e10vk

DATE: February 22, 2007

/s/ Timothy D. Harris

Timothy D. Harris

Chief Executive Officer

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K


(Mark One)
þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the fiscal year ended December 31, 2006
or
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the transition period from to

Commission file number 0-16852

Komag, Incorporated

(Exact name of registrant as specified in its charter)


Delaware	94-2914864
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.	)

1710 Automation Parkway, San Jose, California 95131

(Address of Principal Executive Offices, including Zip Code)

Registrant’s telephone number, including area code:

(408) 576-2000

Securities registered pursuant to Section 12(b) of the Act:


Title of Each Class		Name of Each Exchange on Which Registered

None		None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.01 par value

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ

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 þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ Accelerated filer o Non-accelerated filer o

Indicate by check mark whether the Registrant is a shell company (as defined in Exchange Act rule 12b-2 of the Act). Yes o No þ

On June 30, 2006, which was the last business day of the Registrant’s most recently completed second quarter, the aggregate market value of voting stock held by non-affiliates of the Registrant was approximately $940 million based on the closing sale price of $46.18 for shares of the Registrant’s common stock as reported by the Nasdaq National Market. Shares of Common Stock held by each executive officer and director of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

On February 1, 2007, 31,158,189 shares of the Registrant’s Common Stock, $0.01 par value, were outstanding.

APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the Registrant has filed all reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes þ No o

Documents Incorporated by Reference

Designated portions of the following document are incorporated by reference into this Report on Form 10-K where indicated: Komag, Incorporated Proxy Statement for the Annual Meeting of Stockholders to be held on May 23, 2007, Part III.

PART I

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the U.S. federal securities laws that involve risks and uncertainties. Certain statements contained in this report are not purely historical, including, without limitation, statements regarding our expectations, beliefs, intentions, anticipations, commitments, or strategies regarding the future that are forward-looking. These statements include those discussed in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, including “Results of Operations,” “Critical Accounting Policies,” and “Liquidity and Capital Resources,” and elsewhere in this report. These statements include statements concerning product development, product acceptance, product demand, shipping volumes, projected revenues, international revenues, pricing pressures, sales returns, gross profit, expenses, reserves, taxes, net income, capital spending and liquidity requirements.

In this report, the words “may,” “could,” “would,” “might,” “will,” “should,” “plan,” forecast,” “anticipate,” “believe,” “expect,” “intend,” “estimate,” “predict,” “potential,” “continue,” “future,” “moving toward” or the negative of these terms or other similar expressions also identify forward-looking statements. Our actual results could differ materially from those forward-looking statements contained in this report as a result of a number of risk factors, including, but not limited to, those set forth in the section entitled “Risk Factors” and elsewhere in this report. You should carefully consider these risks, in addition to the other information in this report and in our other filings with the Securities and Exchange Commission (SEC). All forward-looking statements and reasons why results may differ included in this report are made as of the date of this report, and we assume no obligation to update any such forward-looking statement or reason why such results might differ.


Item 1.	*Business*

General

We design, manufacture and market thin-film media (disks), which are incorporated into disk drives. As a result of our market leadership and significant research and development efforts, we believe that we have developed a strong understanding of the market needs in the disk drive market, and offer a broad portfolio of advanced solutions to address those needs. Our customers include Hitachi Global Storage Technologies (HGST), Seagate Technology (Seagate) and Western Digital Corporation (Western Digital), which are the world’s three largest disk drive manufacturers. In 2006, we added Samsung as a customer. With this addition, our customer base represents nearly all of the aluminum market customers for thin-film media.

Disks, such as the ones we manufacture, are the primary storage medium for digital data. Technology advances have greatly increased the storage capacity of individual disks, lowering the per gigabyte (GB) cost of storage. The lower cost of storage has facilitated the adoption of disk drives into a broad range of new applications, providing new areas of market growth for disks and disk drives. High-volume, high-growth applications for disk drives include personal computers (PC), notebook computers, high-end server (enterprise) storage systems, communications infrastructure, and consumer electronics appliances, which is currently the fastest growing market segment. We expect the increase in storage capacity used in existing and new applications to continue to generate increased demand for disk drives and higher demand for disks such as those we sell.

Komag was founded in 1983 and incorporated in Delaware in October 1986. Our principal executive offices are located at 1710 Automation Parkway, San Jose, California 95131, and our telephone number at that location is (408) 576-2000. Our Internet address is www.komag.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports and other SEC filings are available free of charge through our website as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. Our common stock trades on the Nasdaq National Market under the symbol KOMG. The inclusion of our website address in this Report does not include or incorporate by reference into this Report any information on our website.

Industry Background

Demand for Disks

Increasing demand for digital data storage and low-cost, high-performance disk drives has resulted in increasing demand for disks. We believe there are a number of key factors driving this demand. These factors include:


	•	increased demand for desktop and notebook PCs with high storage capacities driven by consumer multi-media, broadband, and wireless applications, increased business usage, and an increased number of computers in developing economies;

	•	increased demand for enterprise storage driven by a broader deployment of applications, which require significant storage capacity, such as enterprise software, data warehousing, data recovery and data security operations; and

	•	increased demand for new consumer electronic applications, which require significant digital data storage capability, including digital video and audio recorders, video game platforms, emerging high-definition television applications and global positioning systems.

Disk drives are the primary devices used for storing, managing and protecting the digital data associated with most of these applications.

Due to the significant challenges raised by the need to continually innovate and improve manufacturing and operational efficiencies, the disk drive industry has undergone significant consolidation. We believe that consolidation could continue in our industry as the technological challenges and associated levels of required investment grow, increasing the competitive necessity of large-scale operations.

Disk Market

Disks are enabling components in disk drives. The technical advances by disk suppliers, along with those of other component suppliers, have improved the performance and storage capacity of disk drives, and dramatically lowered the cost per GB stored. Disk suppliers help drive technology innovation in disk drives by increasing storage capacities per square inch of disk surface, referred to as areal density, and improving reliability. For example, today’s areal densities allow for up to approximately 188 GB of storage per 31/2-inch disk. We expect that current technologies, including perpendicular magnetic recording (PMR) which is discussed further below under Technology, will soon lead to increases in areal densities allowing over 200 GB of storage per 31/2-inch disk. We are currently in the development stages for developing advanced products with over 200 GB per platter storage capacity, utilizing PMR technology, which we currently expect to deliver to our customers beginning in 2007. Initial shipments of PMR media used in 31/2-inch applications began shipping in the industry during the second half of 2006.

There are significant barriers to entry to the disk market. To succeed, we believe disk suppliers must have strong relationships with the leading disk drive manufacturers, the engineering expertise to enable technology leadership, and the economies of scale to achieve efficient low-cost operations and meet customer timing and volume requirements.

We believe that as the disk drive industry has continued to grow and demand for new products has accelerated, leading disk drive makers have increasingly relied on independent disk suppliers for a broad range of products and to meet their growing disk requirements. We believe that only a few independent disk suppliers remain that have the established customer relationships, technology and scale to meet the requirements of large disk drive manufacturers.

Competitive Strengths

We are a leading independent supplier of disks and the only independent disk supplier headquartered in the United States (U.S.). We believe that our leadership position is attributable to our ability to simultaneously drive technological advances, collaborate with our customers and manufacture high-performance, low-cost products. Our major competitive strengths include the following:


	•	Leading Independent Disk Supplier. We believe that we have developed a deep understanding of market needs in the disk drive market and offer a broad portfolio of advanced solutions to address those needs. Additionally, we believe the scale of our manufacturing and our technology development programs provide us with competitive advantages in maintaining and growing our market share.

	•	Technology Leadership. We have been in the thin-film media business for over 23 years, during which time we have invested heavily in research and development. Our research, development and engineering team has 448 employees in the U.S. and Malaysia, and is focused on developing next-generation products and efficient manufacturing processes. As a recent example of our success in technology innovation, 36% of our 2006 fourth quarter shipments were 160 GB and greater disks, compared to less than 1% in the same period in 2005. Further, we believe we are the only independent disk supplier shipping greater than one million units of 31/2-inch PMR disks in the fourth quarter of 2006, which demonstrates our leadership in developing next-generation technologies, such as PMR, to allow us to stay at the forefront of technology development in the disk industry. We believe our research and development strategy allows us to design and manufacture high volumes of advanced disks for our customers.

	•	Strong Relationships with Top-Tier Disk Drive Manufacturers. We believe that we have developed strong relationships with many of the leading disk drive manufacturers, including HGST, Seagate and Western Digital. Further, we added Samsung as a customer in 2006. Our San Jose, California headquarters and research and development operations are in close proximity to the design centers of many of the world’s largest disk drive manufacturers. Our ability to have our design teams work in such close proximity to our customers has, in part, facilitated the strong and collaborative customer relationships that we have established with these large disk drive manufacturers. We devote significant time working with our customers to produce disks that are highly specialized and customized for our customers’ particular technological requirements, and these close relationships provide added insight into our customers’ product and technology roadmaps.

	•	Low-Cost Efficient Manufacturing Operations. We believe our manufacturing costs are among the lowest in our industry. Our manufacturing operations, all of which are located in Malaysia, are located in the same region as the manufacturing operations of many of the world’s largest disk drive manufacturers. We believe the location of our manufacturing operations, together with our experience in the industry and our economies of scale, provide us with timing and cost advantages in delivering consistently high-quality products to our customers in high volumes.

	•	Broad Range of Disk Products to Address Large and Emerging Markets. We provide a broad range of disk products that are incorporated into disk drives for desktop, enterprise and consumer electronics applications. Our primary market focus has been 31/2-inch disks for the desktop and consumer electronic applications, which constitute the majority of the highest volume business of our largest customers. As our customers pursue applications and products in other growth areas, such as the enterprise server, mobile and small form factor consumer electronics storage markets, we believe that we are well positioned to meet their needs based on our ability to produce a wide range of products with varying areal densities and form factors. To meet customer demand and the growing market for 21/2-inch disk drives, we entered the 21/2-inch market with aluminum disks and are currently designing and sampling 21/2-inch glass disks for shipment in 2007.

Strategy

Our primary goal is to maintain our position as a leading independent provider of disks. The key elements of our strategy are as follows:


	•	Maintain Technology Leadership. We intend to maintain and extend our technology leadership in the disk market by continuing to invest in leading-edge research and development. We intend to continue to focus our technology development efforts primarily on large and emerging market opportunities, such as high-density storage for PCs, enterprise storage systems, communications infrastructure and consumer electronics appliances. We currently manufacture disks at various capacity points from 80 GB to 188 GB for 31/2-inch disks, and expect to ship disks at 200 GB and greater in 2007. We are currently shipping disks using both longitudinal magnetic recording (LMR) and PMR technology. Additionally, we are pursuing new technologies, such as discrete track recording (DTR), in an effort to achieve technological advantages over our competitors.

	•	Continue Improving Manufacturing Efficiency and Reducing Production Costs. We intend to continue to improve the efficiency and quality of our manufacturing operations in Malaysia where we believe we can achieve lower costs than other disk manufacturers. We believe that our advanced manufacturing operations allow us to accelerate delivery of high volumes of reasonably priced disks, which enable our customers to rapidly introduce new products. As a leading independent disk supplier, we believe our highly experienced operations personnel can continue to drive yield improvements and reduce costs faster than our competitors. We believe our strategy of improving our manufacturing efficiency while reducing costs contributes to our customers’ success and will help grow our market share.

	•	Leverage Collaborative Relationships with Disk Drive Manufacturers. We believe that we have established strong relationships with our customers, enabling us to participate in establishing technological and design requirements for new products. We believe that close technical collaboration with our customers and their other component suppliers during the design of our customers’ new disk drives facilitates integration of our disks, improves our ability to achieve cost-effective, high-volume manufacturing rapidly, and enhances the likelihood that we will remain a significant supplier of disks for high-performance disk drive products.

	•	Maintain a Strong Customer Base. Our principal customers include HGST, Seagate and Western Digital. In 2006, we added Samsung as a customer. We continue to target increased volumes with disk drive manufacturers and believe that our combination of high-performance products and competitive pricing will enable us to further diversify our products and customer mix. In combination with offering a broad product mix to address multiple storage markets, we believe this strategy will reduce our dependence on the success of any one customer or market.

	•	Balance Capacity Growth with Customer Demand. Our strategy is to balance, in a cost-effective manner, our investments in new capacity with the expected growth in demand for our products. In 2005 and 2006, we expanded our facilities to increase our capacity. Our expansion plans were based on strategic supply agreements with several of our customers. As part of these agreements, we made certain commitments to increase capacity, and our customers have agreed to purchase certain amounts of disks. Additionally, our customers agreed to make certain prepayments for media to help mitigate the cash impact of the capital spending that was required for us to increase our capacity. We believe that these arrangements with our customers were the correct strategy to allow for prudent capacity increases to meet the continuing growing demand for disks, as disk drives further expand penetration into multiple growing consumer applications. Any future capacity expansion will be based on customer requirements and overall industry demand.

Technology

We believe that our technological strength allows us to maintain our position as a leading independent supplier to the thin-film media market. Our technological strength stems from the depth of our understanding of material science and the interplay between disks, heads, and other disk drive components. Our disk manufacturing expertise is evidenced by our history of delivering reliable products in high volume.

We manufacture and sell thin-film magnetic media for use in disk drives. These drives are used to record, store, retrieve and protect digital information. Inside a disk drive, the disk rotates typically at speeds of 7,200 rpm, and for high performance drives, at 15,000 rpm. The head scans across the disk as it spins, magnetically recording or reading information. The location on the disk where each bit of magnetic code is stored is extremely small and precisely placed. The tolerances of the disks and recording heads are extremely demanding and the interaction between these components is one of the most critical design aspects in an advanced disk drive.

Our key technological components and challenges are as follows:


	•	Transition from LMR Media to PMR Media. The hard disk drive industry is currently in the process of converting from a longitudinal magnetic recording (LMR) system to a perpendicular magnetic recording (PMR) system. This change allows transition to higher areal densities, which translates to higher recording capacity per platter. This change in technology is one of the most significant ones to take place in the industry in many years. The processes and materials used for making PMR media are significantly different compared to those used for making LMR media. For example, the manufacture of PMR products requires the use of increased quantities of ruthenium. Ruthenium has recently become increasingly more expensive and at times difficult to acquire. We are currently making this transition. Our PMR volume production and sales began in the fourth quarter of 2006. Completion of our transition to PMR products is expected by the end of 2008.

	•	Density of Disk Storage. The primary factors governing the density of storage achievable on a disk’s surface are:


	•	the minimum distance at which read/write heads can reliably pass over the surface of the disk to detect a change in magnetic polarity when reading from the disk, which is called flying height now typically measured in nanometers (one nanometer equals one billionth of a meter).

	•	the strength of the magnetic field required to change the polarity of a bit of data on the magnetic layer of a disk when writing, which is called coercivity; and

	•	the ability of the head to discriminate a signal from background media noise, which is called the signal-to-noise ratio (SNR).

As flying height is reduced, the head can read and write smaller bits. The higher the coercivity of the media is, the smaller the width of the bit that can be stored. SNR is determined by the choice of magnetic materials and the method for depositing those materials on the disk’s surface, as well as the recording head used.

Our plating, polishing and texturing processes produce a uniform disk surface that is smooth at an atomic level. This smoothness permits the read/write heads to fly over the disk surface at a distance of 5-6 nanometers. Disks must be made in a clean environment to limit surface defects. Even a small number of defects, a fraction of a micro-meter in diameter, could cause the recording head-disk interface to fail. The magnetic alloys deposited on the surfaces of our disks have high coercivity, low noise, and other desirable magnetic characteristics.

Finally, a protective layer of diamond-hard carbon and a layer of lubricant, each of which is controlled to a tolerance of a few tenths of a nanometer, are applied to the disk surface to prevent wear. The continued improvement in these and other factors has resulted in rapid advancement in the amount of data a disk is capable of storing.


	•	Aluminum Substrates. In order to manufacture the best possible disks and achieve the high yields we desire, we require superb substrates. The substrate is constructed out of an aluminum base which is then plated with electroless nickel phosphorus (NiP) coating. The NiP coating is then highly-polished to sub-nano-meter smoothness. We believe that our polished substrates, in conjunction with our automatic optical inspection systems, provide us with the highest quality aluminum based substrates available in the market. We are the largest producer of NiP coated and polished aluminum substrates in the world.

	•	Glass Substrates. Another type of substrate used for hard disks is based on glass. Typically the glass substrates are used for hard disk drives in mobile applications, including notebook computers, high-capacity


		IPods^® and other high-capacity mp-3 players, digital cameras and other mobile devices. Recently, we have decided to introduce glass based PMR media for notebook and consumer applications in 2007. Although we do not intend to make our own glass substrates, it is expected that there will be sufficient volume of glass substrates available to be purchased for our requirements. If market acceptance of the product is good, we are prepared to develop and manufacture larger volumes of glass based media in the future.


	•	Sputter Process. We have developed our cleaning, sputter (film deposition), lubrication, final test, and packaging technology to achieve not only high performance but at low cost for the materials and operating supplies needed to make our disks. Our multi-layer sputter process, with nanometer-thin structures, provides magnetic stability, mechanical durability, and corrosion resistance, which we believe are at the forefront of our industry. To improve durability and corrosion resistance, we have developed and qualified advanced diamond-like carbon films specifically for each of our sputter tools.

Research, Development and Engineering

Our research, development and engineering efforts focus on emphasizing key technology advancements in disk functionality, reliability, quality and manufacturing efficiency. We believe that improving yields and reducing costs are critical to improving our overall operating results. We also focus on emerging media storage technologies aimed at disk designs that we expect to be needed several years from now.

We often partner with our customers and other disk drive component makers in areas of technology development such as magnetic recording heads. The 31/2-inch diameter PMR disk which we began producing in the fourth quarter of 2006 has an areal density of approximately 188 GB per disk capacity. We expect that the following generation of 31/2-inch PMR media will become available in 2007 and will have capacity of 200 GB and greater per disk. Although the processes and materials used for making PMR media are significantly different compared to those used for making LMR media, we expect that our PMR disks will be produced using our current production equipment, which suggests a limited need to replace such equipment to keep pace with PMR technology improvement during the next few years.

As of December 31, 2006, our worldwide research, development, and engineering program employed 448 people.

Products and Customers

We sell our disks primarily to disk drive manufacturers for incorporation into disk drives. Disk drives, in turn, are sold to computer or consumer appliance manufacturers that incorporate the disk drives into their systems, or are sold directly to consumers. We work closely with our customers as they design new high-performance disk drives, and generally customize our products according to their specifications.

Our customers include Hitachi Global Storage Technologies (HGST), Seagate Technology (Seagate) and Western Digital Corporation (Western Digital), which are the world’s three largest disk drive manufacturers. In 2006, we added Samsung as a customer.

Our products offer a range of coercivities, glide height capabilities and other parameters to meet specific customer requirements. Finished disk sales of 31/2-inch (95mm) 80 GB to 160 GB and above disks for desktop and high capacity consumer applications, together represented 98.7% of our fourth quarter of 2006 unit shipment volume. Our remaining shipments in the fourth quarter of 2006 were smaller form factor disks for enterprise storage applications.

We manufacture aluminum substrates primarily for our own use in producing finished disks. By doing so, we reduce our dependence on third-party suppliers of substrates. We also sell some substrates to customers and other third parties By selling our substrates to third parties, we better-utilize our factories, reduce our overall cost per disk, and enhance customer relationships with disk drive manufacturers.

For the year ended December 31, 2006, our significant customers, HGST, Seagate and Western Digital, together accounted for approximately 96% of our net sales (Seagate acquired Maxtor in May of 2006 and therefore we have reflected sales to Maxtor in the Seagate numbers for all of 2006).

Competition

The market for our products is highly competitive, with manufacturers competing for a limited number of major customers. We expect competition to continue in the future. Competitors in the thin-film media industry fall mainly into two groups: Asian-based independent disk manufacturers and captive disk manufacturers. Our major Asian-based independent competitors include Fuji Electric, Hoya, and Showa Denko. The captive disk manufacturers that produce thin-film media internally for their own use include HGST and Seagate. Many of these competitors have greater financial resources, greater technical and manufacturing resources, and more extensive name recognition. We are the only U.S.-headquartered independent disk manufacturer.

We believe that some of the principal factors used by customers to distinguish among disk manufacturers include consistent time to market, advanced technology, consistent high quality products produced in high volume at low cost and responsiveness to customer preferences and demands. We believe that our products are competitive with respect to each of these factors in the markets that we currently serve.

Manufacturing

We believe that our manufacturing expertise in thin-film media is evidenced by our history of delivering reliable state of the art products in high volumes. We have four manufacturing facilities located in Penang, Sarawak, and Johor, Malaysia. These facilities have approximately 1,303,000 square feet, a large portion of which contains Class 100 or better clean room environments. These facilities currently have a production capacity of approximately 41 million finished disks a quarter. From time to time we may increase our capacity, depending on our customer requirements. Our strategy is to balance, in a cost-effective manner, our investments in new capacity with the expected growth in demand for our products.

Maintaining low product cost is critical to our ability to sustain profitability. The cost of our products is sensitive to many factors, including production volume, yield, materials and operating supplies consumed, and manufacturing location. Our processes have required substantial investment in equipment and factory buildings. This investment leads to a high fixed cost structure, making our costs sensitive to changes in production volume. Over the last several years, we have successfully reduced the per-unit manufacturing costs of our disks. We believe that our production volumes, yield, and the low cost of our Malaysian manufacturing facilities affords us a comparable or better cost structure compared to others within the industry.

