Applied Micro Circuits (AMCC) 10-Q 2007 Q2 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 quarterly period ended September 30, 2006

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: (408) 542-8600

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, 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  ¨    No  x

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  x                Accelerated filer  ¨                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 December 31, 2006, 281,826,071 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 September 30, 2006 (unaudited) and March 31, 2006	3
	Condensed Consolidated Statements of Operations (unaudited) for the three and six months ended September 30, 2006 and 2005	4
	Condensed Consolidated Statements of Cash Flows (unaudited) for the six months ended September 30, 2006 and 2005	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36
Item 4.	Controls and Procedures	37
Part II.	OTHER INFORMATION
Item 1.	Legal Proceedings	38
Item 1A.	Risk Factors	38
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	56
Item 6.	Exhibits	56
Signatures		57

2

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

APPLIED MICRO CIRCUITS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par value)

	September 30, 2006			March 31, 2006
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	36,936		$	49,125
Short-term investments-available-for-sale		228,840			286,540
Accounts receivable		36,967			26,324
Inventories		34,128			24,941
Other current assets		14,436			12,618
Total current assets		351,307			399,548
Property and equipment, net		33,438			36,127
Goodwill and purchased intangibles, net		427,809			381,066
Other assets		9,716			8,685
Total assets	$	822,270		$	825,426
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	29,673		$	24,656
Accrued payroll and related expenses		8,104			7,409
Other accrued liabilities		24,819			27,017
Deferred revenue		3,278			3,536
Total current liabilities		65,874			62,618
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 September 30, 2006 and March 31, 2006 Issued and outstanding shares—281,770 at September 30, 2006 and 295,440 at March 31, 2006		2,817			2,954
Additional paid-in capital		5,946,278			5,945,555
Deferred compensation, net		—			(2,087	)
Accumulated other comprehensive loss		(5,746	)		(11,367	)
Accumulated deficit		(5,186,953	)		(5,172,247	)
Total stockholders’ equity		756,396			762,808
Total liabilities and stockholders’ equity	$	822,270		$	825,426

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 September 30,						Six Months Ended September 30,
	2006			2005			2006			2005
Net revenues	$	76,364		$	64,935		$	146,043		$	129,608
Cost of revenues		35,536			31,093			67,064			61,926
Gross profit		40,828			33,842			78,979			67,682
Operating expenses:
Research and development		24,853			23,835			47,692			47,505
Selling, general and administrative		17,312			15,127			34,312			31,462
Acquired in-process research and development		13,300			—			13,300			—
Amortization of purchased intangible assets		1,188			1,107			2,295			2,374
Restructuring charges		1,419			3,559			2,666			3,559
Total operating expenses		58,072			43,628			100,265			84,900
Operating loss		(17,244	)		(9,786	)		(21,286	)		(17,218	)
Interest income, net		3,254			3,884			6,595			7,473
Other income (expense), net		175			(347	)		199			(532	)
Loss before income taxes		(13,815	)		(6,249	)		(14,492	)		(10,277	)
Income tax expense		74			175			214			351
Net loss	$	(13,889	)	$	(6,424	)	$	(14,706	)	$	(10,628	)
Basic and diluted net loss per share:
Net loss per share	$	(0.05	)	$	(0.02	)	$	(0.05	)	$	(0.03	)
Shares used in calculating basic and diluted net loss per share		281,762			305,476			286,470			305,902

See Accompanying Notes to Condensed Consolidated Financial Statements

4

APPLIED MICRO CIRCUITS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

	Six Months Ended September 30,
	2006			2005
Operating activities:
Net loss	$	(14,706	)	$	(10,628	)
Adjustments to reconcile net loss to net cash provided from (used in) operating activities
Depreciation and amortization		4,678			7,039
Amortization of purchased intangibles		10,674			12,768
Acquired in-process research and development		13,300			—
Stock-based compensation expense
Stock options		5,153			2,985
Restricted stock units		36			—
Non-cash restructuring charges		1,977			2,156
Net gain on disposals of property and equipment		—			(4	)
Changes in operating assets and liabilities
Accounts receivable		(9,199	)		2,236
Inventories		(6,473	)		(683	)
Other assets		(350	)		35,983
Accounts payable		3,994			1,968
Accrued payroll and other accrued liabilities		(5,141	)		(68,731	)
Deferred revenue		(415	)		(284	)
Net cash provided by (used in) operating activities		3,528			(15,195	)
Investing activities:
Proceeds from sales and maturities of short-term investments		281,502			775,898
Purchases of short-term investments		(217,982	)		(747,779	)
Purchase of property, equipment and other assets		(4,293	)		(6,021	)
Proceeds from sale of property, equipment and other assets		—			101
Net cash paid for acquisitions		(71,971	)		—
Net cash (used in) provided by investing activities		(12,744	)		22,199
Financing activities:
Proceeds from issuance of common stock		243			2,939
Repurchase of common stock		(20,137	)		—
Funding of structured stock repurchase programs		—			(36,500	)
Funds received from structured stock repurchases, including gains		17,379			—
Payments on capital lease obligations		—			(34	)
Payments on long-term debt		(289	)		—
Other		(169	)		(87	)
Net cash used in financing activities		(2,973	)		(33,682	)
Net decrease in cash and cash equivalents		(12,189	)		(26,678	)
Cash and cash equivalents at beginning of period		49,125			75,396
Cash and cash equivalents at end of period	$	36,936		$	48,718
Supplementary cash flow disclosure:
Cash paid for:
Interest	$	—		$	46
Income taxes	$	357		$	443

See Accompanying Notes to Condensed Consolidated Financial Statements

5

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, 2006.

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 its cost of sales and gross margin; the valuation of purchased intangibles and goodwill, which affects its 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 its 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

In December 2004, the Financial Accounting Standards Board (“FASB”) issued a revised Statement of Financial Accounting Standards No. 123 (“SFAS 123(R)”),Share-Based Payment. Under SFAS 123(R), the estimated fair value of share-based payments is measured at the grant date and is recognized as stock-based compensation expense over the employee’s requisite service period. The Company adopted the provisions of SFAS 123(R) on April 1, 2006 using the modified prospective method, which provides for certain changes to the method for valuing stock-based compensation. Under the modified prospective method, prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123(R) apply both to new stock-based awards issued beginning April 1, 2006 and to awards that were already outstanding on April 1, 2006, but are subsequently modified or cancelled. The estimated fair value of new stock-based awards is recognized as stock-based compensation over the requisite service period associated with the award. For awards already outstanding at April 1, 2006, the estimated stock-based compensation will be recognized over the remaining service period using the compensation cost calculated for pro forma purposes under FASB Statement of Financial Accounting Standards No. 123 (“SFAS 123”),Accounting for Stock-Based Compensation.

6

As a result of the adoption of SFAS 123(R), the Company recorded $5.4 million of stock-based compensation expense during the first six months of fiscal 2007. The Company has not recognized, and does not expect to recognize in the near future, any tax benefit related to stock-based compensation cost as a result of the full valuation allowance of its net deferred tax assets and its net operating loss carryforwards.

Prior to the adoption of SFAS 123(R), the Company accounted for share-based payment awards to employees and non-employee directors in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”),Accounting for Stock Issued to Employees, and related interpretations, and had adopted the disclosure-only alternative of SFAS 123 and FASB Statement of Financial Accounting Standards No. 148 (“SFAS 148”),Accounting for Stock-Based Compensation—Transition and Disclosure.In accordance with APB 25, stock-based compensation expense was not recorded in connection with share-based payment awards granted with exercise prices equal to or greater than the fair market value of the Company’s common stock on the date of grant. The Company recorded deferred compensation in connection with stock options assumed in acquisitions with exercise prices less than the fair market value of the common stock on the date of assumption. The amount of such deferred compensation per share was equal to the excess of the fair market value over the exercise price on such date. Recorded deferred compensation was recognized as stock-based compensation expense ratably over the applicable vesting periods. In accordance with the provisions of SFAS 123(R), all deferred compensation previously recorded has been eliminated with a corresponding reduction in additional paid in capital.

Derivative Financial Instruments

The Company uses 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 September 30, 2006, the Company did not have any foreign exchange contracts outstanding. The Company accounts for derivatives pursuant to FASB Statement of Financial Accounting Standards No. 133 (“SFAS 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.

Segments of a Business Enterprise

FASB Statement of Financial Accounting Standards No. 131 (“SFAS 131”),Disclosures about Segments of an Enterprise and Related Information, establishes standards for the way public business enterprises report information about operating segments in annual consolidated financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers.

Under SFAS 131, two or more operating segments may be aggregated into a single reportable operating segment for financial reporting purposes if aggregation is consistent with the objective and basic principles of SFAS 131, if the segments have similar economic characteristics, and if the segments are similar in each of the following areas:

• the nature of products and services;

• the nature of the production processes;

• the type or class of customer for their products and services; and

• the methods used to distribute their products or provide their services.

7

Although the Company had three operating segments at September 30, 2006, the Company met each of the criteria set forth in SFAS 131 and the three operating segments as of September 30, 2006 share similar economic characteristics, therefore, the Company aggregates its results of operations into one reportable operating segment, communications.

2. CERTAIN FINANCIAL STATEMENT INFORMATION

Accounts receivable (in thousands):

	September 30, 2006			March 31, 2006
Accounts receivable	$	38,562		$	27,678
Less: allowance for doubtful accounts		(1,595	)		(1,354	)
	$	36,967		$	26,324

Inventories (in thousands):

	September 30, 2006		March 31, 2006
Finished goods	$	4,577	$	17,883
Work in process		9,711		5,277
Raw materials		19,840		1,781
	$	34,128	$	24,941

The inventory balance as of September 30, 2006 includes $2.9 million of inventory relating to the acquisition of Quake Technologies, Inc.

