UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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

For the Quarterly Period Ended October 3, 2004

OR

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______ to ________

Commission File Number: 0-11674

LSI LOGIC CORPORATION

1621 Barber Lane
Milpitas, California 95035
(Address of principal executive offices)
(Zip code)

(408) 433-8000
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES [X]                      NO [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) YES [X] NO [  ]

As of November 5, 2004, there were 384,930,760 shares of the registrant’s Common Stock, $.01 par value, outstanding.

LSI LOGIC CORPORATION
Form 10-Q
For the Quarter Ended September 30, 2004
INDEX

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PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

LSI LOGIC CORPORATION

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

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LSI LOGIC CORPORATION

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

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LSI LOGIC CORPORATION

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

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LSI LOGIC CORPORATION

NOTE 1 — BASIS OF PRESENTATION

     In the opinion of LSI Logic Corporation (the “Company” or “LSI”), the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments and restructuring and other items, net as discussed in Note 5 to the Unaudited Consolidated Financial Statements, hereafter referred to as the “Notes”), necessary to present fairly the financial information included herein. While the Company believes that the disclosures are adequate to make the information not misleading, it is suggested that these financial statements be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

     For financial reporting purposes, the Company reports on a 13 or 14-week quarter with a year ending December 31. The current quarter ended October 3, 2004. For presentation purposes, the consolidated financial statements refer to the calendar quarters for convenience. The results of operations for the quarter ended October 3, 2004, are not necessarily indicative of the results to be expected for the full year. The nine months ended October 3, 2004 consisted of approximately 40 weeks, while the nine months ended September 28, 2003 consisted of approximately 39 weeks. The third quarter of 2004 and 2003 both consisted of 13 weeks.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates.

Recent Accounting Pronouncements

     In October 2004, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 04-08, “Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings Per Share.” This issue addresses when contingently convertible instruments should be included in diluted earnings per share computations. The pronouncement will be effective for reporting periods ending after December 15, 2004. The adoption of this standard is not expected to have an impact on the Company’s computation of diluted earnings per share.

     In October 2004, the EITF issued EITF Issue No. 04-10, “Applying Paragraph 19 of Statement of Financial Accounting Standards (“SFAS”) No. 131 in Determining Whether to Aggregate Operating Segments that do not meet the Quantitative Thresholds.” SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” requires that a public business enterprise report financial and descriptive information about its reportable operating segments. This issue addresses how to aggregate operating segments that do not meet the quantitative thresholds in SFAS No. 131. The pronouncement is effective for fiscal years ending after October 13, 2004. The adoption of this standard did not have an impact to the existing reportable operating segments of the Company.

     In July 2004, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 02-14, “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock.” This issue addresses the determination of whether an investment is in-substance common stock and when to perform that evaluation, but does not address the determination of whether an investor has the ability to exercise significant influence over the operating and financial policies of the investee. The pronouncement is effective for fiscal periods beginning after September 15, 2004. For existing investments, the investor should make an initial determination as to whether the investment is in-substance common stock based on the circumstances existing as of the date of first application of this issue. The Company does not believe that the adoption of this standard will have a material impact on its consolidated balance sheet or statement of operations.

     In March 2004, the EITF issued EITF Issue No. 03-06, “Participating Securities and the Two-class Method Under SFAS No. 128, Earnings Per Share.” EITF Issue No. 03-06 addresses a number of questions regarding the computation of earnings per share (“EPS”) by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating EPS. It clarifies what constitutes a participating security and how to apply the two-class method of computing EPS once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. This pronouncement is effective for fiscal periods beginning after March 31, 2004. The adoption of this standard did not have an impact on the Company’s computation of EPS.

     In March 2004, the EITF reached a consensus on Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF No. 03-01 provides guidance on recording other-than-temporary impairments of cost method investments and requires additional disclosures for those investments. In September 2003, a FASB Staff Position was issued that delays the recognition and measurement guidance in EITF No. 03-01 until the final issuance of Financial Accounting Standards Board (“FASB”) Staff Position Issue 03-01a. The adoption of the recognition and measurement provisions is not expected to have a material impact on the Company’s consolidated balance sheet or statement of operations. The disclosure requirements are effective for fiscal years ending after June 15, 2004, and are required only for annual periods.

     In December 2003, the FASB released a revision to FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a

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controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A public entity shall apply the provisions of the FIN 46 revision no later than the end of the first reporting period that ends after March 15, 2004. However, a public entity shall apply FIN 46 to entities considered to be special-purpose entities no later than as of the end of the first reporting period that ends after December 15, 2003. The adoption of this standard did not have a material impact on the consolidated balance sheet or statement of operations.

NOTE 2 — SEPARATION OF LSI LOGIC STORAGE SYSTEMS, INC.

     On July 29, 2004, LSI announced jointly with Engenio (“Engenio” or “Storage Systems segment”) the postponement of the initial public offering of its common stock due to market conditions. During the nine months ended September 30, 2004, the Company recorded $3.5 million in fees related to the initial public offering as selling, general and administrative (“SG&A”) expenses in the statement of operations. The fees include professional services that were directly and solely related to the initial public offering of Engenio common stock.

     The separation of Engenio from the Company, including the transfer of related assets, liabilities and intellectual property rights, was substantially completed in December 2003. At that time, the Company and Engenio entered into a Master Separation Agreement, General Assignment and Assumption Agreement, Intellectual Property Agreement, Employee Matters Agreement and an Indemnification and Insurance Matters Agreement, as more fully described in the Company’s Annual Report on Form 10-K. In March 2004, the Company and Engenio entered into the following additional agreements that further specify the terms of the separation.

