UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549
________________

FORM 10-Q
________________

T		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the quarterly period ended July 3, 2005
		OR
£		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 1-10079

CYPRESS SEMICONDUCTOR CORPORATION

Delaware		94-2885898
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

198 Champion Court, San Jose, California 95134
(Address of principal executive offices and zip code)

(408) 943-2600
(Registrant’s telephone number, including area code)

3901 North First Street, San Jose, California 95134
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes T No £

Indicate by check mark whether the registrant is an accelerated filer (as outlined in Rule 12b-2 of the Exchange Act):
Yes T No £

The total number of shares of the registrant’s common stock outstanding as of August 1, 2005 was 133,650,713.

 

 

INDEX

		Page
PART I — FINANCIAL INFORMATION
Forward-Looking Statements			3
Item 1.Financial Statements			4
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations			28
Item 3.Quantitative and Qualitative Disclosures about Market Risk			47
Item 4.Controls and Procedures			49
PART II — OTHER INFORMATION
Item 1.Legal Proceedings			49
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds			49
Item 3.Defaults Upon Senior Securities			50
Item 4.Submission of Matters to a Vote of Security Holders			50
Item 5.Other Information			50
Item 6.Exhibits			50
Signatures			51
EXHIBIT 3.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I – FINANCIAL INFORMATION

Forward-Looking Statements

     The discussion in this Quarterly Report on Form 10-Q contains statements that are not historical in nature, but are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties, including, but not limited to, statements as to sustained demand for Cypress and SunPower products, our ability to develop new products, the general economy and its impact on the market segments we serve, the changing environment and cycles of the semiconductor industry, competitive pricing, the successful integration and achievement of the objectives of acquired businesses, cost goals emanating from manufacturing efficiencies, the adequacy of cash and working capital, risks related to investing in development stage companies, and other liquidity risks. We use words such as “anticipates,” “believes,” “expects,” “future,” “intends” and similar expressions to identify forward-looking statements. Such forward-looking statements are made as of the date hereof and are based on our current expectations, information, beliefs or intention regarding future events and our financial performance. Except as required by law, we assume no responsibility to update any such forward-looking statements. Our actual results could differ materially from those projected in the forward-looking statements for any number of reasons, including, but not limited to, the materialization of one or more of the risks set forth above and in the “Risk Factors” section in this Quarterly Report on Form 10-Q.

ITEM 1. FINANCIAL STATEMENTS

CYPRESS SEMICONDUCTOR CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per-share amounts)
(Unaudited)

		July 3,				January 2,
		2005				2005
ASSETS
Current assets:
Cash and cash equivalents		$	63,351			$	66,619
Short-term investments			113,025				178,278
Total cash, cash equivalents and short-term investments			176,376				244,897
Accounts receivable, net			128,152				107,288
Inventories			83,136				99,709
Other current assets			108,047				111,986
Total current assets			495,711				563,880
Property, plant and equipment, net			427,337				444,651
Goodwill			403,308				382,284
Intangible assets, net			57,605				64,719
Other assets			126,324				117,460
Total assets		$	1,510,285			$	1,572,994
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	62,341			$	78,624
Accrued compensation and employee benefits			36,287				42,750
Other current liabilities			63,446				75,295
Deferred income on sales to distributors			29,513				33,426
Income taxes payable			1,987				3,515
Total current liabilities			193,574				233,610
Convertible subordinated notes			599,997				599,998
Deferred income taxes and other tax liabilities			73,290				68,477
Other long-term liabilities			22,126				10,551
Total liabilities			888,987				912,636
Commitments and contingencies (Note 7)
Stockholders’ equity:
Preferred stock, $.01 par value, 5,000 shares authorized; none issued and outstanding			—				—
Common stock, $.01 par value, 650,000 and 650,000 shares authorized; 142,443 and 142,157 shares issued; 133,189 and 128,493 shares outstanding at July 3, 2005 and January 2, 2005, respectively			1,424				1,421
Additional paid-in-capital			1,159,565				1,149,267
Deferred stock compensation			(1,101	)			(1,989	)
Accumulated other comprehensive income (loss)			498				(2,124	)
Accumulated deficit			(440,556	)			(306,312	)
			719,830				840,263
Less: shares of common stock held in treasury, at cost; 9,254 and 13,664 shares at July 3, 2005 and January 2, 2005, respectively			(98,532	)			(179,905	)
Total stockholders’ equity			621,298				660,358
Total liabilities and stockholders’ equity		$	1,510,285			$	1,572,994

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

CYPRESS SEMICONDUCTOR CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per-share amounts)
(Unaudited)

		Three Months Ended								Six Months Ended
		July 3,				June 27,				July 3,				June 27,
		2005				2004				2005				2004
Revenues		$	220,506			$	264,269			$	420,810			$	518,662
Costs and expenses:
Cost of revenues			129,556				124,855				256,205				248,215
Research and development			57,043				66,797				115,083				129,955
Selling, general and administrative			36,791				38,823				75,200				67,519
Restructuring costs (credits)			4,986				—				27,695				(81	)
Amortization of intangible assets			7,113				9,607				15,513				19,798
In-process research and development charge			—				—				12,300				—
Total costs and expenses			235,489				240,082				501,996				465,406
Operating income (loss)			(14,983	)			24,187				(81,186	)			53,256
Interest income			2,499				2,688				5,049				5,282
Interest expense			(2,094	)			(2,710	)			(4,267	)			(5,578	)
Other expense, net			(1,197	)			(657	)			(3,856	)			(1,131	)
Income (loss) before income taxes			(15,775	)			23,508				(84,260	)			51,829
Benefit from (provision for) income taxes			521				(1,528	)			210				(3,369	)
Net income (loss)		$	(15,254	)		$	21,980			$	(84,050	)		$	48,460
Net income (loss) per share:
Basic		$	(0.12	)		$	0.18			$	(0.64	)		$	0.39
Diluted		$	(0.12	)		$	0.13			$	(0.64	)		$	0.30
Weighted-average common shares outstanding:
Basic			132,081				123,366				131,293				122,892
Diluted			132,081				167,467				131,293				169,649

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

CYPRESS SEMICONDUCTOR CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

		Six Months Ended
		July 3,				June 27,
		2005				2004
Cash flow from operating activities:
Net income (loss)		$	(84,050	)		$	48,460
Adjustments to reconcile net income (loss) to net cash generated from operating activities:
Depreciation and amortization			76,010				86,360
Amortization (reversal) of deferred stock-based compensation			(1,334	)			2,413
Impairment of investments			821				—
Impairment related to synthetic lease			609				—
In-process research and development charge			12,300				—
Loss on disposal of property, plant and equipment, net			762				8
Employee stock purchase assistance plan (“SPAP”) interest			(827	)			(1,050	)
Decrease in SPAP allowance			—				(7,752	)
Changes in foreign currency derivatives			235				10
Gain on changes in fair value of warrants			(120	)			—
Non-cash restructuring charges (credits)			19,148				(81	)
Stock received for manufacturing services			—				(2,500	)
Deferred income taxes and other tax liabilities			14				73
Other adjustments			(483	)			(1,279	)
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable, net			(19,956	)			(39,088	)
Inventories, net			18,096				4,993
Other assets			1,704				408
Accounts payable and other accrued liabilities			(14,011	)			2,502
Deferred income on sales to distributors			(3,912	)			6,866
Income taxes payable			(1,528	)			(932	)
Net cash flow generated from operating activities			3,478				99,411
Cash flow from investing activities:
Purchase of investments			(48,640	)			(82,527	)
Proceeds from sale or maturities of investments			114,046				41,991
Cash received from (used for) acquisitions, net			(39,606	)			955
Acquisitions of property, plant and equipment			(50,775	)			(54,282	)
Proceeds from collection of SPAP loans			—				28,183
Other investments			(4,000	)			6
Net cash flow used for investing activities			(28,975	)			(65,674	)
Cash flow from financing activities:
Repayment of borrowings			(8,152	)			(3,571	)
Conversion of convertible subordinated notes			(1	)			—
Issuance of common shares			30,382				21,109
Structured purchase of options, net			—				1,790
Repayment of notes to stockholders, net			—				127
Net cash flow generated from financing activities			22,229				19,455
Net increase (decrease) in cash and cash equivalents			(3,268	)			53,192
Cash and cash equivalents, beginning period			66,619				152,024
Cash and cash equivalents, end of period		$	63,351			$	205,216
Supplemental disclosure of non-cash information:
Common stock issued for acquisitions		$	4,039			$	6,011
Stock received for manufacturing services			—				2,500

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

CYPRESS SEMICONDUCTOR CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Fiscal Years

     Cypress Semiconductor Corporation (“Cypress” or the “Company”) reports on a fiscal-year basis and ends its quarters on the Sunday closest to the end of the applicable calendar quarter, except in a 53-week fiscal year, in which case the additional week falls into the fourth quarter of that fiscal year. Fiscal 2005 is a 52-week year and fiscal 2004 was a 53-week year. The second quarter of fiscal 2005 ended on July 3, 2005 and the second quarter of fiscal 2004 ended on June 27, 2004.