By using our proprietary processes and techniques, we have produced advanced disk products that generally exhibit uniform performance characteristics. These uniform performance characteristics enhance the reliability of the disk drive products manufactured by our customers. In addition, these characteristics can raise production yields on our customers’ manufacturing lines, which is an important cost consideration for them. Manufacturing costs are highly dependent on our ability to effectively use our installed physical capacity to produce large volumes of products at acceptable yields. To improve yields and capacity utilization, we have adopted formal continuous improvement programs at each of our manufacturing facilities.

While maintaining a low cost, high volume cost structure, it is imperative that our customers receive the best in class service and performance from our products. To this end, our factory teams are in continuous contact with each of our customers receiving daily and weekly yield and quality data from their production lines. This real time feedback allows us to help our customers achieve the best yields and quality from Komag products.

Manufacturing of our disks is a complex, multi-step process that converts aluminum substrates into finished data storage media ready for use in a disk drive. The process requires the deposition of extremely thin, uniform layers of metallic film onto a disk substrate. To achieve this, we use a vacuum deposition, or sputtering, method similar to that used to coat semiconductor wafers. The basic process consists of many interrelated steps that can be grouped into five major categories:


	•	Sizing and Grinding of the Substrate. A raw aluminum blank substrate is sized by precisely cutting the inner and outer diameter of the blank. A mechanical grinding process is then utilized to provide a relatively flat surface on the substrate prior to nickel alloy plating.


	•	Nickel Alloy Plating and Polishing of the Substrate. Through a series of chemical baths, aluminum substrates are plated with a uniform nickel phosphorus layer in order to provide support for the magnetic layer. Next, this layer is polished to produce surface characteristics required for magnetic deposition.

	•	Texturing and Cleaning. During these process steps, a precisely controlled, fine texture is applied to the polished disk surface to allow the read/write heads of the disk drives to fly at low and constant levels and then the disks are cleaned in preparation for the sputtering process.

	•	Sputtering and Lube. By a technically demanding vacuum deposition process, magnetic layers are successively deposited on the disk and a hard protective overcoat is applied. After sputtering, a microscopic layer of lubrication is applied to the disk’s surface to improve durability and reduce surface friction.

	•	Glide Test and Certification. In robotically-controlled test cells, disks are tested for glide height and surface defects, and then certified for magnetic properties. Based on these test results, disks are graded against our customers’ specific performance requirements.

Most of the critical process steps are conducted in Class 100 or better clean room environments. Throughout the process, disks are handled by highly automated equipment to reduce contamination and enhance process precision. Minute impurities in materials, particulate contamination or other production problems can reduce production yields and, in extreme cases, cause production to be suspended for prolonged periods.

Environmental Regulation

We are subject to a variety of environmental and other regulations in connection with our operations and believe that we have obtained all necessary permits for our operations. We use various industrial hazardous materials, including metal-plating solutions, in our manufacturing processes. Wastes from our manufacturing processes are either stored in areas with secondary containment before removal to a disposal site, or processed on-site and discharged to the industrial sewer system in accordance with state and federal regulations.

We have, from time to time, upgraded our wastewater treatment facilities to improve the performance and consistency of our wastewater processing. Our Penang and Sarawak manufacturing facilities are ISO 14001-certified. ISO 14001 is a voluntary set of standards that provides companies with a structure for managing the potential environmental impact of their operations. In order to obtain ISO certification, we developed and implemented a formal program to ensure that our manufacturing operations are consistent with minimizing hazardous waste, preventing pollution of air and water, and protecting the environment.

Nonetheless, industrial wastewater discharges from our facilities may, in the future, be subject to more stringent regulations. If we fail to comply with present or future regulations, part or all of our operations would be suspended or terminated. These regulations could restrict our ability to expand at our present locations or could require us to acquire costly equipment or incur other significant expenses.

Patents and Proprietary Information

We hold, and have applied for, U.S. and foreign patents and have entered into cross-licenses with certain of our customers. While these patents could present obstacles to the introduction of new products by competitors and possibly result in royalty-bearing licenses from third parties, we believe that our success does not generally depend on the ownership of intellectual property rights but rather on our innovative skills, technical competence, manufacturing execution, and marketing abilities. Accordingly, we do not expect that the patents we hold or apply for will constitute any assurance of our future success.

We regard elements of our equipment designs and processes as proprietary and confidential and rely upon employee and vendor nondisclosure agreements and a system of internal safeguards for protection. In spite of these steps for protecting proprietary and confidential information, there is a risk that competitors may obtain and use such information. Further, the laws of certain foreign countries in which we do business may provide a lesser degree of protection to our proprietary and confidential information than that provided by the laws of the U.S. Moreover, from time to time, we receive proprietary and confidential information from vendors, customers, and partners, the use and disclosure of which are governed by nondisclosure agreements. Through internal communication and the

monitoring of use and disclosure of such information, we comply with our obligations regarding use and nondisclosure. However, despite these efforts, there is a risk that we may use or disclose this information in violation of our obligations of nondisclosure.

We have occasionally received, and may receive in the future, communications from third parties asserting violation of intellectual rights alleged to cover certain of our products or manufacturing processes or equipment. In these cases, we evaluate whether it would be necessary to defend against the claims or to seek licenses to the rights referred to in such communications. If we must defend those claims, or if we are not able to negotiate necessary licenses on reasonable terms, our business and financial results would suffer.

Employees

As of December 31, 2006, on a worldwide basis, we had 8,441 employees. Of the total, 7,960 were full-time employees and 481 were employed on a temporary basis, 7,750 were employed in manufacturing, 448 were employed in research, development, and engineering, and 243 were employed in sales, administrative, and management positions, and 8,015 were employed in Malaysia and 426 were employed in the U.S.

We believe that our future success will depend in large part on our ability to continue to attract, retain, and motivate highly-skilled and dedicated employees. We have no employees who are represented by a labor union, and we have never experienced a work stoppage.


Item 1A.	*Risk Factors*

These risks and uncertainties are not the only ones facing our company. Additional risks and uncertainties that we are unaware of or currently deem immaterial may also become important factors that may harm our business. If any of the following risks actually occur, or other unexpected events occur, our business, financial condition and results of operations could be materially adversely affected, the value of our stock could decline, and investors may lose part or all of their investment. Further, this Form 10-K contains forward-looking statements, and actual results may differ significantly from the results contemplated by our forward-looking statements.

Risks Related to Our Business

Our business is concentrated in the disk drive market, so downturns in the disk drive manufacturing market and related markets may decrease our revenues and margins, which would materially and adversely affect our business.

Our business is concentrated in the disk drive market, so the market for our products depends on the economic conditions affecting the disk drive manufacturing market and related markets. Our products are incorporated into disk drives manufactured by our customers for the desktop personal computer market as well as the enterprise storage systems market and consumer electronic device market. Historically, it has been very difficult to achieve and maintain profitability and revenue growth in the disk drive industry because the average selling price of a disk drive rapidly declines over its commercial life as a result of technological enhancement, productivity improvement and increases in supply. In addition, intense price competition among personal computer manufacturers also tends to cause the average selling price of a disk drive to decline even further. Because of the concentration of our products in the disk drive market, which we expect to continue, our business is linked to the success of this market, so any downturns in the disk drive market and related markets may decrease our revenues and margins, which would materially and adversely affect our business.

The disk drive market in which our business is concentrated is seasonal and cyclical, so it is difficult to predict our revenues and margins, which could make our stock price more volatile.

The disk drive market in which our business is concentrated has historically been seasonal and cyclical, and has experienced periods of oversupply and reduced production levels, resulting in significantly reduced demand for disks and pricing pressures. The effect of these cycles on suppliers like us historically has been magnified by disk drive manufacturers’ practice of ordering components, including disks, in excess of their needs during periods of rapid growth, thereby increasing the severity of the drop in the demand for components during periods of reduced

growth or contraction. Further, downturns in the disk drive market may cause disk drive manufacturers to delay or cancel projects, reduce their production, or reduce or cancel orders for our products. This, in turn, may lead to longer sales cycles, delays in payment and collection, pricing pressures, and unused capacity, causing us to realize lower revenues and margins and causing our operating results to suffer. For example, during the third quarter of 2006, disk drive manufacturers appear to have overbuilt product, which resulted in an excess supply of disk drives. Due to these factors, forecasts may not be achieved, either because expected sales do not occur or because they occur at lower prices or on terms that are less favorable to us. This increases the chance that our revenues and margins could be lower than the expectations of investors and analysts, which could make our stock price more volatile.

If we are unable to perform successfully in the highly competitive and increasingly concentrated disk industry, we may not be able to maintain or gain additional market share and our business and operating results would be harmed.

The market for our products is highly competitive, and we expect competition to continue in the future. Competitors in the thin-film media industry fall primarily into two groups: Asian-based independent disk manufacturers, and captive disk manufacturers. Our major Asian-based independent competitors include Fuji Electric, Hoya, and Showa Denko. The captive disk manufacturers who produce thin-film media internally for their own use include HGST and Seagate. Many of these competitors have greater financial resources than we have, which could allow them to adjust to fluctuating market conditions better than we. Further, they may have greater technical and manufacturing resources, more marketing power, and a broader array of products. To the extent our competitors continue to consolidate and achieve greater economies of scale, we will face additional competitive challenges. Our competitors may also lower their product prices to gain market share, develop new technology which would significantly reduce the cost of their products, or offer more products than we do and therefore enter into agreements with customers to supply their products as part of a larger supply agreement. Price declines are also affected by any imbalances between demand and supply. We may be forced to lower our prices or add new products and features at lower prices to remain competitive, and we may otherwise be unable to introduce new products at higher prices. We cannot be assured that we will be able to compete successfully in this kind of price competitive environment. If we are not able to compete successfully in the future, we may lose our existing market share and may not be able to gain additional market share for our products, our business and operating results would be harmed.

If we do not keep pace with the rapid technological changes in the disk drive industry, we will not be able to compete effectively, and our operating results could suffer.

Our products primarily serve the 31/2-inch disk drive market where product performance, consistent quality, price, and availability are important competitive factors. The continuing need for high-capacity disk drives requires disks with higher storage capacity. Higher storage capacity on the surface of a disk is achieved by increasing its areal density. Areal density continues to increase rapidly, requiring significant improvements in every aspect of disk design. These advances require substantial on-going process and technology development. New process technologies, such as perpendicular magnetic recording media (PMR), must support cost-effective, high-volume production of disks that meet these ever-advancing customer requirements for enhanced magnetic recording performance. We may not be able to develop and implement these technologies in a timely manner in order to compete effectively against our competitors’ products or entirely new data storage technologies. In addition, we must transfer our technology from our US-based research and development center to our Malaysian manufacturing operations. If we cannot effectively develop and implement adequate process technologies or do not successfully transfer our technologies to our Malaysian operations, or if technologies that we choose not to develop prove to be viable competitive alternatives, we would not be able to compete effectively. As a result, we would lose market share and face increased price competition from other manufacturers, and our operating results could suffer.

If we fail to effectively implement our perpendicular magnetic recording media (PMR) product transition plans, our operating results will suffer.

We have begun a significant product transition program from longitudal magnetic recording (LMR) to advanced perpendicular magnetic recording media (PMR) products. This is an important and substantial product

undertaking for us, and presents many operational challenges. For example, for both internal and external reasons, we may not be able to complete our PMR product transition plans quickly enough in order for us to compete effectively against our competitors. Internally, we may be unable to increase production of PMR products in a timely manner. Externally, we may face shortages or unexpected price increases in critical supplies, such as the precious metals necessary for the manufacture of our PMR products. In addition, our product transition plans will require us to dedicate significant financial and management resources, and if we fail to effectively manage and utilize these resources, we would not be able to compete effectively. If any of the risks occur and we are not able to effectively implement our product transition plans, our operating results will suffer.

If we are unable to minimize the use of precious metals in our products and the price and scarcity of these precious metals continue to increase, our ability to transition to PMR products could be delayed or eliminated.

The manufacture of our PMR products currently requires the use of precious metals, such as platinum and ruthenium. These precious metals, particularly ruthenium, recently have experienced a significant increase in price and, at times, have become difficult to acquire. If we are unable to replace or minimize the use of ruthenium in our PMR products and cannot obtain sufficient quantities of ruthenium at commercially reasonable prices, as an initial matter, our ability to transition over to the manufacture of our PMR products may be slowed. If shortages in ruthenium supplies continue and the price of ruthenium continues to rise, we could experience the following adverse effects:


	•	our PMR products could become more expensive and therefore less competitive than alternative or existing technologies regardless of technological superiority; or

	•	our PMR products could simply become unsustainably expensive to manufacture, which would require us to abandon the development of PMR products and cause us to sell more LMR products.

Because we depend on a limited number of suppliers, if our suppliers experience capacity constraints or production failures, our production, operating results and growth potential could be harmed.

We rely on a limited number of qualified suppliers for some of the materials and equipment used in our manufacturing processes, including aluminum blanks, aluminum substrates, nickel plating solutions, polishing and texturing supplies, and sputtering target materials. For example, Kobe Steel, Ltd. is our primary supplier of aluminum substrate blanks, which is a fundamental component in producing our disks. We also rely on Heraeus Incorporated and Williams Advanced Materials, Incorporated for a substantial quantity of our sputtering target requirements, and on OMG Fidelity, Inc. for supplies of nickel plating solutions. As a result of increased worldwide demand, the supply of sputtering target materials, such as ruthenium, has been constrained recently, resulting in longer lead times and limited product allocations from certain target suppliers. The increasing demand for many of these materials provides our sole-source suppliers with additional bargaining power. Further, the production cycle for certain sputter target supplies has increased, requiring us to increase inventories of precious metals decreasing our operating cash flow. We have also entered into volume purchase commitments for precious metals. If we have not accurately forecasted our requirements for these precious metals, we may have excess or insufficient supplies. If we have excess supplies of precious metals we may not be able to sell the excess in a timely manner or without incurring a loss. If we have insufficient supplies of precious metals we may be required to slow our transition plans to PMR. If one or more of these materials were to become unavailable or available in reduced quantities and we were not able to find an alternative supplier for that material, in addition to the risks delineated above with respect to ruthenium in particular, we could experience the following adverse effects to our business in general:


	•	our production capacity could be reduced if we lack the supplies necessary to manufacture the number of products for which we have sales orders, which could cause us to breach agreements with our customers, make price concessions or otherwise cause a reduction in our revenues;

	•	we might have to modify our products, which could both delay shipment of those products and cause those modified products to be more expensive to manufacture resulting is a lower rate of return on those products;


	•	even if we were able to obtain alternative supplies, those supplies could be more expensive, thereby causing our costs of production to increase;

	•	if we are not able to pass these price increases along to our customers, our operating margins would decline; and

	•	we might be delayed in shipping products or unable to ship products at all, which could cause existing and potential customers to make purchases from our competitors, thus causing our revenues and margins to decline.

We cannot be assured that we will be able to obtain adequate supplies of critical materials and equipment in a timely and economic manner, or at all. The success of our products also depends on our ability to effectively integrate materials that use leading-edge technology. In addition, if we are unable to successfully manage the integration of materials obtained from third party suppliers, our business, financial condition and operating results could suffer. If our sources of materials and supplies were limited or unavailable for a significant period of time or the costs of such materials were to increase, our production, operating results and ability to grow our business could be harmed.

We receive a large percentage of our net sales from only a few disk drive manufacturing customers, the loss or reduction of any of which would materially and adversely affect our business and sales.

We sell our products to a limited number of customers. Our customers are disk drive manufacturers. Because of our small customer base, the loss of any one significant customer would materially and adversely affect our business and sales. In addition, if our current customers do not continue to place orders with us or if we are unable to obtain orders from new customers, our business and sales will likewise suffer. A relatively small number of disk drive manufacturers dominate the disk drive market. We expect that the success of our business will continue to depend on a limited number of customers. In 2006, 37% of our total net sales were to Western Digital, 36% were to Seagate and 23% were to HGST. In 2005, 24% of our net sales were to Western Digital, 16% were to Seagate, 21% were to HGST and 32% were to Maxtor. In May 2006, Seagate acquired Maxtor, making the combined Seagate company the largest disk drive manufacturer in the industry. We have reflected sales to Maxtor in the Seagate numbers for all of 2006. If any one of our significant customers reduces its disk requirements, cancels existing orders, develops or expands capacity to produce its own disks, or requires us to reduce our prices before we are able to reduce costs, and we are unable to replace these orders with sales to new customers, our sales would be reduced and our business, financial condition, and operating results would suffer. Our ability to maintain strong relationships with our significant customers is essential to our future performance.

In addition, if our customers cancel orders, our sales could suffer and we are generally not entitled to receive cancellation penalties to offset the loss of sales revenue. Our sales are generally made pursuant to purchase orders that are subject to cancellation, modification, or rescheduling without significant penalties. As a result, if a customer cancels, modifies, or reschedules an order, we may have already made expenditures that are not recoverable, and our profitability will suffer.

Our agreements with each of our major customers require us to meet certain production volumes and to provide certain credits on future disk sales, and if we fail to successfully perform under these agreements, we may incur substantial costs and expenses, and our business and financial condition could be materially and adversely affected.

We have entered into strategic supply agreements, including certain amendments to these agreements, with each of our major customers that require us to meet certain production volume goals. In addition, under the terms of these supply agreements, our customers are required to pay certain advances to us covering future purchases of media from us. The customer advances, which totaled $127.2 million as of December 31, 2006, are to be repaid to our customers via a credit of a specified dollar amount per disk on future sales. Pursuant to these agreements, monies have been advanced to us to help fund the expansion of our capacity, and if we fail to meet the agreed upon volume goals, due to our inability to meet product specifications or timetables required by our customers for delivery, we may need to refund some of our customer advances. In addition, the agreements generally provide for repayment of the advances at the end of the term of the agreement if the advances are not fully paid by credits

applied to purchases. The terms of the current arrangements expire on various dates through December 2009. Our inability to successfully and competently perform our obligations under our agreements may cause us to incur substantial costs and expenses, and would have a material adverse effect on our business and financial condition.

Our failure to timely and efficiently transition our enterprise resource planning software from the system we currently use to a new system, could adversely affect our business and financial results.

We use enterprise resource planning software in the operation of our business and maintenance of business and financial data related to our daily operations. We are in the process of transitioning to new resource planning software during 2007. We may experience unexpected difficulties in transitioning to the new software, including difficulties related to the failure or inefficient operation of the new software. Such difficulties or failures could result in our inability to access business and financial information stored on the system or the loss of such information. Any inability to access, or loss of, such information as a result of the transition or otherwise could affect our daily operations, including our ability to ship products and invoice our customers, which could have a significant adverse impact on our business and financial results.

If we are not able to attract and retain key personnel our business and operation results could be harmed.

Our future success depends on the continued service of our executive officers, our highly-skilled research, development and engineering team, our manufacturing team, and our key administrative, sales and marketing, and support personnel, many of whom would be extremely difficult to replace. Acquiring and retaining talented personnel who possess the advanced skills we require has been difficult, particularly at our Malaysian manufacturing facilities where there is high growth in the marketplace. We may not be able to attract, assimilate, or retain highly-qualified personnel to maintain the capabilities that are necessary to compete effectively. Further, we do not have key person life insurance on any of our key personnel. If we are unable to retain existing or hire key personnel, our business and operating results could be harmed.

If our production capacity is underutilized, our gross margin will be adversely affected and we could sustain significant losses.

Our business is characterized by high fixed overhead costs, including expensive plant facilities and production equipment. Our per-unit costs and our gross profit are significantly affected by the number of units we produce and the amount of our production capacity that we utilize. We have significantly increased the production capacity of our manufacturing operations in Malaysia in 2006. We have in the past, and may in the future, experience periods of underutilized capacity. For example, in the third quarter of 2004, we completed the installation of additional equipment, which increased our production capacity from approximately 20 million disks a quarter to approximately 24 million disks a quarter. Our finished disk shipments were below this capacity level in the third quarter and fourth quarter of 2004. If our capacity utilization decreases for any reason, including lack of customer demand or cancellation or delay of customer orders, we could experience significantly higher unit production costs, lower margins, and potentially significant losses. Underutilization of our production capacity could also result in asset impairment charges, restructuring charges, and employee layoffs. If our production capacity is underutilized for any reason, our financial results and our business would be severely harmed.

Internal disk operations of disk drive manufacturers may adversely affect our ability to sell our disk products.

Disk drive manufacturers such as HGST and Seagate have large internal thin-film media manufacturing operations, and are able to produce a substantial percentage of their disk requirements. We have strategic supply agreements with both of these customers. However, we also compete directly with these customers’ internal operations, and compete indirectly when we sell our disks to customers who must compete with vertically-integrated disk drive manufacturers. Vertically-integrated companies have the opportunity to keep their disk-making operations fully utilized, thus lowering their costs of production. This cost advantage contributes to the pressure on us and other independent disk manufacturers to sell disks at lower prices and can severely affect our profitability. Vertically-integrated companies are also able to achieve a large manufacturing scale that supports the

development resources necessary to advance technology rapidly. Both Seagate and HGST are adding internal thin film media manufacturing capacity to support the growing demand for disks drives. We may not have sufficient resources or manufacturing scale to be able to compete effectively with these companies as to production costs or technology development, which would negatively impact our net sales and market share.

All of our manufacturing operations are in Malaysia and our foreign operations and international sales subject us to additional risks inherent in doing business on an international level that could make it more costly and difficult to conduct our business.

Our manufacturing operations are consolidated in Malaysia. As a result, technology developed at our US-based research and development center must be first implemented for high-volume production at our Malaysian facilities. Therefore, we rely heavily on electronic communications between our US headquarters and our Malaysian facilities to transfer specifications and procedures, diagnose operational issues, and meet customer requirements. If our operations in Malaysia or overseas communications are disrupted for a prolonged period for any reason, including a failure in electronic communications with our US operations, the manufacture and shipment of our products would be delayed, and our results of operations would suffer. In addition, a tsunami, flood, earthquake, political instability, act of terrorism or other disaster or condition that adversely affects our facilities or ability to manufacture our products could significantly harm our business, financial condition and operating results.

