<PAGE>
Form 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark one)
|X| Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the quarterly period ended September 30,
1999
OR
|_| 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 0-26734
SANDISK CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 77-0191793
(State or other jurisdiction of (I.R.S. Employer
incorporation of organization) Identification No.)
140 CASPIAN COURT, SUNNYVALE, CALIFORNIA 94089
(Address of principal executive offices) (Zip code)
(408) 542-0500
(Registrant's telephone number, including area code)
N/A
(Former name,former address, and former fiscal year,
if changed since last report.)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
----- ------
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of September 30, 1999
COMMON STOCK, $0.001 PAR VALUE 27,506,245
------------------------------ ----------
Class Number of shares
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SanDisk Corporation
Index
PART I. FINANCIAL INFORMATION
PAGE NO.
--------
ITEM 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets
September 30, 1999 and December 31, 1998....................... 3
Condensed Consolidated Statements of Income
Three and nine months ended September 30, 1999 and 1998........ 4
Condensed Consolidated Statements of Cash Flows
Nine months ended September 30, 1999 and 1998.................. 5
Notes to Condensed Consolidated Financial Statements............. 6
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................... 10
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk...... 30
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings............................................... 31
ITEM 2. Changes in Securities........................................... 31
ITEM 3. Defaults upon Senior Securities................................. 31
ITEM 4. Submission of Matters to a Vote of Security Holders............. 31
ITEM 5. Other Information............................................... 31
ITEM 6. Exhibits and Reports on Form 8-K................................ 32
Signatures...................................................... 34
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PART I. FINANCIAL INFORMATION
SanDisk Corporation
Condensed Consolidated Balance Sheets
(In thousands)
ASSETS SEPTEMBER 30, DECEMBER 31,
1999 1998*
------------- ------------
(unaudited)
Current Assets:
Cash and cash equivalents $ 22,469 $ 15,384
Short-term investments 116,717 119,074
Accounts receivable, net 43,700 20,400
Inventories 20,684 8,922
Deferred tax assets 15,900 15,900
Prepaid expenses and other current assets 3,888 6,694
-------- --------
Total current assets 223,358 186,374
Property and equipment, net 28,869 17,542
Investment in foundry 51,208 51,208
Deposits and other assets 4,768 617
-------- --------
Total Assets $308,203 $255,741
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 25,806 $ 6,938
Accrued payroll and related expenses 7,156 3,768
Other accrued liabilities 20,492 9,745
Deferred revenue 24,103 27,452
-------- --------
Total current liabilities 77,557 47,903
Stockholders' Equity:
Common stock 193,090 186,120
Retained earnings 37,556 21,718
-------- --------
Total stockholders' equity 230,646 207,838
-------- --------
Total Liabilities and
Stockholders' Equity $308,203 $255,741
======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
* Information derived from the audited Consolidated Financial Statements.
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SanDisk Corporation
Condensed Consolidated Statements of Income
(In thousands, except per share data; unaudited)
Three months ended Nine months ended
September 30, September 30,
1999 1998 1999 1998
-------- -------- -------- --------
Revenues:
Product $ 57,624 $ 24,143 $135,850 $ 73,049
License and royalty 9,910 7,935 28,369 24,492
-------- -------- -------- --------
Total revenues 67,534 32,078 164,219 97,541
Cost of sales 43,897 18,840 101,264 57,172
-------- -------- -------- --------
Gross profits 23,637 13,238 62,955 40,369
Operating expenses:
Research and development 6,943 4,805 18,162 13,610
Sales and marketing 6,647 3,964 17,575 12,163
General and administrative 3,091 1,836 8,381 5,589
-------- -------- -------- --------
Total operating expenses 16,681 10,605 44,118 31,362
Operating income 6,956 2,633 18,837 9,007
Interest and other income, net 2,753 1,283 5,822 3,900
-------- -------- -------- --------
Income before taxes 9,709 3,916 24,659 12,907
Provision for income taxes 3,204 1,410 8,137 4,645
-------- -------- -------- --------
Net income $ 6,505 $ 2,506 $ 16,522 $ 8,262
======== ======== ======== ========
Net income per share
Basic $ 0.24 $ 0.09 $ 0.61 $ 0.32
Diluted $ 0.21 $ 0.09 $ 0.55 $ 0.30
Shares used in computing
net income per share
Basic 27,316 26,411 27,009 26,200
Diluted 30,497 27,392 29,775 27,749
The accompanying notes are an integral part of these condensed consolidated
financial statements.
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SanDisk Corporation
Condensed Consolidated Statements of Cash Flows
(In thousands; unaudited)
Nine months ended
September 30,
1999 1998
--------- ---------
Cash flows from operating activities:
Net income $ 16,522 $ 8,262
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 5,931 4,674
Accounts receivable, net (23,299) 1,614
Inventories (11,762) (2,557)
Prepaid expenses and other assets (1,345) 10
Accounts payable 18,868 (8,117)
Accrued payroll and related expenses 3,388 (1,193)
Other accrued liabilities 10,747 (1,432)
Deferred revenue (3,349) 3,755
--------- ---------
Total adjustments (821) (3,246)
--------- ---------
Net cash provided by operating activities 15,701 5,016
Cash flows from investing activities:
Purchases of short term investments (88,178) (114,556)
Proceeds from sale of short term investments 89,850 115,968
Investment in foundry -- (10,925)
Acquisition of capital equipment (17,258) (4,800)
--------- ---------
Net cash used in investing activities (15,586) (14,313)
Cash flows from financing activities:
Sale of common stock 6,970 2,289
--------- ---------
Net cash provided by financing activities 6,970 2,289
--------- ---------
Net increase (decrease) in cash and cash equivalents 7,085 (7,008)
Cash and cash equivalents at beginning of period 15,384 20,888
--------- ---------
Cash and cash equivalents at end of period $ 22,469 $ 13,880
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
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SanDisk Corporation
Notes to Condensed Consolidated Financial Statements
1. These interim condensed consolidated financial statements are unaudited
but reflect, in the opinion of management, all normal recurring
adjustments necessary to present fairly the financial position of SanDisk
Corporation and its subsidiaries (the "Company") as of September 30,
1999, the results of operations for the three and nine month periods
ended September 30, 1999 and 1998 and cash flows for the nine month
periods ended September 30, 1999 and 1998. Because all the disclosures
required by generally accepted accounting principles are not included,
these interim condensed consolidated financial statements should be
read in conjunction with the audited financial statements and notes
thereto in the Company's annual report on Form 10-K/A as of, and for the
year ended December 31, 1998. The condensed consolidated balance sheet
data as of December 31, 1998 was derived from the audited financial
statements.
The results of operations for the three and nine month periods ended
September 30, 1999 and cash flows for the nine month period ended
September 30, 1999 are not necessarily indicative of results of
operations and cash flows for any future period.
2. The Company's fiscal year ends on the Sunday closest to December 31, and
each fiscal quarter ends on the Sunday closest to March 31, June 30, and
September 30. The third fiscal quarter of 1999 and 1998 ended on
September 26, 1999 and September 27, 1998, respectively. Fiscal year 1998
was 52 weeks long and ended on December 27, 1998. Fiscal year 1999 is 53
weeks long and ends on January 2, 2000. For ease of presentation, the
accompanying financial statements have been shown as ending on the last
day of the calendar month.
3. The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements
and accompanying notes. Actual results could differ from those estimates.
4. The components of inventory consist of the following:
September 30, December 31,
1999 1998
---- ----
(In thousands)
Raw materials $ 4,096 $ 2,710
Work-in-process 12,614 3,818
Finished goods 3,974 12,394
------- -------
$20,684 $ 8,922
5. The following table sets forth the computation of basic and diluted
earnings per share:
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<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
1999 1998 1999 1998
---- ---- ---- ----
(In thousands, except
per share amounts)
<S> <C> <C> <C> <C>
Numerator:
Numerator for basic and diluted
net income per share - net income $ 6,505 $ 2,506 $16,522 $ 8,262
Denominator for basic net income per share:
Weighted average common shares 27,316 26,411 27,009 26,200
------- ------- ------- -------
Shares used in computing basic net income
per share 27,316 26,411 27,009 26,200
Basic net income per share $ 0.24 $ 0.09 $ 0.61 $ 0.32
Denominator for diluted net income per share:
Weighted average common shares 27,316 26,411 27,009 26,200
Employee stock options and warrants
to purchase common stock 3,181 981 2,766 1,549
------- ------- ------- -------
Shares used in computing diluted net income
per share 30,497 27,392 29,775 27,749
Diluted net income per share $ 0.21 $ 0.09 $ 0.55 $ 0.30
</TABLE>
For the three and nine month periods ending September 30, 1999, options
to purchase 25,926 and 54,857 shares of common stock, respectively have
been excluded from the earnings per share calculation, as their effect is
antidilutive. For the three and nine month periods ended September 30,
1998, options to purchase 1,484,466 and 767,049 shares of common stock,
respectively, have been excluded from the earnings per share calculation,
as their effect is antidilutive.
6. To preserve its intellectual property rights, the Company believes it may
be necessary to initiate litigation with one or more third parties,
including but not limited to those the Company has notified of possible
patent infringement. In addition, one or more of these parties, or
others, may bring suit against the Company.
In March 1998, the Company filed a complaint in federal court against
Lexar Media, Inc. ("Lexar") for infringement of a fundamental flash
memory card patent. Lexar has disputed the Company's claim of patent
infringement, claimed SanDisk's patent is invalid or unenforceable and
asserted various counterclaims including unfair competition, violation of
the Lanham Act, patent misuse, interference with prospective economic
advantage, trade defamation and fraud. SanDisk has denied all of Lexar's
counterclaims.
In July 1998, the federal district court denied Lexar's request to have
the case dismissed on the grounds the Company failed to perform an
adequate prefiling investigation. Discovery in the Lexar suit commenced
in August 1998. On February 22, 1999, the court considered arguments and
papers submitted by the parties regarding the scope and proper
interpretation of the asserted claims in SanDisk's patent at issue in the
Lexar suit. On March 4, 1999, the Federal District Court issued its
ruling on the proper construction of the claim terms in SanDisk's patent.
On July 30, 1999, the Company filed a motion for partial summary judgment
that Lexar CompactFlash and PC Cards contributorily infringe SanDisk's
patent. A hearing on this motion has been deferred by the court until
January 2000. In August 1999 the Company had a mandatory settlement
meeting with Lexar. No settlement was reached through this meeting. A
trial date has not yet been set. The Company intends to vigorously
enforce its patents, but there can be no assurance that these efforts
will be successful.
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In May 1999, Lexar filed a complaint against the Company in federal court
for claims of unfair competition, false advertising, trade libel and
intentional and negligent interference with prospective business
advantage. In Lexar's complaint, Lexar alleged that statements by the
Company regarding the comparative performance of SanDisk's and Lexar's
CompactFlash products in digital cameras were false, and further alleged
that SanDisk had interfered with the certification of certain Lexar
products by the CompactFlash Association. On July 1, 1999, the Company
filed a motion to dismiss the Lexar complaint. Also, in July 1999, Lexar
filed a motion for preliminary injunction seeking to stop certain
advertising practices that Lexar alleges were misleading. On August 26,
1999, the parties executed and filed with the court a joint stipulation
withdrawing the Company's motion to dismiss and granting Lexar permission
to amend its complaint. Lexar has amended its complaint to remove any
allegations and causes of action based on the Company's alleged
interference in certification by the CompactFlash Association. On
September 17, 1999, the court conducted a hearing on Lexar's motion for
preliminary injunction. On September 24, 1999, the court issued an order
granting a limited preliminary injunction which enjoins the Company from
using or implying certain terminology in advertising regarding the
comparative performance of its memory products in digital cameras. On
October 1, 1999, the Company filed counterclaims against Lexar asserting
causes of action including unfair competition and false advertising under
both federal and California law. Although the Company cannot predict the
ultimate outcome of the case, it believes that Lexar's claims are without
merit and that it has meritorious counterclaims against Lexar.
From time to time the Company agrees to indemnify certain of its
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 from
time to time be engaged in litigation as a result of such indemnification
obligations. Third party claims for patent infringement are excluded from
coverage under the Company's insurance policies. There can be no
assurance that any future obligation to indemnify the Company's customers
or suppliers, will not have a material adverse effect on the Company's
business, financial condition and results of operations.
Any litigation, whether as a plaintiff or as a defendant, will likely
result in significant expense to the Company and divert the efforts of
the Company's technical and management personnel, whether or not such
litigation is ultimately determined in favor of the Company. In the event
of an adverse result in any such litigation, the Company could be
required to pay substantial damages, cease the manufacture, use and sale
of infringing products, expend significant resources to develop
non-infringing technology or obtain licenses to the infringing
technology, or discontinue the use of certain processes. Accordingly,
there can be no assurance that any of the foregoing matters, or any
future litigation, will not have a material adverse effect on the
Company's business, financial condition and results of operations.
Compaq Corporation has opposed in several countries, including the United
States, the Company's attempts to register CompactFlash as a trademark.
The Company does not believe that its failure to obtain registration for
the CompactFlash mark will materially harm our business.
7. Certain of the Company's balance sheet accounts and purchase commitments
are denominated in Japanese Yen. The Company enters into foreign exchange
contracts to hedge against changes in foreign currency exchange rates.
The effects of movements in currency exchange rates on these instruments
are recognized when the related operating revenues and expenses are
recognized. The impact of movements in currency exchange rates on foreign
exchange contracts substantially mitigates the related impact on the
underlying items hedged. At September 30, 1999, forward contracts with a
notional amount of $3.1 million were outstanding. In the third quarter of
1999, the Company had a net foreign currency transaction gain of $1.3
million, primarily due to transaction gains on its Japanese yen based
assets.
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8. Accumulated other comprehensive income presented in the accompanying
balance sheet consists of the accumulated unrealized gains and loses on
available-for-sale marketable securities, net of the related tax effects,
for all periods presented.
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
1999 1998 1999 1998
---- ---- ---- ----
(In thousands) (In thousands)
<S> <C> <C> <C> <C>
Net income $ 6,505 $ 2,506 $ 16,522 $ 8,262
Unrealized gain (loss) on
available-for-sale securities 120 203 (684) 347
-------- -------- -------- --------
Comprehensive income $ 6,625 $ 2,709 $ 15,838 $ 8,609
</TABLE>
Accumulated other comprehensive income (loss) was ($213,000) and $471,000
at September 30, 1999 and December 31, 1998, respectively.
9. In October 1999, the Company entered into a nonbinding memorandum of
understanding with Toshiba providing for the joint development and
manufacturing of 512 megabit and 1 gigabit flash memory chips and Secure
Digital Memory Card controllers. Further, the Company and Toshiba intend to
form and fund a joint venture to equip and operate a silicon wafer
manufacturing line in Virginia. The cost of equipping the Virginia wafer
manufacturing line is estimated at between $700 million and $800 million.
The Company, as part of its 50% ownership of the joint venture, expect to
invest up to $150 million in cash, and, if necessary, guarantee equipment
lease lines for an additional $250 million. The Company does not expect any
material revenues from the 512 megabit technology for at least one year and
from the 1 gigabit technology for at least two years. A definitive
agreement based upon this memorandum of understanding is being negotiated
and is expected to be concluded by January 2000, subject to final approval
by the Company's board of directors and that of Toshiba.
10. In August 1999 the Company filed a Form S-3 with the Securities and
Exchange Commission for the registration of 3,000,000 shares of its common
stock. The Company plans to close this transaction in the fourth quarter of
1999.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Certain statements in this discussion and analysis are forward looking
statements based on current expectations, and entail various risks and
uncertainties that could cause actual results to differ materially from those
expressed in such forward looking statements. Such risks and uncertainties are
discussed below and in our Form 10-K/A for the year ended December 31, 1998
under the heading "Factors That May Affect Future Results." Readers are
cautioned not to place undue reliance on these forward looking statements, which
speak only as of the date hereof. We undertake no obligation to update these
forward looking statements to reflect events or circumstances occurring after
the date hereof. The following discussion should be read in conjunction with our
consolidated financial statements and the notes thereto.
OVERVIEW
We were founded in 1988 to develop and market flash data storage systems. We
sell our products to the consumer electronics and industrial/communications
markets. During the course of 1998, the percentage of our product revenues
attributable to the consumer electronics market, particularly sales of
CompactFlash for use in digital camera applications, increased substantially. In
the first nine months of 1999, consumer electronics continued to represent a
significant portion of our product revenues. This increase in sales to the
consumer market resulted in a shift to lower capacity products, which typically
have lower average selling prices and gross margins than higher capacity
products. In addition, these products are frequently sold into the retail
channel, which usually has shorter customer order lead-times than the other
channels we use, thereby decreasing our ability to accurately forecast future
production needs. We believe sales of our CompactFlash products will continue to
represent a majority of our sales as the popularity of consumer applications,
including digital cameras, increases. Historically, the percentage of sales
attributable to orders received and fulfilled in the same quarter has been
significant. In response, we are continuing to work to shorten manufacturing
cycle times.
Our operating results are affected by a number of factors including the
volume of product sales, the timing of significant orders, competitive pricing
pressures, our ability to match supply with demand, changes in product and
customer mix, market acceptance of new or enhanced versions of our products,
changes in the channels through which our products are distributed, timing of
new product announcements and introductions by us and our competitors, the
timing of license and royalty revenues, fluctuations in product costs,
availability of foundry capacity, variations in manufacturing cycle times,
fluctuations in manufacturing yields and manufacturing utilization, increased
research and development expenses, and exchange rate fluctuations. In addition,
as the proportion of our products sold for use in consumer electronics
applications increases, our revenues may become subject to seasonal declines in
the first quarter of each year. See "Factors That May Affect Our Future Results
- - Our operating results may fluctuate significantly which may adversely affect
our stock price."
Beginning in late 1995, we adopted a strategy of licensing our flash
technology, including our patent portfolio, to selected third party
manufacturers of flash products. To date, we have entered into patent
cross-license agreements with several companies, and we intend to pursue
opportunities to enter into additional licenses. Our current license agreements
provide for the payment of license fees, royalties, or a combination thereof, to
us. The timing and amount of these payments can vary substantially from quarter
to quarter, depending on the terms of each agreement and, in some cases, the
timing of sales of products by the other parties. As a result, license and
royalty revenues have fluctuated significantly in the past and are likely to
continue to fluctuate in the future. Given the relatively high gross margins
associated with license and royalty revenues, gross margins and net income are
likely to fluctuate more with changes in license and royalty revenues than with
changes in product revenues.
We market our products using a direct sales organization, distributors,
manufacturers' representatives, private label partners, OEMs and retailers. We
expect that sales and distribution through the retail channel will comprise an
increasing share of total revenues in the future, and that a substantial portion
of
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our sales through the retail channel will be made to participants that will have
the right to return unsold products. We do not recognize revenues from these
sales until the products are sold to the end customers.
Historically, a majority of our sales have been to a limited number of
customers. We expect that sales of our products to a limited number of customers
will continue to account for a substantial portion of our product revenues for
the foreseeable future. We have also experienced significant changes in the
composition of our customer base from year to year and expect this pattern to
continue as market demand for such customers' products fluctuates. The loss of,
or significant reduction in purchases by major customers, could have a material
adverse effect on our business, financial condition and results of operations.
See "Factors That May Affect Our Future Results - Sales to a small number of
customers represent a significant portion of our revenues."
Due to the emerging nature of our target markets and certain planned
product transitions, we have had difficulty forecasting future inventory levels
required to meet customer demand. As a result of both contractual obligations
and manufacturing cycle times, we have been required to order wafers from our
wafer suppliers several months in advance of the ultimate shipment of our
products. Under our wafer supply agreements, there are limits on the number of
wafers we can order and our ability to change that quantity is restricted.
Accordingly, our ability to react to significant fluctuations in demand for our
products is limited. As a result, we have not been able to match our purchases
of wafers to specific customer orders and therefore we have from time to time
taken write-downs for potential excess inventory purchased prior to the receipt
of customer orders. For example, in the second quarter of 1998, our product
gross margins were negatively impacted by an inventory write-down. These
adjustments decrease gross margins in the quarter reported and have resulted,
and could in the future result, in fluctuations in gross margins on a quarter to
quarter basis. See "Factors That May Affect Future Results - Our operating
results may adversely affect our stock price."
Export sales are an important part of our business. While a majority of our
revenues from sales to Japan and other Asian countries are derived from OEM
customers who plan to export a portion of their products to countries outside of
Asia, the Asian economic crisis may continue to adversely affect our revenues to
the extent that demand for our products in Asia declines. Given the recent
economic conditions in Asia and the weakness of many Asian currencies relative
to the United States dollar, our products may be relatively more expensive in
Asia, which could result in a decrease in our sales in that region. We may also
experience pressure on our gross margins as a result of increased price
competition from Asian competitors. While most of our sales are denominated in
U.S. dollars, we invoice certain Japanese customers in Japanese yen and are
subject to exchange rate fluctuations on these transactions. See "Factors That
May Affect Our Future Results - Our international operations make us vulnerable
to changing conditions and currency fluctuations."
For the foreseeable future, we expect to realize a significant portion of
our revenues from recently introduced and new products. Typically new products
initially have lower gross margins than more mature products because the
manufacturing yields are typically lower at the start of manufacturing each
successive product generation. In addition, manufacturing yields are generally
lower at the start of manufacturing any product at a new foundry. To remain
competitive, we are focusing on a number of programs to lower our manufacturing
costs, including development of future generations of Double Density, or D2
flash, and advanced technology wafers. We cannot assure you that such products
or processes will be successfully developed by us or that development of such
processes will lower manufacturing costs. In addition, we anticipate that price
competition will increase in the future, which could result in decreased average
selling prices and lower gross margins. See "Factors That May Affect Future
Results - In transitioning to new processes and products we face production and
market acceptance risks."
YEAR 2000 READINESS DISCLOSURE
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We are aware of problems associated with computer systems as the Year 2000
approaches. Year 2000 problems are the result of common computer programming
techniques that result in systems that do not function properly when
manipulating dates later than December 31, 1999. The issue is complex and
wide-ranging. The problem may affect transaction processing computer
applications we use for accounting, distribution, manufacturing, planning and
communications. The problem may also affect embedded systems such as building
security systems, machine controllers and production testing equipment. Year
2000 problems with these systems may affect the ability or efficiency with which
we can perform many significant functions, including but not limited to order
processing and fulfillment, material planning, product assembly, product
testing, invoicing and financial reporting. While there can be no guarantee of
unaffected operation, the completed implementation of our new management
information system, and the completed assessment of our embedded systems
indicates limited exposure in these areas. The Year 2000 problem may also affect
the computer systems of our suppliers and customers, potentially disrupting
their operations. Year 2000 problems with our business partners may impact our
sources of supply and demand.
YEAR 2000 READINESS. We have a Year 2000 risk management program to assess
the impact of the Year 2000 issue on us, and to coordinate remediation
activities. We completed the evaluation of our products for Year 2000 compliance
in the third quarter of 1998. Our FlashDisk, FlashDrive, Flash ChipSet,
CompactFlash, MultiMediaCard and ImageMate product lines do not perform date
related processing and do not contain real time clock circuitry and, therefore,
are Year 2000 ready. Our storage and connectivity products are used as
components in a variety of host systems. The firmware, operating system and
application software of these host systems are designed and manufactured by
others. We make no claim with regard to the Year 2000 readiness of host systems
designed by others in which our products are used. Independent system designers
make derivative works from our Host Developer's Toolkit source code product.
Sample date related subroutines and data structures are included in the Toolkit
for use by system designers. Designers modify the sample routines in order to
fit the specific requirements of their host operating system. The designer is
responsible for the formatting and processing logic associated with the date
values that pass through the Toolkit subsystem and for the Year 2000 readiness
of the systems in which the Toolkit is used. We make no claims with regard to
the Year 2000 readiness of host firmware and operating systems designed by
others that contain derivative works of the Toolkit.
The Year 2000 remediation of our transaction processing systems was
completed with the installation and testing of our new management information
system in the fourth quarter of 1998. The new system is a commercially
available, fully integrated materials requirement planning and accounting system
software application. This system is used for accounting, order processing,
planning, inventory control, shop floor control and distribution.
In the second quarter of 1999, we completed all of the primary elements of
our Year 2000 assessment and remediation program for our principal hardware and
software. Tests of software applications, which have been identified by their
vendors as Year 2000 compliant, and several minor software upgrades were
successfully completed in the third quarter of 1999. Well over 90% of our
investment in desktop personal computer hardware is known to be Year 2000
compliant, and proven remediation solutions are being implemented for the
remaining 10%. The majority of the software used on these systems and network
servers are recent versions of vendor supported, commercially available
products. Upgrading these applications as Year 2000 compliant patches are
released by the respective vendors has not been a significant burden on us and
is expected to be completed before the end of 1999.
Our assessment and remediation of Year 2000 problems in computer systems
used for facilities control, machine control and manufacturing testing is
complete. The most significant Year 2000 issue in this area has been found to be
related to older wafer testing equipment. This equipment is not expected to be
used in the year 2000. We are phasing in new Year 2000 compliant wafer testing
equipment in conjunction with the introduction of new generations of flash
memory.
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Our assessment of Year 2000 risks related to material suppliers,
customers and other third parties is substantially complete. Inquiries were made
of all critical suppliers and an assessment of their Year 2000 readiness was the
basis for strategic decisions regarding alternate material sourcing and/or
increasing inventory safety stocks. The survey of our service suppliers is
ongoing, as many of these suppliers have fourth quarter 1999 target compliance
dates for their Year 2000 programs. We are also contacting our significant
customers regarding their Year 2000 readiness in order to understand the
potential for any disruptions in their ordering patterns. Completion of these
reviews will depend on the responsiveness of our vendors and customers, over
which we have no control.
YEAR 2000 RISK MANAGEMENT PROGRAM COSTS. The cost of the Year 2000
project related to upgrading our core management information system was
approximately $1.0 million, $400,000 of which was related to the purchase of
software and hardware which we capitalized. In the first nine months of 1999, we
spent approximately $175,000 for application software upgrades and computer
hardware. We estimate that costs to upgrade or replace any remaining software
applications and non-compliant computer hardware will not be material to our
operating results. We would have incurred the majority of these costs, in spite
of Year 2000 issues, due to the need to upgrade our management information
system, application software and personal computers to support our growth. Our
Year 2000 remediation projects were funded from operating cash flows. No
material projects were deferred in order to complete our Year 2000 assessment
and remediation project. The additional expenses related to the management of
the Year 2000 compliance program and completing the remaining assessment of our
internal and external risks are not expected to be material to our quarterly
operating results.
The costs and time schedule for the Year 2000 problem abatement are based
on management's best estimates for the remediation of Year 2000 problems
uncovered to date. These estimates were derived utilizing numerous assumptions,
including that the most significant Year 2000 risks have already been
identified, that certain resources will continue to be available, that third
party plans will be fulfilled and other factors. However, we cannot guarantee
that these estimates will be achieved or that the anticipated time schedule will
be met and actual results could differ significantly from those anticipated.
CONTINGENCY PLANS. Specific contingency plans for systems that pose
significant risk to ongoing operations are being developed under the auspices of
our Year 2000 risk management program. Should previously undetected Year 2000
problems be found in other systems, these systems will either be upgraded,
replaced, turned off or operated in place with manual procedures to compensate
for their deficiencies. While we believe that these alternative plans would be
adequate to meet our needs without materially impacting our operations, we
cannot assure you that these alternatives would be successful or that our
results of operations would not be harmed by the delays and inefficiencies
inherent in conducting operations in this manner.
RISKS RELATED TO YEAR 2000 READINESS. Success of our Year 2000 compliance
effort depends, in part, on the success of our key suppliers and customers in
dealing with their Year 2000 issues. We do not have any control over the
remediation efforts of our key suppliers and customers and cannot fully
determine the extent to which they have resolved their Year 2000 compliance
issues. We currently purchase several critical components from single or sole
source vendors. While this issue is being carefully managed, disruptions in the
supply of components from any of these sole source suppliers due to Year 2000
issues, could cause delays in our fulfillment of customer orders which could
result in reduced or lost revenues. Furthermore, our sales have historically
been to a limited number of customers. Any disruption in the purchasing patterns
of these customers or potential customers due to Year 2000 issues could cause a
decline in our revenues. We cannot assure you that we and our key suppliers and
customers will identify and remediate all significant Year 2000 problems on a
timely basis. Furthermore, we cannot assure you that our insurance will cover
losses from business interruptions arising from Year 2000 problems or those of
our suppliers. If our key suppliers and customers have Year 2000 problems, our
business could be harmed.
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The foregoing statements regarding our Year 2000 readiness are based upon
management's best estimates at the present time, which were derived utilizing
assumptions regarding future events, including the continued availability of
certain resources, third party modification plans and other factors. We cannot
guarantee that these estimates will be achieved and actual results could differ
materially from those anticipated. Specific factors that might cause such
material differences include, but are not limited to:
the availability and cost of personnel trained in this area;
the ability to locate and correct all relevant computer codes;
the nature and amount of programming required to upgrade or replace each
of the affected programs;
the rate and magnitude of related labor and consulting costs; and
the success of our external customers and suppliers in addressing the
Year 2000 issue.
Our evaluation is ongoing and we expect that new and different information
will become available to us as the evaluation continues. Consequently, we cannot
guarantee that all material elements will be Year 2000 ready in time.
RESULTS OF OPERATIONS
PRODUCT REVENUES. Our product revenues were $57.6 million in the third
quarter of 1999, up $33.5 million or 139% from the third quarter of 1998.
Product revenues for the nine months ended September 30, 1999 were $135.9
million, up $62.8 million or 86% from the same period in 1998. During the three
and nine month periods ended September 30, 1999, units shipped increased 136%
and 147%, respectively over the same periods in 1998. The largest increase in
both periods came from sales of CompactFlash which represented 63% and 60% of
product revenues, respectively, for the three and nine month periods ended
September 30, 1999. Average selling prices declined 2% in the third quarter of
1999 compared to the same period of 1998. A shift in product mix to higher
capacity cards partially offset a decline in the average selling price per
megabyte of capacity shipped. The average megabyte capacity per unit shipped
increased 78% while the average selling price per megabyte of flash memory
shipped declined 48% in the third quarter of 1999 compared to the same period of
the previous year. The mix of products sold varies from quarter to quarter and
will continue to vary in the future, affecting our overall average selling
prices and gross margins. Average selling prices declined 27% for the first nine
months of 1999 compared to the first nine months of 1998.
In September 1999, both USIC and USC, the foundries that currently produce
all of our flash memory wafers, were damaged and temporarily shut down by an
earthquake in Taiwan. As a result, 8 to 10% of our silicon wafers in production
at the time of the earthquake had to be discarded and no new wafers could be
manufactured for 11 days, resulting in the loss or destruction of a portion of
our fourth quarter wafer supply. We expect that our existing silicon wafer
inventory, combined with our planned output from USIC and USC, will allow us to
ship more megabytes in the fourth quarter of 1999 than in the third quarter of
1999. However, due to this disruption in wafer supply, we expect fourth quarter
financial results to be affected by spot shortages and increased expediting
costs and that our quarter-over-quarter revenue growth rate in the fourth
quarter will be lower than in the third quarter. This expectation is based,
however, on the assumption that resumed production at USIC and USC will continue
at historical rates. Additional earthquakes, aftershocks or other natural
disasters in Taiwan could preclude us from obtaining adequate supply of wafers
to fill customer orders, and could significantly harm our business, financial
condition and results of operations. Due to a number of factors described herein
and in "Factors That May Affect Future Results," our ability to adjust our
operating expenses is limited in the short term.
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As a result, if product revenues are lower than anticipated, our results of
operations will be adversely affected.
Export sales represented 50% and 46%, respectively, of our product revenues
for the three and nine month periods ended September 30, 1999 compared to 47%
and 46% for the same periods of the previous year. We expect international sales
to continue to represent a significant portion of our product revenues. For the
three and nine month periods ended September 30, 1999, our top ten customers
represented approximately 55% of our product revenues compared to 65% and 62%,
respectively, for the same periods in 1998. In the first nine months of fiscal
1999, one customer accounted for more than 10% of product sales. Two customers
each accounted for more than 10% of product sales in the first nine months of
1998. We expect that sales to a limited number of customers will continue to
represent a substantial portion of our revenues for the foreseeable future.
LICENSE AND ROYALTY REVENUES. We currently earn patent license fees and
royalties under several cross-license agreements. License and royalty revenues
from patent cross-license agreements were $9.9 million in the third quarter of
1999, up from $7.9 million in the same period of the previous year, due
primarily to an increase in royalty revenues. In the first nine months of 1999,
revenue from patent license and royalties was $28.4 million, up from $24.5
million in the same period of the prior year. Revenues from licenses and
royalties decreased to 15% of total revenues in the third quarter of 1999 from
25% in the third quarter of 1998. For the nine months ended September 30, 1999,
patent license and royalty revenues represented 17% of total revenues, compared
to 25% for the first nine months of 1998.
GROSS PROFITS. In the third quarter of 1999, gross profits were $23.6
million, or 35% of total revenues compared to $13.2 million, or 41% of total
revenues in the same period of 1998. Gross profits for the first nine months of
1999 were $63.0 million compared to $40.4 million for the same period of the
previous year. Gross margin was 38% compared to 41% of total revenues for the
nine month periods ended September 30, 1999 and 1998, respectively.
Product gross margin increased to 24% of product revenues in the third
quarter of 1999 from 22% in the third quarter of 1998 primarily due to a lower
cost per megabyte of our flash memory products in 1999. During the third quarter
of 1999, we accelerated the production ramp up of our 128Mbit products to meet
increased demand. However, lower than anticipated yields on our 128Mbit flash
memory contributed to a decline in product gross margins to 24% of product
revenues in the third quarter of 1999 from 27% of product revenues in the second
quarter of 1999. We also experienced higher than anticipated production costs
due to spot shortages of critical components during the quarter. We completed
internal qualification of our 256Mbit technology during the third quarter. We
will begin shipping CompactFlash, MultiMediaCard and FlashDisk products
utilizing our new 256Mbit flash chip in the fourth quarter of 1999. The 256Mbit
flash chip has a lower manufacturing cost per megabyte and we currently expect
it to contribute to improved product gross margins in the fourth quarter. The
initial production period of each new generation of flash technology is subject
to many risks and uncertainties as described in "Factors That May Affect Future
Results - In transitioning to new processes and products we face production and
market acceptance risks." There can be no assurance that we will realize
expected cost reductions in the fourth quarter of 1999.
RESEARCH AND DEVELOPMENT. Research and development expenses consist
principally of salaries and payroll related expenses for design and development
engineers, prototype supplies and contract services. Research and development
expenses were $6.9 million in the third quarter of 1999, up $2.1 million or 44%
from $4.8 million in the same period of 1998. In the first nine months of 1999,
research and development expenses increased to $18.2 million up $4.6 million or
33% from $13.6 million in the same period of 1998. The increases were primarily
due to increased salary and related expenses and higher nonrecurring engineering
and project related expenses. Research and development expenses represented 10%
of total revenues in the third quarter of 1999 compared to 15% in the third
quarter of 1998. For the first nine months of 1999, research and development
expenses represented 11% of total revenues compared to 14% for the same period
of the prior year. We expect that our research and development expenses to
continue to increase in absolute dollars to support the development and
introduction of new
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generations of flash data storage products, including the 512Mbit and 1 Gigabit
flash memory co-development and manufacturing joint venture with Toshiba.
SALES AND MARKETING. Sales and marketing expenses include salaries, sales
commissions, benefits and travel expenses for our sales, marketing, customer
service and applications engineering personnel. These expenses also include
other selling and marketing expenses, such as independent manufacturer's
representative commissions, advertising and tradeshow expenses. Sales and
marketing expenses were $6.6 million in the third quarter of 1999 up $2.7
million or 68% from $4.0 million in the third quarter of 1998. In the first nine
months of 1999, sales and marketing expenses were $17.6 million, up $5.4 million
or 44% from the same period of 1998. The increases were primarily due to
increased salary and related expenses, higher commission expenses due to
increased product revenues and higher marketing expenses. Sales and marketing
expenses represented approximately 10% of total revenues in the third quarter of
1999 compared to 12% in the third quarter of 1998. For the first nine months of
1999, sales and marketing expenses represented 11% of total revenues compared to
12% for the same period of the prior year. We expect sales and marketing
expenses to increase as sales of our products grow and as we continue to develop
the retail channel for our products.
GENERAL AND ADMINISTRATIVE. General and administrative expenses include the
cost of our finance, information systems, human resources, shareholder
relations, legal and administrative functions. General and administrative
expenses were $3.1 million in the third quarter of 1999, up $1.3 million or 68%
from $1.8 million in the third quarter of 1998. In the first nine months of
1999, general and administrative expenses were $8.4 million, up $2.8 million or
50% from the same period in 1998. The increases were primarily due to increased
salary and related expenses, an increase in the allowance for doubtful accounts
and higher consulting expenses. For the three and nine month periods ended
September 30, 1999, general and administrative expenses represented 5% of total
revenues compared to 6% for the same period in 1998. We expect general and
administrative expenses to increase as our general and administrative functions
grow to support our overall growth. General and administrative expenses could
also increase substantially in the future if we continue to pursue litigation to
defend our patent portfolio. See "Factors That May Affect Future Results - Risks
Associated with Patents, Proprietary Rights and Related Litigation."
INTEREST AND OTHER INCOME, NET. Interest and other income, net, was $2.8
million in the third quarter of 1999 compared to $1.3 million in the third
quarter of 1998. The increase was due primarily to foreign currency transaction
gains of $1.3 million on our Japanese yen based assets.
PROVISION FOR INCOME TAXES. We recorded a provision for income taxes at a
33% effective tax rate for the three and nine month periods ended September 30,
1999 compared to a 36% effective tax rate for the same periods of 1998. The
lower effective tax rate in 1999 reflects greater benefits from federal and
state tax credits.
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 1999, we had working capital of $145.8 million, which
included $22.5 million in cash and cash equivalents and $116.7 million in
short-term investments. Operating activities provided $15.7 million of cash in
the first nine months of 1999 primarily from net income and an increase in
current liabilities of $29.7 million, which were partially offset by increases
in accounts receivable of $23.3 million and inventory of $11.8 million.
Net cash used in investing activities of $15.6 million in the first nine
months of 1999 consisted of net proceeds of investments of $1.7 million which
were offset by capital equipment purchases and leasehold improvements of $17.3
million. In the first nine months of 1999, cash provided by financing activities
of $7.0 million came primarily from the sale of common stock through our stock
option and employee stock purchase plans.
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In October, 1999, we entered into a nonbinding memorandum of understanding
with Toshiba providing for the joint development and manufacturing of 512
megabit and 1 gigabit flash memory chips and Secure Digital Memory Card
controllers. Further, we and Toshiba intend to form and fund a joint venture to
equip and operate a silicon wafer manufacturing line in Virginia. The cost of
equipping the Virginia wafer manufacturing line is estimated at between $700
million and $800 million. We, as part of our 50% ownership of the joint venture,
expect to invest up to $150 million in cash, and, if necessary, guarantee
equipment lease lines for an additional $250 million.
Depending on the future demand for our products, we may decide to make
additional investments, which could be substantial, in assembly and test
manufacturing equipment or foundry capacity to support our business in the
future.
IMPACT OF CURRENCY EXCHANGE RATES
A portion of our revenues are denominated in Japanese yen. We enter into
foreign exchange forward contracts to hedge against changes in foreign currency
exchange rates. At September 30, 1999, forward contracts with a notional amount
of $3.1 million were outstanding. Future exchange rate fluctuations could have a
material adverse effect on our business, financial condition and results of
operations.
FACTORS THAT MAY AFFECT FUTURE RESULTS
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY WHICH MAY ADVERSELY AFFECT OUR
STOCK PRICE.
Our quarterly and annual operating results have fluctuated significantly
in the past and we expect that they will continue to fluctuate in the future.
This fluctuation is a result of a variety of factors, including the following:
unpredictable demand for our products;
decline in the average selling prices of our products due to competitive
pricing pressures;
seasonality in sales of our products;
adverse changes in product and customer mix;
slower than anticipated market acceptance of new or enhanced versions of
our products;
competing flash memory card standards which displace the standards used
in our products;
changes in our distribution channels;
timing of license and royalty revenue;
fluctuations in product costs, particularly due to fluctuations in
manufacturing yields and utilization;
availability of sufficient silicon wafer foundry capacity to meet
customer demand;
significant yield losses which could affect our ability to fulfill
customer orders and could increase our costs;
lengthening in manufacturing cycle times due to our suppliers operating
at peak capacity;
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increased research and development expenses;
exchange rate fluctuations, particularly the U.S. dollar to Japanese yen
exchange rate;
changes in general economic conditions, in particular the economic
recession in Japan;
natural disasters affecting the countries in which we conduct our
business, particularly Taiwan, Japan and the United States;
difficulty of forecasting and management of inventory levels; and
expenses related to obsolescence of unsold inventory.
DIFFICULTY OF ESTIMATING SILICON WAFER NEEDS
When we order silicon wafers from our foundries, we have to estimate the
number of silicon wafers needed to fill product orders several months into the
future. If we overestimate this number, we will build excess inventories which
could harm our gross margins and operating results. For example, in the second
quarter of 1998, our product gross margins declined to 12% from 30% in the
previous quarter due in part to a write down of inventory to reflect net
realizable value. If we underestimate the number of silicon wafers needed to
fill product orders, we may be unable to obtain an adequate supply of wafers
which could harm our product revenues. Because our largest volume product,
CompactFlash, is sold into an emerging consumer market, it is very difficult to
accurately forecast future sales. A substantial majority of our quarterly sales
have historically been from orders received and fulfilled in the same quarter.
In addition, our product order backlog may fluctuate substantially from quarter
to quarter.
ANTICIPATED GROWTH IN EXPENSE LEVELS
Due to anticipated growth, we increased our expense levels in the first nine
months of 1999. We expect operating expenses to continue to increase as a result
of the need to hire additional personnel to support expected growth in sales
unit volumes, sales and marketing efforts and research and development
activities, including our recently announced collaboration with Toshiba
providing for the joint development of 512 megabit and 1 gigabit flash memory
chips. In addition, we have significant fixed costs and we cannot readily reduce
these expenses over the short term. If revenues do not increase proportionately
to operating expenses, or if revenues decrease or do not meet expectations for a
particular period, our business, financial condition and results of operations
will be harmed.
VARIABILITY OF AVERAGE SELLING PRICES AND GROSS MARGIN
Our product mix varies quarterly, which affects our overall average selling
prices and gross margins. Our CompactFlash products, which currently represent
the majority of our product revenues, have lower average selling prices and
gross margins than our higher capacity FlashDisk and FlashDrive products. We
believe that sales of CompactFlash products may become an even more significant
percentage of our product revenues as consumer applications, such as digital
cameras, become more popular. Dependence on CompactFlash sales, together with
lower pricing caused by increased competition, caused average unit selling
prices to decline 28% during fiscal 1998, and 27% in the first nine months of
1999 compared to the same period in 1998. We expect this trend to continue.
VARIABILITY OF LICENSE FEES AND ROYALTIES
Our intellectual property strategy is to cross-license our patents to other
manufacturers of flash products. Under these arrangements, we earn license fees
and royalties on individually negotiated terms. The timing of revenue
recognition from these payments is dependent on the terms of each contract and
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on the timing of product shipments by the third parties. This may cause license
and royalty revenues to fluctuate significantly from quarter to quarter. Because
these revenues have higher gross margins than product revenues, gross margins
and net income fluctuate significantly with changes in license and royalty
revenues. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations."
IN TRANSITIONING TO NEW PROCESSES AND PRODUCTS WE FACE PRODUCTION AND MARKET
ACCEPTANCE RISKS.
GENERAL
Successive generations of our products have incorporated semiconductor
devices with greater memory capacity per chip. Two important factors that enable
us to decrease the costs per megabyte of our flash data storage products are the
development of higher capacity semiconductor devices and the implementation of
smaller geometry manufacturing processes. A number of challenges exist in
achieving a lower cost per megabyte, including:
overcoming lower yields often experienced in the early production of new
semiconductor devices;
problems with design and manufacturing of products that will incorporate
these devices; and
production delays.
Because our products are complex, we periodically experience significant
delays in the development and volume production ramp up of our products. Similar
delays could occur in the future and could harm our business, financial
condition and results of operations.
128 MEGABIT TECHNOLOGY
We began shipments of 128 megabit products in the second quarter of 1999. In
the third quarter of 1999, we accelerated the production ramp up of our 128
megabit flash memory technology to meet increased demand. Lower than anticipated
yields on our 128 megabit flash memory contributed to a decline in gross margins
in the third quarter of 1999. If we continue to experience unplanned yield
problems, we may be unable to meet our customers' demand for high capacity
MultiMediaCard and CompactFlash products which could result in lost sales and
reduced revenues. In addition, our gross margins may be harmed by any problems
we encounter in the production of our 128 megabit flash memory.
D2 FLASH TECHNOLOGY
We have developed new products based on D2 flash technology, a new flash
architecture designed to store two bits in each flash memory cell. High density
flash memory, such as D2 flash, is a complex technology that requires strict
manufacturing controls and effective test screens. Problems encountered in the
shift to volume production for new flash products could impact both reliability
and yields, and result in increased manufacturing costs and reduced
availability. We may not be able to manufacture reliable and cost effective D2
flash products in commercial volumes and with yields sufficient to result in
lower costs per megabyte. Furthermore, D2 flash technology needs significantly
improved write speed so that it can be usefully applied to market applications
such as digital cameras. It is possible that we may not be able to achieve the
targeted write speed for our 256 megabit product.
In the fourth quarter of 1999, we expect to increase production of our 256
megabit flash memory technology, which has a lower cost per megabyte than the
128 megabit technology. If we are unable to bring our 256 megabit flash memory
into full production as quickly as planned or if we experience unplanned yield
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problems, we will not be able to meet our customers' forecasted demand in the
fourth quarter of 1999 and beyond, which would result in lost sales, reduced
revenues and reduced margins.
We expect the majority of products shipped in the fourth quarter of 1999 to
be built with our 128 megabit and 256 megabit flash memory. If we are unable to
successfully achieve the planned yields for these designs, we will be unable to
meet our forecasted customer needs, and consequently our revenues and profits
may fall significantly below our expectations.
MULTIMEDIACARD PRODUCTS
We expect to increase the MultiMediaCard product family production volumes
in the fourth quarter of 1999. This product presents new challenges in assembly
and testing. During the startup phase, we have experienced fluctuations in
yields which have reduced MultiMediaCard product availability, increased
manufacturing costs and reduced product margins for this product family. We are
currently unable to meet customer demand for MultiMediaCard products. This is
primarily due to demand exceeding previous forecasts from our customers.
Although we are steadily resolving the assembly manufacturing issues, we have
not yet achieved the production assembly yields necessary for high volume
production. In the third quarter of 1999, these lower-than-planned assembly
yields constrained MultiMediaCard availability and adversely impacted our gross
margins.
SECURE DIGITAL MEMORY CARD PRODUCTS
We recently announced a memorandum of understanding, under which we, along
with Matsushita and Toshiba, will jointly develop and promote the Secure Digital
Memory Card. The Secure Digital Memory Card is an enhanced version of our
MultiMediaCard that will incorporate advanced security and copyright protection
features required by the emerging markets for the electronic distribution of
music, video and other copyrighted works. We expect to begin shipping our Secure
Digital Memory Card products in the second quarter of 2000. Negotiations for a
definitive agreement concerning this collaboration are underway, but we cannot
assure you that these negotiations will be successful or that we, Matsushita and
Toshiba will enter into a definitive agreement.
The Secure Digital Memory Card will incorporate a number of new features,
including SDMI compliant security and copy protection, a mechanical write
protect switch and a high data transfer rate. We have never built products
incorporating these features. Any problems or delays in establishing production
capabilities or ramping up production volumes of our Secure Digital Memory Card
products could result in lost sales or increased manufacturing costs in 2000. In
addition, we cannot be sure that manufacturers of consumer electronic products
will develop new products that use the Secure Digital Memory Card. Conversely,
broad acceptance of our Secure Digital Memory Card by consumers may reduce
demand for our MultiMediaCard and CompactFlash card products. See "--The success
of our business depends on emerging markets and new products."
WE DEPEND ON THIRD PARTY FOUNDRIES FOR SILICON WAFERS.
All of our products require silicon wafers. We rely on USC and USIC in
Taiwan to supply all of our silicon wafers. We depend on these foundries to
allocate a portion of their capacity to our needs, produce acceptable quality
wafers with acceptable manufacturing yields and deliver our wafers on a timely
basis at a competitive price. If these foundries are unable to satisfy these
requirements, our business, financial condition and operating results may
suffer. For example, in September 1999, both USIC and USC were damaged and
temporarily shut down by an earthquake in Taiwan. As a result, 8 to 10% of our
silicon wafers in production at the time of the earthquake had to be discarded
and no new wafers could be manufactured for 11 days, resulting in the loss or
destruction of a portion of our fourth quarter wafer supply. We expect that our
existing silicon wafer inventory, combined with our planned output from USIC and
USC, will allow us to ship more megabytes in the fourth quarter of 1999 than in
the third quarter of 1999. However, due to this disruption in wafer supply, we
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expect fourth quarter financial results to be affected by spot shortages and
increased expediting costs, and that our quarter-over-quarter revenue growth
rate in the fourth quarter will be lower than in the third quarter. This
expectation is based, however, on the assumption that resumed production at USIC
and USC will continue at historical rates. Additional earthquakes, aftershocks
or other natural disasters in Taiwan could preclude us from obtaining an
adequate supply of wafers to fill customer orders, and could significantly harm
our business, financial condition and results of operations.
Currently, demand for semiconductor wafers has increased significantly, due
to increased demand in the consumer electronics and cellular phone markets.
Increased demand for advanced technology silicon wafers is increasing the price
of these wafers as supply becomes constrained. We expect this trend to continue
throughout 1999 and 2000 which could adversely impact the rate of growth of our
business, either through reduced supply, higher wafer prices or a combination of
the two.
USC and USIC are subsidiaries of UMC. We currently own 10% of USIC, have
the right to appoint one of its directors and are entitled to 12.5% of its total
wafer production. In the second quarter of 1999, UMC announced plans to merge
the USC and USIC foundries into the UMC parent company. When the merger is
complete, which is currently expected to occur in early 2000, we will receive
UMC shares in exchange for the USIC shares we currently own. However, we will
not have a right to a seat on the board of directors of the combined company. We
have received assurances from the senior management of UMC that it intends to
continue to supply us the same wafer capacity at the prices we currently enjoy
under our agreement with USIC. However, there can be no assurance that we will
be able to maintain our current wafer capacity and competitive pricing
arrangement in our future supply negotiations with UMC.
Under the wafer supply agreements with our foundries, we are obligated to
provide monthly rolling forecasts for our anticipated wafer purchases.
Generally, the estimates for the first three months of each forecast are binding
commitments. The estimates for the remaining months may only be changed by a
certain percentage from the previous month's forecast. This limits our ability
to react to fluctuations in demand for our products. For example, if customer
demand falls below our forecast and we are unable to reschedule or cancel our
wafer orders, we may end up with excess wafer inventories, which could result in
higher operating expenses and reduced gross margins. Conversely, if customer
demand exceeds our forecasts, we may be unable to obtain an adequate supply of
wafers to fill customer orders, which could result in lost sales and lower
revenues. In addition, if we are unable to obtain scheduled quantities of wafers
with acceptable price and yields from any foundry, our business, financial
condition and results of operations could be harmed.
THE SUCCESS OF OUR BUSINESS DEPENDS ON EMERGING MARKETS AND NEW PRODUCTS.
In order for demand for our products to grow, the markets for new products
that use CompactFlash and the MultiMediaCard, such as MP3 portable music players
and smart phones, must develop and grow. If sales of these products do not grow,
our revenues and profit margins could level off or decline.
Because we sell our products for use in many new applications, it is
difficult to forecast demand. For example, in the second quarter of 1999, demand
for our 32 megabyte capacity MultiMediaCard for use in MP3 portable digital
music players grew faster than anticipated and we were unable to fill all
customer orders during the quarter. Although we are increasing production of the
MultiMediaCard, if we are unable to fulfill customer demand for these products
in the future, we may lose sales to our competitors.
SECURE DIGITAL MEMORY CARD PRODUCTS
We recently announced a collaboration under which we will jointly develop
our Secure Digital Memory Card, an enhanced version of our MultiMediaCard, which
will incorporate advanced security and copyright protection features required by
the emerging markets for the electronic distribution of music, video and other
copyrighted works. We expect to begin shipping our Secure Digital Memory Cards
in 32 and 64 megabyte capacities in the second quarter of 2000. The Secure
Digital Memory Card is slightly thicker and uses a different interface than our
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MultiMediaCard. Because of these differences, the Secure Digital Memory Card
will not work in current products that include a MultiMediaCard slot. In order
for the market for our Secure Digital Memory Card to develop, manufacturers of
digital audio/video and portable computing products must include a Secure
Digital Memory Card compatible slot in their products and acquire a license to
the security algorithms. If OEMs do not incorporate Secure Digital Memory Card
slots in their products or do not buy our Secure Digital Memory Cards, our
business, financial condition and results of operations may be harmed. In
addition, consumers may postpone or altogether forego buying products that
utilize our MultiMediaCard and CompactFlash cards in anticipation of new
products that will incorporate the Secure Digital Memory Card. If this occurs,
sales of our MultiMediaCard and CompactFlash products may be harmed. The main
competition for the Secure Digital Memory Card is expected to come from the Sony
Memory Stick. Sony has substantially greater resources, financial and other,
than we do and extensive marketing and sales channels and brand recognition. We
cannot assure you that our Secure Digital Memory Card will be successful in the
face of such competition.
In addition, the market for MP3 portable digital music players is very new
and it is uncertain how quickly consumer demand for these players will grow. If
this market does not grow as quickly as anticipated or our customers are not
successful in selling their MP3 portable music players to consumers, our
revenues could be adversely affected. In addition, it is often the case with new
consumer markets that after an initial period of new market formation and
initial acceptance by early adopters, the market enters a period of slow growth
as standards emerge and infrastructure develops. In the event that this occurs
in the MP3 music market or other emerging markets, sales of our products would
be harmed.
The success of our new product strategy will depend upon, among other
things, the following:
our ability to successfully develop new products with higher memory
capacities and enhanced features at a lower cost per megabyte;
the development of new applications or markets for our flash data
storage products;
the extent to which prospective customers design our products into their
products and successfully introduce their products; and
the extent to which our products or technologies become obsolete or
noncompetitive due to products or technologies developed by others.
512 MEGABIT AND 1 GIGABIT SCALE FLASH MEMORY CARD PRODUCTS
In October 1999, we entered into a nonbinding memorandum of understanding with
Toshiba providing for the joint development and manufacture of 512 megabit and 1
gigabit flash memory chips and Secure Digital Memory Card controllers. As part
of this collaboration, we and Toshiba plan to employ Toshiba's future 0.16
micron and 0.13 micron NAND flash integrated circuit manufacturing technology
and SanDisk's multilevel cell flash and controller system technology. The
development of 512 megabit and 1 gigabit flash memory chips and Secure Digital
Memory Card controllers is expected to be complex and may incorporate SanDisk
and Toshiba technology that is still under development. We cannot assure you
that we and Toshiba will successfully develop these new products or the
underlying technology, or that any development will be completed in a timely or
cost-effective manner. If we are not successful in any of the above, our
business, financial condition and results of operations could suffer.
WE MAY BE UNABLE TO MAINTAIN MARKET SHARE.
We may be unable to increase our production volumes at a sufficiently rapid
rate so as to maintain our market share. Ultimately, our growth rate depends on
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our ability to obtain sufficient flash memory wafers to meet demand. If we are
unable to do so in a timely manner, we may lose market share to our competitors.
OUR INTERNATIONAL OPERATIONS MAKE US VULNERABLE TO CHANGING CONDITIONS AND
CURRENCY FLUCTUATIONS.
POLITICAL RISKS
Currently, all of our flash memory wafers are produced by two foundries in
Taiwan. We also use a third-party subcontractor in Taiwan for the assembly and
testing of our MultiMediaCard products. We may therefore be affected by the
political, economic and military conditions in Taiwan. Taiwan is currently
engaged in various political disputes with China and both countries have
recently conducted military exercises in or near the other's territorial waters
and airspace. The Taiwanese and Chinese governments may continue to escalate
these disputes, resulting in an economic embargo, a disruption in shipping
routes or even military hostilities. This could harm our business by
interrupting or delaying the production or shipment of flash memory wafers or
MultiMediaCard products by our Taiwanese foundries and subcontractor. See "-- We
depend on our suppliers and third party subcontractors."
In addition, in the second quarter of 1999, we began using a third-party
subcontractor in China for the assembly and testing of our CompactFlash
products. As a result, our business could be harmed by the effect of political,
economic, legal and other uncertainties in China. Under its current leadership,
the Chinese government has been pursuing economic reform policies, including the
encouragement of foreign trade and investment and greater economic
decentralization. The Chinese government may not continue to pursue these
policies and, even if it does continue, these policies may not be successful.
The Chinese government may also significantly alter these policies from time to
time. In addition, China does not currently have a comprehensive and highly
developed legal system, particularly with respect to the protection of
intellectual property rights. As a result, enforcement of existing and future
laws and contracts is uncertain, and the implementation and interpretation of
such laws may be inconsistent. Such inconsistency could lead to piracy and
degradation of our intellectual property protection.
ECONOMIC RISKS
We price our products primarily in U.S. dollars. As a result, if the value
of the U.S. dollar increases relative to foreign currencies, our products could
become less competitive in international markets. For example, our products are
relatively more expensive in Asia because of the weakness of many Asian
currencies relative to the US dollar. In addition, we currently invoice some of
our customers in Japanese yen. Therefore, fluctuations in the Japanese yen
against the U.S. dollar could harm our business, financial condition and results
of operations.
Our sales are also highly dependent upon global economic conditions. In
fiscal 1998, sales to Japan declined to 31.6% of total product sales from 38.1%
in 1997. In the first nine months of 1999, sales to Japan represented 25.2% of
product revenue compared to 31.7% for the same period of 1998. We believe these
declines were primarily due to the Japanese economic crisis and market
recession. If the current market conditions in Japan do not improve, or if they
decline further, our results of operations may suffer. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
GENERAL RISKS
Our international business activities could also be limited or disrupted by
any of the following factors:
the need to comply with foreign government regulation;
general geopolitical risks such as political and economic instability,
potential hostilities and changes in diplomatic and trade relationships;
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natural disasters affecting the countries in which we conduct our
business, particularly Taiwan and Japan;
imposition of regulatory requirements, tariffs, import and export
restrictions and other barriers and restrictions;
longer payment cycles and greater difficulty in accounts receivable
collection;
potentially adverse tax consequences;
less protection of our intellectual property rights; and
delays in product shipments due to local customs restrictions.
WE DEPEND ON OUR SUPPLIERS AND THIRD PARTY SUBCONTRACTORS.
We rely on our vendors, some of which are sole source suppliers, for several
of our critical components. We do not have long-term supply agreements with some
of these vendors. Our business, financial condition and operating results could
be harmed by delays or reductions in shipments if we are unable to develop
alternative sources or obtain sufficient quantities of these components. For
example, we rely on USIC and USC for all of our flash memory wafers and
Motorola, Inc. and NEC to supply certain designs of microcontrollers. In
September 1999, both USIC and USC were damaged and temporarily shut down by an
earthquake in Taiwan. In addition, due to industry-wide increasing demand for
semiconductors, we have recently experienced resistance to price reductions from
some of our important suppliers. See "--We depend on third party foundries for
silicon wafers."
We also rely on third-party subcontractors to assemble and test the memory
components for our products. We have no long-term contracts with these
subcontractors and cannot directly control product delivery schedules. This
could lead to product shortages or quality assurance problems which could
increase the manufacturing costs of our products and have adverse effects on our
operating results.
During the second and third quarters of 1999, we transferred a substantial
portion of wafer testing, packaged memory final testing, card assembly and card
testing to Silicon Precision Industries Co., Ltd. in Taiwan and Celestica, Inc.
in China. By the end of the year we expect that they will be assembling and
testing a majority of our mature, high-volume products. This increased reliance
on subcontractors is expected to reduce manufacturing costs and give us access
to increased production capacity. During this transition period, we will
continue full operations at our Sunnyvale production facility while
simultaneously transferring testing equipment and training personnel of our
subcontractors. However, we do not have sufficient duplicative production
testing equipment at Sunnyvale and at our subcontractors. Therefore, any
significant problems in this complex transfer of operations may result in a
disruption of production and a shortage of product to meet customer demand in
the fourth quarter of 1999 and beyond.
CONTINUING DECLINES IN OUR AVERAGE SALES PRICES MAY RESULT IN DECLINES IN OUR
GROSS MARGINS.
In 1998, the average unit selling prices of our products declined 28%
compared to 1997. In the first nine months of 1999, the average unit selling
prices of our products declined 27% compared to the same period of 1998. Because
flash data storage markets are characterized by intense competition and price
reductions for our products are necessary to meet consumer price points, we
expect that market-driven pricing pressures will continue. This will likely
result in a further decline in average sales prices for our products. We believe
that we can offset declining average sales prices by achieving manufacturing
cost reductions and developing new products that incorporate more advanced
technology, include more advanced features and can be sold at stable average
gross margins despite continued declines in average selling price per megabyte.
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However, if we are unable to achieve such cost reductions and technological
advances, this could result in lost sales and declining gross margins, and as a
result, our business, financial condition and results of operations could
suffer.
The semiconductor industry is cyclical and we believe it is currently in a
recovery from one of its most severe down cycles. During most of 1997 and 1998,
the semiconductor industry experienced significant production over capacity,
which reduced margins for substantially all flash memory suppliers.
OUR MARKETS ARE HIGHLY COMPETITIVE.
FLASH MEMORY MANUFACTURERS AND MEMORY CARD ASSEMBLERS
We compete in an industry characterized by intense competition, rapid
technological changes, evolving industry standards, declining average selling
prices and rapid product obsolescence. Our competitors include many large
domestic and international companies that have greater access to advanced wafer
foundry capacity, substantially greater financial, technical, marketing and
other resources, broader product lines and longer standing relationships with
customers. Our primary competitors include:
storage flash chip producers, such as Hitachi Ltd., Samsung Electronics
Company Ltd. and Toshiba Corporation;
socket flash, linear flash and component manufacturers, such as Advanced
Micro Devices, Inc., Atmel Corporation, Intel Corporation, Macronix
International Co., Ltd., Micron Technology, Inc., Mitsubishi Electronic
Corporation, Sharp Electronics Corporation and STMicroelectronics NV;
and
module or card assemblers, such as Lexar Media, Inc., M-Systems, Inc.,
Pretec Electronics Corp., Simple Technology Inc., SMART Modular
Technologies, Inc., Sony Corporation, Kingston Technology Company,
Panasonic Consumer Electronic Company, Silicon Storage Technology, Inc.,
TDK Corporation, Matsushita Battery, Inc. and Viking Components, Inc.,
who combine controllers and flash memory chips developed by others into
flash storage cards.
In addition, over 25 companies have been certified by the CompactFlash
Association to manufacture and sell their own brand of CompactFlash. We believe
additional manufacturers will enter the CompactFlash market in the future.
We have announced a memorandum of understanding under which we, Matsushita
and Toshiba will jointly develop and promote a next generation flash memory card
called the Secure Digital Memory Card. Under this agreement, Secure Digital
Memory Card licenses will be granted to other flash memory card manufacturers,
which will increase the competition for our Secure Digital Memory Card,
CompactFlash and MultiMediaCard products. In addition, Matsushita and Toshiba
will sell Secure Digital Memory Cards that will compete directly with our
products. While other flash card manufacturers will be required to pay the three
companies license fees and royalties, there will be no royalties or license fees
payable among the three companies for their respective sales of the Secure
Digital Memory Card.
In October 1999, we entered into a nonbinding memorandum of understanding
with Toshiba providing for the joint development and manufacture of 512 megabit
and 1 gigabit flash memory chips and Secure Digital Memory Card controllers. We
and Toshiba will each separately market and sell any products developed and
manufactured under this relationship. Accordingly, we will compete directly with
Toshiba for sales of these advanced chips and controllers and no royalties or
license fees will be payable between the two companies for their respective
sales.
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We have entered into patent cross-license agreements with several of our
leading competitors including, Hitachi, Samsung, Toshiba, Intel and Sharp. Under
these agreements, each party may manufacture and sell products that incorporate
technology covered by the other party's patents related to flash memory devices.
As we continue to license our patents to certain competitors, competition will
increase and may harm our business, financial condition and results of
operations.
ALTERNATIVE STORAGE MEDIA
Competing products have been introduced that promote industry standards that
are different from our CompactFlash and MultiMediaCard products, including
Toshiba's SmartMedia, Sony Corporation's Memory Stick, Sony's standard floppy
disk used for digital storage in its Mavica digital cameras, Panasonic's Mega
Storage cards, Iomega's Clik drive, a miniaturized, mechanical, removable disk
drive and M-Systems' Diskonchip for embedded storage applications. Each
competing standard is mechanically and electronically incompatible with
CompactFlash and MultiMediaCard. If a manufacturer of digital cameras or other
consumer electronic devices designs in one of these alternative competing
standards, CompactFlash or MultiMediaCard will be eliminated from use in that
product.
In September 1998, IBM introduced the microdrive, a rotating disk drive in a
Type II CompactFlash format. Initially, this product will compete directly with
our Type II CompactFlash memory cards, which we introduced in the second quarter
of 1999, for use in high-end professional digital cameras. In October 1998,
M-Systems introduced their Diskonchip 2000 Millennium product which competes
against our Flash ChipSet products in embedded storage applications such as set
top boxes and networking appliances.
According to independent industry analysts, Sony's Mavica digital camera
captured a considerable portion of the United States market for digital cameras
in 1998. The Mavica uses a standard floppy disk to store digital images and
therefore uses no CompactFlash, or any other flash cards. Our sales prospects
for CompactFlash cards have been adversely impacted by the success of the
Mavica.
Our MultiMediaCard products also have faced significant competition from
Toshiba's SmartMedia flash cards and we expect to face similarly significant
competition from Sony's Memory Stick. Although the Memory Stick is proprietary
to Sony, if it is adopted and achieves widespread use in future products, sales
of our MultiMediaCard and CompactFlash products may decline.
ALTERNATIVE FLASH TECHNOLOGIES
We also face competition from products based on multilevel cell flash
technology such as Intel's 64 megabit and 128 megabit StrataFlash chips and
Hitachi's 256 megabit multilevel cell flash chip. These products compete with
our D2 multilevel cell flash technology. Multilevel cell flash is a
technological innovation that allows each flash memory cell to store two bits of
information instead of the traditional single bit stored by the industry
standard flash technology. In the second quarter of 1999, Intel announced their
new 128 megabit multilevel cell chip and Hitachi began shipping customer samples
of CompactFlash cards employing their new multilevel cell flash chip. In
addition, Toshiba has begun customer shipments of 32 megabyte SmartMedia cards
employing their new 256 megabit flash chip. Although Toshiba has not
incorporated multilevel cell flash technology in their 256 megabit flash chip,
their use of more advanced lithographic design rules has resulted in a
comparably-sized die and may allow them to achieve a more competitive cost
structure than that of our 256 megabit D2 flash chip.
Furthermore, we expect to face competition from existing competitors and
from other companies that may enter our existing or future markets that have
similar or alternative data storage solutions which may be less costly or
provide additional features. Price is an important competitive factor in the
market for consumer products. Increased price competition could lower gross
margins if our average selling prices decrease faster than our costs and could
also result in lost sales.
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OUR BUSINESS DEPENDS UPON CONSUMER PRODUCTS.
In 1998 and the first nine months of 1999, we received more product revenue
and shipped more units of products destined for consumer electronics
applications, principally digital cameras, than for any other application. We
believe that these products will encounter intense competition and be more price
sensitive than products sold into our other target markets. In addition, we must
spend more on marketing and promotion in consumer markets to establish brand
name recognition and preference.
A significant portion of sales to the consumer electronics market is made
through distributors and to retailers. Sales through these channels typically
include rights to return unsold inventory. As a result, we do not recognize
revenue until after the product has been sold to the end user. If our
distributors and retailers are not successful in this market, there could be
substantial product returns, which would harm our business, financial condition
and results of operations.
SALES TO A SMALL NUMBER OF CUSTOMERS REPRESENT A SIGNIFICANT PORTION OF OUR
REVENUES.
More than half of our revenues come from a small number of customers. For
example, sales to our top 10 customers accounted for approximately 59%, 67%, and
71%, respectively, of our product revenues for 1998, 1997, and 1996. In the
first nine months of 1999, our top 10 customers represented approximately 55% of
product revenues. In the first nine months of fiscal 1999 one customer accounted
for more than 10% of product sales. In fiscal year 1998, two customers each
accounted for 10% or more of our product sales. If we were to lose any of these
customers or experience any material reduction in orders from these customers,
our revenues and operating results would suffer. Our sales are generally made by
standard purchase orders rather than long-term contracts. In addition, the
composition of our major customer base changes from year to year as the market
demand for our customers' products change. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
OUR MULTIPLE SALES CHANNELS MAY COMPETE FOR A LIMITED NUMBER OF CUSTOMER SALES.
Web based sales of our products today represent a small but growing portion
of our overall sales. Sales on the Internet tend to undercut the traditional
distribution channels and may dramatically change the way our consumer products
are purchased in future years. We cannot assure you that we will successfully
manage the inherent channel conflicts between our retail channel customers and
customers that wish to purchase directly on the Internet.
THERE IS SEASONALITY IN OUR BUSINESS.
Sales of our products, in particular the sale of CompactFlash products, in
the consumer electronics applications market are subject to seasonality. As a
result, product sales are impacted by seasonal purchasing patterns with higher
sales generally occurring in the second half of each year. In addition, in the
past we have experienced a decrease in orders in the first quarter from our
Japanese OEM customers primarily because most customers in Japan operate on a
fiscal year ending in March and prefer to delay purchases until the beginning of
their next fiscal year. For example, our product revenues were 24% lower in the
first quarter of 1998 than in the fourth quarter of 1997, mostly due to these
seasonal factors and the Asian economic crisis. Although we did not experience
this seasonality in the first quarter of 1999, we cannot assure you that we will
not experience seasonality in the future. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
WE MUST ACHIEVE ACCEPTABLE WAFER MANUFACTURING YIELDS.
The fabrication of our products requires wafers to be produced in a highly
controlled and ultra clean environment. Semiconductor companies that supply our
wafers sometimes have experienced problems achieving acceptable wafer
manufacturing yields. Semiconductor manufacturing yields are a function of both
our design technology and the foundry's manufacturing process technology. Low
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yields may result from design errors or manufacturing failures. Yield problems
may not be determined or improved until an actual product is made and can be
tested. As a result, yield problems may not be identified until the wafers are
well into the production process. The risks associated with yields are even
greater because we rely on independent offshore foundries for our wafers which
increases the effort and time required to identify, communicate and resolve
manufacturing yield problems. If the foundries cannot achieve the planned
yields, this will result in higher costs and reduced product availability, and
could harm our business, financial condition and results of operations.
Under the terms of our nonbinding memorandum of understanding with Toshiba,
we and Toshiba will jointly form and fund a joint venture which will equip and
operate a silicon wafer manufacturing line in Virginia to manufacture 512
megabit and 1 gigabit flash memory chips and Secure Digital Memory Card
controllers. However, we cannot assure you that this manufacturing line will
produce satisfactory quantities of wafers with acceptable prices and yields. Any
failure in this regard could materially harm our business, financial condition
and results of operations. In addition, the construction and operation of this
line will cause us to incur significant expense and may result in the diversion
of resources from other important areas of business. We cannot assure you that
we or Toshiba will be able to secure sufficient funding to support this
manufacturing line. In addition, we have no experience in operating a wafer
manufacturing line and we cannot assure you that we will be successful in
operating it on a cost-effective basis or at all.
RISKS ASSOCIATED WITH PATENTS, PROPRIETARY RIGHTS AND RELATED LITIGATION.
GENERAL
We rely on a combination of patents, trademarks, copyright and trade secret
laws, confidentiality procedures and licensing arrangements to protect our
intellectual property rights. In the past, we have been involved in significant
disputes regarding our intellectual property rights and claims that we may be
infringing third parties' intellectual property rights. We expect that we may be
involved in similar disputes in the future. We cannot assure you that:
any of our existing patents will not be invalidated;
patents will be issued for any of our pending applications;
any claims allowed from existing or pending patents will have sufficient
scope or strength; or
our patents will be issued in the primary countries where our products
are sold in order to protect our rights and potential commercial
advantage.
In addition, our competitors may be able to design their products around our
patents.
We intend to vigorously enforce our patents but we cannot be sure that our
efforts will be successful. If we were to have an adverse result in any
litigation, we could be required to pay substantial damages, cease the
manufacture, use and sale of infringing products, expend significant resources
to develop non-infringing technology, discontinue the use of certain processes
or obtain licenses to the infringing technology. Any litigation is likely to
result in significant expense to us, as well as divert the efforts of our
technical and management personnel. For example the Lexar litigation described
below has resulted in cumulative litigation expenses approaching $1 million.
CROSS-LICENSES AND INDEMNIFICATION OBLIGATIONS
If we decide to incorporate third party technology into our products or if
we are found to infringe on others' intellectual property, we could be required
to license intellectual property from a third party. We may also need to license
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some of our intellectual property to others in order to enable us to obtain
cross-licenses to third party patents. Currently, we have patent cross-license
agreements with several companies, including Hitachi, Intel, Samsung, Sharp and
Toshiba and we are in discussions with other companies regarding potential
cross-license agreements. We cannot be certain that licenses will be offered
when we need them, or that the terms offered will be acceptable. If we do obtain
licenses from third parties, we may be required to pay license fees or royalty
payments. In addition, if we are unable to obtain a license that is necessary to
the manufacture of our products, we could be required to suspend the manufacture
of products or stop our wafer suppliers from using processes that may infringe
the rights of third parties. We cannot assure you that we would be successful in
redesigning our products or that the necessary licenses will be available under
reasonable terms.
We have historically agreed to indemnify various 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
attorney's fees. We may periodically engage in litigation as a result of these
indemnification obligations. We are not currently engaged in any such
indemnification proceedings. Our insurance policies exclude coverage for third
party claims for patent infringement. Any future obligation to indemnify our
customers or suppliers could harm our business, financial condition or results
of operations.
LITIGATION RISKS ASSOCIATED WITH OUR INTELLECTUAL PROPERTY
From time to time, it may be necessary to initiate litigation against third
parties to preserve our intellectual property rights. These parties could in
turn bring suit against us. For example, in March 1998 we filed a complaint in
federal court against Lexar Media, Inc. for infringement of one of our flash
card patents. Lexar disputed this claim and asserted that our patent was invalid
or unenforceable, as well as asserting various counterclaims including unfair
competition, violation of the Lanham Act, patent misuse, interference with
prospective economic advantage, trade defamation and fraud. We have denied all
of these counterclaims. In July 1998, the court denied Lexar's request to have
the case dismissed. Discovery in this suit began in August 1998. On February 22,
1999, the court considered arguments and papers submitted by the parties
regarding the scope and proper interpretation of the asserted claims in our
patent at issue in the Lexar suit. On March 4, 1999, the court issued its ruling
on the proper construction of the claim terms in our patent. On July 30, 1999,
we filed a motion for partial summary judgment that Lexar CompactFlash and PC
Cards contributorily infringe our patent. A hearing on this motion has been
deferred by the court until January 2000. In August 1999, we had a mandatory
settlement meeting with Lexar. No settlement was reached through this meeting. A
trial date has not yet been set.
OUR RAPID GROWTH MAY STRAIN OUR OPERATIONS.
We are currently experiencing rapid growth, which has placed, and continues
to place, a significant strain on our personnel and other resources. To
accommodate this growth, we must continue to hire, train, motivate and manage
our employees. We are having difficulty hiring the necessary engineering, sales
and marketing personnel to support our growth. In addition, we must make a
significant investment in our existing internal information management systems
to support increased manufacturing, as well as accounting and other management
related functions. Our systems, procedures and controls may not be adequate to
support our rapid growth, which could in turn harm our business, financial
condition and results of operations.
OUR SUCCESS DEPENDS ON KEY PERSONNEL, INCLUDING OUR EXECUTIVE OFFICERS, THE LOSS
OF WHOM COULD DISRUPT OUR BUSINESS.
Our success greatly depends on the continued contributions of our senior
management and other key research and development, sales, marketing and
operations personnel, including Dr. Eli Harari, our founder, President and Chief
Executive Officer. Our success will also depend on our ability to recruit
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additional highly skilled personnel. We cannot assure you that we will be
successful in hiring or retaining such key personnel, or that any of our key
personnel will remain employed with us.
YEAR 2000 ISSUES MAY HARM OUR BUSINESS.
Many existing computer systems and applications may not function properly
when using dates beyond December 31, 1999. We have established a Year 2000 Risk
Management program to assess the impact that the Year 2000 issue may have on our
business. Based on our assessment to date, all of our flash memory and
connectivity products are Year 2000 compliant. Other Year 2000 issues that we
face include assessment and remediation of the computer systems used for
facilities control, machine control and manufacturing testing and Year 2000
compliance of our key suppliers and customers.
Our estimated total costs for Year 2000 compliance issues are not expected
to have a material adverse affect on our business. However, the failure of our
key suppliers and customers to take proper remedial efforts could harm our
business, financial condition and results of operations. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--Year
2000 Readiness Disclosure."
ANTI-TAKEOVER PROVISIONS IN OUR CHARTER DOCUMENTS, STOCKHOLDER RIGHTS PLAN AND
IN DELAWARE LAW COULD PREVENT OR DELAY A CHANGE IN CONTROL AND, AS A RESULT,
NEGATIVELY IMPACT OUR STOCKHOLDERS.
We have taken a number of actions that could have the effect of discouraging
a takeover attempt. For example, we have adopted a stockholder rights plan that
would cause substantial dilution to a stockholder who attempts to acquire us on
terms not approved by our board of directors. In addition, our certificate of
incorporation grants the board of directors the authority to fix the rights,
preferences and privileges of and issue up to 4,000,000 shares of preferred
stock without stockholder action. Although we have no present intention to issue
shares of preferred stock, such an issuance could have the effect of making it
more difficult and less attractive for a third party to acquire a majority of
our outstanding voting stock. Preferred stock may also have other rights,
including economic rights senior to the common stock that could have a material
adverse effect on the market value of the common stock. In addition, we are
subject to the anti-takeover provisions of Section 203 of the Delaware General
Corporation Law. This section provides that a corporation shall not engage in
any business combination with any interested stockholder during the three-year
period following the time that such stockholder becomes an interested
stockholder. This provision could have the effect of delaying or preventing a
change of control of SanDisk.
OUR STOCK PRICE HAS BEEN, AND MAY CONTINUE TO BE, VOLATILE.
The market price of our stock has fluctuated significantly in the past and
is likely to continue to fluctuate in the future. For example, between July 1,
1998 and October 20, 1999, our closing stock price has fluctuated from a low of
$5 7/8 to a high of $94 1/8. We believe that such fluctuations will continue as
a result of future announcements concerning us, our competitors or principal
customers regarding technological innovations, new product introductions,
governmental regulations, litigation or changes in earnings estimates by
analysts. In addition, in recent years the stock market has experienced
significant price and volume fluctuations and the market prices of the
securities of high technology companies have been especially volatile, often for
reasons outside the control of the particular companies. These fluctuations as
well as general economic, political and market conditions may have an adverse
affect on the market price of our common stock.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Please refer to the Company's Form 10-K/A for the year ended December
31, 1998.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information required by this item is set forth in Note 6 of the
Notes to the Condensed Consolidated Financial Statements on pages 7 and 8 and
under "Factors That May Affect Future Results - Risks Associated with Patents,
Proprietary Rights and Related Litigation" on pages 28 and 29 of this Form 10-Q
for the quarterly period ended September 30, 1999, and is incorporated herein by
reference.
ITEM 2. CHANGES IN SECURITIES
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A. Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT TITLE
- -------- -------------
<S> <C>
3.1 Certificate of Incorporation of the Registrant, as amended to date. (2)
3.2 Form of Amended and Restated Certificate of Incorporation of the Registrant. (2)
3.3 Bylaws of the Registrant, as amended. (2)
3.4 Form of Amended and Restated Bylaws of the Registrant. (2)
3.5 Certificate of Designation for the Series A Junior Participating Preferred Stock, as filed with the Delaware
Secretary of State on April 24, 1997. (4)
4.1 Reference is made to Exhibits 3.1, 3.2, 3.3 and 3.4. (2)
4.3 Amended and Restated Registration Rights Agreement, among the
Registrant and the investors and founders named therein, dated
March 3, 1995. (2)
4.5 Series F Preferred Stock Purchase Agreement between Seagate Technology, Inc. and
the Registrant, dated January 15, 1993. (2)
4.8 Rights Agreement, dated as of April 18, 1997, between the Company and
Harris Trust and Savings Bank. (4)
4.9 First Amendment to Rights Agreement dated
October 22, 1999, between Harris Trust and the Registrant. (11)
9.1 Amended and Restated Voting Agreement, among the Registrant and the investors
named therein, dated March 3, 1995. (2)
10.10 License Agreement between the Registrant and Dr. Eli Harari, dated September 6, 1988. (2)
10.13 1989 Stock Benefit Plan. (2)
10.14 1995 Stock Option Plan. (2)
10.15 Employee Stock Purchase Plan. (2)
10.16 1995 Non-Employee Directors Stock Option Plan. (2)
10.18 Lease Agreement between the Registrant and G.F. Properties, dated March 1, 1996. (3)
10.21 Amendment to Lease Agreement between the Registrant and G.F. Properties, dated April 3, 1997. (5)
10.23 Foundry Venture Agreement between the Registrant and United Microelectronics Corporation, dated June 27, 1997. (1, 6)
10.24 Written Assurances Re: Foundry Venture Agreement between the Registrant and United Microelectronics Corporation,
dated September 13, 1995. (1, 6)
10.25 Side Letter between Registrant and United Microelectronics Corporation,
dated May 28, 1997. (1, 6)
10.27 Clarification letter with regards to Foundry Venture Agreement between the Registrant and United Microelectronics
Corporation dated October 24, 1997. (7)
10.28 Lease Agreement between the Registrant and G.F. Properties, dated June 10, 1998. (8)
10.29 Trade Finance Agreement between the Registrant and Union Bank of California, dated July 15, 1998. (9)
10.30 1995 Stock Option Plan Amended and Restated as of December 17, 1998. (12)
10.31 1995 Non-Employee Directors Stock Option Plan Amended and Restated as of December 17, 1998. (12)
10.32 1995 Employee Stock Purchase Plan Amended and Restated as of December 17, 1998. (12)
21.1 Subsidiaries of the Registrant. (10)
27.1 Financial Data Schedule for the quarter ended September 30, 1999. (In EDGAR format only)
</TABLE>
- ----------
(1) Confidential treatment granted as to certain portions of these exhibits.
(2) Previously filed as an Exhibit to the Registrant's Registration Statement
on Form S-1 (No. 33-96298).
Page 32
<PAGE>
(3) Previously filed as an Exhibit to the Registrant's 1995 Annual Report on
Form 10-K.
(4) Previously filed as an Exhibit to the Registrant's Current Report on
Form 8-K/A dated April 18, 1997.
(5) Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended June 30, 1997.
(6) Previously filed as an Exhibit to the Registrant's Current Report on form
8-K dated October 16, 1997.
(7) Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended September 30, 1997.
(8) Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended June 30, 1998.
(9) Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended September 30, 1998.
(10) Previously filed as an Exhibit to the Registrant's Annual Report on Form
10-K.
(11) Previously filed as an Exhibit to the Registrant's Current Report on Form
8-K dated January 1, 1999.
(12) Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended March 31, 1999.
B. Reports on Form 8-K
No reports on form 8-K were filed during the quarter ended September
30, 1999.
Page 33
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.
SanDisk Corporation
(Registrant)
By: /S/ CINDY L. BURGDORF
--------------------------------------
Cindy L. Burgdorf
Chief Financial Officer, Senior Vice
President, Finance and
Administration and Secretary
(On behalf of the Registrant and as
Principal Financial Officer.)
DATED: NOVEMBER 3, 1999
Page 34
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<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> SEP-30-1999
<CASH> 22,469
<SECURITIES> 116,717
<RECEIVABLES> 43,700
<ALLOWANCES> 0
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<CURRENT-ASSETS> 223,358
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0
0
<COMMON> 193,090
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<TOTAL-LIABILITY-AND-EQUITY> 308,203
<SALES> 57,624
<TOTAL-REVENUES> 67,534
<CGS> 43,897
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