Basis of Presentation

     In the opinion of the management of the Company, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting solely of normal recurring adjustments) necessary to state fairly the financial information included therein. The Company believes that the disclosures are adequate to make the information not misleading. However, this financial data should be read in conjunction with the audited consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 2, 2005.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

     The results of operations for the three and six months ended July 3, 2005 are not necessarily indicative of the results to be expected for the full fiscal year.

Recent Accounting Pronouncements

     In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 154, “Accounting Changes and Error Corrections,” which changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 replaces Accounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statement.” It requires retrospective application to prior period’s financial statements of a voluntary change in accounting principle unless it is impracticable. In addition, under SFAS No. 154, if an entity changes its method of depreciation, amortization, or depletion for long-lived, non-financial assets, the change must be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 applies to accounting changes and error corrections made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS No. 154 in the first quarter of fiscal 2006 will have a material impact on its consolidated results of operations and financial condition.

     In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” Interpretation No. 47 clarifies that an entity must record a liability for a “conditional” asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective no later than the end of the fiscal year ending after December 15, 2005. The Company is currently evaluating the provision and does not expect the adoption of Interpretation No. 47 in the fourth quarter of fiscal 2005 will have a material impact on its results of operations or financial condition.

     In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides guidance on the implementation of SFAS No. 123(R), “Share-Based Payment” (see discussion below). In particular, SAB No. 107 provides key guidance related to valuation methods (including assumptions such as expected volatility and expected term), the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123(R), the modification of employee share options prior to the adoption of SFAS No. 123(R), the classification of compensation expense, capitalization of compensation cost related to share-based payment arrangements, first-time adoption of SFAS No. 123(R) in an interim period, and disclosures in Management’s Discussion and Analysis subsequent to the adoption of SFAS No. 123(R). SAB No. 107 became effective on March 29, 2005. It did not have a material impact on the Company’s financial statements.

     In December 2004, the FASB issued SFAS No. 123(R), which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Under SFAS No. 123(R), companies are required to measure the compensation costs of share-based compensation arrangements based on the grant-date fair value and recognize the costs in the financial statements over the period during which employees are required to provide services. Share-based compensation arrangements include stock options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. In April 2005, the SEC postponed the implementation date to the fiscal year beginning after June 15, 2005. The Company will adopt SFAS No. 123(R) in the first quarter of fiscal 2006. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods. The Company is currently evaluating which method to adopt. The adoption of SFAS No. 123(R) will have a significant adverse impact on the Company’s results of operations, although it will have no impact on its overall financial position. The precise impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) using the modified retrospective application for all prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described under the “Accounting for Stock-Based Compensation” section in Note 1. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized for such excess tax deductions was zero for the six months ended July 3, 2005 and June 27, 2004.

     In December 2004, the FASB issued FASB Staff Position (“FSP”) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to U.S. companies, provided certain criteria are met. FSP No. 109-2 provides accounting and disclosure guidance on the impact of the repatriation provision on a company’s income tax expense and deferred tax liability. The Company is currently studying the impact of the one-time foreign dividend provision and intends to complete the analysis by the end of fiscal 2005. Accordingly, the Company has not adjusted its income tax expense or deferred tax liability to reflect the tax impact of any repatriation of non-U.S. earnings it may make.

     In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF Issue No. 03-01 provides guidance on evaluating and recording impairment losses on debt and equity investments and requires additional disclosures for those investments. In September 2004, the FASB delayed the measurement and recognition provisions of EITF Issue No. 03-01; however, the disclosure requirements remain effective. The Company will evaluate the impact of EITF Issue No. 03-01 once final guidance is issued.

Accounting for Stock-Based Compensation

     The Company has a number of stock-based employee compensation plans and accounts for these plans under the recognition and measurement principles of APB Opinion No. 25 and the related interpretation. In certain instances, the Company reflects stock-based employee compensation cost in net income (loss). If there is any compensation under APB Opinion No. 25, the expense is amortized using an accelerated method prescribed under the rules of FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” The following table illustrates the effect on net income (loss) and related per-share amounts if the Company had applied the fair value recognition provisions of SFAS No. 123 to all stock-based employee awards:

		Three Months Ended								Six Months Ended
		July 3,				June 27,				July 3,				June 27,
(In thousands, except per-share amounts)		2005				2004				2005				2004
Net income (loss), as reported		$	(15,254	)		$	21,980			$	(84,050	)		$	48,460
Add: Total stock-based compensation expense reported in net income (loss), net of related tax effects (see Note 8)			3,613				1,181				5,389				2,413
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects			(18,692	)			(19,921	)			(31,649	)			(39,983	)
Pro forma net income (loss)		$	(30,333	)		$	3,240			$	(110,310	)		$	10,890
Net income (loss) per share:
Basic—as reported		$	(0.12	)		$	0.18			$	(0.64	)		$	0.39
Diluted—as reported			(0.12	)			0.13				(0.64	)			0.30
Basic—pro forma			(0.23	)			0.03				(0.84	)			0.09
Diluted—pro forma			(0.23	)			0.01				(0.84	)			0.07
Shares used in per-share calculation:
Basic—as reported			132,081				123,366				131,293				122,892
Diluted—as reported			132,081				167,467				131,293				169,649
Basic—pro forma			132,081				123,366				131,293				122,892
Diluted—pro forma			132,081				127,320				131,293				130,275

Change in Accounting Estimate

     During the first quarter of fiscal 2005, the Company determined that the useful lives of certain equipment and production assets used in certain of its manufacturing operations were longer than historically estimated. Accordingly, the Company revised the useful lives of the newly acquired equipment from 5 years to 7 years and the production assets from 10 months to 2 years beginning in the first quarter of fiscal 2005. Useful lives for those equipment and production assets acquired prior to the first quarter of fiscal 2005 remained unchanged. The impact of the revised useful lives resulted in a decrease of approximately $0.9 million and $1.4 million in depreciation for the three and six months ended July 3, 2005, respectively.

NOTE 2 — BUSINESS COMBINATION

     The Company completed the acquisition of SMaL Camera Technologies, Inc. (“SMaL”) during the first quarter of fiscal 2005. No acquisition was completed during other periods presented.

SMaL

     On February 14, 2005, the Company completed the acquisition of SMaL, a company specializing in the digital imaging solutions for a variety of business and consumer applications, such as digital still cameras, automotive vision systems and mobile phone cameras. SMaL is part of the Company’s MID segment (see Note 14).

     The fair value of assets acquired and liabilities assumed was recorded in the Company’s consolidated balance sheet as of February 14, 2005, the effective date of the acquisition, and the results of operations of SMaL were included in the Company’s consolidated results of operations subsequent to February 14, 2005. There were no significant differences between the accounting policies of the Company and SMaL.

     The Company acquired 100% of the outstanding capital stock of SMaL in exchange for $42.5 million in cash. In addition, the Company assumed SMaL’s outstanding stock options and, in exchange, issued approximately 319,000 Cypress stock options with a fair value of $3.2 million. The fair value of the Cypress stock options was determined under the Black-Scholes model using the following assumptions: volatility of 75%, expected life of 1 to 3.75 years, and risk-free interest rate of 3.14%.