Additionally, because a large portion of our payroll, certain manufacturing and operating expenses, and inventory and capital purchases is transacted in the Malaysian ringgit (ringgit), we are particularly sensitive to any change in the foreign currency exchange rate for the ringgit. For approximately seven years, the exchange rate between the ringgit and the US dollar was pegged at 3.8 ringgits to one US dollar by the Malaysian government. In July 2005, Malaysia removed its currency peg to the US dollar in favor of a managed float system. The change in exchange rates could adversely affect the amount we spend on our payroll, certain manufacturing and operating expenses, and raw materials and capital purchases. In 2006, our spending on payroll, manufacturing, and operating expenses, and raw materials and capital purchases that were denominated in ringgit was approximately $327.5 million. Additionally, in 2006, we paid approximately $120.3 million US dollars to a Malaysian supplier for raw materials purchases, based on a cost plus a percentage arrangement. This Malaysian supplier incurs certain costs that are denominated in ringgit; therefore, any change in the valuation of the ringgit could materially impact the cost per unit we pay for such raw materials. Furthermore, our ability to transfer funds from our Malaysian operations to the US is subject to Malaysian rules and regulations.

There are a number of other risks associated with conducting business outside of the US. Our Malaysian operations account for substantially all of our net sales. Our sales are primarily made to Asian customers, including the foreign subsidiaries of domestic disk drive companies. Accordingly, our operating results are subject to the risks inherent with international operations, including, but not limited to:


	•	compliance with changing legal and regulatory requirements of foreign jurisdictions;

	•	fluctuations in tariffs or other trade barriers;

	•	difficulties in staffing and managing foreign operations;

	•	political, social, and economic instability;

	•	increased exposure to threats and acts of terrorism;

	•	exposure to taxes in multiple jurisdictions;

	•	exposure to fluctuations in the value of currency;

	•	local infrastructure problems or failures including but not limited to loss of power and water supply; and

	•	transportation delays and interruptions.

If we do not effectively manage the risks associated with international operations and sales, our business, financial condition, and operating results could suffer.

Because our products require a lengthy sales cycle with no assurance of high volume sales, we may expend significant financial and other resources without a return.

We must frequently qualify new products with our disk drive manufacturing customers, based on criteria such as quality, storage capacity, performance, and price. Qualifying disks for incorporation into new disk drive products requires us to work extensively with our customer and the customer’s other suppliers to meet product specifications. Therefore, customers often require a significant number of product presentations and demonstrations, as well as substantial interaction with our senior management, before making a purchasing decision. Accordingly, our products typically have a lengthy sales cycle, which can range from six to twelve months or longer. During this time, we may expend substantial financial resources and management time and effort, while having no assurances that a sale will result, or that disk drive programs ultimately will result in high-volume production. To the extent we expend significant resources to qualify products without realizing sales, our operations will suffer.

Disk drive programs are highly customized. If we fail to respond to our customers’ demanding requirements, we will not be able to compete effectively.

The disk industry is subject to rapid technological change, and if we are unable to anticipate and develop products and production technologies on a timely basis, our competitive position could be harmed. Customization has increased the risk of product obsolescence, and as a result, supply chain management, including just-in-time delivery, has become a standard industry practice. In order to sustain customer relationships and sustain profitability, we must be able to develop new products and technologies in a timely fashion in order to help customers reduce their time-to-market performance, and continue to maintain operational excellence that supports high-volume manufacturing ramps and tight inventory management throughout the supply chain. The success of any new product introduction is dependent on a number of factors, including market acceptance, our ability to manage the risks associated with product transitions, and the risk that a new product will have quality problems or other defects in the early stages of introduction that were not anticipated in the design of such product. Accordingly, we have invested, and intend to continue to invest heavily, in our research and development program. If we cannot respond to this rapidly changing environment or fail to meet our customers’ demanding product and qualification requirements, we will not be able to compete effectively. As a result, we would not be able to maximize the use of our production facilities, and our profitability would be negatively impacted.

If we fail to improve the quality of, and control contamination in our manufacturing processes, we will lose our ability to remain competitive.

The manufacture of our products requires a tightly-controlled, multi-stage process, and the use of high-quality materials. Efficient production of our products requires utilization of advanced manufacturing techniques and clean room facilities. Disk fabrication occurs in a highly controlled, clean environment to minimize particles and other yield-limiting and quality-limiting contaminants. In spite of stringent manufacturing controls, weaknesses in process control or minute impurities in materials may cause a substantial percentage of the disks in a production lot to be defective. The success of our manufacturing operations depends, in part, on our ability to maintain process control and minimize such impurities in order to maximize yield of acceptable high-quality disks. Minor variations from specifications could have a disproportionately adverse impact on our manufacturing yields. If we are not able to continue to improve on our manufacturing processes or maintain stringent quality controls, or if contamination problems arise, we will not remain competitive, and our operating results would be harmed.

An industry trend towards glass-based applications could negatively impact our ability to remain competitive.

Our finished disks are manufactured primarily from aluminum substrates, which are the primary substrate used in desktop PC, enterprise applications, and high-capacity consumer applications. Some disk manufacturers emphasize the use of glass as a basis for the manufacture of their disks to primarily serve the mobile PC market and certain other mobile consumer applications. These applications are expected to achieve significant growth in the near future. Although we are currently developing glass-based products for shipment in 2007, there is no guarantee that our production efforts will be successful. To the extent glass-based applications were to achieve

significant growth in the market place, we may lose market share if we were unable to move rapidly and effectively to produce glass-based disks to address the demand.

If we do not protect our patents and other intellectual property rights, our net sales could suffer.

Our protection of our intellectual property is limited. It is commonplace to protect technology through patents and other forms of intellectual property rights in technically sophisticated fields. We may not receive patents for our pending or future patent applications, and any patents that we own or that are issued to us may be invalidated, circumvented or challenged. In the disk and disk drive industries, companies and individuals have initiated actions against others in the industry to enforce intellectual property rights. Although we attempt to protect our intellectual property rights through patents, copyrights, trade secrets, and other measures, we may not be able to protect adequately our technology. In addition, we may not be able to discover significant infringements of our technology or successfully enforce our rights to our technology if we discover infringing uses by others, and such infringements could have a negative impact on our ability to compete effectively. Competitors may be able to develop similar technology and also may have or may develop intellectual property rights and enforce those rights to prevent us from using such technologies, or demand royalty payments from us in return for using such technologies. Either of these events may affect our production, which could materially reduce our net sales and harm our operating results.

We may face intellectual property infringement claims that are costly to resolve, may divert our management’s attention, and may negatively impact our business and operating results.

We have occasionally received, and may receive in the future, communications from third parties that assert violation of intellectual property rights alleged to cover certain of our products or manufacturing processes or equipment. We evaluate on a case-by-case basis whether it would be necessary to defend against such claims or to seek licenses to the rights referred to in such communications. We may have to litigate to enforce patents issued or licensed to us, to protect trade secrets or know-how owned by us or to determine the enforceability, scope and validity of our proprietary rights and the proprietary rights of others. Enforcing or defending our proprietary rights could be expensive and might not bring us timely and effective relief. In certain cases, we may not be able to negotiate necessary licenses on commercially reasonable terms, or at all. Also, if we have to defend such claims, we could incur significant expenses and our management’s attention could be diverted from our core business. Further, we may not be able to anticipate claims by others that we infringe on their technology or successfully defend ourselves against such claims. Any litigation resulting from such claims could have a material adverse effect on our business and operating results.

Historical quarterly results may not accurately predict our performance due to a number of uncertainties and market factors, and as a result it is difficult to predict our future results.

Our operating results historically have fluctuated significantly on both a quarterly and annual basis. We believe that our future operating results will continue to be subject to quarterly variations based on a wide variety of factors, including:


	•	timing of significant orders, or order cancellations;

	•	changes in our product mix and average selling prices;

	•	modified, adjusted, or rescheduled shipments;

	•	actions by our competitors, including announcements of new products or technological innovations;

	•	availability of disks versus demand for disks;

	•	the cyclical nature of the disk drive industry;

	•	our ability to develop and implement new and efficient manufacturing process technologies;

	•	increases in our production and engineering costs associated with initial design and production of new product programs;

	•	availability and price of key materials;


	•	our ability to execute future product development and production ramps effectively;

	•	fluctuations in exchange rates, particularly between the US dollar and the Malaysian ringgit;

	•	the ability of our process equipment to meet more stringent future product requirements;

	•	our ability to introduce new products that achieve cost-effective high-volume production in a timely manner, timing of product announcements, and market acceptance of new products;

	•	the availability of our production capacity, and the extent to which we can use that capacity;

	•	changes in our manufacturing efficiencies, in particular product yields and input costs for direct materials, operating supplies and other running costs;

	•	prolonged disruptions of operations at any of our facilities for any reason;

	•	changes in the cost of or limitations on availability of labor;

	•	structural changes within the disk industry, including combinations, failures, and joint venture arrangements; and

	•	changes in tax regulations in foreign jurisdictions that could potentially reduce our tax incentives in areas such as Malaysian capital allowances, tax holidays, and exemptions on withholding tax on royalty payments made by our Malaysian operations to our subsidiary in the Netherlands.

We cannot forecast with certainty the impact of these and other factors on our revenues and operating results in any future period. Our expense levels are based, in part, on expectations as to future revenues. Many of our expenses are relatively fixed and difficult to reduce or modify. The fixed nature of our operating expenses will magnify any adverse effect of a decrease in revenue on our operating results. Because of these and other factors, period to period comparisons of our historical results of operations are not a good predictor of our future performance. If our future operating results are below the expectations of stock market analysts, our stock price may decline. Our ability to predict demand for our products and our financial results for current and future periods may be affected by economic conditions. This may adversely affect both our ability to adjust production volumes and expenses and our ability to provide the financial markets with forward-looking information. If our revenue levels are below expectations, our operating results are likely to suffer.

If we make unprofitable acquisitions or are unable to successfully integrate future acquisitions, our business could suffer.

We have in the past acquired, and in the future may acquire, businesses, products, equipment, or technologies that we believe will complement or expand our existing business. Acquisitions involve numerous risks, including the following:


	•	difficulties in integrating the operations, technologies, products and personnel of the acquired companies, especially given the specialized nature of our technology;

	•	diversion of management’s attention from normal daily operations of the business;

	•	potential difficulties in completing projects associated with in-process research and development;

	•	initial dependence on unfamiliar supply chains or relatively small supply partners; and

	•	the potential loss of key employees of the acquired companies.

Acquisitions may also cause us to:


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

	•	assume liabilities;

	•	record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges;


	•	incur amortization expenses related to certain intangible assets;

	•	incur large and immediate write-offs; or

	•	become subject to litigation.

Mergers and acquisitions of high-technology companies are inherently risky, and no assurance can be given that any future acquisitions by us will be successful and will not materially adversely affect our business, operating results, or financial condition. The failure to manage and successfully integrate acquisitions we make could harm our business and operating results in a material way. Even if an acquired company has already developed and marketed products, there can be no assurance that product enhancements will be made in a timely fashion or that pre-acquisition due diligence will have identified all possible issues that might arise with respect to products or the integration of the company into our company.

The nature of our operations makes us susceptible to material environmental liabilities, which could result in significant compliance and clean-up expenses and adversely affect our financial condition.

We are subject to a variety of federal, state, local, and foreign regulations relating to:


	•	the use, storage, discharge, and disposal of hazardous materials used during our manufacturing process;

	•	the treatment of water used in our manufacturing process; and

	•	air quality management.

We are required to obtain necessary permits for expanding our facilities. We must also comply with new regulations on our existing operations, which may result in significant costs. Public attention has increasingly been focused on the environmental impact of manufacturing operations that use hazardous materials.

If we fail to comply with environmental regulations or fail to obtain the necessary permits:


	•	we could be subject to significant penalties;

	•	our ability to expand or operate in California or Malaysia could be restricted;

	•	our ability to establish additional operations in other locations could be restricted; or

	•	we could be required to obtain costly equipment or incur significant expenses to comply with environmental regulations.

Even if we are in compliance in all material respects with all present environmental regulations, it is often difficult to estimate the future impact of environmental matters, including potential liabilities. If we have to make significant capital expenditures or pay significant expense in connection with remedial actions or to continue to comply with applicable environmental laws, our business, financial condition and operating results could suffer. Furthermore, our manufacturing processes rely on the use of hazardous materials, and any accidental hazardous discharge could result in significant liability and clean-up expenses, which could harm our business, financial condition, and results of operations.

From time to time, we may have to defend against lawsuits in connection with the operation of our business.

We are subject to litigation in the ordinary course of our business. If we do not prevail in any lawsuit which may occur we could be subject to significant liability for damages, our patents and other proprietary rights could be invalidated, and we could be subject to injunctions preventing us from taking certain actions. If any of the above occurs, our business and financial position could be harmed.

Earthquakes, tsunamis or other natural or man-made disasters could disrupt our operations.

Our US facilities are located in San Jose, California. In addition, Kobe Steel, Ltd. and other Japanese suppliers of our key manufacturing supplies and sputtering machines are located in areas with seismic activity. Our Malaysian operations have been subject to temporary production interruptions due to localized flooding, disruptions in the

delivery of electrical power, and, on one occasion in 1997, by smoke generated by large, widespread fires in Indonesia. If any natural or man-made disasters do occur, operations could be disrupted for prolonged periods, and our business would suffer.

Terrorist attacks may adversely affect our business and operating results.

The continued threat of terrorist activity and other acts of war or hostility, including the war in Iraq, have created uncertainty in the financial and insurance markets, and have significantly increased the political, economic, and social instability in some of the geographic areas in which we operate. Acts of terrorism, either domestic or foreign, could create further uncertainties and instability. To the extent this results in disruption or delays of our manufacturing capabilities or shipments of our products, our business, operating results, and financial condition could be adversely affected.

Compliance with the rules and regulations concerning corporate governance may be costly, time-consuming, and difficult to achieve, which could harm our operating results and business.

The Sarbanes-Oxley Act (the Act), which was signed into law in October 2002, mandates that, among other things, companies maintain rigorous corporate governance measures, and imposes comprehensive reporting and disclosure requirements. The Act also imposes increased civil and criminal penalties on a corporation, its chief executive and chief financial officers, and members of its board of directors, for securities law violations. In addition, the Nasdaq National Market, on which our common stock is traded, has adopted and is considering the adoption of additional comprehensive rules and regulations relating to corporate governance. These rules, laws, and regulations have increased the scope, complexity, and cost of our corporate governance, reporting, and disclosure practices. Because compliance with these rules, laws, and regulations is costly and time-consuming, our management’s attention could be diverted from managing our day-to-day business operations, and our operating expenses could increase. In addition, because of the inherent limitations in all financial control systems, it is possible that, in the future, a material weakness may be found in our internal controls over financial reporting, which could affect our ability to insure proper financial reporting.

Further, our board members, Chief Executive Officer and Chief Financial Officer face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficulty attracting and retaining qualified board members and executive officers, which could harm our business.

In the future, we may need additional capital, which may not be available on favorable terms, or at all.

Our business is capital-intensive and we may need more capital in the future. Our future capital requirements will depend on many factors, including:


	•	the rate of our sales growth;

	•	the level of our profits or losses;

	•	the timing and extent of our spending to increase inventories to support our transition to PMR products, support facilities upgrades and product development efforts;

	•	the timing and size of business or technology acquisitions;

	•	the timing of introductions of new products and enhancements to our existing products; and

	•	the length of product life cycles.

If we require additional capital it is uncertain whether we will be able to obtain additional financing on favorable terms, if at all. Further, if we issue equity securities in connection with additional financing, our stockholders may experience dilution and/or the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products and services in a timely manner, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements or may be forced to limit the number of products and services we offer, any of which could seriously harm our business.

Anti-takeover provisions in our certificate of incorporation could discourage potential acquisition proposals or delay or prevent a change of control.

We have in place protective provisions designed to provide our board of directors with time to consider whether a hostile takeover is in our and our stockholders’ best interests. Our certificate of incorporation provides for three classes of directors. As a result, a person could not take control of the board until the third annual meeting after the closing of the takeover, since a majority of our directors will not stand for election until that third annual meeting. This provision could discourage potential acquisition proposals and could delay or prevent a change in control of the company, and also could diminish the opportunities for a holder of our common stock to participate in tender offers, including offers at a price above the then-current market price for our common stock. These provisions also may inhibit fluctuations in our stock price that could result from takeover attempts.

Risks Related to our Indebtedness

We are leveraged, and our debt obligations will continue to make us vulnerable to economic downturns.

In 2004, we completed a public common stock offering of 4.0 million shares (of which 0.5 million were sold by selling stockholders) and a public $80.5 million Convertible Subordinated Notes offering. Debt service obligations arising from the offering of our Convertible Subordinated Notes could limit our ability to borrow more money for operations and implement our business strategy in the future.

We are dependent on cash flow from our subsidiaries to meet our obligations.

Most of our operations are conducted through, and most of our assets are held by, our subsidiaries. Therefore, we are dependent on the cash flow of our subsidiaries to meet our debt obligations. Our subsidiaries are separate legal entities that have no obligation to pay any amounts due under the Convertible Subordinated Notes, or to make any funds available therefore, whether by dividends, loans, or other payments. Our subsidiaries have not guaranteed the payment of the Convertible Subordinated Notes, and payments on the Convertible Subordinated Notes are required to be made only by us. Except to the extent we may ourselves be a creditor with recognized claims against our subsidiaries, subject to any limitations contained in our debt agreements, all claims of creditors and holders of preferred stock, if any, of our subsidiaries will have priority with respect to the assets of such subsidiaries over the claims of our creditors, including holders of the Convertible Subordinated Notes.

The assets of our subsidiaries may not be available to make payments on our debt obligations.

We may not have direct access to the assets of our subsidiaries unless these assets are transferred by dividend or otherwise to us. The ability of our subsidiaries to pay dividends or otherwise transfer assets to us could be subject to various restrictions in the future.


Item 1B.	*Unresolved Staff Comments*

None.


Item 2.	*Properties*

The following table summarizes the location, description, current status and size of our facilities:

Current Lease

Location

Description

Term Expires

Renewal Options

Square Feet

Leased Facilities

San Jose, California

Headquarters and R&D Center

December 2014

two 5-year options

188,000

Owned Facilities

Penang, Malaysia

Manufacturing

—

785,000

Sarawak, Malaysia

Manufacturing

—

275,000

Johor, Malaysia

Manufacturing

—

243,000

We believe that the facilities under lease or owned by us will be adequate for at least the next 12 months. For additional information regarding our obligations under property leases, see Note 12 of Notes to Consolidated Financial Statements, which is included in Part II, Item 8 of this Report.


Item 3.	*Legal Proceedings*

In the normal course of business, we receive and make inquiries with regard to possible patent infringement. Where deemed advisable, we may seek to enter into or extend licenses or negotiate settlements. Outcomes of such negotiations may not be determinable at any one point in time; however, management currently does not believe that such licenses or settlements will materially affect our financial position or results of operations.


Item 4.	*Submission of Matters to a Vote of Security Holders*

No matters were submitted to our stockholders during our fourth quarter of 2006.

Our Executive Officers

The following table sets forth the name, age, and other information regarding our executive officers as of February 1, 2007. No family relationship exists between any of our directors and executive officers.


Timothy D. Harris	51	Chief Executive Officer
Ray L. Martin	63	Executive Vice President, Customer Sales and Service
Peter S. Norris	55	Executive Vice President, Strategic Business Development
Tsutomu T. Yamashita	52	Executive Vice President, Chief Technical Officer
Kathleen A. Bayless	50	Senior Vice President, Chief Financial Officer, and Secretary
William G. Hammack	57	Senior Vice President, Human Resources
Edward J. Casey	52	Vice President, Chief Operating Officer
Paul G. Judy	44	Vice President, Corporate Controller, and Chief Accounting Officer

Mr. Harris joined our company in October 2005 as Executive Vice President, Chief Operating Officer. He was appointed Chief Executive Officer in 2006. Before joining our company, he worked at iolon, Inc. where he served as Vice President of Operations from 2000 to 2004 and Chief Operating Officer from 2004 to 2005. From 1990 to 2000, Mr. Harris served in various management and executive positions at Seagate Technology, including Senior Vice President of Worldwide Technology Operations, and Vice President/Managing Director of Malaysian Head Operations. Before joining Seagate Mr. Harris held manufacturing and management positions at Conner Peripherals, Domain Technology, and Memorex. Mr. Harris holds a Master of Business Administration degree from Santa Clara University and a B.A. degree from the University of California, Santa Cruz.

Mr. Martin joined our company in 1997 as Vice President, Product Assurance and Product Test, and became our Senior Vice President, Customer Sales and Service in 1998. In 2001, Mr. Martin became our Executive Vice President, Customer Sales and Service. From 1990 to 1997, he was Director of Process and Technology at Quantum Corporation. Prior to working at Quantum, Mr. Martin held a number of management and engineering positions at several leading disk drive manufacturers, including Western Digital, Seagate Technology, and IBM. Mr. Martin holds a B.S. degree in Mechanical Engineering from Kansas State University.

Mr. Norris joined our company in October 2000, as Executive Vice President, Strategic Business Development, after the merger with HMT Technology Corporation (HMT). He joined HMT in 1995 as Vice President, Finance, Chief Financial Officer and Treasurer and became its Executive Vice President, Finance, Chief Financial Officer and Treasurer in 1999. From 1975 to 1995, Mr. Norris worked for General Instrument Corporation. Mr. Norris holds a B.A. degree in Economics from Upsala College.

