e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended January 1, 2006


o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File No. 001-31353

EMULEX CORPORATION

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		51-0300558 (I.R.S Employer Identification No.)


3333 Susan Street Costa Mesa, California (Address of principal executive offices)		92626 (Zip Code)

(714) 662-5600
(Registrant’s telephone number, including area code)

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

As of February 1, 2006, the registrant had 84,046,859 shares of common stock outstanding.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

EMULEX CORPORATION AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands, except share data)

(unaudited)


	January 1,			July 3,
	2006			2005

Assets

Current assets:
Cash and cash equivalents	$	142,193		$	120,317
Investments		423,634			346,675
Accounts and other receivables, net		68,806			47,730
Inventories, net		24,537			36,266
Prepaid expenses		4,406			4,508
Deferred income taxes		27,609			28,961

Total current assets		691,185			584,457

Property and equipment, net		63,586			65,976
Investments		23,955			54,936
Intangibles, net		82,600			95,806
Other assets		596			606

	$	861,922		$	801,781


Liabilities and Stockholders’ Equity

Current liabilities:
Accounts payable	$	24,609		$	29,778
Accrued liabilities		20,829			21,505
Income taxes payable		36,545			25,361

Total current liabilities		81,983			76,644

Convertible subordinated notes		234,280			233,382
Deferred income taxes and other		13,021			14,164

Total liabilities		329,284			324,190


Commitments and contingencies (notes 7 and 8)

Stockholders’ equity:
Preferred stock, $0.01 par value; 1,000,000 shares authorized (150,000 shares designated as Series A Junior Participating Preferred Stock); none issued and outstanding		—			—
Common stock, $0.10 par value; 240,000,000 shares authorized; 83,990,203 and 83,201,002 issued and outstanding at January 1, 2006 and July 3, 2005, respectively		8,399			8,320
Additional paid-in capital		962,461			944,545
Deferred compensation		—			(3,407	)
Accumulated deficit		(438,222	)		(471,867	)

Total stockholders’ equity		532,638			477,591

	$	861,922		$	801,781

See accompanying notes to the condensed consolidated financial statements.

EMULEX CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Income

(in thousands, except per share data)

(unaudited)


	Three Months Ended						Six Months Ended
	January 1,			December 26,			January 1,			December 26,
	2006			2004			2006			2004

Net revenues	$	110,268		$	91,671		$	214,647		$	164,896
Cost of sales		41,712			33,546			79,861			62,792

Gross profit		68,556			58,125			134,786			102,104


Operating expenses:
Engineering and development		22,335			19,746			44,190			39,943
Selling and marketing		9,254			7,587			17,211			15,011
General and administrative		5,904			3,579			11,848			3,158
Amortization of intangibles		6,373			6,548			12,757			13,095
Impairment of goodwill		—			—			—			1,793

Total operating expenses		43,866			37,460			86,006			73,000


Operating income		24,690			20,665			48,780			29,104


Nonoperating income:
Interest income		4,792			2,867			8,538			5,901
Interest expense		(622	)		(1,056	)		(1,246	)		(2,403	)
Gain on repurchase of convertible subordinated notes		—			—			—			13,090
Other income (expense), net		(18	)		82			(20	)		72

Total nonoperating income		4,152			1,893			7,272			16,660


Income before income taxes		28,842			22,558			56,052			45,764

Income tax provision		11,633			8,357			22,407			17,264


Net income	$	17,209		$	14,201		$	33,645		$	28,500


Net income per share:
Basic	$	0.21		$	0.17		$	0.40		$	0.34

Diluted	$	0.19		$	0.16		$	0.38		$	0.32

Number of shares used in per share computations:
Basic		83,821			82,732			83,609			82,646

Diluted		91,266			92,632			91,115			93,659

See accompanying notes to the condensed consolidated financial statements.

EMULEX CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)


	Six Months Ended
	January 1,			December 26,
	2006			2004

Cash flows from operating activities:
Net income	$	33,645		$	28,500
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of property and equipment		8,159			6,684
Amortization of discount on 0.25% convertible subordinated notes		898			1,579
Gain on repurchase of convertible subordinated notes		—			(13,090	)
Insurance recovery on shareholder litigation settlements		—			(4,649	)
Stock-based compensation		10,637			2,381
Amortization of intangibles		12,758			13,095
Impairment of goodwill		—			1,793
Deferred income taxes		237			8,684
Tax benefit from exercise of stock options		—			459
Other		62			52
Changes in assets and liabilities:
Accounts and other receivables		(21,076	)		11,511
Inventories		11,857			8,846
Prepaid expenses and other assets		112			(66	)
Accounts payable and accrued liabilities		(5,873	)		1,454
Net reimbursement of litigation settlements		—			9,052
Income taxes payable		11,184			7,075

Net cash provided by operating activities		62,600			83,360


Cash flows from investing activities:
Net proceeds from sale of property and equipment		3			26
Additions to property and equipment		(5,834	)		(6,643	)
Net decrease in restricted cash related to the construction escrow account		—			23
Purchases of investments		(1,059,040	)		(322,087	)
Maturities of investments		1,013,062			312,555

Net cash used in investing activities		(51,809	)		(16,126	)


Cash flows from financing activities:
Proceeds from issuance of common stock under stock option plans		8,609			3,125
Repurchase of convertible subordinated notes		—			(137,206	)
Excess tax benefits from stock-based payment arrangements		2,476			—

Net cash provided by (used in) financing activities		11,085			(134,081	)


Net increase (decrease) in cash and cash equivalents		21,876			(66,847	)
Cash and cash equivalents at beginning of period		120,317			192,137

Cash and cash equivalents at end of period	$	142,193		$	125,290


Supplemental disclosures:
Cash paid during the period for:
Interest	$	297		$	611
Income taxes		8,771			1,280

See accompanying notes to the condensed consolidated financial statements.

EMULEX CORPORATION AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

1.		Summary of Significant Accounting Policies and Basis of Presentation

		In the opinion of the Company, the accompanying unaudited condensed consolidated financial statements contain all adjustments (which are normal recurring accruals) necessary to present fairly its financial position as of January 1, 2006 and July 3, 2005, and its condensed consolidated statements of income and cash flows for the three and six months ended January 1, 2006 and December 26, 2004. Interim results for the six months ended January 1, 2006, are not necessarily indicative of the results that may be expected for the year ending July 2, 2006. The interim financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended July 3, 2005. Certain reclassifications have been made to prior period amounts to conform to the current period presentation.

		New and Recently Adopted Accounting Standards

		Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs” requires that items such as idle facility expense, excessive spoilage, double freight and rehandling costs be recognized as current-period charges and requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company has applied the provisions of SFAS No. 151 to the inventory costs prospectively from July 4, 2005. The adoption of SFAS No. 151 did not have a significant impact on the Company’s consolidated results of operations for the three and six months ended January 1, 2006 or financial position at January 1, 2006.

		In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”), which replaces Accounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effect or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

		In September 2005, the FASB reached a final consensus on Emerging Issues Task Force (“EITF”) Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty.” EITF 04-13 concludes that two or more legally separated exchange transactions with the same counterparty should be combined and considered as a single arrangement for purposes of applying APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” when the transactions were entered into “in contemplation” of one another. The consensus contains several indicators to be considered in assessing whether two transactions are entered into in contemplation of one another. If, based on consideration of the indicators and the substance of the arrangement, two transactions are combined and considered a single arrangement, an exchange of finished goods inventory for either raw material or work-in-process should be accounted for at fair value. The provisions of EITF 04-13 are applied to transactions completed in reporting periods beginning after March 15, 2006.

		In November 2005, the FASB issued FASB Staff Position (“FSP”) SFAS No. 115-1 and SFAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amends FASB Statements No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, and APB Opinion No. 118, “The Equity Method of Accounting for Investments in Common Stock.” The FSP is effective for reporting periods beginning after December 15, 2005. The FSP is not expected to have a significant impact on the carrying value of the Company’s investments.

		In December 2004, the FASB issued SFAS No. 123R (revised 2004), “Share-Based Payment,” or SFAS No. 123(R). Effective July 4, 2005, the Company adopted SFAS No. 123(R) and related guidance, using the modified prospective application transition method which provides for only current and future period stock-based awards to be measured and recognized at fair value. See note 9 for additional information.

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

2.		Business Combination

		On November 13, 2003, the Company completed the cash tender offer to acquire all outstanding shares of Vixel Corporation for $10.00 net per share, without interest. On November 17, 2003, the Company completed its acquisition of Vixel. The Company acquired Vixel to expand its Fibre Channel product line and paid $298.4 million in cash for all outstanding common stock, preferred stock and warrants of Vixel Corporation. The Company also incurred acquisition-related expenses of $6.7 million in cash. In addition, the Company issued 2.2 million stock options with a fair value of approximately $47.5 million and kept the original vesting periods for the options in exchange for the outstanding Vixel options for a total acquisition value of $352.7 million. The Company calculated the fair value of the 2.2 million stock options issued at the date of acquisition using the Black-Scholes option-pricing model.

		In connection with the preparation of Vixel Corporation’s tax return in the first quarter of fiscal 2005, the Company revised estimates and discovered errors related to the deferred tax assets of Vixel Corporation (acquired in November 2003). As a result, the Company recorded a $1.8 million impairment of goodwill in the three months ended September 26, 2004. The Company does not believe that this $1.8 million impairment of goodwill was material to fiscal 2005 operations or financial results. Excluding this adjustment, net income for the six months ended December 26, 2004, would have been $30.3 million.

3.		Inventories

		Inventories, net, are summarized as follows:


	January 1,		July 3,
	2006		2005
	(in thousands)
Raw materials	$	5,616	$	20,269
Finished goods		18,921		15,997


	$	24,537	$	36,266

4.		Intangibles, net

		Intangibles, net, are as follows:


	January 1,			July 3,
	2006			2005
	(in thousands)
Intangible assets subject to amortization:
Core technology and patents	$	98,516		$	98,742
Accumulated amortization, core technology and patents		(46,336	)		(39,216	)
Developed technology		9,304			9,341
Accumulated amortization, developed technology		(4,940	)		(3,818	)
Customer relationships		37,809			37,962
Accumulated amortization, customer relationships		(16,103	)		(12,415	)
Tradename		4,949			4,969
Accumulated amortization, tradename		(1,509	)		(1,161	)
Covenants not-to-compete		3,068			3,081
Accumulated amortization, covenants not-to-compete		(2,158	)		(1,679	)


Intangible assets subject to amortization	$	82,600		$	95,806

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

The intangible assets subject to amortization are being amortized on a straight-line basis over lives ranging from two to seven years. Aggregated amortization expense for these intangibles for the three months ended January 1, 2006, and December 26, 2004 was $6.4 million and $6.5 million, respectively. Aggregated amortization expense for these intangibles for the six months ended January 1, 2006 and December 26, 2004 was $12.8 and $13.1 million, respectively. For the following five full fiscal years aggregated amortization expense is expected to be (in thousands):


2006	$	25,416
2007	$	24,816
2008	$	20,890
2009	$	11,854
2010	$	8,491

5.		Other Assets

		Components of other assets are as follows:


	January 1,		July 3,
	2006		2005
	(in thousands)
Deferred debt issuance costs- convertible subordinated notes, net	$	99	$	151
Long-term prepaid assets		424		354
Refundable deposits		73		101

	$	596	$	606

6.		Accrued Liabilities

		Components of accrued liabilities are as follows:


	January 1,		July 3,
	2006		2005
	(in thousands)
Payroll and related costs	$	7,584	$	8,204
Warranty reserves		3,246		4,085
Sales returns and allowances		2,788		3,442
Accrued advertising and promotions		1,718		1,674
Accrued property, sales, franchise and related taxes		1,951		1,280
Other		3,542		2,820

	$	20,829	$	21,505

The Company provides a warranty of between one and five years on its Fibre Channel, Internet Protocol and other networking products. The Company records a provision for estimated warranty-related costs based on historical product returns and the Company’s expected future cost of fulfilling its warranty obligations.

Changes to the warranty reserve were:


	Three Months Ended						Six Months Ended
	January 1,			December 26,			January 1,			December 26,
	2006			2004			2006			2004
	(in thousands)
Balance at beginning of period	$	3,606		$	3,949		$	4,085		$	4,046
Additions to costs and expenses		553			751			1,252			1,237
Amounts charged against reserve		(913	)		(548	)		(2,091	)		(1,131	)

Balance at end of period	$	3,246		$	4,152		$	3,246		$	4,152

7.		Convertible Subordinated Notes

		In 2002, the Company completed a $345.0 million private placement of 1.75 percent convertible subordinated notes due February 1, 2007. These notes were convertible by the holder at any time into shares of the Company’s common stock at the conversion price of $53.84 per share, subject to the potential adjustments described in the terms of the notes issued. The Company incurred associated issuance costs of approximately $11.0 million. Beginning in the three months ended September 29, 2002 through July 3, 2005, the Company

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

repurchased all of the outstanding $345.0 million face value of its 1.75 percent convertible subordinated notes for approximately $315.9 million, resulting in a net pre-tax gain of approximately $31.1 million recorded in prior periods. The repurchased notes were cancelled leaving no 1.75 percent convertible notes outstanding at January 1, 2006 and July 3, 2005.

In 2004, the Company completed a $517.5 million private placement of 0.25 percent contingently convertible subordinated notes due December 15, 2023. Interest is payable in cash on June 15 and December 15 of each year beginning June 15, 2004. Under the terms of the offering, the notes will be convertible into shares of the Company’s common stock at a price of $43.20 per share at the option of the holder upon the occurrence of any of the following:

	•		prior to December 15, 2021, on any date during any fiscal quarter (and only during such fiscal quarter) after the fiscal quarter ending December 31, 2003, if the closing sale price of the Company’s common stock was more than 120 percent of the then current conversion price for at least 20 trading days in the period of the 30 consecutive trading days ending on the last day of the previous fiscal quarter;

	•		on or after December 15, 2021, at all times on or after any date on which the closing sale price of the Company’s common stock is more than 120 percent of the then current conversion price of the notes;

	•		if the Company elects to redeem the notes on or after December 20, 2008;

	•		upon the occurrence of specified corporate transactions or significant distributions to holders of the Company’s common stock; or

	•		subject to specified exceptions, for the ten business day period after any five consecutive trading day period in which the average trading prices for the notes for such five trading day period was less than 98 percent of the average conversion value of the notes during that period.

