4,780	7.8	%	$	(529	)	(11.1	)%
Other income (expense), net	$	689	1.1	%	$	—	—	%	$	689		—

	Nine Months Ended December 31,
	2005				2004
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Interest income, net	$	11,724	6.0	%	$	14,591	7.7	%	$	(2,867	)	(19.6	)%
Other income (expense), net	$	157	0.0	%	$	—	—	%	$	157		—

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Interest Income, net. Interest income, net reflects interest earned on cash and cash equivalents and short-term investment balances, as well as realized gains and losses from the sale of short-term investments, less interest expense on our debt and capital lease obligations. The decrease for the three and nine months ended December 31, 2005 is primarily due to lower coupon interest from lower cash and short-term investment balances as well as increased net realized losses on the sales of short-term investments.

Other Income (Expense), net. Other income (expense), net for the three and nine months ended December 31, 2005 includes net gains on sale of strategic equity investment and the disposals of property and equipment offset by realized losses on foreign currency hedges.

Income Taxes. The following tables present our income tax expense (benefit) for the three and nine months ended December 31, 2005 and 2004 (dollars in thousands):

	Three Months Ended December 31,
	2005					2004
	Amount			% of Net Revenue		Amount		% of Net Revenue		Decrease			Change
Income tax expense (benefit)	$	(1,315	)	(2.0	)%	$	2,526	4.1	%	$	(3,841	)	(152.1	)%

	Nine Months Ended December 31,
	2005					2004
	Amount			% of Net Revenue		Amount		% of Net Revenue		Decrease			Change
Income tax expense (benefit)	$	(964	)	(0.5	)%	$	2,861	1.5	%	$	(3,825	)	(133.7	)%

Our income tax benefit relates to the reversal of a $1.1 million tax contingency at our Israeli subsidiary in the three and nine months ended December 31, 2005. The contingency was originally set up in fiscal 2005 when we made a decision to exit our operations in Israel and we violated the terms of a tax holiday in that country. As the result of a letter we received from the Israeli authorities, which cleared us of any tax exposure, we have reversed the contingent accrual.

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FINANCIAL CONDITION AND LIQUIDITY

As of December 31, 2005, our principal source of liquidity consisted of $350.8 million in cash, cash equivalents and short-term investments. Working capital as of December 31, 2005 was $347.4 million. Total cash, cash equivalents, and short-term investments decreased by $72.6 million during the nine months ended December 31, 2005 primarily as a result of the use of $50.8 million to fund our structured stock repurchase program, $9.9 million to repurchase stock on the open market, $3.5 million to purchase a strategic equity investment, $6.7 million to purchase property, equipment and other assets, and $1.9 million to fund our operating activities. Included in the cash flows was the repurchase of 9.5 million shares from open market transactions and structured stock repurchase agreements totaling $23.9 million which occurred during the three months ended December 31, 2005. At December 31, 2005, we had contractual obligations not included on our balance sheet totaling $50.5 million, primarily related to facilities leases, engineering design software tool licenses and inventory purchase commitments.

For the nine months ended December 31, 2005, we used $1.9 million of cash for our operations compared to using $14.8 million from our operations in the nine months ended December 31, 2004. Our net loss of $10.0 million for the nine months ended December 31, 2005 included $34.8 million of non-cash charges consisting of $10.1 million of depreciation, $17.5 million of amortization of purchased intangibles, $4.4 million of stock-based compensation charges, and $2.8 million of non cash restructuring charges. Included in operating cash flows for the nine months ended December 31, 2005 was the payment of $29.3 million for the settlement of our shareholder litigation in April 2005. The remaining change in operating cash flows for the nine months ended December 31, 2005 primarily reflected increases in inventories and accounts payable offset by decreases in accounts receivables, other assets, accrued payroll and other accrued liabilities, and deferred revenue. Net cash provided by operations for the nine months ended December 30, 2004 primarily reflected our operating results before non-cash charges, as well as an increase in inventories, other assets, and accrued payroll and other accrued liabilities, offset by decreases in accounts receivable, accounts payable, and deferred revenue.

We generated $25.4 million of cash from investing activities during the nine months ended December 31, 2005, compared to using $225.8 million during the nine months ended December 31, 2004. The inflow of cash for the nine months ended December 31, 2005 primarily reflected proceeds from sales and maturities of short-term investments, offset by purchases of short term and strategic investments, property, equipment and other assets. The use of cash for the nine months ended December 31, 2004 primarily reflected the net cash paid for acquisitions and the purchase of land and a building in Andover, Massachusetts, offset by proceeds from the sale of short-term investments.

We used $57.9 million of cash for the nine months ended December 31, 2005 for financing activities compared to using $38.8 million for the nine months ended December 31, 2004. The major financing uses of cash for the nine months ended December 31, 2005 were the repurchase of our common stock, and the funding of our structured stock repurchase agreements offset by the proceeds from the exercise of our common stock options and issuance of shares under our ESPP plan. The major financing uses of cash for the nine months ended December 31, 2004 was related to the repurchase of company stock and the funding of structured stock repurchase agreements offset by the proceeds from the exercise of common stock options and issuance of shares under our ESPP plan.

During the three months ended December 31, 2005, we repurchased 4.0 million shares of our common stock for approximately $9.9 million on the open market. These shares were retired upon delivery to us. During fiscal 2005, we repurchased 7.9 million shares of our common stock for approximately $24.4 million on the open market or through structured stock repurchase agreements. These shares were retired upon delivery to us.

During the three months ended December 31, 2005, five structured stocks repurchase agreements settled with us receiving $3.2 million in cash and 5.5 million shares of our common stock at an effective purchase price of $2.52 per share. At December 31, 2005, two open agreements mature in January in which we could receive up to $8.9 million in cash or the delivery of up to 3.2 million of our common stock, or a combination of cash and shares.

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In addition, during the three months ended December 31, 2005, we entered into five additional structured stock repurchase agreements totaling $17.5 million that have varying maturities through May 2006. Under these new agreements, we could receive up to $19.4 million in cash or the delivery of up to 7.2 million shares of our common stock, or a combination of cash and shares.

We believe that our available cash, cash equivalents and short-term investments will be sufficient to meet our capital requirements and fund our operations for at least the next 12 months, although we could elect or could be required to raise additional capital during such period. There can be no assurance that such additional debt or equity financing will be available on commercially reasonable terms or at all.

The following table summarizes our contractual obligations not included on the balance sheet as of December 31, 2005 (in thousands):

	Operating Leases		Other Purchase Commitments		Total
Three months ending March 31, 2006	$	2,383	$	27,147	$	29,530
Fiscal year 2007		6,244		—		6,244
Fiscal year 2008		6,644		—		6,644
Fiscal year 2009		3,744		—		3,744
Fiscal year 2010		2,105		—		2,105
Thereafter		2,249		—		2,249
Total	$	23,369	$	27,147	$	50,516

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RISK FACTORS

Before deciding to invest in us or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and in our other filings with the SEC. We update our descriptions of the risks and uncertainties facing us in our periodic reports filed with the SEC. The risks and uncertainties described below and in our other filings are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks or uncertainties actually occurs, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose your investment.

Our operating results may fluctuate because of a number of factors, many of which are beyond our control.

If our operating results are below the expectations of public market analysts or investors, then the market price of our common stock could decline. Some of the factors that affect our quarterly and annual results, but which are difficult to control or predict are:

• communications, information technology and semiconductor industry conditions;

• fluctuations in the timing and amount of customer requests for product shipments;

• the reduction, rescheduling or cancellation of orders by customers, including as a result of slowing demand for our products or our customers’ products or over-ordering of our products or our customers’ products;

• changes in the mix of products that our customers buy;

• the gain or loss of one or more key customers or their key customers, or significant changes in the financial condition of one or more of our key customers or their key customers;

• our ability to introduce, certify and deliver new products and technologies on a timely basis;

• the announcement or introduction of products and technologies by our competitors;

• competitive pressures on selling prices;

• the ability of our customers to obtain components from their other suppliers;

• market acceptance of our products and our customers’ products;

• fluctuations in manufacturing output, yields or other problems or delays in the fabrication, assembly, testing or delivery of our products or our customers’ products;

• increases in the costs of products or discontinuance of products by suppliers;

• the availability of external foundry capacity, contract manufacturing services, purchased parts and raw materials including packaging substrates;

• problems or delays that we and our foundries may face in shifting the design and manufacture of our future generations of IC products to smaller geometry process technologies and in achieving higher levels of design and device integration;

• the amounts and timing of costs associated with warranties and product returns;

• the amounts and timing of investments in research and development;

• the amounts and timing of the costs associated with payroll taxes related to stock option exercises;

• costs associated with acquisitions and the integration of acquired companies, products and technologies;

• the impact of potential one time charges related to purchased intangibles;

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• our ability to successfully integrate acquired companies, products and technologies;

• the impact on interest income of a significant use of our cash for an acquisition, stock repurchase or other purpose;

• the effects of changes in interest rates or credit worthiness on the value and yield of our short-term investment portfolio;

• costs associated with compliance with applicable environmental, other governmental or industry regulations including costs to redesign products to comply with those regulations or lost revenue due to failure to comply in a timely manner;

• the effects of changes in accounting standards, including the recently announced rule requiring the recognition of expense related to employee stock options;

• costs associated with litigation, including without limitation, attorney fees, litigation judgments or settlements, relating to the use or ownership of intellectual property or other claims arising out of our operations;

• our ability to identify, hire and retain senior management and other key personnel;

• the effects of war, acts of terrorism or global threats, such as disruptions in general economic activity and changes in logistics and security arrangements; and

• general economic conditions.

Our business, financial condition and operating results would be harmed if we do not achieve anticipated revenues.

We can have revenue shortfalls for a variety of reasons, including:

• the reduction, rescheduling or cancellation of customer orders;

• declines in the average selling prices of our products;

• a decrease in demand for our products or our customers’ products;

• a decline in the financial condition or liquidity of our customers or their customers;

• delays in the availability of our products or our customers’ products;

• the failure of our products to be qualified in our customers’ systems or certified by our customers;

• excess inventory of our products at our customers resulting in a reduction in their order patterns as they work through the excess inventory of our products;

• fabrication, test, product yield, or assembly constraints for our products that adversely affect our ability to meet our production obligations;

• the failure of one of our subcontract manufacturers;

• our failure to successfully integrate acquired companies, products and technologies; and

• shortages of raw materials or production capacity constraints that lead our suppliers to allocate available supplies or capacity to other customers, which may disrupt our ability to meet our production obligations.

Our business is characterized by short-term orders and shipment schedules. Customer orders typically can be cancelled or rescheduled without significant penalty to the customer. Because we do not have substantial noncancellable backlog, we typically plan our production and inventory levels based on internal forecasts of customer demand, which is highly unpredictable and can fluctuate substantially. Customer orders for our products typically have non-standard lead times, which makes it difficult for us to predict revenues and plan

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inventory levels and production schedules. If we are unable to plan inventory levels and production schedules effectively, our business, financial condition and operating results could be materially harmed.

From time to time, in response to anticipated long lead times to obtain inventory and materials from our outside contract manufacturers, suppliers and foundries, we may order materials in advance of anticipated customer demand. This advance ordering has in the past and may in the future result in excess inventory levels or unanticipated inventory write-downs if expected orders fail to materialize, or other factors render our products less marketable. If we are forced to hold excess inventory or we incur unanticipated inventory write-downs, our financial condition and operating results could be materially harmed.

Our expense levels are relatively fixed and are based on our expectations of future revenues. We have limited ability to reduce expenses quickly in response to any revenue shortfalls.

If the recovery of the technology sector does not continue, our revenues and profitability will be adversely affected.

We derive a majority of our revenues from sales of IC products and subsystems to technology equipment manufacturers. The technology equipment industry is cyclical and has experienced a significant extended downturn from which it has only recently begun recovery. We cannot predict whether this recovery will continue, and if so, how long this recovery will last, but if it ends, our revenues and profitability will be negatively impacted.

Our business substantially depends upon the continued growth of the internet.

A substantial portion of our business and revenue depends on the continued growth of the Internet. We sell our communications IC products primarily to communications equipment manufacturers that in turn sell their equipment to customers that depend on the growth of the Internet. OEMs and other customers that buy our storage products are similarly dependent on continued internet growth and information technology spending. If there is an economic slowdown or reduction in capital spending our business, operating results, and financial condition may be materially harmed.

The loss of one or more key customers, the diminished demand for our products from a key customer, or the failure to obtain certifications from a key customer or its distribution channel could significantly reduce our revenues and profits.

A relatively small number of customers have accounted for a significant portion of our revenues in any particular period. We have no long-term volume purchase commitments from our key customers. One or more of our key customers may discontinue operations as a result of consolidation, liquidation or otherwise. Continued reductions, delays and cancellation of orders from our key customers or the loss of one or more key customers could significantly further reduce our revenues and profits. We cannot assure you that our current customers will continue to place orders with us, that orders by existing customers will continue at current or historical levels or that we will be able to obtain orders from new customers.