Mr. Yamashita joined our company in 1984 as an engineer, and became Vice President, Research and Development in 1995. Mr. Yamashita then became Vice President, Process Development and became Senior Vice President in 2005. In 2006, Mr. Yamashita was promoted to Executive Vice President, Chief Technical Officer. Mr. Yamashita holds a B.S. degree in Chemistry and a M.S. degree in Materials Science from Stanford University.

Ms. Bayless joined our company in 1994 as Corporate Controller, became a Vice President in 2000, our Chief Financial Officer in September 2002, and a Senior Vice President in 2005. Before joining us, Ms. Bayless worked for the public accounting firm of Ernst & Young, LLP. Ms. Bayless holds a B.S. degree in Accounting from California State University Fresno, and is a Certified Public Accountant.

Mr. Hammack joined our company in June 2002, as Vice President, Human Resources. Mr. Hammack left Komag in January 2005 to take a position as Vice President with IDT Inc. Mr. Hammack returned to Komag in March 2005, and became a Senior Vice President in 2005. Before joining Komag in 2002, Mr. Hammack served as Vice President, Human Resources at Zambeel, Inc. from 2001 to 2002. Prior to that, he served as Vice President, Human Resources at QRS Corporation from 1999 to 2001. From 1982 to 1999, he served as Vice President, Human Resources at General Electric Medical Systems/Diasonics. Mr. Hammack holds a B.A. degree from San Diego State University.

Mr. Casey joined our company in October 2000 as Director of New Technologies, after our merger with HMT. Mr. Casey was promoted to Executive Director of New Technologies in 2005. Prior to his role at the company, Mr. Casey held various manufacturing and operations management positions for HMT, StorMedia, Nashua Computer Products and Lin Data Corporation.

Mr. Judy joined our company in 1988 as a senior accountant, and served in various accounting and financial reporting roles through September 1999. From March 2000 to March 2004, Mr. Judy worked for New Focus, Inc. in financial reporting management roles, including Corporate Controller. Mr. Judy rejoined our Company in March 2004 as Corporate Controller and Chief Accounting Officer, and was promoted to Vice President in October 2005. Before joining us in 1988, Mr. Judy worked for the public accounting firm of Arthur Andersen LLP. Mr. Judy holds a B.S. degree in Commerce from Santa Clara University, and is a Certified Public Accountant.

PART II


Item 5.	*Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities*

Our common stock is traded on the Nasdaq National Market under the symbol “KOMG”. The following table sets forth, for the periods indicated, the high and low closing sale price per share for our common stock, as reported by the Nasdaq National Market.


	High		Low

2005
First Quarter	$	23.33	$	17.33
Second Quarter		32.30		19.96
Third Quarter		39.95		28.33
Fourth Quarter		37.62		24.93
2006
First Quarter		53.48		34.73
Second Quarter		48.83		40.35
Third Quarter		47.54		30.83
Fourth Quarter		40.72		32.47

As of February 1, 2007, 31,158,189 shares of our common stock were outstanding. These shares were held by 47 holders of record.

Dividend Policy

We have never declared cash dividends on our common stock. We presently intend to retain all cash to repay our debt and operate and expand our business, and do not anticipate paying any cash dividends in the near future.

Recent Sales of Unregistered Securities

The following table provides information about the repurchase of our common stock during the fourth quarter ended December 31, 2006:

Total

Number of

Shares

Maximum Number

Purchased

(or Approximate

as Part of

Dollar Value)

Total

Average

Publicly

of Shares

Number of

Price

Announced

that May Yet be

Shares

Paid per

Plans or

Purchased Under the

Period

Purchased(1)

Share

Programs

Plans or Programs

October 2 to October 29

29,099

32.49

—

October 30 to November 26

512

37.49

—

November 27 to December 31

—

Total

29,611

32.57

—


(1)		Shares purchased from certain of our officers and employees pursuant to net share settlement transactions upon the vesting of shares of restricted common stock held by such officers and employees.

Securities Authorized for Issuance Under Equity Compensation Plans

See Part III, Item 12, of this Report on Form 10-K for information on securities authorized for issuance under our equity compensation plans, which is incorporated herein by reference. In addition, see Note 11 of our Notes to Consolidated Financial Statements, which is included in Part II, Item 8 of this Report on Form 10-K, for further information on our equity compensation plans.

Stock Performance Graph

The graph below compares the cumulative total stockholder return on our common stock with the cumulative total return on the Nasdaq Composite Index and the Nasdaq Computer Manufacturers Index. Komag reorganized on June 30, 2002. As a result, stock prices, financial statements, as well as the related earnings per share calculations for the periods ended prior to June 30, 2002, are not comparable to the stock prices, financial statements and earnings per share calculations for periods ended after June 30, 2002. After our reorganization, the first date that our common stock began trading was on July 19, 2002, which date is therefore reflected as the measurement point in the performance graph below.

The performance graph below does not cover the period from December 31, 2001 until July 18, 2002, since such period preceded the date that our common stock first began trading after our reorganization. Prior to our reorganization, an investment of $100 in our common stock on December 28, 2001 would have shown no return as of the date of and following our reorganization.


Item 6.	*Selected Consolidated Financial Data*

The following table sets forth selected consolidated financial data and other operating information of Komag, Incorporated. The financial data and operating information is derived from the consolidated financial statements of Komag, Incorporated, and should be read in conjunction with the consolidated financial statements, related notes, and other financial information included herein (in thousands, except per share amounts).


	Successor Company													Predecessor Company
												Six Months		Six Months
	Fiscal Year Ended											Ended		Ended
	Decmber 31,			January 1,			January 2,			December 28,		December 29,		June 30,
Consolidated Statements of Operations Data	2006			2006			2005			2003		2002		2002
													(1)		(2)(3)(4)(5)(6)
Net sales	$	937,676		$	685,946		$	458,377		$	438,292	$	174,749	$	111,955
Gross profit		247,682			188,733			112,117			107,422		31,740		1,558
Restructuring/impairment charges		—			—			—			—		34,763		4,318
Operating income (loss)		149,452			117,932			54,382			49,419		(36,380)		(27,674)
Interest expense		1,764			1,765			3,176			13,153		6,553		—
Other income (expense), net		(426	)		(415	)		(151	)		250		2,150		397,009
Reorganization costs, net		—			—			—			—		—		6,511
Income (loss) before cumulative effect of change in accounting principle		157,533			115,637			51,355			36,040		(41,919)		359,924
Cumulative effect of change in accounting principle		—			—			—			—		—		(47,509)
Net income (loss)	$	157,533		$	115,637		$	51,355		$	36,040	$	(41,919)	$	312,415
Basic net income (loss) per share	$	5.27		$	3.99		$	1.88		$	1.53	$	(1.84)		—
Diluted net income (loss) per share	$	4.75		$	3.55		$	1.71		$	1.47	$	(1.84)		—


	Successor Company
	As of
	December 31,		January 1,		January 2,		December 28,		December 29,
Consolidated Balance Sheet Data	2006		2006		2005		2003		2002
Property, plant, and equipment, net, and land and buildings held for sale	$	542,585	$	351,046	$	205,642	$	184,536	$	221,014
Total assets		977,687		731,451		431,095		347,807		317,200
Current portion of long-term debt		—		—		—		20,247		10,229
Long-term debt, less current portion		80,500		80,500		80,500		95,801		129,923
Stockholders’ equity	$	602,026	$	419,005	$	287,626	$	166,588	$	127,960


(1)		Results of operations for the six months ended December 29, 2002 included a $33.9 million impairment charge related to the write-off of all remaining goodwill, in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets (SFAS No. 142).

(2)		Results of operations for the six months ended June 30, 2002 included other income of $379.0 million associated with the extinguishment of liabilities subject to compromise as of June 30, 2002, and other income of $17.3 million to revalue the Company’s assets and liabilities at June 30, 2002 to fair value as prescribed by fresh-start reporting under Statement of Position 90-7 (SOP 90-7), Financial Reporting by Entities in Reorganization Under the Bankruptcy Code.

(3)		Results of operations for the six months ended June 30, 2002, included a $4.3 million restructuring/impairment charge in connection with the shutdown of the Company’s research and development facility in Santa Rosa, California.

(4)		Results of operations for the six months ended June 30, 2002, included a $47.5 million transitional impairment loss under SFAS No. 142. The loss was recognized as the cumulative effect of a change in accounting principle in the Company’s consolidated statement of operations.

(5)		In accordance with SOP 90-7, we did not record interest expense on our outstanding debt during the chapter 11 proceedings from August 24, 2001, through June 30, 2002.

(6)		Earnings per share of the Predecessor Company are not presented, as the amounts are not meaningful.


Item 7.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*

The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes included in Item 8, Consolidated Financial Statements and Supplementary Data of this Report on Form 10-K.

The following discussion contains predictions, estimates, and other forward-looking statements that involve a number of risks and uncertainties about our business, including but not limited to: our belief that we are a leading independent supplier of disks; our belief that we have developed a deep understanding of market needs in the disk drive market; our belief that our manufacturing and technology development programs provide us with competitive advantages in maintaining and growing our market share; our belief that we will effectively implement our PMR

product transition plans; our belief that we have developed strong relationships with many of the leading disk drive manufacturers; our belief that our manufacturing operations, together with our experience in the industry and our economies of scale, provide us with timing and cost advantages in delivering consistently high-quality products to our customers in high volumes; our plan to continue to generate cash from our operations in 2007; our belief that we will continue to investigate areas where we can expand our presence in the disk market; our expectation that we will continue to generate cash from operations; our expectation that we may increase our capacity, depending upon customer requirements and overall industry demand, and fund any necessary capital spending for such capacity expansions from cash generated from operations; and our belief that the estimates and judgments made regarding future events in connection with the preparation of our financial statements are reasonable. These statements may be identified by the use of words such as “expects,” “anticipates,” “intends,” “plans,” and similar expressions. In addition, forward-looking statements include, but are not limited to, statements about our beliefs, estimates, or plans about our ability to maintain low manufacturing and operating costs and costs per unit, our ability to estimate revenues, shipping volumes, pricing pressures, returns, reserves, demand for our disks, selling, general, and administrative expenses, taxes, research, development, and engineering expenses, spending on property, plant, and equipment, expected sales of disks and the market for disk drives generally and certain customers specifically, and our beliefs regarding our liquidity needs.

Forward-looking statements are estimates reflecting the best judgment of our senior management, and they involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by the forward-looking statements. Our business is subject to a number of risks and uncertainties. While this discussion represents our current judgment on the future direction of our business, these risks and uncertainties could cause actual results to differ materially from any future performance suggested herein. Some of the important factors that may influence possible differences are continued competitive factors, technological developments, pricing pressures, changes in customer demand, and general economic conditions, as well as those discussed in the Risk Factors section below. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of such statements. Readers should review the Risk Factors section above, as well as other documents filed from time to time by us with the SEC.

Results of Operations

Overview

We design, manufacture, and market thin-film media (disks), which are incorporated into disk drives. Our net sales are driven by the level of demand for our disks by disk drive manufacturers, and the average selling prices of our disks. Demand for our disks is dependent on unit growth in the disk drive market, the growth of storage capacity in disk drives, which affects the number of disks needed per drive, and the number of disks our customers purchase from external suppliers. Average selling prices are dependent on overall supply and demand for disks and our product mix.

Our business is capital-intensive and is characterized by high fixed costs, making it imperative that we sell disks in high volume. Our contribution margin per disk sold varies with changes in selling price, input material costs and production yield. We are currently transitioning our product mix from LMR to PMR products. PMR products require increased quantities of precious metals such as platinum and ruthenium, which have experienced recent cost increases. Further, the production cycle for certain sputter target supplies has increased, requiring us to increase inventories of precious metals, decreasing our operating cash flow. As demand for our disks increases, our total contribution margin increases, improving our financial results because we do not have to increase our fixed cost structure in proportion to increases in demand and resultant capacity utilization. Conversely, our financial results deteriorate rapidly when the disk market worsens and our production volume decreases or when our costs increase unexpectedly.

To address increasing demand, we expanded our media capacity in 2004, 2005 and 2006. We installed additional equipment at our media manufacturing facilities to expand our media capacity from approximately 20 million a quarter in 2003 to approximately 41 million a quarter at the end of 2006. To help balance media capacity, we expanded our substrate capacity in the first quarter of 2004 by purchasing a Malaysian substrate facility from Trace Storage Technology (Trace), and have subsequently expanded production capacity at that facility.

As a result of continuing strong customer demand, we entered into supply agreements in 2005 with three of our major customers and one in 2006 with another major customer. We expanded our capacity to approximately 41 million units a quarter by the end of 2006 to support the volume commitments in these strategic customer agreements.

Our 2006, 2005, and 2004 fiscal years included 52 weeks, 52 weeks, and 53 weeks, respectively.

The following discussions compare the results of operations for the fiscal year ended December 31, 2006, to the results of operations for the fiscal year ended January 1, 2006, and compare the results of operations for the fiscal year ended January 1, 2006, to the results of operations for the fiscal year ended January 2, 2005. To facilitate an understanding of these discussions, we have provided the following table.

The table (in thousands) reflects our results of operations for the 2006, 2005, and 2004 fiscal years, and also reflects statement of operations components as a percentage of net sales.


	Year Ended
	December 31, 2006					January 1, 2006					January 2, 2005

Net sales	$	937,676		100.0	%	$	685,946		100.0	%	$	458,377		100.0	%
Cost of sales		689,994		73.6	%		497,213		72.5	%		346,260		75.5	%

Gross profit		247,682		26.4	%		188,733		27.5	%		112,117		24.5	%
Research, development, and engineering expense		64,185		6.7	%		48,873		7.1	%		40,783		9.0	%
Selling, general, and administrative expense		34,409		3.7	%		23,622		3.4	%		17,980		3.9	%
Gain on disposal of assets		(364	)	(0.0	)%		(1,694	)	(0.2	)%		(1,028	)	(0.2	)%
Interest income		7,007		0.7	%		5,327		0.8	%		1,371		0.3	%
Interest expense		(1,764	)	(0.2	)%		(1,765	)	(0.3	)%		(3,176	)	(0.7	)%
Other expense, net		(426	)	0.0	%		(415	)	(0.1	)%		(151	)	0.0	%
Provision for (benefit from) income taxes		(3,264	)	(0.3	)%		5,442		0.8	%		1,071		0.2	%

Net income	$	157,533		16.8	%	$	115,637		16.8	%	$	51,355		11.2	%

Fiscal Year 2006 versus Fiscal Year 2005

Net Sales

Consolidated net sales in 2006 were $937.7 million, a 36.7% increase compared to $685.9 million in 2005. Our finished unit sales volume increased to 148.6 million units in 2006 from 107.0 million units in 2005. The increase in consolidated net sales primarily reflected the increase in our sales volume. Our average selling price in 2006 was slightly higher compared to 2005.

Other disk sales, which generally include single-sided disks, aluminum substrate disks, plated disks, textured disks, and polished disks, were $100.0 million in 2006, compared to $86.5 million in 2005. The increase reflected higher sales of polished disks and plated disks, offset partially by lower sales of single sided disks, aluminum substrates and textured disks. The increase in other disk sales was related to higher customer demand. Disk substrate sales vary from period to period based on customer requirements.

Finished disk shipments for desktop and consumer applications together represented 96.2% of our unit shipment volume in 2006 compared to 93.4% in 2005. The remaining finished disk shipments were disks for enterprise drives. Sales of 160 GB and greater per platter disks in 2006 increased to 25.0% of net sales, compared to 0.1% in 2005. The increase reflected customer migration to higher storage densities.

In 2006, sales to Western Digital, Seagate and HGST accounted for 37%, 36% and 23%, respectively, of our revenue . During the second quarter of 2006, Seagate acquired Maxtor. Sales to Seagate for all of 2006 include sales to Maxtor. In 2005, sales to Western Digital, Seagate, HGST and Maxtor accounted for 24%, 16%, 22% and 32%,

respectively, of our revenue. Our sales are concentrated among a few customers. We expect to continue to derive a substantial portion of our sales from these customers and from a small number of other customers. We entered into supply agreements, including certain amendments to these agreements, with Western Digital, Maxtor and Seagate in 2005, and with HGST in the first quarter of 2006. The supply agreement with Maxtor was assigned to Seagate as a result of Seagate’s acquisition of Maxtor in May 2006. Under the supply agreements, we supply certain media volumes subject to the terms and conditions of the agreements. The customers are required to pay certain advances to us covering future purchases of media from us. The customer advances, which totaled $127.2 million and $102.9 million as of December 31, 2006 and January 1, 2006, respectively, are to be repaid to the customers via a credit of a specified dollar amount per disk on future sales.

Gross Profit

In 2006 we achieved a gross profit percentage of 26.4% which decreased 1.1 percentage points compared to 27.5% in 2005. The decrease was due to increased manufacturing costs, primarily higher fixed costs related to our expanded manufacturing capacity. Increased manufacturing costs accounted for a 1.6-point decrease in gross profit. This was slightly offset by a 0.5-point increase due to a slight increase in the finished unit average selling price.

Research, Development, and Engineering Expenses

Research, development, and engineering (R&D) expenses of $64.2 million in 2006 were $15.3 million higher than the $48.9 million in 2005. The increase primarily reflected higher payroll costs of $4.2 million associated with an increase in headcount in 2006, higher materials and operating costs of $7.8 million, higher equipment related costs of $3.7 million due to new equipment added to support R&D activities (including our PMR product transition plans), and higher deferred stock-based compensation expense of $2.7 million. The increases were partially offset by lower incentive compensation expense of $2.9 million.

Selling, General, and Administrative Expenses

Selling, general, and administrative (SG&A) expenses of $34.4 million in 2006 were $10.8 million higher compared to the $23.6 million incurred in 2005. The increase primarily reflected higher deferred stock-based compensation expense of $8.8 million and an increase in headcount and related compensation expense of $3.2 million, partially offset by lower incentive compensation of $1.4 million.

Gain on Disposal of Assets

Gain on disposal of assets in 2006 was $0.4 million, and primarily reflected sales of idle equipment. Gain on disposal of assets in 2005 was $1.7 million, and primarily reflected the sale of a facility in Eugene, Oregon.

Interest Expense

Interest expense in 2006 and 2005 was $1.8 million, and reflected interest expense on the Convertible Subordinated Notes (see Note 9 to the consolidated financial statements).

Other Income

In 2006, we entered into a number of forward contracts for the purchase of precious metal inventory which were not accounted for at fair value at December 31, 2006 under the normal purchase exception of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS No. 133). In February 2007, we sold a portion of our precious metal inventory which will result in non-operating income of $3.4 million in the first quarter of 2007. We have entered into other forward contracts for the purchase of precious metal inventory which we will record at fair value under SFAS 133. As a result, we may record additional non-operating gains or losses in the first quarter of 2007.

Income Taxes

Our annual effective income tax rate for 2006 was a benefit of 2.1% and for 2005 was a tax provision of 4.5%. The 2006 tax benefit was related to the partial release of our valuation allowance. Prior to 2006, the Company had established a full valuation allowance against its deferred tax assets due to the uncertainty regarding its ability to

generate sufficient future taxable income. In the fourth quarter of 2006, the Company reassessed the valuation allowance previously established and determined that it was more likely than not that a portion of the deferred tax assets would be realized in 2007. As a result the Company released a portion of the allowance resulting in an income tax benefit of $7.0 million recorded in the fourth quarter of 2006 and a net overall benefit of $3.3 million in 2006. The Company will continue to assess the potential realization of the remaining deferred tax assets, and will adjust the valuation allowance in future periods, as appropriate.

Our overall tax rate is lower than the statutory rates because of the tax holiday granted to our Malaysian subsidiary. Our manufacturing facilities, which are located in Malaysia, have been granted various tax holidays with varying expiration dates. In July 2005, the Malaysian government agreed to reset the expiration dates of the existing tax holidays to December 2006 and approved a new, 10-year tax holiday covering all of our Malaysian operations. The new tax holiday commenced in January 2007 and expires in December 2016.

Fiscal Year 2005 versus Fiscal Year 2004

Net Sales

Consolidated net sales in 2005 were $685.9 million, a 49.6% increase compared to $458.4 million in 2004. Our finished unit sales volume increased to 107.0 million units in 2005 from 70.7 million units in 2004. The increase in consolidated net sales primarily reflected the increase in our sales volume. Our average selling price in 2005 was slightly lower compared to 2004.

Other disk sales, which generally include single-sided disks, aluminum substrate disks, plated disks, textured disks, and polished disks, were $86.5 million in 2005, compared to $52.8 million in 2004. The increase reflected higher sales of textured disks, polished disks, and aluminum substrates. The increase in other disk sales was related to higher customer demand.

Finished disk shipments for desktop and consumer applications together represented 93% of our unit shipment volume in 2005 compared to 91% in 2004. The remaining finished disk shipments (7% in 2005 and 9% in 2004) were disks for enterprise drives. Sales of 100 GB and greater per platter disks in 2005 increased to 26.4% of net sales, compared to 8.4% in 2004.

In 2005, sales to Maxtor, Western Digital, HGST, and Seagate accounted for 32%, 24%, 21%, and 16% respectively, of our revenue. In 2004, sales to Maxtor, Western Digital , HGST, and Seagate in 2004 accounted for 47%, 14%, 29%, and 4% respectively, of our revenue.

Gross Profit

Our gross profit percentage increased 3.0 percentage points to 27.5% in 2005, compared to 24.5% in 2004. In 2005, a positive gross profit impact of 4.9 percentage points due to a lower cost per disk was partially offset by a negative 1.9 percentage point impact from lower finished unit average selling prices.

Research, Development, and Engineering Expenses

Research, development, and engineering (R&D) expenses of $48.9 million in 2005 were $8.1 million higher than the $40.8 million in 2004. The increase primarily reflected higher incentive compensation expense of $5.3 million, higher payroll costs of $1.8 million associated with an increase in headcount in 2005, higher equipment related costs of $1.1 million due to new equipment added to support R&D activities, and higher deferred stock-based compensation expense of $0.7 million. The increases were partially offset by $1.2 million lower materials and operating costs.

Selling, General, and Administrative Expenses

Selling, general, and administrative (SG&A) expenses of $23.6 million in 2005 were $5.6 million higher compared to the $18.0 million incurred in 2004. The increase primarily reflected higher incentive compensation of $2.7 million, higher deferred stock-based compensation expense of $1.2 million and an increase in headcount and related compensation expense of $1.6 million.

Gain on Disposal of Assets

Gain on disposal of assets in 2005 was $1.7 million, and primarily reflected the sale of a facility in Eugene, Oregon. Gain on disposal of assets in 2004 was $1.0 million, and primarily reflected sales of idle equipment.

Interest Expense

Interest expense in 2005 was $1.8 million, and reflected interest expense on the Convertible Subordinated Notes (see Note 9 to the consolidated financial statements). Interest expense in 2004 was $3.2 million, and included $1.6 million of interest expense on the Convertible Subordinated Notes, and $1.6 million of interest expense on the Senior Secured Notes and certain promissory notes. The Senior Secured Notes and promissory notes were redeemed in full, including accrued interest, in February 2004. There were no gains or losses on the redemptions, and there were no unamortized debt issuance costs.

Income Taxes

Our annual effective income tax rate for 2005 was 4.5% and for 2004 was 2%. The tax provision includes taxes related to our U.S. and international operations and is lower than applicable statutory rates because of the tax holiday granted our Malaysian subsidiary.

Critical Accounting Policies

In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the U.S. We regularly evaluate our estimates, including those related to our revenues, allowance for inventories, commitments and contingencies, income taxes, and asset impairments. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ significantly from those estimates if our assumptions are incorrect. We believe that the following discussion addresses our most critical accounting policies. These policies are most important to the portrayal of our financial condition and results and require management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Allowance for Sales Returns

We estimate our allowance for sales returns based on historical data as well as current knowledge of product quality. We have not experienced material differences between our estimated reserves for sales returns and actual results. It is possible that the failure rate on products sold could be higher than it has historically been, which could result in significant changes in future returns.

Since estimated sales returns are recorded as a reduction in revenues, any significant difference between our estimated and actual experience or changes in our estimate would be reflected in our reported revenues in the period we determine that difference. There were no significant changes from prior year estimates in 2006.

Inventory Obsolescence

Our policy is to provide for inventory obsolescence based upon an estimated obsolescence percentage applied to the inventory based on age, historical trends, and requirements to support forecasted sales. In addition, and as necessary, we may provide additional charges for future known or anticipated events. There were no significant changes from prior year estimates in 2006.

Provision for Income Tax and Valuation Allowance

We account for income taxes using the asset and liability method. Deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases, and operating loss and tax credit carryforwards. Our consolidated financial statements contain certain deferred tax assets which have arisen

primarily as a result of operating losses, credits, as well as other temporary differences between financial and tax accounting. Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes,” requires the establishment of a valuation allowance if the likelihood of realization of the deferred tax assets is reduced based on an evaluation of objective verifiable evidence. Significant management judgment is required in determining the provision for income taxes, the deferred tax assets and liabilities and any valuation allowance recorded against those net deferred tax assets. We evaluate the weight of all available evidence to determine whether it is more likely than not that some portion or all of the net deferred income tax assets will be realized.

During 2006, based on positive evidence obtained from recent financial performance and forecasted future taxable income in the U.S., we released a portion of our deferred tax valuation allowance to recognize deferred tax assets that, in our judgement, are more likely than not to be realized in 2007.

Stock-based Compensation

We account for all stock-based compensation in accordance with the fair value recognition provisions of SFAS No. 123R, Share-Based Payment. Under these provisions, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Under SFAS No. 123R, we are required to use judgment in estimating the amount of stock-based awards that are expected to be forfeited. If actual forfeitures differ significantly from the original estimate, stock-based compensation expense and our results of operations could be materially impacted.

Prior to the adoption of SFAS No. 123-R, we accounted for stock-based employee compensation plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and its related interpretations (APB No. 25), and followed the pro forma net income, pro forma income per share, and stock-based compensation plan disclosure requirements set forth in SFAS No. 123, Accounting for Stock-Based Compensation.

The fair values of all stock options granted were estimated using the Black-Scholes-Merton option pricing model. The Black-Scholes-Merton model requires the input of highly subjective assumptions such as risk-free interest rates, volatility factor of the expected market price of our common stock and the weighted-average expected option life. The expected volatility factor used to value stock options in 2006 was based on the historical volatility of the market price of the Company’s common stock over a period equal to the estimated weighted average life of the options. The weighted average life of the options was estimated based on an evaluation of the vesting term, contractual life, and historical and expected exercise behavior. We base the risk-free interest rate on zero coupon yields implied from U.S. Treasury issues with remaining terms similar to the expected term of the options.

Liquidity and Capital Resources

Cash, cash equivalents, and short-term investments of $171.1 million at the end of 2006 decreased by $33.9 million from the end of 2005, representing a 16.5% decrease. The decrease primarily reflected a $251.4 million increase resulting from consolidated operating activities and $5.6 million in proceeds from the sale of common stock, a $3.8 million increase due to the effect of exchange rate changes on cash and cash equivalents, offset by $286.1 million of spending on property, plant, and equipment, $7.1 million change in other assets and $2.0 million on the repurchase of common stock.

In July 2005, Malaysia removed its currency peg to the U.S. dollar in favor of a managed float system. As of December 31, 2006, we held approximately $4.4 million (Malaysian ringgit 15.5 million) of cash and cash equivalents that were denominated in Malaysian ringgit.

Consolidated operating activities generated $251.4 million in cash in 2006. The primary components of this change include the following:


	•	net income of $157.5 million, net of non-cash depreciation and amortization of property, plant and equipment of $79.5 million and other non-cash charges and gains of $15.9 million;

	•	an accounts receivable increase of $23.9 million, which primarily reflected an increase in sales in 2006 compared to 2005;


	•	an inventory increase of $50.2 million, which primarily reflected increased inventory to support increased production and sales volumes;

	•	an accounts payable increase of $51.7 million, which primarily reflected increased spending for inventory and other costs to support our increased level of operations; and

	•	a customer advance of $24.3 million, which primarily reflected the receipt of customer advances, offset by $3.6 million in lower incentive compensation accruals.

Our total capital spending in 2006 was $271.1 million (on an accrual basis), and included capital expenditures to increase our substrate and finished disk capacity, to improve our equipment capability for the manufacture of advanced products, and for projects designed to improve yield and productivity. We had approximately $1.1 million of non-cancellable capital commitments as of December 31, 2006. In 2007, we plan to spend approximately $100 million to $120 million on property, plant, and equipment to support process improvements.

We have $80.5 million of 2% Convertible Subordinated Notes (the Notes) outstanding. The Notes mature on February 1, 2024, bear interest at 2.0%, and require semiannual interest payments, which began on August 1, 2004. The Notes will be convertible, under certain circumstances, into shares of our common stock based on an initial effective conversion price of $26.40. Holders of the Notes may convert the Notes into shares of our common stock prior to maturity if: (1) the sale price of our common stock equals or exceeds $31.68 for at least 20 trading days in any 30 consecutive trading day period within any of our fiscal quarters; (2) the trading price of the Notes falls below a specified threshold prior to February 19, 2019; (3) the Notes have been called for redemption; or (4) certain specified corporate transactions (as described in the offering prospectus for the Notes) occur. The conditions for conversion have been met, and the debt is currently convertible. We may redeem the Notes on or after February 6, 2007, at specified declining redemption premiums. Holders of the Notes may require us to purchase the Notes on February 1, 2011, 2014, or 2019, or upon the occurrence of a fundamental change, at a purchase price equal to 100% of the principal amount of the Notes, plus accrued and unpaid interest. There are no financial covenants, guarantees, or collateral associated with the Notes.

We have arranged bank guarantees of Malaysian ringgit 29.5 million (approximately $8.4 million) which are required by Malaysian utility companies and other Malaysian vendors. There is no expiration date on the bank guarantees. No interest will be charged on the bank guarantees, but there is a commission charge ranging between 0.05% and 0.10% on the amount of bank guarantee utilized. As of December 31, 2006, there were no liabilities outstanding related to the bank guarantees.

We lease our research and administrative facility in San Jose, California under an operating lease, which expires in 2014. Additionally, we lease certain equipment under operating leases. These leases expire on various dates through 2011. We have no capital leases.

As of December 31, 2006, our long-term debt obligations, operating lease obligations, and unconditional purchase obligations were as follows (in thousands):


	2007		2008		2009		2010		2011		Thereafter		Total

Long-Term Debt Obligations(1)	$	—	$	—	$	—	$	—	$	80,500	$	—	$	80,500
Operating Lease Obligations		2,512		2,057		3,159		3,150		3,143		10,101		24,122
Unconditional Purchase
Obligations(2)		3,763		2,604		2,604		2,604		2,581		9,189		23,345

Total Contractual Cash Obligations	$	6,275	$	4,661	$	5,763	$	5,754	$	86,224	$	19,290	$	127,967


(1)		The long-term debt obligations have a maturity date of February 1, 2024; however, the Holders of the Notes may require us to purchase the Notes on February 1, 2011, 2014, or 2019, or upon the occurrence of a fundamental change, at a purchase price equal to 100% of the principal amount of the Notes, plus accrued and unpaid interest.

(2)		Unconditional purchase obligations are defined as agreements to purchase goods or services that are enforceable and legally binding, and that specify all significant terms, including: fixed or minimum quantities


		to be purchased; fixed, minimum, or variable pricing provisions; and the approximate timing of the transactions. The amounts are based on our contractual commitments.

As of December 31, 2006, we had approximately $1.1 million of non-cancellable capital commitments. This amount is included in the table above under Unconditional Purchase Obligations.

Based on current operating forecasts, we estimate that the cash balance and cash from operations and customer advances will be adequate to support our continuing operations, capital spending plan, and interest payments for at least the next twelve months.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet financing arrangements or transactions.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 151 (SFAS 151), Inventory Costs. SFAS 151 clarifies the accounting for inventory when there are abnormal amounts of idle facility expense, freight, handling costs, and wasted materials. Under existing generally accepted accounting principles, items such as idle facility expense, excessive spoilage, double freight, and re-handling costs may be “so abnormal” as to require treatment as current period charges rather than recorded as adjustments to the value of the inventory. SFAS 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. We adopted this pronouncement at the beginning of fiscal 2006. The adoption of SFAS 151 did not have a material effect on our financial position or results of operations.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154). SFAS 154 replaces APB No. 20 and FASB Statement No. 3. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS 154. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 had no material effect on our financial position or results of operations.

In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 provides guidance on recognition and measurement of uncertainties in income taxes and is applicable for fiscal years beginning after December 15, 2006. We do not expect the adoption of FIN 48 to have a material impact on our financial position or results of operations.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements and is applicable for fiscal years beginning after November 15, 2007. We have not yet completed the evaluation or determined the impact of adopting SFAS 157.

In September 2006, the SEC released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, (SAB 108) which addresses how uncorrected errors in previous years should be considered when quantifying errors in current-year financial statements. SAB 108 requires companies to consider the effect of all carry over and reversing effects of prior-year misstatements when quantifying errors in current-year financial statements. Specifically, registrants should quantify errors using both the “rollover” approach (current period statement of income effect) and “iron curtain” approach (period end balance sheet effect) and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 allows companies to record the effects of adopting the guidance as a cumulative-effect adjustment to retained earnings. We adopted SAB 108 in the fourth quarter of 2006 and there was no financial impact on our financial statements.


Item 7A.	*Quantitative and Qualitative Disclosures About Market Risk*

The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. We invest primarily in high-quality, short-term debt instruments and auction rate preferred securities, which are accounted for as cash equivalents or short-term investments, depending on the period of time from the purchase date to the maturity date. The fair value of these securities approximated their carrying amounts at December 31, 2006.

We are exposed to foreign currency exchange rate risk. A majority of our revenue, expense, and capital purchasing activities is transacted in U.S. dollars. However, a large portion of our payroll, certain manufacturing and operating expenses, and inventory and capital purchases is transacted in the Malaysian ringgit (ringgit). For approximately seven years, the exchange rate between the ringgit and the U.S. dollar has been pegged at 3.8 ringgits to one U.S. dollar by the Malaysian government. On July 21, 2005, Malaysia removed its currency peg to the U.S. dollar in favor of a managed float system. Changes in exchange rates could adversely affect the amount we spend on our payroll, certain manufacturing and operating expenses, and raw materials and capital purchases. In 2006, our U.S. dollar-equivalent spending on payroll, manufacturing and operating expenses, and raw materials and capital purchases that were denominated in ringgit was approximately $327.5 million. Additionally, we paid approximately $120.3 million denominated in Malaysian ringgit to a Malaysian supplier for raw materials purchases in 2006, based on a cost plus a percentage arrangement. The Malaysian supplier incurs certain costs denominated in ringgit; therefore, any change in the valuation of the ringgit could impact the cost per unit we pay for such raw materials. As of December 31, 2006, we held approximately $4.4 million (Malaysian ringgit 15.5 million) of cash and cash equivalents that were denominated in Malaysian ringgit. We currently do not hedge the exposure to fluctuations in the Malaysian ringgit.

In September 2005, we began to hedge some of our foreign currency risk related to anticipated foreign currency denominated equipment purchases by entering into foreign exchange forward contracts that generally have maturities of 12 months or less. These transactions are designated and qualify as cash flow hedges in accordance with SFAS No. 133. The derivatives associated with our hedging activities are marked to market at fair value and any resulting liability is recorded in other liabilities and any resulting asset is recorded to prepaid and other current assets in the Consolidated Balance Sheets. The effective portion of gains or losses resulting from changes in fair value is initially reported as a component of accumulated other comprehensive income (loss), net of any tax effects, in stockholders’ equity and subsequently reclassified into depreciation expense in the periods in which the related equipment purchase is depreciated after the forecasted transaction actually occurs. In 2005 and 2006, the hedges were perfectly effective and no ineffectiveness in the hedges occurred. Our hedging programs reduce, but do not entirely eliminate, the impact of currency exchange rate movements.

As of December 31, 2006, we had foreign exchange contracts to purchase approximately $0.7 million of Japanese Yen. The fair value of our outstanding forward contracts was recorded as $0.02 million other current liability as of December 31, 2006. The counterparty to these forward contracts is a creditworthy multinational commercial bank. The risk of counterparty nonperformance associated with these contracts is not considered to be material. Notwithstanding our efforts to mitigate some foreign currency exchange rate risks, there can be no assurances that our mitigating activities will adequately protect us against the risks associated with foreign currency fluctuations.

In 2006, we entered into a number of forward contracts for the purchase of precious metal inventory which were not accounted for at fair value at December 31, 2006 under the normal purchase exception of SFAS No. 133. In February 2007, we sold a portion of our precious metal inventory which will result in non-operating income of $3.4 million in the first quarter of 2007. We have entered into other forward contracts for the purchase of precious metal inventory which we will record at fair value under SFAS 133. As a result, we may record additional non-operating gains or losses in the first quarter of 2007.

We have $80.5 million in convertible subordinated notes outstanding. As of December 31, 2006, these notes were convertible into approximately 3.0 million shares of common stock. These notes bear interest at 2% and mature in February 2024. A hypothetical 100 basis point increase in interest rates would result in approximately $0.8 million of additional interest expense each year.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Komag, Incorporated:

We have audited the accompanying consolidated balance sheets of Komag, Incorporated and subsidiaries (the Company) as of December 31, 2006 and January 1, 2006 and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006. In connection with our audits of the consolidated financial statements, we also have audited financial statement Schedule II. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Komag, Incorporated and subsidiaries as of December 31, 2006 and January 1, 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As discussed in Note 11 to the consolidated financial statements, the Company changed its method of accounting for stock-based compensation in 2006 upon adoption of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 21, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

KPMG LLP

Mountain View, California

February 21, 2007

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Komag, Incorporated:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting in Item 9A, Controls and Procedures, that Komag, Incorporated and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by COSO. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by COSO.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Komag, Incorporated and subsidiaries as of December 31, 2006 and January 1, 2006, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006. In connection with our audits of the consolidated financial statements, we also have audited financial statement Schedule II. Our report dated February 21, 2007 expressed an unqualified opinion on those consolidated financial statements and financial statement schedule.

KPMG LLP

Mountain View, California

February 21, 2007

KOMAG, INCORPORATED

CONSOLIDATED STATEMENTS OF INCOME


	Year Ended
	December 31, 2006			January 1, 2006			January 2, 2005
	(In thousands, except per share amounts)

Net sales	$	937,676		$	685,946		$	458,377
Cost of sales		689,994			497,213			346,260

Gross profit		247,682			188,733			112,117
Operating expenses:
Research, development, and engineering		64,185			48,873			40,783
Selling, general, and administrative		34,409			23,622			17,980
Gain on disposal of assets		(364	)		(1,694	)		(1,028	)

		98,230			70,801			57,735

Operating income		149,452			117,932			54,382
Other income (expense):
Interest income		7,007			5,327			1,371
Interest expense		(1,764	)		(1,765	)		(3,176	)
Other expense, net		(426	)		(415	)		(151	)

		4,817			3,147			(1,956	)

Income before income taxes		154,269			121,079			52,426
Provision for (benefit from) income taxes		(3,264	)		5,442			1,071

Net income	$	157,533		$	115,637		$	51,355

Basic net income per share	$	5.27		$	3.99		$	1.88

Diluted net income per share	$	4.75		$	3.55		$	1.71

Number of shares used in basic per share computations		29,919			29,003			27,384

Number of shares used in diluted per share computations		33,566			33,042			31,017

See accompanying notes to consolidated financial statements.

KOMAG, INCORPORATED

CONSOLIDATED BALANCE SHEETS


	December 31, 2006			January 1, 2006
	(In thousands)

ASSETS
Current assets
Cash and cash equivalents	$	129,632		$	99,984
Short-term investments		41,500			105,050
Accounts receivable (less allowances of $2,326 and $2,866, respectively)		140,230			116,217
Inventories		104,181			54,000
Prepaid expenses and other current assets		2,119			1,846

Total current assets		417,662			377,097
Property, plant, and equipment, net		542,585			351,046
Deferred income taxes		7,346			—
Other assets		10,094			3,308

	$	977,687		$	731,451


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Trade accounts payable	$	139,477		$	97,901
Customer advances		127,181			102,898
Accrued expenses and other liabilities		25,412			28,585

Total current liabilities		292,070			229,384
Long-term debt		80,500			80,500
Deferred rent		3,091			2,562

Total liabilities		375,661			312,446
Stockholders’ equity
Common stock, $0.01 par value per share:
Authorized — 120,000 shares
Issued and outstanding — 31,178 and 30,092 shares, respectively		312			301
Additional paid-in capital		283,679			267,920
Deferred stock-based compensation		—			(9,695	)
Accumulated other comprehensive loss		(611	)		(634	)
Retained earnings		318,646			161,113

Total stockholders’ equity		602,026			419,005

	$	977,687		$	731,451

See accompanying notes to consolidated financial statements.

KOMAG, INCORPORATED

CONSOLIDATED STATEMENTS OF CASH FLOWS


	Year Ended
	December 31, 2006			January 1, 2006			January 2, 2005
	(In thousands)

Operating Activities
Net income	$	157,533		$	115,637		$	51,355
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of property, plant, and equipment		79,488			44,519			37,086
Deferred income tax benefit		(6,978	)		—			—
Tax provision charged to additional paid-in capital		2,971			5,194			—
Amortization and adjustments of intangible assets		231			1,072			3,023
Stock-based compensation		18,086			3,308			555
Deferred rent		529			2,562			—
Non-cash interest charges		154			154			436
Gain on disposal of assets		(364	)		(1,694	)		(1,028	)
Foreign exchange loss		1,309			—			—
Changes in operating assets and liabilities:
Accounts receivable, net		(23,939	)		(37,004	)		(18,585	)
Inventories		(50,181	)		(18,185	)		(10,314	)
Prepaid expenses and other current assets		181			(31	)		221
Trade accounts payable		51,728			18,741			3,338
Customer advances		24,283			102,898			—
Accrued expenses and other liabilities		(3,591	)		8,353			(4,820	)
Other non-current assets		(7,066	)		—			—

Net cash provided by operating activities		244,374			245,524			61,267
Investing Activities
Acquisition of property, plant, and equipment		(286,082	)		(155,613	)		(59,202	)
Purchases of short-term investments		(157,755	)		(282,450	)		(157,000	)
Proceeds from short-term investments		221,305			255,100			122,150
Proceeds from disposal of property, plant, and equipment		456			3,173			2,038
Other		(42	)		(34	)		(257	)

Net cash used in investing activities		(222,118	)		(179,824	)		(92,271	)
Financing Activities
Payment of debt		—			—			(116,341	)
Proceeds from the issuance of long-term debt		—			—			77,419
Proceeds from sale of common stock, net of issuance costs		5,630			7,874			69,128
Repurchase of common stock		(2,044	)		—			—

Net cash provided by financing activities		3,586			7,874			30,206

Effect of exchange rate changes on cash and cash equivalents		3,806			—			—

Increase (decrease) in cash and cash equivalents		29,648			73,574			(798	)
Cash and cash equivalents at beginning of year		99,984			26,410			27,208

Cash and cash equivalents at end of year	$	129,632		$	99,984		$	26,410

Supplemental disclosure of cash flow information
Cash paid for interest	$	1,610		$	1,611		$	2,739
Cash paid for income taxes	$	908		$	541		$	331

See accompanying notes to consolidated financial statements.

