UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

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

SANDISK CORPORATION

DELAWARE (State or other jurisdiction of incorporation or organization)		77-0191793 (I.R.S. Employer Identification No.)

601 McCarthy Blvd. Milpitas, California (Address of principal executive offices)		95035 (Zip Code)

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.

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

Number of shares outstanding of the issuer’s common stock $0.001 par value, as of September 30, 2007: 229,086,886.

 

 

SanDisk Corporation
Index

				Page No.
PART I. FINANCIAL INFORMATION
Item 1.		Condensed Consolidated Financial Statements:
		Condensed Consolidated Balance Sheets as of September 30, 2007 and December 31, 2006			3
		Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2007 and October 1, 2006			4
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2007 and October 1, 2006			5
		Notes to Condensed Consolidated Financial Statements			6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			44
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			54
Item 4.		Controls and Procedures			54
PART II. OTHER INFORMATION
Item 1.		Legal Proceedings			55
Item 1A.		Risk Factors			60
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			78
Item 3.		Defaults Upon Senior Securities			78
Item 4.		Submission of Matters to a Vote of Security Holders			78
Item 5.		Other Information			78
Item 6.		Exhibits			78
		Signatures			79
		Exhibit Index			80
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements (in thousands)

SANDISK CORPORATION

		September 30, 2007				December 31, 2006*
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	970,920			$	1,580,700
Short-term investments			1,334,677				1,251,493
Accounts receivable from product revenues, net			438,016				611,740
Inventory			545,199				495,984
Deferred taxes			174,352				176,007
Other current assets			142,496				125,937
Total current assets			3,605,660				4,241,861
Long-term investments			923,965				457,184
Property and equipment, net			383,943				317,965
Notes receivable and investments in flash ventures			900,382				462,307
Deferred taxes			109,944				102,100
Goodwill			847,977				910,254
Intangibles, net			342,580				389,078
Other non-current assets			66,255				87,034
Total assets		$	7,180,706			$	6,967,783
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable trade		$	223,343			$	261,870
Accounts payable to related parties			163,869				139,627
Other current accrued liabilities			226,410				311,000
Deferred income on shipments to distributors and retailers and deferred revenue			204,653				183,950
Total current liabilities			818,275				896,447
Convertible long-term debt			1,225,000				1,225,000
Non-current liabilities and deferred taxes			128,004				72,226
Total liabilities			2,171,279				2,193,673
Minority interest			1,067				5,976
Commitments and contingencies
Stockholders’ equity:
Preferred stock			—				—
Common stock			229				226
Capital in excess of par value			3,835,880				3,656,895
Retained earnings			1,151,915				1,105,520
Accumulated other comprehensive income			20,336				5,493
Total stockholders’ equity			5,008,360				4,768,134
Total liabilities and stockholders’ equity		$	7,180,706			$	6,967,783

The accompanying notes are an integral part of these condensed consolidated financial statements.

SANDISK CORPORATION

		Three months ended								Nine months ended
		September 30, 2007				October 1, 2006				September 30, 2007				October 1, 2006
		(In thousands, except per share amounts)
Revenues:
Product		$	918,810			$	673,189			$	2,328,158			$	1,847,592
License and royalty			118,613				78,196				322,383				246,238
Total revenues			1,037,423				751,385				2,650,541				2,093,830
Cost of product revenues			680,521				455,345				1,839,345				1,270,389
Amortization of acquisition-related intangible assets			14,582				—				50,227				—
Total cost of product revenues			695,103				455,345				1,889,572				1,270,389
Gross profit			342,320				296,040				760,969				823,441
Operating expenses:
Research and development			110,533				78,073				307,358				215,620
Sales and marketing			72,455				44,961				189,178				133,403
General and administrative			45,581				40,247				133,737				107,445
Write-off of acquired in-process technology			—				—				—				39,600
Amortization of acquisition-related intangible assets			4,600				4,432				20,750				12,579
Restructuring			—				—				6,728				—
Total operating expenses			233,169				167,713				657,751				508,647
Operating income			109,151				128,327				103,218				314,794
Interest income			31,790				29,943				104,005				68,462
Interest (expense) and other income (expense), net			(2,590	)			2,280				10				4,238
Total other income			29,200				32,223				104,015				72,700
Income before taxes			138,351				160,550				207,233				387,494
Provision for income taxes			53,713				57,269				89,475				153,457
Income after taxes			84,638				103,281				117,758				234,037
Minority interest			—				—				5,211				—
Net income		$	84,638			$	103,281			$	112,547			$	234,037
Net income per share:
Basic		$	0.37			$	0.53			$	0.49			$	1.20
Diluted		$	0.36			$	0.51			$	0.48			$	1.15
Shares used in computing net income per share:
Basic			228,689				196,317				228,034				194,974
Diluted			236,930				202,747				235,992				202,660

The accompanying notes are an integral part of these condensed consolidated financial statements.

SANDISK CORPORATION

		Nine months ended
		September 30, 2007				October 1, 2006
		(In thousands)
Cash flows from operating activities:
Net income		$	112,547			$	234,037
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred and other taxes			89,475				(24,021	)
Gain on equity investments			(2,701	)			(1,364	)
Depreciation and amortization			196,444				89,709
Provision for doubtful accounts			2,977				2,760
Share-based compensation expense			102,317				69,848
Excess tax benefit from share-based compensation			(15,714	)			(64,080	)
Write-off of acquired in-process technology			—				39,600
Other non-cash charges			2,649				3,201
Changes in operating assets and liabilities:
Accounts receivable from product revenues			171,177				28,276
Inventory			(47,211	)			(57,765	)
Other assets			47,001				47,108
Accounts payable trade			(38,596	)			(88,363	)
Accounts payable to related parties			22,513				28,380
Other liabilities			(139,163	)			95,837
Total adjustments			391,168				169,126
Net cash provided by operating activities			503,715				403,163
Cash flows from investing activities:
Purchases of short and long-term investments			(3,145,884	)			(1,438,195	)
Proceeds from sale and maturities of short and long-term investments			2,635,082				881,772
Investment in Flash Partners and Flash Alliance			(38,003	)			(132,209	)
Acquisition of property and equipment, net			(179,903	)			(123,443	)
Proceeds from notes receivable from FlashVision			37,512				8,524
Issuance of notes receivable to Flash Partners			(409,601	)			(95,445	)
Purchased technology and other assets			(27,803	)			—
Cash acquired in business combination, net of acquisition costs			—				9,432
Net cash used in investing activities			(1,128,600	)			(889,564	)
Cash flows from financing activities:
Proceeds from issuance of convertible senior notes, net of issuance costs			—				1,125,500
Purchase of convertible bond hedge			—				(386,090	)
Proceeds from issuance of warrants			—				308,672
Proceeds from debt financing			7,803				—
Proceeds from employee stock programs			97,310				86,108
Distribution to minority interest			(9,880	)			—
Excess tax benefit from share-based compensation			15,714				64,080
Share repurchase programs			(97,417	)			—
Net cash provided by financing activities			13,530				1,198,270
Effect of changes in foreign currency exchange rates on cash			1,575				228
Net increase (decrease) in cash and cash equivalents			(609,780	)			712,097
Cash and cash equivalents at beginning of the period			1,580,700				762,058
Cash and cash equivalents at end of the period		$	970,920			$	1,474,155
Supplemental disclosures of cash flow information:
Issuance of stock for acquisition		$	—			$	260,908

The accompanying notes are an integral part of these condensed consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.

Organization and Summary of Significant Accounting Policies

Organization

     These interim condensed consolidated financial statements are unaudited but reflect, in the opinion of management, all adjustments, consisting of normal recurring adjustments and accruals, necessary to present fairly the financial position of SanDisk Corporation and its subsidiaries (the “Company”) as of September 30, 2007, the condensed consolidated statements of operations for the three and nine months ended September 30, 2007 and October 1, 2006 and the condensed consolidated statements of cash flows for the nine months ended September 30, 2007 and October 1, 2006. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been omitted in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”). These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Company’s most recent Annual Report on Form 10-K. Certain prior period amounts have been reclassified to conform to the current period presentation, including the reclassification of publicly traded unrestricted equity securities from other current assets to short-term investments. The results of operations for the three and nine months ended September 30, 2007 are not necessarily indicative of the results to be expected for the entire fiscal year.

     The Company’s fiscal year ends on the Sunday closest to December 31, and its fiscal quarters end on the Sunday closest to March 31, June 30, and September 30, respectively. The third quarters of fiscal 2007 and fiscal 2006 ended on September 30, 2007 and October 1, 2006, respectively. Fiscal 2007 ends on December 30, 2007 and fiscal 2006 ended on December 31, 2006.

     Organization and Nature of Operations. The Company was incorporated in Delaware on June 1, 1988. The Company designs, develops and markets flash storage products used in a wide variety of consumer electronics products. The Company operates in one segment, flash memory storage products.

     Principles of Consolidation. The condensed consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All intercompany balances and transactions have been eliminated. Minority interest represents the minority shareholders’ proportionate share of the net assets and results of operations of our majority-owned subsidiaries. The condensed consolidated financial statements also include the results of companies acquired by the Company from the date of each acquisition.

     Use of Estimates. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The estimates and judgments affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to customer programs and incentives, product returns, bad debts, inventories and related reserves, investments, income taxes, warranty obligations, restructuring and contingencies, stock compensation and litigation. The Company bases estimates on historical experience and on other assumptions that its management believes are reasonable under the circumstances. These estimates form the basis for making judgments about the carrying values of assets and liabilities when those values are not readily apparent from other sources. Actual results could materially differ from these estimates.

Recent Accounting Pronouncements

     SFAS No. 157. In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, (“SFAS 157”), Fair Value Measurements. SFAS 157 defines fair value, establishes a market-based framework or hierarchy for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measures. The provisions of SFAS 157 are to be applied

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

prospectively and are effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is currently evaluating what effect, if any, the adoption of SFAS 157 will have on the Company’s consolidated results of operations and financial position.

     SFAS No. 159. In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159 (“SFAS 159”), Establishing the Fair Value Option for Financial Assets and Liabilities. The FASB has issued SFAS 159 to permit all entities to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157. An entity is prohibited from retrospectively applying SFAS 159, unless it chooses early adoption. SFAS 159 also applies to eligible items existing at November 15, 2007 (or early adoption date). The Company has not completed its analysis but does not expect the adoption of SFAS 159 to have a material effect on the Company’s results of operations and financial condition.

     EITF Issue No. 07-3. In the June 2007 meeting, the Emerging Issues Task Force (“EITF”), reached a final consensus on EITF Issue No. 07-3 (“EITF 07-3”), Accounting for Advance Payments for Goods or Services to be Received for Use in Future Research and Development Activities. The consensus requires companies to defer and capitalize prepaid, nonrefundable research and development payments to third parties over the period that the research and development activities are performed or the services are provided, subject to an assessment of recoverability. EITF 07-3 is effective for new contracts entered into in fiscal years beginning after December 15, 2007, including interim periods within those fiscal years. The Company will adopt this pronouncement beginning in the first quarter of fiscal 2008 and does not expect the adoption of EITF 07-3 to have a material impact on its consolidated results of operations and financial condition.

     FSP No. APB 14-a. The FASB issued a proposed FASB Staff Position (“FSP”) No. APB 14-a, Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement). The proposed FSP would require the issuer to separately account for the liability and equity components of the instrument in a manner that reflects the issuer’s economic interest cost. Further, the proposed FSP would require bifurcation of a component of the debt, classification of that component to equity, and then accretion of the resulting discount on the debt to result in the “economic interest cost” being reflected in the statement of operations. In applying this FSP, the FASB emphasized that the FSP would be applied to the terms of the instruments as they existed for the time periods they existed, therefore, the application of the FSP would be applied retrospectively to all periods presented. If the final FSP is issued as currently drafted, it will be effective for the fiscal years beginning after December 15, 2007. While the proposed FSP has not yet been finalized by the FASB, the Company’s initial estimate based upon the current interpretations by the FASB, is that the Company would be required to report an additional before tax, non-cash interest expense of approximately $400 million over the life of the 1% Senior Convertible Notes due 2013, including approximately $50 million to $55 million in fiscal 2008. However, these amounts are subject to material change based upon finalization of the proposed FSP.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

2.	Balance Sheet Detail

     Accounts Receivable from Product Revenues, net. Accounts receivable from product revenues, net, were as follows (in thousands):

		September 30, 2007				December 31, 2006
Trade accounts receivable		$	826,469			$	1,056,616
Related party accounts receivable			10,209				41,708
Allowance for doubtful accounts			(14,235	)			(11,452	)
Price protection, promotions and other activities			(384,427	)			(475,132	)
Total accounts receivable from product revenues, net		$	438,016			$	611,740

     Inventory. Inventories, net of reserves, were as follows (in thousands):

		September 30, 2007				December 31, 2006
Raw material		$	192,825			$	157,163
Work-in-process			84,530				64,009
Finished goods			267,844				274,812
Total inventory		$	545,199			$	495,984

     Other Current Assets. Other current assets were as follows (in thousands):

		September 30, 2007				December 31, 2006
Royalty and other receivables		$	96,623			$	82,569
Prepaid expenses			29,767				22,276
Other current assets			16,106				21,092
Total other current assets		$	142,496			$	125,937

     Notes Receivable and Investments in Flash Ventures. Notes receivable and investments in flash ventures were as follows (in thousands):

		September 30, 2007				December 31, 2006
Notes receivable, FlashVision		$	—			$	38,229
Notes receivable, Flash Partners			515,800				92,421
Investment in FlashVision			166,228				159,144
Investment in Flash Partners			175,079				168,210
Investment in Flash Alliance			43,275				4,303
Total notes receivable and investments in flash ventures		$	900,382			$	462,307

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     Other Current Accrued Liabilities. Other current accrued liabilities were as follows (in thousands):

		September 30, 2007				December 31, 2006
Accrued payroll and related expenses		$	80,734			$	61,050
Taxes payable			5,504				119,502
Research and development liability, related party			4,121				5,850
Other accrued liabilities			136,051				124,598
Total other current accrued liabilities		$	226,410			$	311,000

     Convertible Long-term Debt. The carrying value of convertible long-term debt as of September 30, 2007 and December 31, 2006 was as follows (in thousands):

		September 30, 2007				December 31, 2006
1% Senior Convertible Notes due 2013		$	1,150,000			$	1,150,000
1% Convertible Notes due 2035			75,000				75,000
Total convertible long-term debt		$	1,225,000			$	1,225,000

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

3. Share-Based Compensation

     Share-Based Plans. The Company has a share-based compensation program that provides its Board of Directors with broad discretion in creating equity incentives for employees, officers, non-employee board members and non-employee service providers. This program includes incentive and non-statutory stock option awards, stock appreciation right awards, restricted stock awards, performance-based cash bonus awards for Section 16 executive officers and an automatic grant program for non-employee board members pursuant to which such individuals will receive option grants or other stock awards at designated intervals over their period of board service. These awards are granted under various plans, all of which are stockholder approved. Option awards generally vest as follows: 25% of the shares vest on the first anniversary of the vesting commencement date and the remaining 75% vest proportionately each quarter over the next 12 quarters of continued service. Awards under the stock issuance program generally vest in equal annual installments over a 4 year period. Initial grants under the automatic grant program vest over a 4-year period and subsequent grants vest over a 1-year period in accordance with the specific vesting provisions set forth in that program. Additionally, the Company has an Employee Stock Purchase Plan (“ESPP”) that allows employees to purchase shares of common stock at 85% of the fair market value at the subscription date or the date of purchase, whichever is lowest.

     Valuation Assumptions. The fair value of the Company’s stock options granted to employees, officers and non-employee board members and ESPP shares granted to employees for the three and nine months ended September 30, 2007 and October 1, 2006 was estimated using the following weighted average assumptions:

		Three months ended								Nine months ended
		September 30, 2007				October 1, 2006				September 30, 2007				October 1, 2006
Option Plan Shares
Dividend yield		None				None				None				None
Expected volatility			0.39				0.50				0.43				0.53
Risk free interest rate			4.33	%			4.85	%			4.54	%			4.63	%
Expected lives		3.3 years				3.3 years				3.4 years				3.8 years
Estimated annual forfeiture rate			7.59	%			7.74	%			7.59	%			7.74	%
Weighted average fair value at grant date		$	17.74			$	20.34			$	15.90			$	26.70
Employee Stock Purchase Plan Shares
Dividend yield		None				None				None				None
Expected volatility			0.41				0.51				0.43				0.52
Risk free interest rate			4.96	%			5.18	%			5.08	%			4.96	%
Expected lives		1/2 year				1/2 year				1/2 year				1/2 year
Weighted average fair value for grant period		$	14.52			$	13.73			$	12.75			$	16.73

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

Share-Based Compensation Plan Activities

     Stock Options and SARs. Stock option and Stock Appreciation Right (“SAR”) activity for the nine months ended September 30, 2007, is presented below (in thousands, except exercise price and contractual term):

										Weighted
										Average
						Weighted				Remaining				Aggregate
						Average				Contractual				Intrinsic
		Shares				Exercise Price				Term (Years)				Value
Options and SARs outstanding at December 31, 2006			26,392			$	31.97
Granted			5,200				44.15
Exercised			(4,393	)			20.84
Forfeited			(1,411	)			46.15
Expired			(207	)			57.44
Options and SARs outstanding at September 30, 2007			25,581				35.38				6.0			$	528,652
Options and SARs vested and expected to vest after September 30, 2007, net of forfeitures			23,700				34.42				5.9				508,711
Options and SARs exercisable at September 30, 2007			11,751			$	25.09				5.2			$	361,729

     During the three and nine months ended September 30, 2007 and October 1, 2006, the aggregate intrinsic value of stock options and SARs exercised under the Company’s share-based compensation plans was $59.2 million, $115.5 million, $18.2 million and $194.6 million, respectively. At September 30, 2007, the total compensation cost related to options granted to employees under the Company’s share-based compensation plans but not yet recognized was approximately $220.4 million, net of estimated forfeitures. The unamortized compensation expense will be amortized on a straight-line basis, and the weighted average period of this expense is approximately 2.7 years.

     Restricted Stock Units. Restricted stock units (“RSUs”) are converted into shares of the Company’s common stock upon vesting on a one-for-one basis. Typically, vesting of RSUs is subject to the employee’s continuing service to the Company. The cost of these awards is determined using the fair value of the Company’s common stock on the date of the grant, and compensation is recognized on a straight-line basis over the requisite vesting period.

     A summary of the changes in RSUs outstanding under the Company’s share-based compensation plan during the nine months ended September 30, 2007 is presented below (in thousands, except for grant date fair value):

						Weighted
						Average Grant				Aggregate
		Shares				Date Fair Value				Intrinsic Value
Non-vested RSUs at December 31, 2006			598			$	58.71
Granted			130				44.95
Vested			(179	)			56.49
Forfeited			(38	)			66.61
Non-vested RSUs at September 30, 2007			511			$	55.42			$	28,146

     As of September 30, 2007, the Company had $24.0 million of total unrecognized compensation expense, net of estimated forfeitures, related to RSUs. The unamortized compensation expense will be recognized on a straight-line basis, and the weighted average estimated remaining life is 2.6 years.

     Employee Stock Purchase Plan. At September 30, 2007, there was $1.5 million of total unrecognized compensation cost related to the ESPP that is expected to be recognized over a period of approximately 4 months.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     Share-Based Compensation Expense. Share-based compensation expense for the three and nine months ended September 30, 2007 and October 1, 2006, is presented below (in thousands):

		Three months ended								Nine months ended
		September 30, 2007				October 1, 2006				September 30, 2007				October 1, 2006
Share-based compensation expense by caption:
Cost of product sales		$	4,162			$	2,621			$	10,683			$	5,098
Research and development			12,528				10,269				38,228				29,476
Sales and marketing			7,956				4,623				25,240				13,788
General and administrative			9,481				7,679				28,166				21,486
Total share-based compensation expense		$	34,127			$	25,192			$	102,317			$	69,848
Share-based compensation expense by type of award:
Stock options and SARs		$	28,552			$	21,262			$	85,216			$	59,010
Restricted stock and RSUs			4,095				2,888				13,275				8,127
ESPP			1,480				1,042				3,826				2,711
Total share-based compensation expense		$	34,127			$	25,192			$	102,317			$	69,848

     Share-based compensation expense of $4.1 million and $2.9 million related to manufacturing personnel was capitalized into inventory as of September 30, 2007 and October 1, 2006, respectively.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

4. Restructuring

     During the first quarter of fiscal 2007, the Company implemented a restructuring plan which included reductions in workforce in all functions of the organization worldwide and closures of redundant facilities in order to reduce the Company’s cost structure. A restructuring charge of $6.7 million was recorded during the nine months ended September 30, 2007, of which $6.0 million related to severance and benefits to 149 terminated employees and the remaining was primarily for excess lease obligations. All expenses, including adjustments, associated with the Company’s restructuring plans are included in “Restructuring” in the Condensed Consolidated Statements of Operations.

     The following table sets forth an analysis of the components of the restructuring charge and payments made against the reserve for the nine months ended September 30, 2007 (in thousands):

						Lease
						Obligations
		Severance and				and Other
		Benefits				Charges				Total
Restructuring provision		$	5,970			$	758			$	6,728
Cash paid			(5,631	)			(360	)			(5,991	)
Reserve balance at September 30, 2007		$	339			$	398			$	737

     The Company anticipates that the remaining restructuring reserve balance will be paid out in cash through the first quarter of fiscal 2010.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

5.

Warranty

     Changes to the Company’s warranty reserve activity are presented below (in thousands):

		Three months ended								Nine months ended
		September 30, 2007				October 1, 2006				September 30, 2007				October 1, 2006
Balance, beginning of period		$	13,164			$	9,661			$	15,338			$	11,258
Additions and adjustments to costs of product revenue			2,492				1,836				7,280				627
Usage			(856	)			(924	)			(7,818	)			(1,312	)
Balance, end of period		$	14,800			$	10,573			$	14,800			$	10,573

     The majority of the Company’s products have a warranty ranging from one to five years. A provision for the estimated future cost related to warranty expense is recorded at the time of customer invoice. The Company’s warranty obligation is affected by customer and consumer returns, product failures and repair or replacement costs incurred.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

6. Goodwill and Other Intangible Assets

     Goodwill. Goodwill balance is presented below (in thousands):

Balance at December 31, 2006		$	910,254
Goodwill adjustment			(62,277	)
Balance at September 30, 2007		$	847,977

     The goodwill adjustment in the nine months ended September 30, 2007 was primarily the result of purchase price adjustments related to the msystems Ltd. (“msystems”) acquisition and to a lesser extent from the Matrix Semiconductor, Inc. (“Matrix”) acquisition. See Note 12, “Business Acquisition.”

     Intangible Assets. Intangible asset balances are presented below (in thousands):

		September 30, 2007												December 31, 2006
		Gross								Net				Gross								Net
		Carrying				Accumulated				Carrying				Carrying				Accumulated				Carrying
		Amount				Amortization				Amount				Amount				Amortization				Amount
Core technology		$	311,801			$	(64,688	)		$	247,113			$	311,801			$	(18,135	)		$	293,666
Developed product technology			12,900				(4,199	)			8,701				12,900				(2,103	)			10,797
Trademarks			4,000				(4,000	)			—				4,000				(911	)			3,089
Backlog			5,000				(5,000	)			—				5,000				(1,139	)			3,861
Supply agreement			2,000				(2,000	)			—				2,000				(46	)			1,954
Customer relationships			80,100				(19,432	)			60,668				80,100				(6,008	)			74,092
Acquisition-related intangible assets			415,801				(99,319	)			316,482				415,801				(28,342	)			387,459
Technology licenses and patents			38,911				(12,813	)			26,098				7,388				(5,769	)			1,619
Total		$	454,712			$	(112,132	)		$	342,580			$	423,189			$	(34,111	)		$	389,078

     Gross intangible assets increased by $31.5 million in the nine months ended September 30, 2007, primarily due to technology licenses and patents obtained from third parties.

     The annual expected amortization expense of intangible assets that existed as of September 30, 2007, is presented below (in thousands):

		Estimated Amortization Expenses
		Acquisition-Related				Technology Licenses
Fiscal periods:		Intangible Assets				and Patents
2007 (remaining three months)		$	19,140			$	2,791
2008			76,229				10,478
2009			71,724				3,023
2010			71,529				3,023
2011			64,809				3,023
2012 and thereafter			13,051				3,760
Total		$	316,482			$	26,098

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

7. Accumulated Other Comprehensive Income

     Accumulated other comprehensive income, net of tax, presented in the accompanying balance sheets consists of the accumulated unrealized gains and losses on available-for-sale marketable securities, including the Company’s investments in equity securities, as well as currency translation adjustments relating to local currency denominated subsidiaries and equity investees (in thousands).

		September 30, 2007				December 31, 2006
Accumulated net unrealized gain (loss) on:
Available-for-sale investments		$	8,243			$	(2,528	)
Foreign currency translation			12,093				8,021
Total accumulated other comprehensive income		$	20,336			$	5,493

     Comprehensive net income is presented below (in thousands):

		Three months ended								Nine months ended
		September 30, 2007				October 1, 2006				September 30, 2007				October 1, 2006
Net income		$	84,638			$	103,281			$	112,547			$	234,037
Unrealized income on available-for-sale investments			8,792				1,340				10,771				4,880
Foreign currency translation income (loss)			17,754				(6,109	)			4,072				(1,310	)
Comprehensive net income		$	111,184			$	98,512			$	127,390			$	237,607

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

8.

Net Income Per Share

     The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share amounts):

		Three months ended								Nine months ended
		September 30, 2007				October 1, 2006				September 30, 2007				October 1, 2006
Numerator for basic net income per share:
Net income, as reported		$	84,638			$	103,281			$	112,547			$	234,037
Denominator for basic net income per share:
Weighted average common shares outstanding			228,689				196,317				228,034				194,974
Basic net income per share		$	0.37			$	0.53			$	0.49			$	1.20
Numerator for diluted net income per share:
Net income, as reported		$	84,638			$	103,281			$	112,547			$	234,037
Interest on the 1% Convertible Notes due 2035, net of tax			116				—				348				—
Net income used in computing diluted net income per share		$	84,754			$	103,281			$	112,895			$	234,037
Denominator for diluted net income per share:
Weighted average common shares outstanding			228,689				196,317				228,034				194,974
Effect of dilutive 1% Convertible Notes due 2035			2,012				—				2,012				—
Effect of dilutive options and restricted stock			6,229				6,430				5,946				7,686
Shares used in computing diluted net income per share			236,930				202,747				235,992				202,660
Diluted net income per share		$	0.36			$	0.51			$	0.48			$	1.15
Anti-dilutive shares excluded from net income per share calculation			39,840				34,478				39,777				32,679

     Basic earnings per share exclude any dilutive effects of stock options, SARs, RSUs, warrants and convertible securities. Diluted earnings per share include the dilutive effects of stock options, SARs, RSUs, warrants and the 1% Convertible Notes due 2035. Certain common stock issuable under stock options, SARs, warrants and the 1% Senior Convertible Notes due 2013 have been omitted from the diluted net income per share calculation because their inclusion is considered anti-dilutive.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

9. Share Repurchase Program

     During the fourth quarter of fiscal 2006, the Company’s Board of Directors authorized the repurchase of up to $300 million of the Company’s common stock in the open market over two years following the date of authorization. Share repurchases have been and will be made from time-to-time in the open market at the Company’s discretion within the authorized program. The stock repurchase program does not obligate the Company to repurchase any particular amount of shares and may be suspended at the Company’s discretion. During the nine months ended September 30, 2007, the Company repurchased 2.3 million shares, for an aggregate purchase price of approximately $97.4 million, all of which are held as treasury stock and accounted for using the cost method. Approximately $70.0 million of the shares repurchased during the nine months ended September 30, 2007 were effected through prepaid forward variable share repurchase agreements with a third-party investment bank, which enable the Company to repurchase shares at a discount of the Volume Weighted Average Price of its common shares over the period.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

10. Commitments, Contingencies and Guarantees

     FlashVision. The Company has a 49.9% ownership interest in FlashVision Ltd. (“FlashVision”), a business venture with Toshiba Corporation (“Toshiba”), formed in fiscal 2000. In the venture, the Company and Toshiba have collaborated in the development and manufacture of NAND flash memory products. These NAND flash memory products are manufactured by Toshiba at its 200-millimeter wafer fabrication facilities, located in Yokkaichi, Japan, using the semiconductor manufacturing equipment owned or leased by FlashVision. FlashVision purchases wafers from Toshiba at cost and then resells those wafers to the Company and Toshiba at cost plus a markup. Toshiba owns 50.1% of this venture. The Company accounts for its 49.9% ownership position in FlashVision under the equity method of accounting. The terms of the FlashVision venture contractually obligate the Company to purchase its provided three-month forecast of FlashVision’s NAND wafer supply, which generally equals 50 percent of the venture’s output. The Company cannot estimate the total amount of this commitment as of September 30, 2007, because it is based upon future costs and volumes. In addition, the Company is committed to fund 49.9% of FlashVision’s costs to the extent that FlashVision’s revenues from wafer sales to the Company and Toshiba are insufficient to cover these costs.

     The Company agreed to indemnify Toshiba for certain liabilities Toshiba incurs as a result of Toshiba’s guarantee of the FlashVision equipment lease arrangement. If FlashVision fails to meet its lease commitments, and Toshiba fulfills these commitments under the terms of Toshiba’s guarantee, then the Company will be obligated to reimburse Toshiba for 49.9% of any claims and associated expenses under the lease, unless the claims result from Toshiba’s failure to meet its obligations to FlashVision or its covenants to the lenders. Because FlashVision’s equipment lease arrangement is denominated in Japanese yen, the maximum amount of the Company’s contingent indemnification obligation on a given date when converted to U.S. dollars will fluctuate based on the exchange rate in effect on that date. See “Off Balance Sheet Liabilities.”

     Flash Partners. The Company has a 49.9% ownership interest in Flash Partners Ltd. (“Flash Partners”), a business venture with Toshiba, formed in fiscal 2004. In the venture, the Company and Toshiba have collaborated in the development and manufacture of NAND flash memory products. These NAND flash memory products are manufactured by Toshiba at the 300-millimeter wafer fabrication facility, Fab 3, located in Yokkaichi, Japan, using the semiconductor manufacturing equipment owned or leased by Flash Partners. Flash Partners purchases wafers from Toshiba at cost and then resells those wafers to the Company and Toshiba at cost plus a markup. Toshiba owns 50.1% of this venture. The Company accounts for its 49.9% ownership position in Flash Partners under the equity method of accounting. The Company is committed to purchase its provided three-month forecast of Flash Partner’s NAND wafer supply, which generally equals 50 percent of the venture’s output. The Company cannot estimate the total amount of this commitment as of September 30, 2007 because it is based upon future costs and volumes. In addition, the Company is committed to fund 49.9% of Flash Partners’ costs to the extent that Flash Partners’ revenues from wafer sales to the Company and Toshiba are insufficient to cover these costs.

     As of September 30, 2007, the Company had notes receivable from Flash Partners of 59.3 billion Japanese yen, or approximately $516 million based upon the exchange rate at September 30, 2007. These notes are secured by the equipment purchased by Flash Partners using the note proceeds. The Company has additional guarantee obligations to Flash Partners, see “Off Balance Sheet Liabilities.”

     Flash Alliance. The Company has a 49.9% ownership interest in Flash Alliance Ltd. (“Flash Alliance”), a business venture with Toshiba, formed in fiscal 2006. In the venture, the Company and Toshiba have collaborated in the development and manufacture of NAND flash memory products. These NAND flash memory products are manufactured by Toshiba at its 300-millimeter wafer fabrication facility, Fab 4, in Yokkaichi, Japan, using the semiconductor manufacturing equipment owned or leased by Flash Alliance. Flash Alliance purchases wafers from Toshiba at cost and then resells those wafers to the Company and Toshiba at cost plus a markup. Toshiba owns 50.1% of this venture. The Company accounts for its 49.9% ownership position in Flash Alliance under the equity method of accounting. The Company is committed to purchase its provided three-month forecast of Flash Alliance’s NAND wafer supply, which is expected to equal 50 percent of the venture’s output. In addition, the Company is committed to fund 49.9% of Flash Alliance’s costs to the extent that Flash Alliance’s revenues from wafer sales to the Company and Toshiba are insufficient to cover these costs.

     As a part of the FlashVision, Flash Partners and Flash Alliance venture agreements, the Company is required to fund direct and common research and development expenses related to the development of advanced NAND flash memory technologies. As of September 30, 2007, the Company had accrued liabilities related to these expenses of $4.1 million.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     Toshiba Foundry. The Company has the ability to purchase additional capacity under a foundry arrangement with Toshiba. Under the terms of this agreement, the Company is required to provide Toshiba with a purchase order commitment based on a nine-month rolling forecast.

     TwinSys. The Company had a 50.1% beneficial ownership in TwinSys Data Storage Limited Partnership (“TwinSys”), a business venture with Toshiba, consisting of (i) 49.9% ownership in TwinSys and (ii) 0.2% interest held by TwinSys Ltd., in which the Company has a 51% ownership interest. The Company and Toshiba terminated the operations of TwinSys as of March 31, 2007.

     Business Ventures and Foundry Arrangement with Toshiba. Purchase orders placed under the Toshiba ventures and the foundry arrangement with Toshiba for up to three months are binding and cannot be canceled.

     Other Silicon Sources. The Company’s contracts with the other sources of silicon wafers generally require the Company to provide purchase order commitments based on nine-month rolling forecasts. The purchase orders placed under these arrangements relating to the first three months of the nine-month forecast are generally binding and cannot be canceled. Outstanding purchase commitments for other sources of silicon wafers are included as part of the total “Noncancelable production purchase commitments” in the “Contractual Obligations” table below.

     Subcontractors. In the normal course of business, the Company’s subcontractors periodically procure production materials based on the forecast the Company provides to them. The Company’s agreements with these subcontractors require that it reimburse them for materials that are purchased on the Company’s behalf in accordance with such forecast. Accordingly, the Company may be committed to certain costs over and above its open noncancelable purchase orders with these subcontractors. Outstanding purchase commitments to subcontractors are included as part of the total “Noncancelable production purchase commitments” in the “Contractual Obligations” table below.

Off Balance Sheet Liabilities

     The following table details the Company’s portion of the remaining indemnification or guarantee obligations under each of the FlashVision and Flash Partners master lease facilities in both Japanese yen and United States dollar equivalent based upon the exchange rate at September 30, 2007.

Master Lease Agreements by Execution Date		Lease Amounts(1)								Expiration
		(Yen in billions)				(Dollars in millions)
FlashVision
June 2006		¥	4.0			$	34				2009
Flash Partners
December 2004			17.0				148				2010
December 2005			13.0				113				2011
June 2006			12.3				108				2011
September 2006			41.2				358				2011
March 2007			28.5				248				2012
Total Flash Partners			112.0				975
Total indemnification and guarantee obligations		¥	116.0			$	1,009

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     FlashVision. FlashVision has an equipment lease arrangement of approximately 15.0 billion Japanese yen, or approximately $131 million based upon the exchange rate at September 30, 2007. Lease payments are due quarterly and are scheduled to be completed in February 2009 and a residual payment of 3.0 billion Japanese yen, or approximately $26 million based upon the exchange rate at September 30, 2007, will be due in May 2009. Under the terms of the refinanced lease, Toshiba guaranteed these commitments on behalf of FlashVision. The Company agreed to indemnify Toshiba for certain liabilities Toshiba incurs as a result of Toshiba’s guarantee of the FlashVision equipment lease arrangement. If FlashVision fails to meet its lease commitments, and Toshiba fulfills these commitments under the terms of Toshiba’s guarantee, then the Company will be obligated to reimburse Toshiba for 49.9% of any claims and associated expenses under the lease, unless the claims result from Toshiba’s failure to meet its obligations to FlashVision or its covenants to the lenders. Because FlashVision’s equipment lease arrangement is denominated in Japanese yen, the maximum amount of the Company’s contingent indemnification obligation on a given date when converted to U.S. dollars will fluctuate based on the exchange rate in effect on that date. As of September 30, 2007, the maximum amount of the Company’s contingent indemnification obligation, which reflects payments and any lease adjustments, was approximately 4.0 billion Japanese yen, or approximately $34 million based upon the exchange rate at September 30, 2007.

     Flash Partners. Flash Partners sells and leases-back from a consortium of financial institutions a portion of its tools and has entered into and drawn down five equipment master lease agreements totaling approximately 275.0 billion Japanese yen, or approximately $2.4 billion based upon the exchange rate at September 30, 2007, of which 224.1 billion Japanese yen, or approximately $2.0 billion based upon the exchange rate at September 30, 2007, was outstanding at September 30, 2007. The Company and Toshiba have each guaranteed, on a several basis, 50% of Flash Partners’ obligations under the master lease agreements. As of September 30, 2007, the maximum amount of the Company’s guarantee obligation of the Flash Partners master lease agreements, which reflects payments and any lease adjustments, was approximately 112.0 billion Japanese yen, or approximately $975 million based upon the exchange rate at September 30, 2007. Lease payments are due quarterly or semi-annually and are scheduled to be completed in stages through fiscal 2012. At the end of each of the lease terms, Flash Partners has the option of purchasing the tools from the lessors. Flash Partners is obligated to insure the equipment, maintain the equipment in accordance with the manufacturers’ recommendations and comply with other customary terms to protect the leased assets. The master lease agreements contain covenants, the most restrictive of which require the Company to maintain a minimum shareholder equity balance of $1.16 billion as well as a long-term loan rating of BB- or Ba3, based on a named independent rating service. In addition, the master lease agreements contain customary events of default for a Japanese lease facility. The master lease agreements are exhibits to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006. These agreements should be read carefully in their entirety for a comprehensive understanding of their terms and the nature of the obligations the Company guaranteed. The fair value of the Company’s guarantee of Flash Partners’ lease obligations was insignificant at inception of each of the guarantees. In addition, Flash Partners expects to secure additional equipment lease facilities over time, which the Company may be required to guarantee in whole or in part.

Guarantees

     Indemnification Agreements. The Company has agreed to indemnify suppliers and customers for alleged patent infringement. The scope of such indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorneys’ fees. The Company may periodically engage in litigation as a result of these indemnification obligations. The Company’s insurance policies exclude coverage for third-party claims for patent infringement. Although the liability is not remote, the nature of the patent infringement indemnification obligations prevents the Company from making a reasonable estimate of the maximum potential amount it could be required to pay to its suppliers and customers. Historically, the Company has not made any significant indemnification payments under any such agreements. As of September 30, 2007, no amount had been accrued in the accompanying condensed consolidated financial statements with respect to these indemnification guarantees.

     As permitted under Delaware law and the Company’s charter and bylaws, the Company has agreements, or has assumed agreements in connection with its acquisitions, whereby it indemnifies certain of its officers, employees and each of its directors for certain events or occurrences while the officer, employee or director is, or was, serving at the Company’s or the acquired company’s request in such capacity. The term of the indemnification period is for the officer’s, employee’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is generally unlimited; however, the Company has a Director and Officer insurance policy that may reduce its exposure and enable it to recover all or a portion of any future amounts paid. As a result of its insurance policy

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. The Company has no liabilities recorded for these agreements as of September 30, 2007 or December 31, 2006, as this liability is not reasonably estimable even though liability under these agreements is not remote.

     The Company and Toshiba have agreed to mutually contribute to, and indemnify each other, Flash Partners and Flash Alliance, for environmental remediation costs or liability resulting from Flash Partners or Flash Alliance’s manufacturing operations in certain circumstances. In fiscal 2004 and 2006, respectively, the Company and Toshiba each engaged consultants to perform a review of the existing environmental conditions at the site of the facilities at which Flash Partners and Flash Alliance operations are located to establish a baseline for evaluating future environmental conditions. The Company and Toshiba have also entered into a Patent Indemnification Agreement under which in many cases the Company will share in the expenses associated with the defense and cost of settlement associated with such claims. This agreement provides limited protection for the Company against third-party claims that NAND flash memory products manufactured and sold by Flash Partners or Flash Alliance infringe third-party patents. The Company has not made any indemnification payments under any such agreements and as of September 30, 2007, no amounts have been accrued in the accompanying condensed consolidated financial statements with respect to these indemnification guarantees.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

Contractual Obligations and Off Balance Sheet Arrangements

     Contractual Obligations. The following summarizes the Company’s contractual cash obligations, commitments and off balance sheet arrangements at September 30, 2007, and the effect such obligations are expected to have on its liquidity and cash flows in future periods (in thousands).

																		More than 5
						Less than				2 - 3 Years				4 –5 Years				Years
						1 Year				(Fiscal 2008				(Fiscal 2010				(Beyond
		Total				(3 months)				and 2009)				and 2011)				Fiscal 2011)				Other
Operating leases		$	42,444			$	2,177			$	16,479			$	13,409			$	10,379			$	—
FlashVision fabrication capacity expansion costs, and reimbursement for certain other costs including depreciation			150,106	(4)			16,943				115,943				16,949				271				—
Flash Partners fabrication capacity expansion and reimbursement for certain other costs including depreciation			2,079,778	(4)			220,790				1,071,311				660,932				126,745				—
Flash Alliance fabrication capacity expansion and reimbursement for certain other costs including depreciation and start-up			2,450,369	(4)			105,428				1,538,875				523,999				282,067				—
Toshiba research and development			14,200	(4)			4,200				10,000				—				—				—
Capital equipment purchases commitments			74,979				74,979				—				—				—				—
Convertible notes principal and interest (1)			1,310,241				3,063				24,500				24,500				1,258,178				—
Income taxes payable (2)			55,731				—				—				—				—				55,731
Operating expense commitments			80,730				80,730				—				—				—				—
Noncancelable production purchase commitments (3)			437,449	(4)			437,449				—				—				—				—
Total contractual cash obligations		$	6,696,027			$	945,759			$	2,777,108			$	1,239,789			$	1,677,640			$	55,731

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

Off Balance Sheet Arrangements.

		As of
		September 30, 2007
Indemnification of FlashVision foundry equipment lease (5)		$	34,260
Guarantee of Flash Partners equipment leases (6)		$	975,371

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     The Company leases many of its office facilities and operating equipment for various terms under long-term, noncancelable operating lease agreements. The leases expire at various dates from fiscal 2007 through 2016. Future minimum lease payments at September 30, 2007 are presented below (in thousands):

Fiscal Year Ending:
2007 (three months)		$	2,365
2008			9,176
2009			9,035
2010			8,044
2011			6,387
2012 and beyond			10,379
Total operating leases			45,386
Sublease income			2,942
		$	42,444

     Foreign Currency Exchange and Other Contracts. The Company transacts business in various foreign currencies. Exposure to foreign currency exchange rate fluctuations arises mainly from non-functional currency denominated trade accounts payable, intercompany accounts and loans receivable from related parties. The Company utilizes foreign currency forward contracts to minimize the risk associated with foreign exchange effects of trade accounts payable, intercompany accounts and loans receivable from related parties. As a result, increases or decreases in these accounts due to foreign exchange rate changes are offset by gains and losses on the forward contracts so as to minimize foreign currency transaction gains and losses. All foreign currency balances and all outstanding forward contracts are marked-to-market at September 30, 2007 with unrealized gains and losses included in “Other income” of the Condensed Consolidated Statements of Operations. As of September 30, 2007, the Company had foreign currency exchange contract lines available in the amount of $1.57 billion to enter into foreign currency forward contracts. The Company had foreign currency forward contracts in place with a net notional amount of 48.0 billion Japanese yen, or approximately $417 million based upon the exchange rate at September 30, 2007. For the three and nine months ended September 30, 2007, foreign currency contracts resulted in a loss of $9.5 million and $5.2 million, respectively, including forward point income, offset by the foreign currency exposures hedged by these forward contracts which had gains of $13.1 million and $10.1 million for the three and nine months ended September 30, 2007, respectively. The Company has outstanding cash flow hedges designated to mitigate equity risk associated with certain available-for-sale equity securities totaling approximately $64.3 million. The changes in the fair value of the cash flow hedges are included in accumulated other comprehensive income and were immaterial for the nine months ended September 30, 2007. The Company does not enter into derivatives for speculative or trading purposes.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

11.

Related Parties and Strategic Investments

     Toshiba. The Company and Toshiba have collaborated in the development and manufacture of NAND flash memory products. These NAND flash memory products are manufactured by Toshiba at Toshiba’s Yokkaichi, Japan operations using the semiconductor manufacturing equipment owned or leased by FlashVision, Flash Partners or Flash Alliance. See also Note 10, “Commitments, Contingencies and Guarantees.” The Company purchased NAND flash memory wafers from FlashVision, Flash Partners and Toshiba, made payments for shared research and development expenses, made loans to Flash Partners and made investments in Flash Partners and Flash Alliance totaling approximately $324.1 million, $890.8 million, $228.6 million and $791.2 million in the three months and nine months ended September 30, 2007 and October 1, 2006, respectively. The purchases of NAND flash memory wafers are ultimately reflected as a component of the Company’s cost of product revenues. During the three months and nine months ended September 30, 2007, the Company had sales to Toshiba of $9.6 million and $19.1 million, respectively, compared to zero in the comparable periods in the prior year. At September 30, 2007 and December 31, 2006, the Company had accounts payable balances due to Toshiba of $1.7 million and $19.2 million, respectively, and accounts receivable balances from Toshiba of $6.9 million and $1.4 million, respectively. At September 30, 2007 and December 31, 2006, the Company had accrued current liabilities due to Toshiba for shared research and development expenses of $4.1 million and $5.9 million, respectively.

     Flash Ventures with Toshiba. The Company owns 49.9% of FlashVision, Flash Partners and Flash Alliance, jointly called “Flash Ventures.” The Company accounts for its 49.9% ownership position in Flash Ventures under the equity method of accounting. The Company’s obligations with respect to the Flash Ventures’ lease arrangements, capacity expansion, take-or-pay supply arrangements and research and development cost sharing are described in Note 10, “Commitments, Contingencies and Guarantees.” The Flash Ventures are all variable interest entities as defined under FASB Interpretation No. 46 (“FIN 46R”), Consolidation of Variable Interest Entities, and the Company is not the primary beneficiary of any of the Flash Ventures because it absorbs less than a majority of the expected gains and losses of each venture. At September 30, 2007 and December 31, 2006, the Company had accounts payable balances due to the Flash Ventures of $131.8 million and $61.6 million, respectively.

     TwinSys. The Company assumed msystems’ ownership interest in the venture with Toshiba, TwinSys, designed to enable the parties to benefit from a portion of each party’s respective sales of USB flash drives. The Company had a 50.1% beneficial ownership in TwinSys, consisting of (i) 49.9% ownership in TwinSys and (ii) 0.2% interest held by TwinSys Ltd., in which the Company has a 51% ownership interest. The Company consolidated the venture under FIN 46R. During the three months ended September 30, 2007, TwinSys had no sales to or purchases from Toshiba. During the nine months ended September 30, 2007, TwinSys had sales to and purchases from Toshiba of $53.0 million and $28.5 million, respectively. The Company and Toshiba terminated the operations of TwinSys as of March 31, 2007.

     Tower Semiconductor. As of September 30, 2007, the Company owned approximately 13.5% of the outstanding shares of Tower Semiconductor Ltd. (“Tower”), one of its suppliers of wafers for its controller components, has prepaid wafer credits issued by Tower, and has convertible debt and a warrant to purchase Tower ordinary shares. The Company’s Chief Executive Officer is also a member of the Tower Board of Directors. As of September 30, 2007, the Company owned approximately 14.9 million Tower shares with a market value of $26.7 million, and Tower prepaid wafer credits with a carrying value of zero. In addition, the Company holds a Tower convertible debenture with a market value of $5.6 million. As of September 30, 2007, the Company had an outstanding loan of $8.6 million to Tower for expansion of Tower’s 0.13 micron logic wafer capacity. The loan to Tower is secured by the equipment purchased. The Company purchased controller wafers and related non-recurring engineering of $15.3 million and $53.8 million in the three and nine months ended September 30, 2007, respectively. These purchases of controller wafers are ultimately reflected as a component of the Company’s cost of product revenues. At September 30, 2007 and December 31, 2006, the Company had amounts payable to Tower of $9.1 million and $7.7 million, respectively.

     Flextronics. The Chairman of Flextronics International Ltd. (“Flextronics”) has served on the Company’s Board of Directors since September 2003. For the three and nine months ended September 30, 2007 and October 1, 2006, the Company recorded revenues related to Flextronics and its affiliates of $2.6 million, $74.9 million, $28.6 million and $77.4 million, respectively, and at September 30, 2007 and December 31, 2006, the Company had receivables from Flextronics and its affiliates of $3.3 million and $18.9 million, respectively. In addition, the Company purchased from Flextronics and its

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

affiliates $21.3 million, $53.5 million, $20.8 million and $41.4 million of services for card assembly and testing during the three and nine months ended September 30, 2007 and October 1, 2006, respectively, which are ultimately reflected as a component of the Company’s cost of product revenues. At September 30, 2007 and December 31, 2006, the Company had amounts payable to Flextronics and its affiliates of $10.3 million and $6.7 million, respectively, for these services.

     Solid State Storage Solutions LLC. During the second quarter of fiscal 2007, the Company formed a venture with third parties that will license intellectual property. This venture qualifies as a variable interest entity under FIN 46R. The Company is considered the primary beneficiary of this venture, and in accordance with FIN 46R, the Company consolidates this venture in its financial statements. The venture was financed with $10.2 million of initial aggregate capital contributions from the partners. In July 2007, Solid State Storage Solutions LLC invested $10.0 million for the acquisition of intellectual property. The venture has an obligation of up to an additional $32.5 million related to the acquisition of intellectual property should the venture be profitable.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

12. Business Acquisition

     msystems Ltd. On November 19, 2006, the Company completed the acquisition of msystems in an all stock transaction. This combination joined together two flash memory companies with complementary products, customers and channels. In the transaction, each msystems common share was converted into 0.76368 shares of the Company’s common stock. The transaction was accounted for using the purchase method of accounting in accordance with Statement of Financial Accounting Standards No. 141, (“SFAS 141”), Business Combinations.

      The purchase price is comprised of the following (in thousands):

Fair value of SanDisk common stock issued		$	1,365,150
Estimated fair value of options and stock appreciation rights assumed			115,670
Direct transaction costs			14,918
Total estimated purchase price		$	1,495,738

     Direct transaction costs of approximately $15 million include investment banking, legal and accounting fees, and other external costs directly related to the acquisition. As of September 30, 2007, substantially all costs for accounting, legal and other professional services had been paid.

     Net Tangible Assets. The preliminary allocation of the msystems’ purchase price to the tangible assets acquired and liabilities assumed is summarized below (in thousands). The preliminary allocation was based on management’s estimates of fair value, which included a third-party appraisal. The allocation of the purchase price may be subject to change based on final estimates of fair value, primarily related to acquisition-related restructuring, deferred taxes and actual transaction costs. In the nine months ended September 30, 2007, the Company booked adjustments to the net tangible assets acquired of approximately $59.3 million, largely related to a revised estimate of the assumed deferred purchase credits.

Cash		$	41,657
Short-term investments			100,341
Accounts receivable			163,705
Inventory			134,677
Property and equipment, net			35,872
Other assets			109,316
Total assets acquired			585,568
Accounts payable			(133,263	)
Other liabilities			(179,042	)
Total liabilities assumed			(312,305	)
Net tangible assets acquired		$	273,263

     Purchase Price Allocation. In accordance with SFAS 141, the total preliminary purchase price was allocated to msystems net tangible and intangible assets based upon their estimated fair values as of November 19, 2006. The excess purchase price over the value of the net tangible and identifiable intangible assets was recorded as goodwill. The fair values assigned to tangible and intangible assets acquired and liabilities assumed are based on estimates and assumptions of management which included a third party appraisal. Some of these estimates are subject to change, particularly those estimates relating to potential restructuring activities, deferred taxes and actual transaction costs.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     The following represents the allocation of the preliminary purchase price to the acquired net assets of msystems (in thousands):

Net tangible assets acquired		$	273,263
Goodwill			699,975
Other identifiable intangible assets:
Core technology			235,500
Trademarks			4,000
Customer relationships			66,000
Backlog			5,000
Supply agreement			2,000
Total other identifiable intangible assets			312,500
Acquired in-process technology			186,000
Deferred tax liability			(31,339	)
Assumed unvested share-based awards to be expensed			55,339
Total preliminary estimated purchase price		$	1,495,738

     Acquisition-Related Restructuring. During the fourth quarter of fiscal 2006, the Company established its plans to integrate the msystems operations, which included the involuntary termination of approximately 100 employees and the exiting of duplicative facilities, and recorded $1.6 million for acquisition-related restructuring activities, of which $0.3 million relates to excess lease obligations and $1.3 million is related to personnel. The lease obligations extend through the end of the lease term in fiscal 2009. These acquisition-related restructuring liabilities were included in the purchase price allocation of the cost to acquire msystems. In the nine months ended September 30, 2007, the Company reversed through goodwill approximately $0.6 million of the restructuring accrual based on actual costs being less than the original estimates. As of September 30, 2007, there was no remaining acquisition-related restructuring accrual that had not been paid or utilized.

     In-process Technology. As part of the msystems purchase agreement, a certain amount of the purchase price was allocated to acquired in-process technology, which was determined through established valuation techniques in the high-technology industry and written-off in the fourth quarter of fiscal 2006 because technological feasibility had not been established and no alternative future uses existed. The value was determined by estimating the net cash flows and discounting forecasted net cash flows to their present values. The Company wrote-off the acquired in-process technology of $186.0 million in the fourth quarter of fiscal 2006. As of September 30, 2007, it was estimated that these in-process projects would be completed at an estimated total cost of $19.2 million. The net cash flows from the identified projects were based on estimates of revenues, costs of revenues, research and development expenses, including costs to complete the projects, selling, marketing and administrative expenses, and income taxes from the projects. The Company believes the assumptions used in the valuations were reasonable at the time of the acquisition. The estimated net revenues and gross margins were based on management’s projections of the projects and were in line with industry averages. Estimated total net revenues from the projects were expected to grow through fiscal 2009 and decline thereafter as other new products are expected to become available. Estimated operating expenses included research and development expenses and selling, marketing and administrative expenses based upon historical and expected direct expense level and general industry metrics. Estimated research and development expenses included costs to bring the projects to technological feasibility and costs associated with ongoing maintenance after a product is released, estimated at 2% of the expected net revenues for the in-process technologies.

     The effective tax rate used in the analysis of the in-process technologies reflects a historical industry-specific average for the United States federal income tax rates. A discount rate (the rate utilized to discount the net cash flows to their present values) of 19% was used in computing the present value of net cash flows for the projects. The percentage of completion was determined using costs incurred by msystems prior to the acquisition date compared to the estimated remaining research and development to be completed to bring the projects to technological feasibility.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     Matrix Semiconductor, Inc. On January 13, 2006, the Company completed the acquisition of Matrix, a designer and developer of three-dimensional (3-D) integrated circuits. Matrix^® 3-D Memory is used for one-time programmable storage applications that complement the Company’s existing flash storage memory products. The Company acquired 100% of the outstanding shares of Matrix for a total purchase price of $296.4 million.

      The purchase price is comprised of the following (in thousands):

Fair value of SanDisk common stock issued		$	242,303
Estimated fair value of options assumed			33,169
Cash consideration			20,000
Direct transaction costs			907
Total purchase price		$	296,379

     Acquisition-Related Restructuring. During the first quarter of fiscal 2006, the Company established its plans to integrate the Matrix operations, which included exiting duplicative facilities and recorded $17.5 million for acquisition-related restructuring activities, of which $17.4 million relates to excess lease obligations. The lease obligations extend through the end of the lease term in fiscal 2016. These acquisition-related restructuring liabilities were included in the purchase price allocation of the cost to acquire Matrix. As of September 30, 2007, the outstanding accrual balance was $13.7 million. The reduction in the accrual balance was primarily related to lease obligation payments.

     In-process Technology. As part of the Matrix purchase agreement, a certain amount of the purchase price was allocated to acquired in-process technology, which was determined through established valuation techniques in the high-technology computer industry and written-off in the first quarter of fiscal 2006 because technological feasibility had not been established and no alternative future uses existed. The value was determined by estimating the net cash flows and discounting forecasted net cash flows to their present values. The Company wrote-off the acquired in-process technology of $39.6 million in the first quarter of fiscal 2006. As of September 30, 2007, it was estimated that these in-process projects were completed.

     The net cash flows from the identified projects were based on estimates of revenues, costs of revenues, research and development expenses, including costs to complete the projects, selling, marketing and administrative expenses, and income taxes from the projects. The Company believes the assumptions used in the valuations were reasonable at the time of the acquisition. The estimated net revenues and gross margins were based on management’s projections of the projects and were in line with industry averages. Estimated total net revenues from the projects were expected to grow through fiscal 2009 and decline thereafter as other new products are expected to become available. Estimated operating expenses included research and development expenses and selling, marketing and administrative expenses based upon historical and expected direct expense level and general industry metrics. Estimated research and development expenses included costs to bring the projects to technological feasibility and costs associated with ongoing maintenance after a product is released. These activities range from 0% to 5% of Matrix’s portion of the Company’s net revenues for the in-process technologies.

     The effective tax rate used in the analysis of the in-process technologies reflects a historical industry-specific average for the United States federal income tax rates. Discount rates (the rates utilized to discount the net cash flows to their present values) ranging from 12.5% to 15.5% were used in computing the present value of net cash flows for the projects. The percentage of completion was determined using costs incurred by Matrix prior to the acquisition date compared to the estimated remaining research and development to be completed to bring the projects to technological feasibility.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     Pro Forma Results. The following unaudited pro forma financial information for the three and nine months ended October 1, 2006 presents the combined results of the Company, Matrix and msystems, as if the acquisitions had occurred at the beginning of the period presented (in thousands, except per share amounts). Certain adjustments have been made to the combined results of operations, including amortization of acquired other intangible assets; however, charges for acquired in-process technology were excluded as these items were non-recurring.

		Three months				Nine months
		ended				ended
		October 1, 2006				October 1, 2006
Net revenues		$	968,460			$	2,740,350
Net income		$	97,531			$	223,639
Net income per share:
Basic		$	0.43			$	0.99
Diluted		$	0.41			$	0.95

     The pro forma financial information does not necessarily reflect the results of operations that would have occurred had the Company, Matrix and msystems constituted a consolidated entity during such periods.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

13. Income Taxes

     The Company’s effective tax rates of 38.8% and 43.2% for the three and nine months ended September 30, 2007, respectively, differed from the statutory federal rate of 35.0% primarily due to the impact of state taxes, share-based compensation adjustments recorded under SFAS 123(R), tax-exempt interest income, research and development tax credits and the tax impact of non-US operations including benefits associated with earnings considered as indefinitely reinvested in foreign operations. The Company’s effective tax rates of 35.7% and 39.6% for the three and nine months ended October 1, 2006, respectively, differed from the statutory federal rate of 35.0% primarily due to the impact of state taxes, share-based compensation adjustments recorded under SFAS 123(R), tax-exempt interest income, in-process R&D write-offs and the tax impact of non-US operations, including benefits associated with earnings considered as indefinitely reinvested in foreign operations.

     The Company adopted FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, on January 1, 2007. As a result of the implementation, the Company recognized an increase of approximately $1.0 million in the liability for unrecognized tax benefits, which was accounted for as a reduction to retained earnings at January 1, 2007. The unrecognized tax benefits on uncertain tax positions of $44.0 million at January 1, 2007 is before tax benefit on state taxes and on interest of $6.1 million. Of the net taxes payable of $37.9 million, $33.2 million could favorably impact the effective tax rate in future periods and $4.7 million would increase capital in excess of par value. The total increase in unrecognized tax benefits of $11.8 million for the nine months ended September 30, 2007 offset by the tax benefit on state taxes and on interest of $1.9 million would result in $9.9 million that could favorably impact the effective tax rate in future periods.

     It is reasonably possible that the unrecognized tax benefits could decrease by $3.0 million within the next 12 months as a result of the expiration of statutes of limitation. Although timing of the resolution and/or closure on audits is highly uncertain, it is possible that the balance of gross unrecognized tax benefits would materially change in the next 12 months. However, given the number of years remaining subject to audit and the number of matters being examined, we are unable to further estimate the range of possible adjustments to the balance of gross unrecognized tax benefits. The Company had recognized interest and/or penalties of $5.0 million at date of adoption and recognized an additional $0.5 million and $1.6 million in the three and nine months ended September 30, 2007 in income tax expense, respectively.

     The Company is subject to U.S. federal income tax as well as income taxes in many state and foreign jurisdictions. The federal statute of limitations on assessment remains open for the tax years 2004 through 2006, and the statute of limitations in state jurisdictions remain open in general from tax years 2002 through 2006. The major foreign jurisdictions remain open for examination in general for tax years 2001 through 2006. The Company also had federal and state net operating loss carryforwards of approximately $89 million and $52 million, respectively, at December 31, 2006.

     The tax benefit associated with the exercise of stock options for the three and nine months ended September 30, 2007 and October 1, 2006 was credited to capital in excess of par value in the amount of $11.5 million, $16.1 million, $3.1 million and $64.1 million, respectively.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

14. Litigation

     From time-to-time, it has been and may continue to be necessary to initiate or defend litigation against third parties. These and other parties could bring suit against us. In each case listed below where we are the defendant, we intend to vigorously defend the action. At this time, the Company does not believe it is reasonably possible that losses related to the litigation described below have occurred beyond the amounts, if any, that have been accrued.

     On October 31, 2001, the Company filed a complaint for patent infringement in the United States District Court for the Northern District of California against Memorex Products, Inc. (“Memorex”), Pretec Electronics Corporation (“Pretec”), Ritek Corporation (“Ritek”), and Power Quotient International Co., Ltd (“PQI”). In the suit, captioned SanDisk Corp. v. Memorex Products, Inc., et al., Civil Case No. CV 01 4063 VRW, the Company seeks damages and injunctions against these companies from making, selling, importing or using flash memory cards that infringe its U.S. Patent No. 5,602,987. On May 6, 2003, The District Court entered a stipulated consent judgment against PQI. The District Court granted summary judgment of non-infringement in favor of defendants Ritek, Pretec and Memorex and entered judgment on May 17, 2004. On June 2, 2004, the Company filed a notice of appeal of the summary judgment rulings to the United States Court of Appeals for the Federal Circuit. On July 8, 2005, the Federal Circuit held in favor of the Company, vacating the judgment of non-infringement and remanding the case back to the District Court. The District Court issued an order on claim construction on February 22, 2007. On June 29, 2007, defendant Ritek entered into a settlement agreement and cross-license with the Company. In light of the agreement, SanDisk agreed to dismiss all current patent infringement litigation against Ritek. A stipulated dismissal with prejudice between SanDisk and Ritek was entered on July 23, 2007. On August 30, 2007, the Company entered into a settlement agreement with Memorex regarding the accused products. On September 7, 2007, in light of the settlement between the Company and Memorex, the Court entered a stipulation dismissing the Company’s claims against Memorex. On October 25, 2007, the Court Clerk entered a default against Pretec.

     On or about June 9, 2003, the Company received written notice from Infineon Technologies AG, (“Infineon”), that it believes the Company has infringed its U.S. Patent No. 5,726,601 (the ’601 patent). On June 24, 2003, the Company filed a complaint against Infineon for a declaratory judgment of patent non-infringement and invalidity regarding the ’601 patent in the United States District Court for the Northern District of California, captioned SanDisk Corporation v. Infineon Technologies AG, a German corporation, et al., Civil Case No. C 03 02931 BZ. On October 6, 2003, Infineon filed an answer and counterclaim: (a) denying that the Company is entitled to the declaration sought by the Company’s complaint; (b) requesting that the Company be adjudged to have infringed, actively induced and/or contributed to the infringement of the ’601 patent and an additional patent, U.S. Patent No. 4,841,222 (the “’222 patent”). On August 12, 2004, Infineon filed an amended counterclaim for patent infringement alleging that the Company infringes U.S. Patent Nos. 6,026,002 (the “’002 patent”); 5,041,894 (the “’894 patent”); and 6,226,219 (the “’219 patent”), and omitting the ’601 and ’222 patents. On August 18, 2004, the Company filed an amended complaint against Infineon for a declaratory judgment of patent non-infringement and invalidity regarding the ’002, ’894, and ’219 patents. On February 9, 2006, the Company filed a second amended complaint to include claims for declaratory judgment that the ’002, ’894 and ’219 patents are unenforceable. On March 17, 2006, the Court granted a stipulation by the parties withdrawing all claims and counterclaims regarding the ’002 patent. On February 20, 2007, the Court entered an order staying the case to facilitate settlement negotiations. On September 21, 2007, the Court entered the parties’ stipulation dismissing the action, including all claims and counterclaims, without prejudice.

     On February 20, 2004, the Company and a number of other manufacturers of flash memory products were sued in the Superior Court of the State of California for the City and County of San Francisco in a purported consumer class action captioned Willem Vroegh et al. v. Dane Electric Corp. USA, et al., Civil Case No. GCG 04 428953, alleging false advertising, unfair business practices, breach of contract, fraud, deceit, misrepresentation and violation of the California Consumers Legal Remedy Act. The lawsuit purports to be on behalf of a class of purchasers of flash memory products and claims that the defendants overstated the size of the memory storage capabilities of such products. The lawsuit seeks restitution, injunction and damages in an unspecified amount. The parties have reached a settlement of the case, which received final approval from the Court on November 20, 2006. Four objectors to the settlement filed appeals from the Court’s order granting final approval. The appeal is currently pending in the First District of the California Court of Appeal, No. A116242. On October 18, 2007, the case was argued before the Court of Appeal and submitted.

     On October 15, 2004, the Company filed a complaint for patent infringement and declaratory judgment of non-infringement and patent invalidity against STMicroelectronics N.V. and STMicroelectronics, Inc. (collectively, “ST”) in the United States District Court for the Northern District of California, captioned SanDisk Corporation v. STMicroelectronics,

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

Inc., et al., Civil Case No. C 04 04379 JF. The complaint alleges that ST’s products infringe one of the Company’s U.S. patents, U.S. Patent No. 5,172,338 (the “’338 patent”), and also alleges that several of ST’s patents are invalid and not infringed. On June 18, 2007, the Company filed an amended complaint, removing several of the Company’s declaratory judgment claims. A case management conference was conducted on June 29, 2007. At that conference, the parties agreed that the remaining declaratory judgment claims will be dismissed, pursuant to a settlement agreement in two matters being litigated in the Eastern District of Texas (Civil Case No. 4:05CV44 and Civil Case No. 4:05CV45, discussed below). The parties also agreed that the ’338 patent and a second SanDisk patent, presently at issue in Civil Case No. C0505021 JF (discussed below), will be litigated together in this case. ST filed an answer and counterclaims on September 6, 2007. ST’s counterclaims included assertions of antitrust violations. On October 19, 2007, SanDisk filed a motion to dismiss ST’s antitrust counterclaims. The case is scheduled to go to trial in July 2008.

     On February 4, 2005, STMicroelectronics, Inc. (“STMicro”) filed two complaints for patent infringement against the Company in the United States District Court for the Eastern District of Texas, captioned STMicroelectronics, Inc. v. SanDisk Corporation, Civil Case No. 4:05CV44 (the “’44 Action”), and STMicroelectronics, Inc. v. SanDisk Corporation, Civil Case No. 4:05CV45 (the “’45 Action”), respectively. The complaints sought damages and injunctions against certain SanDisk products. On April 22, 2005, the Company filed counterclaims on two patents against ST in the ’45 Action. The counterclaims sought damages and injunctive relief against ST’s flash memory products. On February 6, 2007, the District Court dismissed the ’44 Action with prejudice. On June 25, 2007, the District Court dismissed the ’45 Action, including all claims and counterclaims, with prejudice.

     On October 14, 2005, STMicro filed a complaint against the Company and the Company’s CEO, Dr. Eli Harari, in the Superior Court of the State of California for the County of Alameda, captioned STMicroelectronics, Inc. v. Harari, Case No. HG 05237216 (the “Harari Matter”). The complaint alleges that STMicro, as the successor to Wafer Scale Integration, Inc.’s (“WSI”) legal rights, has an ownership interest in several SanDisk patents that issued from applications filed by Dr. Harari, a former WSI employee. The complaint seeks the assignment or co-ownership of certain inventions and patents conceived of by Dr. Harari, including some of the patents asserted by the Company in its litigations against STMicro, as well as damages in an unspecified amount. On November 15, 2005, Dr. Harari and the Company removed the case to the U.S. District Court for the Northern District of California, where it was assigned case number C05-04691. On December 13, 2005, STMicro filed a motion to remand the case back to the Superior Court of Alameda County. The case was remanded to the Superior Court of Alameda County on July 18, 2006, after briefing and oral argument on a motion by STMicro for reconsideration of an earlier order denying STMicro’s request for remand. Due to the remand, the District Court did not rule upon a summary judgment motion previously filed by the Company. In the Superior Court of Alameda County, the Company filed a Motion to Transfer Venue to Santa Clara County on August 10, 2006, which was denied on September 12, 2006. On October 6, 2006, the Company filed a Petition for Writ of Mandate with the First District Court of Appeal which asks that the Superior Court’s September 12, 2006 Order be vacated, and the case transferred to Santa Clara County. On October 20, 2006, the Court of Appeal requested briefing on the Company’s petition for a writ of mandate and stayed the action during the pendency of the writ proceedings. On January 17, 2007, the Court of Appeal issued an alternative writ directing the Superior Court to issue a new order granting the Company’s venue transfer motion or to show cause why a writ of mandate should not issue compelling such an order. On January 23, 2007, the Superior Court of Alameda transferred the case to Santa Clara County as a result of the writ proceeding at the Court of Appeal. The Company also filed a special motion to strike STMicro’s unfair competition claim, which the Superior Court denied on September 11, 2006. The Company has appealed the denial of that motion, and the proceedings at the Superior Court are stayed during the pendency of the appeal.

     On December 6, 2005, the Company filed a complaint for patent infringement in the United States District Court for the Northern District of California against ST (Case No. C0505021 JF). In the suit, the Company seeks damages and injunctions against ST from making, selling, importing or using flash memory chips or products that infringe the Company’s U.S. Patent No. 5,991,517 (the “’517 patent”). As discussed above, the ’517 patent will be litigated together with the ’338 patent in Civil Case No. C 04 04379JF, which is scheduled to go to trial in July of 2008.

     On August 7, 2006, two purported shareholder class and derivative actions, captioned Capovilla v. SanDisk Corp., No. 106 CV 068760, and Dashiell v. SanDisk Corp., No. 106 CV 068759, were filed in the Superior Court of California in Santa Clara County, California. On August 9, 2006 and August 17, 2006, respectively, two additional purported shareholder class and derivative actions, captioned Lopiccolo v. SanDisk Corp., No. 106 CV 068946, and Sachs v. SanDisk Corp., No. 106 CV 069534, were filed in that court. These four lawsuits were subsequently consolidated under the caption In re msystems Ltd. Shareholder Litigation, No. 106 CV 068759 and on October 27, 2006, a consolidated amended complaint was filed that

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

supersedes the four original complaints. The lawsuit is brought by purported shareholders of msystems Ltd. (“msystems”), and names as defendants the Company and each of msystems’ former directors, including its President and Chief Executive Officer, and its former Chief Financial Officer, and names msystems as a nominal defendant. The lawsuit asserts purported class action and derivative claims. The alleged derivative claims assert, among other things, breach of fiduciary duties, abuse of control, constructive fraud, corporate waste, unjust enrichment and gross mismanagement with respect to past stock option grants. The alleged class and derivative claims also assert claims for breach of fiduciary duty by msystems’ board, which the Company is alleged to have aided an abetted, with respect to allegedly inadequate consideration for the merger, and allegedly false or misleading disclosures in proxy materials relating to the merger. The complaints seek, among other things, equitable relief, including enjoining the proposed merger, and compensatory and punitive damages.

     On September 11, 2006, Mr. Rabbi, a shareholder of msystems filed a derivative action and a motion to permit him to file the derivative action against four directors of msystems and msystems, arguing that options were allegedly allocated to officers and employees of msystems in violation of applicable law. Mr. Rabbi claimed that the aforementioned actions allegedly caused damage to msystems. On January 25, 2007, msystems filed a motion to dismiss the motion to seek leave to file the derivative action and the derivative action on the grounds, inter alia, that Mr. Rabbi ceased to be a shareholder of msystems after the merger between msystems and the Company. msystems received an extension to file its comprehensive response to the motion, to be submitted 30 days after the decision of the court in its motion to dismiss. The court had set a date for a hearing to be held on December 23, 2007.

     On February 16, 2007, Texas MP3 Technologies, Ltd. (“Texas MP3”) filed suit against the Company, Samsung Electronics Co., Ltd., Samsung Electronics America, Inc. and Apple Inc., Case No. 2:07-CV-52, in the Eastern District of Texas, Marshall Division, alleging infringement of U.S. Patent 7,065,417 (the “’417 patent”). On June 19, 2007, the Company filed an answer and counterclaim: (a) denying infringement; (b) seeking a declaratory judgment that the ’417 patent is invalid, unenforceable and not infringed by the Company. On July 31, 2007, Texas MP3 filed an amended complaint against the Company and the other parties named in the original complaint, alleging infringement of the ’417 patent. On August 1, 2007, defendant Apple Inc. filed a motion to stay the litigation pending completion of an inter-partes reexamination of the ’417 patent by the U.S. Patent and Trademark Office. That motion was denied. On August 10, 2007, the Company filed an answer to the amended complaint and a counterclaim: (a) denying infringement; (b) seeking a declaratory judgment that the ’417 patent is invalid, unenforceable and not infringed by the Company. A status conference in the case has been set for November 2, 2007. A trial date has not been set.

     On or about May 11, 2007, the Company received written notice from Alcatel-Lucent, S.A., (“Lucent”), alleging that SanDisk digital music players require a license to U.S. Patent No. 5,341,457 (the “’457 patent”) and U.S. Patent No. RE39,080 (the “’080 patent”). On July 13, 2007, the Company filed a complaint for a declaratory judgment of non-infringement and patent invalidity against Lucent Technologies Inc. and Alcatel-Lucent, S.A. in the United States District Court for the Northern District of California, captioned SanDisk Corporation v. Lucent Technologies Inc., et al., Civil Case No. C 07 03618. The complaint seeks a declaratory judgment that the Company does not infringe the two patents asserted by Lucent against the Company’s digital music players. The complaint further seeks a judicial determination and declaration that Lucent’s patents are invalid. Defendants have answered and defendant Lucent has asserted a counterclaim of infringement in connection with the ’080 patent. Defendants have also moved to dismiss the case without prejudice and/or stay the case pending their appeal of a judgment involving the same patents in suit entered by the United States District Court for the Southern District of California. The Company has moved for summary judgment on its claims for declaratory relief, and has moved to dismiss defendant Lucent’s counterclaim for infringement of the ’080 patent as a matter of law.

     On July 11, 2007, the Company filed a complaint for patent infringement against Imation Corp., Imation Enterprises Corp., and Memorex Products, Inc., (collectively, “Imation”) in the United States District Court for the Northern District of California, captioned SanDisk Corporation v. Imation Corporation, et al., Civil Case No. C 07 3588. The complaint alleges that the defendants’ products infringe one of the Company’s U.S. patents relating to USB flash memory drive technology and seeks damages and an injunction. On September 6, 2007, SanDisk voluntarily dismissed its complaint without prejudice.

     On August 10, 2007, Lonestar Invention, L.P. (“Lonestar”) filed suit against the Company in the Eastern District of Texas, Civil Action No. 6:07-cv-00374-LED. The complaint alleges that a memory controller used in the Company’s flash memory devices infringes U.S. Patent No. 5,208,725. Lonestar is seeking a permanent injunction, actual damages, treble damages for willful infringement, and costs and attorney fees. Lonestar has not served the complaint on the Company. Lonestar and the Company have met to discuss the merits of the infringement allegation.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     On or about August 31, 2007, the Company and a number of other manufacturers of flash memory products were sued in Federal Court in the Northern District of California in a purported class action captioned Stuart Go, et al v. Lexar Media, Inc., et al, Civil Case No. C-07-4547, alleging a conspiracy to fix, raise, maintain or stabilize the pricing of flash memory, and concealment thereof, in violation of state and federal laws. The lawsuit purports to be on behalf of a class of purchasers of flash memory indirectly from defendants between January 1, 1999 through the present. The lawsuit seeks restitution, injunction and damages, including treble damages, in an unspecified amount, disgorgement of profits obtained as a result of the acts alleged in the complaint, interest on any damages awarded, attorneys fees and any other relief the court may grant.

     On September 11, 2007 the Company and its Chief Executive Officer received grand jury subpoenas issued from the United States District Court for the Northern District of California indicating a Department of Justice investigation into possible antitrust violations in the NAND flash memory industry. The Company also received a notice from the Canadian Competition Bureau that the Bureau has commenced an industry-wide investigation with respect to alleged anti-competitive activity regarding the conduct of companies engaged in the supply of NAND flash memory chips to Canada and requesting that the Company preserve any records relevant to such investigation. The Company is cooperating in these investigations.

     On September 11, 2007, Premier International Associates LLC (“Premier”) filed suit against the Company and 19 other named defendants, including Microsoft Corporation, Verizon Communications Inc. and AT&T Inc., in the United States District Court for the Eastern District of Texas (Marshall Division). The suit, Case No.2-07-CV-396, alleges infringement of Premier’s U.S. Patents 6,243,725 and 6,763,345 by certain of the Company’s portable digital music players, and seeks an injunction and damages in an unspecified amount.

     On September 17, 2007, the Company and a number of other manufacturers of flash memory products were sued in the Northern District of California, in a purported class action captioned Thal v. Hitachi America, Ltd., et al., Civil Case No. C-07-4785, alleging a conspiracy to fix, raise, maintain or stabilize the pricing of flash memory, and concealment thereof, in violation of federal laws. The lawsuit purports to be on behalf of a class of purchasers of flash memory directly from defendants between January 1, 1999 through the date of class certification. The lawsuit seeks restitution, injunction and damages.

     On September 19, 2007, the Company and a number of other manufacturers of flash memory products were sued in the Northern District of California in a purported class action captioned Juskiewicz v. Samsung Electronics Co. Ltd., et al., Civil Case No. C-07-4818, alleging a conspiracy to fix, raise, maintain or stabilize the pricing of flash memory, and concealment thereof, in violation of federal laws. The lawsuit purports to be on behalf of a class of purchasers of flash memory directly from defendants between January 1, 1999 through the present. The lawsuit seeks restitution, injunction and damages.

      On September 24, 2007, the Company and a number of other manufacturers of flash memory products were sued in the Northern District of California, in a purported class action captioned Kindt et al v. Samsung Electronics Co., Ltd. et al, Civil Case No. C07-04938, alleging a conspiracy to fix, raise, maintain or stabilize the pricing of flash memory, and concealment thereof, in violation of state and federal laws. The lawsuit purports to be on behalf of a class of purchasers of flash memory indirectly from defendants between January 1, 1999 through July 16, 2007. The lawsuit seeks restitution, injunction and damages.

     On October 24, 2007, the Company filed a complaint under Section 337 of the Tariff Act of 1930 (as amended) (Case No. Unassigned) titled, “In the matter of flash memory controllers, drives, memory cards, and media players and products containing same” in the ITC, naming the following companies as respondents: Phison Electronics Corp. (“Phison”); Silicon Motion Technology Corporation, Silicon Motion, Inc. (Taiwan), Silicon Motion, Inc. (California), Silicon Motion International, Inc., and Synergistic Sales, Inc. (collectively, “Silicon Motion”); USBest Technology, Inc. (“USBest”); Skymedi Corporation (“Skymedi”); Chipsbrand Microelectronics (HK) Co., Ltd., Chipsbank Technology (Shenzhen) Co., Ltd., and Chipsbank Microelectronics Co., Ltd., (collectively, “Chipsbank”); Zotek Electronic Co., Ltd., Zodata Technology Ltd., Infotech Logistic LLC, (collectively, “Zotek”); Power Quotient International Co., Ltd., and PQI Corp. (collectively, “PQI”); PNY Technologies, Inc. (“PNY”); Kingston Technology Co., Inc., Kingston Technology Corp., Payton Technology Corp., and MemoSun, Inc. (collectively, “Kingston”); Buffalo, Inc., Melco Holdings, Inc., and Buffalo Technology (USA), Inc. (collectively, “Buffalo”); Verbatim Corp. (“Verbatim”); Transcend Information Inc. (Taiwan), Transcend Information Inc. (California, U.S.A.), and Transcend Information Maryland, Inc., (collectively, “Transcend”); Imation; Add-On Computer Peripherals, Inc., Add-On Computer Peripherals, LLC, and Add-On Technology Co., (collectively, “Add-On”); A-Data Technology Co., Ltd., and A-Data Technology (USA) Co., Ltd., (collectively, “A-DATA”); Apacer Technology Inc., Apacer Memory America, Inc., and Acer, Inc., (collectively, “Apacer”); Behavior Tech Computer Corp., and Behavior Tech Computer USA Corp., (collectively, “Behavior”); Corsair Memory, Inc. (“Corsair”); Dane-Elec Memory S.A., and Dane-Elec

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

Corp. USA, (collectively, “Dane-Elec”); EDGE Tech Corp. (“EDGE”); Interactive Media Corp, (“Interactive”); Kaser Corporation (“Kaser”); LG Electronics, Inc., and LG Electronics U.S.A., Inc., (collectively, “LG”); TSR Silicon Resources Inc. (“TSR”); and Welldone Co. (“Welldone”). In the complaint, the Company alleges that defendants’ flash memory products, such as USB flash drives, Compact Flash cards, and flash media players, infringe the following patents: U.S. Patent No. 5,719,808 (the “’808 patent”); U.S. Patent No. 6,763,424 (the “’424 patent”); U.S. Patent No. 6,426,893 (the “’893 patent”); U.S. Patent No. 6,947,332 (the “’332 patent”); and U.S. Patent No. 7,137,011 (the “’011 patent”). The Company seeks an order excluding the respondents’ flash memory controllers, drives, memory cards, and media players from entry into the United States as well as a permanent cease and desist order against the respondents. The Commission will decide whether to institute an investigation no later than November 26, 2007.

     On October 24, 2007, the Company filed a complaint for patent infringement in the United States District Court for the Western District of Wisconsin against the following defendants: Phison, Silicon Motion, USBest, Skymedi, Chipsbank, Zotek, PQI, PNY, Kingston, Buffalo, Verbatim, Transcend, Imation, Add-On, A-DATA, Apacer, Behavior, Corsair, Dane-Elec, EDGE, Interative, LG, TSR and Welldone. The complaint accuses the defendants of infringing the ’808 patent, the ’424 patent, the ’893 patent, the ’332 patent and the ’011 patent and seeks damages and injunctive relief.

     On October 24, 2007, the Company filed a complaint for patent infringement in the United States District Court for the Western District of Wisconsin against the following defendants: Phison, Silicon Motion, USBest, Skymedi, Zotek, PQI, PNY, Kingston, Buffalo, Verbatim, Transcend, Imation, A-DATA, Apacer, Behavior, and Dane-Elec. The complaint accuses the defendants of infringing the U.S. Patent No. 6,149,316 (the “’316 patent”) and U.S. Patent No. 6,757,842 (the “’842 patent”) and seeks damages and injunctive relief.

     On or about October 26, 2007, the Company and a number of other manufacturers of flash memory products were sued in Federal Court in the Northern District of California in a purported class action captioned Georgejon, Inc., et al. v. Samsung Electronics Co., Ltd., et al., Civil Case No. C-07-5480, alleging a conspiracy to fix, raise, maintain or stabilize the pricing of flash memory, and concealment thereof, in violation of federal laws. The lawsuit purports to be on behalf of a class of purchasers of flash memory directly from defendants between January 1, 1999 through the present. The lawsuit seeks restitution, injunction and damages, including treble damages, in an unspecified amount, disgorgement of profits obtained as a result of the acts alleged in the complaint, interest on any damages awarded, attorneys fees and any other relief the court may grant.

     On or about October 29, 2007, the Company and a number of other manufacturers of flash memory products were sued in Federal Court in the Northern District of California in a purported class action captioned Fred J. Gentile, et al. v. Samsung Electronics Co., Ltd., et al., Civil Case No. C-07-5349, alleging a conspiracy to fix, raise, maintain or stabilize the pricing of flash memory, and concealment thereof, in violation of federal and state laws. The lawsuit purports to be on behalf of a class of purchasers of NAND flash memory indirectly from defendants between January 1, 1999 through the present. The lawsuit seeks restitution, injunction and damages, including treble damages, in an unspecified amount, disgorgement of profits obtained as a result of the acts alleged in the complaint, interest on any damages awarded, attorneys fees and any other relief the court may grant.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

15. Condensed Consolidating Financial Statements

     As part of the acquisition of msystems in November 2006, the Company entered into a supplemental indenture whereby the Company became an additional obligor and guarantor of the assumed $75 million 1% Convertible Notes due 2035 issued by msystems Finance Company, (the “Subsidiary Issuer” or “mfinco”) and guaranteed by SanDisk IL Ltd. (the “Other Guarantor Subsidiary” or formerly “msystems”). SanDisk Corporation’s (the “Parent Company” or the “Company”) guarantee is full and unconditional, jointly and severally with msystems. Both msystems and mfinco are wholly-owned subsidiaries of the Company. The following condensed consolidating financial statements present separate information for mfinco as the subsidiary issuer, the Company and msystems as guarantors and the Company’s other combined non-guarantor subsidiaries, and should be read in conjunction with the condensed consolidated financial statements of the Company.

     These condensed consolidating financial statements have been prepared using the equity method of accounting. Earnings of subsidiaries are reflected in the Company’s investment in subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholders’ equity and other intercompany balances and transactions. Only the three and nine months ended September 30, 2007 are presented for the Condensed Consolidating Statements of Operations, and the nine months ended September 30, 2007 for the Condensed Consolidating Statement of Cash Flows, as the inception of the guarantee by the Company coincides only with the consummation of the acquisition of msystems on November 19, 2006.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

Condensed Consolidating Statements of Operations
For the three months ended September 30, 2007

										Other				Combined Non-
		Parent				Subsidiary				Guarantor				Guarantor				Consolidating				Total
		Company (1)				Issuer (1)				Subsidiary (1)				Subsidiaries (2)				Adjustments				Company
		(In thousands)
Total revenues		$	540,479			$	—			$	63,929			$	1,442,818			$	(1,009,803	)		$	1,037,423
Total cost of revenues			298,311				—				71,364				1,294,954				(969,526	)			695,103
Gross margin			242,168				—				(7,435	)			147,864				(40,277	)			342,320
Total operating expenses			137,832				—				40,515				95,767				(40,945	)			233,169
Operating income (loss)			104,336				—				(47,950	)			52,097				668				109,151
Total other income (expense)			32,729				6				(4,137	)			(1,021	)			1,623				29,200
Income (loss) before taxes			137,065				6				(52,087	)			51,076				2,291				138,351
Provision (benefit) for income taxes			45,385				—				(2,485	)			10,824				(11	)			53,713
Equity in net income (loss) of consolidated subsidiaries			43,185				—				(10,490	)			(6,185	)			(26,510	)			—
Net income (loss)		$	134,865			$	6			$	(60,092	)		$	34,067			$	(24,208	)		$	84,638