     Of the total Cypress stock options issued, approximately 166,000 were unvested. In accordance with FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” the intrinsic value of these unvested options, totaling $0.8 million, was excluded from the purchase consideration and accounted for as deferred stock-based compensation, which is being amortized over the remaining vesting periods.

     The following table summarizes the total purchase consideration:

(In thousands)
Cash		$	42,500
Fair value of stock options, net of intrinsic value of unvested portion			2,373
Acquisition costs			443
Total purchase consideration		$	45,316

     The allocation of the purchase consideration was as follows:

(In thousands)
Net tangible assets		$	3,592
Acquired identifiable intangible assets:
Patents			5,200
Purchased technology			1,400
Customer contracts			800
Non-compete agreement			700
Trademarks and order backlog			300
In-process research and development charge			12,300
Goodwill			21,024
Total purchase consideration		$	45,316

     Net tangible assets consisted of the following:

(In thousands)
Cash and cash equivalents		$	2,894
Trade accounts receivable, net			1,210
Inventories			1,398
Property and equipment			294
Other assets			420
Total assets acquired			6,216
Accounts payable			(982	)
Other accrued expenses and liabilities			(1,642	)
Total liabilities assumed			(2,624	)
Total net tangible assets		$	3,592

     In addition to the purchase consideration, the terms of the acquisition include contingent consideration of up to approximately $22.5 million in cash through fiscal 2006. Of this amount, $1.7 million is based on employment and the achievement of certain individual performance milestones and $20.8 million is based on the achievement of certain sales milestones and employment. Such payments will be accounted for as compensation and expensed in the appropriate periods. See Note 7 for the discussion of the status of the contingent consideration.

Acquired Identifiable Intangible Assets:

     The fair value of patents was determined using the royalty savings approach method, which calculated the present value of the royalty savings related to the intangible assets using a royalty rate of 5% and a discount rate of 38%. The fair value of patents is being amortized over 6 years on a straight-line basis.

     The fair value attributed to purchased technology was determined using the income approach method, which was based on a discounted forecast of the estimated net future cash flows to be generated from the technology using discount rates ranging from 25% to 30%. The fair value of purchased technology is being amortized over 4 years on a straight-line basis.

     The fair value attributed to customer contracts was determined using a cost approach method with a discount rate of 28%. The fair value of customer contracts is being amortized over 6 years on a straight-line basis.

     The fair value attributed to non-compete agreements was determined using the income approach method, which was based on a discounted forecast of the estimated net future cash flows associated with the savings resulting from having the agreements in place, using a discount rate of 30%. The fair value of non-compete agreements is being amortized over 2 years on a straight-line basis.

In-Process Research and Development:

     The Company identified in-process research and development projects in areas for which technological feasibility had not been established and no alternative future use existed. These in-process research and development projects include the development of first generation automotive camera, and mobile phone sensor and modules.

     In assessing the projects, the Company considered key characteristics of the technology as well as its future prospects, the rate technology changes in the industry, product life cycles, and various projects’ stage of development. The Company allocated $12.3 million of the purchase price to the in-process research and development projects and wrote off the amount in the first quarter of fiscal 2005.

     The value of in-process research and development was determined using the income approach method, which calculated the sum of the discounted future cash flows attributable to the projects once commercially viable using discount rates ranging from 35% to 45%, which were derived from a weighted-average cost of capital analysis and adjusted to reflect the stage of completion of the projects and the level of risks associated with the projects. The percentage of completion for each project was determined by identifying the research and development expenses invested in the project as a ratio of the total estimated development costs required to bring the project to technical and commercial feasibility. The following table summarizes certain information of each significant project as of the acquisition date:

Stage of

Total Costs Incurred

Total Estimated

Estimated

Projects

Completion

as of Acquisition Date

Costs to Complete

Completion Dates

First generation automotive camera

58

%

$4.2 million

$3.1 million

March 2006

Mobile phone sensor and modules

28

%

2.4 million

6.0 million

March 2006

Goodwill:

     SMaL offers industry-leading digital imaging solutions for a variety of business and consumer applications. The acquisition will significantly accelerate the Company’s entry into the high-volume complimentary metal oxide semiconductor image sensor business, and SMaL’s product line will complement new mobile phone products introduced by FillFactory NV, which the Company acquired in fiscal 2004. The result could position the Company to have the broadest line of image sensors currently available for the mobile phone market. These factors primarily contributed to a purchase price which resulted in goodwill. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized but is tested for impairment at least annually. Goodwill from the SMaL acquisition is not expected to be deductible for tax purposes.

Combined Pro Forma Information

     In addition to the acquisition of SMaL during the first quarter of fiscal 2005, the Company completed the acquisition of FillFactory NV during the third quarter of fiscal 2004 and the buy-out of the minority interests in SunPower during the fourth quarter of fiscal 2004. The following unaudited pro forma financial information presents the combined results of operations of the Company, SMaL and FillFactory NV as if the acquisitions had occurred as of the beginning of the periods presented. The historical results of operations of SunPower have already been consolidated into the Company’s results beginning in fiscal 2003.

		Three Months Ended								Six Months Ended
		July 3,				June 27,				July 3,				June 27,
(In thousands, except per-share amounts)		2005				2004 (2)				2005 (1)				2004 (2)
Revenues		$	220,506			$	273,504			$	421,270			$	536,081
Net income (loss)			(15,254	)			18,775				(88,153	)			41,635
Basic net income (loss) per share			(0.12	)			0.15				(0.67	)			0.34
Diluted net income (loss) per share			(0.12	)			0.12				(0.67	)			0.26

     The unaudited pro forma financial information presented above is not intended to represent or be indicative of the consolidated results of operations or financial condition of the Company that would have actually been reported had the acquisitions been completed as of the beginning of the periods presented, and should not be taken as representative of the future consolidated results of operations or financial condition of the Company.

NOTE 3 — GOODWILL AND PURCHASED INTANGIBLE ASSETS

Goodwill

     During the first quarter of fiscal 2005, the Company changed its internal organization and identified five new reportable business segments (see Note 14). The following table presents the changes in the carrying amount of goodwill under the reportable business segments:

(In thousands)		CCD				DCD				MID				SunPower				Other				Total
Balance at January 2, 2005		$	128,357			$	187,877			$	63,167			$	2,883			$	—			$	382,284
Goodwill acquired			—				—				21,024				—				—				21,024
Balance at July 3, 2005		$	128,357			$	187,877			$	84,191			$	2,883			$	—			$	403,308

     Goodwill of $21.0 million acquired during the first half of fiscal 2005 was related to SMaL (see Note 2).

Purchased Intangible Assets

     During the first quarter of fiscal 2005, the Company acquired SMaL (see Note 2). The acquisition resulted in a $1.4 million increase in gross value of purchased technology, a $0.7 million increase in gross value of non-compete agreement and a $6.3 million increase in gross value of patents, customer contracts, licenses and trademarks. The following table presents details of the Company’s total purchased intangible assets:

As of July 3, 2005:

						Accumulated
(In thousands)		Gross				Amortization				Net
Purchased technology		$	223,256			$	(189,914	)		$	33,342
Non-compete agreements			19,415				(18,830	)			585
Patents, customer contracts, licenses and trademarks			33,617				(10,851	)			22,766
Other			5,062				(4,150	)			912
Total purchased intangible assets		$	281,350			$	(223,745	)		$	57,605

As of January 2, 2005:

						Accumulated
(In thousands)		Gross				Amortization				Net
Purchased technology		$	221,856			$	(178,748	)		$	43,108
Non-compete agreements			18,715				(18,596	)			119
Patents, customer contracts, licenses and trademarks			27,318				(7,156	)			20,162
Other			5,062				(3,732	)			1,330
Total purchased intangible assets		$	272,951			$	(208,232	)		$	64,719

     Amortization expense for the three and six months ended July 3, 2005 was $7.1 million and $15.5 million, respectively. Amortization expense for the three and six months ended June 27, 2004 was $9.6 million and $19.8 million, respectively.