KOMAG, INCORPORATED

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME


												Retained			Accumulated
						Additional			Deferred			Earnings			Other
	Common Stock					Paid-in			Stock-Based			(Accumulated			Comprehensive
	Shares			Amount		Capital			Compensation			Deficit)			Loss			Total
	(In thousands)

Balance at December 28, 2003		23,753		$	238	$	172,457		$	(228	)	$	(5,879	)	$	—		$	166,588
Net income		—			—		—			—			51,355			—			51,355
Issuance of common stock, net of issuance costs		3,525			35		66,356			—			—			—			66,391
Deferred stock-based compensation		—			—		252			(252	)		—			—			—
Stock-based compensation		—			—		166			389			—			—			555
Exercise of warrants		90			1		1			—			—			—			2
Common stock issued under stock plans		697			7		2,728			—			—			—			2,735

Balance at January 2, 2005		28,065			281		241,960			(91	)		45,476			—			287,626
Net income		—			—		—			—			115,637			—			115,637
Unrealized loss on cash flow hedging arrangements		—			—		—			—			—			(634	)		(634	)

Comprehensive income																			115,003
Deferred stock-based compensation		—			—		12,769			(12,769	)		—			—			—
Stock-based compensation		—			—		143			3,165			—			—			3,308
Income tax adjustments		—			—		5,194			—			—			—			5,194
Exercise of warrants		604			6		2,103			—			—			—			2,109
Common stock issued under stock plans		1,423			14		5,751			—			—			—			5,765

Balance at January 1, 2006		30,092			301		267,920			(9,695	)		161,113			(634	)		419,005
Net income		—			—		—			—			157,533			—			157,533
Net change to unrealized gain or loss under cash flow hedging arrangements		—			—		—			—			—			23			23

Comprehensive income																			157,556
Reversal of deferred stock-based compensation		—			—		(9,695	)		9,695			—			—			—
Stock-based compensation		—			—		18,086			—			—			—			18,086
Income tax adjustments		—			—		3,793			—			—			—			3,793
Common stock issued under stock plans		1,139			11		5,619			—			—			—			5,630
Repurchase of common stock		(53	)		—		(2,044	)		—			—			—			(2,044	)

Balance at December 31, 2006		31,178		$	312	$	283,679		$	—		$	318,646		$	(611	)	$	602,026

See accompanying notes to consolidated financial statements.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 1.	Basis of Presentation and Significant Accounting Policies

Company Business: The Company is a leading independent supplier of thin-film disks, the primary high-capacity storage medium for digital data in computers and consumer electronic appliances. Since it was founded in 1983, the Company has been an industry leader in production volume and technology for thin-film disks.

Consolidation: The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Fiscal Year: The Company uses a 52-53 week fiscal year ending on the Sunday closest to December 31. The Company’s 2006 and 2005 fiscal years were 52-week years. The Company’s 2004 fiscal year was a 53-week year; accordingly, the additional week in 2004 was included in the Company’s first quarter of 2004.

Use of Estimates in the Preparation of Financial Statements: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S.) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Foreign Currency Translation: The Company’s functional currency for its Malaysian operations is the U.S. dollar. Remeasurement gains and losses resulting from the process of remeasuring these foreign currency financial statements into U.S. dollars are included in operations.

Cash and Cash Equivalents: The Company considers as a cash equivalent any bank deposit, money market investments and any highly-liquid investment that has an original maturity date of three months or less at the date of purchase.

Short-Term Investments: The Company invests its excess cash in high-quality, short-term debt instruments and auction rate preferred securities. The Company’s investments are considered “available-for-sale” under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS 115). The costs of the Company’s investments approximate fair value; accordingly, there were no unrealized gains or losses as of December 31, 2006 and January 1, 2006. Interest and dividends on the investments are included in interest income. The information in the following table (in thousands) reflects a summary of the Company’s investments by major security type at amortized cost, which approximates fair value:


	December 31, 2006		January 1, 2006

Municipal auction rate preferred securities	$	41,500	$	105,050
Corporate debt securities		76,529		73,168
Mortgage-backed securities		10,672		13,527

	$	128,701	$	191,745

Amounts included in cash and cash equivalents	$	87,201	$	86,695
Amounts included in short-term investments		41,500		105,050

	$	128,701	$	191,745

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market, and consist of the following (in thousands):


	December 31, 2006		January 1, 2006

Raw materials	$	78,701	$	39,230
Work in process		15,900		6,489
Finished goods		9,580		8,281

	$	104,181	$	54,000

Property, Plant, and Equipment: Property, plant, and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets. The estimated useful lives of the Company’s buildings in Penang and Sarawak, Malaysia is 30 years, and 22 years for the Company’s building in Johor, Malaysia. Furniture and equipment are generally depreciated over five years, and leasehold improvements are amortized over the shorter of the lease term or their estimated useful life.

Property, plant, and equipment consists of the following (in thousands):


	December 31, 2006			January 1, 2006

Land	$	8,206		$	8,206
Buildings		221,571			153,433
Leasehold improvements		5,499			3,974
Furniture		3,959			1,968
Equipment		522,738			324,123

		761,973			491,704
Less accumulated depreciation and amortization		(219,388	)		(140,658	)

	$	542,585		$	351,046

Impairment of Long-lived Assets: Long-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that such assets may be impaired or the estimated useful lives are no longer appropriate. The Company reviews its long-lived assets for impairment based on estimated future undiscounted cash flows attributable to the assets. In the event that such cash flows are not expected to be sufficient to recover the recorded value of the assets, the assets are written down to their estimated fair values utilizing discounted estimates of future cash flows.

Revenue Recognition: In recognizing revenue, the Company applies the provisions of the Securities and Exchange Commission (SEC) Staff Accounting Bulletin 104, Revenue Recognition. The Company recognizes revenue from the sale of its products when persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed or determinable, and collection of the resulting receivable is reasonably assured. Amounts billed to customers for shipping and handling costs associated with products sold are classified as revenue.

The Company generally uses a purchase order as evidence of an arrangement. In certain cases its products are sold with terms signifying that delivery occurs at the destination point. The Company defers revenue associated with these transactions until the delivery has occurred to the customers’ premises and it has evidence of such delivery.

The Company provides an allowance for estimated returns of defective products based on historical data, as well as current knowledge of product quality.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Cost of Sales: Cost of sales includes direct and indirect manufacturing costs, inbound, outbound, and internal freight costs, purchasing and receiving costs, quality inspection costs, and warehousing costs.

Research and Development: Research and development costs are expensed as incurred.

Leases: The Company leases one facility in the U.S. The Company accounts for this lease as an operating lease under the provisions of SFAS No. 13, Accounting for Leases (SFAS 13), and subsequent amendments. SFAS 13 requires leases to be evaluated and classified as operating or capitalized leases for financial reporting purposes. In addition, the Company records the total rent payable during the operating lease term as an expense on a straight-line basis over the term of the lease, and records the difference between the rent paid and the straight-line rent expense as a deferred rent liability.

Stock-Based Compensation: Effective January 2, 2006, the Company adopted SFAS No. 123R, Share-Based Payment (SFAS 123R), using the modified prospective method, in which compensation cost is recognized based on the requirements of SFAS 123R for (a) all share-based payments granted or modified after the effective date and (b) for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date. The Company elected to amortize stock-based compensation for awards outstanding and unvested on its adoption of SFAS 123R as well as for awards granted on or after its adoption of SFAS 123R on a straight line basis over the requisite service (vesting) period for the entire award. The vesting period for stock options has generally been four years and the vesting for stock purchase rights generally has been three years.

Prior to January 2, 2006 and as permitted under SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), the Company elected to follow APB 25, and related interpretations in accounting for stock-based awards to employees. Accordingly, compensation cost for stock options and stock purchase rights was measured as the excess, if any, of the market price of the Company’s common stock at the date of grant over the exercise price. In accordance with SFAS 123 and SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of SFAS 123, prior to fiscal 2006, the Company provided pro forma disclosure of the effect on net income and earnings per share had the fair value method been used, as prescribed by SFAS 123.

Income Taxes: The Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax laws expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Realization of deferred tax assets is dependent upon future earnings in specific tax jurisdictions, the timing and amount of which are uncertain. Accordingly, the Company evaluates all significant available positive and negative evidence, including the existence of losses in recent years and the forecast of future taxable income, in assessing the need for a valuation allowance. The Company records a valuation allowance to reduce its deferred tax assets to the amount that is believed more likely than not to be realized.

Comprehensive Income: Comprehensive income is defined as the change in equity during a period for non-owner transactions, and is composed of net income and other comprehensive income (loss). Other comprehensive income (loss) includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards. The Company’s other comprehensive loss included the unrealized losses, net of income taxes, related to the Company’s foreign currency forward contracts that are designated as cash flow hedges.

Computation of Net Income Per Share: The Company determines net income per share in accordance with SFAS No. 128, Earnings per Share. Basic net income per common share is computed by dividing income available to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing income available to common stockholders by the weighted-average number of shares and dilutive potential shares of common stock outstanding during the period. The dilutive effect of outstanding options and stock purchase rights is reflected in diluted net income per share by application of the treasury stock method. The dilutive effect of outstanding contingently convertible debt is reflected in diluted net

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

income per share by application of the if-converted method. Interest expense related to the contingently convertible debt is an adjustment to income available to common stockholders for the diluted net income per share calculations.

The following table sets forth the computation of net income per share. The table is in thousands, except per share amounts.


	Year Ended
	December 31, 2006		January 1, 2006		January 2, 2005

Numerator for basic net income per share:
Net income as reported	$	157,533	$	115,637	$	51,355

Numerator for diluted net income per share:
Net income as reported	$	157,533	$	115,637	$	51,355
Interest adjustment related to contingently convertible debt		1,764		1,765		1,642

	$	159,297	$	117,402	$	52,997

Denominator for basic net income per share:
Weighted average shares		29,919		29,003		27,384

Denominator for diluted net income per share:
Weighted average shares		29,919		29,003		27,384
Effect of dilutive securities:
Contingently convertible shares under convertible debt		3,049		3,049		2,803
Stock options		343		572		468
Warrants		—		220		362
Stock purchase rights		255		198		—

		33,566		33,042		31,017

Basic net income per share	$	5.27	$	3.99	$	1.88

Diluted net income per share	$	4.75	$	3.55	$	1.71

Outstanding common stock options that were not included in the diluted net income per share computation because the effect would have been anti-dilutive were approximately 42,000 in 2006, zero in 2005, and approximately 264,000 in 2004.

In January 2004, the Company issued $80.5 million of 2.0% Convertible Subordinated Notes (the Notes). The Notes are convertible, under certain circumstances, into shares of the Company’s common stock at an initial conversion price of $26.40, or approximately 3,049,000 shares. These shares have been included in the Company’s diluted earnings per share calculations for fiscal 2006, 2005 and 2004.

Recent Accounting Pronouncements: In December 2004, the FASB issued SFAS No. 151, Inventory Costs (SFAS 151). SFAS 151 clarifies the accounting for inventory when there are abnormal amounts of idle facility expense, freight, handling costs, and wasted materials. Under existing generally accepted accounting principles, items such as idle facility expense, excessive spoilage, double freight, and re-handling costs may be “so abnormal” as to require treatment as current period charges rather than recorded as adjustments to the value of the inventory. SFAS 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company adopted this pronouncement at the beginning of fiscal year 2006. The adoption of SFAS 151 had no material impact on the Company’s financial position or results of operations.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154). SFAS 154 replaces APB No. 20 and FASB Statement No. 3. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS 154. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company adopted SFAS 154 in fiscal 2006. The adoption of this standard had no material impact on the Company’s financial position or results of operations.

In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 provides guidance on recognition and measurement of uncertainties in income taxes and is applicable for fiscal years beginning after December 15, 2006. The Company does not expect the adoption of this Interpretation to have a material impact on its financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements and is applicable for fiscal years beginning after November 15, 2007. The Company has not yet completed the evaluation or determined the impact of adopting SFAS 157.


Note 2.	Segment and Geographic Information

The Company operates in one business segment, which is the development, production, and marketing of high-performance thin-film media (disks) for use in hard disk drives. The Company primarily sells to original equipment manufacturers in the rigid disk drive market. The Company’s operations are treated as one operating segment, as the Company reports profit and loss information on an aggregate basis to the chief operating decision-maker of the Company.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Summary information for the Company’s operations by geographic location is as follows (in thousands):


	Year Ended
	December 31, 2006			January 1, 2006			January 2, 2005

Net sales:
To customers from U.S. parent	$	29,912		$	37,021		$	21,520
To customers from Malaysian subsidiary		907,764			648,925			436,857
Intercompany from Malaysian subsidiary		19,584			24,284			20,868
Intercompany from U.S. parent		986			808			170

		958,246			711,038			479,415
Intercompany eliminations		(20,570	)		(25,092	)		(21,038	)

Total net sales	$	937,676		$	685,946		$	458,377

Operating income (loss):
U.S. parent	$	(14,520	)	$	1,604		$	(5,823	)
Malaysian subsidiary		163,972			116,328			60,205

Total operating income	$	149,452		$	117,932		$	54,382

Long-lived assets:
U.S. parent	$	36,357		$	31,475
Malaysian subsidiary		506,228			319,571

Total long-lived assets	$	542,585		$	351,046

External sales by geographic location, which is determined by the customers’ sold-to address, are as follows (in thousands):


	Year Ended
	December 31, 2006		January 1, 2006		January 2, 2005

Thailand	$	559,770	$	272,392	$	111,904
Malaysia		157,340		78,047		42,704
Singapore		93,073		201,007		201,686
China		71,626		65,341		1,792
Taiwan		33,932		32,855		25,940
United States		19,992		33,735		53,535
Europe		1,563		1,574		37
Japan		380		995		20,779

Total net sales	$	937,676	$	685,946	$	458,377


Note 3.	Concentration of Customer and Supplier Risk

Most of the Company’s sales are derived from a relatively small number of customers, which results in a concentration of credit risk regarding trade receivables. The Company performs ongoing credit evaluations of its customers, and generally requires no collateral for sales to these customers. Based on management’s evaluation of potential credit losses and the relative strength of the disk drive industry, the Company believes that an allowance for doubtful accounts as of December 31, 2006 is not required.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Seagate accounted for $57.9 million of the Company’s accounts receivable at December 31, 2006, and 36% of its net sales for 2006 (Seagate acquired Maxtor in May of 2006 and therefore we have reflected sales to Maxtor in the Seagate numbers for all of 2006). Western Digital accounted for $46.1 million of the Company’s accounts receivable at December 31, 2006, and 37% of its net sales for 2006. Hitachi Global Storage Technologies (HGST) accounted for $28.5 million of the Company’s accounts receivable at December 31, 2006, and 23% of its net sales for 2006.

The Company’s customers are concentrated in the disk drive industry. Accordingly, the Company’s future success depends on the buying patterns of these customers and the continued demand by these customers for the Company’s products. Additionally, the disk drive market is characterized by rapidly changing technology, evolving industry standards, changes in end user requirements, and frequent new product introductions and enhancements. The Company’s continued success will depend upon its ability to enhance existing products and to develop and introduce, on a timely basis, new products and features that keep pace with technological developments and emerging industry standards. Furthermore, as a result of its international sales, the Company’s operations are subject to risks of doing business abroad, including but not limited to, fluctuations in the value of currency, longer payment cycles, and greater difficulty in collecting accounts receivable.

Because of the Company’s small customer base, the loss of any one significant customer would have a material impact on the Company’s business operations. During the second quarter of 2006, Seagate acquired Maxtor Corporation (Maxtor). Sales to Seagate for all of 2006 include sales to Maxtor. The Company expects to continue to derive a substantial portion of our sales from these customers, and from a small number of other customers. We entered into supply agreements, including certain amendments to these agreements, with Western Digital, Maxtor and Seagate in 2005, and with HGST in the first quarter of 2006. The supply agreement with Maxtor was assigned to Seagate as a result of Seagate’s acquisition of Maxtor in May 2006. Under the supply agreements, the Company supplies certain media volumes subject to the terms and conditions of the agreements. The customers are required to pay certain advances to the Company covering future purchases of media from the Company. The customer advances, which totaled $127.2 million and $102.9 million as of December 31, 2006 and January 1, 2006, respectively, are to be repaid to the customers via a credit of a specified dollar amount per disk on future sales.

Significant customers accounted for the following percentages of net sales in 2006, 2005, and 2004:


	Year Ended
	December 31,			January 1,			January 2,
	2006			2006			2005

Western Digital Corporation		37	%		24	%		14	%
Seagate Technology(1)		36	%		16	%		4	%
Hitachi Global Storage Technologies(2)		23	%		21	%		29	%
Maxtor Corporation		—			32	%		47	%


(1)		Seagate Technology acquired Maxtor Corporation in the second quarter of 2006. Sales to Maxtor for all of 2006 have been presented on a combined basis with Seagate Technology.

(2)		Sales to HGST include sales made to its contract manufacturer.

The Company relies on a limited number of suppliers for some of the materials and equipment used in its manufacturing processes, including aluminum blanks, aluminum substrates, nickel plating solutions, polishing and texturing supplies, and sputtering target materials. Kobe Steel, Ltd. is the Company’s primary supplier of aluminum blanks, which is a fundamental component in producing disks. The Company also relies on Heraeus Incorporated and Williams Advanced Materials, Incorporated for its sputtering target requirements, and on OMG Fidelity, Incorporated for supplies of nickel plating solutions.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Note 4.	Employee Savings and Deferred Profit Sharing Plan

The Company maintains a savings and deferred profit sharing plan. Employees in the United States who meet certain criteria are eligible to participate. In addition to voluntary employee contributions to the plan, the Company matches a portion of each employee’s contributions to the plan, up to a maximum amount. The Company contributed a total of $1.4 million to the plan in 2006, $2.2 million in 2005, and $0.8 million in 2004. Plan expenses are included in selling, general, and administrative expenses.


Note 5.	Income Taxes

The Company’s income (loss) before the provision for income taxes consisted of the following (in thousands):


	Year Ended
	December 31,			January 1,		January 2,
	2006			2006		2005

Domestic	$	(1,368	)	$	9,311	$	(3,977	)
Foreign		155,637			111,768		56,403

	$	154,269		$	121,079	$	52,426

The Company’s provision for (benefit from) income taxes consisted of the following (in thousands):


	Year Ended
	December 31,			January 1,		January 2,
	2006			2006		2005

U.S. Federal:
Current	$	2,646		$	4,747	$	—
Deferred		(6,280	)		—		—

		(3,634	)		4,747		—

U.S. State:
Current		226			525		1
Deferred		(698	)		—		—

		(472	)		525		1

Foreign:
Current		842			170		1,070
Deferred		—			—		—

		842			170		1,070

Total Current		3,714			5,442		1,071
Total Deferred		(6,978	)		—		—

Provision for (benefit from) income taxes	$	(3,264	)	$	5,442	$	1,071

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

A reconciliation of the actual income tax provision to the expected income tax provision (as measured by the U.S. statutory corporate income tax rate of 35% to pretax earnings) is as follows (in thousands):


	Year Ended
	December 31,			January 1,			January 2,
	2006			2006			2005

Income tax expense at federal statutory rate	$	53,994		$	42,378		$	18,349
State income taxes, net of federal benefit		(472	)		525			1
Foreign withholding taxes (refund)		49			—			(182	)
Foreign rate differential		(53,685	)		(38,431	)		(18,489	)
Change in valuation allowance		(4,566	)		1,176			1,392
Other		1,416			(206	)		—

	$	(3,264	)	$	5,442		$	1,071

Deferred income taxes reflect the tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The significant components of the Company’s deferred tax assets and liabilities are as follows (in thousands):


	December 31,			January 1,
	2006			2006

Deferred tax assets
Property, plant and equipment	$	13,702		$	16,469
Accrued compensation and benefits		5,144			2,547
Other		4,550			3,772
Tax benefit of net operating loss carryforwards		72,510			75,340
Tax benefit of credit carryforwards		36,090			33,810

Gross deferred tax assets		131,996			131,938
Valuation allowance		(124,196	)		(131,938	)

Total net deferred tax assets	$	7,800		$	—


	December 31,			January 1,
	2006			2006

Current:
Gross deferred tax assets	$	7,326		$	4,005
Valuation allowance		(6,872	)		(4,005	)

Net deferred tax assets — current		454			—
Long-term:
Gross deferred tax assets		124,670			127,933
Valuation allowance		(117,324	)		(127,933	)

Net deferred tax assets — long-term		7,346			—

Total net deferred tax assets	$	7,800		$	—

Prior to 2006, the Company had established a full valuation allowance against its deferred tax assets due to the uncertainty regarding its ability to generate sufficient future taxable income. In the fourth quarter of 2006, the Company reassessed the valuation allowance previously established and determined that it was more likely than not that a portion of the deferred tax assets would be realized in 2007. As a result, the Company released a portion of the

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

allowance resulting in an income tax benefit of $7.0 million and a credit to equity of $0.8 million in 2006. The Company will continue to assess the potential realization of the remaining deferred tax assets, and will adjust the valuation allowance in future periods, as appropriate. The recorded valuation allowance against deferred tax assets decreased by $7.7 million in 2006, increased by $4.9 million in 2005, and increased by $3.4 million in 2004. Approximately $7.3 million of the valuation allowance as of December 31, 2006 was attributable to the federal and state income tax benefits of stock compensation deductions, the benefit of which will be credited to additional paid in capital when, and if, realized.

Pursuant to Statement SFAS No. 123R, excess tax benefits associated with the stock awards are not recognized until the associated tax deduction reduces cash taxes payable. As such, the Company has been tracking the deductions attributable to these excess benefits separately. The additional tax benefits of net operating loss and tax credit carryforwards related to the stock awards was $5.5 million in 2006. These excess benefits will not be recognized as a credit to additional paid in capital until such deduction reduces tax payable.

At December 31, 2006, the Company has unrecognized deferred tax assets generated prior to the Company’s reorganization in 2002 of approximately $94.5 million. Upon realization of those deferred tax assets, the Company first reduces intangible assets associated with the reorganization to zero and then credits additional paid-in capital. In 2006, the Company utilized $2.9 million of pre-emergence deferred tax assets to reduce taxes payable. In 2005 and 2004, the Company utilized $4.9 million and $1.0 million pre-emergence deferred tax assets to reduce taxes payable, respectively. These deferred tax assets were previously fully reserved by a valuation allowance. The benefit of realizing these deferred tax assets was credited to additional paid-in capital in 2006, 2005 and 2004.

At December 31, 2006, the Company had federal and state net operating loss carryforwards of approximately $208.5 million and $78.5 million, which are available to offset future federal and state taxable income through 2026 and 2016, respectively. In addition, the Company had various federal and state tax credit carryforwards of approximately $46.0 million, of which $13.9 million are available to offset future taxable income through 2026, and the remaining $32.1 million are available indefinitely.

The utilization of the Company’s net operating loss and tax credit carryforwards are subject to certain annual limitations due to the ownership change, as defined by the Internal Revenue Code of 1986. The annual limitation on these NOL’s and credits are $8.4 million and $2.9 million, respectively, for losses and credits generated before June 30, 2002.

The Company’s Malaysian manufacturing facilities operate under various tax holidays. The net impact of these tax holidays increased the Company’s net income by $47.7 million ($1.59 per basic share and $1.42 per diluted share) in 2006, $41.1 million ($1.42 per basic share and $1.24 per diluted share) in 2005, and $25.1 million ($0.92 per basic share and $0.81 per diluted share) in 2004. In July 2005, the Malaysian government agreed to reset the expiration dates of the existing tax holidays to December 2006 and approved a new, 10-year tax holiday covering all of the Company’s Malaysian operations. The new tax holiday commences in January 2007 and expires in December 2016.

A substantial majority of the Company’s income is generated by its foreign subsidiaries covered by tax holidays. No federal and state income taxes have been provided on the net undistributed earnings from foreign subsidiaries, which, as of December 31, 2006, amounted to $291.3 million. The net undistributed earnings are intended to finance local operating requirements and to satisfy the intercompany payables to the parent company and are therefore considered permanently reinvested.


Note 6.	Fair Value of Financial Instruments

The carrying values of cash and cash equivalents, short-term investments, accounts receivable, and accounts payable approximate their fair values as of December 31, 2006 and January 1, 2006, due to the relatively short period to maturity of these instruments.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

As of December 31, 2006 and January 1, 2006, the fair value of the Company’s Convertible Subordinated Notes was $115.9 million and $109.9 million, respectively. These values were based on the quoted price of the Notes (which are traded in the open market) as of the last business day of the Company’s 2006 and 2005 fiscal years.


Note 7.	Accrued Expenses and Other Liabilities

The following table (in thousands) summarizes accrued expenses and other liabilities for fiscal 2006 and fiscal 2005:


	December 31,		January 1,
	2006		2006

Accrued compensation and benefits	$	22,481	$	24,986
Other liabilities		2,931		3,599

	$	25,412	$	28,585


Note 8.	Customer Advances

The Company entered into supply agreements, including certain amendments to these agreements, with three major customers in 2005, and another major customer in the first quarter of 2006. Under the supply agreements, the Company supplies certain media volumes subject to the terms and conditions of the agreements. The customers are required to pay certain advances covering future purchases of media from the Company. The customer advances, which totaled $127.2 million and $102.9 million as of December 31, 2006 and January 1, 2006, respectively, are to be repaid to the customers via a credit of a specified dollar amount per disk on future sales. During 2006 and 2005, customer advance credits applied to purchases of media were $119.5 million and $1.4 million, respectively, and additional customer advance payments were $143.8 million and $104.3 million, respectively. The agreements generally provide for repayment at the end of the term of the agreement if not fully paid by credits applied to purchases. The terms of the current arrangements expire on various dates through December 2009.


Note 9.	Debt and Bank Guarantee

In January 2004, the Company completed an offering of $80.5 million of 2.0% Convertible Subordinated Notes (the Notes). The Notes mature on February 1, 2024, bear interest at 2.0%, and require semiannual interest payments beginning on August 1, 2004. The Notes will be convertible, under certain circumstances, into shares of the Company’s common stock based on an initial effective conversion price of $26.40. Holders of the Notes may convert the Notes into shares of the Company’s common stock prior to maturity if: 1) the sale price of the Company’s common stock equals or exceeds $31.68 for at least 20 trading days in any 30 consecutive trading day period within any fiscal quarter of the Company; 2) the trading price of the Notes falls below a specified threshold prior to February 19, 2019; 3) the Notes have been called for redemption; or 4) specified corporate transactions (as described in the offering prospectus for the Notes) occur. The conditions for conversion have been met, and the debt is currently convertible. The Company may redeem the Notes on or after February 6, 2007, at specified declining redemption premiums. Holders of the Notes may require the Company to purchase the Notes on February 1, 2011, 2014, or 2019, or upon the occurrence of a fundamental change, at a purchase price equal to 100% of the principal amount of the Notes, plus accrued and unpaid interest.

There are no financial covenants, guarantees, or collateral associated with the Notes. In connection with the issuance of the Notes, the Company incurred $3.1 million of loan fees. The loan fees, which are included in other assets on the condensed consolidated balance sheet, are being amortized on a straight-line basis over the 20-year life of the Notes. On December 31, 2006, unamortized loan fees were $2.6 million.

The Company has arranged bank guarantees of Malaysian ringgit 29.5 million (approximately $8.4 million) which are required by Malaysian utility companies and other Malaysian vendors. There is no expiration date on the bank guarantees. No interest will be charged on the bank guarantees, but there is a commission charge ranging

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

between 0.05% and 0.10% on the amount of bank guarantee utilized. As of December 31, 2006, there were no liabilities outstanding related to the bank guarantees.


Note 10.	Derivative Financial Instruments

The Company accounts for its derivative and hedging activities under SFAS 133. The assets or liabilities associated with its derivative instruments and hedging activities are recorded at fair value in prepaid expenses and other current assets or other current liabilities, respectively, in the consolidated balance sheets. As discussed below, the accounting for gains and losses resulting from changes in fair value depends on the use of the derivative and whether it is designated and qualifies for hedge accounting.

As of December 31, 2006, the Company had a foreign exchange forward contract to purchase approximately $0.7 million of Japanese Yen for cash flow payments denominated in Japanese Yen for future equipment purchases. The contract has been designated as a cash flow hedge in accordance with SFAS 133. The fair value of the Company’s forward contract was recorded as a $23 thousand other current liability as of December 31, 2006. Fair value is determined by a dealer quote. The effectiveness of the contracts that qualify as cash flow hedges is assessed quarterly through an evaluation of critical terms and other criteria required by SFAS 133. The effective portion of gains or losses resulting from changes in fair value is initially reported as a component of accumulated other comprehensive income or (loss), net of any tax effects, in stockholders’ equity and subsequently reclassified into depreciation expense over the useful life of the purchased equipment. In 2006, the hedges were perfectly effective and no ineffectiveness in hedges occurred.

The Company’s foreign exchange forward contracts have maturities of less than 12 months. The Company does not use foreign exchange forward contracts for speculative or trading purposes. As of December 31, 2006, forward contracts used for purchases of raw materials are not accounted for at fair value under the normal purchases exception provided in SFAS 133.


Note 11.	Stockholders’ Equity

Common Stock

As of December 31, 2006, the Company is authorized to issue 120.0 million shares of common stock. The following shares of common stock are reserved for future issuance (in thousands):


Convertible Subordinated Notes			3,049
2002 Qualified Stock Plan			5,390

			8,439

Amended and Restated 2002 Qualified Stock Plan

The 2002 Qualified Stock Plan (the 2002 Stock Plan) provides for the grant of incentive stock options to the Company’s employees, and for the grant of non-statutory stock options, stock purchase rights, stock appreciation rights, performance shares and performance units to the Company’s employees, directors, and consultants. The term for stock options granted may not exceed 10 years. In May 2005, shareholders voted to terminate the Employee Stock Purchase Plan (ESPP) and transfer the remaining 317,054 unissued shares that were previously reserved under the ESPP to the 2002 Stock Plan. In May 2006, the Company increased the number of shares reserved for issuance by 5,000,000 shares from 4,242,054 shares to 9,242,054 shares.

As of December 31, 2006, the Company had authorized a total of 9,242,054 shares of its common stock for issuance under the 2002 Stock Plan. As of December 31, 2006, the Company had a net balance of 5,390,492 shares of the Company’s common stock reserved for issuance under the 2002 Stock Plan. Of the 5,390,492 shares reserved for future issuance under the 2002 Stock Plan, 12,500 are for stock purchase rights deferred under the Deferred

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Compensation Plan, 485,262 are for the exercise of outstanding stock options, and 4,892,730 are for future grants of stock options and stock purchase rights.

Stock-Based Compensation

Effective January 2, 2006, the Company adopted SFAS No. 123R using the modified prospective method, in which compensation cost is recognized based on the requirements of SFAS 123R for (a) all share-based payments granted or modified after the effective date and (b) for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date. The Company elected to amortize stock-based compensation for awards outstanding and unvested on its adoption of SFAS 123R as well as for awards granted on or after its adoption of SFAS 123R on a straight line basis over the requisite service (vesting) period for the entire award. The vesting period for stock options has generally been four years and the vesting period for stock purchase rights generally has been three years.

Stock-based compensation expense related to outstanding stock options and stock purchase rights amounted to $3.1 million and zero for 2006 and 2005, respectively, and $15.0 million and $3.2 million for 2006 and 2005, respectively. As a result of adopting SFAS 123R on January 2, 2006, the Company’s income before income taxes and net income for 2006 were approximately $3.4 million and $3.3 million lower, than if it had continued to account for stock-based compensation under APB 25. Basic and diluted net income per share for 2006 were approximately $0.10 and $0.08 lower, respectively, due to the adoption of SFAS 123R.

As of December 31, 2006, there was approximately $27.2 million of total unrecognized compensation cost related to stock-based compensation arrangements. The cost is expected to be recognized on a straight line basis over the remaining vesting period of the stock-based awards through the third quarter of 2010. The weighted average remaining vesting period is approximately two years.

Summary of Assumptions and Activity

In 2006 and 2005, the Company recorded $3.1 million and zero, respectively, of stock-based compensation expense related to stock options. The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model. The following assumptions were used to estimate the fair value of option grants in 2006: risk-free interest rate of 4.80%; expected volatility of the market price of the Company’s common stock of 54.3%; no dividend yield, and a weighted-average expected life of 4.0 years. The fair value of options granted in 2006, 2005 and 2004 was $18.10, $11.57 and $7.02 per share, respectively. Options to purchase 100,000 shares of the Company’s common stock were granted in 2006.

Compensation expense related to stock options is amortized on a straight line basis over the vesting period of 48 months. As of December 31, 2006, the unamortized fair value of unvested stock options was $3.0 million and will be amortized on a straight line basis over a remaining weighted average vesting period of approximately 2.3 years.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

A summary of stock option transactions is as follows:


						Weighted-Average
						Remaining		Aggregate
				Weighted-Average		Contractual		Intrinsic
	Shares			Exercise Price		Term		Value
				(Per share)		(Years)

Outstanding at December 28, 2003		1,220,085		$	8.68
Granted		422,880		$	17.19
Exercised		(237,912	)	$	5.78
Cancelled		(37,669	)	$	12.50

Outstanding at January 2, 2005		1,367,384		$	11.72
Granted		53,436		$	20.34
Exercised		(489,716	)	$	10.13
Cancelled		(62,251	)	$	13.80

Outstanding at January 1, 2006		868,853		$	12.99
Granted		100,000		$	38.65
Exercised		(479,209	)	$	11.73
Cancelled		(4,382	)	$	14.55

Outstanding at December 31, 2006(1)		485,262		$	19.51		7.53	$	8,990,193

Exercisable at December 31, 2006		244,341		$	12.99		6.75	$	6,082,026


(1)		Also represents vested and expected to vest.

The total intrinsic value of options exercised during 2006, 2005 and 2004 was $14.7 million, $8.8 million and $3.0 million, respectively. In 2006, 2005 and 2004 the cash received from exercise of options was $5.6 million, $5.0 million and $1.4 million, respectively. Upon the exercise of options, the Company issues new common stock from its authorized shares.

The following table sets forth a summary of the Company’s stock purchase rights for 2006:


				Weighted-Average
				Grant Date
	Shares			Fair Value
				(Per share)

Outstanding at January 1, 2006		573,201		$	22.34
Granted		659,809		$	44.25
Vested		(240,719	)	$	24.03
Cancelled		(17,823	)	$	34.87

Outstanding at December 31, 2006		974,468		$	36.53

In 2006, 2005 and 2004, the Company recorded $15.0 million, $3.2 million and $0.4 million, respectively, of stock-based compensation expense related to stock purchase rights. The cumulative effect of adopting SFAS 123R related to applying an estimated forfeiture rate to unvested stock purchase rights outstanding on the date of adoption was a $0.2 million credit, which was credited to operating costs and expenses. The Company determines the fair value of stock purchase rights based on the Nasdaq closing stock price on the date of grant. Compensation expense related to stock purchase rights is amortized on a straight line basis over the vesting period of 36 months (one-third vests annually upon the anniversary date of the grant date). As of December 31, 2006, the unamortized fair value of

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

unvested restricted stock awards was $24.1 million and will be amortized on a straight line basis over a remaining weighted average vesting period of approximately 1.8 years.

During the first quarter of 2006, the Company announced the anticipated retirement of its Chief Executive Officer (CEO), which became effective on October 1, 2006. Certain agreements were entered into with the CEO as a result of the anticipated retirement. These agreements were filed as exhibits to the Form 10-K filed for the year ended January 1, 2006. Under the agreements, the vesting of certain stock options and stock purchase rights were accelerated to provide additional compensation in connection with the CEO’s retirement and for his assistance during a planned transition period. The Company recorded an additional $5.1 million of stock-based compensation expense related to the modification of the CEO’s stock options and stock purchase rights for 2006, respectively. Effective October 1, 2006, Timothy Harris, the Company’s then-Chief Operating Officer, became the Company’s new CEO. The Company’s then-CEO retired effective as of such date, and continued to provide transitional consulting services to the Company for three months.

Pro forma information for Periods Prior to the Adoption of SFAS 123R

Prior to January 2, 2006 and as permitted under SFAS No. 123, the Company elected to follow APB 25, and related interpretations in accounting for stock-based awards to employees. Accordingly, compensation cost for stock options and stock purchase rights was measured as the excess, if any, of the market price of the Company’s common stock at the date of grant over the exercise price. In accordance with SFAS 123 and SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of SFAS 123, prior to fiscal 2006, the Company provided pro forma disclosure of the effect on net income and earnings per share had the fair value method been used, as prescribed by SFAS 123.

The following table reflects the effect on the Company’s net income and income per share had the fair value method been applied to all outstanding and unvested awards in 2005 and 2004. The table is in thousands, except per share amounts.


	Year Ended
	January 1,			January 2,
	2006			2005

Net income, as reported	$	115,637		$	51,355
Add stock-based employee compensation expense included in reported net income		3,308			555
Deduct stock-based compensation expense determined under the fair value method for all awards		(5,973	)		(3,571	)

Pro forma net income	$	112,972		$	48,339

Net income per share:
Basic — as reported	$	3.99		$	1.88

Diluted — as reported	$	3.55		$	1.71

Basic — pro forma	$	3.90		$	1.77

Diluted — pro forma	$	3.49		$	1.63

For pro forma disclosure purposes, the Company used the Black-Scholes-Merton option pricing model to estimate the fair value of each option and stock purchase right grant on the date of grant.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following assumptions were used to estimate the fair value of option grants in fiscal 2005 and 2004:


	2005			2004

Risk-free interest rate		4.0	%		2.7	%
Volatility factor of the expected market price of the Company’s common stock		71.8	%		81.8	%
Weighted-average expected option life (in years)		4.0			4.0
Weighted-average per share fair value of options granted	$	11.57		$	7.02

The following assumptions were used to estimate the fair value of employee purchase rights under the Amended and Restated 2002 Employee Stock Purchase Plan in 2005, and 2004:


	2005			2004

Risk-free interest rate		1.7	%		1.6	%
Volatility factor of the expected market price of the Company’s common stock		50.8	%		61.2	%
Weighted-average expected purchase rights life (in years)		0.5			0.5
Weighted-average fair value of purchase rights granted	$	3.12		$	3.43

Because the Company does not pay out dividends, no dividend yield was included in the fair value calculation.

Deferred Compensation Plan

Employees at or above the director level are eligible to participate in the Company’s Deferred Compensation Plan, which provides for the deferral of stock purchase rights. Eligible employees may elect to defer any stock purchase rights they are eligible to receive during any calendar year the plan remains in effect. All deferrals must equal 100% of the shares to be awarded at the fair market value, calculated on the date of grant, of the stock purchase rights that would have otherwise been received. Distributions shall be paid in the form of shares of the Company’s common stock at such time as may be elected by each participant.

As of December 31, 2006, the issuance of 12,500 shares have been deferred in accordance with the Deferred Compensation Plan.

Warrants

In June 2002, the Company issued warrants to purchase 1,000,000 shares of the Company’s common stock. The warrants were exercisable until June 30, 2005 and had an exercise price of $9.00. In 2003 through 2005, approximately 992,000 warrants were exercised, and approximately 300,000 were surrendered in lieu of paying cash upon the exercise of certain warrants. The remaining approximate 8,000 warrants which expired as of June 30, 2005 were cancelled.


Note 12.	Leases and Commitments

The Company leases a research and administrative facility under an operating lease that expires in 2014. The lease includes two renewal options of five years each.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

As of December 31, 2006, the future minimum commitments for the non-cancelable operating facility lease, and non-cancelable equipment leases, are as follows (in thousands):


	Minimum
	Lease
	Payments

2007	$	2,512
2008		2,057
2009		3,159
2010		3,150
2011		3,143
Thereafter		10,101

	$	24,122

Rental expense for all operating leases was $3.4 million in 2006, $3.5 million in 2005, and $3.9 million in 2004.

During 2006 and 2005, the Company recorded $0.5 million and $2.6 million, respectively, of deferred rent related to the Company’s renewal of its leased headquarters facility in San Jose, California. As of December 31, 2006, the deferred rent balance was $3.1 million.


Note 13.	Quarterly Financial Data (Unaudited, in thousands, except per share data)


	2006
	1st Quarter(1)		2nd Quarter		3rd Quarter		4th Quarter

Net sales	$	208,512	$	233,627	$	239,608	$	255,929
Gross profit		59,093		64,968		61,780		61,841
Operating income		36,054		39,788		34,321		39,289
Net income	$	36,237	$	40,289	$	34,498	$	46,509
Basic net income per share	$	1.22	$	1.35	$	1.15	$	1.54
Diluted net income per share	$	1.09	$	1.21	$	1.04	$	1.39
Number of shares used in basic per share computations		29,685		29,883		29,969		30,138
Number of shares used in diluted per share computations		33,499		33,544		33,565		33,715


(1)		Fourth quarter results included a release of $7.0 million, representing a portion of the Company’s deferred tax valuation allowance, to recognize deferred tax assets that in the Company’s judgment are more likely than not to be realized in 2007.

KOMAG, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

2005

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Net sales
$ 140,275 $ 172,740 $ 180,011 $ 192,920

Gross profit
35,063 48,080 50,887 54,703

Operating income
18,762 30,819 32,343 36,008

Net income
$ 18,527 $ 29,893 $ 31,982 $ 35,235

Basic net income per share
$ 0.66 $ 1.04 $ 1.09 $ 1.20

Diluted net income per share
$ 0.59 $ 0.92 $ 0.97 $ 1.07

Number of shares used in basic per share computations
28,261 28,834 29,396 29,476

Number of shares used in diluted per share computations
32,313 32,971 33,381 33,329


Note 14.	Subsequent Events

Stock Purchase Rights and Stock Options

On February 15, 2007, the Company’s Compensation Committee of its Board of Directors approved the grant of a total of 380,854 stock purchase rights with an exercise price of $0.01 to employees. Of this total, 313,881 was to non-officers and 66,973 was to officers. The vesting for the stock purchase rights granted is one-third at the end of each of the first three anniversaries of the date of grant, subject to the employee continuing to be a service provider. In addition, 180,819 stock options were granted to officers with an exercise price of $32.10. The vesting for the stock options granted is one-third at the end of the first anniversary of the date of grant and 1/24^th each month thereafter.


Item 9.	*Changes in and Disagreements with Accountants on Accounting and Financial Disclosure*

None.


Item 9A.	*Controls and Procedures*

Evaluation of Disclosure Controls and Procedures

As of December 31, 2006, our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), has conducted an evaluation of the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation, the CEO and CFO concluded that as of December 31, 2006, our disclosure controls and procedures are effective in ensuring that all material information required to be filed in this annual report has been made known to them in a timely manner.

Internal Control over Financial Reporting

Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that:


	•	pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;

	•	provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and

	•	provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions and that the degree of compliance with the policies or procedures may deteriorate.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our independent registered public accounting firm, KPMG LLP, have issued an auditors’ report on management’s assessment of Komag’s internal report over financial reporting. This report is on page 39.

Our management assessed the effectiveness of Komag’s internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on its assessment and those criteria, management concluded that Komag maintained effective internal control over financial reporting as of December 31, 2006.

Changes in Internal Control Over Financial Reporting

There has been no change in Komag’s internal control over financial reporting during its fourth fiscal quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, Komag’s internal control over financial reporting.


Item 9B.	*Other Information*

None.

PART III

Item(s) 10, 11, 12, 13, and 14.

Items 10 through 14 of Part III will be contained in our Proxy Statement for the Annual Meeting of Stockholders to be held on May 23, 2007 (the 2007 Proxy Statement), which will be filed with the SEC no later than April 30, 2007. The cross-reference table below sets forth the primary captions under which the responses to these items will be found:


10-K Item		Description	Caption in 2007 Proxy Statement

	10	Directors and Executive Officers of the Registrant	‘‘Item No. 1 — Election of Class II Directors,” ‘‘Corporate Governance Matters,” and ‘‘Other Information”
	11	Executive Compensation	‘‘Executive Compensation and Related Information” and “Director Compensation and Related Information”
	12	Security Ownership of Certain Beneficial Owners	‘‘Principal Stockholders,” ‘‘Stock
		and Management and Related Stockholder Matters	Ownership by Directors, Nominees and Executive Officers” and ‘‘Equity Compensation Plan Information”
	13	Certain Relationships and Related Transactions	“Other Information”
	14	Principal Accountant Fees and Services	‘‘Principal Accountant Fees and Services”

See Part I, Item 4, of this Report on Form 10-K for a list of our executive officers, which is hereby incorporated by reference in response to Item 10 of this Report on Form 10-K.

The information set forth under the captions listed above, which is to be contained in our 2007 Proxy Statement, are hereby incorporated herein by reference in response to Items 10 through 14 of this Report on Form 10-K.

Most of our executive officers have entered into individual Rule 10b5-1 trading plans pursuant to which stock of the Company will be sold for their account from time to time in accordance with the provisions of the plans without any further action or involvement by the officers.

PART IV


Item 15.	*Exhibits and Financial Statement Schedules*

(a) List of Items filed as part of this Report

1. Financial Statements.

The following consolidated financial statements of Komag, Incorporated are filed in Part II, Item 8 of this Report on Form 10-K:

Consolidated Statements of Operations — Fiscal Years 2006, 2005, and 2004

Consolidated Balance Sheets — December 31, 2006 and January 1, 2006

Consolidated Statements of Cash Flows — Fiscal Years 2006, 2005, and 2004

Consolidated Statements of Stockholders’ Equity — Fiscal Years 2006, 2005, and 2004

Notes to Consolidated Financial Statements

2. Financial Statement Schedules.

The following financial statement schedule of Komag, Incorporated is filed in Part IV, Item 15(c) of this report on Form 10-K:

Schedule II — Valuation and Qualifying Accounts

All other schedules for which provision is made in the applicable accounting regulation of the SEC are not required under the related instructions or are inapplicable and therefore have been omitted.

3. Exhibits.

The list of exhibits to this Report set forth under Part IV, Item 15(b) below, is incorporated herein by reference.

(b) Exhibits


Exhibit
Number			Description

	3	.1	Amended and Restated Certificate of Incorporation of Komag, Incorporated (incorporated by reference from Exhibit 3.1 filed with the Company’s Form 10-Q filed on August 13, 2002), as amended by Certificate of Amendment of Amended and Restated Certificate of Incorporation of Komag, Incorporated (incorporated by reference from Exhibit 3.1 filed with the Company’s report on Form 10-Q filed for the quarter ended on July 2, 2006).
	3	.2	Bylaws of Komag, Incorporated (incorporated by reference from Exhibit 3.2 filed with the Company’s Form 10-Q filed on August 13, 2002).
	4	.1	Form of Stock Certificate for Common Stock (incorporated by reference from Exhibit 4.1 filed with the Company’s Form 10-Q filed on August 13, 2002).
	4	.2	Form of Indenture by and between Komag, Incorporated and U.S. Bank National Association (incorporated by reference from Exhibit 4.8 filed with the Company’s Form S-3/A filed on January 15, 2004).
	10	.1	Lease Agreement (B10) dated May 24, 1996 between Sobrato Development Companies #871 and Komag, Incorporated (incorporated by reference from Exhibit 10.1.1.1 filed with the Company’s report on Form 10-K for the year ended January 2, 2005).
	10	.1.1	Second Amendment to Lease (B10) dated December 17, 2004, between DIVCO West Properties and Komag, Incorporated (incorporated by reference from Exhibit 10.1.1.1 filed with the company’s report on form 10-K for the year ended January 2, 2005).
	10	.2	Form of Indemnification Agreement (incorporated by reference from Exhibit 10.2 filed with the Company’s report on Form S-1 on August 27, 2002).
	10	.3	Amended and Restated 2002 Qualified Stock Option Plan (incorporated by reference from Appendix A of the Company’s Proxy Statement filed with the Company’s Schedule 14A as filed on April 14, 2006).
	10	.3.1	Komag, Incorporated 2002 Deferred Compensation Plan (incorporated by reference from Exhibit 10.4.2 filed with the Company’s report on Form S-1 on August 27, 2002).
	10	.4	Letter dated August 6, 2003 from the Malaysian Industrial Development Authority addressed to Komag USA (Malaysia) Sdn. extending the ‘‘Pioneer Status” of the Company’s thin-film media venture in Malaysia (incorporated by reference from Exhibit 10.5.2 filed with the Company’s report on Form 10-Q for the quarter ended September 28, 2003).
	10	.4.1	Letter dated July 21, 2005 from the Malaysian Industrial Development authority addressed to Komag USA (Malaysia) Sdn. extending the ‘‘Pioneer Status” of the Company’s thin-film media venture in Malaysia (incorporated by reference from Exhibit 10.4.1 filed with the Company’s report on Form 10-K for the year ended January 1, 2006).
	10	.5	Business Agreement by and between the Company and Maxtor Corporation dated October 6, 2003 (incorporated by reference from Exhibit 10.7 filed with the Company’s Form S-3/A filed on December 9, 2003).*
	10	.5.1	Addendum to Business Agreement between Maxtor, Inc. and Komag, Incorporated dated October 6, 2003, as amended on July 8, 2005 (incorporated by reference from Exhibit 10.2 filed with the Company’s report on Form 10-Q for the quarter ended October 2, 2005).*


Exhibit
Number			Description

	10	.6	Discretionary Bonus Plan (incorporated by reference from Exhibit 10.7 filed with the Company’s Form 10-K for the year ended January 2, 2005).
	10	.7	Bonus Plan (incorporated by reference from Exhibit 10.7 filed with the Company’s Form 10-K for the year ended January 1, 2006).
	10	.7.1	Target Incentive Plan (incorporated by reference from Exhibit 10.7.1 filed with the Company’s Form 10-K for the year ended January 1, 2006).
	10	.8	Form of Notice of Grant of Stock Purchase Right — Employees (incorporated by reference from Exhibit 10.9 filed with the Company’s Form 10-K for the year ended January 2, 2005).
	10	.8.1	Form of Notice of Grant of Stock Purchase Right — Officers and Directors (incorporated by reference from Exhibit 10.9.1 filed with the Company’s Form 10-K for the year ended January 2, 2005).
	10	.9	Form of Stock Option Agreement (incorporated by reference from Exhibit 10.10 filed with the Company’s Form 10-K for the year ended January 2, 2005).
	10	.10	Volume Purchase Agreement dated June 6, 2005 between the Company, Komag USA (Malaysia) Sdn, and Western Digital Technologies, Inc. as amended by Amendment No. 1 thereto dated July 22, 2005 (incorporated by reference from Exhibit 10.1 filed with the Company’s report on Form 10-Q for the quarter ended July 3, 2005).*
	10	.10.1	Amendment No. 2 to Volume Purchase Agreement, dated November 29, 2005, and Amendment No. 3 to Volume Purchase Agreement, dated January 31, 2006, between the Company, Komag USA (Malaysia) Sdn., and Western Digital Technologies, Incorporated (incorporated by reference from Exhibit 10.10.1 filed with the Company’s Form 10-K for the year ended January 1, 2006).*
	10	.11	Media Supply Agreement dated July 4, 2005 between the Company, Komag USA (Malaysia) Sdn, and Seagate Technology International. (incorporated by reference from Exhibit 10.1 filed with the Company’s report on Form 10-Q for the quarter ended October 2, 2005).*
	10	.12	Form of Officer Employment Agreements (incorporated by reference from Exhibit 10.3 filed with the Company’s report on Form 10-Q for the quarter ended October 2, 2005).
	10	.13	Amendment to Stock Option Agreements, Amendment to Stock Purchase Agreements, Amended and Restated Notice of Grant of Stock Purchase Right, and Consulting Services Agreement, each dated February 15, 2006, between the company and Thian H. Tan (incorporated by reference from Exhibit 10.13 filed with the Company’s Form 10-K for the year ended January 1, 2006).
	10	.14	Volume Purchase Agreement dated March 31, 2006 between Hitachi Global Storage Technologies Singapore Pte., Ltd. And Komag USA (Malaysia) Sdn., and Komag, Incorporated (incorporated by reference from Exhibit 10.1 filed with the Company’s report on Form 10-Q for the quarter ended April 2, 2006).*
	10	.15	Executive Employment Agreement, dated August 1, 2006, between the Company and Timothy Harris (incorporated by reference from Exhibit 10.1 filed with the Company’s report on Form 10-Q for the quarter ended October 1, 2006).
	10	.16	Separation Agreement and Release dated October 3, 2006, between the Company and Michael Russak (incorporated by reference from Exhibit 10.2 filed with the Company’s report on Form 10-Q for the quarter ended October 1, 2006).
	10	.17	Consulting Agreement, dated October 3, 2006, between the Company and Michael Russak (incorporated by reference from Exhibit 10.3 filed with the Company’s report on Form 10-Q for the quarter ended October 1, 2006).
	10	.18	Second Amendment to Stock Option Agreements, dated October 3, 2006, between the Company and Thian H. Tan (incorporated by reference from Exhibit 10.4 filed with the Company’s report on Form 10-Q for the quarter ended October 1, 2006).
	21		Subsidiaries of Komag, Incorporated.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in San Jose, California on this 22nd day of February, 2007.

KOMAG, INCORPORATED


	By:	/s/ Timothy D. Harris

Timothy D. Harris

Chief Executive Officer

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears herein constitutes and appoints Timothy D. Harris and Kathleen A. Bayless, and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated:


Signature	Title	Date

/s/ TIMOTHY D. HARRIS (Timothy D. Harris)	Chief Executive Officer and Director (Principal Executive Officer)	February 22, 2007

/s/ KATHLEEN A. BAYLESS (Kathleen A. Bayless)	Senior Vice President, Chief Financial Officer, and Secretary (Principal Financial Officer)	February 22, 2007

/s/ PAUL G. JUDY (Paul G. Judy)	Vice President, Corporate Controller, and Chief Accounting Officer (Principal Accounting Officer)	February 22, 2007

/s/ PAUL A. BRAHE (Paul A. Brahe)	Director	February 22, 2007

/s/ CHRIS A. EYRE (Chris A. Eyre)	Director	February 22, 2007

/s/ RICHARD A. KASHNOW (Richard A. Kashnow)	Director	February 22, 2007

EXHIBIT INDEX


Exhibit
Number			Description

	3	.1	Amended and Restated Certificate of Incorporation of Komag, Incorporated (incorporated by reference from Exhibit 3.1 filed with the Company’s Form 10-Q filed on August 13, 2002), as amended by Certificate of Amendment of Amended and Restated Certificate of Incorporation of Komag, Incorporated (incorporated by reference from Exhibit 3.1 filed with the Company’s report on Form 10-Q filed for the quarter ended on July 2, 2006).
	3	.2	Bylaws of Komag, Incorporated (incorporated by reference from Exhibit 3.2 filed with the Company’s Form 10-Q filed on August 13, 2002).
	4	.1	Form of Stock Certificate for Common Stock (incorporated by reference from Exhibit 4.1 filed with the Company’s Form 10-Q filed on August 13, 2002).
	4	.2	Form of Indenture by and between Komag, Incorporated and U.S. Bank National Association (incorporated by reference from Exhibit 4.8 filed with the Company’s Form S-3/A filed on January 15, 2004).
	10	.1	Lease Agreement (B10) dated May 24, 1996 between Sobrato Development Companies #871 and Komag, Incorporated (incorporated by reference from Exhibit 10.1.1.1 filed with the Company’s report on Form 10-K for the year ended January 2, 2005).
	10	.1.1	Second Amendment to Lease (B10) dated December 17, 2004, between DIVCO West Properties and Komag, Incorporated (incorporated by reference from Exhibit 10.1.1.1 filed with the company’s report on form 10-K for the year ended January 2, 2005).
	10	.2	Form of Indemnification Agreement (incorporated by reference from Exhibit 10.2 filed with the Company’s report on Form S-1 on August 27, 2002).
	10	.3	Amended and Restated 2002 Qualified Stock Option Plan (incorporated by reference from Appendix A of the Company’s Proxy Statement filed with the Company’s Schedule 14A as filed on April 14, 2006).
	10	.3.1	Komag, Incorporated 2002 Deferred Compensation Plan (incorporated by reference from Exhibit 10.4.2 filed with the Company’s report on Form S-1 on August 27, 2002).
	10	.4	Letter dated August 6, 2003 from the Malaysian Industrial Development Authority addressed to Komag USA (Malaysia) Sdn. extending the ‘‘Pioneer Status’’ of the Company’s thin-film media venture in Malaysia (incorporated by reference from Exhibit 10.5.2 filed with the Company’s report on Form 10-Q for the quarter ended September 28, 2003).
	10	.4.1	Letter dated July 21, 2005 from the Malaysian Industrial Development authority addressed to Komag USA (Malaysia) Sdn. extending the ‘‘Pioneer Status” of the Company’s thin-film media venture in Malaysia (incorporated by reference from Exhibit 10.4.1 filed with the Company’s report on Form 10-K for the year ended January 1, 2006).
	10	.5	Business Agreement by and between the Company and Maxtor Corporation dated October 6, 2003 (incorporated by reference from Exhibit 10.7 filed with the Company’s Form S-3/A filed on December 9, 2003).*
	10	.5.1	Addendum to Business Agreement between Maxtor, Inc. and Komag, Incorporated dated October 6, 2003, as amended on July 8, 2005 (incorporated by reference from Exhibit 10.2 filed with the Company’s report on Form 10-Q for the quarter ended October 2, 2005).*
	10	.6	Discretionary Bonus Plan (incorporated by reference from Exhibit 10.7 filed with the Company’s Form 10-K for the year ended January 2, 2005).
	10	.7	Bonus Plan (incorporated by reference from Exhibit 10.7 filed with the Company’s Form 10-K for the year ended January 1, 2006).
	10	.7.1	Target Incentive Plan (incorporated by reference from Exhibit 10.7.1 filed with the Company’s Form 10-K for the year ended January 1, 2006).
	10	.8	Form of Notice of Grant of Stock Purchase Right — Employees (incorporated by reference from Exhibit 10.9 filed with the Company’s Form 10-K for the year ended January 2, 2005).
	10	.8.1	Form of Notice of Grant of Stock Purchase Right — Officers and Directors (incorporated by reference from Exhibit 10.9.1 filed with the Company’s Form 10-K for the year ended January 2, 2005).
	10	.9	Form of Stock Option Agreement (incorporated by reference from Exhibit 10.10 filed with the Company’s Form 10-K for the year ended January 2, 2005).


Exhibit
Number			Description

	10	.10	Volume Purchase Agreement dated June 6, 2005 between the Company, Komag USA (Malaysia) Sdn, and Western Digital Technologies, Inc. as amended by Amendment No. 1 thereto dated July 22, 2005 (incorporated by reference from Exhibit 10.1 filed with the Company’s report on Form 10-Q for the quarter ended July 3, 2005).*
	10	.10.1	Amendment No. 2 to Volume Purchase Agreement, dated November 29, 2005, and Amendment No. 3 to Volume Purchase Agreement, dated January 31, 2006, between the Company, Komag USA (Malaysia) Sdn., and Western Digital Technologies, Incorporated (incorporated by reference from Exhibit 10.10.1 filed with the Company’s Form 10-K for the year ended January 1, 2006).*
	10	.11	Media Supply Agreement dated July 4, 2005 between the Company, Komag USA (Malaysia) Sdn, and Seagate Technology International. (incorporated by reference from Exhibit 10.1 filed with the Company’s report on Form 10-Q for the quarter ended October 2, 2005).*
	10	.12	Form of Officer Employment Agreements (incorporated by reference from Exhibit 10.3 filed with the Company’s report on Form 10-Q for the quarter ended October 2, 2005).
	10	.13	Amendment to Stock Option Agreements, Amendment to Stock Purchase Agreements, Amended and Restated Notice of Grant of Stock Purchase Right, and Consulting Services Agreement, each dated February 15, 2006, between the company and Thian H. Tan (incorporated by reference from Exhibit 10.13 filed with the Company’s Form 10-K for the year ended January 1, 2006).
	10	.14	Volume Purchase Agreement dated March 31, 2006 between Hitachi Global Storage Technologies Singapore Pte., Ltd. And Komag USA (Malaysia) Sdn., and Komag, Incorporated (incorporated by reference from Exhibit 10.1 filed with the Company’s report on Form 10-Q for the quarter ended April 2, 2006).*
	10	.15	Executive Employment Agreement, dated August 1, 2006, between the Company and Timothy Harris (incorporated by reference from Exhibit 10.1 filed with the Company’s report on Form 10-Q for the quarter ended October 1, 2006).
	10	.16	Separation Agreement and Release dated October 3, 2006, between the Company and Michael Russak (incorporated by reference from Exhibit 10.2 filed with the Company’s report on Form 10-Q for the quarter ended October 1, 2006).
	10	.17	Consulting Agreement, dated October 3, 2006, between the Company and Michael Russak (incorporated by reference from Exhibit 10.3 filed with the Company’s report on Form 10-Q for the quarter ended October 1, 2006).
	10	.18	Second Amendment to Stock Option Agreements, dated October 3, 2006, between the Company and Thian H. Tan (incorporated by reference from Exhibit 10.4 filed with the Company’s report on Form 10-Q for the quarter ended October 1, 2006).
	21		Subsidiaries of Komag, Incorporated.
	23	.1	Consent of KPMG LLP, Independent Registered Public Accounting Firm.
	24		Power of Attorney. Reference is hereby made to the signature pages of this report.
	31	.1	Rule 13a-14(a) Certification of Chief Executive Officer.
	31	.2	Rule 13a-14(a) Certification of Chief Financial Officer.
	32		Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer.


*		Confidential treatment has been requested with respect to certain portions of this exhibit. Omitted portions have been filed separately with the SEC.


			Page

	Item 1.	Business		3
	Item 1A.	Risk Factors		11
	Item 1B.	Unresolved Staff Comments		22
	Item 2.	Properties		22
	Item 3.	Legal Proceedings		23
	Item 4.	Submission of Matters to a Vote of Security Holders		23
	Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		24
	Item 6.	Selected Consolidated Financial Data		27
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		27
	Item 7A.	Quantitative and Qualitative Disclosures about Market Risk		36
	Item 8.	Consolidated Financial Statements and Supplementary Data		37
	Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		62
	Item 9A.	Controls and Procedures		62
	Item 9B.	Other Information		62
	Item 10.	Directors and Executive Officers of the Registrant		63
	Item 11.	Executive Compensation		63
	Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		63
	Item 13.	Certain Relationships and Related Transactions		63
	Item 14.	Principal Accountant Fees and Services		63
	Item 15.	Exhibits and Financial Statement Schedules		63
EXHIBIT 21
EXHIBIT 23.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32


Item 8.	*Consolidated Financial Statements and Supplementary Data*


Reports of Independent Registered Public Accounting Firm			38
Consolidated Statements of Income			40
Consolidated Balance Sheets			41
Consolidated Statements of Cash Flows			42
Consolidated Statements of Stockholders’ Equity and Comprehensive Income			43
Notes to Consolidated Financial Statements			44


	2005
	1st Quarter		2nd Quarter		3rd Quarter		4th Quarter

Net sales	$	140,275	$	172,740	$	180,011	$	192,920
Gross profit		35,063		48,080		50,887		54,703
Operating income		18,762		30,819		32,343		36,008
Net income	$	18,527	$	29,893	$	31,982	$	35,235
Basic net income per share	$	0.66	$	1.04	$	1.09	$	1.20
Diluted net income per share	$	0.59	$	0.92	$	0.97	$	1.07
Number of shares used in basic per share computations		28,261		28,834		29,396		29,476
Number of shares used in diluted per share computations		32,313		32,971		33,381		33,329


Column A	Column B		Column C			Column D		Column E
			Additions
	Balance at		Charged to					Balance
	Beginning		Costs and					at End
Description	of Year		Expenses			Deductions		of Year
	(In thousands)

Year ended January 2, 2005
Allowance for doubtful accounts	$	398	$	(398	)	$	—	$	—

Year ended January 1, 2006
Allowance for doubtful accounts	$	—	$	—		$	—	$	—

Year ended December 31, 2006
Allowance for doubtful accounts	$	—	$	—		$	—	$	—