Other current assets (in thousands):

	September 30, 2006		March 31, 2006
Deposits	$	1,200	$	933
Prepaid expenses		9,448		8,882
Interest receivable		1,168		1,630
Other		2,620		1,173
	$	14,436	$	12,618

Property and equipment (in thousands):

	Useful Life	September 30, 2006			March 31, 2006
	(in years)
Machinery and equipment	5-7	$	43,244		$	41,634
Leasehold improvements	1-15		10,515			11,225
Computers, office furniture and equipment	3-7		78,868			74,760
Buildings	31.5		5,860			5,860
Land	N/A		12,202			12,202
			150,689			145,681
Less: accumulated depreciation and amortization			(117,251	)		(109,554	)
		$	33,438		$	36,127

8

Goodwill and purchased intangibles:

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

	September 30, 2006							March 31, 2006
	Gross		Accumulated Amortization and Impairments			Net		Gross		Accumulated Amortization and Impairments			Net
Goodwill	$	4,440,859	$	(4,105,402	)	$	335,457	$	4,401,662	$	(4,105,402	)	$	296,260
Developed technology		425,000		(356,244	)		68,756		413,500		(348,675	)		64,825
Backlog/customer relationships		6,400		(3,610	)		2,790		3,600		(3,480	)		120
Patents/core technology rights/tradename		62,400		(41,594	)		20,806		59,200		(39,339	)		19,861
	$	4,934,659	$	(4,506,850	)	$	427,809	$	4,877,962	$	(4,496,896	)	$	381,066

As of September 30, 2006, 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 2007	$	9,720	$	2,680	$	12,400
Fiscal year 2008		18,373		5,301		23,674
Fiscal year 2009		17,823		5,260		23,083
Fiscal year 2010		12,097		4,040		16,137
Fiscal year 2011		10,500		4,040		14,540
Thereafter		876		1,423		2,299
Total	$	69,389	$	22,744	$	92,133

Other accrued liabilities (in thousands):

	September 30, 2006		March 31, 2006
Accrued warranty and excess purchase commitments	$	4,047	$	5,407
Current tax liabilities		1,034		1,177
Restructuring liabilities		2,886		7,644
Executive deferred compensation liability		3,662		3,294
Other		13,190		9,495
	$	24,819	$	27,017

Interest income, net (in thousands):

	Three Months Ended September 30,						Six Months Ended September 30,
	2006			2005			2006			2005
Interest income	$	3,898		$	4,347		$	7,899		$	8,309
Net realized loss on short-term investments		(644	)		(436	)		(1,304	)		(790	)
Interest expense		—			(27	)		—			(46	)
	$	3,254		$	3,884		$	6,595		$	7,473

9

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

	Three Months Ended September 30,					Six Months Ended September 30,
	2006		2005			2006		2005
Net gains on disposals of property and equipment	$	25	$	—		$	20	$	4
Foreign currency loss		97		(347	)		97		(536	)
Other		53		—			82		—
	$	175	$	(347	)	$	199	$	(532	)

Net loss per share:

Net loss per share (basic) is calculated by dividing net loss by the weighted average number of common shares outstanding during the year. Net loss per share (diluted) also includes any dilutive effects of stock options and restricted stock units calculated using the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock results in a greater dilutive effect from outstanding stock options and restricted stock units. Additionally, the exercise of stock options and the vesting of restricted stock units results in a greater dilutive effect on net income per share. The reconciliation of shares used to calculate basic and diluted net loss per share consists of the following (in thousands, except per share data):

	Three Months Ended September 30,						Six Months Ended September 30,
	2006			2005			2006			2005
Net loss	$	(13,889	)	$	(6,424	)	$	(14,706	)	$	(10,628	)
Shares used in basic and diluted net loss per share computation (denominator):
Weighted average common shares outstanding		281,762			305,476			286,470			305,902
Less: Unvested common shares outstanding		—			—			—			—
Shares used in basic and diluted net loss per share computation		281,762			305,476			286,470			305,902
Basic and diluted net loss per share	$	(0.05	)	$	(0.02	)	$	(0.05	)	$	(0.03	)

Because the Company incurred losses for the three and six months ended September 30, 2006 and 2005, the effect of dilutive securities totaling 824,000 and 886,000 equivalent shares for the three and six months ended September 30, 2006, respectively, and 1,680,000 and 1,355,000 equivalent shares for the three and six months ended September 30, 2005, respectively, have been excluded from the net loss per share computations as their impact would be antidilutive.

10

3. RESTRUCTURING CHARGES

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

	Workforce Reduction			Facilities Consolidation and Operating Lease Commitments			Property and Equipment Impairments			Total
Liability, March 31, 2006	$	5,830		$	1,814		$	—		$	7,644
Charged to expense		500			189			1,977			2,666
Cash payments		(5,135	)		(312	)		—			(5,447	)
Noncash charges		—			—			(1,977	)		(1,977	)
Liability, September 30, 2006	$	1,195		$	1,691		$	—		$	2,886

The following tables provide detailed activity related to the four most recent restructuring programs during the six months ended September 30, 2006 (in thousands):

	Workforce Reduction			Facilities Consolidation and Operating Lease Commitments			Property and Equipment Impairments			Total
April 2003 Restructuring Program
Liability, March 31, 2006	$	—		$	907		$	—		$	907
Cash payments		—			(88	)		—			(88	)
Liability, September 30, 2006	$	—		$	819		$	—		$	819
July 2005 Restructuring Program
Liability, March 31, 2006	$	—		$	907		$	—		$	907
Cash payments		—			(88	)		—			(88	)
Liability, September 30, 2006	$	—		$	819		$	—		$	819
March 2006 Restructuring Program
Liability, March 31, 2006	$	5,830		$	—		$	—		$	5,830
Charged to expense		—			189			1,977			2,166
Cash payments		(4,794	)		(137	)		—			(4,931	)
Noncash charge		—			—			(1,977	)		(1,977	)
Liability, September 30, 2006	$	1,036		$	52		$	—		$	1,088
June 2006 Restructuring Program
Charged to expense	$	500		$	—		$	—		$	500
Cash payments		(340	)		—			—			(340	)
Liability, September 30, 2006	$	160		$	—		$	—		$	160

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. The Company recognized a total of $23.8 million in restructuring costs related to the program. The restructuring costs consisted of approximately $5.7 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 a building in San Diego and an adjustment for overestimated severance to be paid.

11

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, the disposal of idle fixed assets, and the consolidation of San Diego facilities. As a result of the July 2005 restructuring program, the 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 facilities.

In March 2006, the Company communicated and began implementation of a plan to exit its operations in France and India and reorganize part of its manufacturing operations. The restructuring program included the elimination of approximately 68 employees. In fiscal 2006, the Company recorded a charge of approximately $7.6 million, consisting of $6.0 million for employee severances, $1.0 million for operating lease write-offs, and $0.6 million for asset impairments. For the three months ended September 30, 2006, the Company recorded an additional charge of $1.4 million for asset impairments. For the six months ended September 30, 2006, the Company recorded an additional charge of approximately $2.2 million, consisting of $0.1 million for excess lease liability, $0.1 million for operating lease commitments and $2.0 million for asset impairments. The Company estimates that it will record additional restructuring charges related to this program of up to $1.7 million in the remaining six months of fiscal year 2007. These actions are not anticipated to affect revenues from current products. The Company anticipates saving approximately $9.0 million annually as a result of this restructuring program.

In June 2006, the Company implemented another restructuring program. The June 2006 restructuring program was implemented to reduce job redundancies. The restructuring program consisted of the elimination of approximately 20 employees. As a result of the June 2006 restructuring program, the Company recorded a charge of approximately $0.5 million, consisting of employee severances. The Company anticipates saving approximately $4.0 million annually as a result of this restructuring program.

4. COMPREHENSIVE LOSS

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

	Three Months Ended September 30,						Six Months Ended September 30,
	2006			2005			2006			2005
Net loss	$	(13,889	)	$	(6,424)		$	(14,706	)	$	(10,628	)
Change in net unrealized gain (loss) on short-term investments		7,351			(2,660	)		5,820			912
Foreign currency translation adjustment gain (loss)		25			6			(200	)		(201	)
Comprehensive loss	$	(6,513	)	$	(9,078	)	$	(9,086	)	$	(9,917	)

5. STOCKHOLDERS’ EQUITY

Preferred Stock

The Company’s Certificate of Incorporation allows for the issuance of up to 2.0 million shares of preferred stock in one or more series and permits the Company’s Board of Directors to fix the rights, preferences, privileges and restrictions thereof, including dividend rights, dividend rates, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences, and the number of shares constituting any series so designated by the Board of Directors, without further vote or action by the stockholders.

Common Stock

At September 30, 2006 the Company had 630.0 million shares of common stock authorized for issuance. At September 30, 2006 and March 31, 2006, there were approximately 281.8 million shares and 295.4 million shares issued and outstanding, respectively.

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Employee Stock Purchase Plan

The Company has in effect an employee stock purchase plan under which 19.2 million shares of common stock have been reserved for issuance. Under the terms of this plan, purchases are made semiannually and the purchase price of the common stock is equal to 85% of the fair market value of the common stock on the first or last day of the offering period, whichever is lower. At September 30, 2006, approximately 10.0 million shares had been issued under this plan and approximately 9.2 million shares were available for future issuance.