     The estimated future amortization expense of purchased intangible assets as of July 3, 2005 was as follows:

(In thousands)
2005 (remaining six months)		$	12,126
2006			15,346
2007			12,262
2008			9,172
2009			5,742
Thereafter			2,957
Total amortization expense		$	57,605

NOTE 4 — RESTRUCTURING

Overview

     The semiconductor industry has historically been characterized by wide fluctuations in demand for, and supply of, semiconductors. In some cases, industry downturns have lasted more than a year. Prior experience has shown that restructuring of operations, resulting in significant restructuring charges, may become necessary if an industry downturn persists. In addition, events and circumstances specific to the Company may result in restructuring charges.

     As of July 3, 2005, the Company had one active restructuring plan initiated in the first quarter of fiscal 2005 (“Fiscal 2005 Restructuring Plan”). In addition, the Company has two other restructuring plans — one initiated in the fourth quarter of fiscal 2002 (“Fiscal 2002 Restructuring Plan”) and one initiated in the third quarter of fiscal 2001 (“Fiscal 2001 Restructuring Plan”). Both the Fiscal 2002 Restructuring Plan and the Fiscal 2001 Restructuring Plan have been substantially completed with reserves remaining for lease payments for restructured facilities.

Fiscal 2005 Restructuring Plan

     During the first quarter of fiscal 2005, management implemented the Fiscal 2005 Restructuring Plan aimed to reorganize its internal structure and reduce operating costs as the Company continued to experience softness in demand in the semiconductor industry. The Fiscal 2005 Restructuring Plan primarily includes the following initiatives:

	•		An internal organizational change which consolidated four product divisions into three and reorganized the sales and marketing function to support the product divisions;
	•		Exiting certain building leases as a result of the internal reorganization;
	•		A reduction in workforce as a result of both the internal reorganization and the Company’s plan to reduce the number of layers of management within the organization;
	•		Removal and disposal of excess equipment from operations as a result of the internal reorganization; and
	•		Removal and disposal of equipment related to Silicon Magnetic Systems (“SMS”), a subsidiary of Cypress, as a result of management’s decision to cease operations of SMS.

     The Company recorded total restructuring charges of $22.7 million in the first quarter of fiscal 2005, consisting of $8.8 million related to the write-down of restructured property and equipment and $13.9 million related to other items as summarized in the table below. During the second quarter of fiscal 2005, the Company recorded additional provisions of $5.0 million, consisting of $0.1 million related to the write-down of restructured property and equipment and $4.9 million related to other items as summarized in the table below.

						Leased
(In thousands)		Disposal Costs				Facilities				Personnel				Other				Total
Provision		$	1,180			$	893			$	11,805			$	—			$	13,878
Non-cash charges			—				—				(3,739	)			—				(3,739	)
Cash payments			—				—				(6,415	)			—				(6,415	)
Balance at April 3, 2005			1,180				893				1,651				—				3,724
Provision			—				282				3,866				730				4,878
Non-cash charges			—				—				(3,432	)			—				(3,432	)
Cash payments			—				(199	)			(667	)			—				(866	)
Balance at July 3, 2005		$	1,180			$	976			$	1,418			$	730			$	4,304

Property and Equipment:

     The restructuring charge of $8.8 million in the first quarter of fiscal 2005 consisted of:

	1.		$5.2 million related to the write-down of excess property and equipment as a result of the internal reorganization; and
	2.		$3.6 million related to the write-down of equipment due to the termination of the SMS operations (see “Termination of SMS Operations” below).

     During the first quarter of fiscal 2005, the Company recorded charges of $5.2 million related to the write-down of property and equipment that were removed from operations, resulting in a new cost basis of $1.3 million. In addition, the Company recorded disposal costs of $0.4 million. These assets consisted primarily of manufacturing and test equipment located in the Company’s manufacturing facility in Minnesota, as well as manufacturing and test equipment and prototype tools previously used in operations by Silicon Light Machines and SunPower, two subsidiaries of Cypress. As management has committed to plans to dispose of the assets by sale, the Company classified the assets as held for sale and recorded the assets at the lower of their carrying amount or fair value less costs to sell. Fair value was determined by market prices estimated by a third party that specializes in sales of used equipment. The assets were originally purchased based on internal forecast of growth in demand that subsequently did not materialize. Prior to the Company’s restructuring announcement, the Company did not determine the assets were impaired as assets to be held and used, as there was no indication of impairment. The Company used a contra account to record the adjustment to reflect the assets held for sale at their new cost basis. The contra account was included within property and equipment in the Condensed Consolidated Balance Sheets, thereby adjusting the assets held for sale to fair value less costs to sell, and not as a liability within the restructuring reserves. The Company expects to complete the disposal of the restructured assets by the end of fiscal 2005.

     During the second quarter of fiscal 2005, the Company closed a design center in Europe and recorded a charge of $0.1 million related to the write-down of miscellaneous property and equipment that were removed from operations.

Termination of SMS Operations:

     During the first quarter of fiscal 2005, management approved a plan to cease operations of SMS, a subsidiary specializing in magnetic random access memories. SMS generated no revenues historically and as of the end of fiscal 2004, total assets, which primarily consisted of property and equipment, were less than 1% of the Company’s consolidated total assets.

     As a result of management’s decision to cease operations, the Company had committed to a plan to dispose of the assets by sale during the first quarter of fiscal 2005 and recorded charges of $3.6 million related to the write-down of the assets, resulting in a new cost basis of $3.2 million. In addition, the Company recorded disposal costs of $0.8 million. These assets consisted primarily of manufacturing and test equipment. The Company classified the assets as held for sale and recorded the assets at the lower of their carrying amount or fair value less costs to sell. Fair value was determined by market prices estimated by a third party that specializes in sales of used equipment. Prior to the Company’s restructuring announcement, the Company did not determine the assets were impaired as assets to be held and used, as there was no indication of impairment. The Company expects to complete the disposal of the restructured assets by the end of fiscal 2005.

     In addition, SMS had 29 employees, which were less than 1% of the Company’s total headcount. The Company re-assigned twenty employees to other functions within the organization and terminated nine employees.

Leased Facilities:

     During the first quarter of fiscal 2005, the Company recorded charges totaling $0.9 million for exiting leases related to a design center and a sales office in the United States. During the second quarter of fiscal 2005, the Company closed one additional design center in Europe as a result of the Fiscal 2005 Restructuring Plan and recorded additional charges of $0.3 million related to the lease and certain closing costs. The Company estimated the costs of exiting leases based on the contractual terms of the agreements, the current real estate market condition and the assumptions of sublease rental income, if applicable. Amounts related to the lease expense will be paid over the respective lease terms through fiscal 2007.

Personnel:

     During the first quarter of fiscal 2005, the Company incurred charges of $11.8 million consisting of: (1) severance and benefits of $8.1 million associated with the reduction of the global workforce, and (2) a non-cash compensation charge of $3.7 million associated with the modification of stock option agreements for certain terminated employees. During the second quarter of fiscal 2005, the Company recorded an additional provision of $3.9 million consisting of: (1) severance and benefits of $0.9 million as the Company

identified and terminated additional employees, and (2) a non-cash compensation charge of $3.0 million associated with the modification of stock option agreements for certain terminated employees.

     The Company identified and terminated 219 employees in the first quarter of fiscal 2005 and 35 employees in the second quarter of fiscal 2005. In total, the reduction in workforce included 254 employees, of which 78 employees were engaged in manufacturing, 120 employees in research and development, and 56 employees in selling general and administrative functions. Geographically, the reduction in workforce included 209 employees located in the U.S., 22 employees in the Philippines, and 23 in other countries. Of the 254 terminated employees, 248 employees have left the Company as of July 3, 2005. The Company expects the majority of the payments related to severance and benefits to be completed by the end of fiscal 2005.

     The Company may identify and terminate additional employees in future periods as it continues to evaluate its organizational structure under the Fiscal 2005 Restructuring Plan.

Other:

     As part of the reorganization of the worldwide sales force under the Fiscal 2005 Restructuring Plan, the Company recorded a charge of $0.7 million associated with the termination of a contract with a sales representative in Europe during the second quarter of fiscal 2005. The termination fee is expected to be paid by the end of fiscal 2005.