     Tax Sharing Agreement. The Tax Sharing Agreement sets forth the principal arrangements between the Company and Engenio regarding the filing of tax returns, the payment of taxes and the conduct of tax audits or disputes. The Tax Sharing Agreement provides that Engenio’s stand-alone tax liability equals its taxable income multiplied by the highest corporate tax rate in effect for the year, modified by taking into account its losses and loss carryovers from prior years and, to the extent actually used, its credits. Engenio is obligated to pay the Company the amount of its stand-alone tax liability to the extent Engenio is included in any consolidated, combined or unitary tax return with the Company.

     Under the Tax Sharing Agreement, the Company is required to prepare and file all consolidated, combined or unitary tax returns of the Company and Engenio through the date that Engenio ceases to be a member of the Company’s consolidated or combined group, including the final consolidated federal income tax return. The Company has the right to review and consent to the federal and state income tax returns filed for the first tax year after Engenio ceases to be a member of the Company’s consolidated group, which may not be withheld unreasonably. In addition, the Company has sole and complete authority to control and resolve all tax audits and other disputes relating to any consolidated, combined or unitary returns filed by the Company. However, the Company may not enter into any dispute settlement that would materially increase Engenio’s liability under the Tax Sharing Agreement without Engenio’s consent, which cannot be withheld unreasonably.

     Transition Services Agreement. The Transition Services Agreement governs the provisions by the Company to Engenio of services such as finance, accounting and treasury, human resources, sales support, legal matters and information technology.

     Real Estate Matters Agreement. The Real Estate Matters Agreement describes the manner in which the Company will transfer to or share with Engenio various properties leased and owned by the Company. The agreement provides that all reasonable costs required to effect the transfers, including landlord consent fees and landlord attorneys’ fees, will be paid by the Company.

     Investor Rights Agreement. The Investor Rights Agreement provides for specified registration and other rights relating to the Company’s ownership of Engenio’s shares of Class B common stock.

NOTE 3 — BUSINESS COMBINATIONS

     Acquisition of Accerant Inc. On May 11, 2004, the Company acquired Accerant Inc. (“Accerant”). The acquisition is anticipated to expand consumer product offerings within the Semiconductor segment. The acquisition was accounted for as a purchase of a business.

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     The Company paid approximately $14.1 million in cash for the acquisition. The Company will also issue approximately 234,000 restricted common shares to certain Accerant employees hired as part of the transaction. Resulting deferred stock compensation will be amortized over a vesting period of two years using the straight-line method. The total purchase price was allocated to the estimated fair value of net assets acquired based on management estimates as follows:

     The Company may also pay additional cash of up to $4.0 million if certain revenue targets are achieved over a period ending December 31, 2005. Such contingent consideration will represent additional purchase price and be included in goodwill when and if such targets are met.

     Useful life of intangible assets. The amounts allocated to current technology and non-compete agreements are being amortized over their estimated useful lives of 5 and 2 years, respectively using the straight-line method.

     Acquisition of Velio Communications. On April 2, 2004, the Company acquired Velio Communications, Inc. (“Velio”). The acquisition is anticipated to expand product offerings for high-speed interconnect and switch fabric application specific standard products (“ASSPs”) in the global communications market within the Semiconductor segment. The acquisition was accounted for as a purchase of a business.

     The Company paid approximately $19.8 million in cash for the acquisition. The Company will also issue approximately 100,000 restricted common shares to certain Velio employees hired as part of the transaction. Resulting deferred stock compensation will be amortized over a vesting period of two years using the straight-line method. The total purchase price was allocated to the estimated fair value of net assets acquired based on management estimates as follows:

     Useful life of intangible assets. The amounts allocated to current technology, customer base, non-compete agreements and existing purchase orders are being amortized over their estimated useful lives of 9 months to 5.5 years using the straight-line method.

     Pro forma statements of earnings information have not been presented because the effect of these acquisitions was not material either individually or on an aggregate basis.

NOTE 4 — STOCK-BASED COMPENSATION

     The following table provides pro forma disclosures as if the Company had recorded compensation costs based on the estimated grant date fair value, as defined by the Statement of Financial Accounting Standards (“SFAS”) No. 123, for awards granted under its stock option and stock purchase plans. The estimated weighted-average grant date fair value, as defined by SFAS No. 123, was calculated using the Black-Scholes model. The Black-Scholes model was developed to estimate the fair value of freely tradable, fully

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transferable options without vesting restrictions, which significantly differ from the Company’s stock option awards. These models also require highly subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affect the calculated grant date fair value.

* This amount excludes amortization of non-cash deferred stock compensation on restricted stock awards.

** The amounts for the three and nine months ended September 30, 2003 have been adjusted to reflect higher calculated fair values for the Employee Stock Purchase Plan, which resulted in a 3% and 2% increase in the pro forma net loss in the three months and nine months ended September 30, 2003, respectively.

NOTE 5 — RESTRUCTURING AND OTHER ITEMS

     The Company recorded charges of $229 million and $231 million in restructuring of operations and other items for the three and nine months ended September 30, 2004, respectively, primarily in the Semiconductor segment. The Company recorded a charge of $25 million and $185 million in restructuring of operations and other items for the three and nine months ended September 30, 2003, respectively. For a complete discussion of the 2003 restructuring actions, please refer to the Company’s Annual Report on Form 10-K for fiscal year 2003.

