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

For the quarterly period ended October 1, 2006

OR

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

For the transition period from                      to                     

Commission file number: 000-26734

Registrant’s telephone number, including area code
(408) 801-1000

     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 October 1, 2006: 196,691,104.

 

 

SanDisk Corporation

Index

				Page No.
PART I. FINANCIAL INFORMATION
Item 1.		Condensed Consolidated Financial Statements:
		Condensed Consolidated Balance Sheets as of October 1, 2006 and January 1, 2006			3
		Condensed Consolidated Statements of Income for the three and nine months ended October 1, 2006 and October 2, 2005			4
		Condensed Consolidated Statements of Cash Flows for the nine months ended October 1, 2006 and October 2, 2005			5
		Notes to Condensed Consolidated Financial Statements			6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			34
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			44
Item 4.		Controls and Procedures			44
PART II. OTHER INFORMATION
Item 1.		Legal Proceedings			45
Item 1A.		Risk Factors			49
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			67
Item 3.		Defaults upon Senior Securities			67
Item 4.		Submission of Matters to a Vote of Security Holders			67
Item 5.		Other Information			67
Item 6.		Exhibits			68
		Signatures			70
		Exhibit Index			71
EXHIBIT 10.1
EXHIBIT 10.2
EXHIBIT 10.3
EXHIBIT 10.4
EXHIBIT 10.5
EXHIBIT 10.6
EXHIBIT 10.8
EXHIBIT 10.9
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I. FINANCIAL INFORMATION

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

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

SANDISK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

2. Share-Based Compensation

Share-Based Benefit Plans

      2005 Incentive Plan . In May 2005, the Company’s board of directors adopted the 2005 Stock Incentive Plan, which was amended in May 2006 and renamed the 2005 Incentive Plan (the “2005 Plan”). Shares of the Company’s common stock may be issued under the 2005 Plan pursuant to three separate equity incentive programs: (i) the discretionary grant program under which stock options and stock appreciation rights may be granted to officers and other employees, non-employee board members and independent consultants, (ii) the stock issuance program under which shares may be awarded to such individuals through restricted stock or restricted stock unit awards or as a stock bonus for services rendered to the Company, and (iii) an automatic grant program for the 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. The 2005 Plan also includes a performance-based cash bonus awards program for employees classified under Section 16. Grants and awards under the discretionary grant program generally vest as follows: 25% of the shares will vest on the first anniversary of the vesting commencement date and the remaining 75% will vest proportionately each quarter over the next 16 quarters of continued service. Awards under the stock issuance program generally vest in equal annual installments over a 4 year period. Grants under the automatic grant program will vest in accordance with the specific vesting provisions set forth in that program. A total of 21,456,669 shares of the Company’s common stock have been reserved for issuance under this plan. The share reserve may increase by up to an additional 10,000,000 shares of common stock to the extent that outstanding options under the 1995 Stock Option Plan and the 1995 Non-Employee Directors Stock Option Plan expire or terminate unexercised, of which as of October 1, 2006, 756,669 shares of common stock has been added to the 2005 Plan reserve. All options granted under the 2005 Plan were granted with an exercise price equal to the fair market value of the common stock on the date of grant and will expire seven years from the date of grant. Through October 1, 2006, awards to purchase a total of 6,968,361 shares of common stock were granted to employees under the 2005 Plan, net of cancellations. For the three and nine months ended October 1, 2006, awards of 495,884 and 5,304,548 shares of common stock, respectively, were granted to employees under the 2005 Plan, net of cancellations.

      1995 Stock Option Plan and 1995 Non-Employee Directors Stock Option Plan. Both of these plans terminated on May 27, 2005, and no further option grants were made under the plans after that date. However, options that were outstanding under these plans on May 27, 2005 will continue to be governed by their existing terms and may be exercised for shares of the Company’s common stock at any time prior to the expiration of the ten-year option term or any earlier termination of those options in connection with the optionee’s cessation of service with the Company. Grants and awards under these plans generally vest as follows: 25% of the shares will vest on the first anniversary of the vesting commencement date and the remaining 75% will vest proportionately each quarter over the next 36 months of continued service. As of October 1, 2006, options had been granted, net of cancellations, to purchase 38,345,570 and 1,616,000 shares of common stock under the 1995 Stock Option Plan and the 1995 Non-Employee Directors Stock Option Plan, respectively.

      2005 Employee Stock Purchase Plan. The 2005 Employee Stock Purchase Plan (“ESPP”) was approved by the stockholders on May 27, 2005. The ESPP plan consists of two components: a component for employees residing in the United States and an international component for employees who are non-U.S. residents. The ESPP plan allows eligible employees to purchase shares of the Company’s common stock at the end of each six-month offering period at a purchase price equal to 85% of the lower of the fair market value per share on the start date of the offering period or the fair market value per share on the purchase date. As of October 1, 2006, a total of 5,000,000 shares were reserved for issuance and a total of 264,851 shares of common stock have been issued under the 2005 ESPP plan. For the three and nine months ended October 1, 2006, 150,942 and 264,851 shares of common stock were issued under the ESPP plan, respectively.

Adoption of SFAS 123(R)

     Effective January 2, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123(R), SFAS 123(R), Share-Based Payment , using the modified-prospective transition method, and therefore, has not restated its financial statements for prior periods. For awards expected to vest, compensation cost recognized in the three and nine months ended October 1, 2006 includes the following: (a) compensation cost, based on the grant-date estimated fair value and expense attribution method of SFAS 123, related to any share-based awards granted through, but not yet vested as of January 1, 2006, and (b) compensation cost for any share-based awards granted on or subsequent to January 2, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). The Company recognizes compensation expense for the fair values of these awards, which have graded vesting, on a straight-line basis over the requisite service period of each of these awards, net of estimated forfeitures.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     The Company estimates the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single-option award approach. The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience regarding similar awards, giving consideration to the contractual terms of the stock-based awards. The Company’s expected volatility is based on the implied volatility of its traded options in accordance with the guidance provided by the U.S. Securities and Exchange Commission’s Staff Accounting Bulletin 107 to place exclusive reliance on implied volatilities to estimate our stock volatility over the expected term of its awards. The Company has historically not paid dividends and has no foreseeable plans to issue dividends. The risk-free interest rate is based on the yield from U.S. Treasury zero-coupon bonds with an equivalent term.

     As a result of adopting SFAS 123(R), the impact to the Condensed Consolidated Financial Statements for the three and nine months ended October 1, 2006 to income before income taxes and net income was $25.2 million, $69.8 million, $20.3 million and $55.5 million lower, respectively, than if the Company had continued to account for share-based compensation under APB 25. The basic and diluted earnings per share for the three and nine months ended October 1, 2006 was $0.10, $0.10, $0.28 and $0.27 lower, respectively, than if the Company had continued to account for share-based compensation under APB 25. In addition, prior to the adoption of SFAS 123(R), the Company presented the tax benefit of stock option exercises as operating cash flows. Upon the adoption of SFAS 123(R), tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are classified as financing cash flows and a corresponding deduction from operating cash flows.

Stock Options

     The fair value of the Company’s stock options granted to employees for the three and nine months ended October 1, 2006 and October 2, 2005 was estimated using the following weighted average assumptions:

     A summary of option activity under all of the Company’s share-based compensation plans as of October 1, 2006 and changes during the nine months ended October 1, 2006 is presented below:

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     During the three and nine months ended October 1, 2006 and October 2, 2005, the aggregate intrinsic value of options exercised under the Company’s share-based compensation plans was $18.2 million, $194.6 million, $49.5 million and $78.7 million, respectively. At October 1, 2006, the total compensation cost related to options granted to employees under the Company’s share-based compensation plans but not yet recognized was approximately $187.9 million, net of estimated forfeitures. This cost will be amortized on a straight-line basis over a weighted average period of approximately 2.5 years.

Restricted Stock

     Restricted stock and restricted stock units are converted into shares of the Company’s common stock upon vesting on a one-for-one basis. Typically, vesting of restricted stock 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 restricted stock units outstanding under the Company’s share-based compensation plan during the nine months ended October 1, 2006 is presented below:

     As of October 1, 2006, the Company had $31.7 million of total unrecognized compensation expense, net of estimated forfeitures, related to restricted stock, which will be recognized over a weighted average estimated remaining life of 3.2 years.

Employee Stock Purchase Plans (ESPP)

     The fair value of grants under the employee stock purchase plans was estimated on the first date of the purchase period, with the following weighted average assumptions:

     At October 1, 2006, there was $1.1 million of total unrecognized compensation cost related to the ESPP that is expected to be recognized over a period of approximately 0.3 years.

     Share-based compensation expense of $2.9 million related to manufacturing personnel was capitalized into inventory as of October 1, 2006.

     Prior to fiscal 2006, the Company followed the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, or SFAS 123, Accounting for Stock-Based Compensation , as amended. The following table illustrates the effect on net income and earnings per share for the three months and nine months ended October 2, 2005 if the fair value recognition provisions of SFAS 123, as amended, had been applied to options granted under the Company’s share-based compensation plans. For purposes of this pro forma disclosure, the estimated value of the share-based compensation is recognized over the vesting periods. If the Company had recognized the expense of share-based compensation in the condensed consolidated statement of income, additional paid-in capital would have increased by a corresponding amount, net of applicable taxes.

     Disclosures for the three and nine months ended October 1, 2006 are not presented because share-based compensation was accounted for under SFAS 123(R) fair-value method during this period.

     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.

     In the three months ended October 1, 2006 and October 2, 2005, the Company sold approximately $3.7 million and $9.0 million, respectively, of inventory that had been fully written-off or reserved at the end of the previous fiscal quarter. In the nine months ended October 1, 2006 and October 2, 2005, the Company sold approximately $11.0 million and $6.2 million, respectively, of inventory that had been fully written off or reserved at the end of the previous fiscal year.

Notes Receivables and Investments in Flash Ventures

     Notes receivable and investments in flash ventures were as follows (in thousands):

     In accordance with Statement of Financial Accounting Standards No. 142, or SFAS 142, Goodwill and Other Intangible Assets , goodwill is not amortized, but instead is reviewed and tested for impairment at least annually and whenever events or circumstances occur which indicate that goodwill might be impaired. Impairment of goodwill is tested at the Company’s reporting unit level by comparing the carrying amount, including goodwill, to the fair value. In performing the analysis, the Company uses the best information available, including reasonable and supportable assumptions and projections. If the carrying amount of the reporting unit exceeds its implied fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any. The Company will perform an annual goodwill impairment test with an effective date of the first day of the fourth fiscal quarter.

Other Intangible Assets

     Other intangible assets balances were as follows (in thousands):

     Other intangible assets increased by $101.8 million in the nine months ended October 1, 2006 as a result of the Company’s acquisition of Matrix Semiconductor, Inc., or Matrix. Technology licenses represent technology licenses purchased from third parties.

     The annual amortization expense of other intangible assets that existed as of October 1, 2006 is expected to be as follows:

     Comprehensive income is as follows:

     Certain common stock issuable under stock options, warrants and the 1% Convertible Senior Notes have been omitted from the diluted net income per share calculation because their inclusion would be anti-dilutive.

     Basic net income per share excludes any dilutive effects of options, unvested stock units, warrants and convertible securities. Diluted net income per share includes the dilutive effects of stock options, unvested stock units, warrants and convertible securities.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

8. Financing Arrangements

     The following table reflects the carrying value of our long-term borrowings as of October 1, 2006 and January 1, 2006:

		October 1, 2006				January 1, 2006
		(In millions)
1% Convertible Senior Notes due 2013			$1,150.0			$	—

     In May 2006, the Company issued and sold $1.15 billion in aggregate principal amount of 1% Convertible Senior Notes due 2013 (the “1% Notes”) at par. The 1% Notes may be converted, under certain circumstances described below, based on an initial conversion rate of 12.1426 shares of common stock per $1,000 principal amount of notes (which represents an initial conversion price of approximately $82.36 per share). The net proceeds to the Company from the offering of the 1% Notes were $1.13 billion.

     The 1% Notes may be converted prior to the close of business on the scheduled trading day immediately preceding February 15, 2013, in multiples of $1,000 principal amount at the option of the holder under any of the following circumstances: 1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the trading price per note for each day of such measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such day; 2) during any calendar quarter after the calendar quarter ending June 30, 2006, if the last reported sale price of the Company’s common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 120% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or 3) upon the occurrence of specified corporate transactions. On and after February 15, 2013 until the close of business on the scheduled trading day immediately preceding the maturity date of May 15, 2013, holders may convert their notes at any time, regardless of the foregoing circumstances.

     Upon conversion, a holder will receive the conversion value of the 1% Notes to be converted equal to the conversion rate multiplied by the volume weighted average price of the Company’s common stock during a specified period following the conversion date. The conversion value of each 1% Note will be paid in: 1) cash equal to the lesser of the principal amount of the note or the conversion value, as defined, and 2) to the extent the conversion value exceeds the principal amount of the note, a combination of common stock and cash. The conversion price will be subject to adjustment in some events but will not be adjusted for accrued interest. In addition, upon a fundamental change at any time, as defined, the holders may require the Company to repurchase for cash all or a portion of their notes upon a “designated event” at a price equal to 100% of the principal amount of the notes being repurchased plus accrued and unpaid interest, if any.

     The Company will pay cash interest at an annual rate of 1%, payable semi-annually on May 15 and November 15 of each year, beginning November 15, 2006. Debt issuance costs of approximately $24.5 million are being amortized to interest expense over the term of the 1% Notes.

     Concurrently with the issuance of the 1% Notes, the Company purchased a convertible bond hedge and sold warrants. The separate convertible bond hedge and warrant transactions are structured to reduce the potential future economic dilution associated with the conversion of the 1% Notes and to increase the initial conversion price to $95.03 per share. Each of these components are discussed separately below:

•

Convertible Bond Hedge . Counterparties agreed to sell to the Company up to approximately 14.0 million shares of the Company’s common stock, which is the number of shares initially issuable upon conversion of the 1% Notes in full, at a price of $82.36 per share. The convertible bond hedge transaction will be settled in net shares and will terminate upon the earlier of the maturity date of the 1% Notes or the first day none of the 1% Notes remain outstanding due to conversion or otherwise. Settlement of the convertible bond hedge in net shares, based on the number of shares issued upon conversion of the 1% Notes, on the expiration date would result in the Company receiving net shares equivalent to the number of shares issuable by the Company upon conversion of the 1% Notes. Should there be an early unwind of the convertible bond hedge transaction, the number of net shares potentially received by the Company will depend upon 1) the then existing overall market conditions, 2) the Company’s stock price, 3) the volatility of the Company’s stock, and 4) the

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

			amount of time remaining before expiration of the convertible bond hedge. The convertible bond hedge transaction cost of $386.1 million has been accounted for as an equity transaction in accordance with Emerging Issues Task Force No. 00-19, or EITF 00-19, Accounting for Derivative Financial Statements Indexed to, and Potentially Settled in, a Company’s Own Stock . The Company recorded a tax benefit of approximately $145.6 million in stockholders’ equity from the deferred tax assets related to the convertible bond hedge.
	•		Sold Warrants. The Company received $308.7 million from the same counterparties from the sale of warrants to purchase up to approximately 14.0 million shares of the Company’s common stock at an exercise price of $95.03 per share. The warrants have an expected life of 7.25 years and expire in August 2013. At expiration, the Company may, at its option, elect to settle the warrants on a net share basis. As of October 1, 2006, the warrants had not been exercised and remained outstanding. The value of the warrants has been classified as equity because they meet all the equity classification criteria of EITF 00-19.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

9. Commitments, Contingencies and Guarantees

Commitments

      FlashVision. The Company has a 49.9% ownership interest in FlashVision Ltd., or FlashVision, a business venture with Toshiba Corporation, or 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 mark-up. 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 half of FlashVision’s NAND wafer supply. The Company cannot estimate the total amount of this commitment as of October 1, 2006, 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.

     As of October 1, 2006, the Company had notes receivable from FlashVision of 6.3 billion Japanese yen, or approximately $53 million based upon the exchange rate at October 1, 2006. These notes are secured by the equipment purchased by FlashVision using the note proceeds. In the quarter ended October 1, 2006, the Company received its first cash repayment against the note receivable and expects FlashVision to continue generating cash to pay down this note receivable over time. 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., or 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 mark-up. 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 half of Flash Partners’ NAND wafer supply. The Company cannot estimate the total amount of this commitment as of October 1, 2006, 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 October 1, 2006, the Company and Toshiba had committed to expand Flash Partners’ capacity to 110,000 wafer starts per month. The Company currently estimates the total equipment funding obligation at the 110,000 wafer starts per month level to be approximately 500 billion Japanese yen, or approximately $4.3 billion, based upon the exchange rate at October 1, 2006. Of this amount, the Company is obligated to fund 250.0 billion Japanese yen, or approximately $2.1 billion based upon the exchange rate at October 1, 2006, of which approximately $1.0 billion was left to fund as of October 1, 2006. After considering the commitments between the Company and Toshiba to expand capacity at Flash Partners, the Company continues to not be the primary beneficiary of Flash Partners.