Fiscal 2002 Restructuring Plan and Fiscal 2001 Restructuring Plan

     As of December 28, 2003, the Fiscal 2002 Restructuring Plan and the Fiscal 2001 Restructuring Plan had been completed with accruals remaining only for restructured leased facilities and employee benefit payments. As of July 3, 2005, accruals remained only for leased facilities, which will decrease over time as the Company continues to make lease payments. See the 2004 Annual Report on Form 10-K for a detailed discussion of the Fiscal 2002 Restructuring Plan and the Fiscal 2001 Restructuring Plan.

     The following table summarizes the remaining restructuring accruals related to the Fiscal 2002 Restructuring Plan and the Fiscal 2001 Restructuring Plan:

		Fiscal 2002								Fiscal 2001
		Restructuring								Restructuring
		Plan								Plan
		Leased								Leased
(In thousands)		Facilities				Personnel				Facilities				Total
Balance at December 28, 2003		$	1,128			$	554			$	2,746			$	4,428
Benefit			(56	)			—				—				(56	)
Cash payments			(68	)			(299	)			(328	)			(695	)
Balance at March 28, 2004			1,004				255				2,418				3,677
Cash payments			(87	)			(52	)			(366	)			(505	)
Balance at June 27, 2004			917				203				2,052				3,172
Benefit			—				(203	)			—				(203	)
Cash payments			(129	)			—				(464	)			(593	)
Balance at September 26, 2004			788				—				1,588				2,376
Provision			353				—				—				353
Non-cash charges			22				—				—				22
Cash payments			(73	)			—				(174	)			(247	)
Balance at January 2, 2005			1,090				—				1,414				2,504
Cash payments			(94	)			—				(589	)			(683	)
Balance at April 3, 2005			996				—				825				1,821
Cash payments			(139	)			—				(481	)			(620	)
Balance at July 3, 2005		$	857			$	—			$	344			$	1,201

Reconciliation

     The following table reconciles the restructuring charges (credits) recognized in the Condensed Consolidated Statements of Operations:

		Three Months Ended								Six Months Ended
		July 3,				June 27,				July 3,				June 27,
(In thousands)		2005				2004				2005				2004
Fiscal 2005 Restructuring Plan:
Amounts included in the rollforward table:
Provision		$	4,878			$	—			$	18,756			$	—
Amounts not included in the rollforward table:
Property and equipment			108				—				8,939				—
Fiscal 2002 Restructuring Plan:
Amounts included in the rollforward table:
Benefit			—				—				—				(56	)
Amounts not included in the rollforward table:
Disposal costs			—				—				—				(25	)
Total restructuring charges (credits)		$	4,986			$	—			$	27,695			$	(81	)

NOTE 5 — BALANCE SHEET COMPONENTS

Accounts Receivable, Net

		As of
		July 3,				January 2,
(In thousands)		2005				2005
Accounts receivable, gross		$	131,591			$	110,883
Allowance for doubtful accounts and customer returns			(3,439	)			(3,595	)
Total accounts receivable, net		$	128,152			$	107,288

Inventories

		As of
		July 3,				January 2,
(In thousands)		2005				2005
Raw materials		$	11,119			$	8,048
Work-in-process			50,559				63,888
Finished goods			21,458				27,773
Total inventories		$	83,136			$	99,709

Other Current Assets

		As of
		July 3,				January 2,
(In thousands)		2005				2005
Employee stock purchase assistance plan, net		$	46,466			$	45,639
Deferred tax assets			29,408				29,702
Prepaid expenses			19,770				18,410
Other			12,403				18,235
Total other current assets		$	108,047			$	111,986

Other Assets

		As of
		July 3,				January 2,
(In thousands)		2005				2005
Restricted cash		$	63,225			$	62,743
Key employee deferred compensation plan			21,580				22,000
Other			41,519				32,717
Total other assets		$	126,324			$	117,460

Other Current Liabilities

		As of
		July 3,				January 2,
(In thousands)		2005				2005
Customer advances		$	6,309			$	6,151
Accrued interest payable			393				462
Sales representative commissions			3,141				4,210
Accrued royalties			1,337				2,618
Current portion of long-term debt			6,446				7,234
Key employee deferred compensation plan			25,565				25,547
Other			20,255				29,073
Total other current liabilities		$	63,446			$	75,295

Deferred Income Taxes and Other Tax Liabilities

		As of
		July 3,				January 2,
(In thousands)		2005				2005
Deferred income taxes		$	38,327			$	33,514
Non-current tax liabilities			34,963				34,963
Total deferred income taxes and other tax liabilities		$	73,290			$	68,477

NOTE 6 — FINANCIAL INSTRUMENTS

     Available-for-sale securities were as follows:

						Gross Unrealized				Gross Unrealized
As of July 3, 2005:		Cost				Gains				Losses				Fair Market Value
(In thousands)
Cash equivalents:
Corporate notes / bonds		$	22,628			$	—			$	—			$	22,628
Money market funds			33,454				—				—				33,454
Total cash equivalents		$	56,082			$	—			$	—			$	56,082
Short-term investments:
Federal agency notes		$	45,318			$	8			$	(343	)		$	44,983
Corporate notes / bonds			68,717				—				(725	)			67,992
Certificate of deposits			50				—				—				50
Total short-term investments		$	114,085			$	8			$	(1,068	)		$	113,025
Long-term equity investment (1)		$	2,360			$	134			$	—			$	2,494
Total available-for-sale securities		$	172,527			$	142			$	(1,068	)		$	171,601

						Gross Unrealized				Gross Unrealized
As of January 2, 2005:		Cost				Gains				Losses				Fair Market Value
(In thousands)
Cash equivalents:
Federal agency notes		$	4,121			$	1			$	(17	)		$	4,105
Money market funds			44,673				—				—				44,673
Certificate of deposits			7,048				—				—				7,048
Corporate notes / bonds			2,503				—				—				2,503
Total cash equivalents		$	58,345			$	1			$	(17	)		$	58,329
Short-term investments:
Federal agency notes		$	68,286			$	19			$	(411	)		$	67,894
Corporate notes / bonds			104,695				20				(839	)			103,876
Auction rate securities			6,508				—				—				6,508
Total short-term investments		$	179,489			$	39			$	(1,250	)		$	178,278
Total available-for-sale securities		$	237,834			$	40			$	(1,267	)		$	236,607

     The Company classifies all available-for-sale securities that are intended to be available for use in current operations as either cash equivalents or short-term investments.

     During the fourth quarter of fiscal 2004, the Company reclassified all auction rate securities from cash equivalents to short-term investments. The reclassification had no impact on the Condensed Consolidated Statements of Operations for the three and six months ended June 27, 2004. The impact on the Condensed Consolidated Statements of Cash Flows was an increase of $0.9 million in cash used for investing activities for the six months ended June 27, 2004.

     As of July 3, 2005, contractual maturities of the Company’s short-term debt investments were as follows:

						Estimated
(In thousands)		Cost				Fair Value
Maturing in less than 1 year		$	79,992			$	79,468
Maturing in 2 to 3 years			34,093				33,557
Total		$	114,085			$	113,025

     Realized losses were $0.1 million and $0.3 million for the three and six months ended July 3, 2005, respectively, and zero for the three and six months ended June 27, 2004.

     Proceeds from sales and maturities of available-for-sale investments were $114.0 million and $42.0 million for the six months ended July 3, 2005 and June 27, 2004, respectively.

Fair Value of Debt Instruments

     The estimated fair values of the Company’s debt instruments have generally been determined using available market information. However, considerable judgment is required in interpreting market data to develop the estimates of fair values. Accordingly, the estimates presented are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair value amounts.

     The carrying amounts and estimated fair values are as follows:

		As of
		July 3, 2005								January 2, 2005
		Carrying				Estimated				Carrying				Estimated
(In thousands)		Amount				Fair Value				Amount				Fair Value
Convertible subordinated notes		$	599,997			$	642,777			$	599,998			$	626,626
Collateralized debt instruments			9,772				9,772				13,924				13,924
Total		$	609,769			$	652,549			$	613,922			$	640,550

     The Company’s liabilities for all periods presented are the amounts shown as carrying values, not the estimated fair values.

NOTE 7 — COMMITMENTS AND CONTINGENCIES

Guarantees and Product Warranties

     The Company applies the disclosure provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others,” to its agreements that contain guarantee or indemnification clauses. These disclosure provisions expand those required by SFAS No. 5, “Accounting for Contingencies,” by requiring that guarantors disclose certain types of guarantees, even if the likelihood of requiring the guarantor’s performance is remote. As of July 3, 2005, Cypress has accrued its estimate of liability incurred under these indemnification arrangements and guarantees, as applicable. The Company maintains self-insurance for certain liabilities of its officers and directors.

Indemnification Obligations:

     The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts entered into by the Company, under which the Company customarily agrees to hold the other party harmless against losses arising from a breach of representations and covenants related to such matters as title to assets sold, certain intellectual property rights, specified environmental matters and certain income

taxes. In these circumstances, payment by the Company is customarily conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by it under these agreements.

     It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements did not have a material effect on its business, financial condition or results of operations. The Company believes that if it were to incur a loss in any of these matters, such loss would not have a material effect on its business, financial condition, cash flows or results of operations.

Product Warranties:

     The Company estimates its warranty costs based on historical warranty claim experience and applies this estimate to the revenue stream for products under warranty. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The warranty accrual is reviewed quarterly to verify that it properly reflects the remaining obligations based on the anticipated expenditures over the balance of the obligation period. Adjustments are made when actual warranty claim experience differs from estimates.

     The following table presents the changes in the Company’s warranty reserve activities:

		Three Months Ended								Six Months Ended
		July 3,				June 27,				July 3,				June 27,
(In thousands)		2005				2004				2005				2004
Beginning balance		$	3,181			$	2,732			$	2,717			$	2,364
Settlements made			(918	)			(2,438	)			(3,059	)			(4,774	)
Provisions made			657				2,971				3,262				5,675
Ending balance		$	2,920			$	3,265			$	2,920			$	3,265

Acquisition-Related Contingent Compensation

     The Company recorded acquisition-related contingent compensation charges of $1.2 million and $2.2 million for the three and six months ended July 3, 2005, respectively, and $1.7 million and $3.2 million for the three and six months ended June 27, 2004, respectively. Substantially all acquisition-related contingent compensation charges were recorded as research and development expenses. The status of the acquisition-related contingent compensation is as follows:

SMaL:

     The terms of the acquisition include contingent consideration of up to approximately $22.5 million in cash through fiscal 2006. Of this amount, $1.7 million is based on employment and the achievement of certain individual performance milestones and $20.8 million is based on the achievement of certain sales milestones and employment. When the contingency is based on milestone achievements and employment conditions, no charge is recognized until it is probable that the milestone conditions will be reached at which point any contingent consideration will be recognized over the employment-vesting period. Such payments will be accounted for as compensation and expensed in the appropriate periods. The Company recorded no expense in the first quarter of fiscal 2005 and a charge of $0.3 million in the second quarter of fiscal 2005 related to the achievement of individual performance milestones and employment.

Cascade Semiconductor Corporation:

     The terms of the acquisition include contingent consideration of approximately $9.4 million payable to employees based on either revenue milestone achievement and employment conditions, or employment conditions alone, through January 2007. When the contingency is based on milestone achievements and employment conditions, no charge is recognized until it is probable that the milestone conditions will be reached at which point any contingent consideration will be recognized over the employment-vesting period. Employment-only contingent consideration is recognized over the employment-vesting period.

     To date, the Company recorded total charges of $6.3 million related to the contingent consideration, of which $0.7 million and $1.5 million were recorded in the second quarter and first six months of fiscal 2005, respectively, and $4.8 million was recorded in fiscal 2004. The $6.3 million charges consisted of the following: (1) 155,000 shares of the Company’s common stock valued at $1.6

million were issued in the fourth quarter of fiscal 2004, (2) 145,000 shares of the Company’s common stock valued at $1.6 million were issued in the first quarter of fiscal 2005, and (3) an accrual of $3.1 million to be paid in cash or shares at the Company’s option as of July 3, 2005.

Sahasra Networks:

     The terms of the acquisition include provisions for contingent cash payments to employees and third parties of up to $2.3 million through December 2005 based on the amount of revenues generated by certain products in future periods. Cash payments to third parties based solely on product revenues will be recorded as an increase in the purchase price, if paid. Cash payments to employees for achievement of revenue targets require that individuals remain employed by the Company and are accounted for as compensation for services and expensed in the appropriate periods. To date, no payments have been recorded as achievements of product revenue targets have not been met.

     In addition, the agreement includes provisions for the contingent issuance to employees of up to 259,000 shares of the Company’s common stock based on the achievement of certain product development milestones. Issuance of shares to employees upon successful completion of product milestones requires that individuals remained employed by the Company and are accounted for as compensation for services and expensed in the appropriate periods.

     To date, the Company recorded total charges of $3.1 million related to the contingent consideration, of which $0.2 million and $0.4 million were recorded in the second quarter and first six months of fiscal 2005, respectively, $0.2 million was recorded in fiscal 2004, and $2.5 million was recorded prior to fiscal 2004. The $3.1 million charges consisted of the following: (1) 42,000 shares of the Company’s common stock valued at $0.7 million were issued in the fourth quarter of fiscal 2004; (2) 39,000 shares of the Company’s common stock valued at $0.8 million were issued in the first quarter of fiscal 2005; (3) 41,000 shares of the Company’s common stock valued at $0.9 million were issued in the second quarter of fiscal 2005; and (4) an accrual of $0.7 million for future issuance of shares as of July 3, 2005.

Synthetic Lease

     On June 27, 2003, the Company entered into an operating lease agreement, commonly known as a synthetic lease, for manufacturing and office facilities located in Minnesota and California. A synthetic lease obligation of $62.7 million with restricted cash collateral was established as of the second quarter of fiscal 2003. The synthetic lease requires the Company to purchase the properties or to arrange for the properties to be acquired by a third party at lease expiration, which is June 2008. In addition, the Company may extend the lease if the lessor allows. If the Company had exercised its right to purchase all the properties subject to the new synthetic lease at July 3, 2005, the Company would have been required to make a payment and record assets totaling $62.7 million (the “Termination Value”). If the Company exercised its option to sell the properties to a third party, the proceeds from such a sale could be less than the properties’ Termination Value, and the Company would be required to pay the difference up to the guaranteed residual value of $54.5 million (the “Guaranteed Residual Value”).

     In accordance with FASB Interpretation No. 45, the Company determined that the fair value associated with the Guaranteed Residual Value embedded in the synthetic operating lease was $2.0 million, which was recorded in other assets and other long-term liabilities in the Condensed Consolidated Balance Sheets.

     The Company is required to evaluate periodically the expected fair value of the properties at the end of the lease term. In the event the Company determines that it is estimable and probable that the expected fair value of the properties at the end of the lease term will be less than the Termination Value, the Company will ratably accrue the loss over the remaining lease term. During fiscal 2004, the Company performed the analysis and accrued a loss contingency of approximately $1.8 million in other long-term liabilities in the Condensed Consolidated Balance Sheets relating to the potential decline in the fair value of the facilities in California. The loss contingency was determined by management with the assistance of a market analysis performed by an independent appraisal firm. During the second quarter and first half of fiscal 2005, the Company accrued an additional $0.3 million and $0.6 million, respectively, related to the loss contingency. As of July 3, 2005, the accrued loss contingency totaled $2.4 million.

     The Company is required to maintain restricted cash or investments to serve as collateral for this lease. As of July 3, 2005, the balance of restricted cash and accrued interest was $63.2 million and was classified in other assets in the Condensed Consolidated Balance Sheets.

     During the first quarter of fiscal 2005, the Company amended its synthetic lease agreement, whereby amounts due under the Company’s convertible subordinated notes are excluded from certain financial covenant calculations under the amended agreement. As of July 3, 2005, the Company was in compliance with the financial covenants.

