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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 29, 2002

OR

Commission File No.   0-11007

EMULEX CORPORATION

(714) 662-5600

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

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

As of November 5, 2002, the registrant had 81,950,169 shares of common stock outstanding.

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EMULEX CORPORATION AND SUBSIDIARIES

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

EMULEX CORPORATION AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands, except share and per share data)
(unaudited)

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EMULEX CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)

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EMULEX CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

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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 the financial position as of September 29, 2002, and June 30, 2002, and the condensed consolidated statements of operations for the three months ended September 29, 2002, and September 30, 2001, and the condensed consolidated statements of cash flows for the three month periods then ended. Certain reclassifications have been made to the condensed consolidated balance sheet as of June 30, 2002, to conform to the presentation as of September 29, 2002. Interim results for the three months ended September 29, 2002, are not necessarily indicative of the results that may be expected for the year ending June 29, 2003. The interim financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2002.
		Effective July 1, 2002, the Company adopted Financial Accounting Standards Board (“FASB”) Statement (“Statement”) 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” under which the recoverability of long-lived assets is assessed by determining whether the carrying value of an asset can be recovered through projected undiscounted future operating cash flows over its remaining life. 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.
2.		Inventories
		Inventories, net, are summarized as follows:

Starting in late September 2001, some of the Company’s major customers made announcements that general economic conditions, exacerbated by the increase in economic uncertainty in the aftermath of the terrorist events of September 11, 2001, were having a negative impact on their financial results. The announcements made, and forecasts received, indicated deteriorating demand for the Company’s one gigabit per second (“Gbps”) products as these customers were expected to migrate to two Gbps products for future purchases. As a result, the Company recorded an excess and obsolete inventory charge totaling $13.6 million during the first quarter of fiscal 2002. Subsequently, as a result of the sale of products for which a reserve had been recorded, the Company recorded a reduction of $0.2 million of this excess and obsolete inventory charge for the first three months of fiscal 2003 ended September 29, 2002. As of September 29, 2002, the remaining reserve for one Gbps products was $8.2 million. As with all inventory, the Company regularly compares forecasted demand for its one Gbps products against inventory on hand and open purchase commitments. Accordingly, the Company may have to increase excess and obsolete inventory reserves as forecasted demand changes. As of September 29, 2002, the Company had unreserved inventory on hand of approximately $4.1 million related to its one Gbps products.

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3.		Goodwill and Other Intangibles
		Goodwill and other intangibles, net, are as follows:

		Effective July 1, 2002, the Company adopted Statement 142. As a result, the Company ceased amortizing goodwill of $397.3 million beginning July 1, 2002. Included in goodwill is $1.8 million of assembled workforce that was reclassified to goodwill effective July 1, 2002. In conjunction with the adoption of Statement 142, the Company completed its transitional goodwill impairment test for its one reporting unit during the three months ended September 29, 2002, with no impairment charges resulting. The goodwill will be tested for impairment at least annually.
		The intangible assets subject to amortization are being amortized on a straight-line basis over the following estimated useful lives:

Aggregated amortization expense for the three months ended September 29, 2002, was $1.5 million and for the next five fiscal years is expected to be (in thousands):

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The following table presents the impact on net income (loss) and net income (loss) per share had Statement 142 been in effect for the three months ended September 30, 2001.

4.		Other Assets
		Components of other assets are as follows:

5.		Accrued Liabilities
		Components of accrued liabilities are as follows:

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6.		Convertible Subordinated Notes
		On January 23, 2002, the Company announced a private placement of $300.0 million aggregate principal amount of 1.75 percent convertible subordinated notes due February 1, 2007. Interest is payable in cash on February 1 and August 1 of each year beginning August 1, 2002. In addition, the Company granted the initial purchasers of the notes a 30-day option, which they exercised, to purchase an additional $45.0 million principal amount of the notes. These notes may be converted 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 may redeem the notes on or after February 5, 2005, in whole or in part. The Company incurred associated issuance costs of approximately $11.0 million (see note 4). The $345.0 million transaction closed on January 29, 2002.
		During the three months ended September 29, 2002, the Company’s Board of Directors expanded the Company’s stock repurchase program to include the repurchase of the Company’s convertible subordinated notes as well as shares of the Company’s common stock. The combined program authorizes the repurchase of up to four million shares with three million shares of common stock still available for repurchase at September 29, 2002, and up to an additional $125.0 million to be spent on the repurchase of the convertible subordinated notes. In August 2002, the Company bought back approximately $136.5 million of its convertible subordinated notes at a discount to face value, spending $104.2 million. The repurchased notes were cancelled, leaving convertible subordinated notes outstanding with a face value of $208.5 million, which, if converted, would result in the issuance of approximately 3.9 million shares. The resulting net pre-tax gain of $28.7 million from the repurchase of the convertible subordinated notes was recorded for the three months ended September 29, 2002.
7.		Commitments and Contingencies
		Litigation
		Beginning on or about February 20, 2001, the Company and certain of its officers and directors were named as defendants in a number of securities class action lawsuits filed in the United States District Court, Central District of California. The plaintiffs in the actions purport to represent purchasers of the Company’s common stock during various periods ranging from January 18, 2001, through February 9, 2001. The complaints allege that the Company and certain of its officers and directors made misrepresentations and omissions in violation of sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints generally seek compensatory damages, costs and attorney’s fees in an unspecified amount. Pursuant to a Stipulation and Court Order, the actions have been consolidated. On August 24, 2001, an Amended and Consolidated Complaint was filed. Defendants’ motion to dismiss was denied by way of an order dated March 7, 2002. Defendants’ motion for reconsideration of that order was denied by an order dated May 3, 2002. Plaintiffs have commenced discovery. The court certified the class action by an order dated September 30, 2002. The court has scheduled a trial setting conference on June 6, 2003, with an expectation that the case will be set for trial in July, 2003. As a result of these class action lawsuits, a number of derivative cases were filed in state courts in California and Delaware, and in federal court in California, alleging that certain officers and directors breached their fiduciary duties to the Company in connection with the events alleged in the class action lawsuits. The derivative cases filed in California state courts have been consolidated in Orange County Superior Court and plaintiffs filed a consolidated and amended complaint on January 31, 2002. On May 10, 2002, the Orange County Superior Court ordered that the consolidated actions be stayed pending resolution of the federal class action described above. The derivative suit in Delaware was dismissed on August 28, 2001. On March 15, 2002, the United States District Court for the Central District of California ordered that the federal derivative action be stayed pending resolution of the class action lawsuit described above. The plaintiffs in that action filed a motion for reconsideration of that order, which was denied by an order dated June 3, 2002. The above-described litigation could result in substantial costs to the Company and a diversion of management’s attention and resources. While the Company believes that the lawsuits are without legal merit and intends to defend them vigorously, because the lawsuits are at an early stage, it is not possible to predict whether the Company will incur any material liability in connection with such lawsuits. The Company has received inquiries about events giving rise to the lawsuits from the Securities and Exchange Commission and the Nasdaq Stock Market.

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		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 is undergoing examination by the Internal Revenue Service of Emulex Corporation’s 1998 U.S. tax return. It is management’s belief that the outcome of this examination will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.
		Effective October 11, 2002, the Board of Directors approved authorization of an additional 750 thousand shares for issuance under the Employee Stock Purchase Plan, subject to stockholder approval. As a result, in the event the fair market value of the Company’s common stock increases above $10.85 (the fair market value as of the close of business on October 11, 2002) on the date the amendment is approved by the stockholders, the Company will incur a charge against earnings. Because the amount of such charge depends on employee participation levels as well as the future price of the Company’s common stock, the exact amount of any such charge cannot be calculated at this time. The annual meeting of the stockholders of the Company will be held on November 21, 2002.
		The Company recorded an estimated excess and obsolete inventory charge of $13.6 million associated with older-generation one Gbps products during the three months ended September 30, 2001. Subsequently, as a result of the sale of products for which a reserve had been recorded, the Company recorded a reduction of $0.2 million of this excess and obsolete inventory charge for the first three months of fiscal 2003 ended September 29, 2002. As of September 29, 2002, the remaining reserve for one Gbps products was $8.2 million. As with all inventory, the Company regularly compares forecasted demand for its one Gbps products against inventory on hand and open purchase commitments. Accordingly, the Company may have to increase excess and obsolete inventory reserves as forecasted demand changes. As of September 29, 2002, the Company had unreserved inventory on hand of approximately $4.1 million related to its one Gbps products.
		The Company was previously required to enter into an end-of-life purchase agreement for a key inventory component as the sole-source manufacturer of this component announced their discontinued manufacturing of the component. As of September 29, 2002, the Company’s remaining purchase obligation was $10.4 million. In relation to the excess and obsolete inventory charge associated with older generation one Gbps products, the Company has accrued $3.2 million, which represented the Company’s commitment to purchase this key component in excess of forecasted demand and as a result was impaired.
		During the third quarter of fiscal 2002, the Company entered into an agreement to relocate its headquarters locally in Costa Mesa, California. The Company will finance the build to suit construction phase of the new facility with its own capital, before beginning a 10-year lease term with an option to buy the land and buildings during the first six months of the lease term. If the Company does not exercise its option to purchase the facility, the landlord will obtain permanent financing and reimburse the Company for the construction costs. The Company’s total gross undiscounted financial commitment for the 10-year lease term would be approximately $46.0 million. At September 29, 2002, the Company had restricted cash of $1.7 million in escrow associated with the construction of the headquarters.
8.		Earnings per Share
		Basic net income (loss) per share and diluted net loss per share are computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income per share is 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 have been outstanding if the dilutive potential common shares from stock option 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 following table sets forth the computation of basic and diluted net income (loss) per share:

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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 three months ended September 29, 2002. As the Company recorded a net loss for the three months ended September 30, 2001, all outstanding stock options were excluded from the calculation of diluted net loss per share, because the effect would have been antidilutive.

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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. The Company 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, the Company’s 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” set forth therein, and in the Company’s most recently filed Annual Report on Form 10-K. These factors include the fact that the economy generally, and the technology and storage segments specifically, have recently 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. Recently, the Company’s results have been significantly impacted by a widespread slowdown in technology investment that has also pressured the storage networking market that is the mainstay of the Company’s business. A prolonged downturn in information technology spending could adversely affect the Company’s revenues and results of operations. As a result of this uncertainty, the Company is 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 the Company’s Original Equipment Manufacturer (“OEM”) customers to successfully incorporate the Company’s products into their systems; the Company’s 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 payment; the timing and market acceptance of the Company’s or the Company’s OEM customers’ new or enhanced products; the Company’s lack of backlog and the booking patterns of the Company’s customers; the effects of terrorist activities and resulting political or economic instability; the highly competitive nature of the markets for the Company’s products as well as pricing pressures that may result from such competitive conditions; the Company’s ability and the ability of the Company’s OEM customers to keep pace with the rapid technological changes in the Company’s industry and gain market acceptance for new products and technologies; the effect of rapid migration of customers towards newer product platforms; possible transitions from board level to application specific integrated circuit (“ASIC”) solutions for selected applications; a shift in unit product mix from high end to midrange products; a decrease in the average unit selling prices or an increase in the manufactured cost of the Company’s Fibre Channel products; delays in product development; the Company’s reliance on third-party suppliers and subcontractors for components and assembly; any inadequacy of the Company’s intellectual property protection or the potential for third-party claims of infringement; the Company’s ability to attract and retain key technical personnel; the Company’s dependence on foreign sales; the effect of acquisitions and changes in accounting standards.

Readers should carefully review these cautionary statements as 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 the Company’s filings with the Securities and Exchange Commission or in materials incorporated therein by reference. The Company cautions the reader, however, that these lists of risk factors may not be exhaustive. The Company expressly disclaims 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. References contained herein to “Emulex,” the “Company,” “our” and “us” refer to Emulex Corporation and its subsidiaries. References to dollar amounts are in thousands, except share and per-share data, unless otherwise specified.

Company Overview

Emulex Corporation is a leading designer, developer and supplier of a broad line of storage networking host bus adapters (“HBAs”) and application-specific computer chips (“ASICs”) that provide connectivity solutions for storage area networks (“SANs”), network attached storage (“NAS”), and redundant array of independent disks

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(“RAID”) storage. 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 network. The Company’s products are based on internally developed ASIC and embedded firmware and software technology, and offer support for a wide variety of SAN protocols, configurations, system interfaces and operating systems. Emulex’s architecture offers customers a stable applications program interface (“API”), that has been preserved across multiple generations of adapters and to which many of the world’s leading OEMs have customized software for mission-critical server and storage system applications.

Recently, the majority of the Company’s revenues have been comprised of products based on Fibre Channel technology. The Company’s Fibre Channel development efforts began in 1992 and the Company shipped its first Fibre Channel product in volume in 1996. According to IDC and Dataquest, in calendar 2001 the Company was the world’s largest provider of Fibre Channel host bus adapters. In March 2001, the Company acquired Giganet, a leading developer of storage networking products based on Ethernet and Internet Protocol (“IP”) technologies. Effective July 2, 2001, Giganet was merged with and into Emulex Corporation, a California corporation that is the primary operating subsidiary of the Company. The Company’s strategy with this acquisition is to leverage Giganet’s technology and extend the Company’s market-leading HBA APIs into Internet Small Computer Systems Interface (“iSCSI”) and Virtual Interface (“VI”) based portions of the storage networking market. The Company has secured significant customer relationships with the world’s leading storage and server suppliers, including Dell, EMC, Fujitsu-Siemens, Groupe Bull, Hewlett-Packard, Hitachi Data Systems, IBM, NEC, Network Appliance and Unisys. In addition, the Company includes industry leaders Brocade, Intel, INRANGE, Legato, McDATA, Microsoft, and Veritas among its strategic partners. The Company markets to OEMs and end-users through its own worldwide selling organization, as well as to distribution partners. Corporate headquarters are located in Costa Mesa, California. As of September 29, 2002, the Company had a total of 356 employees.

Results of Operations

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

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Net Revenues

Net revenues for the first three months of fiscal 2003 ended September 29, 2002, were $70.4 million, an increase of $17.7 million, or 34 percent, from $52.7 million for the same three months of fiscal 2002 ended September 30, 2001. Net revenues for the three months ended September 29, 2002, consisted of $48.6 million from sales to OEMs, $21.7 million from sales through distribution channels and $0.1 million from sales directly to end-users. This represents an increase in OEM sales of $7.6 million, or 18 percent, an increase in distribution sales of $10.3 million, or 90 percent, and a decrease in end-user sales of $0.2 million, or 63 percent, compared to the same three months of fiscal 2002. A major factor in this shift from OEM to distribution net revenues is that beginning in the three months ended June 30, 2002, one of the Company’s larger OEM customers began sourcing more product through distribution rather than purchasing it directly. The Company continues to believe net revenues in this market are being generated primarily from OEMs taking product directly and through other distribution channels. Additionally, the widespread slowdown in technology investment has affected the Company’s OEM and distribution customers, both domestically and internationally, at different times and in varying degrees of severity.

From a product line perspective, net revenues generated from the Company’s Fibre Channel products for the three months ended September 29, 2002, were $68.8 million, or 98 percent of total net revenues. This represents an increase of $17.2 million, or 33 percent, from the same three months of fiscal 2002. During the second half of fiscal 2001, the Company first experienced a downturn in Fibre Channel host bus adapter demand that continued into the three months ended September 30, 2001. The Company believes industry-wide decreases in end-user demand for technology solutions caused this downturn in demand. Although the Company’s Fibre Channel revenues for the three months ended September 29, 2002, increased compared to the same three months of fiscal 2002, there is still a significant amount of uncertainty as to what stage of a recovery, if any, the market for technology solutions, and consequently, the Company, is experiencing. Net revenues from the Company’s IP Storage Networking products, which were added to the Company’s product offerings in the third quarter of fiscal 2001 with the acquisition of Giganet, were $1.6 million, or two percent of total net revenues for the three months ended September 29, 2002. This represents an increase of $0.9 million, or approximately 111 percent, compared to the same three months of fiscal 2002 due primarily to increased demand for the Company’s Virtual Interface/Internet Protocol (“VI/IP”) products. Net revenues from the Company’s traditional networking products were immaterial for the three months ended September 29, 2002, and $0.4 million, or one percent, of total net revenues for the same three months of fiscal 2002. This decrease in net revenues from the Company’s traditional networking products was principally due to the planned discontinuance of the Company’s efforts related to these products. The Company’s traditional networking products entered end-of-life status in fiscal 2000 and the Company expects that these will contribute negligible, if any, revenues in future periods.

For the three months ended September 29, 2002, direct sales to IBM and Hewlett-Packard each separately accounted for 23 percent of the Company’s total net revenues. Direct sales to no other customer accounted for more than 10 percent of total net revenues. Additionally, some of the Company’s larger OEM customers purchased products indirectly through distributors, resellers or other third parties. Total net revenues, including direct sales to the Company’s customers and their customer-specific models purchased indirectly through other distribution channels, amounted to 25 percent of the Company’s total net revenues for IBM, 23 percent for Hewlett-Packard, and 18 percent for EMC for the three months ended September 29, 2002. For the same three months of fiscal 2002, direct sales to Hewlett-Packard and Compaq (if aggregated); IBM; and EMC accounted for 29 percent, 19 percent, and 11 percent of the Company’s total net revenues, respectively. Direct sales to no other customer accounted for more than 10 percent of total net revenues during this period. Total net revenues, including direct sales to the Company’s customers and their customer-specific models purchased indirectly through other distribution channels, amounted to 29 percent of the Company’s total net revenues for Hewlett-Packard and Compaq (if aggregated); 24 percent for EMC; and 22 percent for IBM for the three months ended September 30, 2001. Direct sales to the Company’s top five customers accounted for 67 percent of total net revenues for both the three months ended September 29, 2002, and the same three months of fiscal 2002. The Company’s net revenues from its customers can be significantly impacted by changes in the business models of its customers. Beginning in the three months ended June 2002, EMC began sourcing more product through distribution rather than purchasing it directly. Consequently, direct sales to EMC could be impacted. Additionally, EMC has formed an alliance with Dell and entered into a worldwide manufacturing agreement with Dell. Consequently, some Emulex models previously sold under EMC-specific model numbers are now being sold under Dell-specific model numbers, and total net revenues for EMC, including direct sales to EMC and their customer-specific models purchased indirectly through other distribution channels, have been reduced as a result of this Dell alliance.

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Domestic net revenues were $48.3 million, or 69 percent of total net revenues, for the three months ended September 29, 2002, and $33.8 million, or 64 percent of total net revenues for the same three months of fiscal 2002. International net revenues were $22.1 million, or 31 percent of total net revenues, for the three months ended September 29, 2002, and $19.0 million, or 36 percent of total net revenues for the same three months of fiscal 2002. The Company believes the increase in domestic net revenues of $14.5 million, or 43 percent, and the increase in international net revenues of $3.2 million, or 17 percent, are principally a function of the overall size of the market for Fibre Channel products and increased market acceptance of the Company’s Fibre Channel products.

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. For the three months ended September 29, 2002, gross profit increased $28.8 million, or 209 percent, to $42.5 million from $13.8 million in the three months ended September 30, 2001. Gross margin increased to 60 percent for the three months ended September 30, 2002 compared to 26 percent in the comparable three months of fiscal 2002, primarily due to the comparable three months of fiscal 2002 including an excess and obsolete inventory charge of $13.6 million associated with older-generation one gigabit per second (“Gbps”) products. Starting in late September 2001, some of the Company’s major customers made announcements that general economic conditions, exacerbated by the increase in economic uncertainty in the aftermath of the terrorist events of September 11, 2001, were having a negative impact on their financial results. The announcements made, and forecasts received, indicated deteriorating demand for the Company’s one Gbps products as these customers were expected to migrate to two Gbps products for future purchases. As a result, the Company recorded an estimated excess and obsolete inventory charge totaling $13.6 million during the first quarter of fiscal 2002. Subsequently, as a result of generally improved demand exceeding prior estimates and the sale of products for which a reserve had been recorded, the Company recorded reductions of this excess and obsolete inventory charge. For the three months ended September 29, 2002 the reduction was $0.2 million. Excluding the reduction of the excess and obsolete inventory reserve of $0.2 million for the three months ended September 29, 2002, and the excess and obsolete charge of $13.6 million from the comparable three months of fiscal 2002, gross profit would have been $42.4 million and $27.4 million, respectively, and gross margin would have been 60 percent and 52 percent, respectively. The increase in gross profit and gross margin, excluding the inventory charge and subsequent reduction, for the three months ended September 29, 2002, compared to the same three months of fiscal 2002 was primarily due to cost reductions for Fibre Channel products, higher Fibre Channel net revenues, and changes in product mix. Additionally, cost of sales included $4 thousand and $17 thousand of amortized deferred compensation expense related to the acquisition of Giganet for the three months ended September 29, 2002, and September 30, 2001, respectively.

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 the Company’s 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 design process. Engineering and development expenses were $13.7 million and $10.9 million for the three months ended September 29, 2002, and September 30, 2001, representing 19 and 21 percent of net revenues, respectively. Engineering and development expenses increased by $2.8 million, or 25 percent, for the three months ended September 29, 2002, compared to the same three months of fiscal 2002, due to the Company’s increased investment in its Fibre Channel and Internet Protocol engineering and development, which included increased engineering and development headcount. Engineering and development expenses included $0.5 million of amortized deferred compensation expenses related to the acquisition of Giganet for both the three months ended September 29, 2002, and September 30, 2001. Due to the technical nature of the Company’s products, engineering support is a critical part of the Company’s strategy during both the development of its products and the support of its customers from product design through deployment into the market. Management intends to continue to make significant investments in the technical support and enhancement of the Company’s current products, as well as the continued development of new products. Engineering expenses can fluctuate from quarter to quarter depending on several factors, including new product introduction schedules, hiring patterns and depreciation of capital equipment.

Selling and Marketing

Selling and marketing expenses consisted primarily of salaries, commissions and related expenses for personnel engaged in the marketing and sales of the Company’s products, as well as trade shows, product literature,

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promotional support costs and other advertising related costs. Selling and marketing expenses were $4.7 million and $5.3 million for the three months ended September 29, 2002, and September 30, 2001, representing seven and 10 percent of net revenues, respectively. Selling and marketing expenses decreased by $0.6 million, or 12 percent, for the three months ended September 29, 2002, compared to the same three months of fiscal 2002. This decrease was primarily due to lower selling and marketing headcount and decreased promotion and advertising costs. Selling and marketing expenses included $0.2 million and $0.3 million of amortized deferred compensation expense related to the acquisition of Giganet for the three months ended September 29, 2002, and September 30, 2001, respectively. Additionally, the Company recognized $63 thousand and $50 thousand of amortized deferred compensation expense for the three months ended September 29, 2002, and September 30, 2001, respectively, associated with a change to the United Kingdom’s tax laws.

General and Administrative

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 $2.7 million and $2.8 million for the three months ended September 29, 2002, and September 30, 2001, representing four and five percent of net revenues, respectively. General and administrative expenses remained essentially flat; decreasing by $0.1 million, or four percent, for the three months ended September 29, 2002, compared to the same three months of fiscal 2002, due to the Company’s emphasis on operating expense controls. General and administrative expenses included $56 thousand and $60 thousand of amortized deferred compensation expenses related to the acquisition of Giganet for the three months ended September 29, 2002, and September 30, 2001, respectively.

Amortization of Goodwill and Other Intangibles

Amortization of goodwill and other intangibles included the amortization of intangible assets with estimable lives for the three months ended September 29, 2002. For the three months ended September 30, 2001, amortization of goodwill and other intangible assets included the amortization of goodwill and the amortization of other intangible assets with estimable lives. All intangible assets relate to the purchase of Giganet, completed during fiscal 2001. The amortization of intangibles was $1.5 million for the three months ended September 29, 2002, and amortization of goodwill and other intangibles was $39.1 million for the same three months of fiscal 2002, representing two and 74 percent of net revenues, respectively. For the three months ended September 29, 2002, the amortization consisted of amortization for core technology and patents of $1.5 million and $3 thousand for completed technology. For the comparable three months of fiscal 2002, the amortization consisted primarily of $37.4 million and $0.2 million for goodwill and assembled workforce, respectively; as well as $1.5 million for core technology and patents and $3 thousand for completed technology. The goodwill will be tested for impairment at least annually. The Company has completed its transitional goodwill impairment analysis under Financial Accounting Standards Board (“FASB”) Statement (“Statement”) 142 with no impairment charges resulting.

Nonoperating Income

Nonoperating income for the three months ended September 29, 2002, consisted primarily of a net gain on the repurchase of convertible subordinated notes and interest income partially offset by interest expense. The Company’s nonoperating income increased $27.9 million to $30.6 million for the three months ended September 29, 2002, from $2.7 million for the same three months of fiscal 2002. The increase is due primarily to a $28.7 million gain from the repurchase of convertible subordinated notes during the three months ended September 29, 2002. Additionally, while lower interest rates caused lower interest percentage yields, the increase in the Company’s invested funds caused an increase in interest income to $3.7 million for the three months ended September 29, 2002, from $2.6 million for the three months ended September 30, 2001. For the three months ended September 29, 2002, interest expense of $1.8 million associated with the Company’s issuance of convertible subordinated notes during the second half of fiscal 2002 was included.

Income Taxes

For the three months ended September 29, 2002, the Company recorded a tax provision in the amount of $18.6 million or approximately 37 percent of income before income taxes. For the same three months of the prior fiscal year, the Company recorded a tax benefit in the amount of $1.6 million, or four percent of the loss before income taxes. The tax benefit for the same three months of fiscal 2002 was lower than the statutory federal tax rate primarily due to the non-deductibility of the goodwill amortization.

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The Company is undergoing examination by the Internal Revenue Service of its 1998 U.S. tax return. In the opinion of management, this examination will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

New Accounting Standards

In July 2002, the FASB issued Statement 146, “Accounting for Costs Associated with Exit or Disposal Activities”. Statement 146 requires the recognition of costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by Statement 146 include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operations, plant closing or other exit or disposal activities. Statement 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002, with earlier adoption encouraged. The Company believes the adoption of this standard will not have a material impact on the Company’s financial position, results of operations or liquidity.

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. The Company bases its estimates on historical experience and on various other assumptions that the Company believes 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 potentially result in materially different results under different assumptions and conditions.

The Company has identified the following as critical accounting policies: revenue recognition; allowance for doubtful accounts; goodwill, other intangibles, and long-lived assets; inventories; income taxes; and stock-based compensation.

Revenue Recognition. The Company’s revenue recognition policies are in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 101. The Company recognizes revenue at the time of shipment when title and risk of loss have passed, evidence of an arrangement has been obtained, and collectibility has been reasonably assured. The Company makes certain sales through two-tier distribution channels and has various agreements with certain of its distributors and Master Value Added Resellers (collectively the “Distributors”). These 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, the Company recognizes revenues on standard products to its 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. Additionally, the Company maintains appropriate accruals and allowances for these programs.

For products with software upgrade rights, the Company applies the American Institute of Certified Public Accountants Statement of Position, or SOP, 97-2, as amended by SOP 98-9. Under SOP 97-2, as amended by SOP 98-9, revenue is recognized from software licenses, provided the software has been delivered to the customer, persuasive evidence of an arrangement exists, the price charged to the customer is fixed or determinable at fair value and there are no significant Company obligations related to the sale, and the resulting receivable is deemed collectible, net of an allowance for doubtful accounts.

Furthermore, the Company provides a warranty of between one and five years on all products and provides a reserve for warranty costs at the time of shipment based upon actual historic experience.

Allowance for Doubtful Accounts. The Company maintains an allowance for doubtful accounts based upon historical write-offs as a percentage of net revenues. Historically, the Company has not experienced significant losses on accounts receivable.

Goodwill, Other Intangibles, and Long-Lived Assets. Goodwill and other intangibles resulting from the acquisition of Giganet are carried at cost less accumulated amortization. Amortization is computed using the straight-line method over the estimated economic lives of the respective intangible assets, ranging from two to seven years. The Company adopted Statement 142 effective July 1, 2002, and no longer amortizes goodwill and other intangibles that have

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indeterminate useful lives. The adoption of Statement 142 had a significant effect on the Company’s results of operations. The Company has completed its transitional impairment analysis under Statement 142 and found no impairment upon the adoption of Statement 142 as of July 1, 2002. In accordance with Statement 142, goodwill and other intangibles that have indeterminate lives will be tested for impairment at least annually. Any impairment loss could materially and adversely affect the Company’s results of operations.

The Company applies Statement 144, under which the recoverability of long-lived assets is assessed by determining whether the carrying value of an asset can be recovered through projected undiscounted future operating cash flows over its remaining life. 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 (first-in, first-out) or net realizable value. The Company uses a standard cost system for purposes of determining cost. The standards are adjusted periodically to ensure they approximate actual cost. The Company regularly compares forecasted demand and the composition of the forecast for its products against inventory on hand and open purchase commitments to ensure the carrying value of inventory is at net realizable value. Accordingly, the Company may have to increase excess and obsolete inventory reserves as forecasted demand changes.

Income Taxes. The Company accounts for income taxes using the asset and liability method, which recognizes deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. 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. The Company regularly reviews historical and anticipated future pre-tax results of operations to determine whether the Company will be able to realize the benefit of net deferred tax assets.

Stock-Based Compensation. The Company accounts for its stock-based awards to employees using the intrinsic value method. Stock-based awards to non-employees are recorded using the fair value method. See Note 12 of the Consolidated Financial Statements in the Company’s most recently filed Form 10-K for more information.

Liquidity and Capital Resources

At September 29, 2002, the Company had $380.6 million in working capital, and $548.0 million in cash and cash equivalents, restricted cash, current investments and long-term investments. At June 30, 2002, the Company had $558.2 million in working capital, and $631.8 million in cash and cash equivalents, restricted cash, current investments and long-term investments. The Company’s cash and cash equivalents decreased by $153.2 million from $282.6 million as of June 30, 2002, to $129.4 million as of September 29, 2002. This decrease in cash and cash equivalents was due to the Company’s investing and financing activities, which used $71.7 million and $104.0 million of cash and cash equivalents, respectively. The use of cash by investing and financing activities was partially offset by operating activities, which provided $22.5 million of cash and cash equivalents.

Operating activities provided $22.5 million of cash and cash equivalents for the three months ended September 29, 2002. This increase in cash and cash equivalents was primarily from net income before non-cash activity. Such non-cash activity consisted primarily of the gain on the repurchase of convertible subordinated notes, deferred income taxes, depreciation and amortization of property and equipment, amortization of intangibles, stock-based compensation, and the tax benefit from the exercise of stock options. Additional increases in cash and cash equivalents were due to an increase in accounts payable, an increase in income taxes payable; and a decrease in prepaid expenses and other assets. These increases to net cash provided by operating activities were partially offset by an increase in accounts and other receivables, an increase in inventories, and a decrease in accrued liabilities. The increase in inventories of $3.5 million for the three months ended September 29, 2002, included the effect of the reduction of the excess and obsolete inventory reserve of $0.2 million associated with older generation one Gbps products. For the three months ended September 30, 2001, operating activities provided $9.4 million of cash and cash equivalents. This increase in cash and cash equivalents provided by operating activities for the three months ended September 30, 2001, was primarily due to the Company’s net income before non-cash activity such as the amortization of goodwill and other intangibles, stock-based compensation, and depreciation and amortization of property and equipment, as well as changes in other working capital balances. The changes in other working capital balances included the effect of an excess and obsolete charge of $13.6 million associated with older generation one Gbps products.

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Investing activities; including primarily the purchases of investments of $228.8 million, maturities of investments of $159.1 million, and additions to property and equipment of $2.4 million; used $71.7 million of cash and cash equivalents for the three months ended September 29, 2002. For the same three months of fiscal 2002, investing activities; which included purchases of investments of $119.3 million, maturities of investments of $123.1 million, and additions to property and equipment of $2.3 million; provided $1.4 million of cash and cash equivalents.

Financing activities used $104.0 million of cash and cash equivalents for the three months ended September 29, 2002. This decrease in cash and cash equivalents was primarily due to the Company’s repurchase of approximately $136.5 million of convertible subordinated notes at a discount to face value, spending $104.2 million. This decrease in cash and cash equivalents was offset by $0.2 million of proceeds from the issuance of common stock under stock option plans. For the three months ended September 30, 2001, financing activities, which were limited to the repurchase of common stock partially offset by the net proceeds from the exercise of stock options, used $10.3 million of cash and cash equivalents. The Company’s Board of Directors has authorized the repurchase of up to four million common shares over the two years beginning in September 2001. The repurchase plan authorizes the Company to make repurchases in the open market or through privately negotiated transactions with the timing and terms of any purchase to be determined by management based on market conditions. During the first quarter of fiscal 2002, the Company repurchased one million common shares and did not subsequently repurchase any more shares during 2002, or during the three months ended September 29, 2002. During the three months ended September 29, 2002, the Company’s Board of Directors expanded the Company’s repurchase program to include the repurchase of the Company’s convertible subordinated notes as well as shares of the Company’s common stock. The combined program authorized the repurchase of up to four million shares of common stock, leaving three million common shares authorized for repurchase at September 29, 2002, and up to an additional $125.0 million to be spent on the repurchase of convertible subordinated notes, leaving $20.8 million authorized for repurchase at September 29, 2002.

On January 23, 2002, the Company announced a private placement of $300.0 million aggregate principal amount of 1.75 percent convertible subordinate notes due February 1, 2007. Interest is payable in cash on February 1 and August 1 of each year, beginning August 1, 2002. In addition, the Company granted the initial purchasers of the notes a 30-day option, which they exercised, to purchase an additional $45.0 million principal amount of the notes. These notes may be converted 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 may redeem the notes on or after February 5, 2005, in whole or in part. The Company incurred associated issuance costs of approximately $11.0 million. The $345.0 million transaction closed on January 29, 2002. The Company expects to use the net proceeds for general corporate purposes, including working capital and potential acquisitions. The Company currently has no understanding or agreements with respect to any acquisitions, and no assurance can be given that such transactions will be completed. Pending use of the net proceeds, the Company plans to invest the net proceeds in interest–bearing, investment grade securities and money-market instruments.

As noted above, in August 2002 the Company bought back approximately $136.5 million of its convertible subordinated notes at a discount to face value, spending $104.2 million. The repurchased notes were cancelled, leaving convertible subordinated notes outstanding with a face value of $208.5 million, which, if converted, would result in the issuance of approximately 3.9 million shares. The resulting net pre-tax gain of approximately $28.7 million from the repurchase of the convertible subordinated notes was recorded for the three months ended September 29, 2002.

The Company was previously required to enter into an end-of-life purchase agreement for a key inventory component as the sole-source manufacturer of this component announced their discontinued manufacturing of the component. As of September 29, 2002, the Company’s remaining purchase obligation was $10.4 million.

In 2002, the Company entered into an agreement to relocate its headquarters locally in Costa Mesa, California. The Company will finance the build to suit construction phase of the approximately 180 thousand square feet facility with its own capital, before beginning a 10-year lease term with an option to buy the land and buildings during the first six months of the lease term. If the Company does not exercise its option to purchase the facility, the landlord will obtain permanent financing and reimburse the Company for the construction costs. The Company believes the total cost would be less than $40.0 million if purchased. The Company’s total gross undiscounted financial commitment for the 10-year lease term would be approximately $46.0 million. At September 29, 2002, the Company had restricted cash of $1.7 million associated with the construction of the headquarters.

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As part of the Company’s commitment to storage networking product development, including Fibre Channel and IP Networking, the Company expects to continue its investments in property and equipment, most notably for additional engineering equipment, continued enhancement of the Company’s global IT infrastructure, and the local relocation of its Costa Mesa, California facility. The Company believes that its existing cash and cash equivalents balances, facilities and equipment leases, investments, and anticipated cash flows from operating activities will be sufficient to support its working capital needs and capital expenditure requirements for at least the next 12 months.

The following summarizes the Company’s contractual obligations at September 29, 2002, and the effect such obligations are expected to have on the Company’s liquidity and cash flow in future periods: