The following discussion should be read in conjunction with the condensed consolidated financial statements and the accompanying notes included in Part I., Financial Information, Item 1. Condensed Consolidated Financial Statements of this report.

The following discussion contains predictions, estimates, and other forward-looking statements that involve a number of risks and uncertainties about our business. These statements may be identified by the use of words such as "expects," "anticipates," "intends," "plans," and similar expressions. In addition,

forward-looking statements include, but are not limited to, statements about our beliefs, estimates, or plans about our ability to maintain low manufacturing and operating costs and costs per unit, our ability to estimate revenues, shipping volumes, pricing pressures, returns, reserves, demand for our disks, selling, general, and administrative expenses, taxes, research, development, and engineering expenses, spending on property, plant, and equipment, expected sales of disks and the market for disk drives generally and certain customers specifically, and our beliefs regarding our liquidity needs.

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

Results of Operations

Overview

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

Our business is capital-intensive and is characterized by high fixed costs, making it imperative that we sell disks in high volume. Our contribution margin per disk sold varies with changes in selling price, input material costs and production yield. As demand for our disks increases, our total contribution margin increases, improving our financial results because we do not have to increase our fixed cost structure in proportion to increases in demand and resultant capacity utilization. Conversely, our financial results deteriorate rapidly when the disk market worsens and our production volume decreases.

Because our 2004 fiscal year will include 53 weeks, our three-month and six-month reporting periods ended July 4, 2004, included 13 weeks and 27 weeks, respectively. Our three-month and six-month reporting periods ended June 29, 2003, included 13 weeks and 26 weeks, respectively.

Net Sales

Consolidated net sales of $101.1 million in the second quarter of 2004 were
4.0% lower compared to $105.3 million in the second quarter of 2003. Finished unit sales volume declined, to 15.1 million units in the second quarter of 2004 from 16.3 million units in the second quarter of 2003. The volume decrease

was somewhat offset by an increase in the finished unit average selling price, to $5.80 in the second quarter of 2004 from $5.67 in the second quarter of 2003.

Other disk sales (which generally include single-sided disks, aluminum substrate disks, plated disks, textured disks, and polished disks) in the second quarter of 2004 were $13.4 million, compared to $13.7 million in the second quarter of 2003.

Consolidated net sales in the first half of 2004 increased by $13.8 million, to $224.7 million in the first half of 2004 from $210.9 million in the first half of 2003. The increase was driven by increases in our sales volume and finished unit average selling price. Our sales volume increased by 3.9%, to 34.3 million units in the first half of 2004 from 33.0 million units in the first half of 2003. Our finished unit average selling price increased, to $5.88 in the first half of 2004 from $5.62 in the first half of 2003.

Other disk sales in the first half of 2004 were $23.0 million, compared to $26.1 million in the first half of 2003.

The finished unit shipment increase in the first half of 2004 compared to the same period in 2003 resulted from a combination of an additional fiscal week in the first quarter of 2004, an overall improvement in industry conditions, and an expansion of our customer base. The finished unit average selling price improvement in the second quarter and first half of 2004 compared to the same periods in 2003 primarily reflected the transition to higher capacity product offerings for desktop and consumer applications and disk shipments for high-end server (enterprise) drives.

In the third quarter of 2004, we expect flat net revenue, compared to the second quarter of 2004.

In the second quarter of 2004, sales to Maxtor Corporation (Maxtor), Hitachi Global Storage Technologies (HGST), Seagate Technology (Seagate), Western Digital, and IBM accounted for 50%, 30%, 8%, 6%, and zero, respectively, of our revenue. In the second quarter of 2003, sales to Maxtor, HGST, Seagate, Western Digital, and IBM accounted for 38%, 11%, zero, 39%, and 12% respectively, of our revenue. We expect to continue to derive a substantial portion of our sales from Maxtor, HGST, Seagate, and Western Digital.

Sales of 80GB per platter disks increased to 83% of net sales in the second quarter of 2004, compared to 20% in the same period of 2003. The increase reflected the continued customer migration to higher storage densities. All of our customers completed the transition from 40 GB to 80 GB programs in the first quarter of 2004.

Finished disk shipments for desktop and consumer applications together represented 88% of our second quarter of 2004 unit shipment volume. The remaining finished disk shipments (12%) in the second quarter of 2004 were disks for high-end server (enterprise) drives.

Gross Profit

For the second quarter of 2004, our overall gross profit percentage was 21.4%, a 0.3 point decline compared to a gross profit percentage of 21.7% for the second quarter of 2003. Lower sales and production, as well as annual preventive maintenance costs, resulted in a higher fixed cost per disk, which accounted for a 2.1 point decline. However, the cost per disk increase was partially offset by an increase in our finished unit average selling price (as discussed above), which resulted in a 1.8 point increase.

For the first half of 2004, we achieved a gross profit percentage of 26.1% compared to a gross profit percentage of 21.6% for the first half of 2003, a 4.5 point increase. The economies of scale associated with higher sales and production volumes (as discussed above) lowered our fixed cost per disk, and accounted for 1.0 point of the gross profit percentage increase in the first half of 2004. Additionally, an increase in the finished unit average selling prices (as discussed above), accounted for the remaining 3.5 point increase in the gross profit percentage in the first half of 2004.

We expect to maintain our variable cost per unit at levels similar to the first half of 2004 while continuing to advance our technology. Our fixed cost per unit is dependent on the production levels we achieve.

Research, Development, and Engineering Expenses

Research, development, and engineering (R&D) expenses of $9.0 million in the second quarter of 2004 were $1.4 million lower compared to the $10.4 million in the second quarter of 2003. The decrease primarily reflected lower spending and lower incentive compensation expense in the second quarter of 2004 compared to the second quarter of 2003.

R&D expenses of $20.7 million in the first half of 2004 were $0.4 million higher than the $20.3 million in the first half of 2003. The increase primarily reflected a $1.4 million non-recurring payroll-related charge, offset by a $1.0 million decrease in other spending, primarily incentive compensation expense and deferred compensation expense.

Selling, General, and Administrative Expenses

Selling, general, and administrative (SG&A) expenses of $3.9 million in the second quarter of 2004 were relatively flat compared to the $4.0 million incurred in the second quarter of 2003. Increases in payroll and other spending were more than offset by decreases in deferred compensation and incentive compensation charges.

SG&A expenses of $9.3 million in the first half of 2004 were $0.7 million higher compared to the $8.6 million incurred in the first half of 2003. The increase primarily reflected higher payroll spending resulting from higher headcount.

Interest Expense

Interest expense in the second quarter of 2004 was $0.4 million, and represented interest on the new $80.5 million, 2% Convertible Subordinated Notes, which were issued on January 28, 2004. Interest expense in the first half of 2004 was $2.3 million, and included $1.6 million of interest on the Senior Secured Notes and certain promissory notes, and $0.7 million of interest expense on the new Notes.

We recorded $3.4 million of interest expense in the second quarter of 2003 and $6.7 million in the first half of 2003. Interest expense primarily represented interest on the Senior Secured Notes, the Junior Secured Notes, and certain promissory notes.

The Senior Secured Notes and promissory notes were redeemed in full, including accrued interest, in February 2004. The Junior Secured Notes were redeemed in full, including accrued interest, in the fourth quarter of 2003. There were no gains or losses on the redemptions, and there were no unamortized debt issuance costs.

Income Taxes

Our wholly-owned thin-film media operation, Komag USA (Malaysia) Sdn. (KMS), received an eight-year extension of its tax holiday for its first plant site in Malaysia. The extension provides a tax holiday through June 2011. The extended tax holiday applies to income generated by sales of disk products using new technologies. KMS has also been granted additional tax holidays for its second, third, and fourth plant sites in Malaysia. These tax holidays expire between December 2006 and 2008. A substantial majority of our income is generated by sales of disk products covered by these tax holidays.

Our estimated annual effective income tax rate for 2004 is 3% and includes taxes on income generated by sales of product no longer covered under the tax holiday at our first Malaysian plant site and other tax expenses related to our U.S. and international operations.

Our income tax provisions of $1.0 million and $0.8 million for the first and second quarters of 2003, respectively, represented foreign withholding taxes on royalty and interest payments. In the third quarter of 2003, we received approval from the Malaysian Ministry of Finance for the exemption of withholding tax on royalty payments made by our Malaysian operations to our subsidiary in the Netherlands. The exemption is for a period of five years effective retroactively from January 2002 through December 2006. Therefore, in the first and second quarters of 2003, we had an accrual for foreign withholding taxes on royalty and interest payments. We reversed the accrual and recorded an income tax benefit of $0.8 million in the third quarter of 2003. The withholding taxes are no longer payable.

Critical Accounting Policies

In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of

America. Actual results could differ significantly from those estimates if our assumptions are incorrect. We believe that the following discussion addresses our most critical accounting policies. These policies are most important to the portrayal of our financial condition and results and require management's most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Allowance for Sales Returns

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

Since estimated sales returns are recorded as a reduction in revenues, any significant difference between our estimated and actual experience or changes in our estimate would be reflected in our reported revenues in the period we determine that difference.

There were no significant changes from prior quarter estimates during the first six months of 2004.

Impairment of Long-lived Assets

Long-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that these assets may be impaired or the estimated useful lives are no longer appropriate. We consider the primary indicators of impairment to include significant decreases in unit volumes, unit prices or significant increases in production costs. We review our long-lived assets for impairment based on estimated future undiscounted cash flows attributable to the assets. In the event that these cash flows are not expected to be sufficient to recover the recorded value of the assets, the assets are written down to their estimated fair values utilizing discounted estimates of future cash flows. The discount rate used is based on the estimated incremental borrowing rate at the date of the event that triggers the impairment.

There were no impairments of long-lived assets during the first six months of 2004.

Inventory Obsolescence

Our policy is to provide for inventory obsolescence based upon an estimated obsolescence percentage applied to the inventory based on age, historical trends, and requirements to support forecasted sales. In addition, and as necessary, we may provide additional charges for future known or anticipated events.

There were no significant changes from prior quarter estimates during the first six months of 2004.

Liquidity and Capital Resources

Cash and cash equivalents of $84.6 million at the end of the second quarter of 2004 increased by $14.6 million from the end of the 2003 fiscal year. The increase primarily reflected the receipt of $77.4 million and $66.4 million in net proceeds from our January 2004 debt and equity offerings, respectively, and a $24.4 million increase resulting from consolidated operating activities, offset by $116.3 million in debt repayments, and $39.2 million of spending on property, plant, and equipment.

Consolidated operating activities generated $24.4 million in cash in the first six months of 2004. The primary components of this change include the following:

• net income of $26.3 million, plus non-cash charges of $20.4 million;

• an accounts receivable increase of $6.4 million primarily related to the timing of sales, as well as changes in certain payment terms in 2004;

• an inventory increase of $8.6 million, due to the timing of production and sales of product to certain customers; and

• an accrued expenses and other liabilities decrease of $6.8 million, which primarily reflected payments of the 2003 incentive compensation plan in early 2004.

Our total capital spending in the first half of 2004 was $39.2 million, which included capital expenditures for our capacity expansion as well as the $10.0 million purchase price for the acquisition of the Trace substrate facility and equipment. Current non-cancelable capital commitments as of July 4, 2004 totaled $0.4 million. For the remainder of 2004, we plan to spend approximately $23.0 million on property, plant, and equipment for projects designed to complete a capacity expansion and improve yield and productivity, as well as to improve equipment capability for the manufacture of advanced products.

On January 28, 2004, we completed the offering of 4.0 million shares of our common stock at $20.00 per share, of which selling security holders sold
0.5 million shares, and $80.5 million of 2.0% Convertible Subordinated Notes (the Notes).

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

On February 26, 2004, we used $116.3 million of the $143.8 million in net proceeds from the offerings to redeem in full the Senior Secured Notes and certain promissory notes, including accrued interest.

We lease our research and administrative facility in San Jose, California under an operating lease. We also lease, and have sublet, another building in San Jose. Both of these leases expire in 2007, and have renewal options for five years. Additionally, we lease certain equipment under operating leases. These leases expire on various dates through 2008. We have no capital leases.

At July 4, 2004, our long-term debt obligations, operating lease obligations, and unconditional purchase obligations, were as follows (in thousands):

                                         Remainder
                                             of
                                            2004          2005         2006        2007       2008       Thereafter         Total
                                        ------------    ---------    ---------    -------    ------    --------------    -----------
Long-Term Debt Obligations               $       -      $     -      $     -      $   -       $ -       $   80,500       $ 80,500
Operating Lease Obligations (1)              1,771        3,482        3,341        415         5                -          9,014
Unconditional Purchase Obligations
(2)                                          1,987          977          137          -         -                -          3,101
                                           -------        -----        -----        ---         -         --------         ------

Total Contractual Cash Obligations       $   3,758      $ 4,459      $ 3,478      $ 415       $ 5       $   80,500       $ 92,615
                                           -------        -----        -----        ---         -         --------         ------

(1) These represent gross operating lease obligations, and are not reduced by sublease income.

(2) Unconditional purchase obligations are defined as agreements to purchase goods or services that are enforceable and legally binding, and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable pricing provisions; and the approximate timing of the transactions. The amounts are based on our contractual commitments; however, it is possible we may negotiate lower payments if we choose to exit these contracts earlier.

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

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

Risks Related to Our Business

We had a history of operating losses and emerged from chapter 11 bankruptcy in 2002. Despite operating profitability during each of our six most recent fiscal quarters, we cannot assure you that we will be able to maintain or improve our profitability in the future.

In 2001, after defaulting on our debt obligations, we filed a voluntary petition for relief under chapter 11 of the United States Bankruptcy Code. We emerged from chapter 11 bankruptcy in June 2002. Although we have been profitable in our most recent six quarters, we have a history of losses. Due to the factors discussed below in this Risk Factors section, including the very competitive, capital intensive and historically cyclical nature of the disk and disk drive markets on which our business is dependent, we cannot assure you that we will be able to sustain or improve our profitability in the future.

Downturns in the disk drive manufacturing market and related markets may decrease our revenues and margins.

The market for our products depends on economic conditions affecting the disk drive manufacturing and related markets, particularly the desktop personal computer market. We believe that a substantial majority of our finished unit sales are incorporated into disk drives manufactured by our customers for the desktop personal computer market. Because of this concentration in a single market, which we expect to continue, our business is tightly linked to the success of the personal computer market. The personal computer market has historically been seasonal and cyclical and has experienced periods of oversupply and reduced production levels, resulting in significantly reduced demand for disks and pricing pressures. The effect of these cycles on suppliers, including disk manufacturers, has been magnified by disk drive manufacturers' practice of ordering components, including disks, in excess of their needs during periods of rapid growth, thereby increasing the severity of the drop in the demand for components during periods of reduced growth or contraction. Accordingly, downturns in the desktop personal computer market may cause disk drive manufacturers to delay or cancel projects, reduce their production or reduce or cancel orders for our products. This, in turn, may lead to longer sales cycles, delays in payment and collection, pricing pressures, and unused capacity, causing us to realize lower revenues and margins.

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

Our business is characterized by high fixed overhead costs including expensive plant facilities and production equipment. Our per unit costs and our gross margin are significantly affected by the number of units we produce and the amount of our production capacity that we utilize. We are in the process of increasing our production capacity to approximately 24 million to 25 million disks per quarter. We are currently operating below this capacity level. If we are unable to utilize our expanded capacity, we may be unable to increase or sustain our gross margins. If our capacity utilization decreases for any reason, including lack of customer demand or cancellation or delay of customer orders, we could experience significantly higher unit production costs, lower margins and potentially significant losses. Underutilization of our production capacity could also result in equipment write-offs, restructuring charges and employee

layoffs. For example, from our 1997 fiscal year to the third quarter of our 2002 fiscal year, our gross margin was severely adversely affected by the underutilization of our capacity. If our production capacity is underutilized for any reason, our financial results and our business would be severely harmed.

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

Our customers are disk drive manufacturers. A relatively small number of disk drive manufacturers dominate the disk drive market. According to TrendFOCUS, four of these manufacturers accounted for 83% of disk drive sales during the first quarter of 2004. Accordingly, we expect that the success of our business will continue to depend on a limited number of customers who have comparatively strong bargaining power in negotiating contracts with us.

In the first half of 2004, 48% of our net sales were to Maxtor, 25% were to HGST, 14% were to Western Digital, and 8% were to Seagate. In fiscal 2003, 38% of our net sales were to Western Digital, 37% were to Maxtor and 17% were to HGST. If any one of our significant customers reduces its disk requirements or develops or expands capacity to produce its own disks, and we are unable to replace these orders with sales to new customers, our sales would be reduced and our business would suffer.

Price competition may force us to lower our prices, causing our gross margin to suffer.

We face significant price competition in the disk industry. High levels of competition have historically put downward pressure on prices per unit. . . .