Stock Repurchase Program

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 repurchase agreements. During the six months ended September 30, 2006, the Company repurchased 6.2 million shares on the open market at a weighted average price of $3.23 per share. From the time the program was first implemented through September 30, 2006, the Company repurchased 15.6 million shares on the open market at a weighted average price of $3.01 per share. At September 30, 2006, $85.5 million remained available to repurchase shares under the stock repurchase program.

The Company also utilizes structured stock repurchase agreements consisting of 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 inception of the agreement. 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 FASB Emerging Issues Task Force Issue No. 00-19,Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.

During the six months ended September 30, 2006, the Company received $17.4 million in cash and 7.7 million shares of its common stock from open structured stock repurchase programs. At September 30, 2006, the Company had no structured stock repurchase agreements open. From the time of the stock repurchase program inception through September 30, 2006, the Company entered into structured stock repurchase agreements totaling $164.5 million. Upon settlement of these underlying agreements, the Company received $105.9 million in cash and 23.0 million shares of its common stock at an effective purchase price of $2.55 per share.

The table below is a summary of the Company’s repurchase program share activity for the six months ended September 30, 2006 and 2005 (in thousands, except per share data):

	Six Months Ended September 30,
	2006		2005
Open market repurchases:
Aggregate repurchase price	$	20,137	$	16,931
Repurchased shares		6,242		5,380
Average price per share	$	3.23	$	3.15
Structured agreements:
Shares acquired in settlement		7,696		—
Average price per share	$	3.25	$	—
Total shares acquired by repurchase or in settlement		13,938		5,380
Average price per share	$	3.24	$	3.15

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Stock Options

The Company has in effect several stock option plans under which stock options have been granted to employees and non-employee directors. Certain of these plans allow the grant of restricted stock units. The option plans include two stockholder-approved plans (the 1992 Stock Option Plan and 1997 Directors’ Stock Option Plan) and four plans not approved by stockholders (the 2000 Equity Incentive Plan, Cimaron’s 1998 Stock Incentive Plan assumed in the fiscal 1999 merger, and JNI’s 1997 and 1999 Stock Option Plans assumed in the fiscal 2004 merger). Certain other outstanding options were assumed through the Company’s various acquisitions.

The Board of Directors has delegated administration of these plans to the Compensation Committee, which generally determines eligibility, vesting schedules and exercise prices for options granted under the plans. Options and other stock awards under the plans expire not more than ten years from the date of grant and are generally exercisable upon vesting. Vesting generally occurs over four years. In fiscal 2006, stock options covering 5.1 million shares were granted with a 2.5-year vesting schedule. New hire grants generally vest and become exercisable at the rate of 25% on the first anniversary of the date of grant and ratably on a monthly basis over a period of 36 months thereafter; subsequent option grants to existing employees generally vest and become exercisable ratably on a monthly basis over a period of 48 months measured from the date of grant.

In connection with its annual review of officer compensation in April 2006, the Compensation Committee granted to each of the Company’s executive officers performance options that vest based on pre-determined Company goals. There are two types of performance options. The first type vests in 48 equal monthly installments beginning one month after the grant date; provided, however, if the Company achieves specific stretch goals under its fiscal 2007 operating plan, the vesting of the option will accelerate such that the option will be fully exercisable at the end of two years instead of four years. The second type becomes exercisable only if the Company achieves specific revenue and non-GAAP pre-tax profit targets in any fiscal quarter before fiscal 2010.

Restricted Stock Units

In addition, the Company grants restricted stock units pursuant to its 2000 Equity Incentive Plan as part of its regular annual employee equity compensation review program as well as to new hires and non-employee members of the Board of Directors. Restricted stock units are share awards that upon vesting entitle the holder to receive shares of the Company’s common stock. Generally, restricted stock units vest ratably on a quarterly basis over 16 quarters from the date of grant.

Combined plan incentive information

Option activity under the Company’s stock incentive plans in the six months ended September 30, 2006 is set forth below:

	Number of Shares (in thousands)		Weighted Average Exercise Price Per Share		Weighted Average Remaining Contractual Term (in years)
Outstanding at the beginning of the period	54,096		$	5.82	—
Granted and assumed	6,262			3.05	—
Exercises	(264	)		0.93	—
Cancellations	(5,394	)		6.22	—
Outstanding at the end of the period	54,700		$	5.49	5.89
Vested at the end of the period	41,678		$	6.25	5.29

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The total pretax intrinsic value of options exercised during the six months ended September 30, 2006 was $180,000. This intrinsic value represents the excess of the fair market value of the Company’s common stock on the date of exercise over the exercise price of such options.

The aggregate pretax intrinsic value, weighted average remaining contractual life, and weighted average per share exercise price of options outstanding and of options exercisable as of September 30, 2006 were as follows (in thousands, except exercise prices and years):

	Options Outstanding						Options Exercisable
Range of Exercise Prices	Number of Shares	Weighted Average Exercise Price		Aggregate Pretax Intrinsic Value		Weighted Average Remaining Contractual Term (in years)	Number of Shares	Weighted Average Exercise Price		Aggregate Pretax Intrinsic Value
$  0.05 - $  2.98	10,278	$	2.33	$	6,129	6.36	4,582	$	2.26	$	3,083
2.99 -     3.67	12,108		3.44		—	7.84	5,908		3.43		—
3.67 -     5.65	11,366		4.67		—	6.82	10,240		4.75		—
5.69 -     6.48	3,825		6.21		—	4.87	3,825		6.21		—
6.54 -     6.54	13,121		6.54		—	3.81	13,121		6.54		—
6.55 -   87.24	4,002		17.94		—	3.97	4,002		17.94		—
$  0.05 - $87.24	54,700	$	5.49	$	6,129	5.89	41,678	$	6.25	$	3,083

The aggregate pretax intrinsic values in the preceding table were calculated based on the closing price of the Company’s common stock of $2.88 on September 30, 2006.

Restricted stock unit activity under the 2000 Equity Incentive Plan in the six months ended September 30, 2006 is set forth below:

	Restricted Stock Units Outstanding
	Number of Shares (in thousands)		Weighted Average Grant-Date Fair Value Per Share		Weighted Average Remaining Contractual Term (in years)
Balance at beginning of period	—		$	—	—
Awarded during the period	125			3.20	—
Vested during the period	(5	)		3.20	—
Cancelled during the period	(9	)		3.20	—
Balance at end of period	111		$	3.20	1.86

Based on the closing price of the Company’s common stock of $2.88 on September 30, 2006, the total pretax intrinsic value of all outstanding restricted stock units on that date was $320,000.

6. STOCK-BASED COMPENSATION

Effective April 1, 2006, the Company adopted SFAS 123(R), using the modified prospective method. This method does not require a revision of prior periods for comparative purposes. No change to the value of the awards granted prior to the adoption of SFAS 123(R) is required. However, awards granted and still unvested on the date of adoption will be attributed to expense under SFAS 123(R), including the application of the forfeiture rate on a prospective basis. The Company’s Consolidated Financial Statements as of and for the quarter ended September 30, 2006 reflect the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the three and six months ended September 30, 2006 was $2.7 million and $5.2 million, respectively.

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Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as permitted under SFAS 123. Under SFAS 123, stock-based compensation expense had been disclosed but not recognized in the Company’s Consolidated Statement of Operations. In the Company’s pro forma disclosure required under SFAS 123 for the periods prior to fiscal 2007, the Company accounted for forfeitures as they occurred.

SFAS 123(R) requires companies to estimate the fair value of stock-based compensation on the date of grant using an option-pricing model. The Company will continue to use the Black-Scholes model to value stock-based compensation. This is the same model which it previously used in preparing its pro forma disclosure required under SFAS 123. The Black-Scholes model determines the fair value of share-based payment awards based on the stock price on the date of grant and is affected by assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Although the fair value of stock options granted by the Company is determined in accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

The following table summarizes stock-based compensation expense related to stock options and restricted stock units under SFAS 123(R) for the six months ended September 30, 2006, which is allocated as follows (in thousands, except per share data):

	Three Months Ended September 30, 2006			Six Months Ended September 30, 2006
Stock-based compensation expense by type of awards
Stock options	$	2,654		$	5,153
Restricted stock units		24			36
Total stock-based compensation expense	$	2,678		$	5,189
Effect on basic and diluted net loss per share:	$	(.01	)	$	(.02	)

The fair value of the options granted is estimated as of the grant date using the Black-Scholes option-pricing model assuming the weighted-average assumptions listed in the following table:

	Stock Options
	Three Months Ended September 30,						Six Months Ended September 30,
	2006			2005			2006			2005
Expected life (years)		5.7			2.7			4.5			2.8
Volatility		54	%		53	%		55	%		53	%
Risk-free interest rate		4.8	%		4.0	%		4.9	%		4.0	%
Dividend yield		—	%		—	%		—	%		—	%
Weighted average fair value per share	$	2.04		$	1.09		$	1.79		$	1.13

Compensation Amortization Period. All stock-based compensation is amortized over the requisite service period of the awards, which is generally the same as the vesting period of the awards. For all stock options, the Company amortizes the fair value on a straight-line basis over the service periods.

Expected Term or Life. The expected term or life of stock options granted represents the expected weighted average period of time from the date of grant to the estimated date that the stock option would be fully

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exercised. To calculate the expected term, the Company assumes that unexercised stock options would be exercised at the midpoint of the valuation date of its analysis and the full contractual term of the option.