Litigation and Asserted Claims

     In January 1998, an attorney representing the estate of Mr. Jerome Lemelson contacted the Company and charged that the Company infringed certain patents owned by Mr. Lemelson and/or a partnership controlled by Mr. Lemelson’s estate. On February 26, 1999, the Lemelson Partnership sued the Company and 87 other companies in the United States District Court for the District of Arizona for infringement of 16 patents. In May 2000, the Court stayed litigation on 14 of the 16 patents in view of concurrent litigation in the United States District Court, District of Nevada, on the same 14 patents. On January 23, 2004, the Nevada Court held in favor of plaintiffs, that all asserted claims of the 14 patents are unenforceable, invalid, and not infringed. The Nevada ruling is now being appealed, and the 14 patents remain stayed as to the Company during the appeal. In October 2001, the Lemelson Partnership amended its Arizona complaint to add allegations that two more patents were infringed. Therefore, there are currently four patents that are not stayed in this litigation. The case is in the “claim construction” (i.e., patent claim interpretation) phase on the four non-stayed patents. The claim construction hearing concluded on December 10, 2004, and the Company is awaiting the Judge’s order. The Company has reviewed and investigated the allegations in both Lemelson’s original and amended complaints. The Company believes that it has meritorious defenses to these allegations and will vigorously defend itself in this matter. However, because of the nature and inherent uncertainties of litigation, should the outcome of this action be unfavorable, the Company’s business, financial condition, results of operations or cash flows could be materially and adversely affected.

     The Company is currently a party to various other legal proceedings, claims, disputes and litigation arising in the ordinary course of business, including those noted above. The Company currently believes that the ultimate outcome of these proceedings, individually and in the aggregate, will not have a material adverse effect on its financial position, results of operation or cash flows. However, because of the nature and inherent uncertainties of litigation, should the outcome of these actions be unfavorable, the Company’s business, financial condition, results of operations or cash flows could be materially and adversely affected.

NOTE 8 — DEBT AND EQUITY TRANSACTIONS

Line of Credit

     In September 2003, the Company entered into a $50.0 million, 24-month revolving line of credit with a major financial institution. In December 2004, this line of credit was extended to December 2006 and the total amount was increased to $70.0 million. As of July 3, 2005 and January 2, 2005, the outstanding balance related to the line of credit was zero and $4.0 million, respectively. In addition, as of July 3, 2005 and January 2, 2005, $0.3 million and $0.4 million were outstanding, respectively, related to a standby letter of credit. Loans made under the line of credit bear interest based upon the Wall Street Journal Prime Rate or LIBOR plus a spread at the Company’s election. The line of credit agreement includes a variety of covenants including restrictions on the incurrence of indebtedness, incurrence of loans, the payment of dividends or distribution on its capital stock, and transfers of assets and financial covenants with respect to tangible net worth and a quick ratio. As of July 3, 2005, the Company was in compliance with all of the financial covenants. The Company’s obligations under the line of credit are guaranteed and collateralized by the common stock of certain of the Company’s subsidiaries. The Company intends to use the line of credit on an as-needed basis to fund working capital and capital expenditures.

Option Contracts

     As of July 3, 2005, the Company had outstanding a series of equity options on its common stock with an initial cost of $26.0 million that were originally entered into in fiscal 2001. These options were included in stockholders’ equity in the Condensed Consolidated Balance Sheets. The contracts require physical settlement and will expire on August 18, 2005. Upon expiration of the options, if the Company’s stock price is above the threshold price of $21 per share, the Company will receive a settlement value totaling $30.3 million in cash. If the Company’s stock price is below the threshold price of $21 per share, the Company will receive 1.4 million shares of its common stock. Alternatively, the contracts may be renewed and extended.

     The Company received total premiums of zero and $1.8 million during the three and six months ended June 27, 2004, respectively, upon extensions of the contracts. The Company received no premiums for the three and six months ended July 3, 2005. The premiums were recorded in additional paid-in capital in the Condensed Consolidated Balance Sheets.

Stock-Based Compensation

     Stock-based compensation expense generally includes the amortization of deferred stock-based compensation related to the Company’s acquisitions. Deferred stock-based compensation is amortized on an accelerated basis over the vesting periods of the individual stock options or restricted stock, generally a period of four to five years, in accordance with FASB Interpretation No. 28.

     The following table summarizes the stock-based compensation expense recorded in the Condensed Consolidated Statements of Operations:

		Three Months Ended								Six Months Ended
		July 3,				June 27,				July 3,				June 27,
(In thousands)		2005				2004				2005				2004
Cost of revenues		$	6			$	—			$	6			$	—
Research and development (1)			489				1,176				(1,415	)			2,408
Selling, general and administrative			75				5				75				5
Restructuring (2)			3,043				—				6,723				—
Total stock-based compensation expense		$	3,613			$	1,181			$	5,389			$	2,413

NOTE 9 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) AND COMPREHENSIVE INCOME (LOSS)

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

		As of
		July 3,				January 2,
(In thousands)		2005				2005
Accumulated net unrealized losses on available-for-sale investments		$	(556	)		$	(736	)
Accumulated net unrealized gains (losses) on derivatives			1,054				(1,388	)
Total accumulated other comprehensive income (loss)		$	498			$	(2,124	)

     The components of comprehensive income (loss), net of tax, were as follows:

		Three Months Ended								Six Months Ended
		July 3,				June 27,				July 3,				June 27,
(In thousands)		2005				2004				2005				2004
Net income (loss)		$	(15,254	)		$	21,980			$	(84,050	)		$	48,460
Net unrealized gains (losses) on available-for-sale investments			347				(1,306	)			180				(928	)
Net unrealized gains (losses) on derivatives			1,226				(273	)			2,442				(273	)
Total comprehensive income (loss)		$	(13,681	)		$	20,401			$	(81,428	)		$	47,259

NOTE 10 — FOREIGN CURRENCY DERIVATIVES

     The Company operates and sells products in various global markets and purchases capital equipment using foreign currencies. Additionally, the Company is exposed to risks associated with changes in foreign currency exchange rates. The Company may use various hedge instruments from time to time to manage the exposures associated with forecasted purchases of equipment, net asset or liability positions of its subsidiaries and forecasted revenues and expenses. The Company does not enter into foreign currency derivative financial instruments for speculative or trading purposes.

     As of July 3, 2005, the Company’s hedge instruments consisted entirely of forward contracts. The Company calculates the fair value of its forward contracts based on forward rates from published sources.

     Under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” the Company accounts for its hedges of forecasted foreign currency revenues as cash flow hedges, such that changes in fair value of the effective portion of hedge contracts

are recorded in accumulated other comprehensive income (loss) in stockholders’ equity in the Condensed Consolidated Balance Sheets. Amounts deferred in accumulated other comprehensive income (loss) are reclassified into the Condensed Consolidated Statements of Operations in the periods in which the related revenue is recognized. The effective portion of unrealized gains (losses) recorded in accumulated other comprehensive income (loss), net of tax, was $1.1 million and $(1.4) million as of July 3, 2005 and January 2, 2005, respectively. Cash flow hedges are tested for effectiveness each period on a spot to spot basis using the dollar-offset method and both the excluded time value and any ineffectiveness are recorded in other income and (expense), net. The changes in excluded time value were immaterial for the three and six months ended July 3, 2005 and zero for the three and six months ended June 27, 2004. No ineffectiveness was recorded for any periods presented. As of July 3, 2005 and January 2, 2005, the Company had outstanding cash flow hedge forward contracts with an aggregate notional value of $20.6 million and $34.0 million, respectively, related to forecasted Euro revenue transactions. The maturity dates of the outstanding contracts range from September 2005 to February 2006.

     The Company records its hedges of foreign currency denominated monetary assets and liabilities at fair value with the related gains or losses recorded in other income and (expense), net. The gains or losses on these contracts are substantially offset by transaction gains or losses on the underlying balances being hedged. As of July 3, 2005 and January 2, 2005, the Company held forward contracts with an aggregate notional value of $7.7 million and $0.7 million, respectively, to hedge the risks associated with Euro foreign currency denominated assets and liabilities. Aggregate net foreign exchange losses were $0.2 million and $0.6 million for the three and six months ended July 3, 2005, respectively, and immaterial for the three and six months ended June 27, 2004.