		The notes will mature in December 2023 and may not be called by the Company prior to December 20, 2008. Holders of the notes may require the Company to purchase the notes for cash by giving written notice within the 20 business days prior to each of December 15, 2006, December 15, 2008, December 15, 2013 or December 15, 2018 or upon a change in control. The Company incurred total associated bankers’ fees of approximately $11.6 million, which were recorded as a reduction to the proceeds from the issuance of the notes and will be accreted over the effective life of the notes, as well as $0.7 million of other associated debt issuance costs, which have been included in other assets and will also be amortized over the effective life of the notes. The effective life of the Company’s 0.25 percent contingent convertible subordinated notes due 2023 is three years, which is the period up to the first date that the holders can require us to repurchase the notes.

		During the six months ended December 26, 2004, the Company repurchased approximately $153.0 million of its 0.25 percent convertible subordinated notes at a discount to face value, spending approximately $137.2 million. The resulting net pre-tax gain of $13.1 million from the repurchase of these 0.25 percent convertible subordinated notes was recorded in the six months ended December 26, 2004. The repurchased notes were cancelled.

		Throughout the remainder of fiscal 2005, the Company repurchased approximately $128.5 million of its 0.25 percent convertible subordinated notes at a discount to face value, spending approximately $119.3 million. The resulting net pre-tax gain of $7.7 million from the repurchase of these 0.25 percent convertible subordinated notes was recorded in subsequent periods throughout fiscal 2005. The repurchased notes were cancelled, leaving 0.25 percent convertible subordinated notes outstanding at January 1, 2006 with a face value of approximately $236.0 million that, if converted, would result in the issuance of approximately 5.5 million shares.

8.		Commitments and Contingencies

		Litigation

		On November 15, 2001, prior to the Company’s acquisition of Vixel Corporation, a securities class action was filed in the United States District Court in the Southern District of New York as Case No. 01 CIV. 10053

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

		(SAS), Master File No. 21 MC 92 (SAS) against Vixel and two of its officers and directors and certain underwriters who participated in the Vixel initial public offering in late 1999. The amended complaint alleges violations under Section 10(b) of the Exchange Act and Section 11 of the Securities Act and seeks unspecified damages on behalf of persons who purchased Vixel stock during the period October 1, 1999 through December 6, 2000. In October 2002, the parties agreed to toll the statute of limitations with respect to Vixel’s officers and directors until September 30, 2003, and on the basis of this agreement, Vixel’s officers and directors were dismissed from the lawsuit without prejudice. During June 2003, Vixel and the other issuer defendants in the action reached a tentative settlement with the plaintiffs that would, among other things, result in the dismissal with prejudice of all claims against the defendants and their officers and directors. In connection with the possible settlement, those officers and directors who had entered tolling agreements with the plaintiffs agreed to extend those agreements so that they would not expire prior to any settlement being finalized. Although Vixel approved this settlement proposal in principle, it remains subject to a number of procedural conditions, as well as formal approval by the court. On August 31, 2005, a Preliminary Order In Connection With Settlement Proceedings was issued by the court which among other items, sets a date for a Settlement Fairness Hearing, and the form of notice to the Settlement Classes of the Issuers’ Settlement Stipulation. In December 2005, the settlement notices authorized by the court were sent to former Vixel stockholders and the web site www.iposecuritieslitigation.com was created for claimants, as well as a March 24, 2006 objection deadline. The Company believes the final resolution of this litigation will not have a material adverse effect on the Company’s consolidated financial position, results of operation or liquidity.

		Ongoing lawsuits present inherent risks, any of which could have a material adverse effect on the Company’s business, financial condition or results of operations. Such potential risks include the continuing expenses of litigation, counterclaims and attorneys’ fee liability.

		Additionally, the Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

		Other Commitments and Contingencies

		The Company has entered into various agreements for purchases. As of January 1, 2006, the Company’s purchase obligation associated with inventory was $40.3 million.

9.		Stock-Based Compensation

		In December 2004, the FASB issued SFAS No. 123R (revised 2004), “Share-Based Payment,” or SFAS No. 123(R). SFAS No. 123(R) requires that the compensation cost related to share-based payment transactions, measured based on the fair value of the equity or liability instruments issued, be recognized in the financial statements. The adoption of SFAS No. 123(R) is required in fiscal years beginning after June 15, 2005. Determining the fair value of options using the Black-Scholes model requires subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affect the calculated fair value on the grant date.

		For the three and six months ended December 26, 2004, the Company accounted for its stock-based awards to employees using the intrinsic value method under APB Opinion No. 25, “Accounting for Stock Issued to Employees” and related Interpretations. Stock-based awards to non-employees, if any, were recorded using the fair value method. Had the Company determined compensation cost based on the fair value at the grant date for all its stock options under SFAS No. 123, “Accounting for Stock Based Compensation,” the Company’s net income would have been the pro forma amounts indicated below (in thousands, except per share data):

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements


	Three			Six
	Months Ended			Months Ended
	December 26,			December 26,
	2004			2004
Net income as reported	$	14,201		$	28,500
Add: total employee stock-based compensation expense included in net income as reported, net of related tax effects		748			1,679
Deduct: Total employee stock-based compensation expense determined under fair value method for all awards, net of related tax effects		(6,592	)		(13,471	)

Pro forma net income	$	8,357		$	16,708

Pro forma net income per share:
Basic – as reported	$	0.17		$	0.34

Basic – pro forma	$	0.10		$	0.20

Diluted – as reported	$	0.16		$	0.32

Diluted – pro forma	$	0.09		$	0.18

The fair value of each option granted during the three and six months ended December 26, 2004, was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:


	Three			Six
	Months Ended			Months Ended
	December 26,			December 26,
	2004			2004
Risk-free interest rate		2.0% - 3.3	%		2.0% - 3.3	%
Stock volatility		51.3% - 51.7	%		51.3% - 84.0	%
Dividend yield		0.0	%		0.0	%
Average expected lives (years)		0.5 – 2.7			0.5 – 2.8
Weighted-average fair value per option granted	$	3.49 - $4.64		$	3.49 - $5.34

Effective July 4, 2005, the Company adopted SFAS No. 123(R), Share-Based Payment and related guidance, using the modified prospective transition method which provides for only the current and future period stock-based awards to be measured and recognized at fair value. Previously, benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows. As a result of the adoption of SFAS No. 123(R) such tax benefits are reported as a financing cash inflow rather than as a reduction of taxes paid.

At January 1, 2006 the Company had four stock-based payment plans for employees and Directors, which are described below. Amounts recognized in the financial statements with respect to these plans are as follows:


	Three Months Ended			Six Months Ended
	January 1,			January 1,
	2006			2006
	(in thousands)			(in thousands)
Total cost of stock-based payment plans during the period	$	5,780		$	10,767
Amounts capitalized in inventory and fixed assets during the period		(128	)		(282	)
Amounts recognized in income for amounts previously capitalized in inventory and fixed assets		154			154

Amounts charged against income, before income tax benefit	$	5,806		$	10,639

Amount of related income tax benefit recognized in income	$	1,216		$	2,204

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

Employee Stock Option and Equity Incentive Plans

On December 1, 2005, the Company’s shareholders ratified and approved the Emulex Corporation 2005 Equity Incentive Plan (the “Equity Incentive Plan”). The Company’s Equity Incentive Plan permits the grant of stock options, restricted stock awards consisting of shares of common stock that are subject to a substantial risk of forfeiture (vesting restrictions) for some period of time, unrestricted stock awards that are free of any vesting restrictions, performance awards entitling the recipient of acquired shares of common stock or to vest in shares of common stock upon the attainment of specified performance goals (“Performance Awards”) and stock appreciation rights to its domestic and international employees. The aggregate number of shares which may be used under the Equity Incentive Plan shall consist of newly authorized shares, not to exceed 2,000,000 shares of common stock, plus the number of shares available for grant under the 2004 Plan (as defined below) are the Plan (as defined below), not to exceed 1,448,442 shares, plus the number of shares underlying options that were outstanding on the effective date of the Equity Incentive Plan (October 24, 2005) that expire, are forfeited, cancelled or terminate for any reason under the Employee Stock Option Plan and the Employee Stock Incentive 2004 Plan (the “Existing Plans”) without having been exercised in full. Stock option awards are granted with an exercise price not less than fair market value of the Company’s stock at the date of grant; these awards generally vest based on three years of continuous service and have a six-year contractual term. Certain stock option awards provide for accelerated vesting if there is a change in control (as defined in the Equity Incentive Plan).

The Equity Incentive Plan is administered by the Board of Directors, or in the discretion of the Board, by a Committee (“Committee”) consisting of two or more Directors of the Company. Restricted and unrestricted stock awards may be awarded (or sold at a purchase price determined by the Board or the Committee) upon terms established by them in its sole discretion. The vesting provisions of a restricted stock award will be determined by the Board or the Committee for each grant. Unrestricted stock awards will be free of any vesting provisions.

Performance Awards will be subject to the attainment of performance goals established by the Board or Committee, the periods during which performance is to be measured, and all other limitations and conditions applicable to the awarded shares. Performance goals shall be based on a pre-established objective formula or standard that specifies the manner of determining the number of Performance Awards that will be granted or will vest if the performance goal is attained. Performance goals will be determined by the Board or the Committee prior to the time 25% of the service period has elapsed and may be based on one or more business criteria that apply to an individual, a business unit or the Company.

Stock appreciation rights entitle the holder to receive the appreciation in the value of common stock underlying the stock appreciation right. The Board or Committee may grant a stock appreciation right either as a stand alone right, or if such right does not provide for the deferral of compensation within the meaning of Section 409A of the Internal Revenue Code of 1986, as amended, in tandem with all or any part of the shares of common stock that may be purchased by the exercise of a stock option. As of January 1, 2006, there were 2,857,287 shares available for future award grants under the Equity Incentive Plan.

The Company’s Employee Stock Option Plan (the “Plan”), which is shareholder approved, permitted the grant of stock options and nonvested shares to its domestic and international employees for up to 33.7 million shares of common stock. Prior to the adoption of the Equity Incentive Plan, stock option awards were granted under the plan with an exercise price not less than the fair market value of the Company’s stock at the date of grant; these stock option awards generally vest based on either three or four years of continuous service and have either a six or 10-year contractual term. Certain stock option awards provide for accelerated vesting if there is a change in control (as defined in the Plan). With the approval and adoption of the Equity Incentive Plan on December 1, 2005, the Plan became closed for future grants of options.

The Company’s 2004 Employee Stock Incentive Plan (the “2004 Plan”), which is shareholder approved, permitted the grant of stock options and restricted (nonvested) or unrestricted shares to its employees for up to 2,000,000 shares of common stock. The purchase price for the shares subject to any option granted under the 2004 Plan was not permitted to be less than 100 percent of the fair market value of the shares of common stock of the Company on the date the option was granted. These stock option awards generally vest based on either three or four years of continuous service and have either a six or 10-year contractual term. With the approval and adoption of the Equity Incentive Plan on December 1, 2005, the 2004 Plan became closed for future award grants.

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

Options granted under the Plan and options granted under the 2004 Plan prior to August 2005 have a 10-year contractual term and become exercisable on a cumulative basis as to 25 percent of the total number of shares covered by the option one year from the date the option is granted with an additional 6.25 percent after the end of each consecutive calendar quarter thereafter, except when otherwise provided by the Board of Directors or the Compensation Committee. Beginning with awards granted in August 2005, each option granted generally has a six-year contractual term and becomes exercisable on a cumulative basis as to 30 percent of the total number of shares covered by the option one year from the date the option is granted with an additional 7.5 percent after the end of each of the next four consecutive calendar quarters and an additional 10 percent after the end of each of the next four consecutive quarters thereafter, except when otherwise provided by the Board of Directors or the Compensation Committee.

The Company’s 1997 Stock Option Plan for Non-Employee Directors (the “Director Plan”), which as amended, allows for a maximum of 1,730,000 shares of common stock to be issued. The Director Plan currently provides that an option to purchase 60,000 shares of common stock of the Company will be granted to each non-employee director of the Company upon the first date that such director becomes eligible to participate. These options shall be exercisable as to one-third of the shares on each anniversary of the grant if the director is still a director of the Company. In addition, on each yearly anniversary of the date of the initial grant, each eligible director shall automatically be granted an additional option to purchase 20,000 shares of common stock. These options shall be exercisable as to one-half of the shares on the six month anniversary, one quarter on the nine month anniversary and one quarter on the year anniversary of the grant date. Options granted under the Director Plan are non-qualified stock options. The exercise price per option granted will not be less than the fair market value at the date of grant. No option granted under the Director Plan shall be exercisable after the expiration of the earlier of (i) ten years following the date the option is granted or (ii) one year following the date the optionee ceases to be a director of the Company for any reason. As of January 1, 2006, there are 215,000 options available for future award grants.

The Company’s Employee Stock Purchase Plan (the “Purchase Plan”) was adopted by the Board of Directors and approved by the stockholders in 2000 and became effective on January 1, 2001. Under the Purchase Plan, employees of the Company who elect to participate have the right to purchase common stock at a 15 percent discount from the lower of the market value of the common stock at the beginning or the end of each six month offering period. The Purchase Plan permits an enrolled employee to make contributions to purchase shares of common stock by having withheld from their salary an amount up to 10 percent of their compensation (which amount may be increased from time to time by the Company but may not exceed 15% of compensation). No employee may purchase more than $25,000 worth of common stock (calculated at the time the purchase right is granted) or 1,000 shares in any calendar year. The Compensation Committee of the Board of Directors administers the Purchase Plan. The Company has reserved a total of 1,950,000 shares of common stock for issuance under the Purchase Plan. As of January 1, 2006 there are 1,131,844 shares available for future award grants.