Expected Volatility. Expected volatility is a measure of the amount by which the stock price is expected to fluctuate. The Company estimates the expected volatility of its stock options at their grant date by equally weighting the historical volatility and the implied volatility of its stock. The historical volatility is calculated using the weekly stock price of its stock over a recent historical period equal to its expected term. The implied volatility is calculated from the implied market volatility of exchange-traded call options on its common stock.

Risk-Free Interest Rate. The risk-free interest rate is the implied yield currently available on zero-coupon government issues with a remaining term equal to the expected term.

Expected Dividends. The Company has never paid any cash dividends on our common stock and does not anticipate paying any cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero percent in valuation models.

Expected Forfeitures. As stock-based compensation expense recognized in the Condensed Consolidated Statements of Income for the three and six months ended September 30, 2006 is based on awards that are ultimately expected to vest, it should be reduced for estimated forfeitures. FAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Pre-vesting forfeitures were estimated to be 5.73% for all stock options granted in fiscal 2007 based upon the average of expected forfeitures data using the Company’s current demographics and standard probabilities of employee turnover and the annual forfeiture rate based on the Company’s historical forfeiture rates.

The following table summarizes stock-based compensation expense as it relates to the Company’s statement of operations (in thousands):

	Three Months Ended September 30, 2006		Six Months Ended September 30, 2006
Stock-based compensation included in operating expenses:
Cost of revenues	$	158	$	291
Research and development		1,028		2,097
Selling, general and administrative		1,492		2,801
Total stock-based compensation expense	$	2,678	$	5,189

The weighted average fair value per share of the restricted stock units awarded in the six months ended September 30, 2006 was $3.20, calculated based on the fair market value of the Company’s common stock on the respective grant dates.

The adoption of SFAS 123(R) will continue to have a significant adverse impact on the Company’s reported results of operations, although it will have no impact on its overall financial position. The amount of unearned stock-based compensation currently estimated to be expensed from now through fiscal 2011 related to unvested share-based payment awards at September 30, 2006 is $19.2 million. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is approximately 1.9 years. If there are any modifications or cancellations of the underlying unvested securities, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that the Company grants additional equity awards or assumes unvested equity awards in connection with acquisitions.

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In accordance with the requirements of the disclosure-only alternative of SFAS 123, set forth below is a pro forma illustration of the effect on net loss and net loss per share computed as 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 the three and six months ended September 30, 2005 (in thousands, except per share data):

	Three Months Ended September 30, 2005			Six Months Ended September 30, 2005
Net loss—as reported	$	(6,424	)	$	(10,628	)
Plus: Reported stock-based compensation		1,478			2,985
Less: Fair value stock-based compensation		(3,535	)		(14,719	)
Net loss—pro forma	$	(8,481	)	$	(22,362	)
Reported basic and diluted net loss per share	$	(0.02	)	$	(0.03	)
Pro forma basic and diluted net loss per share	$	(0.03	)	$	(0.07	)

7. CONTINGENCIES

Legal Proceedings

In September 2003, Silvaco Data Systems (“Silvaco”) 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 MicroCircuits Corporation, case no. 103CV005696. In its complaint, Silvaco claimed that the Company misappropriated trade secrets and engaged in unfair business practices by using software licensed to the Company by Circuit Semantics, Inc. The Company filed an answer denying Silvaco’s allegations. In October, 2006, the parties agreed to settle the lawsuit. Under the terms of the agreement, the Company paid Silvaco $150,000 and Silvaco released and dismissed all of its claims against the Company.

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 alleged that the Company breached a contract to purchase assets from Cicada by failing to make installment payments due under the contract. Cicada’s complaint sought $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 parties agreed to settle the complaint and cross-complaint effective June 1, 2006. Under the terms of the settlement agreement: (i) Vitesse paid the Company the sum of $221,661 in delayed product payments and interest, released and dismissed all claims against the Company and granted the Company a royalty-free license to the Line Interface Unit technology that was the subject of the original contract between Cicada and the Company; and (ii) the Company paid Vitesse the sum of $700,000 and released and dismissed its counterclaims against Cicada and Vitesse.

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. On May 12, 2006, the Ninth Circuit Court of Appeals issued an order affirming the March 2003 order dismissing plaintiffs’ complaint, but remanding back to the district court to consider whether to allow plaintiffs to file another amended complaint or to articulate specific reasons why an amendment should not be allowed. On August 24, 2006, the district court issued an order reaffirming its dismissal with prejudice. The time

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for plaintiffs to appeal that ruling passed without a notice of appeal being filed, thus resulting in a final judgment in the defendants’ favor.

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 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. In October 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. On April 4, 2006, plaintiff filed his opening brief. The company filed its answer brief on May 26, 2006. Plaintiff’s reply brief was filed on August 17, 2006. No date has been set for a hearing on this appeal.

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 held a hearing for final approval of the settlement on April 24, 2006 and took the issue under submission. The court did not indicate when it will render its decision.

Derivative Litigation:

Various current and former directors and officers of Applied Micro Circuits Corporation have been named as defendants in two consolidated stockholder derivative actions filed in the United States District Court for the Northern District of California, captionedIn re Applied Micro Circuits Derivative Litigation(N.D. Cal.) (The “Federal Action”); and three substantially similar consolidated stockholder derivative actions filed in California state court, captionedIn re Applied Micro Circuits Corporation Shareholder Derivative Litigation(Santa Clara County Superior Court) (the “State Action”). Plaintiffs in the Federal and State Actions allege that the defendant directors and officers backdated stock option grants during the period from 1997 through 2005. Both actions assert claims for breach of fiduciary duty, gross mismanagement, waste of corporate assets, unjust enrichment, imposition of a constructive trust over the option contracts, and violations of Section 25402 of the California Corporations Code. The Federal Action also alleges that the defendants violated Section 14(a) of the Securities Exchange Act of 1934 and Rule 14a-9 promulgated thereunder, and Section 20(a) of the Exchange Act. Both Actions seek to recover unspecified money damages against the individual defendants on behalf of Applied Micro Circuits Corporation, restitution, rescission of the option contracts, disgorgement of profits and benefits, equitable relief and attorneys’ fees and costs. The Company is named as a nominal defendant in both the Federal and State Actions, thus no recovery against the Company is currently sought.

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Regulatory Proceedings

On June 8, 2006, the Company received a request from the Securities and Exchange Commission (“SEC”) to produce voluntarily certain documents concerning our historical stock option grant practices. The Company produced responsive documents and indicated its intent to cooperate fully with the SEC’s investigation.

On June 27, 2006, the Company announced in a press release that it had received a Grand Jury subpoena from the U.S. Attorney’s Office for the Northern District of California relating to its historical stock option practices and that a parallel investigation had been initiated by the U.S. Attorney’s Office for the Southern District of California. The U.S. Attorney’s Office for the Northern District of California subsequently deferred the criminal investigation to the Southern District of California and withdrew its Grand Jury subpoena. On July 28, 2006, the U.S. Attorney’s Office for the Southern District of California served the Company with a Grand Jury subpoena substantially similar to the subpoena previously issued by the Northern District of California.

8. ACQUISITION OF QUAKE TECHNOLOGIES, INC.

On August 25, 2006, the Company acquired Quake Technologies, Inc. (“Quake”), a Delaware corporation, for $81.2 million in cash including merger costs. Of the amount paid, $12.0 million will be placed in escrow for at least one year in order to secure the indemnification obligations of Quake to the Company. In addition, the Company assumed unvested stock options covering 1.7 million shares of the Company’s common stock that had a fair value of $3.5 million in accordance with SFAS 123(R). The fair value of the unvested options was calculated using a Black-Scholes method and will be recorded as stock-based compensation over the requisite service period.

In connection with this transaction, the Company conducted valuations of the intangible assets acquired in order to allocate the purchase price in accordance with FASB Statement of Financial Accounting No. 141 (“SFAS 141”),Business Combinations. In accordance with SFAS 141, the Company has allocated the excess purchase price over the fair value of net tangible assets acquired to the identifiable intangible assets. The Company recorded a one-time charge of $13.3 million for purchased in-process research and development (“IPR&D”) expense. The amounts allocated to IPR&D were expensed upon acquisition as it was determined that the underlying projects had not reached technological feasibility and no alternative future uses existed. The purchase price in the transaction was allocated as follows (in thousands):

Net tangible assets	$	8,411
Purchased inventory fair market value		2,395
Existing technology		11,500
In-process research and development		13,300
Patents/trademarks		3,200
Customer relationships/backlog		2,800
Goodwill		39,597
	$	81,203

The total consideration issued in the acquisition was as follows (in thousands):

Cash	$	80,003
Merger costs		1,200
Total consideration paid	$	81,203

No supplemental pro forma information is presented for the acquisition due to the immaterial effect of the acquisition on the Company’s results of operations.

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9. STOCK-BASED COMPENSATION RESTATEMENT

The Company began a voluntary inquiry into its stock option granting practices at the beginning of May 2006 in response to reported issues within the industry regarding potential stock option backdating. The scope of the investigation was extensive, and included the review of stock option grants during the period commencing with the Company’s initial public offering on November 25, 1997 through March 2006. The Audit Committee, through its outside consultants, reviewed and tested approximately 240 executive level grants, approximately 13,500 non-executive level grants, and approximately 50 director grants which included every grant to every individual since the date of the Company’s initial public offering.

As a result of this investigation the company concluded that it should have used different measurement dates in accordance with APB 25 for certain stock option grants during fiscal years 1998 through 2002. Utilizing the revised measurement dates, the Company has calculated its aggregate incremental stock-based compensation cost for all affected periods to be approximately $95.2 million before tax benefits of $20.9 million for a net amount of $74.3 million. This restatement affected the Company’s financial statements for the fiscal years 1999 through 2004. No revenues or cash related items were affected in any of those years. Because the Company’s statement of operations for those years is not included in this report, please see our annual report on Form 10-K for the fiscal year ended March 31, 2006 for additional details on the restatement and a year-by-year reconciliation of the corrections.

10. SUBSEQUENT EVENTS

On April 14, 2006, the Company filed a definitive proxy statement with the Securities and Exchange Commission relating to a special stockholder meeting to be held on May 31, 2006. The purpose of the meeting was to approve a proposed exchange of certain stock options for a reduced number of restricted stock units and to approve the amendment and restatement of the Company’s 1992 Stock Option Plan, thereafter to be referred to as the 1992 Equity Incentive Plan. The stock option exchange program would have permitted eligible employees to exchange stock options with exercise prices equal to or greater than $4.90 per share for a reduced number or restricted stock units to be granted under the Company’s 2000 Equity Incentive Plan. Assuming 100% participation in the exchange program, 15.0 million shares would have been surrendered and cancelled, while approximately 2.6 million restricted stock units would have been issued, resulting in a net reduction of approximately 12.4 million shares. On November 15, 2006, the Company announced that the special meeting had been cancelled.

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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 (“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 six months ended September 30, 2006 and 2005. 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.

CAUTION CONCERNING FORWARD-LOOKING STATEMENTS

The MD&A should be read in conjunction with the consolidated financial statements and notes thereto included in this report. 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 Part II, Item 1A, “Risk Factors” in this report. 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

We are a leader in semiconductors and printed circuit board assemblies (“PCBAs”) for the communications and storage markets. We design, develop, market and support high-performance integrated circuits (“ICs”) and storage components, which are essential for the processing, transporting and storing of information worldwide. In the communications market, we utilize a combination of design expertise coupled with system-level knowledge and multiple technologies to offer IC products and PCBAs, for wireline and wireless communications equipment such as wireless base stations, edge switches, routers, and gateways, metro transport platforms and core switches and routers. In the storage market, we blend systems and software expertise with high-performance, high-bandwidth silicon integration to deliver high-performance, high capacity serial advanced technology attachment (“SATA”) redundant array of integrated disks (“RAID”) controllers for emerging storage applications such as

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disk-to-disk backup, near-line storage, network-attached storage (“NAS”), video, and high-performance computing. Our corporate headquarters are located in Sunnyvale, California. Sales and engineering offices are located throughout the world.

Net Revenue.We generate revenues primarily through sales of our IC products, embedded processors and PCBAs to original equipment manufacturers (“OEMs”), such as Alcatel, Ciena, Cisco, Brocade, Fujitsu, Hitachi, Huawei, Juniper, Lucent, Ericsson, NEC, Nortel, Siemens, and Tellabs, who in turn supply their equipment principally to communications service providers. In the storage market we generate revenues primarily through sales of our SATA RAID controllers to our distribution channel partners who in turn sell to enterprises, small and mid-size businesses, value added resellers (“VARs”), systems integrators and retail consumers.

The demand for our products has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following:

• the timing, rescheduling or cancellation of significant customer orders and our ability, as well as the ability of our customers, to manage inventory;

• the qualification, availability and pricing of competing products and technologies and the resulting effects on sales and pricing of our products.

• our ability to specify, develop or acquire, complete, introduce, and market new products and technologies in a cost effective and timely manner;

• the rate at which our present and future customers and end-users adopt our products and technologies in our target markets; and

• general economic and market conditions in the semiconductor industry and communications markets.

For these and other reasons, our net revenue and results of operations for the three and six months ended September 30, 2006 and 2005 may not necessarily be indicative of future net revenue and results of operations.

Based on direct shipments, net revenues to customers that exceeded 10% of total net revenues for the three and six months ended September 30, 2006 and 2005 were as follows:

	Three Months Ended September 30,				Six Months Ended September 30,
	2006		2005		2006		2005
Avnet	26	%	18	%	26	%	17	%
Sanmina	*		11	%	*		*

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

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, to the best of our knowledge, net revenues to end customers that exceeded 10% of total net revenues for the three and six months ended September 30, 2006 and 2005 were as follows:

	Three Months Ended September 30,		Six Months Ended September 30,
	2006	2005	2006	2005
Nortel Networks	*	*	*	11	%

We expect that our largest customers will continue to account for a substantial portion of our net revenue in 2007 and for the foreseeable future.

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Net revenues by geographic region were as follows (dollars in thousands):

	Three Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue
United States of America	$	32,869	43.0	%	$	30,059	46.2	%
Other North America		6,160	8.1			5,701	8.8
Europe and Israel		13,436	17.6			12,631	19.5
Asia		23,596	30.9			16,544	25.5
Other		303	0.4			—	—
	$	76,364	100.0	%	$	64,935	100.0	%
	Six Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue
United States of America	$	59,826	41.0	%	$	61,395	47.4	%
Other North America		16,348	11.2			12,049	9.3
Europe and Israel		25,351	17.4			25,174	19.4
Asia		43,677	29.8			30,854	23.8
Other		841	0.6			136	0.1
	$	146,043	100.0	%	$	129,608	100.0	%

All of our revenue to date has been denominated in U.S. dollars.

Net Loss.For the three and six months ended September 30, 2006, our net loss was approximately $13.9 million and $14.7 million as compared to a net loss of $6.4 million and $10.6 million for the three and six months ended September 30, 2005, an increase of $7.5 million and $4.1 million, respectively. This increase in our net loss was primarily the result of a $13.3 million charge for acquired in-process research and development from our acquisition of Quake in August 2006. In addition, we had higher operating expenses for the three months ended September 30, 2006 when compared to the three months ended September 30, 2005 due to a $2.2 million increase in selling, general and administrative expenses and a $1.0 million increase in research and development. The increase in expenses was offset by an increase in revenues of $11.4 million and $16.4 million for the three and six months ended September 30, 2006, respectively. In addition, restructuring charges decreased by $2.1 million during the three months ended September 30, 2006 when compared to the three months ended September 30, 2005.

Our net loss has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following:

• stock-based compensation expense;

• amortization of purchased intangibles;

• goodwill impairment charges;

• restructuring expenses (benefits); and

• income tax expenses (benefits).

Since the start of fiscal 2004, we have invested a total of approximately $368.0 million (excluding stock compensation) 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 and storage products. We have not generated significant revenues from products developed during this time because for most of the products developed by us, due to their complexity and the complexity of our OEM customers’ equipment, it often takes several years to complete development and qualification. In addition, the downturn in the telecommunications

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market has severely impacted our customers and has resulted in significantly less demand for the quantity of these products than expected when some of the developments commenced and, as a result of restructuring activities, we discontinued development of several products that were in process and slowed down development of others as we realized that demand for these products would not materialize as originally anticipated.

Over the last several years, we have undertaken significant restructuring activities in an effort to reduce operating costs. In addition, in an effort to diversify our customer base and markets that we serve and to maintain revenue growth, 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 $51.0 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 for 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 for approximately $232 million in cash. The PowerPC 400 series product line targets Internet, communication, data storage, consumer and imaging applications. In August 2006, we acquired Quake Technologies, Inc., a leader in 10 Gigabit Ethernet (10GE) physical layer technology for approximately $81.2 million in cash.

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 stock based compensation, 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. The actual results experienced by us may differ materially and adversely from management’s estimates. 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. For example, reducing our future demand estimate to six months could increase our current reserve balance by approximately $8.3 million as of September 30, 2006. Alternatively, increasing our future demand forecast to 18 months could reduce ourexposure by

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approximately $0.1 million as of September 30, 2006. 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 and changes to master purchase agreements with our larger customers. 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. Additional change to negotiated master purchase agreements could result in increased warranty reserves and unfavorably impact present and future 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, including in-process research and development (“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 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 No. 142 (“SFAS 142”),Goodwill and Other Intangible Assets. SFAS 142 requires that goodwill be tested for impairment at the reporting unit level on an annual basis and between annual tests in certain circumstances. 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. In fiscal 2006 and 2005, in accordance with SFAS 142, we determined that there were three reporting units to be tested. 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 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 several 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. 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

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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 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.

Stock-Based Compensation Expense for Fiscal 2007 and Thereafter

Effective April 1, 2006 we adopted SFAS 123 (revised 2004),Share-Based Payment, or SFAS 123(R). SFAS 123(R) requires the cost of all share-based payments, including grants of stock options, restricted stock units and employee stock purchase rights, to be recorded in our financial statements based on their respective grant date fair values. Under this standard, the fair value of each employee stock option and employee stock purchase right is estimated on the date of grant using an option pricing model that meets certain requirements. We use the Black-Scholes option pricing model to estimate the fair value of our share-based payments. The Black-Scholes model meets the requirements of SFAS 123(R), but the fair values generated by the model may not be indicative of the actual fair values of our stock-based awards as the model does not consider certain factors important to stock-based awards, such as continued employment, periodic vesting requirements and limited transferability. The determination of the fair value of share based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. We estimate the expected volatility of our stock options at their grant date, placing equal weighting on the historical volatility and the implied volatility of our stock. The expected life of the awards is based on the assumption that unexercised options will be exercised at the midpoint of our valuation date and the full contractual life of the option. The risk-free interest rate assumption is based on the implied yield on zero-coupon government issues with a remaining term equal to the expected term of the stock options. The dividend yield assumption is based on our history and expectation of dividend payouts. The fair value of our restricted stock units is based on the fair market value of our common stock on the date of grant. Stock-based compensation expense recorded in our financial statements in fiscal 2007 and thereafter will be based on awards that are ultimately expected to vest. The amount of stock-based compensation expense in fiscal 2007 and thereafter will be reduced for estimated forfeitures based on historical experience and standard probabilities of employee turnover. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We will evaluate the assumptions used to value stock awards on a quarterly basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. To the extent that we grant additional equity securities to employees or we assume unvested securities in connection with any acquisitions, our stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants or acquisitions. Had we adopted SFAS 123(R) in prior periods, the magnitude of the impact of that standard on our results of operations would have approximated the pro forma number impact of SFAS 123 described in Note 6 of our Notes to Consolidated Financial Statements under SFAS 123.

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Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101 (“SAB 101”),Revenue Recognition in Financial Statements 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. The portion of 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 marketing development programs. 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, we would record additional reductions to revenue.

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 six months ended September 30, 2006 were approximately $76.4 million and $146.0 million, representing an increase of 17.6% and 12.7% from the net revenues of approximately $64.9 million and $129.6 million for the three and six months ended September 30, 2005. We classified our revenues into three categories based on markets that the underlying products serve. The categories were integrated communication products (“ICP”), storage and other. We use this information to analyze the performance and success in these markets. The increase in total net revenues was primarily attributable to an increase in our ICP revenues, offset by decreases in our storage and other revenues. See the following tables (dollars in thousands):

	Three Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount			% of Net Revenue		Increase (Decrease)			Change
ICP	$	63,012	82.6	%	$	49,590		76.4	%	$	13,422		27.1	%
Storage		12,323	16.1			13,275		20.4			(952	)	(7.2	)
Other		1,029	1.3			2,070		3.2			(1,041	)	(50.3	)
	$	76,364	100.0	%	$	64,935		100.0	%	$	11,429		17.6
	Six Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount			% of Net Revenue		Increase (Decrease)			Change
ICP	$	119,005	81.5	%	$	98,856		76.2	%	$	20,149		20.4	%
Storage		24,553	16.8			26,658		20.6			(2,105	)	(7.9	)
Other		2,485	1.7			4,094	��	3.2			(1,609	)	(39.3	)
	$	146,043	100.0	%	$	129,608		100.0	%	$	16,435		12.7

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The ICP revenue increased, largely due to an increase in the volume of our ICP products and in particular, an increase in sales of our new embedded products. Storage revenues declined primarily because of the discontinuance of our Fibre Channel Host Adapter business. Our focus revenues for the three months ended September 30, 2006 increased sequentially from the prior quarter. We will continue to see our Other revenue decline as we focus our efforts on new product development.

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 Power Architecture portfolio to meet the needs of the converged internet protocol (“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 input/output (I/O). The nonfocus product areas are our legacy switching products, application-specific integrated circuits (“ASICs”), Fibre Channel host bus adapters (“HBAs”), storage area network (“SAN”) ICs, pointer processors, and legacy framers. We expect the revenues from our nonfocus products to continue to decline in the future. The following tables illustrate revenue from our focus and nonfocus areas (dollars in thousands):

	Three Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Focus	$	66,066	86.5	%	$	50,329	77.5	%	$	15,737		31.3	%
Nonfocus		10,298	13.5			14,606	22.5			(4,308	)	(29.5	)
	$	76,364	100.0	%	$	64,935	100	%	$	11,429		17.6
	Six Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Focus	$	123,462	84.5	%	$	98,395	75.9	%	$	25,067		25.5	%
Nonfocus		22,581	15.5			31,213	24.1			(8,632	)	(27.7	)
	$	146,043	100.0	%	$	129,608	100	%	$	16,435		12.7

Gross Profit. The following tables present net revenues, cost of revenues and gross profit for the three and six months ended September 30, 2006 and 2005 (dollars in thousands):

	Three Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase		Change
Net revenues	$	76,364	100.0	%	$	64,935	100.0	%	$	11,429	17.6	%
Cost of revenues		35,536	46.5			31,093	47.9			4,443	14.3
Gross profit	$	40,828	53.5	%	$	33,842	52.1	%	$	6,986	20.6
	Six Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase		Change
Net revenues	$	146,043	100.0	%	$	129,608	100.0	%	$	16,435	12.7	%
Cost of revenues		67,064	45.9			61,926	47.8			5,138	8.3
Gross profit	$	78,979	54.1	%	$	67,682	52.2	%	$	11,297	16.7

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The increase in gross profit for the three and six months ended September 30, 2006 was primarily attributable to the increase in net revenues and a decrease of $1.2 million and $2.7 million, respectively, in amortization of purchased intangibles included in our cost of revenues.

The amortization of purchased intangible assets included in cost of revenues during the three and six months ended September 30, 2006 was $4.0 million and $7.7 million, compared to $5.2 million and $10.4 million for the three and six months ended September 30, 2005. Based on the amount of capitalized purchased intangible assets on the balance sheet as of September 30, 2006, we expect amortization expense for purchased intangibles charged to cost of revenues to be $17.4 million in fiscal 2007, $18.4 million in fiscal 2008, and $41.3 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 six months ended September 30, 2006 and 2005 (dollars in thousands):

	Three Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase		Change
Research and development	$	24,853	32.5	%	$	23,835	36.7	%	$	1,018	4.3	%
Selling, general and administrative	$	17,312	22.7	%	$	15,127	23.3	%	$	2,185	14.4	%
	Six Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)		Change
Research and development	$	47,692	32.7	%	$	47,505	36.7	%	$	187	0.4	%
Selling, general and administrative	$	34,312	23.5	%	$	31,462	24.2	%	$	2,850	9.1	%

Research and Development. Research and development (“R&D”) expenses consist primarily of salaries and related costs (including stock based compensation) of employees engaged in research, design and development activities, costs related to engineering design tools, subcontracting costs and facilities expenses. The increase in R&D expenses of 4.3% for the three months ended September 30, 2006 compared to the three months ended September 30, 2005, was primarily due to an increase of $1.2 million for intellectual property and $0.8 million in Quake expenses, $0.4 million for stock based compensation offset by a decrease of $0.7 in software costs and $0.7 million in foundry costs. R&D expenses for the six months ended September 30, 2006 was consistent with the six months ended September 30, 2005. We believe that a continued commitment to R&D is vital to our goal of maintaining a leadership position with innovative ICP and storage products. Currently, R&D expenses are focused on the development of ICP and storage products and we expect to continue this focus. Future acquisitions of businesses may result in substantial additional on-going costs.

Selling, General and Administrative. Selling, general and administrative (“SG&A”) expenses consist primarily of personnel-related expenses, professional and legal fees, corporate branding and facilities expenses. The increase in SG&A expenses of 14.4% for the three months ended September 30, 2006 compared to the three months ended September 30, 2005, was primarily due an increase of $1.2 million in personnel-related expenses $0.7 million for stock based compensation, and $1.1 million in professional and legal fees as a result of our self-initiated review of the historical stock option granting policies offset by a decrease of $0.7 in facilities cost. The increase in SG&A expenses of 9.1% for the six months ended September 30, 2006 compared to the six months ended September 30, 2005, was primarily due to an increase of $1.9 million in professional and legal fees as a result of our self-initiated review of the historical stock option granting policies, $1.2 million related to stock

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based compensation, $0.6 million in marketing communications and $0.5 million in outside services offset by a decrease of $1.3 million in facilities cost. We expect our professional and legal fees to continue at increased levels as we finalize our review of our stock option granting practices. 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, which expense is included in the tables above, for the three and six months ended September 30, 2006 and 2005 (dollars in thousands):

	Three Months Ended September 30,
	2006(1)				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase		Change
Research and development	$	1,028	1.3	%	$	674	1.0	%	$	354	52.5	%
Selling, general and administrative		1,492	2.0			783	1.2			709	90.5
	$	2,520	3.3	%	$	1,457	2.2	%	$	1,063	73.0

	Six Months Ended September 30,
	2006(1)				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase		Change
Research and development	$	2,097	1.4	%	$	1,370	1.1	%	$	727	53.1	%
Selling, general and administrative		2,800	1.9			1,568	1.2			1,232	78.6
	$	5,897	3.4	%	$	2,938	2.3	%	$	1,959	66.7

(1) The amounts included in the three and six months ended September 30, 2006 reflect the adoption of SFAS 123(R). In accordance with the modified prospective transition method, our unaudited condensed consolidated statements of operations for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). See Notes 1 and 6 of Notes to Consolidated Financial Statements.

The adoption of SFAS 123(R) will continue to have a significant adverse impact on our reported results of operations, although it will have no impact on our overall liquidity. The amount of unearned stock-based compensation currently estimated to be expensed from now through fiscal 2011 related to unvested share-based payment awards at September 30, 2006 is $19.2 million. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is approximately 1.9 years. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that we grant additional equity awards to employees or assume unvested equity awards in connection with acquisitions.

For the three and six months ended September 30, 2005, 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 $3.0 million for the three and six months ended September 30, 2005.

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Restructuring Charges. The following tables present restructuring charges for the three and six months ended September 30, 2006 and 2005 (dollars in thousands):

	Three Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Decrease			Change
Restructuring charges	$	1,419	1.9	%	$	3,559	5.5	%	$	(2,140	)	(60.1	)%

	Six Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Decrease			Change
Restructuring charges	$	2,666	1.8	%	$	3,559	2.7	%	$	(893	)	(25.1	)%

In April 2003, we announced a restructuring program that consisted of a workforce reduction of 185 employees, consolidation of excess facilities and fixed asset disposals. We recognized a total of $23.8 million restructuring cost related to the plan. The restructuring costs consisted of approximately $5.7 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 a building in San Diego and an adjustment for overestimated severance to be paid.

In July 2005, we 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, the disposal of idle fixed assets, and the consolidation of San Diego facilities. As a result of the July 2005 restructuring, 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 facilities.

In March 2006, we communicated and began implementation of a plan to exit our operations in France and India and reorganize part of our manufacturing operations. The restructuring program included the elimination of approximately 68 employees. In fiscal year 2006, we recorded a charge of approximately $7.6 million, consisting of $6.0 million for employee severance, $1.0 million for operating leases write-offs, and $0.6 million for asset impairments in connection with this exit plan. For the three months ended September 30, 2006, we recorded an additional charge of $1.4 million for asset impairments. For the six months ended September 30, 2006, the Company recorded an additional charge of approximately $2.2 million, consisting of $0.1 million for excess lease liability, $0.1 million for operating lease commitments and $2.0 million for asset impairments. We estimate that we will record additional restructuring charges of up to $1.7 million in the remaining six months of fiscal year 2007. These actions are not anticipated to affect revenues from current products. We anticipate saving approximately $9.0 million annually as a result of this restructuring program.

In June 2006, we implemented another restructuring program. The June 2006 restructuring program was implemented to reduce job redundancies. The restructuring program consisted of the elimination of approximately 20 employees. As a result of the June 2006 restructuring, we recorded a charge of approximately $0.5 million, consisting of employee severances. We anticipate saving approximately $4.0 million annually, as a result of this restructuring program.

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Interest and Other Income (Expense), net. The following tables present interest and other income (expense), net for the three and six months ended September 30, 2006 and 2005 (dollars in thousands):

	Three Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount			% of Net Revenue		Increase (Decrease)			Change
Interest income, net	$	3,254	4.3	%	$	3,884		6.0	%	$	(630	)	(16.2	)%
Other income (expense), net	$	175	0.2	%	$	(347	)	(0.5	)%	$	522		150.4	%

	Six Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount			% of Net Revenue		Increase (Decrease)			Change
Interest income, net	$	6,595	4.5	%	$	7,473		5.8	%	$	(878	)	(11.7	)%
Other income (expense), net	$	199	0.1	%	$	(532	)	(0.4	)%	$	731		137.4	%

Net Interest Income. Net interest income 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 six months ended September 30, 2006 is primarily due to lower coupon interest rates and from lower cash and short-term investment balances.

Other Income (Expense), net. Other income (expense), net for the three and six months ended September 30, 2006 includes income from subleased property and for the three and six months ended September 30, 2005 includes realized losses on foreign currency hedges and net gains on disposals of property and equipment.

Income Taxes. The following tables present our income tax expense for the three and six months ended September 30, 2006 and 2005 (dollars in thousands):

	Three Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Income tax expense	$	74	0.1	%	$	175	0.3	%	$	(101	)	(57.7	)%

	Six Months Ended September 30,
	2006				2005
	Amount		% of Net Revenue		Amount		% of Net Revenue		Increase (Decrease)			Change
Income tax expense	$	214	0.1	%	$	351	0.3	%	$	(137	)	(39.0	)%

The federal statutory income tax rate was 35% for the three and six months ended September 30, 2006 and 2005. Our income tax expense in fiscal 2007 and 2006 primarily reflects estimated foreign taxes and alternative minimum taxes.

FINANCIAL CONDITION AND LIQUIDITY

As of September 30, 2006, our principal source of liquidity consisted of $265.8 million in cash, cash equivalents and short-term investments. Working capital as of September 30, 2006 was $285.4 million. Total cash, cash equivalents, and short-term investments decreased by $69.9 million during the six months ended September 30, 2006 primarily as a result of our Quake acquisition for $81.2 million. At September 30, 2006, we had contractual obligations not included on our balance sheet totaling $71.7 million, primarily related to facilities leases, engineering design software tool licenses and inventory purchase commitments.

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For the six months ended September 30, 2006, we generated $3.5 million in cash from our operations compared to using $15.2 million for our operations in the six months ended September 30, 2005. Our net loss of $14.7 for the six months ended September 30, 2006 included $35.9 million of non-cash charges such as $4.7 million of depreciation, $10.7 million of amortization of purchased intangibles, $13.3 million in acquired in-process research and development, $5.2 million of stock-based compensation charges recorded in accordance with SFAS 123(R) and $2.0 million in non-cash restructuring charges. The remaining change in operating cash flows for the six months ended September 30, 2006 primarily reflected increases in our accounts receivable, inventories, other assets and accounts payable and decreases in accrued payroll and other accrued liabilities and deferred revenue. The increase in our accounts receivable balance is attributable primarily to accounts receivable relating to the acquisition of Quake Technologies $1.9 million, change in days sales outstanding from 35 days for the period ended March 31, 2006 to 44 days for the period ended September 30, 2006, and an increase attributable to higher revenues. The increase in our inventory is attributable primarily to inventories related to the acquisition of Quake Technologies, $2.9 million and organic growth to serve our longer term inventory requirements. Our net loss of $10.6 for the six months ended September 30, 2005 included $25.0 million of non-cash charges such as $7.0 million of depreciation, $12.8 million of amortization of purchased intangibles, $3.0 million of stock-based compensation charges recorded in accordance with SFAS 123(R) and $2.2 million in non-cash restructuring charges. The remaining change in operating cash flows for the six months ended September 30, 2005 primarily reflected increases in our inventories and accounts payable and decreases in accounts receivable, other assets, accrued payroll and other accrued liabilities, and deferred revenue.

We used $12.8 million of cash in investing activities during the six months ended September 30, 2006, compared to generating cash of $22.2 million during the six months ended September 30, 2005. During the six months ended September 30, 2006, we used approximately $72.0 million net cash for the Quake acquisition and $4.3 million for the purchase of property, equipment and other assets, offset by net proceeds of $63.5 million from short-term investment activities. During the six months ended September 30, 2005, we generated net proceeds of $28.1 million from short-term investment activities offset by net purchases of property, equipment and other assets of $5.9 million.

We used $3.0 million of cash for the six months ended September 30, 2006 for financing activities compared to using $33.7 million for the six months ended September 30, 2005. The major financing use of cash for the six months ended September 30, 2006 was the open market repurchase of our stock offset by funds received from structured stock repurchase programs and the sales of common stock through employee stock options. The major financing use of cash for the six months ended September 30, 2005 was related to the funding of structured stock repurchase programs offset by sales of common stock through employee stock options and employee stock purchase plan.

On August 25, 2006, we acquired Quake Technologies, Inc. (“Quake”). Under the terms of the Merger Agreement, we acquired Quake’s net tangible assets and intellectual property for $81.2 million in cash, including merger costs. Of the amount paid, $12.0 million will be placed in escrow for at least one year in order to secure the indemnification obligation of Quake.

On August 12, 2004, our board of directors authorized a stock repurchase program for the repurchase of up to $200.0 million of our common stock. Under the program, we are authorized to make purchases in the open market or enter into structured agreements. During the six months ended September 30, 2006, we repurchased 6.2 million shares on the open market at a weighted average price of $3.23. From the time the program was first implemented through September 30, 2006, we repurchased on the open market 15.6 million shares at a weighted average price of $3.01 per share. At September 30, 2006, $85.5 million remained available to repurchase shares under the authorized program, as amended.

We also utilize structured stock repurchase agreements to buy back shares which are prepaid written put options on our common stock. We pay 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 our

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common stock on the expiration date of the agreement. Upon expiration of each agreement, if the closing market price of our common stock is above the pre-determined price, we will have our investment returned with a premium. If the closing market price is at or below the pre-determined price, we 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 six months ended September 30, 2006, we received $17.4 million in cash and 7.7 million in shares from open structured stock repurchase programs. At September 30, 2006, we had no structured stock repurchase agreements open. From the time of the stock repurchase program inception through September 30, 2006, the Company entered into structured stock repurchase agreements totaling $164.5 million. Upon settlement of these underlying agreements, the Company received $105.9 million in cash and 23.0 million shares of its common stock at an effective purchase price of $2.55 per share.

The table below is a summary of our repurchase program share activity for the six months ended September 30, 2006 and 2005 (in thousands, except per share data):

	Six Months Ended September 30,
	2006		2005
Open market repurchases:
Aggregate repurchase price	$	20,137	$	16,931
Repurchased shares		6,242		5,380
Average price per share	$	3.23	$	3.15
Structured agreements:
Shares acquired in settlement		7,696		—
Average price per share	$	3.25	$	—
Total shares acquired by repurchase or in settlement		13,938		5,380
Average price per share	$	3.24	$	3.15

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 September 30, 2006 (in thousands):

	Operating Leases		Other Purchase Commitments		Total
Fiscal years ending:
Six months ending March 31, 2007	$	20,773	$	33,631	$	54,404
2008		7,426		—		7,426
2009		7,214		—		7,214
2010		1,864		—		1,864
2011		748		—		748
Thereafter		25		—		25
Total	$	38,050	$	33,631	$	71,681

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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 investments managed by 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 September 30, 2006, our investment portfolio included fixed-income securities classified as available-for-sale investments with a fair market value of $228.8 million and a cost basis of $235.0 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 September 30, 2006 (in thousands):

	Valuation of Securities Given an Interest Rate Decrease of X Basis Points (“BPS”)						Fair Value as of September 30, 2006		Valuation of Securities Given an Interest Rate Increase of X Basis Points (“BPS”)
	(150 BPS)		(100 BPS)		(50 BPS)				50 BPS		100 BPS		150 BPS
Available-for-sale investments	$	243,774	$	238,714	$	233,729	$	228,840	$	224,233	$	219,995	$	215,916

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, for which a firm commitment has been attained, 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 September 30, 2006. 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 7 of Notes to Consolidated Financial Statements, included in Part I, Item 1 of this Report, is incorporated herein by reference.