Restructuring and impairment of long-lived assets:

First quarter of 2004:

     The Company recorded a gain of $3.3 million on the sale of fixed assets that had previously been held for sale and an expense of $1.1 million for the abandonment of fixed assets that had previously been held for sale. In addition, an expense of $1.1 million was recorded for the write-down of fixed assets due to impairment.

     An expense of $0.3 million was recorded to reflect the change in time value of accruals for facility lease termination costs, net of adjustments for changes in sublease assumptions for certain previously accrued facility lease termination costs. An expense of $0.2 million was recorded primarily for severance and termination benefits for four employees involved in research and development.

Second quarter of 2004:

     The Company recorded a gain of $1.0 million on the sale of fixed assets that had previously been held for sale and an expense of $4.0 million primarily for the write-down of the Colorado Springs fabrication facility to reflect a decline in fair market value and to write down certain spare parts for fixed assets.

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     An expense of $0.4 million was recorded to reflect the change in time value of accruals for facility lease termination costs, net of adjustments for changes in sublease assumptions for certain previously accrued facility lease termination costs. Previously accrued contract termination fees of $0.4 million were reversed as the result of more favorable than expected negotiations to terminate those contracts.

Third quarter of 2004:

     As a result of the decline in revenues in the semiconductor industry and a corresponding decline in the Company’s outlook as of the latter part of the third quarter of 2004, the Company initiated a comprehensive restructuring program, which included asset impairments, a global reduction in workforce and the consolidation of certain facilities as described further below.

     The Company concluded in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” that the Gresham manufacturing facility assets were impaired. Accordingly, an asset write-down of $205.5 million was recorded in the semiconductor segment during the third quarter of 2004 and the Company estimates an additional write-down of approximately $177 million will be recorded in the fourth quarter of 2004. The fair value of impaired equipment and facilities were estimated by management. The charge in the fourth quarter will reflect the impairment of the equipment that will be purchased in connection with the termination of the operating leases as described in Note 14. The impairment charges will be non-cash charges. The fourth quarter cash flows will reflect the buyout of the leases, net of the return of the cash collateral associated with the leases for a net outflow of $21 million.

     The Company announced workforce reductions for approximately 558 positions worldwide across all job functions and recorded a charge of $14.6 million in the Semiconductor segment for severance and termination benefits.

     The Company recorded a gain of $1.9 million on the sale of fixed assets that had previously been held for sale and an expense of $3.4 million for the write-down of the Colorado Springs fabrication facility to reflect a decline in fair market value, the impairment of certain acquired intangible assets in the Semiconductor segment and the write-down of leasehold improvements related to the facility operating leases discussed below.

     In the third quarter of 2004, the Company consolidated additional non-manufacturing facilities and recorded $6.1 million for costs associated with exiting certain operating leases for real estate as the facilities ceased being used. An expense of $0.4 million was recorded to reflect the change in time value of prior accruals for facility lease termination costs. In addition, an expense of $1.8 million was recorded for changes in sublease assumptions for certain previously accrued facility lease termination costs.

     Assets held for sale of $24 million and $30 million were included as a component of prepaid expenses and other current assets as of September 30, 2004 and December 31, 2003, respectively. Assets classified as held for sale are not depreciated. The fair values of impaired equipment and facilities were estimated by management. Given that current market conditions for the sale of older fabrication facilities and related equipment may fluctuate, there can be no assurance that the Company will realize the current net carrying value of the assets held for sale. The Company reassesses the realizability of the carrying value of these assets at the end of each quarter until the assets are sold or otherwise disposed of and additional adjustments may be necessary.

     The following table sets forth the Company’s restructuring reserves as of September 30, 2004, which are included in other accrued liabilities on the balance sheet:

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     During the second quarter of 2004, the Company reclassified a parcel of land in Colorado with a book value of $1.4 million from a long-term asset to a current asset held for sale. The land is part of total assets in the Semiconductor segment. The Company expects to sell the property within the next 12 months for an amount not less than book value.

     During the third quarter of 2004, the Company reclassified a parcel of land in Japan with a book value of $1.4 million from a long-term asset to a current asset held for sale. The land is part of the total assets in the Semiconductor segment. The Company expects to sell the property within the next 12 months for an amount not less than book value.

     During the third quarter of 2004, the Company entered into two new lease agreements for wafer fabrication equipment (see Note 14). The equipment was previously on lease immediately prior to the closing of the new lease agreements. The Company had capitalized and was amortizing fees related to the previous lease agreements. Upon entering into the new lease agreements, $2.5 million in remaining unamortized fees for the previous leases were recorded as an expense in the statement of operations.

     During the third quarter of 2004, the Company discontinued hedge accounting treatment on the interest rate swap related to the equipment operating leases that were refinanced and recorded the $3.8 million balance in accumulated comprehensive income as a gain in the statement of operations (see Notes 7 and 14).

NOTE 6 —INVESTMENTS

     An unrealized loss on available-for-sale securities of $0.9 million, net of the related tax effect of $0.5 million, and an unrealized gain of $8 million, net of the related tax effect of $4 million, was included in accumulated other comprehensive income as of September 30, 2004 and December 31, 2003, respectively. Net realized gains on sales of available-for-sale debt securities were $0.5 million and $1.1 million for the three and nine months ended September 30, 2004, respectively. Net realized gains on sales of

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available-for-sale debt securities were $0.1 million and $9 million for the three and nine months ended September 30, 2003, respectively.