NOTE 11 — BENEFIT FROM (PROVISION FOR) INCOME TAXES

     The Company’s effective rate of income tax benefit was 3.3% and 0.2% for the three and six months ended July 3, 2005, respectively. The Company’s effective rate of income tax expense was 6.5% and 6.5% for the three and six months ended June 27, 2004, respectively. The tax benefit for the second quarter and first half of fiscal 2005 was attributable to income earned in certain countries that is not offset by current year net operating losses in other countries, offset by the amortization of deferred tax liabilities in conjunction with the acquisition of FillFactory NV. The tax provision for the second quarter and first half of fiscal 2004 was attributable to income earned in certain countries that is not offset by current year net operating losses in other countries.

     The future tax benefit of certain losses is not currently recognized due to management’s assessment of the likelihood of realization of these benefits. The Company’s effective tax rate may vary from the U.S. statutory rate primarily due to utilization of future benefits, earnings of foreign subsidiaries taxed at different rates, tax credits, amortization of deferred tax liabilities associated with acquisitions and other business factors.

NOTE 12 — 2001 EMPLOYEE STOCK PURCHASE ASSISTANCE PLAN

     On May 3, 2001, the Company’s stockholders approved the adoption of the 2001 employee stock purchase assistance plan (“SPAP”). The SPAP became effective on May 3, 2001 and will terminate on the earlier of May 3, 2011, or such time as determined by the Board of Directors. The SPAP allowed for loans to employees to purchase shares of the Company’s common stock on the open market. Employees of the Company and its subsidiaries, including executive officers but excluding the chief executive officer and the Board of Directors, were allowed to participate in the SPAP. The loans were granted to executive officers prior to Section 402 of the Sarbanes-Oxley Act of 2002, effective July 30, 2002, which prohibits loans to executive officers of public corporations. Loans to executive officers represented approximately 4.3% of the total original loans granted. Each loan was evidenced by a full recourse promissory note executed by the employee in favor of the Company and was secured by a pledge of the shares of the Company’s common stock purchased with the proceeds of the loan. If a participant sells the shares of the Company’s common stock purchased with the proceeds from the loan, the proceeds of the sale must first be used to repay the interest and then the principal on the loan before being received by the participant. The loans are callable and currently bear interest at a minimum rate of 4.0% per annum compounded annually, except for loans to executive officers, whose loans bear interest at the rate of 5.0% per annum, compounded annually.

     As the loans are at interest rates below the estimated market rate, the Company recorded compensation expense to reflect the difference between the rate charged and an estimated market rate for each loan outstanding. Compensation expense was $0.4 million and $1.0 million for the three and six months ended July 3, 2005, respectively, and $0.5 million and $1.0 million for the three and six months ended June 27, 2004, respectively. In addition, the Company records interest income on the outstanding loan balances. Accrued interest outstanding totaled $8.0 million and $7.0 million as of July 3, 2005 and January 2, 2005, respectively. Outstanding loans (including accrued interest) under the SPAP, net of allowance for uncollectible accounts, were $46.5 million and $45.6 million

as of July 3, 2005 and January 2, 2005, respectively. This balance is classified as a current asset in the Condensed Consolidated Balance Sheets.

     The Company has established an allowance for uncollectible accounts representing an amount for estimated uncollectible balances, with changes in the allowance for uncollectible accounts recognized in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations. In determining the allowance for uncollectible accounts, management considered various factors, including a review of borrower demographics (including geographic location and job grade), loan quality and an independent fair value analysis of the loans and the underlying collateral. To date, there have been immaterial write-offs. The allowance for uncollectible accounts was $8.5 million and $8.5 million as of July 3, 2005 and January 2, 2005, respectively.

     In the first quarter of fiscal 2004, the Company instituted a program directed at minimizing losses resulting from these employee loans. Under this program, employees other than executive officers were required to execute either a sell limit order or a stop loss order on the collateral common stock that will be triggered once the common stock price exceeds the employee’s break-even point. Executive officers were precluded from participating in the stop loss program as a result of Section 402 of the Sarbanes-Oxley Act of 2002, which prohibits material modifications to any term of a loan to an executive officer. If the common stock price declines to the stop loss price, the collateral stock is sold and the proceeds are used to repay the employee’s outstanding loan to the Company. The employee loans remain callable and the Company is willing to pursue every available avenue, including those covered under the Uniform Commercial Code, to recover these loans by pursuing employees’ personal assets should the employees not repay these loans.

NOTE 13 — NET INCOME (LOSS) PER SHARE

     Basic net income (loss) per common share and diluted net loss per common share are computed using the weighted-average common shares outstanding for the period. Diluted net income per common share is computed using the weighted-average common shares outstanding plus any potentially dilutive securities, except when their effect is anti-dilutive. The following table sets forth the computation of basic and diluted net income (loss) per share:

		Three Months Ended								Six Months Ended
		July 3,				June 27,				July 3,				June 27,
(In thousands, except per-share amounts)		2005				2004				2005				2004
Basic:
Net income (loss)		$	(15,254	)		$	21,980			$	(84,050	)		$	48,460
Weighted-average common shares			132,081				123,366				131,293				122,892
Basic net income (loss) per share		$	(0.12	)		$	0.18			$	(0.64	)		$	0.39
Dilutive:
Net income (loss)		$	(15,254	)		$	21,980			$	(84,050	)		$	48,460
Interest on convertible subordinated notes, net of taxes			—				1,313				—				2,627
Bond issuance costs on convertible subordinated notes, net of taxes			—				651				—				1,302
Other			—				(1,423	)			—				(1,543	)
Net income (loss) for diluted computation		$	(15,254	)		$	22,521			$	(84,050	)		$	50,846
Weighted-average common shares			132,081				123,366				131,293				122,892
Effect of dilutive securities:
Convertible subordinated notes			—				33,103				—				33,103
Stock options			—				10,777				—				13,433
Other			—				221				—				221
Adjusted weighted-average common shares and assumed conversions			132,081				167,467				131,293				169,649
Diluted net income (loss) per share		$	(0.12	)		$	0.13			$	(0.64	)		$	0.30

Convertible Subordinated Notes:

1.25% Convertible Subordinated Notes (“1.25% Notes”):

     For the three and six months ended July 3, 2005, approximately 33.1 million shares of common stock issuable upon the assumed conversion of the 1.25% Notes were excluded from the calculation of diluted net loss per share as the Company was in a net loss position and therefore, their inclusion would have been anti-dilutive.

     For the three and six months ended June 27, 2004, diluted net income per share included approximately 33.1 million shares assuming conversion of the 1.25% Notes and payment of the $300 portion of each note in cash rather than common stock. Each $1,000 principal value 1.25% Notes issued in June 2003 is convertible at any time prior to maturity into 55.172 shares of common

stock, subject to certain adjustments, plus $300 of cash. The Company, at its option, may pay the $300 in shares of common stock, subject to certain conditions. The Company currently intends to pay the $300 in cash rather than shares of common stock. As a result, for purposes of determining the Company’s diluted earnings per share calculation, it is presumed that the $300 payment will be settled in cash. Therefore, net income in the diluted computation was adjusted by 70% of the interest expense and bond issuance costs.

3.75% Convertible Subordinated Notes (“3.75% Notes”):

     For the three and six months ended June 27, 2004, approximately 1.1 million shares of common stock issuable upon the assumed conversion of the 3.75% Notes were excluded from the calculation of diluted net income per share as the effect was anti-dilutive.

     The Company redeemed all of the 3.75% Notes in the fourth quarter of fiscal 2004.

Stock Options:

     For the three and six months ended July 3, 2005, all outstanding options were excluded from the calculation of diluted net loss per share as the Company was in a net loss position and therefore, their inclusion would have been anti-dilutive. As of July 3, 2005, total outstanding options to purchase common stock were 44.2 million.

     For the three and six months ended June 27, 2004, approximately 21.9 million and 14.1 million, respectively, of the Company’s outstanding stock options were excluded from the calculation of diluted net income per share because the exercise prices of the stock options were greater than or equal to the average share price for the periods, and therefore, their inclusion would have been anti-dilutive.

NOTE 14 — SEGMENT, GEOGRAPHICAL AND CUSTOMER INFORMATION