ITEM 1A. 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. Although we update our descriptions of the risks and uncertainties facing us in our periodic reports filed with the SEC, we have not changed these descriptions from the descriptions contained in our annual report on Form 10-K that we filed concurrently with this report. 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;

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

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

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

• 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 rule requiring the recognition of expense related to share-based payments to employees, such as grants of stock options and restricted stock units;

• 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 to perform its obligations to us;

• 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

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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 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.

Our business substantially depends upon the continued growth of the technology sector and the Internet.

The technology equipment industry is cyclical and has experienced significant and extended downturns in the past. A substantial portion of our business and revenue depends on the continued growth of the technology sector and 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;

• we may successfully design a product to customer specifications but the customer may not be successful in the market;

• 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;

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• 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 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.

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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 Fibre Channel host bus adapter products have resulted 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 Fibre Channel 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. Although sales of these products are no longer material, we continue to 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 while currently being met could expand and result in significantly increased 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 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.

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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 laws in the United States. 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 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.

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

Over the past several years, we have initiated several restructuring activities in an effort to reduce operating costs. Employees whose positions were eliminated in connection with these 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, that any future restructuring efforts will be successful, or that we will be able to realize the cost savings and other anticipated benefits from our previous or future restructuring plans. 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:

• our ability to partner with OEM and channel partners who are successful in the market;

• 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 Adaptec, Areca, Hewlett-Packard, LSI Logic, and Promise. Our embedded processor products compete against products from Freescale Semiconductor, IBM and Intel. 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 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 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.

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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 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.

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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 Statement of Financial Accounting Standards (“SFAS”) 123,Share-Based Payment (“SFAS 123(R)”) which requires companies to expense employee stock options and other stock-based awards for financial reporting purposes. Pursuant to SFAS 123(R), in April 2006 we began valuing our employee stock option grants pursuant to an option valuation model, and then amortizing that value against our reported earnings over the vesting period in effect for those options. Prior to our adoption of SFAS 123(R), we accounted for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and utilized the disclosure-only alternative of SFAS 123 and SFAS 128, each of which was 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 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.

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Our management, including our chief executive officer and chief financial officer, does not expect that our internal controls over financial reporting will prevent all errors 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, 2006. In connection with the investigation of our historical stock option grant practices, we did identify material weaknesses in our internal control over financial reporting that existed in fiscal years prior to fiscal 2005. 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 that the IBM PowerPC employees should not have been transferred to us. As a result, all of our PowerPC employees in France returned to IBM. IBM is currently providing transitional services to us from the employees who returned to IBM. We are in the process of hiring permanent replacements for these 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.

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.

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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 test and assembly facilities are located in San Diego, California and a significant portion of our 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.

We have been named as a party to several derivative action lawsuits arising from our internal option review, and we may be named in additional litigation, all of which could require significant management time and attention and result in significant legal expenses and may result in an unfavorable outcome which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

We are subject to a number of lawsuits purportedly on behalf of Applied Micro Circuits Corporation against certain of our current and former executive officers and board members, and we may become the subject of additional private or government actions. The expense of defending such litigation may be significant. The amount of time to resolve these lawsuits is unpredictable and defending ourselves may divert management’s attention from the day-to-day operations of our business, which could adversely affect our business, results of operations and cash flows. In addition, an unfavorable outcome in such litigation could have a material adverse effect on our business, results of operations and cash flows.

As a result of our option review and restatement, we are subject to investigations by the SEC and Department of Justice (“DOJ”), which may not be resolved favorably and has required, and may continue to require, a significant amount of management time and attention and accounting and legal resources, which could adversely affect our business, results of operations and cash flows.

The SEC and the DOJ are currently conducting investigations relating to our historical stock option grant practices. We have been responding to, and continue to respond to, inquiries from the SEC and DOJ. The period of time necessary to resolve the SEC and DOJ investigations is uncertain, and these matters could require significant management and financial resources which could otherwise be devoted to the operation of our business. If we are subject to an adverse finding resulting from the SEC and DOJ investigations, we could be

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required to pay damages or penalties or have other remedies imposed upon us. The restatement of our financial statements, the ongoing SEC and DOJ investigations and any negative outcome that may occur from these investigations could impact our relationships with customers and our ability to generate revenue. In addition, considerable legal and accounting expenses related to these matters have been incurred to date and significant expenditures may continue to be incurred in the future. The SEC and DOJ investigations could adversely affect our business, results of operations, financial position and cash flows.

The process of restating our financial statements, its associated disclosures, and complying with SEC requirements are subject to uncertainty and evolving requirements.

We are working with our independent registered public accounting firm and the SEC to make our filings comply with all related requirements. The issues surrounding the historical stock option grant practices are complex and the regulatory guidelines or requirements continue to evolve. There can be no assurance that further SEC and other requirements will not evolve and that we will not be required to further amend this filing. In addition to the cost and time to amend financial reports, such an amendment may have a material adverse affect on investors and our common stock price.

If we do not maintain compliance with Nasdaq listing requirements, our common stock could be delisted, which could have a material adverse effect on the trading price of our common stock and cause some investors to lose interest in our company.

As a result of our option investigation, we were delinquent in filing certain of our periodic reports with the SEC, and consequently we were not in compliance with Nasdaq’s Marketplace Rules. As a result, we underwent a review and hearing process with Nasdaq to determine our listing status. Nasdaq ultimately permitted our securities to remain listed on the Nasdaq Global Select Market, but our securities could be delisted in the future if we do not maintain compliance with applicable listing requirements. Being delisted could affect our access to the capital markets and our ability to raise capital through alternative financing sources on terms acceptable to us or at all and could cause our investors, suppliers, customers and employees to lose confidence in us.

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 potentially responsible party (“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.

Environmental laws and regulations could cause a disruption in our business and operations.

We are subject to various state, federal and international laws and regulations governing the environment, including those restricting the presence of certain substances in electronic products and making manufacturers of those products financially responsible for the collection, treatment, recycling and disposal of certain products.

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Such laws and regulations have been passed in several jurisdictions in which we operate, including various European Union (“EU”) member countries. For example, the European Union has enacted the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (“RoHS”) and the Waste Electrical and Electronic Equipment (“WEEE”) directives. RoHS prohibits the use of lead and other substances, in semiconductors and other products put on the market after July 1, 2006. The WEEE directive obligates parties that place electrical and electronic equipment on the market in the EU to put a clearly identifiable mark on the equipment, register with and report to EU member countries regarding distribution of the equipment, and provide a mechanism to take back and properly dispose of the equipment. There can be no assurance that similar programs will not be implemented in other jurisdictions resulting in additional costs, possible delays in delivering products, and even the discontinuance of existing and planned future product replacements if cost were to become prohibitive.

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 September 30, 2006, we had $427.8 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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Any acquisitions we make could disrupt our business and harm our results of operation and financial condition.

In August 2006, we acquired Quake Technologies, Inc, and we may make additional investments in or acquire other companies, products or technologies. These acquisitions involve numerous risks, including:

• problems combining or integrating the purchased operations, technologies or products;

• unanticipated costs;

• diversion of management’s attention from our core business;

• adverse effects on existing business relationships with suppliers and customers;

• risks associated with entering markets in which we have no or limited prior experience; and

• potential loss of key employees, particularly those of the acquired organizations.

In addition, in the event of any such investments or acquisitions, we could

• issue stock that would dilute our current stockholders’ percentage ownership;

• incur debt;

• assume liabilities;

• incur amortization or impairment expenses related to goodwill and other intangible assets; or

• incur large and immediate write-offs.

We cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we might acquire. For example, with the acquisition of Quake, we acquired the technology necessary to introduce 10 Gigabit Ethernet physical layer chips and advance our efforts in the enterprise part of the market. 10 Gigabit Ethernet is an emerging technology, and we cannot assure you that this technology will be successful. In addition, several of our competitors have introduced similar products in the last quarter. If our customers do not purchase our new power amplifier modules, our development and integration efforts will have been unsuccessful, and our business may suffer.

Our subsidiary 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.

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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 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;

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• 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 or governmental investigations;

• 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.

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.

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

Below is a summary of stock repurchases for the quarter ended September 30, 2006 (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
July 1 – July 30, 2006 (1)	1,540	$	3.25	1,540	$	85,467
August 1 – August 31, 2006	—	$	—	—	$	85,467
September 1 – September 30, 2006	—	$	—	—	$	85,467
Total shares repurchased	1,540	$	3.25	1,540	$	85,467

(1) During the three months ended September 30, 2006, we received 1.5 million in shares from open structured stock repurchase agreements. At September 30, 2006, we had no structured stock repurchase agreements outstanding.

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: January 9, 2007

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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