     The Company realized pre-tax gains of $8 million related to the following for the nine months ended September 30, 2004:

     The following table includes the details of pre-tax losses related to investments in equity securities that the Company has recorded during the nine months ended September 30, 2004 and 2003. Management believed that the declines in value were other than temporary.

NOTE 7 — DERIVATIVE FINANCIAL INSTRUMENTS

Foreign currency risk

     The Company enters into forward contracts that are designated as foreign currency cash-flow hedges of forecasted payments in Euros. Changes in the fair value of the forward contracts due to changes in time value are excluded from the assessment of effectiveness and are recognized in interest income and other, net. As of September 30, 2004 and December 31, 2003, the Company held forward contracts designated as foreign currency cash flow hedges of forecasted Euro payment transactions that were set to expire over three-month and twelve-month periods, respectively. For the three and nine months ended September 30, 2004 and 2003, the change in time value of these forward contracts was not significant. As of September 30, 2004, unrealized losses included in accumulated other comprehensive income, which will be recorded in the income statement over the next three months, were not significant. There were no unrealized gains or losses included in accumulated other comprehensive income as of December 31, 2003. The expense for the three and nine months ended September 30, 2004 and the benefit for three and nine months ended September 30, 2003 recorded in the income statement was not significant. The Company did not record any gains or losses due to hedge ineffectiveness for the three and nine months ended September 30, 2004 and 2003.

     Forward exchange contracts and options are also used to hedge certain foreign currency-denominated assets or liabilities. These derivatives do not qualify for SFAS No. 133 hedge accounting treatment. Accordingly, changes in the fair value of these hedges are recorded immediately in earnings to offset the changes in fair value of the assets or liabilities being hedged. The related gains and losses included in interest income and other, net were not significant.

Interest rate risk

     With the objective of protecting cash flows and earnings of the Company from the impact of fluctuations in interest rates, while minimizing the cost of capital, the Company may enter into or terminate interest rate swaps, such as the below mentioned transactions.

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     In the second quarter of 2003, the Company entered into an interest rate swap transaction to effectively convert the LIBOR-based floating rate interest payments on the equipment operating leases discussed in Note 14, with an initial notional amount of $395 million, to a fixed interest rate (the “Lease Swap”). The Lease Swap qualified to be accounted for as a cash flow hedge of the forecasted interest payments attributable to the benchmark interest rate on the equipment operating leases through September 2006. In August 2004, the Company entered into two new equipment operating leases for the wafer fabrication equipment that was previously on the above-mentioned leases. As a result of entering into the new leases, the hedged forecasted interest payments are no longer probable to occur. Hedge accounting treatment was discontinued prospectively and the balance in accumulated other comprehensive income was immediately recorded as a gain of $3.8 million in restructuring and other items in the statement of operations. In September 2004, the Company terminated the Lease Swap. As of September 30, 2004, $12 million was recorded in other current assets for the amount to be received from the termination and the collateral that will be returned to the Company.

NOTE 8 — BALANCE SHEET DETAIL

     The changes in the carrying amount of goodwill for the nine months ended September 30, 2004 are as follows (in thousands):

     The Company monitors the recoverability of goodwill recorded in connection with acquisitions annually, or sooner if events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment, if any, would be determined in accordance with SFAS No. 142, which uses a fair value model for determining the carrying value of goodwill. As a result of the decline in revenues in the semiconductor industry and the corresponding decline in the Company’s outlook as of the latter part of the third quarter of 2004 and the conclusion that the Gresham manufacturing facility was impaired (see Note 5), the Company reviewed goodwill by reporting unit for impairment as of September 30, 2004. The Company’s reporting units are Semiconductor and Storage

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Systems or Engenio. The impairment testing is a two-step process. The first step requires comparing the fair value of each reporting unit to its net book value. The Company uses management estimates of future cash flows to perform the first step of the goodwill impairment test. These estimates include assumptions about future conditions such as future revenues, gross margins and operating expenses. Two methodologies were used to obtain the fair value for each reporting unit as of September 30, 2004: Discounted Cash Flow and Market Multiple. The Company concluded that goodwill was not impaired under the first step as of September 30, 2004. The second step is only performed if impairment exists, as it involves measuring the actual impairment to goodwill.

NOTE 9 — DEBT

* The interest rate on a portion of the Convertible Subordinated Notes (“Convertible Notes”) was converted to floating rates through interest rate swaps. Interest rate swaps with a notional amount of $740 million were terminated in the second quarter of 2003. The weighted average interest rate on the Convertible Subordinated Notes, after adjusting for the impact of the interest rate swaps, for the three months ended September 30, 2004 and 2003, was 4.00% and 4.02%, respectively, and 4.00% and 3.03% for the nine months ended September 30, 2004 and 2003, respectively.

     During the three months ended September 30, 2004, the Company repurchased approximately $69 million of the 2001 Convertible Subordinated Notes (the “2001 Convertible Notes”). A net pre-tax gain of approximately $2 million was recognized, in interest income and other, net, on the repurchases of the 2001 Convertible Notes. The pre-tax gain is net of the write-off of debt issuance costs and a portion of the deferred gain on the related terminated interest rate swap.

NOTE 10 — COMMON STOCK

     Stock purchase plans. In May 2004, the stockholders approved an increase in the number of shares of common stock reserved for issuance under the Company’s Employee Stock Purchase Plan by 10 million shares. As of September 30, 2004, there were approximately 19 million shares of common stock reserved for issuance under the Employee Stock Purchase Plan.