Our ability to maintain or increase sales to key customers and attract new significant customers is subject to a variety of factors, including:

• customers may stop incorporating our products into their own products with limited notice to us and may suffer little or no penalty;

• customers or prospective customers may not incorporate our products in their future product designs;

• design wins with customers may not result in sales to such customers;

• the introduction of new products by customers may be later or less successful in the market than planned;

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• sales of customer product lines using our products may rapidly decline or the product lines may be phased out;

• our agreements with customers typically are non-exclusive and do not require them to purchase a minimum amount of our products;

• many of our customers have pre-existing relationships with current or potential competitors that may cause them to switch from our products to competing products;

• some of our OEM customers may develop products internally that would replace our products;

• we may not be able to successfully develop relationships with additional network equipment vendors;

• our relationships with some of our larger customers may deter other potential customers (who compete with these customers) from buying our products;

• the impact of terminating certain sales representatives or sales personnel; and

• the continued viability of these customers.

The occurrence of any one of the factors above could have a material adverse effect on our business, financial condition and results of operations.

In addition, before we can sell our storage products to an OEM, either directly or through the OEM’s associated distribution channel, that OEM must certify our products. The certification process can take up to 12 months. This process requires the commitment of OEM personnel and test equipment, and we compete with other suppliers for these resources. Any delays in obtaining these certifications or any failure to obtain these certifications would adversely affect our ability to sell our storage products.

Any significant order cancellations or order deferrals could adversely affect our operating results.

We typically sell products pursuant to purchase orders that customers can generally cancel or defer on short notice without incurring a significant penalty. Any significant cancellations or deferrals in the future could materially and adversely affect our business, financial condition and results of operations. Cancellations or deferrals could cause us to hold excess inventory, which could reduce our profit margins, increase product obsolescence and restrict our ability to fund our operations. We generally recognize revenue upon shipment of products to a customer. If a customer refuses to accept shipped products or does not pay for these products, we could miss future revenue projections or incur significant charges against our income, which could materially and adversely affect our operating results.

Our products typically have lengthy design cycles. A customer may decide to cancel or change its product plans, which could cause us to lose anticipated sales.

After we have developed and delivered a product to a customer, the customer will usually test and evaluate our product prior to designing its own equipment to incorporate our product. Our customers may need three to more than six months to test, evaluate and adopt our product and an additional three to more than nine months to begin volume production of equipment that incorporates our product. Due to this lengthy design cycle, we may experience significant delays from the time we increase our operating expenses and make investments in inventory until the time that we generate revenue from these products. It is possible that we may never generate any revenue from these products after incurring such expenditures. Even if a customer selects our product to incorporate into its equipment, we cannot assure you that the customer will ultimately market and sell its equipment or that such efforts by our customer will be successful. The delays inherent in our lengthy design cycle increase the risk that a customer will decide to cancel or change its product plans. Such a cancellation or change in plans by a customer could cause us to lose sales that we had anticipated.

While our design cycles are typically long, some of our product life cycles tend to be short as a result of the rapidly changing technology environment in which we operate. As a result, the resources devoted to product

31

sales and marketing may not generate material revenue for us, and from time to time, we may need to write off excess and obsolete inventory. If we incur significant marketing expenses and investments in inventory in the future that we are not able to recover, and we are not able to mitigate those expenses, our operating results could be adversely affected. In addition, if we sell our products at reduced prices in anticipation of cost reductions but still hold higher cost products in inventory, our operating results would be harmed.

An important part of our strategy is to continue our focus on the markets for communications and storage equipment. If we are unable to further expand our share of these markets, our revenues may not grow and could further decline.

Our markets frequently undergo transitions in which products rapidly incorporate new features and performance standards on an industry-wide basis. If our products are unable to support the new features or performance levels required by OEMs in these markets, or if our products fail to be certified by OEMs, we would lose business from an existing or potential customer and would not have the opportunity to compete for new design wins or certification until the next product transition occurs. If we fail to develop products with required features or performance standards, or if we experience a delay as short as a few months in certifying or bringing a new product to market, or if our customers fail to achieve market acceptance of their products, our revenues could be significantly reduced for a substantial period.

We expect a significant portion of our revenues to continue to be derived from sales of products based on current, widely accepted transmission standards. If the communications market evolves to new standards, we may not be able to successfully design and manufacture new products that address the needs of our customers or gain substantial market acceptance.

Customers for our products generally have substantial technological capabilities and financial resources. They traditionally use these resources to internally develop their own products. The future prospects for our products in these markets are dependent upon our customers’ acceptance of our products as an alternative to their internally developed products. Future prospects also are dependent upon acceptance of third-party sourcing for products as an alternative to in-house development. Network equipment vendors may in the future continue to use internally developed components. They also may decide to develop or acquire components, technologies or products that are similar to, or that may be substituted for, our products.

If our network equipment vendor customers fail to accept our products as an alternative, if they develop or acquire the technology to develop such components internally rather than purchase our products, or if we are otherwise unable to develop strong relationships with network equipment vendors, our business, financial condition and results of operations would be materially and adversely affected.

The discontinuance of our FibreChannel host bus adaptor products will result in a decline in revenue that we realize from sales of these products and we may incur significant costs due to customer obligations relating to these products.

In fiscal 2005, we discontinued our FibreChannel host bus adaptor products designed to operate on Sun’s Solaris servers. These products accounted for a significant portion of our revenue from sales of storage products during fiscal 2005. Though we continue to ship these products, the revenue from sales of these products has declined significantly. We also have obligations to customers that relate to these products, including obligations for warranty support, maintenance and repairs. Our ability to fulfill these obligations has been limited by previous reductions in force. These obligations could result in significant liability, costs, and expenses.

Our industry and markets are subject to consolidation, which may result in stronger competitors, fewer customers and reduced demand.

There has been industry consolidation among communications IC companies, network equipment companies and telecommunications companies in the past. We expect this consolidation to continue as

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companies attempt to strengthen or hold their positions in evolving markets. Consolidation may result in stronger competitors, fewer customers and reduced demand, which in turn could have a material adverse effect on our business, operating results, and financial condition.

Our operating results are subject to fluctuations because we rely heavily on international sales.

International sales account for a significant part of our revenues and may account for an increasing portion of our future revenues. The revenues we derive from international sales may be subject to certain risks, including:

• foreign currency exchange fluctuations;

• changes in regulatory requirements;

• tariffs and other barriers;

• timing and availability of export licenses;

• political and economic instability;

• difficulties in accounts receivable collections;

• difficulties in staffing and managing foreign operations;

• difficulties in managing distributors;

• difficulties in obtaining governmental approvals for communications and other products;

• reduced or uncertain protection for intellectual property rights in some countries;

• longer payment cycles to collect accounts receivable in some countries;

• the burden of complying with a wide variety of complex foreign laws and treaties; and

• potentially adverse tax consequences.

We are subject to risks associated with the imposition of legislation and regulations relating to the import or export of high technology products. We cannot predict whether quotas, duties, taxes or other charges or restrictions upon the importation or exportation of our products will be implemented by the United States or other countries.

Because sales of our products have been denominated to date primarily in United States dollars, increases in the value of the United States dollar could increase the price of our products so that they become relatively more expensive to customers in the local currency of a particular country, leading to a reduction in sales and profitability in that country. Future international activity may result in increased foreign currency denominated sales. Gains and losses on the conversion to United States dollars of accounts receivable, accounts payable and other monetary assets and liabilities arising from international operations may contribute to fluctuations in our results of operations.

Some of our customer purchase orders and agreements are governed by foreign laws, which may differ significantly from United States laws. As a result, our ability to enforce our rights under such agreements may be limited compared with our ability to enforce our rights under agreements governed by laws in the United States.

Our cash and cash equivalents and portfolio of short-term investments are exposed to certain market risks.

We maintain an investment portfolio of various holdings, types of instruments and maturities. These securities are recorded on our consolidated balance sheets at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss), net of tax. Our investment portfolio is

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exposed to market risks related to changes in interest rates and credit ratings of the issuers, as well as to the risks of default by the issuers. Substantially all of these securities are subject to interest rate and credit rating risk and will decline in value if interest rates increase or one of the issuers’ credit ratings is reduced. Increases in interest rates or decreases in the credit worthiness of one or more of the issuers in our investment portfolio could have a material adverse impact on our financial condition or results of operations.

Our restructuring activities could result in management distractions, operational disruptions and other difficulties.

Employees directly affected by our previous restructuring plans may seek future employment with our customers or competitors. Although all employees are required to sign a confidentiality agreement with us at the time of hire, we cannot assure you that the confidential nature of our proprietary information will be maintained in the course of such future employment. Any additional restructuring efforts could divert the attention of our management away from our operations, harm our reputation and increase our expenses. We cannot assure you that we will not undertake additional restructuring activities or that any future restructuring efforts will be successful. In addition, if we continue to reduce our workforce, it may adversely impact our ability to respond rapidly to any new growth opportunities.

Our markets are subject to rapid technological change, so our success depends heavily on our ability to develop and introduce new products.

The markets for our products are characterized by:

• rapidly changing technologies;

• evolving and competing industry standards;

• changing customer needs;

• frequent new product introductions and enhancements;

• increased integration with other functions;

• long design and sales cycles;

• short product life cycles; and

• intense competition.

To develop new products for the communications, storage or other technology markets, we must develop, gain access to and use leading technologies in a cost-effective and timely manner and continue to develop technical and design expertise. We must have our products designed into our customers’ future products and maintain close working relationships with key customers in order to develop new products that meet customers’ changing needs. We must respond to changing industry standards, trends towards increased integration and other technological changes on a timely and cost-effective basis. Our pursuit of technological advances may require substantial time and expense and may ultimately prove unsuccessful. If we are not successful in introducing such advances, we will be unable to timely bring to market new products and our revenues will suffer.

Many of our products are based on industry standards that are continually evolving. Our ability to compete in the future will depend on our ability to identify and ensure compliance with these evolving industry standards. The emergence of new industry standards could render our products incompatible with products developed by major systems manufacturers. As a result, we could be required to invest significant time and effort and to incur significant expense to redesign our products to ensure compliance with relevant standards. If our products are not in compliance with prevailing industry standards or requirements, we could miss opportunities to achieve crucial design wins. If we fail to do so, we may not achieve design wins with key customers or may subsequently lose such design wins, and our business will significantly suffer because once a customer has designed a supplier’s product into its system, the customer typically is extremely reluctant to change its supply source due to significant costs associated with qualifying a new supplier.

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The markets in which we compete are highly competitive, and we expect competition to increase in these markets in the future.

The markets in which we compete are highly competitive, and we expect that domestic and international competition will increase in these markets, due in part to deregulation, rapid technological advances, price erosion, changing customer preferences and evolving industry standards. Increased competition could result in significant price competition, reduced revenues, lower profit margins or loss of market share. Our ability to compete successfully in our markets depends on a number of factors, including:

• success in designing and subcontracting the manufacture of new products that implement new technologies;

• product quality, interoperability, reliability, performance and certification;

• customer support;

• time-to-market;

• price;

• production efficiency;

• design wins;

• expansion of production of our products for particular systems manufacturers;

• end-user acceptance of the systems manufacturers’ products;

• market acceptance of competitors’ products; and

• general economic conditions.

Our competitors may offer enhancements to existing products, or offer new products based on new technologies, industry standards or customer requirements, that are available to customers on a more timely basis than comparable products from us or that have the potential to replace or provide lower cost alternatives to our products. The introduction of enhancements or new products by our competitors could render our existing and future products obsolete or unmarketable. We expect that certain of our competitors and other semiconductor companies may seek to develop and introduce products that integrate the functions performed by our IC products on a single chip, thus eliminating the need for our products. Each of these factors could have a material adverse effect on our business, financial condition and results of operations.

In the communications IC markets, we compete primarily against companies such as Agere, Broadcom, Intel, Mindspeed, PMC-Sierra, and Vitesse. In the storage market, we primarily compete against companies such as Emulex, QLogic, Agilent Technologies, Adaptec and LSI Logic. Our RAID products compete against products from Adaptec and LSI Logic. Our embedded processor products compete against products from Freescale Semiconductor and IBM. Many of these companies have substantially greater financial, marketing and distribution resources than we have. Certain of our customers or potential customers have internal IC design or manufacturing capabilities with which we compete. We may also face competition from new entrants to the storage market, including larger technology companies that may develop or acquire differentiating technology and then apply their resources to our detriment. Any failure by us to compete successfully in these target markets, would have a material adverse effect on our business, financial condition and results of operations.

The storage market continues to mature and become commoditized. To the extent that commoditization leads to significant pricing declines, whether initiated by us or by a competitor, we will be required to increase our product volumes and reduce our costs of goods sold to avoid resulting pressure on our profit margin for these products, and we cannot assure you that we will be successful in responding to these competitive pricing pressures.

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We do not have an internal wafer fabrication capability, which could result in unanticipated liability and reduced revenues.

During fiscal 2003, we closed our internal wafer fabrication facility and no longer have the ability to manufacture products internally. As a result, we are subject to substantial risks, including:

• if we are unable to successfully design and sell products manufactured in external foundries, our revenues will decline;

• if we have not effectively stored certain products manufactured in our internal facility before its closure, we may incur liability to these customers to whom we have committed to deliver such products; and

• we may be unable to repair or replace such products.

Our dependence on third-party manufacturing and supply relationships increases the risk that we will not have an adequate supply of products to meet demand or that our cost of materials will be higher than expected.

We depend upon third parties to manufacture, assemble or package certain of our products. As a result, we are subject to risks associated with these third parties, including:

• reduced control over delivery schedules and quality;

• inadequate manufacturing yields and excessive costs;

• difficulties selecting and integrating new subcontractors;

• potential lack of adequate capacity during periods of excess demand;

• limited warranties on products supplied to us;

• potential increases in prices;

• potential instability in countries where third party manufacturers are located; and

• potential misappropriation of our intellectual property.

Our outside foundries generally manufacture our products on a purchase order basis, and we have very few long-term supply arrangements with these suppliers. We have less control over delivery schedules, manufacturing yields and costs than competitors with their own fabrication facilities. A manufacturing disruption experienced by one or more of our outside foundries or a disruption of our relationship with an outside foundry, including discontinuance of our products by that foundry, would negatively impact the production of certain of our products for a substantial period of time.

Our IC products are generally only qualified for production at a single foundry. These suppliers can allocate, and in the past have allocated, capacity to the production of other companies’ products while reducing deliveries to us on short notice. There is also the potential that they may discontinue manufacturing our products or go out of business. Because establishing relationships, designing or redesigning ICs, and ramping production with new outside foundries may take over a year, there is no readily available alternative source of supply for these products.

Difficulties associated with adapting our technology and product design to the proprietary process technology and design rules of outside foundries can lead to reduced yields of our IC products. The process technology of an outside foundry is typically proprietary to the manufacturer. Since low yields may result from either design or process technology failures, yield problems may not be effectively determined or resolved until an actual product exists that can be analyzed and tested to identify process sensitivities relating to the design rules that are used. As a result, yield problems may not be identified until well into the production process, and resolution of yield problems may require cooperation between us and our manufacturer. This risk could be compounded by the offshore location of certain of our manufacturers, increasing the effort and time required to

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identify, communicate and resolve manufacturing yield problems. Manufacturing defects that we do not discover during the manufacturing or testing process may lead to costly product recalls. These risks may lead to increased costs or delayed product delivery, which would harm our profitability and customer relationships.

If the foundries or subcontractors we use to manufacture our products discontinue the manufacturing processes needed to meet our demands, or fail to upgrade their technologies needed to manufacture our products, we may be unable to deliver products to our customers, which could materially adversely affect our operating results. The transition to the next generation of manufacturing technologies at one or more of our outside foundries could be unsuccessful or delayed.

Our requirements typically represent a very small portion of the total production of the third-party foundries. As a result, we are subject to the risk that a producer will cease production of an older or lower-volume process that it uses to produce our parts. We cannot assure you that our external foundries will continue to devote resources to the production of our products or continue to advance the process design technologies on which the manufacturing of our products are based. Each of these events could increase our costs and materially impact our ability to deliver our products on time.

Some companies that supply our customers are similarly dependent on a limited number of suppliers to produce their products. These other companies’ products may be designed into the same networking equipment into which our products are designed. Our order levels could be reduced materially if these companies are unable to access sufficient production capacity to produce in volumes demanded by our customers because our customers may be forced to slow down or halt production on the equipment into which our products are designed.

Our operating results depend on manufacturing output and yields of our ICs and printed circuit board assemblies, which may not meet expectations.

The yields on wafers we have manufactured decline whenever a substantial percentage of wafers must be rejected or a significant number of die on each wafer are nonfunctional. Such declines can be caused by many factors, including minute levels of contaminants in the manufacturing environment, design issues, defects in masks used to print circuits on a wafer, and difficulties in the fabrication process. Design iterations and process changes by our suppliers can cause a risk of defects. Many of these problems are difficult to diagnose, are time consuming and expensive to remedy, and can result in shipment delays.

We estimate yields per wafer and final packaged parts in order to estimate the value of inventory. If yields are materially different than projected, work-in-process inventory may need to be revalued. We may have to take inventory write-downs as a result of decreases in manufacturing yields. We may suffer periodic yield problems in connection with new or existing products or in connection with the commencement of production at a new manufacturing facility.

We may experience difficulties in transitioning to smaller geometry process technologies or in achieving higher levels of design integration and that may result in reduced manufacturing yields, delays in product deliveries and increased expenses.

As smaller line width geometry processes become more prevalent, we expect to integrate greater levels of functionality into our IC products and to transition our IC products to increasingly smaller geometries. This transition will require us to redesign certain products and will require us and our foundries to migrate to new manufacturing processes for our products. We may not be able to achieve higher levels of design integration or deliver new integrated products on a timely basis. We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometry process technologies to reduce our costs and increase performance, and we have designed IC products to be manufactured at as little as .13 micron geometry processes. We have experienced some difficulties in shifting to smaller geometry process technologies and new manufacturing

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processes. These difficulties resulted in reduced manufacturing yields, delays in product deliveries and increased expenses. We may face similar difficulties, delays and expenses as we continue to transition our IC products to smaller geometry processes. We are dependent on our relationships with our foundries to transition to smaller geometry processes successfully. We cannot assure you that our foundries will be able to effectively manage the transition or that we will be able to maintain our relationships with our foundries. If we or our foundries experience significant delays in this transition or fail to implement this transition, our business, financial condition and results of operations could be materially and adversely affected.

We must develop or otherwise gain access to improved IC process technologies.

Our future success will depend upon our ability to improve existing IC process technologies or acquire new IC process technologies. In the future, we may be required to transition one or more of our IC products to process technologies with smaller geometries, other materials or higher speeds in order to reduce costs or improve product performance. We may not be able to improve our process technologies or otherwise gain access to new process technologies in a timely or affordable manner. Products based on these technologies may not achieve market acceptance.

The complexity of our products may lead to errors, defects and bugs, which could negatively impact our reputation with customers and result in liability.

Products as complex as ours may contain errors, defects and bugs when first introduced or as new versions are released. Our products have in the past experienced such errors, defects and bugs. Delivery of products with production defects or reliability, quality or compatibility problems could significantly delay or hinder market acceptance of the products or result in a costly recall and could damage our reputation and adversely affect our ability to retain existing customers and to attract new customers. Errors, defects or bugs could cause problems with device functionality, resulting in interruptions, delays or cessation of sales to our customers.

We may also be required to make significant expenditures of capital and resources to resolve such problems. We cannot assure you that problems will not be found in new products after commencement of commercial production, despite testing by us, our suppliers or our customers. Any problem could result in:

• additional development costs;

• loss of, or delays in, market acceptance;

• diversion of technical and other resources from our other development efforts;

• claims by our customers or others against us; and

• loss of credibility with our current and prospective customers.

Any such event could have a material adverse effect on our business, financial condition and results of operations.

A change in the accounting treatment of stock-based awards will adversely affect our results of operations.

In December 2004, the Financial Accounting Standards Board issued revised SFAS No. 123,Share-Based Payment, or SFAS 123(R), which requires companies to expense employee stock options and other stock-based awards for financial reporting purposes. Beginning in April 2006, we will be required to value our employee stock option grants pursuant to an option valuation model, and then amortize that value against our reported earnings over the vesting period in effect for those options. We currently account for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and have adopted the disclosure-only alternative of SFAS 123 and SFAS 128, each of which has been superseded by SFAS 123(R). The change in accounting treatment resulting from SFAS 123(R) will materially and adversely affect our reported results of operations as stock-based compensation expense is

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charged directly against our reported earnings. For an illustration of the effect of the new accounting treatment on our recent results of operations, see Note 1 of our Notes to Consolidated Financial Statements.

If our internal controls over financial reporting are not considered effective, our business and stock price could be adversely affected.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal controls over financial reporting as of the end of each fiscal year, and to include a management report assessing the effectiveness of our internal controls over financial reporting in our annual report on Form 10-K for that fiscal year. Section 404 also requires our independent registered public accounting firm to attest to, and report on, management’s assessment of our internal controls over financial reporting.

Our management, including our chief executive officer and chief financial officer, does not expect that our internal controls over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud involving a company have been, or will be, detected. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Our management has concluded, and our independent registered public accounting firm has attested, that our internal control over financial reporting was effective as of March 31, 2005, as required by Section 404. However, we cannot assure you that we or our independent registered public accounting firm will not identify a material weakness in our internal controls in the future. A material weakness in our internal controls over financial reporting would require management and our independent registered public accounting firm to evaluate our internal controls as ineffective. If our internal controls over financial reporting are not considered effective, we may experience a loss of public confidence, which could have an adverse effect on our business and on the market price of our common stock.

Our future success depends in part on the continued service of our key senior management, design engineering, sales, marketing, and manufacturing personnel and our ability to identify, hire and retain additional, qualified personnel.

Our future success depends to a significant extent upon the continued service of our senior management personnel. The loss of key senior executives could have a material adverse effect on us. There is intense competition for qualified personnel in the semiconductor industry, in particular design, product and test engineers, and we may not be able to continue to attract and retain engineers or other qualified personnel necessary for the development of our business, or to replace engineers or other qualified personnel who may leave our employment in the future. There may be significant costs associated with recruiting, hiring and retention of personnel. Periods of contraction in our business may inhibit our ability to attract and retain our personnel. Loss of the services of, or failure to recruit, key design engineers or other technical and management personnel could be significantly detrimental to our product development or other aspects of our business.

In May 2004, we acquired IBM’s Embedded PowerPC business. In conjunction with that transaction, IBM transferred 51 of its PowerPC employees in France to us. The transfer was made pursuant to the “forced march” provisions of the French Labor Code. In October 2004, the IBM Works Council together with the trade union sued IBM, challenging the transfer of employees to us. In December 2005, the Court of Appeals in France ruled

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that the IBM PowerPC employees should not have been transferred to us. As a result, all of our PowerPC employees in France can elect to return to IBM. We do not know at this time how many of these employees will elect to return to IBM, but we believe that most, if not all, will elect to return. Although IBM has agreed to provide transitional services to us from the employees who elect to return to IBM as a result of the ruling, the loss of the service of these employees could be detrimental to our product development efforts. If necessary, we will seek permanent replacements for the departing employees. However, we may be unable to locate and recruit qualified employees for these positions and the cost to re-staff the workforce may be significant and time-consuming.

In November 2005, we proposed a reduction in force (RIF) as part of our decision to limit further investment in our PRS business. At the time we proposed the RIF, we anticipated eliminating 45 positions from our offices in France. It was after this proposal was submitted to AMCC’s Employees Works Council that the Court of Appeals in France ruled that all of our PowerPC employees in France could return as employees to IBM. As a result, we have tentatively withdrawn our proposal for the RIF and are actively assessing the impact that the potential loss of the PowerPC employees and the reduction in our PRS investment will have on our overall situation in France. Our decision could result in a further workforce reductions and in the closing of our operations in France entirely, which in turn could result in significant severance costs to us, potential litigation and product development delays.

To manage operations effectively, we will be required to continue to improve our operational, financial and management systems and to successfully hire, train, motivate, and manage our employees. The integration of future acquisitions would require significant additional management, technical and administrative resources. We cannot assure you that we would be able to manage our expanded operations effectively.

Our ability to supply a sufficient number of products to meet demand could be severely hampered by a shortage of water, electricity or other supplies, or by natural disasters or other catastrophes.

The manufacture of our products requires significant amounts of water. Previous droughts have resulted in restrictions being placed on water use by manufacturers. In the event of a future drought, reductions in water use may be mandated generally and our external foundries’ ability to manufacture our products could be impaired.

Several of our facilities, including our principal executive offices, are located in California. In 2001, California experienced prolonged energy alerts and blackouts caused by disruption in energy supplies. As a consequence, California continues to experience substantially increased costs of electricity and natural gas. We are unsure whether these alerts and blackouts will reoccur or how severe they may become in the future. Many of our customers and suppliers are also headquartered or have substantial operations in California. If we, or any of our major customers or suppliers located in California, experience a sustained disruption in energy supplies, our results of operations could be materially and adversely affected.

Our internal test and assembly facilities are located in San Diego, California and a significant portion of our external manufacturing operations are located in Asia. These areas are subject to natural disasters such as earthquakes or floods. We do not have earthquake or business interruption insurance for these facilities, because adequate coverage is not offered at economically justifiable rates. A significant natural disaster or other catastrophic event could have a material adverse impact on our business, financial condition and operating results.

The effects of war, acts of terrorism or global threats, including, but not limited to, the outbreak of epidemic disease, could have a material adverse effect on our business, operating results and financial condition. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to local and global economies and create further uncertainties. To the extent that such disruptions or uncertainties result in delays or cancellations of customer orders, or the manufacture or shipment of our products, our business, operating results and financial condition could be materially and adversely affected.

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We could incur substantial fines or litigation costs associated with our storage, use and disposal of hazardous materials.

We are subject to a variety of federal, state and local governmental regulations related to the use, storage, discharge and disposal of toxic, volatile or otherwise hazardous chemicals that were used in our manufacturing process. Any failure to comply with present or future regulations could result in the imposition of fines, the suspension of production or a cessation of operations. These regulations could require us to acquire costly equipment or incur other significant expenses to comply with environmental regulations or clean up prior discharges. Since 1993, we have been named as a PRP, along with a large number of other companies that used Omega Chemical Corporation in Whittier, California to handle and dispose of certain hazardous waste material. We are a member of a large group of PRPs that has agreed to fund certain on-going remediation efforts at the Omega Chemical site. To date, our payment obligations with respect to these funding efforts have not been material, and we believe that our future obligations to fund these efforts will not have a material adverse effect on our business, financial condition or operating results. Although we believe that we are currently in material compliance with applicable environmental laws and regulations, we cannot assure you that we are or will be in material compliance with these laws or regulations or that our future obligations to fund any remediation efforts, including those at the Omega Chemical site, will not have a material adverse effect on our business.

Our business strategy contemplates the acquisition of other companies, products and technologies. Merger and acquisition activities involve numerous risks and we may not be able to address these risks successfully without substantial expense, delay or other operational or financial problems.

Acquiring products, technologies or businesses from third parties is part of our business strategy. The risks involved with merger and acquisition activities include:

• potential dilution to our stockholders;

• use of a significant portion of our cash reserves;

• diversion of management’s attention;

• failure to retain or integrate key personnel;

• difficulty in completing an acquired company’s in-process research or development projects;

• amortization of acquired intangible assets and deferred compensation;

• customer dissatisfaction or performance problems with an acquired company’s products or services;

• costs associated with acquisitions or mergers;

• difficulties associated with the integration of acquired companies, products or technologies;

• difficulties competing in markets that are unfamiliar to us;

• ability of the acquired companies to meet their financial projections; and

• assumption of unknown liabilities, or other unanticipated events or circumstances.

Any of these risks could materially harm our business, financial condition and results of operations.

As with past acquisitions, future acquisitions could adversely affect operating results. In particular, acquisitions may materially and adversely affect our results of operations because they may require large one-time charges or could result in increased debt or contingent liabilities, adverse tax consequences, substantial additional depreciation or deferred compensation charges. Our past purchase acquisitions required us to capitalize significant amounts of goodwill and purchased intangible assets. As a result of the slowdown in our industry and reduction of our market capitalization, we have been required to record significant impairment charges against these assets as noted in our financial statements. At December 31, 2005, we had $517.0 million of goodwill and purchased intangible assets. We cannot assure you that we will not be required to take additional significant charges as a result of an impairment to the carrying value of these assets, due to further declines in market conditions.

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Our subsidiary, JNI Corporation, has been named as a defendant in litigation that could result in substantial costs and divert management’s attention and resources.

JNI Corporation, which we acquired in October 2003, has a number of pending lawsuits relating to alleged securities law violations and alleged breaches of fiduciary duty. We believe that the claims pending against JNI are without merit, and we have engaged in a vigorous defense against such claims. If we are not successful in our defense against such claims, we could be forced to make significant payments to the plaintiffs and their lawyers, and such payments could have a material adverse effect on our business, financial condition and results of operations if not covered by our insurance carriers. Even if such claims are not successful, the litigation could result in substantial costs including, but not limited to, attorney and expert fees, and divert management’s attention and resources, which could have an adverse effect on our business. Although insurers have paid defense costs to date, we cannot assure you that insurers will continue to pay such costs, judgments or other expenses associated with the lawsuit.

We may not be able to protect our intellectual property adequately.

We rely in part on patents to protect our intellectual property. We cannot assure you that our pending patent applications or any future applications will be approved, or that any issued patents will adequately protect the intellectual property in our products, will provide us with competitive advantages or will not be challenged by third parties, or that if challenged, any such patent will be found to be valid or enforceable. Others may independently develop similar products or processes, duplicate our products or processes or design around any patents that may be issued to us.

To protect our intellectual property, we also rely on the combination of mask work protection under the Federal Semiconductor Chip Protection Act of 1984, trademarks, copyrights, trade secret laws, employee and third-party nondisclosure agreements, and licensing arrangements. Despite these efforts, we cannot assure you that others will not independently develop substantially equivalent intellectual property or otherwise gain access to our trade secrets or intellectual property, or disclose such intellectual property or trade secrets, or that we can meaningfully protect our intellectual property. A failure by us to meaningfully protect our intellectual property could have a material adverse effect on our business, financial condition and operating results.

We generally enter into confidentiality agreements with our employees, consultants and strategic partners. We also try to control access to and distribution of our technologies, documentation and other proprietary information. Despite these efforts, parties may attempt to copy, disclose, obtain or use our products, services or technology without our authorization. Also, former employees may seek employment with our business partners, customers or competitors and we you that the confidential nature of our proprietary information will be maintained in the course of such future employment. Additionally, former employees or third parties could attempt to penetrate our network to misappropriate our proprietary information or interrupt our business. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques. As a result, our technologies and processes may be misappropriated, particularly in foreign countries where laws may not protect our proprietary rights as fully as in the United States.

We could be harmed by litigation involving patents, proprietary rights or other claims.

Litigation may be necessary to enforce our intellectual property rights, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or misappropriation. The semiconductor industry is characterized by substantial litigation regarding patent and other intellectual property rights. Such litigation could result in substantial costs and diversion of resources, including the attention of our management and technical personnel, and could have a material adverse effect on our business, financial condition and results of operations. We may be accused of infringing on the intellectual property rights of third parties. We have certain indemnification obligations to customers with respect to the infringement of third-party

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intellectual property rights by our products. We cannot assure you that infringement claims by third parties or claims for indemnification by customers or end users resulting from infringement claims will not be asserted in the future, or that such assertions will not harm our business.

Any litigation relating to the intellectual property rights of third parties would at a minimum be costly and could divert the efforts and attention of our management and technical personnel. In the event of any adverse ruling in any such litigation, we could be required to pay substantial damages, cease the manufacturing, use and sale of infringing products, discontinue the use of certain processes or obtain a license under the intellectual property rights of the third party claiming infringement. A license might not be available on reasonable terms.

From time to time, we may be involved in litigation relating to other claims arising out of our operations in the normal course of business. We cannot assure you that the ultimate outcome of any such matters will not have a material, adverse effect on our business, financial condition or operating results.

Our stock price is volatile.

The market price of our common stock has fluctuated significantly. In the future, the market price of our common stock could be subject to significant fluctuations due to general economic and market conditions and in response to quarter-to-quarter variations in:

• our anticipated or actual operating results;

• announcements or introductions of new products by us or our competitors;

• anticipated or actual operating results of our customers, peers or competitors;

• technological innovations or setbacks by us or our competitors;

• conditions in the semiconductor, communications or information technology markets;

• the commencement or outcome of litigation;

• changes in ratings and estimates of our performance by securities analysts;

• announcements of merger or acquisition transactions;

• management changes;

• our inclusion in certain stock indices; and

• other events or factors.

The stock market in recent years has experienced extreme price and volume fluctuations that have affected the market prices of many high technology companies, particularly semiconductor companies. In some instances, these fluctuations appear to have been unrelated or disproportionate to the operating performance of the affected companies. Any such fluctuation could harm the market price of our common stock.

The anti-takeover provisions of our certificate of incorporation and of the Delaware general corporation law may delay, defer or prevent a change of control.

Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges and restrictions, including voting rights, of those shares without any further vote or action by our stockholders. The rights of the holders of common stock will be subject to, and may be harmed by, the rights of the holders of any shares of preferred stock that may be issued in the future. The issuance of preferred stock may delay, defer or prevent a change in control, as the terms of the preferred stock that might be issued could potentially prohibit our consummation of any merger, reorganization, sale of substantially all of our assets, liquidation or other extraordinary corporate transaction without the approval of the holders of the outstanding shares of preferred stock. The issuance of preferred stock could have a dilutive effect on our stockholders.

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If we issue additional shares of stock in the future, it may have a dilutive effect on our stockholders.

We have a significant number of authorized and unissued shares of our common stock available. These shares will provide us with the flexibility to issue our common stock for proper corporate purposes, which may include making acquisitions through the use of stock, adopting additional equity incentive plans and raising equity capital. Any issuance of our common stock may result in immediate dilution of our stockholders.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange rates, interest rates and a decline in the stock market. We are exposed to market risks related to changes in interest rates and foreign currency exchange rates.

We maintain an investment portfolio of various holdings, types and maturities. These securities are classified as available-for-sale and, consequently, are recorded on the consolidated balance sheets at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (or loss). We have established guidelines relative to diversification and maturities that attempt to maintain safety and liquidity. These guidelines are periodically reviewed and modified to take advantage of interest rate trends. We invest our excess cash in debt instruments of the U.S. Treasury, corporate bonds, mortgage-backed and asset backed securities and closed-end bond funds, with credit ratings as specified in our investment policy. We also have invested in preferred stocks, which pay quarterly fixed rate dividends. We generally do not utilize derivatives to hedge against increases in interest rates which decrease market values, except for one investment manager who utilizes U.S. Treasury bond futures options (“futures options”) as a protection against the impact of increases in interest rates on the fair value of preferred stocks managed by that investment manager.

We are exposed to market risk as it relates to changes in the market value of our investments. At December 31, 2005, our investment portfolio included fixed-income securities classified as available-for-sale investments with a fair market value of $309.8 million and a cost basis of $320.3 million. These securities are subject to interest rate risk, as well as credit risk, and will decline in value if interest rates increase or an issuer’s credit rating or financial condition is decreased. The following table presents the hypothetical changes in fair value of our short-term investments held at December 31, 2005 (in thousands):

	Valuation of Securities Given an Interest Rate Decrease of X Basis Points						Fair Value as of December 31, 2005		Valuation of Securities Given an Interest Rate Increase of X Basis Points
	(150 BPS)		(100 BPS)		(50 BPS)				(50 BPS)		(100 BPS)		(150 BPS)
Available-for-sale investments	$	331,013	$	323,699	$	316,615	$	309,846	$	303,441	$	297,274	$	291,349

The modeling technique used measures the change in fair market value arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points, 100 basis points, and 150 basis points.

We invest in equity instruments of private companies for business and strategic purposes. These investments are valued based on our historical cost, less any recognized impairments. The estimated fair values are not necessarily representative of the amounts that we could realize in a current transaction.

We generally conduct business, including sales to foreign customers, in U.S. dollars, and as a result, we have limited foreign currency exchange rate risk. However, we have entered into forward currency exchange contracts to hedge our overseas monthly operating expenses when deemed appropriate. Gains and losses on foreign currency forward contracts that are designated and effective as hedges of anticipated transactions are deferred and included in the basis of the transaction in the same period that the underlying transaction is settled. Gains and losses on any instruments not meeting the above criteria are recognized in income or expenses in the consolidated statement of operations in the current period. The effect of an immediate 10 percent change in foreign exchange rates would not have a material impact on our financial condition or results of operations.

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ITEM 4. CONTROLS AND PROCEDURES

Our chief executive officer and chief financial officer performed an evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) as of December 31, 2005 (the “Evaluation Date”). Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective and sufficient to ensure that the information required to be disclosed in the reports that we file under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.

There was no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The information set forth under Note 6 of the Notes to Condensed Consolidated Financial Statements, included in Part I, Item 1 of this Report, is incorporated herein by reference.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Below is a summary of stock repurchases for the three months ended December 31, 2005 (in thousands, except average price per share).

Period	Total Number of Shares Purchased	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Amount that May Yet Be Purchased Under the Plans or Programs
October 1 – October 31, 2005	1,942	$	2.57	1,942	$	149,604
November 1 – November 30, 2005	6,391	$	2.50	6,391	$	133,657
December 1 – December 31, 2005	1,213	$	2.47	1,213	$	132,657
Total shares repurchased	9,546	$	2.51	9,546	$	130,657

(1) During the three months ended December 31, 2005, we repurchased 4.0 million shares of our common stock for approximately $9.9 million on the open market. These shares were retired upon delivery to us.

During the three months ended December 31, 2005, five structured stocks repurchase agreements settled with us receiving $3.2 million in cash and 5.5 million shares of our common stock at an effective purchase price of $2.52 per share. At December 31, 2005, two open agreements mature in January in which we could receive up to $8.9 million in cash or the delivery of up to 3.2 million of our common stock, or a combination of cash and shares.

ITEM 6. EXHIBITS

31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.
31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.
32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: February 9, 2006

APPLIED MICRO CIRCUITS CORPORATION
By:	/s/    ROBERT G. GARGUS
	Robert G. Gargus
	Senior Vice President and Chief Financial Officer (Duly Authorized Signatory and Principal Financial and Accounting Officer)

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