     As of October 1, 2006, Flash Partners had secured operating lease facilities of 215 billion Japanese yen, or approximately $1.8 billion based on the exchange rate at October 1, 2006. As of October 1, 2006, Flash Partners had utilized operating lease facilities of 117.0 billion Japanese yen, or $991 million based on the exchange rate at October 1, 2006. As of October 1, 2006, the Company’s guarantee of the Flash Partners’ operating lease obligation, net of accumulated lease payments, was approximately 51.6 billion Japanese yen, or approximately $437 million based upon the exchange rate at October 1, 2006. On October 10, 2006, Flash Partners utilized approximately 46.0 billion Japanese yen, or approximately $390 million based upon the exchange rate at

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

October 1, 2006, of outstanding lease lines. The Company’s guarantee for half of this latest 46.0 billion Japanese yen draw-down was 23.0 billion Japanese yen, or approximately $195 million based upon the exchange rate at October 1, 2006. See Note 14, “Subsequent Events.” In addition, Flash Partners expects to secure additional equipment lease facilities over time, which the Company may be obligated to guarantee in whole or in part.

      Flash Alliance. The Company has a 49.9% ownership interest in Flash Alliance Ltd., or Flash Alliance, a business venture with Toshiba, formed on July 7, 2006. In the venture, the Company and Toshiba will collaborate in the development and manufacture of NAND flash memory products. These NAND flash memory products will be manufactured by Toshiba at its 300-millimeter wafer fabrication facility, Fab 4, located in Yokkaichi, Japan, using the semiconductor manufacturing equipment that will be owned or leased by Flash Alliance. Flash Alliance will purchase wafers from Toshiba at cost and then resell those wafers to the Company and Toshiba at cost plus a mark-up. 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 half of Flash Alliance’s NAND wafer supply.

     The capacity of Fab 4 at full expansion is expected to be greater than 150,000 wafers per month and the timeframe to reach full capacity is to be mutually agreed by the parties. To date, the parties have agreed to an expansion plan which is estimated to begin in the fourth quarter of 2007 and reach 67,500 wafers per month. The total investment in Fab 4 for this phase of expansion is currently estimated at approximately $3.0 billion through the end of 2008, of which the Company’s share is currently estimated to be approximately $1.5 billion. Initial NAND production is currently scheduled for the end of 2007. For expansion beyond 67,500 wafers per month, it is expected that investments and output would continue to be shared 50/50 between the Company and Toshiba. The Company expects to fund its portion of the investment through its cash as well as other financing sources and as of October 1, 2006, the Company and Toshiba had not finalized the exact timing of funding. 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 October 1, 2006, the Company had accrued liabilities related to these expenses of $5.9 million.

      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.

      Business Ventures and Foundry Arrangement with Toshiba. Purchase orders placed under the Toshiba ventures and foundry arrangement with Toshiba relating to the first three months of the nine-month forecast are binding and cannot be canceled. At October 1, 2006, the Company had approximately $171.3 million of noncancelable purchase orders for flash memory wafers outstanding to FlashVision, Flash Partners and Toshiba.

      Other Silicon Sources. The Company’s contracts with its 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 for subcontractors are included as part of the total “Noncancelable production purchase commitments” in the “Contractual Obligations” table below.

      FlashVision. In May 2002, FlashVision secured an equipment lease arrangement of approximately 37.9 billion Japanese yen, or approximately $321 million based upon the exchange rate at October 1, 2006, with Mizuho Leasing, and other financial institutions. On May 31, 2006, FlashVision refinanced the remaining balance of this equipment lease arrangement. The refinanced arrangement was approximately 15.0 billion Japanese yen, or approximately $127 million based upon the exchange rate at October 1, 2006. Lease payments are due quarterly and are scheduled to be completed in February 2009 and a residual payment of 3.1 billion Japanese yen, or $26 million based upon the exchange rate at October 1, 2006, 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 October 1, 2006, the maximum amount of the Company’s contingent indemnification obligation, which reflects payments and any lease adjustments, was approximately 6.6 billion Japanese yen, or approximately $56 million based upon the exchange rate at October 1, 2006.

      Flash Partners. Flash Partners intends to sell and lease-back from a consortium of financial institutions a portion of its tools and has entered into four equipment lease agreements of approximately 215.0 billion Japanese yen, or approximately $1.8 billion based upon the exchange rate at October 1, 2006. As of October 1, 2006, Flash Partners had drawn down approximately 117.0 billion Japanese yen, or approximately $991 million based upon the exchange rate at October 1, 2006. The Company and Toshiba have each guaranteed, on a several basis, 50% of Flash Partners’ obligations under the master lease agreements. Lease payments are due quarterly or semi-annually and are scheduled to be completed in stages through 2011. 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

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

terms to protect the leased assets. The master lease agreements contains covenants that 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 most recent annual report for Form 10-K and the most recent lease facility is an exhibit to this quarterly report on Form 10-Q. 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 obligation was insignificant at inception of the guarantee. 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. As of October 1, 2006, 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 51.5 billion Japanese yen, or approximately $437 million based upon the exchange rate at October 1, 2006.

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 October 1, 2006, no amount has 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 whereby it indemnifies certain of its officers and each of its directors for certain events or occurrences while the officer or director is, or was, serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is 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 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 October 1, 2006 or January 1, 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 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 facility at which Flash Partners operations are located and Flash Alliance operations will be 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 October 1, 2006, 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)

Foreign Currency Exchange Contracts

     The Company’s objective for holding derivatives is to minimize the material risks associated with non-functional currency transactions. The Company does not enter into derivatives for speculative or trading purposes. The Company’s derivative instruments are recorded at fair value on the balance sheet with changes in fair value recorded in other income (expense). The Company had foreign currency exchange contract lines available in the amount of $1.74 billion at October 1, 2006 to enter into foreign currency forward contracts. As of October 1, 2006, the Company had foreign currency forward contracts in place with a notional amount of 11.9 billion Japanese yen, or approximately $100 million based upon the exchange rate at October 1, 2006. The fair value of these foreign currency forward contracts as of October 1, 2006 was immaterial. The realized gains and losses on foreign currency forward contracts for the three and nine months ended October 1, 2006 were immaterial.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

10. 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 or Flash Partners. See also Note 9, “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 FlashVision and Flash Partners and made investments in Flash Partners totaling approximately $228.6 million, $791.2 million, $161.9 million and $422.4 million in the three and nine months ended October 1, 2006 and October 2, 2005, respectively. The purchases of NAND flash memory wafers are ultimately reflected as a component of the Company’s cost of product revenues. At October 1, 2006 and January 1, 2006, the Company had accounts payable balances due to FlashVision of $19.8 million and $23.0 million, respectively, balances due to Flash Partners of $39.3 million and $27.0 million, respectively, and balances due to Toshiba of $19.1 million and $11.7 million, respectively. At October 1, 2006 and January 1, 2006, the Company had accrued current liabilities due to Toshiba for shared research and development expenses of $5.9 million and $4.2 million, respectively.

      Tower Semiconductor. As of October 1, 2006, the Company owned approximately 13% of the outstanding shares of Tower Semiconductor Ltd., or 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 October 1, 2006, the Company owned approximately 11.6 million Tower shares with a carrying value and market value of $15.0 million and $16.9 million, respectively, a warrant to purchase 0.4 million Tower ordinary shares at an exercise price of $7.50 per share, with a carrying value of zero and Tower prepaid wafer credits with a carrying value of zero. In addition, the Company holds a Tower convertible debenture with a carrying value and market value of $4.1 million. Also, as of October 1, 2006, the Company loaned $6.8 million out of the Company’s $10.0 million total commitment to Tower to fund a portion of the overall expansion of Tower’s 0.13 micron logic wafer capacity. The loan to Tower is are secured by the equipment purchased. The Company purchased controller wafers and related non-recurring engineering, or NRE, of approximately $19.4 million, $36.0 million, $2.6 million and $17.3 million in the three and nine months ended October 1, 2006 and October 2, 2005, respectively. These purchases of controller wafers are ultimately reflected as a component of the Company’s cost of product revenues. At October 1, 2006 and January 1, 2006, the Company had amounts payable to Tower of approximately $6.3 million and $2.4 million, respectively, related to the purchase of controller wafers and related NRE.

      Flextronics. The Chairman of Flextronics International, Ltd., or Flextronics, has served on the Company’s Board of Directors since September 2003. For the three and nine months ended October 1, 2006 and October 2, 2005, the Company recorded revenues related to Flextronics and its affiliates of $28.6 million, $77.4 million, $6.1 million and $13.3 million, respectively, and at October 1, 2006 and January 1, 2006, the Company had receivables from Flextronics and its affiliates of $32.9 million and $12.5 million, respectively. In addition, the Company purchased from Flextronics and its affiliates $20.8 million, $41.4 million, $10.1 million and $29.4 million of services for card assembly and testing in the three and nine months ended October 1, 2006 and October 2, 2005, respectively, which are ultimately reflected as a component of the Company’s cost of product revenues. At October 1, 2006 and January 1, 2006, the Company had amounts payable to Flextronics and its affiliates of approximately $6.5 million and $5.4 million, respectively, for these services.

      U3, LLC. The Company and msystems Ltd., or msystems, each own 50% of U3, LLC, or U3, an entity established to develop and market a next generation platform for universal serial bus flash drives. The Company has consolidated the statement of financial position and the results of operations of U3 since the first quarter of fiscal 2005. The Company’s total investment in U3 as of October 1, 2006 was $7.8 million.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

11. Business Acquisition

      msystems Ltd. On July 30, 2006, the Company entered into agreements to acquire msystems Ltd., or msystems, in an all stock transaction. This combination will join together two flash memory companies with complementary products, customers and channels. In the transaction, each msystems ordinary share will be converted into 0.76368 of a share of the Company’s common stock. The closing of the transaction remains subject to conditions, including, among others, msystems’ shareholder approval and Israeli court approval, as well as customary closing conditions. The transaction is expected to close in the fourth quarter of 2006.

      Matrix Semiconductor. On January 13, 2006, the Company completed the acquisition of Matrix Semiconductor, Inc., or 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, consisting of $20.0 million in cash, 3,722,591 shares of common stock valued at $242.3 million, assumed equity instruments to issue 567,704 shares of common stock valued at $33.2 million and transaction expenses of $0.9 million primarily for accounting and legal fees. The assumed stock options were valued using the Black-Scholes-Merton valuation model with the following assumptions: stock price of $65.09; a weighted average volatility rate of 52.8%; a risk-free interest rate of 4.3%; a dividend yield of zero and a weighted average expected remaining term of 1.4 years. The fair value of unvested assumed stock options, which was valued at the consummation date, will be recognized as compensation expenses, net of forfeitures, over the remaining vesting period.

     The preliminary allocation of Matrix purchase price to the tangible and identifiable intangible 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.

     The allocation of the purchase price to the tangible and intangible assets acquired and liabilities assumed is as follows (in thousands):

     The core and developed product technology as a result of the acquisition of Matrix are being amortized over an estimated useful life of seven years, and the customer relationships are being amortized over an estimated useful life of three years. No residual value has been estimated for the intangible assets. In accordance with SFAS 142, the Company will not amortize the goodwill, but will evaluate it at least annually for impairment.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

      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 2016. These acquisition-related restructuring liabilities were included in the purchase price allocation of the cost to acquire Matrix.

      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 October 1, 2006, it was estimated that these in-process projects would be completed over the next one to three years at an estimated total cost of $16.0 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. 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.

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

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

12. Income Taxes

     The Company recorded tax provisions of $57.3 million, $153.5 million, $63.1 million and $148.3 million for the three and nine months ended October 1, 2006 and October 2, 2005, respectively, or effective tax rates of 35.7%, 39.6%, 37.0%, and 37.0% for the three and nine months ended October 1, 2006 and October 2, 2005, respectively. The Company’s effective tax rate for the third quarter of fiscal 2006 differed from the statutory federal rate of 35.0% primarily due to the impact of state taxes, stock option compensation adjustments recorded under FAS 123(R), in-process R&D write-off, tax exempt interest income and the tax impact of non-U.S. operations.

     The tax benefits associated with stock option activity for the three and nine months ended October 1, 2006 and October 2, 2005 reduced taxes payable by $3.1 million, $64.1 million, $17.2 million and $26.2 million, respectively. Such benefits are credited to capital in excess of par value when realized.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

13. 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.

     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., Pretec Electronics Corporation, Ritek Corporation, and Power Quotient International Co., Ltd. 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. The 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 district court.

     On or about June 9, 2003, the Company received written notice from Infineon Technologies AG, or 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 August 31, 2006, the Court entered an order staying the case to facilitate settlement negotiations.

     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 is pending final court approval.

     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. in the United States District Court for the Northern District of California, captioned SanDisk Corporation v. STMicroelectronics, Inc., et al., Civil Case No. C 04 04379JF. The complaint alleges that STMicro’s products infringe one of the Company’s U.S. patents and seeks damages and an injunction. The complaint further seeks a declaratory judgment that the Company does not infringe several of STMicro’s U.S. patents. By order dated January 4, 2005, the court stayed the Company’s claim that STMicro infringes the Company’s patent pending an outcome in the ITC investigation initiated on November 15, 2004 (discussed below). On January 20, 2005, the court issued an order granting STMicro’s motion to dismiss the declaratory judgment causes of action. The Company has appealed this decision to the U.S. Court of Appeals for the Federal Circuit. The remainder of the case, including the Company’s infringement claim against STMicro, is stayed pending the outcome of the appeal.

     On February 4, 2005, 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

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

(the “‘44 Action”), and STMicroelectronics, Inc. v. SanDisk Corporation, Civil Case No. 4:05CV45 (the “‘45 Action”), respectively. The complaints seek damages and injunctions against certain SanDisk products. On April 22, 2005, the Company filed counterclaims on two patents against STMicroelectronics N.V. and STMicroelectronics, Inc. in the ‘45 Action. The counterclaims seek damages and injunctive relief against STMicroelectronics N.V. and STMicroelectronics, Inc. flash memory products. In the ‘44 Action, the Magistrate Judge has issued a Report and Recommendation that the Company’s motion for summary judgment of non-infringement on all accused products be granted. STMicro has asked the U.S. District Court Judge to reverse that finding. The ’44 Action is scheduled currently for jury selection and trial on January 24, 2007. The ’45 Action is scheduled currently for jury selection and trial on April 16, 2007.

     On October 15, 2004, the Company filed a complaint under Section 337 of the Tariff Act of 1930 (as amended) (Case No. 337-TA 526) titled, “In the matter of certain NAND flash memory circuits and products containing same” in the United States International Trade Commission, naming STMicroelectronics N.V. and STMicroelectronics, Inc. (“STMicro”) as respondents. In the complaint, the Company alleges that STMicro’s NAND flash memory infringes U.S. Patent No. 5,172,338 (the ‘338 patent), and seek an order excluding their products from importation into the United States. In the complaint, the Company alleges that STMicro’s NAND flash memory infringes the ‘338 patent and seeks an order excluding their products from importation into the United States. On November 15, 2004, the ITC instituted an investigation pursuant to 19 U.S.C. Section 1337 against STMicro in response to the Company’s complaint. A hearing was held from August 1-8, 2005. On October 19, 2005, the Administrative Law Judge issued an initial determination confirming the validity and enforceability of the Company’s United States Patent 5,172,338 (‘338 patent) by rejecting STMicro’s claims that the patent was invalidated by prior art. The initial determination, however, found that STMicro’s NAND flash memory chips did not infringe three claims of the ‘338 patent. On October 31, 2005, the Company filed a petition with the International Trade Commission to review and reverse the finding of non-infringement. Also, on October 31, 2005, STMicro filed a petition for review with the International Trade Commission to review and reverse the finding that the patent was valid and enforceable. On December 6, 2005, the ITC issued its decision. The ITC declined to review the finding of non-infringement, and, after reviewing the finding of validity, declined to take any position on the issue of validity. The Company is appealing the ITC’s decision to the U.S. Court of Appeals for the Federal Circuit.

     On October 14, 2005, STMicroelectronics, Inc. filed a complaint against the Company and the Company’s CEO 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 complaint alleges that STMicroelectronics, Inc., 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 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, 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 November 23, 2005, Harari and the Company filed counterclaims, asserting the Company’s ownership of the patents and applications raised in the complaint. On December 13, 2005, STMicroelectronics, Inc. filed a motion to remand the case back to the Superior Court of Alameda County. STMicro’s remand motion was denied by the Court in March 2006. On April 24, 2006, Dr. Harari and the Company filed a motion for summary judgment on statute of limitations and other grounds that, if granted, would result in dismissal of all of STMicro’s claims. 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 ST’s request for remand. Due to the remand, the District Court did not rule upon SanDisk’s summary judgment motion. 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 Court’s September 12 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. The Company filed a special motion to strike ST’s unfair competition claim, which the Court denied on September 11, 2006. The Company has appealed the denial of that motion.

     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 STMicroelectronics, Inc. and STMicroelectronics, NV (“STMicro”) (Case No. C0505021 JF). In the suit, the Company seeks damages and injunctions against STMicro from making, selling, importing or using flash memory chips or products that infringe the Company’s U.S. Patent No. 5,991,517. The case is presently stayed, pending the termination of the ITC investigation instituted February 8, 2006, discussed below.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     On January 10, 2006, the Company filed a complaint under Section 337 of the Tariff Act of 1930 (as amended) (Case No. 337-TA-560) titled, “In the matter of certain NAND flash memory circuits and products containing same” in the ITC, naming STMicro as respondents. In the complaint, the Company alleges that: (i) STMicro’s NOR flash memory infringes United States Patent 5,172,338 (‘338 patent) ; (ii) STMicro’s NAND flash memory infringes U.S. Patent No. 6,542,956; and (iii) STMicro’s NOR flash memory and NAND flash memory infringe U.S. Patent No. 5,991,517 (‘517 patent). The complaint seeks an order excluding STMicro’s NOR and NAND flash memory products from importation into the United States. The ITC instituted an investigation, based on the Company’s complaint, on February 8, 2006. On March 31, 2006, STMicro filed a motion for partial summary determination or termination of the investigation with respect to the ‘338 patent. On May 1, 2006, the Administrative Law Judge denied STMicro’s motion in an order that is not subject to review by the ITC. On May 17, 2006, SanDisk filed a motion to voluntarily terminate the investigation with respect to U.S. Patent No. 6,542,956. On June 1, 2006, the ALJ issued an Initial Determination granting the Company’s motion. On August 15, 2006, the ALJ set December 4, 2006 as the date for the hearing, April 4, 2007 for the Initial Determination and August 13, 2007 as the target date for completion of the investigation. On September 25, 2006, STMicro filed motions for summary determination of non-infringement of the ‘338 patent with respect to its current products and non-infringement of the ‘338 and ‘517 patents with respect to prospective products and of lack of domestic industry with regard to the ‘338 patent. On the same date, SanDisk filed a motion for summary determination of the economic prong of the domestic industry requirement with regard to the ’517 patent. On September 12, 2006, the Company filed a motion to voluntarily terminate the investigation with respect to claims 1, 2, and 4 of the ’517 patent. On October 10, 2006, the ALJ issued an Initial Determination granting the Company’s motion with respect to claims 2 and 4 of the ’517 patent.

     On or about July 15, 2005, Societa’ Italiana Per Lo Sviluppo Dell’electtronica, S.I.Sv.El., S.p.A., (“Sisvel”) filed suit against the Company and others in the district court of the Netherlands in The Hague in a case captioned Societa’ Italiana Per Lo Sviluppo Dell’electtronica, S.I.Sv.El., S.p.A. adverse to SanDisk International Sales, Moduslink B.V. and UPS SCS (Nederland) B.V., Case No. 999.131.1804 (Cause List numbers 2006/167 and 2006/168). Sisvel alleges that certain of the Company’s MP3 products infringe three European patents of which Sisvel claims to be a licensee with the right to bring suit. Sisvel seeks an injunction and unspecified damages. Sisvel has previously publicly indicated that it will license these and other patents under reasonable and nondiscriminatory terms, and it has specifically offered the Company a license under the patents. The Company has submitted its answer on the substance of Sisvel’s claim. Further pre-trial proceedings must be undertaken and a trial is unlikely in this matter until the end of 2007, at the earliest.

     In a related action, on March 9, 2006, the Company filed an action in the English High Court, Chancery Division, Patents Court, in London, against Sisvel and the owners of the patents Sisvel has asserted against the Company in the Netherlands. The case is SanDisk Corporation v. Koninklijke Philips Electronics N.V. (a Dutch corporation), France Télécom (a French corporation), Télédiffusion de France S.A. (a French corporation), Institut für Rundfunktechnik GmbH (a German corporation) and Societa’ Italiana Per Lo Sviluppo Dell’electtronica, S.I.Sv.El., S.p.A., Case No. HC 06 C 00835. In this action, the Company seeks a declaration of non-infringement of the patents asserted by Sisvel in connection with the Company’s MP3 products. The Company also seeks a declaration that the patents are not “essential” to the technology of MP3 players, as Sisvel presently contends in the case filed in the Netherlands. The defendants have submitted their formal defense and counterclaimed for infringement. The trial in this matter is expected to take place along with the trial for Case No. HC 06 C 00615 in March 2007.

     In another related action, on April 13, 2006, Audio MPEG filed a complaint alleging patent infringement in the District Court for the Eastern District of Virginia. The case is Audio MPEG v. SanDisk Corporation, Case No. 2:06cv209 WDK/JEB. Audio MPEG holds itself out to be the U.S. subsidiary of Sisvel and purports to have the right to enforce certain patents in the U.S. on subject matter related to the patents asserted by Sisvel in the Netherlands. Specifically, Audio MPEG asserts U.S. Patent No. 5,214,678 (entitled “Digital transmission system using subband coding of a digital signal”), U.S. Patent No. 5,323,396 (entitled “Digital transmission system, transmitter and receiver for use in the transmission system”), U.S. Patent No. 5,539,829 (entitled “Subband coded digital transmission system using some composite signals”), and U.S. Patent No. 5,777,992 (entitled “Decoder for decoding and encoded digital signal and a receiver comprising the decoder”). The court has not yet issued a case management order or otherwise indicated when a trial should be expected to take place.

     In another related action, on April 13, 2006, Sisvel filed suit against the Company’s subsidiary, SanDisk GmbH, for patent infringement in the Mannheim District Court in Germany, S.I.Sv.El., S.p.A. v. SanDisk GmbH, file no. 7 O 90/06, which was served on the Company on or about May 10, 2006. The plaintiffs allege that certain of the Company’s MP3 products infringe four German patents of which Sisvel claims to be a licensee with the right to bring suit. Sisvel seeks an injunction and unspecified damages. Sisvel has previously publicly stated that it will license these and other patents under reasonable and nondiscriminatory terms, and it has specifically offered the Company a license under the patents. In a first trial in September of 2006, the Mannheim court expressed reservations about Sisvel’s claim of infringement and ordered further briefing and a resumption of the trial, which is now set for January 2007.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     In another related action, on April 13, 2006, Sisvel filed suit against the Company for patent infringement in the Mannheim District Court in Germany, S.I.Sv.El., S.p.A. v. SanDisk Corporation, file no. 7 O 89/06, which was served on the Company in or about July, 2006. The plaintiffs allege that certain of the Company’s MP3 products infringe four German patents of which Sisvel claims to be a licensee with the right to bring suit. Sisvel seeks an injunction and unspecified damages. Sisvel has previously publicly stated that it will license these and other patents under reasonable and nondiscriminatory terms, and it has specifically offered the Company a license under the patents. Both sides have submitted initial pleadings. There is no trial date yet set for this matter.

     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. 1-06-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 supersedes the four original complaints. The lawsuit is brought by purported shareholders of msystems names as defendants the Company and each of msystems’ directors, including its President and Chief Executive Officer, and its former Chief Financial Officer (now its Chief Operating 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.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

14. Subsequent Events

     In September 2006, Flash Partners entered into a master equipment lease agreement providing for up to 98.0 billion Japanese yen, or approximately $830 million based upon the exchange rate at October 1, 2006, of original lease obligations. There were no amounts outstanding under this master lease agreement at October 1, 2006; however, on October 10, 2006, Flash Partners utilized approximately 46.0 billion Japanese yen, or approximately $390 million based upon the exchange rate at October 1, 2006, of the total amount provided for under the September 2006 master lease agreement, of which the Company guaranteed 23.0 billion Japanese yen, or approximately $195 million based upon the exchange rate at October 1, 2006. See Note 9, “Commitments, Contingencies and Guarantees.”

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Cont’d)

     The capacity of Fab 4 at full expansion is currently expected to be approximately 150,000 wafers per month and the timeframe to reach full capacity is to be mutually agreed by the parties. To date, the parties have agreed to an expansion plan to 67,500 wafers per month for which the total investment in Fab 4 is currently estimated at approximately $3.0 billion through the end of 2008, of which our share is currently estimated to be approximately $1.5 billion. Initial NAND production is currently scheduled for the end of 2007. For expansion beyond 67,500 wafers per month, it is expected that investments and output would continue to be shared 50/50 between us and Toshiba. We expect to fund our portion of the investment through our cash as well as other financing sources. We are also committed to fund 49.9% of Flash Alliance’s costs to the extent that Flash Alliance’s revenues from wafer sales to us and Toshiba are insufficient to cover these costs.

     On July 30, 2006, we entered into agreements to acquire msystems Ltd., or msystems, in an all stock transaction. This combination will join together two flash memory companies with complementary products, customers and channels. In the transaction, each msystems ordinary share will be converted into 0.76368 of a share of our common stock. The closing of the transaction remains subject to conditions, including, among others, msystems’ shareholder approval and Israeli court approval, as well as customary closing conditions. The transaction is expected to close in the fourth quarter of 2006.

     Beginning in the first quarter of fiscal 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123(R), or SFAS 123(R), Share Based Payments , using the modified-prospective transition method. Under that transition method, compensation cost recognized in the nine months ended October 1, 2006 included the following: (a) compensation cost based on the grant date fair value related to any share-based awards granted through, but not yet vested as of January 1, 2006, and (b) compensation cost for any share-based awards granted on or subsequent to January 2, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). As a result of adopting SFAS 123(R), we recognized share-based compensation expense of $25.2 million and $69.8 million during the three months and nine months ended October 1, 2006, which affected our reported cost of sales, research and development, selling and marketing and general and administrative expenses. In addition, at October 1, 2006, we capitalized to inventory $2.9 million of compensation cost for share-based awards that were issued to manufacturing personnel. We calculate this share-based compensation expense based on the fair values of the share-based compensation awards as estimated using the Black-Scholes-Merton closed-form option valuation model. As of October 1, 2006, total unrecognized compensation expense related to unvested share-based compensation arrangements already granted under our various plans was $219.6 million, which we expect will be recognized over a weighted-average period of 2.6 years.