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NOTE 11 — RECONCILIATION OF BASIC AND DILUTED LOSS PER SHARE

     A reconciliation of the numerators and denominators of the basic and diluted loss per share computations are as follows:

* Numerator

+ Denominator

     Options to purchase 70,078,980 shares and 68,664,265 shares were outstanding at September 30, 2004 and 2003, respectively, and were excluded from the computation of diluted shares because of their antidilutive effect on loss per share for the three and nine months then ended. The exercise price of these options ranged from $0.06 to $72.25 at September 30, 2004 and 2003.

     For the three months and nine months ended September 30, 2004, weighted average potentially dilutive common shares of 43,413,634 and 44,266,694, respectively, associated with the 2003 and 2001 Convertible Notes were excluded from the calculation of diluted shares because of their antidilutive effect on net loss per share. For the three and nine months ended September 30, 2003 weighted average potentially dilutive common shares of 57,882,950 and 52,527,478, respectively, associated with the 2003, 2001, 2000 and 1999 Convertible Notes were excluded from the calculation of diluted shares because of their antidilutive effect on loss per share.

NOTE 12 — COMPREHENSIVE LOSS

     Comprehensive loss is defined as a change in equity of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. Comprehensive loss, net of taxes for the current reporting period and comparable period in the prior year is as follows:

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NOTE 13 — SEGMENT REPORTING

     The Company operates in two reportable segments: the Semiconductor segment and the Storage Systems segment. The Storage Systems segment may also be referred to as Engenio. In the Semiconductor segment, the Company uses advanced process technology and comprehensive design methodologies to design, develop, manufacture and market highly complex integrated circuits. These system-on-a-chip solutions include application specific integrated circuits, commonly referred to as ASICs, RapidChip® Platform ASICs and application specific standard products in silicon, or ASSPs. Semiconductor segment product offerings also include RAID host bus adapters and related products and services. In the Storage Systems segment, the Company provides modular, high-performance, disk storage systems and sub-assemblies to server and storage original equipment manufacturers. Products of the Storage Systems segment are sold as complete storage systems or sub-assemblies configured from modular components, including storage controller modules, disk drive enclosure modules and related management software.

     The following is a summary of operations by segment for the three and nine months ended September 30, 2004 and 2003:

     Intersegment revenues for the periods presented above were not significant. For the three and nine months ended September 30, 2004, restructuring of operations and other items, net of $229 million and $231 million, respectively, were primarily included in the Semiconductor segment. For the three months ended September 30, 2003, charges of $25 million for restructuring of operations and other items, net primarily impacted the Semiconductor segment. For the nine months ended September 30, 2003, restructuring of operations and other items, net of $170 million and $15 million were included in the Semiconductor segment and the Storage Systems segment, respectively.

     Significant Customers. The following table summarizes the number of our significant customers, each of whom accounted for 10% or more of our revenues, along with the percentage of revenues they individually represent on a consolidated basis and by segment:

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     The following is a summary of total assets by segment as of September 30, 2004 and December 31, 2003:

     Revenues from domestic operations were $194 million, representing 51% of consolidated revenues for the third quarter of 2004 compared to $209 million, representing 46% of consolidated revenues for the same period of 2003.

     Revenues from domestic operations were $682 million, representing 53% of consolidated revenues, for the first nine months of 2004 compared to $633 million, representing 51% of consolidated revenues, for the same period of 2003.

NOTE 14— COMMITMENTS AND CONTINGENCIES

     On March 28, 2003, the Company entered into two lease and security agreements, each with Bank of America, National Association (“BANA”), acting as the Lessor, and Wells Fargo Bank Northwest, as the Agent, for a total of $395 million for certain wafer fabrication equipment (the “Equipment”). The leases qualify for operating lease accounting treatment. Each lease has a term of 3.5 years with no option for renewal. The Company may, at the end of the lease term, return or purchase, at a pre-determined amount, all of the Equipment. The first lease was for $235 million and was for equipment that was previously on lease immediately prior to closing this transaction. In October 2003, BANA, with the Company’s approval, assigned its rights as Lessor on the first lease to Bank of the West. The second lease was for $160 million and was for Equipment that was sold to BANA and then immediately leased back in a transaction commonly referred to as a sale-leaseback. The Equipment sold had a book value of approximately $103 million. These two leases were terminated on August 6, 2004.

     On August 6, 2004, the Company entered into two lease and security agreements, each with Wells Fargo Bank Northwest, acting as the Agent. One lease for $134 million is with Bank of the West acting as the Lessor, and the second lease for $201 million is with BTM Capital Corporation acting as the Lessor. As of September 30, 2004, the amount under both leases was fully drawn. The leases are for wafer fabrication equipment (the “Equipment”) that was previously on the above-mentioned lease immediately prior to closing this transaction. The new leases qualify for operating lease accounting treatment. Each lease has a term of 3 years. The Company may, at the end of the lease term, return or purchase, at a pre-determined amount, all of the Equipment. The Company has $311 million in cash that is posted as collateral for the leases as of September 30, 2004. The lessor has access to the Company’s cash collateral only in the event of a default. Of this cash collateral, $50 million, representing the amount of cash collateral to be released in the next 12 months, is reflected in other current assets and the remaining cash collateral of $261 million is recorded in other non-current assets. The Company is required to maintain unrestricted cash and short-term investments reserves in an amount no less than the higher of a) the sum of $100 million plus the principal amount of the Company’s 2001 Convertible Subordinated Notes due in 2006 or b) $350 million. The Company was in compliance with this requirement as of September 30, 2004. The $56 million gain on the sale of the Equipment on the former lease will be deferred until the end of the new lease term and has been recorded as a non-current liability as of September 30, 2004. No officer or employee of the Company has any financial interest in these leasing arrangements.