The fair value of each stock option award and purchases under the Equity Incentive Plan, the Existing Plans, the Director Plan and the Purchase Plan are estimated on the date of grant using the Black-Scholes option-pricing model based on the market price of the underlying common stock as of the date of grant, the expected term, stock price volatility and expected risk-free interest rates. This model requires subjective assumptions, including expected stock price volatility and expected time until exercise, which greatly affect the calculated fair value on the grant date, as well as the market price of the underlying common stock as of the date of grant and expected risk-free interest rates. Expected volatilities are based on methodologies utilizing equal weighting involving both historical periods equal to the expected term and implied volatilities based on traded options to buy the Company’s shares.

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

For the three and six months ended January 1, 2006, the assumptions utilized to complete the fair value of stock option grants under the Equity Incentive Plan, the Existing Plans, and the Director Plan (“All Other Plans”), and the Purchase Plan were:


	All Other Plans						Purchase Plan
	Three Months			Six Months			Three Months			Six Months
Expected volatility		41% - 74	%		41% – 74	%		37	%		37	%
Weighted average expected volatility		40% - 56	%		40% – 56	%		37	%		37	%
Expected dividends		0	%		0	%		0	%		0	%
Expected term (in years)		2.0 – 4.2			2.0 – 5.0			0.5			0.5
Weighted average expected term (in years)		3.25			3.25			0.5			0.5
Risk-free rate		4.33% - 4.38	%		4.11% – 4.38	%		3.9	%		3.9	%

A summary of option activity under the plans for the six months ended January 1, 2006 is as follows:


						Weighted
						Average		Aggregate
				Weighted		Remaining		Intrinsic
				Average		Contractual		Value
	Options			Exercise Price		Term (years)		(in millions)
Balance, July 3, 2005		14,110,464		$	22.15
Granted		1,821,789			20.34
Exercised		(691,710	)		10.17
Canceled		(454,433	)		38.17
Forfeited		(28,612	)		18.83

Balance, January 1, 2006		14,757,498		$	22.00		6.2	$	48.1

Exercisable January 1, 2006		9,712,058		$	23.92		5.6	$	33.3

		As of January 1, 2006 there was $23.7 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the plans. That cost is expected to be recognized over a weighted-average period of 1.3 years. The weighted average fair value of option awards granted during the three and six months ended January 1, 2006 was $7.19 and $7.78, respectively.

		The total intrinsic value of stock options exercised was $6.9 million during the six months ended January 1, 2006.

		Cash received from share option exercises under stock-based payment plans for the six months ended January 1, 2006 is $8.6 million. The actual tax benefit realized for the tax deductions from option exercise of stock-based payment plans totaled $2.7 million for the six months ended January 1, 2006.

		As of January 1, 2006, the amount of shares authorized under the Plan, the 2004 Plan, the Directors Plan and the Purchase Plan are sufficient to cover future stock option exercises and the Company issues new shares to satisfy such future exercises. As of January 1, 2006, there are no stock or debt repurchase programs authorized by the Board of Directors.

10.		Earnings per Share

		Basic net income per share for the three and six months ended January 1, 2006 and December 26, 2004 was computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share was computed by dividing adjusted net income by the weighted average number of common shares outstanding during the period increased to include, if dilutive, the number of additional common shares that would be outstanding if the dilutive potential common shares from stock option

EMULEX CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

plans and convertible subordinated notes had been issued. The dilutive effect of outstanding stock options is reflected in diluted net income per share by application of the treasury stock method. The dilutive effect of convertible subordinated notes is reflected in diluted net income per share by application of the if-converted method. The following table sets forth the computation of basic and diluted net income per share:


	Three Months Ended				Six Months Ended
	January 1,		December 26,		January 1,		December 26,
	2006		2004		2006		2004

Numerator:
Net income	$	17,209	$	14,201	$	33,645	$	28,500
Adjustment for interest expense on convertible subordinated notes, net of tax		371		661		747		1,492

Numerator for diluted net income per share	$	17,580	$	14,862	$	34,392	$	29,992


Denominator:
Denominator for basic net income per share – weighted average shares outstanding		83,821		82,732		83,609		82,646
Effect of dilutive securities:
Dilutive options outstanding		1,982		1,147		2,043		1,015
Dilutive common shares from assumed conversion of subordinated notes		5,463		8,753		5,463		9,998

Denominator for diluted net income per share – adjusted weighted average shares outstanding		91,266		92,632		91,115		93,659


Basic net income per share	$	0.21	$	0.17	$	0.40	$	0.34


Diluted net income per share	$	0.19	$	0.16	$	0.38	$	0.32


Antidilutive options excluded from computation		8,927		10,475		8,695		10,785


Average market price of common stock	$	19.54	$	12.69	$	19.71	$	11.97

The antidilutive options were excluded from the computation of diluted net income per share because the options’ exercise price was greater than the average market price of the common shares during the periods presented.

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

Forward-Looking Statements

Certain statements contained in this Form 10-Q may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. We may also make forward-looking statements in other reports filed with the Securities and Exchange Commission, in materials delivered to stockholders and in press releases. In addition, our representatives may from time to time make oral forward-looking statements. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Words such as “anticipates,” “in the opinion,” “believes,” “intends,” “expects,” “may,” “will,” “should,” “could,” “plans,” “forecasts,” “estimates,” “predicts,” “projects,” “potential,” “continue” and similar expressions may be intended to identify forward-looking statements.

Actual future results could differ materially from those described in the forward-looking statements as a result of a variety of factors, including those discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations set forth below, and, in particular, the subsection entitled “Risk Factors.” These factors include risks related to the fact that the economy generally, and the technology and storage segments specifically, have been in a state of uncertainty making it difficult to determine if past experience is a good guide to the future and making it impossible to determine if markets will grow or shrink in the short term. In the past, our results have been significantly impacted by a widespread slowdown in technology investment that pressured the storage networking market that is the mainstay of our business. A downturn in information technology spending could adversely affect our revenues and results of operations. As a result of this uncertainty, we are unable to predict with any accuracy what future results might be. Other factors affecting these forward-looking statements include, but are not limited to, the following: slower than expected growth of the storage networking market or the failure of our Original Equipment Manufacturer, or OEM, customers to successfully incorporate our products into their systems; our dependence on a limited number of customers and the effects of the loss of, or decrease or delays in orders by, any such customers, or the failure of such customers to make payments; the emergence of new or stronger competitors as a result of consolidation movements in the market; the timing and market acceptance of our or our OEM customers’ new or enhanced products; the variability in the level of our backlog and the variable booking patterns of our customers; the effects of terrorist activities, natural disasters and resulting political or economic instability; the highly competitive nature of the markets for our products, as well as pricing pressures that may result from such competitive conditions; our ability and the ability of our OEM customers to keep pace with the rapid technological changes in our industry and gain market acceptance for new products and technologies; the effect of rapid migration of customers towards newer, lower cost product platforms; possible transitions from board or box level to application specific integrated circuit, or ASIC, solutions for selected applications; a shift in unit product mix from high-end to lower-end products; a decrease in the average unit selling prices or an increase in the manufactured cost of our products; delays in product development; our reliance on third-party suppliers and subcontractors for components and assembly; any inadequacy of our intellectual property protection or the potential for third-party claims of infringement; inadequacy of our system of internal controls; our ability to attract and retain key technical personnel; our dependence on foreign sales and foreign-produced products; the effect of acquisitions; impairment charges; changes in tax rates or legislation; and changes in accounting standards. Readers should carefully review these cautionary statements since they identify certain important factors that could cause actual results to differ materially from those in the forward-looking statements and from historical trends and are in addition to other factors discussed elsewhere in this Form 10-Q, in our filings with the Securities and Exchange Commission or in materials incorporated therein by reference. We caution the reader, however, that these lists of risk factors may not be exhaustive. We expressly disclaim any obligation or undertaking to release publicly any updates or changes to these forward-looking statements that may be made to reflect any future events or circumstances.

Executive Overview

Emulex is a leading supplier of a broad range of advanced storage networking infrastructure solutions. Our products and technologies leverage an adaptable common architecture that extends from deep within the storage array to the server edge of storage networks. Our storage networking solution offerings include host bus adapters, or HBAs, embedded storage switches, storage Input/Output controllers, or IOCs, storage area network, or SAN, and storage switch products. HBAs are the data communication products that enable servers to connect to storage networks by offloading communication-processing tasks as information is delivered and sent to the storage network. Embedded storage switches and IOCs are deployed inside storage arrays, tape libraries and other storage appliances, delivering improved performance and reliability and storage connectivity. The world’s largest storage and server OEMs rely on

our highly flexible common architecture to establish a robust foundation for cost-effectively integrating a wide array of storage protocols, standards and speeds.

We rely almost exclusively on OEMs and sales through distribution channels for our revenue. Our OEM customers include the world’s leading server and storage providers, including Bull, Dell, EMC, Engenio, Fujitsu Ltd., Fujitsu Siemens, Hewlett-Packard, Hitachi Data Systems, IBM, Ingram Micro, NEC, Network Appliance, Quantum, Sun Microsystems, Unisys and Xyratex. Our distribution partners include ACAL, Avnet, Bell Microproducts, Info-X, Netmarks, Tech Data and Tokyo Electron. The market for storage networking infrastructure solutions is concentrated among large OEMs and, as such, a significant portion of our revenues are generated from sales to a limited number of customers.

We believe that continued investment in next generation storage networking infrastructure solutions is required in order to achieve future revenue growth and profitability. We continue to, and currently plan to invest in research and development, sales and marketing, and capital equipment to deliver leading-edge products to our customers, including additional four gigabit per second connectivity solutions, increased Linux offerings, and products focused on the small to medium business and blade server markets. As of January 1, 2006 we had a total of 527 employees.

Our corporate headquarters are located at 3333 Susan Street, Costa Mesa, California 92626. Our periodic and current reports filed with or furnished to the Securities and Exchange Commission pursuant to the requirements of the Securities and Exchange Act of 1934 are available free of charge through our website (www.emulex.com) as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. References contained herein to “Emulex,” the “Company,” the “Registrant,” “we,” “our,” and “us” refer to Emulex Corporation and its subsidiaries.

Results of Operations

The following discussion and analysis should be read in conjunction with the Condensed Consolidated Financial Statements included elsewhere herein.


	Percentage of Net Revenues
	Three months ended						Six months ended
	January 1,			December 26,			January 1,			December 26,
	2006			2004			2006			2004

Net revenues		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales		37.8			36.6			37.2			38.1

Gross profit		62.2			63.4			62.8			61.9

Operating expenses:
Engineering and development		20.3			21.5			20.6			24.2
Selling and marketing		8.4			8.3			8.0			9.1
General and administrative		5.3			3.9			5.6			1.9
Amortization of intangibles		5.8			7.2			5.9			8.0
Impairment of goodwill		—			—			—			1.1

Total operating expenses		39.8			40.9			40.1			44.3

Operating income		22.4			22.5			22.7			17.6

Nonoperating income:
Interest income		4.4			3.1			4.0			3.6
Interest expense		(0.6	)		(1.1	)		(0.6	)		(1.4	)
Gain on repurchase of convertible subordinated notes		—			—			—			7.9
Other income (expense), net		—			0.1			—			0.1

Total non-operating income		3.8			2.1			3.4			10.2

Income before income taxes		26.2			24.6			26.1			27.8

Income tax provision		10.6			9.1			10.4			10.5

Net income		15.6	%		15.5	%		15.7	%		17.3	%

Three months ended January 1, 2006, compared to three months ended December 26, 2004

Net Revenues. Net revenues for the second quarter of fiscal 2006 ended January 1, 2006, increased by $18.6 million, or 20 percent, to $110.3 million, compared to $91.7 million for the same quarter of fiscal 2005 ended December 26, 2004.

From a product line perspective, net revenues generated from our Fibre Channel products for the three months ended January 1, 2006, and for the three months ended December 26, 2004 represented substantially all of our net revenues. The following chart details our net revenues by product line for the three months ended January 1, 2006, and December 26, 2004:


	Net Revenues by Product Line
	Three Months					Three Months
	Ended		Percentage			Ended		Percentage					Percentage
	January 1,		of Net			December 26,		of Net			Increase/		Change,
(in thousands)	2006		Revenues			2004		Revenues			Decrease		if meaningful

Fibre Channel	$	110,213		100	%	$	91,668		100	%	$	18,545		20	%
IP networking		52		—			1		—			51		—
Other		3		—			2		—			1		—

Total net revenues	$	110,268		100	%	$	91,671		100	%	$	18,597		20	%

We believe that our net revenues from our broad range of Fibre Channel Input/Output, or I/O, and switching products are being generated primarily as a result of our product certifications and qualifications with OEM customers, which generate both direct OEM sales and indirect sales through distribution. Our IP networking products consist of our iSCSI products. We do not expect material revenue from iSCSI products for the foreseeable future.

In addition to direct sales, some of our larger OEM customers purchased or marketed products indirectly through distributors, resellers or other third parties. We are able to track these indirect purchases to the extent that they are of customer-specific models. However, if these indirect purchases are purchases of our standard models, we are not able to distinguish them by OEM customer. Customers whose direct net revenues, or total direct and indirect net revenues (including customer-specific models purchased or marketed indirectly through distributors, resellers and other third parties), were 10 percent or more of our net revenues for the three months ended January 1, 2006 and December 26, 2004, were as follows:


	Net Revenues by Major Customers
	Direct Revenues						Total Direct and Indirect Revenues ⁽¹⁾
	Three Months			Three Months			Three Months			Three Months
	Ended			Ended			Ended			Ended
	January 1,			December 26,			January 1,			December 26,
	2006			2004			2006			2004

Net revenue percentage ⁽²⁾ :
EMC		—			—			24	%		21	%
Hewlett-Packard		10	%		14	%		10	%		16	%
IBM		32	%		30	%		32	%		30	%
Info-X		22	%		18	%		—			—


⁽¹⁾		Customer-specific models sold indirectly are included with the OEM’s revenues in these columns rather than as revenue for the distributors, resellers or other third parties.

⁽²⁾		Amounts less than 10 percent are not presented.

Direct sales to our top five customers accounted for 72 percent of total net revenues for the three months ended January 1, 2006, compared to 70 percent for the three months ended December 26, 2004, and we expect to be similarly concentrated in the future. Our net revenues from our customers can be significantly impacted by changes to our customers business and their business models. Under the vendor fulfillment role planned by EMC for EMC’s Select Program, a portion of the sales of our EMC-specific models are to be directly purchased by EMC from Emulex instead of being sold from inventory owned by EMC’s distribution partners. The timing of our implementation for the EMC Select program is dependent on EMC.

The following chart details our net revenues by sales channel for the three months ended January 1, 2006 and December 26, 2004:


	Net Revenues by Sales Channel
	Three Months					Three Months
	Ended		Percentage			Ended		Percentage						Percentage
	January 1,		of Net			December 26,		Of Net			Increase/			Change,
(in thousands)	2006		Revenues			2004		Revenues			(Decrease)			if meaningful

OEM	$	71,611		65	%	$	60,146		66	%	$	11,465			19	%
Distribution		38,563		35	%		31,199		34	%		7,364			24	%
Other		94		—			326		—			(232	)		—

Total net revenues	$	110,268		100	%	$	91,671		100	%	$	18,597			20	%

The following chart details our net domestic and international revenues based on billed-to location for the three months ended January 1, 2006 and December 26, 2004:


	Net Domestic and International Revenues
	Three Months					Three Months
	Ended		Percentage			Ended		Percentage
	January 1,		of Net			December 26,		Of Net			Increase/		Percentage
(in thousands)	2006		Revenues			2004		Revenues			Decrease		Change

Domestic	$	58,816		53	%	$	50,695		55	%	$	8,121		16	%
Pacific Rim		12,865		12	%		12,384		14	%		481		4	%
Europe and rest of world		38,587		35	%		28,592		31	%		9,995		35	%

Total net revenues	$	110,268		100	%	$	91,671		100	%	$	18,597		20	%

We believe the increases in domestic and international net revenues were principally a function of the overall size of the market for Fibre Channel products and increased market acceptance of our Fibre Channel products. We believe the increase in international net revenues at a higher rate than domestic net revenues is primarily due to the continued increase in market acceptance of Fibre Channel products outside of the United States. However, because we sell to OEMs and distributors who ultimately resell our products to their customers, the geographic mix of our net revenues may not be reflective of the geographic mix of end-user demand or installations.

Gross Profit. Cost of sales included the cost of production of finished products as well as support costs and other expenses related to inventory management, manufacturing quality and order fulfillment. In the three months ended January 1, 2006 gross profit increased $10.4 million, or 18 percent, to $68.6 million, from $58.1 million in the three months ended December 26, 2004. The increase in gross profit in the three months ended January 1, 2006 compared to the three months ended December 26, 2004, was primarily due to higher net revenues and production volumes. Cost of sales included $0.3 million of stock-based compensation expense for the three months ended January 1, 2006. For the three months ended December 26, 2004, cost of sales included $37 thousand of stock-based compensation expenses related to the acquisitions of Vixel in 2003 and Giganet in 2001. Gross margin decreased from 63 percent for the three months ended December 26, 2004, to 62 percent for the three months ended January 1, 2006. This decrease in gross margin is due primarily to an excess and obsolete inventory charge of approximately $1.0 million incurred in the three months ended January 1, 2006. Such charge was made against an older generation 2 Gigabit per second, or Gb/s, root switch and related to the transition to the 4 Gb/s product line

Engineering and Development. Engineering and development expenses consisted primarily of salaries and related expenses for personnel engaged in the design, development and technical support of our products. These expenses included third-party fees paid to consultants, prototype development expenses and computer services costs related to supporting computer tools used in the engineering and design process. Engineering and development expenses were

$22.3 million and $19.7 million in the three months ended January 1, 2006 and December 26, 2004, representing 20 and 22 percent of net revenues in each period, respectively. Engineering and development expenses increased by $2.6 million, or 13 percent, in the three months ended January 1, 2006, compared to the three months ended December 26, 2004 primarily due to the increase in stock-based compensation expense. Engineering and development expenses included $2.2 million of stock-based compensation expenses for the three months ended January 1, 2006, recognized in accordance with SFAS No. 123(R) adopted at July 4, 2005, the beginning of our fiscal year. For the three months ended December 26, 2004, engineering and development expenses included $0.4 million of stock-based compensation expenses related to the acquisitions of Vixel in 2003 and Giganet in 2001. Due to the technical nature of our products, engineering support is a critical part of our strategy during both the development of our products and the support of our customers from product design through deployment into the market. We intend to continue to make significant investments in our current products as well as the continued development of new products. The decrease in engineering and development expenses as a percentage of revenues is primarily a result of the higher revenue levels in the 2006 period.

Selling and Marketing. Selling and marketing expenses consisted primarily of salaries, commissions and related expenses for personnel engaged in the marketing and sales of our products, as well as trade shows, product literature, promotional support costs and other advertising-related costs. Selling and marketing expenses were $9.3 million and $7.6 million in the three months ended January 1, 2006 and December 26, 2004, both representing eight percent of net revenues. Selling and marketing expenses increased by $1.7 million, or 22 percent, in the three months ended January 1, 2006, compared to the three months ended December 26, 2004. This increase was primarily due to higher personnel related expenses of approximately $1.2 million and higher travel related expenses of approximately $0.2 million in the three months ended January 1, 2006, compared to the three months ended December 26, 2004. With the adoption of SFAS No. 123(R), selling and marketing expenses for the three months ended January 1, 2006 included $1.2 million of stock-based compensation expenses. For the three months ended December 26, 2004, selling and marketing expenses included $0.2 million of stock-based compensation expenses related to the acquisitions of Vixel in 2003 and Giganet in 2001.

General and Administrative. Ongoing general and administrative expenses consisted primarily of salaries and related expenses for executives, financial accounting support, human resources, administrative services, professional fees and other associated corporate expenses. General and administrative expenses were $5.9 million, or five percent of net revenues, in the three months ended January 1, 2006. General and administrative expenses were $3.6 million or four percent of net revenues, in the three months ended December 26, 2004. General and administrative expenses increased $2.3 million, or 65 percent, in the three months ended January 1, 2006 compared to the three months ended December 26, 2004. The increase includes higher expenses related to personnel of approximately $2.4 million partially offset by a refund of legal fees related to the shareholders litigation of $0.4 million received during the three months ended January 1, 2006, compared to the three months ended December 26, 2004. This refund of legal fees was related to the shareholder litigation settled and recorded as general and administrative expense in our fiscal year ended June 29, 2003. With the adoption of SFAS No. 123(R) general and administrative expenses included $2.1 million of stock-based compensation expenses during the three months ended January 1, 2006. For the three months ended December 26, 2004, general and administrative expenses included $0.5 million of stock-based compensation expenses related to the acquisitions of Vixel in 2003 and Giganet in 2001.

Amortization of Intangibles. Amortization of intangibles included the amortization of intangible assets with estimable lives related to the purchases of Vixel and Giganet, as well as the purchase of the technology assets of Trebia Corporation. For the three months ended January 1, 2006, amortization of intangibles was $6.4 million, or six percent of net revenues. Amortization of intangibles for the three months ended December 26, 2004, was $6.5 million, or seven percent of net revenues.

Nonoperating Income. Nonoperating income consisted primarily of interest income, interest expense and other non-operating income and expense items. Our nonoperating income increased by $2.3 million to $4.2 million in the three months ended January 1, 2006, from $1.9 million in the three months ended December 26, 2004. The $2.3 million increase in nonoperating income was primarily a result of higher yields on invested cash balances and lower amounts outstanding of the convertible subordinated notes. Interest income increased $1.9 million to $4.8 million in the three months ended January 1, 2006, compared to $2.9 million in the three months ended December 26, 2004, primarily due to an improvement in interest rates in the three months ended January 1, 2006 as compared to the three months ended December 26, 2004. Further, due to the repurchase of convertible subordinated notes during fiscal year 2005, interest expense decreased by $0.4 million to $0.6 million in the three months ended January 1, 2006 from $1.1 million in the three months ended December 26, 2004.

Income Taxes. In the three months ended January 1, 2006, we recorded a tax provision in the amount of $11.6 million, or approximately 40 percent of our income before income taxes. In the three months ended December 26, 2004, we recorded a tax provision in the amount of $8.4 million, or approximately 37 percent of our income before income taxes. The increase in the tax rate is primarily due to the increase in nondeductible stock-based compensation expenses in the three months ended January 1, 2006 compared to the three months ended December 26, 2004 due to the adoption of SFAS No. 123(R) effective July 4, 2005.

Six months ended January 1, 2006, compared to six months ended December 26, 2004

Net Revenues. Net revenues for the six months ended January 1, 2006, increased by $49.8 million, or 30 percent, to $214.6 million, compared to $164.9 million for the corresponding period of the prior year ended December 26, 2004.

From a product line perspective, net revenues generated from our Fibre Channel products for the six months ended January 1, 2006, and for the six months ended December 26, 2004 represented substantially all of our net revenues. The following chart details our net revenues by product line for the six months ended January 1, 2006 and December 26, 2004:


	Net Revenues by Product Line
	Six Months					Six Months
	Ended		Percentage			Ended		Percentage						Percentage
	January 1,		of Net			December 26,		of Net			Increase/			Change,
(in thousands)	2006		Revenues			2004		Revenues			(Decrease)			if meaningful

Fibre Channel	$	214,562		100	%	$	164,884		100	%	$	49,678			30	%
IP networking		80		—			5		—			75			—
Other		5		—			7		—			(2	)		—

Total net revenues	$	214,647		100	%	$	164,896		100	%		49,751			30	%


	Net Revenues by Major Customers
	Direct Revenues						Total Direct and Indirect Revenues (1)
	Six Months			Six Months			Six Months			Six Months
	Ended			Ended			Ended			Ended
	January 1,			December 26,			January 1,			December 26,
	2006			2004			2006			2004

Net revenue percentage (2) :
EMC		—			—			25	%		18	%
Hewlett-Packard		10	%		15	%		10	%		17	%
IBM		29	%		29	%		29	%		29	%
Info-X		23	%		12	%		—			—

Direct sales to our top five customers accounted for 69 percent of total net revenues for the six months ended January 1, 2006, compared to 65 percent for the six months ended December 26, 2004, and we expect to be similarly concentrated in the future. Our net revenues from our customers can be significantly impacted by changes to our customers business and their business models. Under the vendor fulfillment role planned by EMC for EMC’s Select Program, a portion of the sales of our EMC-specific models are to be directly purchased by EMC from Emulex instead of being sold from inventory owned by EMC’s distribution partners. Our implementation for the EMC Select program is dependent on EMC.


(1)		Customer-specific models sold indirectly are included with the OEM’s revenues in these columns rather than as revenues for the distributors, resellers or other third parties.

(2)		Amounts less than 10 percent are not presented.

The following chart details our net revenues by sales channel for the six months ended January 1, 2006, and December 26, 2004:


	Net Revenues by Sales Channel
	Six Months					Six Months
	Ended		Percentage			Ended		Percentage						Percentage
	January 1,		of Net			December 26,		of Net			Increase/			Change,
(in thousands)	2006		Revenues			2004		Revenues			(Decrease)			if meaningful

OEM	$	133,363		62	%	$	110,997		67	%	$	22,366			20	%
Distribution		81,181		38	%		53,461		33	%		27,720			52	%
Other		103		—			438		—			(335	)		—

Total net revenues	$	214,647		100	%	$	164,896		100	%	$	49,751			30	%

The following chart details our net domestic and international revenues based on billed-to location for the six months ended January 1, 2006 and December 26, 2004:


	Net Domestic and International Revenues
	Six Months					Six Months
	Ended		Percentage			Ended		Percentage
	January 1,		of Net			December 26,		of Net			Increase/		Percentage
(in thousands)	2006		Revenues			2004		Revenues			(Decrease)		Change

Domestic	$	116,143		54	%	$	88,370		54	%	$	27,773		31	%
Pacific Rim		28,957		14	%		23,681		14	%		5,276		22	%
Europe and rest of world		69,547		32	%		52,845		32	%		16,702		32	%

Total net revenues	$	214,647		100	%	$	164,896		100	%	$	49,751		30	%

We believe the increases in domestic and international net revenues were principally a function of the overall size of the market for Fibre Channel products and increased market acceptance of our Fibre Channel products. We believe the increase in domestic net revenues at a higher rate than international net revenues is primarily due to the reduced sales of EMC-specific models to EMC’s distribution partners during the six months ended December 26, 2004 as a result of our preparation for the EMC Select program discussed above. However, because we sell to OEMs and distributors who ultimately resell our products to their customers, the geographic mix of our net revenues may not be reflective of the geographic mix of end-user demand or installations.

Gross Profit. In the six months ended January 1, 2006 gross profit increased $32.7 million, or 32 percent, to $134.8 million, from $102.1 million in the six months ended December 26, 2004. The increase in gross profit in the six months ended January 1, 2006 compared to the six months ended December 26, 2004, was primarily due to higher net revenues. Cost of sales included $0.3 million of stock-based compensation expenses for the six months ended January 1, 2006. For the six months ended December 26, 2004, cost of sales included $0.1 million of stock-based compensation expenses related to the acquisitions of Vixel in 2003 and Giganet in 2001. Gross margin increased slightly from 62 percent for the six months ended December 26, 2004, to 63 percent for the six months ended January 1, 2006. This increase in gross margin is due primarily to higher production volumes in the six months ended January 1, 2006 as compared to the six months ended December 26, 2004, when we temporarily curtailed production to reduce inventory, spreading our fixed manufacturing costs across fewer units.

Engineering and Development. Engineering and development expenses were $44.2 million and $39.9 million in the six months ended January 1, 2006 and December 26, 2004, representing 21 and 24 percent of net revenues in each period, respectively. Engineering and development expenses increased by $4.2 million, or 11 percent, in the six months ended January 1, 2006, compared to the six months ended December 26, 2004 primarily due to the increase in stock-based compensation expense. Engineering and development expenses included $4.1 million of stock-based compensation expenses for the six months ended January 1, 2006, reflecting the adoption of SFAS No. 123(R) at July 4, 2005. For the six months ended December 26, 2004, engineering and development expenses included $0.9 million of stock-based compensation expenses related to the acquisitions of Vixel in 2003 and Giganet in 2001. The decrease in engineering and development expenses as a percentage of revenues to 21 percent for the six months ended January 1, 2006 from 24 percent for the six months ended December 26, 2004 is primarily a result of the higher revenue levels in the 2006 period.

Selling and Marketing. Selling and marketing expenses were $17.2 million and $15.0 million in the six months ended January 1, 2006 and December 26, 2004, representing eight and nine percent of net revenues, respectively. Selling and marketing expenses increased by $2.2 million, or 15 percent, in the six months ended January 1, 2006, compared to the six months ended December 26, 2004. This increase was primarily due to higher personnel expenses, including stock-based compensation expenses, which increased by approximately $2.0 million in the six months ended January 1, 2006, compared to the six months ended December 26, 2004. With the adoption of SFAS No. 123(R), selling and marketing expenses included $2.3 million of stock-based compensation expenses for the six months ended January 1, 2006. For the six months ended December 26, 2004, selling and marketing expenses included $0.5 million of stock-based compensation expenses related to the acquisitions of Vixel and Giganet. As a portion of selling and marketing expenses, including but not limited to employees’ base compensation and stock-based compensation expense, is not driven directly by increases or decreases in net revenues, the expenses have fluctuated as a percent of net revenues.

General and Administrative. General and administrative expenses were $11.8 million, or six percent of net revenues, in the six months ended January 1, 2006. General and administrative expenses were $3.2 million in the six months ended December 26, 2004. General and administrative expenses for the six months ended December 26, 2004, included a $4.6 million reduction related to reimbursement received from our insurance carriers. This reimbursement was related to the shareholder litigation settled and recorded as general and administrative expenses in our fiscal year ended June 29, 2003. General and administrative expenses excluding the $4.6 million insurance reimbursement for the six months ended December 26, 2004 would have been $7.8 million, or five percent of net revenues. This would represent an increase of $4.0 million, or 53 percent, in the six months ended January 1, 2006, as compared to the six months ended December 26, 2004, excluding the insurance recovery. The increase includes higher expenses related to stock-based compensation expenses of $3.9 million, partially offset by a refund of legal fees in the amount of $0.4 million related to the shareholder litigation settled and recorded in our fiscal year ended June 29, 2003. With the adoption of SFAS No. 123(R) in the six months ended January 1, 2006, general and administrative expenses included $3.9 million of stock-based compensation expenses. For the six months ended December 26, 2004, general and administrative expenses included $1.0 million of stock-based compensation expenses related to the acquisitions of Vixel and Giganet.

Amortization of Intangibles. Amortization of intangibles included the amortization of intangible assets with estimable lives related to the purchases of Vixel and Giganet, as well as the purchase of the technology assets of Trebia Corporation. For the six months ended January 1, 2006, amortization of intangibles was $12.8 million, or six percent of net revenues. Amortization of intangibles for the six months ended December 26, 2004, was $13.1 million, or eight percent of net revenues.

Impairment of Goodwill. As a result of a SFAS No. 142, “Goodwill and Other Intangible Assets” analysis, including a second step goodwill impairment test, we fully impaired goodwill as of June 27, 2004. In connection with the preparation of Vixel Corporation’s tax return in the first quarter of fiscal 2005, we revised estimates and discovered errors related to the deferred tax assets of Vixel Corporation (acquired in November 2003). These events resulted in a revision to Vixel’s purchase price allocation to decrease net deferred tax assets and increase goodwill, which was impaired. This resulted in a $1.8 million impairment of goodwill charge for the three months ended September 26, 2004. Had this item been recorded in fiscal 2004, our net loss would have been $1.8 million higher, or $534.1 million, instead of $532.3 million. We do not believe that this $1.8 million impairment of goodwill was material to fiscal 2004 or to fiscal 2005 operations or financial results. Excluding this adjustment, net income for the six months ended December 26, 2004 would have been $30.3 million.

Nonoperating Income. Nonoperating income consisted primarily of interest income, interest expense and other non-operating income and expense items such as the gains on the repurchase of convertible subordinated notes. Our nonoperating income decreased by $9.4 million to $7.3 million in the six months ended January 1, 2006, from $16.7 million in the six months ended December 26, 2004. The $9.4 million decrease in nonoperating income was primarily the result of a gain of $13.1 million related to the partial repurchase of our 0.25 percent contingently convertible subordinated notes in the six months ended December 26, 2004, partially offset by an increase in interest income of $2.6 million and a decrease in interest expense of $1.2 million in the six months ended January 1, 2006 compared to the six months ended December 26, 2004. Interest income increased $2.6 million to $8.5 million in the six months ended January 1, 2006, compared to $5.9 million in the six months ended December 26, 2004, primarily due to an improvement in interest rates in the six months ended January 1, 2006 as compared to the six months ended December 26, 2004. Further, as a result of the repurchase of convertible subordinated notes during fiscal year 2005, interest expense decreased by $1.2 million to $1.2 million in the six months ended January 1, 2006 from $2.4 million in the six months ended December 26, 2004.

Income Taxes. In the six months ended January 1, 2006, we recorded a tax provision in the amount of $22.4 million, or approximately 40 percent of our income before income taxes. In the six months ended December 26, 2004, we recorded a tax provision in the amount of $17.3 million, or approximately 38 percent of our income before income taxes. The increase in the tax rate is primarily due to the increase in nondeductible stock-based compensation expenses in the six months ended January 1, 2006 compared to the six months ended December 26, 2004 previously discussed above.

Critical Accounting Policies

The preparation of the financial statements requires estimation and judgment that affect the reported amounts of net revenues, expenses, assets and liabilities in accordance with accounting principles generally accepted in the United States. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances and which form the basis for making judgments about the carrying values of assets and liabilities. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. If these estimates differ significantly from actual results, the impact to the financial statements may be material.

We believe the following are critical accounting policies and require us to make significant judgments and estimates in the preparation of our consolidated financial statements: revenue recognition; warranty; allowance for doubtful accounts; intangibles and other long-lived assets; inventories; income taxes and stock-based compensation previously discussed.

Revenue Recognition. We recognize revenue at the time of shipment when title and risk of loss have passed, evidence of an arrangement has been obtained, pricing is fixed or determinable and collectibility has been reasonably assured. We make certain sales through two-tier distribution channels and have various distribution agreements with selected distributors and Master Value Added Resellers, or collectively the Distributors. These distribution agreements may be terminated upon written notice by either party. Additionally, these Distributors are generally given privileges to return a portion of inventory and to participate in price protection and cooperative marketing programs. Therefore, we recognize revenue on our standard products sold to our Distributors based on data received from the Distributors and management’s estimates to approximate the point that these products have been resold by the Distributors. As OEM-specific models sold to our Distributors are governed under the related OEM agreements rather than under these distribution agreements, we recognize revenue at the time of shipment to the Distributors when title and risk of loss have passed, evidence of an arrangement has been obtained, pricing is fixed or determinable and collectibility has been reasonably assured. Additionally, we maintain accruals and allowances for price protection and cooperative marketing programs.

Warranty. We provide a warranty of between one and five years on our products. We record a provision for estimated warranty-related costs at the time of sale based on historical product return rates and management’s estimates of expected future costs to fulfill our warranty obligations. We evaluate our ongoing warranty obligation on a quarterly basis.

Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts based upon historical write-offs as a percentage of net revenues and management’s review of outstanding accounts receivable. Amounts due from customers are charged against the allowance for doubtful accounts when management believes that collectibility of the amount is unlikely. Although we have not experienced significant losses on accounts receivable historically, our accounts receivable are concentrated with a small number of customers. Consequently, any write-off associated with one of these customers could have a significant impact on our allowance for doubtful accounts and results of operations.

Intangibles and Other Long-Lived Assets. Intangibles resulting from the acquisitions of Vixel and Giganet and the purchase of the technology assets of Trebia Corporation are carried at cost less accumulated amortization. For assets with determinable useful lives, amortization is computed using the straight-line method over the estimated economic lives of the respective intangible assets, ranging from two to seven years. Furthermore, periodically we assess whether our long-lived assets including intangibles, should be tested for recoverability whenever events or circumstances indicate that their carrying value may not be recoverable. The amount of impairment, if any, is measured based on fair value, which is determined using projected discounted future operating cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

Inventories. Inventories are stated at the lower of cost on a first-in, first-out basis or market. We use a standard cost system for purposes of determining cost. The standards are adjusted periodically to ensure they represent actual cost. We regularly compare forecasted demand and the composition of the forecast against inventory on hand and open

purchase commitments in an effort to ensure the carrying value of inventory does not exceed net realizable value. Accordingly, we may have to record reductions to the carrying value of excess and obsolete inventory if forecasted demand decreases.

Income Taxes. We account for income taxes using the asset and liability method, which recognizes deferred tax assets and liabilities for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and net operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We regularly review historical and anticipated future pre-tax results of operations to determine whether we will be able to realize the benefit of our deferred tax assets. A valuation allowance is required to reduce the potential deferred tax asset when it is more likely than not that all or some portion of the deferred tax asset will not be realized due to the lack of sufficient taxable income. As of January 1, 2006, we have a valuation allowance of $0.9 million established against capital loss carryforwards.

Stock-Based Compensation. Beginning with the three months ended October 2, 2005, we account for our stock-based awards to employees and non-employees using the fair value method as required by SFAS No. 123(R). SFAS No. 123(R) requires that the compensation cost related to share-based payment transactions, measured based on the fair value of the equity or liability instruments issued, be recognized in the financial statements. Determining the fair value of options using the Black-Scholes model, or other currently accepted option valuation models, requires highly subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affect the calculated fair value on the grant date. See notes 1 and 9 to the accompanying condensed Consolidated Financial Statements for additional information and related disclosures.

Liquidity and Capital Resources

As of January 1, 2006 we had $609.2 million in working capital and $589.8 million in cash and cash equivalents, current investments and long-term investments. At July 3, 2005, we had $507.8 million in working capital and $521.9 million in cash and cash equivalents, current investments and long-term investments. Our cash and cash equivalents increased by $21.9 million to $142.2 million as of January 1, 2006 from $120.3 million as of July 3, 2005. The increase in cash and cash equivalents was due to our operating and financing activities, which provided $62.6 million and $11.1 million, respectively. The cash and cash equivalents provided by our operations and financing activities were partially offset by our investing activities, which used $51.8 million of cash and cash equivalents.

In the six months ended January 1, 2006, operating activities provided $62.6 million of cash and cash equivalents compared to providing $83.4 million in the six months ended December 26, 2004. The primary reason for the decrease in cash provided by operating activities for the six months ended January 1, 2006 was an increase in accounts and other receivables in the six month period ended January 1, 2006 of $21.1 million versus a decrease of $11.5 million in the comparable six month period of the prior year. The increase in accounts and other receivables is primarily being driven by a combination of higher revenue levels and customer payment terms. Additionally, net income for the six months ended December 26, 2004 included a gain on the repurchase of convertible subordinated notes of $13.1 million. No convertible subordinated notes were repurchased during the six months ended January 1, 2006.

In the six months ended January 1, 2006 investing activities used $51.8 million of cash and cash equivalents, as the amount of purchases of new investments outpaced the maturities of investments. For the six months ended December 26, 2004, investing activities used $16.1 million of cash and cash equivalents, as the amount of purchases of new investments exceeded the maturities of existing investments. Additionally, during the six months ended January 1, 2006, Emulex spent $5.8 million on additions to property and equipment compared to spending $6.6 million during the six months ended December 26, 2004.

Financing activities provided $11.1 million of cash and cash equivalents in the six months ended January 1, 2006. The increase in cash and cash equivalents was primarily due to the proceeds received from the issuance of common stock under stock options and stock purchase plans. For the six months ended December 26, 2004, financing activities used $134.1 million of cash and cash equivalents due primarily to the repurchase of $153.0 million in face value of our 0.25 percent contingent convertible subordinated notes at a net discount, spending $137.2 million.

As of January 1, 2006 Emulex had approximately $236.0 million in face value of its 0.25 percent contingent convertible subordinated notes due 2023 outstanding. Interest is payable in cash on June 15th and December 15th of each year. Under the terms of the offering, the notes may be converted, at the option of the holder and subject to the satisfaction of certain conditions, into shares of the Company’s common stock at a price of $43.20 per share. Holders of the notes may require us to purchase the notes for cash by giving written notice within the 20 business days prior to each of December 15, 2006, December 15, 2008, December 15, 2013, and December 15, 2018. See note 7 to the condensed consolidated financial statements contained herein for more information.

We entered into various purchase agreements for inventory, and as of January 1, 2006 our inventory purchase obligation associated with these items was $40.3 million.

On November 15, 2001, prior to our acquisition of Vixel Corporation, a securities class action was filed in the United States District Court in the Southern District of New York as Case No. 01 CIV. 10053 (SAS), Master File No. 21 MC 92 (SAS) against Vixel and two of its officers and directors and certain underwriters who participated in the Vixel initial public offering in late 1999. The amended complaint alleges violations under Section 10(b) of the Exchange Act and Section 11 of the Securities Act and seeks unspecified damages on behalf of persons who purchased Vixel stock during the period October 1, 1999 through December 6, 2000. In October 2002, the parties agreed to toll the statute of limitations with respect to Vixel’s officers and directors until September 30, 2003, and on the basis of this agreement, Vixel’s officers and directors were dismissed from the lawsuit without prejudice. During June 2003, Vixel and the other issuer defendants in the action reached a tentative settlement with the plaintiffs that would, among other things, result in the dismissal with prejudice of all claims against the defendants and their officers and directors. In connection with the possible settlement, those officers and directors who had entered tolling agreements with the plaintiffs agreed to extend those agreements so that they would not expire prior to any settlement being finalized. Although Vixel approved this settlement proposal in principle, it remains subject to a number of procedural conditions, as well as formal approval by the court. On August 31, 2005, a Preliminary Order In Connection With Settlement Proceedings was issued by the court which among other items, sets a date for a Settlement Fairness Hearing, and the form of notice to the Settlement Classes of the Issuers’ Settlement Stipulation. In December 2005, the settlement notices authorized by the court were sent to former Vixel stockholders and the web site www.iposecuritieslitigation.com was created for claimants, as well as a March 24, 2006 objection deadline. We believe the final resolution of this litigation will not have a material adverse effect on our consolidated financial position, results of operations or liquidity.

As part of our commitment to storage networking product development, we expect to continue our investments including property and equipment for additional engineering and test equipment, and continued enhancement of our global IT infrastructure.

We believe that our existing cash and cash equivalents balances, facilities and equipment leases, investments and anticipated cash flows from operating activities will be sufficient to support our working capital needs and capital expenditure requirements for at least the next 12 months and will enable us to repay our outstanding convertible subordinated notes, $236.0 million of which we may be required to purchase for cash from the holders as early as December 2006.

As described below, the following summarizes our contractual obligations at January 1, 2006, and the effect such obligations are expected to have on our liquidity and cash flow in future periods:


	Payments Due by Period
	(in thousands)
			Less than		1–3		4-5		After 5
	Total		1 Year ⁽¹⁾		Years⁽²⁾		Years ⁽³⁾		Years

Convertible subordinated notes and interest ⁽⁴⁾	$	236,590	$	295	$	236,295	$	-	$	-
Leases		9,175		779		3,427		3,137		1,832
Inventory purchase commitments		40,289		40,289		—		—		—
Other commitments		1,039		1,039		—		—		—

Total	$	287,093	$	42,402	$	239,722	$	3,137	$	1,832


⁽¹⁾		Fiscal year ending July 2, 2006.

⁽²⁾		Fiscal years ending July 1, 2007, and June 29, 2008

⁽³⁾		Fiscal years ending June 28, 2009, and June 27, 2010.

⁽⁴⁾		The principal payment related to the remaining outstanding 0.25 percent contingent convertible subordinated notes of $236.0 million is shown as a payment in the period for the fiscal years ending July 2007 and June 2008 above as holders of these 20-year notes may require us to purchase the notes for cash by giving us written notice as early as 20 business days prior to each of December 15, 2006, December 15, 2008, December 15, 2013, and December 15, 2018.

Risk Factors

A downturn in information technology spending in general or spending on computer and storage systems in particular could adversely affect our revenues and results of operations.

The demand for our Fibre Channel products, which comprised substantially all of our net revenues, has been driven by the demand for high-performance storage networking products and solutions that support enterprise computing applications, including on-line transaction processing, data mining, data warehousing, multimedia and Internet applications. Any significant downturn in demand for such products, solutions and applications, could adversely affect our business, results of operations and financial condition. The adverse effects of any sustained downturn in information technology spending on our operating results may be exacerbated by our research and development investments, strategic investments and merger and acquisition activity, as well as customer service and support, which are expected to continue despite any such downturn.

Our business depends upon the continued growth of the Fibre Channel storage networking market, and our business will be adversely affected if such growth does not occur or occurs more slowly than we anticipate.

The size of our potential market is largely dependent upon the broadening acceptance of our Fibre Channel storage networking technologies, as well as the overall demand for storage. We believe that our investment in the Fibre Channel storage networking market provides opportunity for revenue growth and profitability for the future. However, the market for Fibre Channel storage networking products may not gain broader acceptance and customers may choose alternative technologies and/or products supplied by other companies. Interest continues for iSCSI storage networking solutions, which may satisfy some I/O connectivity requirements through standard Ethernet adapters and software at little to no incremental cost to end users, or through iSCSI HBAs that provide bundled offload engine hardware and software. Such iSCSI solutions compete with Fibre Channel solutions, particularly in the low end of the market. In addition, other technologies such as Serial Attached SCSI, or “SAS,” and Serial ATA, or “SATA,” may compete with our Fibre Channel embedded switched solutions in the future. Furthermore, since our products are sold as parts of integrated systems, demand for our products is driven by the demand for these integrated systems, including other companies’ complementary products. A lack of demand for the integrated systems or a lack of complementary products required for these integrated systems could have a material adverse effect on our business, results of operations and financial condition. If the Fibre Channel storage networking market does not grow, or grows more slowly than we anticipate, attracts more competitors than we expect, as discussed below, or if our products do not achieve continued market acceptance, our business, results of operations and financial condition could be materially adversely affected.

Because a significant portion of our revenues are generated from sales to a limited number of customers, none of which are the subject of exclusive or long-term contracts, the loss of one or more of these customers, or our customers’ failure to make timely payments to us, could adversely affect our business.

We rely almost exclusively on OEMs and sales through distribution channels for our revenue. For the three months ended January 1, 2006 we derived approximately 65 percent of our net revenues from OEMs and 35 percent from sales through distribution. Furthermore, because some of our sales through distribution channels consists of OEM products, OEM customers effectively generated more than 87 percent of our revenue for the six months ended January 1, 2006. We may be unable to retain our current OEM and distributor customers or to recruit additional or replacement customers.

Although we have attempted to expand our base of customers, including customers for embedded switching products, we believe our revenues in the future will continue to be similarly derived from a limited number of customers. As a result, to the extent that sales to any of our significant customers do not increase in accordance with our expectations or are reduced or delayed, our business, results of operations and financial condition could be materially adversely affected.

As is common in the technology industry, our agreements with OEMs and distributors are typically non-exclusive, have no volume commitments, and often may be terminated by either party without cause. It is increasingly commonplace for our OEM and distributor customers to utilize or carry competing product lines. If we were to lose business from one or more significant OEM or distributor customers to a competitor, our business, results of operations and financial condition could be materially adversely affected. In addition, our OEMs may elect to change their business practices in ways that affect the timing of our revenues, which may materially adversely affect our business, results of operations and financial condition.

Our markets are highly competitive and our business and results of operations may be adversely affected by entry of new competitors into the markets, aggressive pricing and the introduction or expansion of competitive products and technologies.

The markets for our products are highly competitive and are characterized by rapid technological advances, price erosion, frequent new product introductions and evolving industry standards. We expect that our markets will continue to attract new competition. Our current and potential competition consists of major domestic and international companies, some of which have substantially greater financial, technical, marketing and distribution resources than we have. Additional companies, including but not limited to our suppliers, strategic partners, OEM customers and emerging companies, may enter the markets for our storage networking products and new or stronger competitors may emerge as a result of consolidation movements in the marketplace. Additionally, our existing competitors continue to introduce products with improved price/performance characteristics, and we may have to do the same to remain competitive. Furthermore, competitors may introduce new products to the market before we do, and thus obtain a first to market advantage over us. Increased competition could result in increased price competition, reduced revenues, lower profit margins or loss of market share, any of which could have a material adverse effect on our business, results of operations and financial condition.

Alternative legacy technologies such as SCSI and Port Bypass Circuits, or “PBCs,” compete with our Fibre Channel I/O and embedded switch products, respectively, for customers. Our success depends in part on our ability and on the ability of our OEM customers to develop storage networking solutions that are competitive with these alternative legacy technologies. Additionally, in the future other technologies that we are not currently developing may evolve to address the storage networking applications currently served by our Fibre Channel product line today, reducing our market opportunity.

Our operating results are difficult to forecast and could be adversely affected by many factors, and our stock price may decline if our results fail to meet expectations.

Our revenues and results of operations have varied on a quarterly basis in the past and may vary significantly in the future. Accordingly, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful, and you should not rely on such comparisons as indications of our future performance. We may be unable to maintain our current levels of growth or profitability in the future. Our revenues and results of operations are difficult to forecast and could be adversely affected by many factors, including, but not limited to:

	•		changes in the size, mix, timing and terms of OEM and other customer orders;

	•		changes in the sales and deployment cycles for our products and/or desired inventory levels for our products;

	•		acquisitions or strategic investments by our customers, competitors or us;

	•		the timing and market acceptance of new or enhanced product introductions by us, our OEM customers and/or competitors;

	•		market share losses or difficulty in gaining incremental market share growth;

	•		fluctuations in product development, procurement, resource utilization and other operating expenses;

	•		component shortages;

	•		reduced demand from our customers if there is a shortage of, or difficulties in acquiring, components or other products, such as Fibre Channel disk drives, used in conjunction with our products in the deployment of systems;

	•		the inability of our electronics manufacturing service providers to produce and distribute our products in a timely fashion;

	•		difficulties with updates, changes or additions to our information technology systems;

	•		breaches of our network security, including viruses;

	•		changes in general social and economic conditions, including but not limited to natural disasters, terrorism, public health and slower than expected market growth, with resulting changes in customer technology budgeting and spending;

	•		changes in technology, industry standards or consumer preferences;

	•		seasonality; and

	•		changes in our accounting or other policies resulting from the adoption of new laws, regulations or pronouncements.

As a result of these and other unexpected factors or developments, we expect that in the future operating results will be from time to time below the expectations of investors or market analysts, which would have a material adverse effect on our stock price.

Our relatively small backlog of unfilled orders, possible customer delays or deferrals and our tendency to generate a large percentage of our quarterly sales near the end of the quarter contribute to possible fluctuations in our operating results that could have an adverse impact on our results of operations and stock price.

Historically, we have generally shipped products quickly after we receive orders, meaning that we do not always have a significant backlog of unfilled orders. As a result, our revenues in a given quarter may depend substantially on orders booked during that quarter. Alternatively, orders already in backlog may be deferred or cancelled. Also, we have typically generated a large percentage of our quarterly revenues in the last month of the quarter. Because our expense levels are largely based on our expectations of future sales, in the event we experience unexpected decreases in sales, our expenses may be disproportionately large relative to our revenues and we may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. A material shortfall in sales in relation to our quarterly expectations or any delay, deferral or cancellation of customer orders would likely have an immediate and adverse impact on our results of operations and may adversely affect our stock price.

Our industry is subject to rapid technological change, and we must keep pace with the changes to successfully compete.

The markets for our products are characterized by rapidly changing technology, evolving industry standards and the frequent introduction of new products and enhancements. Our future success depends in large part on our ability to enhance our existing products and to introduce new products on a timely basis to meet changes in customer preferences and evolving industry standards. Currently, new and proposed technologies such as four, eight and ten Gb/s, Fibre Channel solutions; Infiniband; PCI-X 2.0; PCI Express; PCI Express Advanced Switching; iSCSI; SATA; SAS; and Remote Direct Memory Access, or RDMA; are in development by many companies and their ultimate acceptance and deployment in the market is uncertain. We are developing some, but not all of these technologies, and we cannot be sure that the technologies we chose to develop will achieve market acceptance, or that technologies that we chose not to develop will be available to purchase or license from third parties or will be immaterial to our business. Furthermore, if our products are not available in time for the qualification cycle at an OEM it may be up to three years, if ever, before another qualification cycle is available to us. In addition, new products and enhancements developed by us may not be backwards compatible to existing equipment already installed in the market. If we are unable, for technological or other reasons, to develop new products, enhance or sell existing products, or consume existing products in a timely and cost-effective manner in response to technological and market changes, our business, results of operations and financial condition may be materially adversely affected.

We have experienced losses in our history and may experience losses in our future that may adversely affect our stock price and financial condition.

We have experienced losses in our history, including a loss of $532.3 million in fiscal 2004. Any losses, including losses caused by impairment of long-lived assets or goodwill, may adversely affect the perception of our business by analysts and investors, which could adversely affect our stock price. To the extent that we are unable to generate positive operating profits or positive cash flow from operations, our financial condition may be materially adversely affected.

The migration of our customers toward newer product platforms may have a significant adverse effect.

As our customers migrate from one platform to the enhanced price/performance of the next platform, we may experience reduced revenue, gross profit or gross margin levels associated with lower average selling prices or higher relative product costs associated with improved performance. While we regularly compare forecasted demand for our products against inventory on hand and open purchase commitments, to the extent that customers migrate more quickly than anticipated, the corresponding reduction in demand for older product platforms may result in obsolete inventory and related charges which could have a material adverse effect on our financial condition and results of operations.

Any failure of our OEM customers to keep up with rapid technological change and successfully market and sell systems that incorporate new technologies could adversely affect our business.

Our revenues depend significantly upon the ability and willingness of our OEM customers to commit significant resources to develop, promote and deliver products that incorporate our technology. In addition, if our customers’ products are not commercially successful, it would have a material adverse effect on our business, results of operations and financial condition.

Rapid changes in the evolution of technology, including the unexpected extent or timing of the transition from HBA solutions or embedded switch box solutions to lower-priced ASIC solutions, could adversely affect our business.

Historically, the electronics industry has developed higher performance ASICs that create chip level solutions that replace selected board level or box level solutions at a significantly lower average selling price. We have previously experienced this trend and expect it to continue in the future. If this transition is more abrupt or is more widespread than anticipated, there can be no assurance that we will be able to modify our business model in a timely manner, if at all, in order to mitigate the effects of this transition on our business, results of operations and financial position.

If customers elect to utilize lower-end HBAs in higher-end environments or applications, our business could be negatively affected.

We supply three families of HBAs that target separate high-end, mid-range and small and medium-sized business, or SMB, markets. Historically, the majority of our Fibre Channel revenue has come from our high-end server and storage solutions. In the future, increased revenues are expected to come from SMB and midrange server and storage solutions, which have lower average selling prices. If customers elect to utilize lower-end HBAs in higher-end environments or applications, our business could be negatively affected.

A decrease in the average unit selling prices and/or an increase in the manufactured cost of our products could adversely affect our revenue, gross margins and financial performance.

In the past, we have experienced downward pressure on the average unit selling prices of our products. Furthermore, we may provide pricing discounts to customers based upon volume purchase criteria, and achievement of such discounts may reduce our average unit selling prices. To the extent that growth in unit demand fails to offset decreases in average unit selling prices, our revenues and financial performance could be materially adversely affected. Although historically we have achieved offsetting cost reductions, to the extent that average unit selling prices of our products decrease without a corresponding decrease in the costs of such products, our gross margins and financial performance could be materially adversely affected. Furthermore, as the majority of our products are manufactured internationally, cost reductions would be more difficult to achieve if the value of the U.S. dollar deteriorates. Moreover, if the manufactured cost of our products were to increase due to inflation or other factors, our gross margins and financial performance could be materially adversely affected.

Delays in product development could adversely affect our business.

We have experienced delays in product development in the past and may experience similar delays in the future. Prior delays have resulted from numerous factors, which may include, but are not limited to:

	•		difficulties in hiring and retaining necessary employees and independent contractors;

	•		difficulties in reallocating engineering resources and other resource limitations;

	•		unanticipated engineering or manufacturing complexity, including from third-party suppliers of intellectual property such as foundries of our ASICs;

	•		undetected errors or failures in software, firmware and hardware;

	•		changing OEM product specifications;

	•		delays in the acceptance or shipment of products by OEM customers; and

	•		changing market or competitive product requirements.

Given the short product life cycles in the markets for our products and the relatively long product development cycles, any delay or unanticipated difficulty associated with new product introductions or product enhancements could have a material adverse effect on our business, results of operations and financial condition.

Our joint development activities may result in products that are not commercially successful or that are not available in a timely fashion.

We have engaged in joint development projects with third parties in the past and we expect to continue doing so in the future. Joint development can magnify several risks for us, including the loss of control over development of aspects of the jointly developed products and over the timing of product availability. Accordingly, we face increased risk that joint development activities will result in products that are not commercially successful or that are not available in a timely fashion.

During April 2003 we announced a joint development activity with Intel Corporation relating to storage processors that integrate SATA, SAS and Fibre Channel interfaces within a single architecture. Under the agreement, we will develop the protocol controller hardware, firmware and drivers. Intel will integrate its Intel(R) Xscale(TM) microarchitecture as the core technology for the new processors and will manufacture the processors on its 90-nanometer process technology. This activity has risks resulting from the licensing of technology to Intel and from increased development costs.

A change in our business relationships with our third-party suppliers or our Electronics Manufacturing Service providers or EMS providers, could adversely affect our business.

We rely on third-party suppliers for components and the manufacture of our products, and we have experienced delays or difficulty in securing components and finished goods in the past. Delays or difficulty in securing components or finished goods at reasonable cost may be caused by numerous factors including, but not limited to:

	•		discontinued production by a supplier;

	•		required long-term purchase commitments;

	•		undetected errors, failures or production quality issues, including projected failures that may exceed epidemic failure rates specified in agreements with our customers or that may require us to make concessions or accommodations for continuing customer relationships;

	•		timeliness of product delivery;

	•		sole sourcing and components made by a small number of suppliers, including the inability to obtain components and finished goods at reasonable cost from such sources and suppliers;

	•		financial stability and viability of our suppliers and EMS providers;

	•		changes in business strategies of our suppliers and EMS providers;

	•		increases in manufacturing costs due to lower volumes or more complex manufacturing process than anticipated;

	•		disruption in shipping channels;

	•		natural disasters;

	•		inability or unwillingness of our suppliers or EMS providers to continue their business with us;

	•		environmental, tax or legislative changes in the location where our products are produced or delivered, including implementation of European Union Directives 2002/95/EC (RoHS) and 2002/96/EC (WEEE) ;

	•		difficulties associated with foreign operations; and

	•		market shortages.

There is a risk that we will not be able to retain our current suppliers or change to alternative suppliers. An interruption in supply, the cost of shifting to a new supplier or EMS providers, disputes with suppliers or EMS providers, or the cost associated with a long-term purchase commitment could have a material adverse effect on our business, results of operations and financial condition.

As we have transitioned the material procurement and management for our key components to our EMS providers, we face increasing risks associated with ensuring product availability. Further, an adverse inventory management control issue by one or more of our third-party suppliers could have a material adverse effect on our business, results of operations and financial condition.

LSI Logic Corporation announced on September 13, 2005 that it intends to sell the Gresham, Oregon manufacturing facility at which certain ASICs are manufactured for us, and the transition of such facility creates a risk of disruption in our supply of certain ASICs should the announced plans of LSI Logic for uninterrupted service of customers not be achieved.

If our intellectual property protections are inadequate, it could adversely affect our business.

We believe that our continued success depends primarily on continuing innovation, marketing and technical expertise, as well as the quality of product support and customer relations. At the same time, our success is partially dependent on the proprietary technology contained in our products. We currently rely on a combination of patents, copyrights, trademarks, trade secret laws and contractual provisions to establish and protect our intellectual property rights in our products. For a more complete description of our intellectual property, you should read “Business-Intellectual Property” contained within our 2005 Annual Report on Form 10-K.

We cannot be certain that the steps we take to protect our intellectual property will adequately protect our proprietary rights, that others will not independently develop or otherwise acquire equivalent or superior technology, or that we can maintain such technology as trade secrets. In addition, the laws of some of the countries in which our products are or may be developed, manufactured or sold may not protect our products and intellectual property rights to the same extent as the laws of the United States or at all. Furthermore, we enter into various development projects and arrangements with other companies. In some cases, these arrangements allow for the sharing or use of our intellectual property. Our failure to protect our intellectual property rights could have a material adverse effect on our business, results of operations and financial condition.

Ongoing lawsuits present inherent risks, any of which could have a material adverse effect on our business, financial condition or results of operations. Such potential risks include the continuing expenses of litigation, the risk of loss of patent rights, the risk of injunction against the sale of products incorporating the technology in question, counterclaims and attorneys’ fee liability.

For more information on legal proceedings related to Emulex, see Part II, Item I- “Legal Proceedings.”

Third-party claims of intellectual property infringement could adversely affect our business.

We believe that our products and technology do not infringe on the intellectual property rights of others or upon intellectual property rights that may be granted in the future pursuant to pending applications. We occasionally receive communications from third parties alleging patent infringement, and there is always the chance that third parties may assert infringement claims against us. Any such claims, with or without merit, could result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements, which may or may not be available. Furthermore, we have in the past obtained, and may be required in the future to obtain, licenses

of technology owned by other parties. We cannot be certain that the necessary licenses will be available or that they can be obtained on commercially reasonable terms. If we were to fail to obtain such royalty or licensing agreements in a timely manner and on reasonable terms, our business, results of operations and financial condition could be materially adversely affected.

The inability or increased cost of attracting, motivating or retaining key managerial and technical personnel could adversely affect our business.

Our success depends to a significant degree upon the performance and continued service of key managers, as well as engineers involved in the development of our storage networking technologies and technical support of our storage networking products and customers. Competition for such highly skilled employees in the communities in which we operate, as well as our industry is intense, and we cannot be certain that we will be successful in recruiting, training and retaining such personnel. In addition, employees may leave our company and subsequently compete against us. Also, many of these key managerial and technical personnel receive stock options as part of our employee retention initiatives. New regulations, volatility in the stock market and other factors could diminish the value of our stock options, putting us at a competitive disadvantage and forcing us to use more cash compensation. If we are unable to attract new managerial and technical employees, or are unable to retain and motivate our current key managerial and technical employees, or are forced to use more cash compensation to retain key personnel, our business, results of operations and financial condition could be materially adversely affected.

Our international business activities subject us to risks that could adversely affect our business.

For the three months ended January 1, 2006 sales in the United States accounted for 53 percent of our total net revenues, sales in the Pacific Rim countries accounted for 12 percent and sales in Europe and the rest of the world accounted for 35 percent of our total net revenues, based on bill-to address. We expect that our sales will be similarly distributed for the foreseeable future. However, because we sell to OEMs and distributors who ultimately resell our products to their customers, the geographic mix of our sales may not be reflective of the geographic mix of end-user demand or installations. All of our sales are currently denominated in U.S. dollars. As a result, if the value of the U.S. dollar increases relative to foreign currencies, our products could become less competitive in international markets. Additionally, a significant portion of our products are produced at our EMS providers’ production facilities in Spain, Mexico and Malaysia. As a result, we are subject to the risks inherent in international operations. Our international business activities could be affected, limited or disrupted by a variety of factors, including, but not limited to:

	•		the imposition of or changes in governmental controls, taxes, tariffs, trade restrictions and regulatory requirements;

	•		the costs and risks of localizing products for foreign countries;

	•		longer accounts receivable payment cycles;

	•		changes in the value of local currencies relative to our functional currency;

	•		import and export restrictions;

	•		loss of tax benefits, or increases in tax expenses, due to international production;

	•		general economic and social conditions within foreign countries;

	•		taxation in multiple jurisdictions; and

	•		political instability, war or terrorism.

All of these factors could harm future sales of our products to international customers or future production outside of the United States of our products, and have a material adverse effect on our business, results of operations and financial condition.

Potential acquisitions or strategic investments may be more costly or less profitable than anticipated and may adversely affect the price of our company stock.

We may pursue acquisitions or strategic investments that could provide new technologies, products or service offerings. Future acquisitions or strategic investments may negatively impact our results of operations as a result of operating losses incurred by the acquired entity, the use of significant amounts of cash, potentially dilutive issuances of equity or equity-linked securities, incurrence of debt, amortization of intangible assets with determinable lives or impairment of intangible assets. Furthermore, we may incur significant expenses pursuing acquisitions or strategic investments that ultimately may not be completed. Moreover, to the extent that any proposed acquisition or strategic investment is not favorably received by stockholders, analysts and others in the investment community, the price of our stock could be adversely affected. In addition, acquisitions or strategic investments involve numerous risks, including, but not limited to:

	•		difficulties in the assimilation of the operations, technologies, products and personnel of the acquired company;

	•		purchased technology that is not adopted by customers in the way or the time frame we anticipated;

	•		the diversion of management’s attention from other business concerns;

	•		risks of entering markets in which we have limited or no prior experience;

	•		risks associated with assuming the legal obligations of the acquired company;

	•		minority interest in a company, resulting from a strategic investment, that could have an impact on our results;

	•		risks related to the effect that the acquired company’s internal control processes might have on our financial reporting and management’s report on our internal controls over financial reporting;

	•		the potential loss of key employees of the company we invested in or acquired; and

	•		there may exist unknown defects of an acquired company’s products or assets that may not be identified due to the inherent limitations involved in the due diligence process of an acquisition.

In the event that an acquisition or strategic investment does occur and we are unable to obtain anticipated profits or successfully integrate operations, technologies, products or personnel or acquire assets that later become worthless, our business, results of operations and financial condition could be materially adversely affected.

Our stock price is volatile, which has and may result in lawsuits against us and our officers and directors.

The stock market in general and the stock prices in technology-based companies in particular have experienced extreme volatility that often has been unrelated to the operating performance of any specific public company. The market price of our common stock has fluctuated in the past and is likely to fluctuate in the future as well. For example, during the calendar year 2005 the sales price of our common stock ranged from a low of $15.06 per share to a high of $22.68 per share. Factors that could have a significant impact on the market price of our stock include, but are not limited to, the following:

	•		quarterly variations in customer demand and operating results;

	•		announcements of new products by us or our competitors;

	•		the gain or loss of significant customers or design wins;

	•		changes in analysts’ earnings estimates;

	•		changes in analyst recommendations, price targets or other parameters that may not be related to earnings estimates;

	•		rumors or dissemination of false information;

	•		pricing pressures;

	•		short selling of our common stock;

	•		general conditions in the computer, storage or communications markets; and

	•		events affecting other companies that investors deem to be comparable to us.

In the past, companies, including us, that have experienced volatility in the market price of their stock have been the objects of securities class action litigation. If we were to be the subject of similar litigation in the future or experience unfavorable outcomes in any of our pending litigation, as discussed in Part II, Item I- “Legal Proceedings” contained elsewhere herein, it could have a material adverse effect on our results of operations and financial condition.

Terrorist activities and resulting military and other actions could adversely affect our business.

The continued threat of terrorism, military action and heightened security measures in response to the threat of terrorism may cause significant disruption to commerce throughout the world. To the extent that such disruptions result in delays or cancellations of customer orders, delays in collecting cash, a general decrease in corporate spending on information technology or our inability to effectively market, manufacture or ship our products, our business, financial condition, and results of operations could be materially and adversely affected. We are unable to predict whether the threat of terrorism or the responses thereto will result in any long-term commercial disruptions or if such activities or responses will have any long-term material adverse effect on our business, results of operations or financial condition.

Our corporate offices and principal product development facilities are located in a region that is subject to earthquakes and other natural disasters.

Our California and Washington facilities, including our corporate offices and principal product development facilities, are located near major earthquake faults. Any disruption in our business activities, personal injury or damage to the facilities in excess of our currently insured amounts as a result of earthquakes or other such natural disasters, could have a material adverse effect on our business, results of operations and financial condition.

Our shareholder rights plan, certificate of incorporation and Delaware law could adversely affect the performance of our stock.

Our shareholder rights plan and provisions of our certificate of incorporation and of the Delaware General Corporation Law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our shareholders. The shareholder rights plan and these provisions of our certificate of incorporation and Delaware law are intended to encourage potential acquirers to negotiate with us and allow our board of directors the opportunity to consider alternative proposals in the interest of maximizing shareholder value. However, such provisions may also discourage acquisition proposals or delay or prevent a change in control, which could harm our stock price. For more information, please read note 12 to the Consolidated Financial Statements contained in our 2005 Annual Report on Form 10-K, our certificate of incorporation and Delaware law for more information on the anti-takeover effects of provisions of our shareholder rights plan.

Our system of internal controls may be inadequate.

We maintain a system of internal controls in order to ensure we are able to collect, process, summarize and disclose the information required by the Securities and Exchange Commission within the time periods specified. Any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. Additionally, public companies in the United States are required to review their internal controls under the Sarbanes-Oxley Act of 2002. If the internal controls put in place by us are not adequate or fail to perform as anticipated, we may be required to restate our financial statements, receive an adverse audit opinion, and/or take other actions that will divert significant financial and managerial resources, as well as be subject to fines and/or other government enforcement actions. Furthermore, the price of our stock could be adversely affected.

Changes in laws, regulations and financial accounting standards may affect our reported results of operations.

New laws, regulations and accounting standards, as well as changes to and varying interpretations of currently accepted accounting practices in the technology industry might adversely affect our reported financial results, which could have an adverse effect on our stock price. Furthermore, new guidance related to the expensing of stock options in SFAS No. 123(R) has materially adversely affected operating and net income for the three and six months ended January 1, 2006, and may affect our stock price.

The final determination of our income tax liability may be materially different from our income tax provisions and accruals.

We are subject to income taxes in both the United States and international jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions where the ultimate tax determination is uncertain. Additionally, our calculations of income taxes are based on our interpretations of applicable tax laws in the jurisdictions in which we file. Although we believe our tax estimates are reasonable, there is no assurance that the final determination of our income tax liability will not be materially different than what is reflected in our income tax provisions and accruals. Should additional taxes be assessed as a result of new legislation, an audit or litigation, if our effective tax rate should change as a result of changes in federal, international or state and local tax laws, or if we were to change the locations where we operate, there could be a material effect on our income tax provision and net income in the period or periods in which that determination is made, and potentially to future periods as well.

We may need additional capital in the future and such additional financing may not be available on favorable terms.

While we believe we have adequate working capital to meet our expected cash requirements for the next twelve months, we may need to raise additional funds through public or private debt or equity financings in order to, without limitation:

	•		take advantage of unanticipated opportunities, including more rapid international expansion or acquisitions of complementary businesses or technologies;

	•		develop new products or services;

	•		repay outstanding indebtedness; and

	•		respond to unanticipated competitive pressures.

Any additional financing we may need may not be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, we may not be able to take advantage of business opportunities, develop new products or services or otherwise respond to unanticipated competitive pressures. In any such case, our business, results of operations and financial condition could be materially adversely affected.

In fiscal 2004, we completed a $517.5 million private placement of 0.25 percent convertible subordinated notes due 2023. During the fiscal year 2005, we repurchased and cancelled $281.5 million in face value of these 0.25 percent notes, leaving approximately $236.0 million still outstanding at January 1, 2006. The holders of our 0.25 percent notes may require us to purchase the notes for cash as early as December 2006. If we have insufficient liquidity and capital resources to repay the principal amounts of our outstanding convertible notes and the notes when due, we may be forced to raise additional funds through public or private debt or equity financings, which may not be available on favorable terms, if at all. If such financings were not available on favorable terms our business, results of operations and financial condition could be materially adversely affected.

Conversion of our outstanding notes would dilute the ownership interest of existing stockholders.

The conversion of our notes into shares of our common stock would dilute the ownership interests of existing stockholders. Any sales in the public market of the common stock issuable upon conversion of the notes could adversely affect prevailing market prices of our common stock. In addition, the existence of the notes may encourage short selling by market participants due to this dilution or to facilitate trading strategies involving notes and common stock.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity

At January 1, 2006, our investment portfolio consisted primarily of fixed income securities, excluding those classified as cash and cash equivalents, of $447.6 million. We have the positive intent and ability to hold these securities to maturity. Currently, the carrying amount of these securities approximates fair market value. However, the fair market value of these securities is subject to interest rate risk and would decline in value if market interest rates increased. If market interest rates were to increase immediately and uniformly by 10 percent from the levels existing as of January 1, 2006, the decline in the fair value of the portfolio would not be material to our financial position, results of operations and cash flows. However, if interest rates decreased and securities within our portfolio matured and were re-invested in securities with lower interest rates, interest income would decrease in the future.

As of January 1, 2006, we had approximately $236.0 million face value 0.25 percent contingent convertible subordinated notes issued and outstanding. The fair value, based on quoted market prices, of our 0.25 percent convertible subordinated notes at January 1, 2006, was $224.8 million. The fair value of these notes may increase or decrease due to various factors, including fluctuations in the market price of our common stock, fluctuations in market interest rates and fluctuations in general economic conditions.

Foreign Currency

We have executed and will continue to execute transactions in foreign currencies. As a result, we may be exposed to financial market risk resulting from fluctuations in foreign currency exchange rates, particularly the British Pound and the Euro. Given the relatively small number of foreign currency transactions, we do not believe that our potential exposure to fluctuations in foreign currency exchange rates is significant.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures designed to ensure that we are able to collect the information we are required to disclose in the reports we file with the Securities and Exchange Commission, or SEC, and to process, summarize and disclose this information within the time periods specified in the rules of the SEC. Based on their evaluation of our disclosure controls and procedures, the Chief Executive and Chief Financial Officers have concluded that, as of the end of the period covered by this Quarterly Report on Form 10-Q, these disclosure controls and procedures were effective to ensure that we are able to record, process, summarize and report the information we are required to disclose in the reports we file with the SEC within the required time periods.

There were no changes in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

Litigation

On November 15, 2001, prior to the Company’s acquisition of Vixel Corporation, a securities class action was filed in the United States District Court in the Southern District of New York as Case No. 01 CIV. 10053 (SAS), Master File No. 21 MC92 (SAS) against Vixel and two of its officers and directors and certain underwriters who participated in the Vixel initial public offering in late 1999. The amended complaint alleges violations under Section 10(b) of the Exchange Act and Section 11 of the Securities Act and seeks unspecified damages on behalf of persons who purchased Vixel stock during the period October 1, 1999 through December 6, 2000. In October 2002, the parties agreed to toll the statute of limitations with respect to Vixel’s officers and directors until September 30, 2003, and on the basis of this agreement, Vixel’s officers and directors were dismissed from the lawsuit without prejudice. During June 2003, Vixel and the other issuer defendants in the action reached a tentative settlement with the plaintiffs that would, among other things, result in the dismissal with prejudice of all claims against the defendants and their officers and directors. In connection with the possible settlement, those officers and directors who had entered tolling agreements with the plaintiffs agreed to extend those agreements so that they would not expire prior to any settlement being finalized. Although Vixel approved this settlement proposal in principle, it remains subject to a number of procedural conditions, as well as formal approval by the court. On August 31, 2005, a Preliminary Order In Connection With Settlement Proceedings was issued by the court which among other items, sets a date for a Settlement Fairness Hearing, and the form of notice to the Settlement Classes of the Issuers’ Settlement Stipulation. In December 2005, the settlement notices authorized by the court were sent to former Vixel stockholders and the web site www.iposecuritieslitigation.com was created for claimants, as well as a March 24, 2006 objection deadline. The Company believes the final resolution of this litigation will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

Ongoing lawsuits present inherent risks, any of which could have a material adverse effect on the Company’s business, financial condition or results of operations. Such potential risks include the continuing expenses of litigation, counterclaims and attorneys’ fee liability.

Additionally, the Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

Item 1A Risk Factors

This item is not applicable as the Company was not required to disclose risk factors in response to Part I, Item 1A of Form 10-K in its Annual Report on Form 10-K for the fiscal year ended July 3, 2005. However, the Company has included a description of risk factors as part of Part I, Item 2 of this Quarterly Report on Form 10-Q.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The Company did not repurchase any equity securities and there were no sales of unregistered securities during the three months ended January 1, 2006.

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

The annual meeting of stockholders of the Company was held on December 1, 2005. There were 83,678,959 shares of the Company’s common stock issued, outstanding and entitled to vote at the meeting as of October 10, 2005, the record date. Proxies representing 78,723,067 common shares were received and tabulated. Four proposals were voted on at this meeting. First, the following members were elected to the Company’s Board of Directors to hold office for the ensuing year:


Nominee	In Favor		Withheld
Fred B. Cox		76,024,335		2,698,723
Michael P. Downey		74,048,852		4,674,215
Bruce C. Edwards		69,796,273		8,926,794
Paul F. Folino		76,082,810		2,640,257
Robert H. Goon		75,968,986		2,754,081
Don M. Lyle		68,750,004		9,973,063
Dean A Yoost		77,104,322		1,618,745

The second proposal submitted to the stockholders of the Company was to ratify and approve the Company’s 2005 Employee Stock Incentive Plan. The proposal was approved with the following votes:


For			37,007,413
Against			22,059,747
Abstain			125,883
Broker Non-Vote			19,530,024

The third proposal submitted to the stockholders of the Company was to ratify and approve the Company’s 1997 Stock Option Plan for Non-Employee Directors, including amendments which (i) extend the termination date of such Plan, and (ii) permit but do not require the issuance of equity-based awards other than stock options. The proposal was approved with the following votes:


For			45,781,187
Against			13,309,987
Abstain			101,869
Broker Non-Vote			19,530,024

The fourth proposal submitted to the stockholders of the Company was to ratify the selection of KPMG LLP as the Company’s independent auditors for fiscal year 2006. This proposal was approved with the following votes:


For			77,875,919
Against			779,907
Abstain			67,241

Item 6. Exhibits


		Exhibit 3.1		Certificate of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Company’s 1997 Annual Report on Form 10-K).

		Exhibit 3.2		Certificate of Amendment of Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.4 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended December 31, 2000).

		Exhibit 3.3		Amended and restated Bylaws of the Company (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on August 30, 2005).

		Exhibit 3.4		Certificate of Designations of Series A Junior Participating Preferred Stock (incorporated by reference to Exhibit 4 to the Company’s Current Report on Form 8-K filed February 2, 1989).

		Exhibit 4.1		Rights Agreement dated January 19, 1989, as amended (incorporated by reference to Exhibit 4 to the Company’s Current Report on Form 8-K filed February 2, 1989).

		Exhibit 4.2		Certificate regarding extension of Final Expiration Date of Rights Agreement dated January 18, 1999 (incorporated by reference to Exhibit 4.2 of Amendment No. 2 to the Registration Statement on Form S-3, filed on May 17, 1999).

		Exhibit 4.3		Form of 0.25% Convertible Subordinated Note due December 15, 2023 (incorporated by reference to Exhibit 4.6 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended December 28, 2003).

		Exhibit 4.4		Indenture between the Company, as Issuer, and State Street Bank and Trust Company of California, N.A., as Trustee, dated December 12, 2003, related to the Company’s 0.25% Convertible Subordinated Notes due 2023 (incorporated by reference to Exhibit 4.7 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended December 28, 2003).

Exhibit Index

Item 6. Exhibits


		Exhibit 3.1		Certificate of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Company’s 1997 Annual Report on Form 10-K).

		Exhibit 3.2		Certificate of Amendment of Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.4 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended December 31, 2000).

		Exhibit 3.3		Amended and restated Bylaws of the Company (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on August 30, 2005).

		Exhibit 3.4		Certificate of Designations of Series A Junior Participating Preferred Stock (incorporated by reference to Exhibit 4 to the Company’s Current Report on Form 8-K filed February 2, 1989).

		Exhibit 4.1		Rights Agreement dated January 19, 1989, as amended (incorporated by reference to Exhibit 4 to the Company’s Current Report on Form 8-K filed February 2, 1989).

		Exhibit 4.2		Certificate regarding extension of Final Expiration Date of Rights Agreement dated January 18, 1999 (incorporated by reference to Exhibit 4.2 of Amendment No. 2 to the Registration Statement on Form S-3, filed on May 17, 1999).

		Exhibit 4.3		Form of 0.25% Convertible Subordinated Note due December 15, 2023 (incorporated by reference to Exhibit 4.6 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended December 28, 2003).

		Exhibit 4.4		Indenture between the Company, as Issuer, and State Street Bank and Trust Company of California, N.A., as Trustee, dated December 12, 2003, related to the Company’s 0.25% Convertible Subordinated Notes due 2023 (incorporated by reference to Exhibit 4.7 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended December 28, 2003).

		Exhibit 4.5		Registration Rights Agreement between the Company and Credit Suisse First Boston Corporation dated December 12, 2003, related to the Company’s 0.25% Convertible Subordinated Notes due 2023 (incorporated by reference to Exhibit 4.8 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended December 28, 2003).

		Exhibit 31A		Certification of the Principal Executive Officer Pursuant to 17 CFR 240.13a-14(a), as Adopted Pursuant to § 302 of the Sarbanes-Oxley Act of 2002.

		Exhibit 31B		Certification of the Principal Financial Officer Pursuant to 17 CFR 240.13a-14(a), as Adopted Pursuant to § 302 of the Sarbanes-Oxley Act of 2002.

		Exhibit 32		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to § 906 of the Sarbanes-Oxley Act of 2002.


	PAGE
Part I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets January 1, 2006 and July 3, 2005		2

Condensed Consolidated Statements of Income Three and six months ended January 1, 2006, and December 26, 2004		3

Condensed Consolidated Statements of Cash Flows Six months ended January 1, 2006, and December 26, 2004		4

Notes to Condensed Consolidated Financial Statements		5

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		15

Item 3. Quantitative and Qualitative Disclosures about Market Risk		37

Item 4. Controls and Procedures		37

Part II. OTHER INFORMATION

Item 1. Legal Proceedings		38

Item 1A. Risk Factors		38

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		38

Item 4. Submission of Matters to a Vote of Security Holders		38

Item 6. Exhibits		39

Signatures		41
EXHIBIT 31.A
EXHIBIT 31.B
EXHIBIT 32


	EMULEX CORPORATION
	By:	/s/ Paul F. Folino
		Paul F. Folino
		Chairman of the Board and Chief Executive Officer


	By:	/s/ Michael J. Rockenbach
		Michael J. Rockenbach
		Executive Vice President and Chief Financial Officer (Principal Financial and Chief Accounting Officer)