     The Company guarantees residual values related to the leased equipment. As of September 30, 2004, the Company’s maximum potential exposure to residual value guarantees was approximately $141 million. The Company concluded that exposure related to residual value guarantees existed in connection with the conclusion that the Gresham manufacturing facility was impaired as discussed in Note 5. The fair value of the guarantee of the residual value of the equipment was determined using management estimates and was recorded as a non-current asset and liability each in the amount of $6 million as of September 30, 2004.

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     On October 27, 2004, the Company notified the required parties of its intention to exercise its early buyout right to purchase all of the Equipment under the two lease and security agreements discussed above, dated August 6, 2004. The date on which the purchase is to occur under each lease is November 29, 2004. The early termination or buyout amount is a total of $332 million for both leases. Termination fees under the lease agreements are not considered to be material. The Company expects to record an impairment charge of approximately $177 million in the fourth quarter of 2004 in connection with the termination of the operating leases. The impairment charges will be non-cash charges. The fourth quarter cash flows will reflect the buyout of both leases, net of the return of collateral associated with the leases for a net outflow of $21 million.

     The Company leases the majority of its facilities under non-cancelable operating leases, which expire through 2014. The facility lease agreements typically provide for base rental rates that are increased at various times during the terms of the lease and for renewal options at the fair market rental value. During the nine months ended September 30, 2004, the Company renegotiated the existing lease agreements for six buildings located in California and established one new lease in California and one new lease in India. The future minimum payments for these new and renegotiated building leases will be $1 million, $5 million, $6 million, $6 million, $6 million and $24 million for the years ending December 31, 2004, 2005, 2006, 2007, 2008 and thereafter, respectively.

     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 connection with contracts and license agreements or the sale of assets, under which the Company customarily agrees to hold the other party harmless against losses arising from a breach of warranties, representations and covenants related to such matters as title to assets sold, validity of certain intellectual property rights, non-infringement of third-party rights, and certain income tax related matters. In each of these circumstances, payment by the Company is typically subject to the other party making a claim to and cooperating with the Company pursuant to the procedures specified in the particular contract. This usually allows the Company to challenge the other party’s claims or, in case of breach of intellectual property representations or covenants, to control the defense or settlement of any third-party claims brought against the other party. Further, the Company’s obligations under these agreements may be limited in terms of activity (typically to replace or correct the products or terminate agreement with a refund to the other party), duration and/or amounts. In some instances, the Company may have recourse against third parties and/or insurance covering certain payments made by the Company.

NOTE 15 — LEGAL MATTERS

     In February 1999, a lawsuit alleging patent infringement was filed in the United States District Court for the District of Arizona by the Lemelson Medical, Education & Research Foundation, Limited Partnership (“Lemelson”) against 88 electronics industry companies, including us. The case number is CIV990377PHXRGS. The patents involved in this lawsuit are alleged to relate to semiconductor manufacturing and computer imaging, including the use of bar coding for automatic identification of articles. The plaintiff has sought a judgment of infringement, an injunction, treble damages, attorneys’ fees and further relief as the court may provide. In September 1999, the Company filed an answer denying infringement and raising affirmative defenses. In addition, the Company asserted a counterclaim for declaratory judgment of non-infringement, invalidity and unenforceability of Lemelson’s patents. As of September 30, 2004, a claim construction hearing has been set to be held in November 2004, but no trial date has been set. While the Company cannot make any assurance regarding the eventual resolution of this matter, the Company does not believe it will have a material adverse effect on the consolidated results of operations or financial condition.

     On May 4, 2001, Ning “Frank” Hui caused a lawsuit to be filed against C-Cube Microsystems Inc. in the Superior Court of California for the County of Santa Clara. Hui caused the lawsuit to be filed on his behalf and on behalf of all others similarly situated, approximately 600 employees of C-Cube Microsystems who were employed by C-Cube Microsystems in May 2000 at the time of the acquisition of certain C-Cube Microsystems’ assets by Harmonic, Inc. Subsequent to the filing of the lawsuit, the Superior Court granted Hui’s motion for class certification. In the Complaint, Hui alleges that C-Cube Microsystems’ management improperly reduced the conversion factor for unvested employee stock options when such options were converted at the time of the Harmonic transaction. The Company denies these allegations. While the Company cannot make any assurance regarding the eventual resolution of this matter, the Company does not believe it will have a material adverse effect on the consolidated results of operations or financial condition.

     The Company is a party to other litigation matters and claims that are normal in the course of its operations, and while the results of such litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of such matters is not expected to have a material adverse effect on the Company’s consolidated results of operations and financial condition.

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NOTE 16 — SUBSEQUENT EVENTS

     See Note 14 of the Notes for a discussion on the termination of the operating leases for Gresham manufacturing equipment on October 27, 2004.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Form 10-Q contains forward-looking statements. In many cases you can identify forward-looking statements by terminology such as “may”, “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “intend” or “continue,” or the negative of such terms and other comparable terminology. In addition, forward-looking statements in this document include, but are not limited to, the following: projected revenues in the fourth quarter of 2004, projections of gross profit margins in the fourth quarter of 2004, projected savings as a result of restructuring actions and projected capital expenditures in 2004. We assume no obligation to update any such forward-looking statements, and these statements involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. For a summary of such risks and uncertainties, please see the paragraphs located at the end of this Item 2 entitled “Factors that May Affect Future Operating Results” and please also see the risk factors located in the Form 10-K for our fiscal year ended December 31, 2003.

OVERVIEW

     Revenues for the three months ended September 30, 2004 were $380 million representing a 16% decrease compared to the same period of 2003 and a 15% decrease from the three months ended June 30, 2004. The decline in revenues reflects customer end-demand reassessments and the ongoing semiconductor industry-wide effort to decrease excess supply chain inventory. As a result of the decline in revenues in the semiconductor industry and a corresponding decline in our outlook as of the latter part of the third quarter of 2004, we initiated a comprehensive restructuring program, which included a reduction in global workforce, asset impairment charges that were mainly for the impairment of our Gresham manufacturing facility and the consolidation of certain non-manufacturing facilities. See Note 5 of the Notes for a more complete description of the actions and related charges.

     Cash, cash equivalents and short-term investments were $809 million as of September 30, 2004. We generated positive operating cash flows for the tenth consecutive quarter. We repurchased approximately $69 million in principal of the 2001 Convertible Notes during the quarter, recognizing a slight gain. See Note 9 of the Notes.

     Customer interest in our RapidChip Platform ASIC accelerated in the third quarter of 2004 with a corresponding increase in our design-win rate. This heightened level of sales activity is expected to continue into the fourth quarter of 2004.

     We expect revenues to be in the $360 million to $390 million range in the fourth quarter of 2004.

     Separation of our Storage Systems business. On July 29, 2004, we announced jointly with Engenio Information Technologies, Inc. (“Engenio” or “Storage Systems segment”) the postponement of the initial public offering of its common stock due to market conditions.

     Significant acquisitions. We are continually exploring strategic acquisitions that build upon our existing library of intellectual property, human capital and engineering talent, and increase our leadership position in the markets in which we operate. We acquired Velio Communications, Inc. (“Velio”) during the first quarter of 2004 and Accerant Inc. (“Accerant”) during the second quarter of 2004. Both were accounted for as purchases of businesses and, accordingly, the estimated fair value of assets acquired and liabilities assumed and the results of operations were included in our Consolidated Financial Statements as of the effective date of the acquisitions. The transactions are summarized in the table below. There were no significant differences between our accounting policies and those of the companies acquired. (See Note 3 of the Notes.)

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     Where more than one significant factor contributed to changes in results from year to year, we have quantified such factors throughout the Management’s Discussion & Analysis, where practicable.

RESULTS OF OPERATIONS

     Revenues:

There were no significant intersegment revenues during the periods presented.

     Third quarter of 2004 compared to the second quarter of 2004

     Total consolidated revenues for the third quarter of 2004 decreased $67.7 million or 15% from the second quarter of 2004.

     Revenues for the Semiconductor segment decreased $52.1 million or 16% in the third quarter of 2004 as compared to the second quarter of 2004. The decrease in the Semiconductor segment was primarily attributable to a decrease in demand for semiconductors used in storage and communication product applications. The decline in semiconductors used in storage product applications is mainly due to the continued softening demand in the SAN adapter and server markets. The decline in semiconductors used in communication product applications is due primarily to lower demand for office automation products. These decreases were partially offset by a seasonal increase in demand for semiconductors used in consumer product applications, in particular the video game products.

     Revenues for the Storage Systems segment decreased $15.6 million or 14% from the second quarter of 2004. The majority of this decline related to lower demand for products sold to IBM. Revenues from IBM decreased $9.3 million for the three months ended September 30, 2004 as compared to the three months ended June 30, 2004. As a percentage of total Storage Systems segment revenues, revenues from IBM represented 54% in the third quarter of 2004 and 55% in the second quarter of 2004.

     Three and nine months ended September 30, 2004 compared to the same period of 2003

     Total consolidated revenues for the third quarter of 2004 decreased $70.0 million or 16% as compared to the third quarter of 2003. For the nine months ended September 30, 2004, revenues increased $50.3 million or 4% as compared to the same period of 2003.

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     Revenues for the Semiconductor segment decreased $62.9 million or 18% for the third quarter of 2004 and increased $30.5 million or 3% for the nine months ended September 30, 2004 as compared to the same periods of the previous year. The decrease in revenues in the Semiconductor segment in the third quarter of 2004, as compared to the same period of 2003, is attributable to a decrease in demand for semiconductors used in consumer product applications, specifically videogame platforms, communication and storage product applications. For the nine months ended September 30, 2004 compared to the same period of the previous year, the increase in revenues for the Semiconductor segment was primarily due to an increase in demand for semiconductors used in storage and communication product applications. In addition, the demand for semiconductors used in consumer product applications, such as DVD recordable increased, partially offset by a decrease in demand for semiconductors used in consumer products applications, such as video game platforms.

     Revenues for the Storage Systems segment decreased $7.1 million or 7% for the third quarter of 2004 and increased $19.8 million or 7% for the nine months ended September 30, 2004 as compared to the same periods of 2003. The decrease in revenues in the Storage Systems segment for the third quarter of 2004 as compared to the same period of 2003 is primarily due to a decrease in demand for products sold to IBM, offset in part by increased revenues for products sold to StorageTek. The increase in revenues for the Storage Systems segment for the nine months ended September 30, 2004 compared to the same period of 2003, is primarily due to an increase in demand from IBM, StorageTek and SGI for new controller products that were introduced in late April 2003 and increased demand for our other controller and disk enclosure related products.         .

     Significant Customers. The following table summarizes the number of our significant customers, each of whom accounted for 10% or more of our revenues, along with the percentage of revenues they individually represent on a consolidated basis and by segment (See Note 13 of the Notes):

Revenues by geography. The following table summarizes our revenues by geography:

     Third quarter of 2004 compared to the second quarter of 2004

     In the third quarter of 2004, revenues decreased in North America, Asia, including Japan and Europe, as compared to the second quarter of 2004. The decrease in North America is primarily attributable to a decline in demand for semiconductors used in storage product applications, such as disk drive solutions and modular storage products associated with Engenio. The decrease in revenues for

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Asia, including Japan is primarily due to the decline in demand for communication product applications, such as office automation products. The decrease in revenues for Europe represents decreased demand across all semiconductor product applications.

     Three and nine months ended September 30, 2004 compared to the same periods of 2003

     Revenues in North America and Asia, including Japan and Europe decreased in the third quarter of 2004 as compared to the third quarter of 2003. The decrease in North America is mainly due to the decrease in demand for semiconductors used in storage product applications, such as disk drive solutions and modular storage products associated with Engenio. The decrease in revenues for Asia, including Japan is primarily due to decreased demand for semiconductors used in consumer product applications, such as video game platforms, offset in part by an increase in demand for semiconductors used in consumer product applications, such as DVD-recordable. The decrease in revenues for Europe represents decreased demand across all semiconductor product applications.

     During the nine months ended September 30, 2004, revenues increased in North America and Europe, and declined slightly in Asia, including Japan, as compared to the same period in 2003. The increase in demand in North America and Europe was for semiconductors used in storage component and communication product applications, such as routers and switches and modular storage products associated with Engenio, partially offset by a decrease in demand for semiconductors used in consumer product applications, such as DVD-recordable. The decrease in revenues in Asia, including Japan was mainly due to a decline in demand for semiconductors used in certain consumer product applications, such as video game platforms and communication product applications, such as office automation products. This decrease was offset by an increase in demand for semiconductors used in storage component applications, such as Ultra 320 SCSI, and certain consumer product applications, such as DVD-recordable.

Operating costs and expenses. Key elements of the consolidated statements of operations for the respective segments are as follows:

  Gross profit margin:

     Third quarter of 2004 compared to the second quarter of 2004

     The consolidated gross profit margin as a percentage of revenues decreased to 40% in the third quarter of 2004 from 47% in the second quarter of 2004.

     The gross profit margin as a percentage of revenues for the Semiconductor segment decreased to 42% in the third quarter of 2004 from 50% in the second quarter of 2004. The decrease in gross profit margin for the Semiconductor segment was primarily attributable to the following factors:

     • Higher inventory charges for non-marketable inventories in the third quarter of 2004 as compared to the second quarter of 2004; and

     • An unfavorable shift in product mix to selling products with relatively lower margins.

     The gross profit margin as a percentage of revenues for the Storage Systems segment decreased to 33% for the third quarter of 2004 from 38% for the second quarter of 2004. The decrease is mainly a result of an unfavorable change in the mix of products sold

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and lower utilization of manufacturing facilities due to lower revenues in the third quarter of 2004 as compared to the second quarter of 2004.

     We expect our consolidated gross profit margin to be in the range of 41% to 43% in the fourth quarter of 2004.

     Three and nine months ended September 30, 2004 compared to the same periods of 2003

     The consolidated gross profit margin as a percentage of revenues decreased to 40% for the third quarter of 2004 from 41% for the same period of 2003. The consolidated gross profit margin as a percentage of revenues increased to 44% for the nine months ended September 30, 2004 as compared to 39% for the same period of 2003.

     The gross profit margin as a percentage of revenues for the Semiconductor segment remained unchanged at 42% in the third quarters of 2004 and 2003. The gross profit margin as a percentage of revenues for the Semiconductor segment increased to 46% for the nine months ended September 30, 2004 as compared to 39% in the same period of 2003. The improvement in gross profit margin for the Semiconductor segment was primarily attributable to the following factors:

     Sales of previously reserved inventory for the nine months ended September 30, 2004 compared to the same period of 2003 was not significant.

     The gross profit margin as a percentage of revenues for the Storage Systems segment decreased to 33% in the third quarter of 2004 as compared with 39% for the third quarter of 2003. The gross profit margin as a percentage of revenues for the Storage Systems segment decreased to 37% for the nine months ended September 30, 2004 as compared to 38% in the same period of 2003. The decrease in gross profit margin as a percentage of Storage Systems segment revenues is primarily a result of an unfavorable shift in mix of products sold.

     Factors that may affect gross profit margins

     We have wafer-manufacturing operations in Gresham, Oregon. We also acquire wafers from foundries in other locations. Utilizing a diversity of manufacturing locations allows us to better manage potential disruption in the manufacturing process due to economic and geographic risks associated with each location.

     Our operating environment, combined with the resources required to operate in the Semiconductor and Storage Systems industries, requires that we manage a variety of factors which could have a significant impact on our gross margin in future periods. These factors include, among other things:

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Research and development: