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ITEM 1.
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LEGAL PROCEEDINGS
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Lemelson Medical, Education &
Research Foundation, LLP—Patent Infringement
We received notice on November 26, 2001, that the Lemelson Medical, Education &
Research Foundation, LLP filed a complaint on November 13, 2001, against us and other defendants. The complaint was filed in the District Court of Arizona and alleges that our manufacturing processes infringe several patents that the Lemelson
Foundation allegedly owns. The complaint also states that these allegedly infringed patents relate to machine vision technology and bar coding technology. On March 7, 2002, we were served with the Lemelson Foundation complaint. Thereafter, the
case was stayed pending the outcome of related cases against parties involving the same patents. On September 9, 2005, in one of these related cases, the U.S. Court of Appeals for the Federal Circuit affirmed a decision by the U.S. District
Court for the District of Nevada that found several Lemelson Foundation patents to be unenforceable. Because the final outcome of the related cases are expected to affect the Lemelson Foundation’s lawsuit against us, an estimate of potential
damages, if any, would be premature and speculative. We believe this lawsuit is without merit and we intend to vigorously defend ourselves against it. As of September 30, 2007, no amounts have been recorded in the consolidated financial
statements for this matter as management believes an unfavorable outcome is not probable.
Hard Drive Class Action Lawsuit
On October 6, 2006, an individual, Boris Brand, filed a purported nationwide class action lawsuit against us in the Superior Court for the State of California,
County of Los Angeles, alleging that our description of the capacity of our hard drive
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products constitutes fraudulent, unfair, deceptive and false advertising under California Business and Professions Code Sections 17200 and 17500 and violates
the California Consumers Legal Remedies Act. In particular, the lawsuit alleges that our description of the storage capacity on our hard drives uses a decimal basis for measuring gigabytes which results in a lower storage capacity when the hard
drives are incorporated into an operating system that uses a binary gigabyte basis for measurement. Plaintiff seeks restitution, disgorgement, compensatory damages and injunctive relief and attorneys’ fees. We believe this lawsuit is without
merit and we intend to vigorously defend ourselves against it. Also, we have notified all of the suppliers who have supplied us with the hard drives involved, since we believe that those suppliers have a legal duty to indemnify us in the event that
we have to pay any damages. There can be no assurance, however, that any of our suppliers will indemnify us for any damages resulting from this lawsuit. Our insurance company has denied our claim for coverage. We continue to pursue all available
remedies against our insurance carrier and suppliers. As of September 30, 2007, no amounts have been recorded in the consolidated financial statements for this matter as management believes it is too early in the proceedings to estimate a
liability and determine a final outcome.
Napster Lawsuit
On February 14, 2006, we filed a lawsuit against Napster, LLC, a licensor, in the Superior Court for the State of California, County of Los Angeles, alleging breach of contract and fraud and demanding monetary damages. On March 2,
2007, Napster filed a cross-complaint against us for breach of contract, fraud, and other claims and demanding monetary damages and specific performance. The cross-complaint was also filed against Fabrik, Inc. and alleges that Fabrik is a successor
to the contract in dispute as a result of Fabrik’s purchase of the assets of our Consumer Division in February 2007. On September 10, 2007, the parties entered into a settlement agreement whereby the parties agreed to dismiss with
prejudice all claims and demands. As part of the settlement, Napster agreed to make a one-time, lump-sum payment to us. This amount was received during the third quarter of 2007 and recorded as income from discontinued operations. This settlement is
a complete and amicable resolution and should not be construed as an admission by any of the parties to this litigation of any wrongdoing
We are not
currently involved in any other material legal proceedings. From time to time, however, we may become subject to additional legal proceedings, claims, and litigation arising in the ordinary course of business, including, but not limited to,
employee, customer and vendor disputes. In addition, in the past we have received, and we may continue to receive in the future, letters alleging infringement of patent or other intellectual property rights. Our management believes that these
letters generally are without merit and we intend to contest them vigorously.
This Report contains forward-looking statements
based on the current expectations, assumptions, estimates and projections about our industry and us. These forward-looking statements involve risks and uncertainties. Our actual results could differ materially from those discussed in these
forward-looking statements as a result of certain factors, as more fully described in this section and elsewhere in this Report. You should carefully consider the following risks before you decide to buy shares of our common stock. The risks and
uncertainties described below are not the only ones facing us. Additional risks and uncertainties, including those risks set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” above, may
also adversely impact and impair our business. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. In such case, the trading price of our common stock could decline, and you
may lose all or part of the money you paid to buy our stock. We do not undertake to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.
We expect our quarterly operating results to fluctuate in future periods, causing our stock price to fluctuate or decline.
Our quarterly operating results have fluctuated in the past, and we believe they will continue to do so in the future. Our future results of operations will depend on
many factors including:
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Our suppliers’ production levels for the components used in our products;
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Our ability to procure required components;
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Fluctuations in the cost of components and changes in the average sales prices of our products;
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Changes in our customer and product revenue mix;
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Our ability to successfully integrate any acquired businesses or assets;
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Market acceptance of new and enhanced versions of our products;
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Expansion of our international business, including the opening of offices and facilities in foreign countries;
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The timing of the introduction of new products or components and enhancements to existing products or components by us, our competitors or our suppliers;
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Order cancellations, product returns, inventory buildups by customers and inventory write-downs;
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Manufacturing inefficiencies associated with the start-up of new products and volume production;
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Expenses associated with strategic transactions, including acquisitions, joint ventures and capital investments;
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Our ability to adequately support potential future rapid growth;
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Our ability to absorb manufacturing overhead if revenues decline;
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The effects of litigation;
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Increases in our sales and marketing expenses in connection with decisions to pursue new product initiatives; and
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Expenses associated with the start-up of new operations or divisions.
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Due to the above and other factors, quarterly revenues and results of operations are difficult to forecast, and period-to-period comparisons of our operating results may not be predictive of future performance. In one
or more future quarters, our results of operations may fall below the expectations of securities analysts and investors. In that event, the trading price of our common stock would likely decline. In addition, the trading price of our common stock
may fluctuate or decline regardless of our operating performance.
We have a less diversified customer base and our future success will be dependent on
our ability to grow our OEM business.
Prior to the divesture of our Consumer Division in February 2007, we sold memory and external hard drive storage
solutions through our Consumer Division to retail customers and sold memory solution through our OEM Division to OEM customers. We are now focused on, and expect to spend significant resources to grow, our business in the OEM market for customized
memory solutions based on Flash memory and DRAM technologies. As a result of the divestiture of our Consumer Division, we have a less diversified customer base and our future success will be dependent on our ability to grow our OEM business. In
addition, our focus on a single market—the OEM market—means that the seasonality and cyclicality of this market will have a greater impact on our operations and revenues than in previous years when we concentrated on the consumer and OEM
markets. There can be no assurance that our focus on the OEM market will be successful or that the resources we commit to grow our OEM business will result in future profitability or market acceptance of our business or products. Our failure to grow
our OEM business will harm our reputation and have a material adverse effect on our business, financial condition and results of operations.
Sales to a
limited number of customers represent a significant portion of our revenues, and the loss of any key customer would materially reduce our revenues.
Our dependence on a limited number of customers means that the loss of a major customer or any reduction in orders by a major customer would materially reduce our revenues. We have no long-term contracts with our customers. Historically, a
relatively limited number of customers have accounted for a significant percentage of our revenues. We expect that the divestiture of our Consumer Division in February 2007 will not change our future dependence on a limited number of customers for a
significant portion of our revenues and, in fact, may exacerbate our dependence since all of our revenues will be derived from our OEM Division. Our ten largest customers accounted for an aggregate of 75.1% and 72.7% of our revenues in the three and
nine months ended September 30, 2007, respectively, compared to 79.7% and 78.8% or our revenues in the three and nine months ended September 30, 2006, respectively. Smart Modular has accounted for more than 50% of our revenues for the
three and nine months ended September 30, 2007. The following table sets forth certain information about each of our customers that accounted for more than 10.0% of our revenues in any of the three and nine months ended September 30, 2007
and 2006.
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Percentage of Revenues
for the Three Months Ended
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Percentage of Revenues
for the Nine Months Ended
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September 30,
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September 30,
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2007
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2006
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2007
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2006
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Smart Modular
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52
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35
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52
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37
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Micron Semiconductor
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27
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%
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*
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%
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Consolidation in some of our customers’ industries
may result in increased customer concentration and the potential loss of customers as a result of acquisitions. In addition, the composition of our major customer base changes from quarter to quarter
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as the market demand for our customers’ products changes, and we expect this variability to continue in the future. We expect that sales of our products
to a limited number of customers will continue to contribute materially to our revenues in the foreseeable future. The loss of, or a significant reduction in purchases by any of our major customers, such as Smart Modular, could harm our business,
financial condition and results of operations.
Our dependence on a small number of suppliers for integrated circuit, or IC, devices and inability to
obtain a sufficient supply of these components on a timely basis could harm our ability to fulfill orders.
Typically, IC devices represent more than
80% of the component costs of our manufactured Flash products and DRAM modules. We are dependent on a small number of suppliers that supply key components used in the manufacture of our products. We have no long-term supply contracts. Some of our
competitors have entered into long-term contracts with suppliers that guarantee them a certain allocation of components, such as Flash IC devices. We have no assurance that our existing suppliers will agree to supply the quantities of components we
may need to meet our production goals. We periodically review opportunities to develop alternative sources for our Flash and DRAM IC device needs. However, our options are very limited because of the small number of memory manufacturers. Samsung
currently supplies substantially all of the IC devices used in our Flash memory products. Micron, Qimonda and Samsung currently supply substantially all of the DRAM IC devices used in our DRAM and IC Tower stacking DRAM memory products. Our
dependence on a small number of suppliers and the lack of any guaranteed sources of supply expose us to several risks, including the inability to obtain an adequate supply of components, price increases, late deliveries and poor component quality. A
disruption in or termination of our supply relationship with any of these significant suppliers due to natural disasters or other factors, or our inability to develop relationships with new suppliers, if required, would cause delays, disruptions or
reductions in product shipments or require product redesigns which could damage relationships with our customers and negatively affect our revenues and could increase our costs or the prices of our products. In particular, if our supply
relationships with Micron, Qimonda and Samsung are disrupted or terminated, our ability to manufacture and sell our products would be harmed and our business would be adversely affected.
Our customers qualify the DRAM ICs of our suppliers for use in their systems. If one of our suppliers should experience quality control problems, it may be disqualified by one or more of our customers. This would
disrupt our supplies of DRAM ICs and reduce the number of suppliers available to us, and may require that we qualify a new supplier.
Our customers
qualify specific Flash and DRAM ICs that are components in our products as part of the product qualification process. If any of our suppliers experience quality control problems with a specific IC that was previously
qualified by our customers, our products that utilize that IC may be disqualified by one or more of our customers. This would disrupt our supply of Flash or DRAM ICs, reduce the number of suppliers available to us and adversely affect
our ability to fulfill our customers’ product orders. Further, we may be required to qualify a new supplier’s IC, which could negatively impact our revenues during the new qualification process. There can be no
assurance that we would be able to find and successfully qualify new suppliers in a timely manner or obtain ICs from new suppliers on commercially reasonable terms.
Moreover, from time to time, our industry experiences shortages in Flash and DRAM IC devices which have driven up the price of those components and required some vendors to place their customers, ourselves included,
on component allocation. This means that while we may have customer orders, we may not be able to obtain the materials that we need to fill those orders in a timely manner or at competitive prices. If we are unable to obtain Flash and DRAM IC
devices at economical prices, our gross margins would decline unless we could raise the prices of our products in a commensurate manner or offset the cost increases elsewhere. In addition, if we are unable to obtain sufficient Flash IC devices and
other components to meet our customers’ requirements, they may reduce future orders or eliminate us as a supplier and our revenues may decline. As a result, our reputation could be harmed, we may not be able to replace any lost business with
new customers, and we may lose market share to our competitors.
Ineffective management of inventory levels or product mix, order cancellations, product
returns, and inventory write-downs could adversely affect our results of operations.
If we are unable to properly monitor, control and manage our
inventory and maintain an appropriate level and mix of products with our customers, we may incur increased and unexpected costs associated with this inventory. For example, if we manufacture products in anticipation of future demand that does not
materialize, or if a customer cancels outstanding orders, we could experience an unanticipated increase in our inventory that we may be unable to sell in a timely manner, if at all. As a result, we could incur increased expenses associated with
writing off excess or obsolete inventory. In addition, while we may not be contractually obligated to accept returned products, we may determine that it is in our best interest to accept returns in order to maintain good relations with our
customers. Product returns would increase our inventory and reduce our revenues. Alternatively, we could end up with too little inventory and we may not be able to satisfy demand, which could have a material adverse effect on our customer
relationships. Our risks related to inventory management are exacerbated by our strategy of closely matching inventory levels with product demand, leaving limited margin for error. We have had to write-down inventory in the past for reasons such as
obsolescence, excess quantities and declines in market value below our costs.
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We have no long-term volume commitments from our customers. Sales of our products are made through individual purchase
orders and, in certain cases, are made under master agreements governing the terms and conditions of the relationships.
Customers may change, cancel or
delay orders with limited or no penalties. We have experienced cancellations of orders and fluctuations in order levels from period-to-period and we expect to continue to experience similar cancellations and fluctuations in the future, which could
result in fluctuations in our revenues.
Declines in our average sales prices may result in declines in our revenues and gross profit.
Our industry is competitive and characterized by historical declines in average sales prices. Our average sales prices may decline due to several factors. From time
to time, overcapacity in the DRAM and Flash memory component markets have resulted in significant declines in component prices, which has negatively impacted our average sales prices, revenues and gross profit. During periods of overcapacity, our
revenues and gross profit will decline if we do not increase unit sales of existing products or fail to introduce and sell new products in quantities sufficient to offset declines in sales prices. Any efforts to reduce costs and develop new products
to offset the impact of further declines in average sales prices may not be successful. Our competitors and customers also impose significant pricing pressures on us. Since a large percentage of our sales are to a small number of customers that are
primarily distributors and large OEMs, these customers have exerted, and we expect they will continue to exert, pressure on us to make price concessions.
In addition, the continued transition to smaller design geometries and the use of 300 millimeter wafers by existing memory manufacturers could lead to a significant increase in the worldwide supply of DRAM and Flash components. Increases in
the worldwide supply of DRAM and Flash components could also result from manufacturing capacity expansions. If not offset by increases in demand, these increases would likely lead to further declines in the average sales prices of our products and
have a material adverse effect on our business and operating results. Furthermore, even if supply remains constant, if demand were to decrease, it would harm our average sales prices.
We are subject to the cyclical nature of the semiconductor industry and any future downturn could adversely affect our business.
The semiconductor industry, including the memory markets in which we compete, is highly cyclical and characterized by constant and rapid technological change, rapid product obsolescence and price erosion, evolving
standards, short product life cycles and wide fluctuations in product supply and demand. The industry has experienced significant downturns often connected with, or in anticipation of, maturing product cycles of both semiconductor companies’
and their customers’ products and declines in general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average sales prices.
Prior downturns in the semiconductor industry negatively impacted our average sales prices, revenues and earnings. Any future downturns could have a material adverse effect on our business and results of operations.
We may be less competitive if we fail to develop new and enhanced products and introduce them in a timely manner.
The memory, high-performance computing, networking and communications, and OEM markets are subject to rapid technological change, product obsolescence, frequent new
product introductions and enhancements, changes in end-user requirements and evolving industry standards. Our ability to compete in these markets will depend in significant part upon our ability to successfully develop, introduce and sell new and
enhanced products on a timely and cost-effective basis, and to respond to changing customer requirements.
We have experienced, and may in the future
experience, delays in the development and introduction of new products. These delays would provide a competitor a first-to-market opportunity and allow a competitor to achieve greater market share. Our product development is inherently risky because
it is difficult to foresee developments in technology, anticipate the adoption of new standards, coordinate our technical personnel, and identify and eliminate design flaws. Defects or errors found in our products after commencement of commercial
shipments could result in delays in market acceptance of these products. New products, even if first introduced by us, may not gain market acceptance. Accordingly, there can be no assurance that our future product development efforts will result in
future profitability or market acceptance. Lack of market acceptance for our new products will jeopardize our ability to recoup research and development expenditures, hurt our reputation and harm our business, financial condition and results of
operations.
We may also seek to develop products with new standards for our industry. It will take time for these new standards and products to be
adopted, for customers to accept and transition to these new products and for significant sales to be generated from them, if this happens at all. Moreover, broad acceptance of new standards or products by customers may reduce demand for our older
products. If this decreased demand is not offset by increased demand for our new products, our results of operations could be harmed. We cannot assure you that any new products or standards we develop will be commercially successful.
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Our efforts to expand our business internationally may not be successful and may expose us to additional risks that
may not exist in the United States, which in turn could cause our business and operating results to suffer.
We sell our products to customers in
foreign countries and seek to increase our level of international business activity through the expansion of our operations into select international markets, including Asia and Europe. Such strategy may include opening sales offices in foreign
countries, the outsourcing of manufacturing operations to third party contract manufacturers, establishing joint ventures with foreign partners, and the establishment of manufacturing operations in foreign countries. Since the beginning of 2004, we
have opened sales, marketing, procurement and engineering offices in Austria, Germany, Italy, Hong Kong, Japan, Malaysia, the Netherlands, Taiwan and the United Kingdom.
In addition, we are investing a significant amount of capital to build a 210,000 square foot manufacturing facility in Malaysia that is expected to be operational in the first quarter of 2008. Over time, we intend for
this facility to serve as a major hub for our Asia operational activities including manufacturing, sales and marketing, procurement, and logistics. Integrating these operations into our global infrastructure is going to present challenges for both
the local and corporate management teams. Failure to successfully integrate these functions into our global infrastructure, including significant and prolonged delays, will have a negative impact on our overall operations. In addition, not being
able to efficiently bring the Malaysian operations on line in a reasonable timeframe will cause us to delay or forego some of the original perceived benefits of operating internationally such as lower average production and engineering labor costs,
better access to growing markets in Asia, improved supply chain efficiency, reduced lead times, increased manufacturing efficiency through investments in new state-of-the-art equipment and a lower overall long-term effective tax rate.
Establishing operations in a foreign country or region presents numerous risks, including:
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foreign laws and regulations, which may vary country by country, may impact how we conduct our business;
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higher costs of doing business in certain foreign countries, including different employment laws;
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difficulty protecting our intellectual property rights from misappropriation or infringement;
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difficulties and costs of staffing and managing operations in certain foreign countries;
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political or economic instability;
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changes in import/export duties;
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necessity of obtaining government approvals;
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work stoppages or other changes in labor conditions;
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difficulties in collecting accounts receivables on a timely basis or at all;
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longer payment cycles and foreign currency fluctuations; and
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seasonal reductions in business activity in some parts of the world, such as Europe.
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In addition, changes in policies and/or laws of the United States or foreign governments resulting in, among other things, higher taxation, currency conversion
limitations, restrictions on fund transfers or the expropriation of private enterprises, could reduce the anticipated benefits of our international expansion. We may also encounter potential adverse tax consequences if taxing authorities in
different jurisdictions worldwide disagree with our interpretation of various tax laws or our determinations as to the income and expenses attributable to specific jurisdictions, which could result in our paying additional taxes, interest and
penalties. Furthermore, any actions by countries in which we conduct business to reverse policies that encourage foreign trade or investment could adversely affect our business. If we fail to realize the anticipated revenue growth of our future
international operations, our business and operating results could suffer.
We expect that our strategy to expand our international operations will require
the expenditure of significant resources and involve the efforts and attention of our management. Unlike some of our competitors, we have limited experience operating our business in foreign countries. Some of our competitors may have substantial
advantage over us in attracting customers in certain foreign countries due to earlier established operations in that country, greater knowledge with respect to cultural differences of customers residing in that country and greater brand recognition
and longer-standing relationships with customers in that country. If our international expansion efforts in any foreign country are unsuccessful, we may decide to cease these foreign operations, which would likely harm our reputation and cause us to
incur expenses and losses.
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Failure to maintain effective internal control over financial reporting could result in a negative market reaction.
Since our common equity public float was greater than $75 million as of June 30, 2007, we are subject to Section 404 of the Sarbanes-Oxley
Act of 2002 for the year ending December 31, 2007.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that we undertake a thorough
examination of our internal control systems and procedures for financial reporting. We also are required to completely document and test those systems. Ultimately, our management will be responsible for assessing the effectiveness of our internal
control over financial reporting, and our independent registered public accounting firm will be requested to attest to that report. We cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact
of the same on our operations since there is no precedent available by which to measure compliance adequacy.
Our filing of our annual report on a timely
basis will depend upon our timely completion of these tasks. A late annual report could have material adverse effects on us, both legally and with respect to the opinions of the participants in the securities market.
If we identify one or more material weaknesses in our internal control over financial reporting, our management will be unable to assert such internal controls are
effective. If we are unable to assert that our internal controls over financial reporting are effective, or if our independent registered public accounting firm is unable to attest that our management’s report is fairly stated or they are
unable to express an opinion on the effectiveness of our internal controls, it could result in a negative market reaction.
Compliance with changing
regulation of corporate governance and public disclosure may result in additional expenses.
Changing laws, regulations and standards relating to
corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq rules, have required most public companies, including us, to devote additional internal and external resources to various governance
and compliance matters. Because we have a relatively small corporate staff, we rely heavily on outside professional advisers to assist us with these efforts.
These costs will include increased accounting related fees associated with preparing the attestation report on our internal controls over financial reporting as required under Section 404 of the Sarbanes-Oxley Act of 2002. These new or
changed laws, regulations and standards are subject to varying interpretations, as well as modifications by the government and Nasdaq. The way in which they are applied and implemented may change over time, which could result in even higher costs to
address and implement revisions to compliance (including disclosure) and governance practices. We intend to invest the necessary resources to comply with evolving laws, regulations and standards. If our efforts to comply with new or changed laws,
regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, our reputation may be harmed and we will be required to incur additional expenses.
The total costs we incurred in connection with the Company’s preparation to comply with Section 404 of the Sarbanes-Oxley Act of 2002 were approximately
$250,000 during the first nine months of 2007. Although it is not yet possible to quantify at this time, we expect to incur additional expenses, including higher audit and legal fees, in the fourth quarter of 2007 related to our Sarbanes-Oxley Act
compliance activities.
We may make acquisitions that are dilutive to existing shareholders, result in unanticipated accounting charges or otherwise
adversely affect our results of operations.
We intend to grow our business through business combinations or other acquisitions of businesses, products
or technologies that allow us to complement our existing product offerings, expand our market coverage, increase our engineering workforce or enhance our technological capabilities. If we make any future acquisitions, we could issue stock that would
dilute our shareholders’ percentage ownership, incur substantial debt, reduce our cash reserves or assume contingent liabilities.
Furthermore,
acquisitions may require material infrequent charges and could result in adverse tax consequences, substantial depreciation, deferred compensation charges, in-process research and development charges, the amortization of amounts related to deferred
compensation and identifiable purchased intangible assets or impairment of goodwill, any of which could negatively impact our results of operations.
Our limited experience in acquiring other businesses, product lines and technologies may make it difficult for us to overcome problems encountered in connection with any acquisitions we may undertake.
We continually evaluate and explore strategic opportunities as they arise, including business combinations, strategic partnerships, capital investments and the purchase,
licensing or sale of assets. Our experience in acquiring other businesses,
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product lines and technologies is limited. The attention of our small management team may be diverted from our core business if we undertake any future
acquisitions. Our recent acquisition of Memtech, SSD Corporation, the assets of a division of Integrated Circuit Solution Incorporation, the assets of Gnutek Ltd. and any potential future acquisitions also involve numerous risks, including, among
others:
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Problems and delays in successfully assimilating and integrating the purchased operations, personnel, technologies, products and information systems;
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Unanticipated costs and expenditures associated with the acquisition, including any need to infuse significant capital into the acquired operations;
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Adverse effects on existing business relationships with suppliers, customers and strategic partners;
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Risks associated with entering markets and foreign countries in which we have no or limited prior experience;
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Contractual, intellectual property or employment issues;
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Potential loss of key employees of purchased organizations; and
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Potential litigation arising from the acquired company’s operations before the acquisition.
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These risks could disrupt our ongoing business, distract our management and employees, harm our reputation and increase our expenses. Our inability to overcome problems
encountered in connection with any acquisitions could divert the attention of management, utilize scarce corporate resources and otherwise harm our business. These challenges are magnified as the size of an acquisition increases, and we cannot
assure you that we will realize the intended benefits of any acquisition. For example, in June 2004 we discontinued the operation of our Xiran Division, which was formed in 2002 as a result of our acquisition of the assets of Irvine Networks, LLC.
The Xiran Division developed advanced board-level solutions that optimize server performance for networked storage applications, including IP storage. We were unable to successfully bring the Xiran Division products to market after funding its
operations for over two years. In connection with the discontinued operation, we recorded a one-time charge of approximately $3.0 million in the second quarter of 2004.
We are unable to predict whether or when any prospective acquisition candidate will become available or the likelihood that any acquisition will be completed. Even if we do find suitable acquisition opportunities, we
may not be able to consummate the acquisitions on commercially acceptable terms or realize the anticipated benefits of any acquisitions we do undertake.
Three of our beneficial shareholders have substantial influence over our operations and could control all matters requiring shareholder approval.
Our founders, Manouch Moshayedi, Mike Moshayedi and Mark Moshayedi, are brothers and beneficially own approximately 50% of our outstanding common stock at September 30, 2007 (assuming the inclusion of shares of common stock subject to
options that are presently exercisable or will become exercisable within 60 days of such date). In addition, Manouch Moshayedi and Mark Moshayedi are executive officers and directors. As a result, they potentially have the ability to control or
influence all matters requiring approval by our shareholders, including the election and removal of directors, approval of significant corporate transactions and the decision of whether a change in control will occur. This potential control could
affect the price that certain investors may be willing to pay in the future for shares of our common stock.
We are involved from time to time in claims
and litigation over intellectual property rights, which may adversely affect our ability to manufacture and sell our products.
The semiconductor
industry is characterized by vigorous protection and pursuit of intellectual property rights. We believe that it may be necessary, from time to time, to initiate litigation against one or more third parties to preserve our intellectual property
rights. Some of our suppliers and licensors have generally agreed to provide us with various levels of intellectual property indemnification for products and technology we purchase or license from them. A third-party could claim that our products,
which incorporate the products purchased or technology licensed from our suppliers and licensors, infringes a patent or other proprietary right. In addition, from time to time, we have received, and may continue to receive in the future, notices
that claim we have infringed upon, misappropriated or misused other parties’ proprietary rights. Any of the foregoing events or claims could result in litigation. Such litigation, whether as plaintiff or defendant, would likely result in
significant expense to us and divert the efforts of our technical and management personnel, whether or not such litigation is ultimately determined in our favor. In the event of an adverse result in such litigation, we could be required to pay
substantial damages, cease the manufacture, use and sale of certain products, expend significant resources to develop non-infringing technology, discontinue the use of certain processes or obtain licenses to use the infringed technology. In
addition, our suppliers’ and licensors’ obligation to indemnify us for intellectual property infringement may be insufficient or inapplicable to any such litigation. A license may not be available on commercially reasonable terms, if at
all. Our failure to obtain a license on commercially reasonable terms, or at all, could cause us to incur substantial costs and suspend manufacturing products using the infringed technology. If we obtain a license, we would likely be required to pay
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sales under the license. Such payments would increase our costs of revenues and reduce our gross margins and gross profit. If we are unable to obtain a
license from a third party for technology, we could incur substantial liabilities or be required to expend substantial resources redesigning our products to eliminate the infringement. There can be no assurance that we would be successful in
redesigning our products or that we could obtain licenses on commercially reasonable terms, if at all. Product development or license negotiating would likely result in significant expense to us and divert the efforts of our technical and management
personnel.
We are currently a party to one lawsuit regarding intellectual property as further described under “Legal Proceedings.” Because
litigation is inherently uncertain, we cannot predict the outcome of this lawsuit. Although this lawsuit has been stayed pending the outcome of related lawsuits against other parties, we expect that if this lawsuit resumes, it is likely to divert
the efforts and attention of our key management and technical personnel. In addition, we expect to incur substantial legal fees and expenses in connection with this lawsuit if it resumes. As a result, our defense of this lawsuit, regardless of its
eventual outcome, is expected to be costly and time consuming.
To manage our growth, we may need to improve our systems, controls and procedures and
relocate portions of our business to new or larger facilities.
We have experienced and may continue to experience rapid growth, which has placed, and
could continue to place a significant strain on our managerial, financial and operations resources and personnel. We expect that our number of employees, including management-level employees, will continue to increase for the foreseeable future. We
must continue to improve our operational, accounting and financial systems and managerial controls and procedures, including fraud procedures, and we will need to continue to expand, as well as, train and manage our workforce. From time to time, we
may need to relocate portions of our business to new or larger facilities which could result in disruption of our business or operations. For example, we announced in August 2006 plans to build a 200,000 square foot manufacturing facility in
Malaysia that is expected to be operational in the first quarter of 2008. If we do not manage our growth effectively, including transitions to new or larger facilities, our business could be harmed.
Our indemnification obligations for the infringement by our products of the intellectual property rights of others could require us to pay substantial damages.
As is common in the industry, we currently have in effect a number of agreements in which we have agreed to defend, indemnify and hold harmless our
customers and suppliers from damages and costs which may arise from the infringement by our products of third-party patents, trademarks or other proprietary rights. The scope of such indemnity varies, but may, in some instances, include
indemnification for damages and expenses, including attorneys’ fees. Our insurance does not cover intellectual property infringement. The term of these indemnification agreements is generally perpetual any time after execution of the agreement.
The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We may periodically have to respond to claims and litigate these types of indemnification obligations. Any such
indemnification claims could require us to pay substantial damages.
Our indemnification obligations to our customers and suppliers for product defects
could require us to pay substantial damages.
A number of our product sales and product purchase agreements provide that we will defend, indemnify and
hold harmless our customers and suppliers from damages and costs which may arise from product warranty claims or claims for injury or damage resulting from defects in our products. We maintain insurance to protect against certain claims associated
with the use of our products, but our insurance coverage may not be adequate to cover all or any part of the claims asserted against us. A successful claim brought against us that is in excess of, or excluded from, our insurance coverage could
substantially harm our business, financial condition and results of operations.
Our intellectual property may not be adequately protected, which could
harm our competitive position.
Our intellectual property is critical to our success. We protect our intellectual property rights through patents,
trademarks, copyrights and trade secret laws, confidentiality procedures and employee disclosure and invention assignment agreements. It is possible that our efforts to protect our intellectual property rights may not:
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Prevent the challenge, invalidation or circumvention of our existing patents;
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Result in patents that lead to commercially viable products or provide competitive advantages for our products;
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Prevent our competitors from independently developing similar products, duplicating our products or designing around the patents owned by us;
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Prevent third-party patents from having an adverse effect on our ability to do business;
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Provide adequate protection for our intellectual property rights;
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Prevent disputes with third parties regarding ownership of our intellectual property rights;
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Prevent disclosure of our trade secrets and know-how to third parties or into the public domain; and
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Result in patents from any of our pending applications.
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As part of our confidentiality procedures, we enter into non-disclosure and invention assignment agreements with all of our employees and attempt to control access to and distribution of our technology, documentation and other proprietary
information. However, if such agreements are found to be unenforceable, we may be unable to adequately protect our intellectual property rights. In addition, despite these procedures, third parties could copy or otherwise obtain and make
unauthorized use of our technologies or independently develop similar technologies.
In addition, if our IC Tower stacking patent is found to be invalid,
our ability to exclude competitors from making, using or selling the same or similar products to our IC Tower stacking products would cease. We have on at least one occasion applied for and may in the future apply for patent protection in foreign
countries. The laws of foreign countries, however, may not adequately protect our intellectual property rights. Many U.S. companies have encountered substantial infringement problems in foreign countries. Because we sell some of our products
overseas, we have exposure to foreign intellectual property risks.
We may not be able to maintain or improve our competitive position because of the
intense competition in the memory industry.
We conduct business in an industry characterized by intense competition, rapid technological change,
evolving industry standards, declining average sales prices and rapid product obsolescence. Our primary competitors in the third-party memory industry include: Crucial Memory, a division of Micron Technology, Netlist, Wintec, SMART Modular, SanDisk,
ST Micro and Viking Interworks. Our competitors include many large domestic and international companies that have substantially greater financial, technical, marketing, distribution and other resources, broader product lines, lower cost structures,
greater brand recognition and longer-standing relationships with customers and suppliers. As a result, our competitors may be able to respond better to new or emerging technologies or standards and to changes in customer requirements. Further, some
of our competitors are in a better financial and marketing position from which to influence industry acceptance of a particular industry standard or competing technology than we are. Our competitors may also be able to devote greater resources to
the development, promotion and sale of products, and may be able to deliver competitive products at a lower price.
We expect to face competition from
existing competitors and new and emerging companies that may enter our existing or future markets with similar or alternative products, which may be less costly or provide additional features. In addition, some of our significant suppliers,
including Micron, Qimonda and Samsung Semiconductor, are also our competitors, many of whom have the ability to manufacture competitive products at lower costs as a result of their higher levels of integration. We also face competition from current
and prospective customers that evaluate our capabilities against the merits of manufacturing products internally. Competition may arise due to the development of cooperative relationships among our current and potential competitors or third parties
to increase the ability of their products to address the needs of our prospective customers. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share.
We expect our competitors will continue to improve the performance of their current products, reduce their prices and introduce new products that may offer greater
performance and improved pricing, any of which could cause a decline in sales or loss of market acceptance of our products. In addition, our competitors may develop enhancements to, or future generations of, competitive products that may render our
technology or products obsolete or uncompetitive.
The manufacturing of our products is complex and subject to yield problems, which could decrease
available supply and increase costs.
The manufacture of our Flash memory products, stacked DRAM products and Flash controllers is a complex process,
and it is often difficult for companies to achieve acceptable product yields. Reduced yields could decrease available supply and increase costs. Flash controller yields depend on both our product design and the manufacturing process technology
unique to our semiconductor foundry partners. Because low yields may result from either design defects or process difficulties, we may not identify yield problems until well into the production cycle, when an actual product defect exists and can be
analyzed and tested. In addition, many of these yield problems are difficult to diagnose and time consuming or expensive to remedy.
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The execution of our growth strategy depends on our ability to retain key personnel, including our executive officers,
and to attract qualified personnel.
Competition for employees in our industry is intense. We have had and may continue to have difficulty hiring the
necessary engineering, sales and marketing and management personnel to support our growth. The successful implementation of our business model and growth strategy depends on the continued contributions of our senior management and other key research
and development, sales and marketing and operations personnel, including Manouch Moshayedi, our Chief Executive Officer, Mark Moshayedi, our President, Chief Operating Officer, Chief Technical Officer and Secretary, and Dan Moses, our Executive Vice
President and Chief Financial Officer. In addition, as a result of our adoption of Statement of Financial Accounting Standards (“SFAS”) 123(R), “Share-Based Payment,” we have begun to significantly reduce the use and quantity of
stock options compared to the quantity of stock options we granted in recent years. We may be at a disadvantage in our ability to maintain and recruit qualified employees since many of the companies that compete with us for the same pool of
qualified employees continue to offer stock options as part of their compensation package. We have experienced difficulties maintaining and attracting qualified employees as a result of our reduction in the use of stock options and we expect this
difficulty to continue in the future unless we are able to develop other forms of incentive compensation to replace stock options. The loss of any key employee, the failure of any key employee to perform in his or her current position, or the
inability of our officers and key employees to expand, train and manage our employee base would prevent us from executing our growth strategy.
We face
risks associated with doing business in foreign countries, including foreign currency fluctuations and trade barriers, that could lead to a decrease in demand for our products or an increase in the cost of the components used in our products.
The volatility of general economic conditions and fluctuations in currency exchange rates affect the prices of our products and the prices of the
components used in our products. International sales of our products accounted for 18.8% and 20.0% of our revenues for the three and nine months ended September 30, 2007, respectively, compared to 14.7% and 13.4% of our revenues for the three
and nine months ended September 30, 2006, respectively. No single foreign country accounted for more than 10.0% of our revenues in each of the three and nine months ended September 30, 2007 and 2006. For the three and nine months ended
September 30, 2007 and 2006, more than 95.0% of our international sales were denominated in U.S. dollars. However, if there is a significant devaluation of the currency in a specific country, the prices of our products will increase relative to
that country’s currency and our products may be less competitive in that country. In addition, we cannot be sure that our international customers will continue to be willing to place orders denominated in U.S. dollars. If they do not, our
revenues and results of operations will be subject to foreign exchange fluctuations, which could harm our business. We do not hedge against foreign currency exchange rate risks.
We purchase a majority of the DRAM and Flash components used in our products from local distributors of foreign suppliers. Although our purchases of DRAM and Flash components are currently denominated in U.S. dollars,
devaluation of the U.S. dollar relative to the currency of a foreign supplier would likely result in an increase in our cost of DRAM and Flash components.
Our international sales are subject to other risks, including regulatory risks, tariffs and other trade barriers, timing and availability of export licenses, political and economic instability, difficulties in accounts receivable
collections, difficulties in managing distributors, lack of a significant local sales presence, difficulties in obtaining governmental approvals, compliance with a wide variety of complex foreign laws and treaties and potentially adverse tax
consequences. In addition, the United States or foreign countries may implement quotas, duties, taxes or other charges or restrictions upon the importation or exportation of our products, leading to a reduction in sales and profitability in that
country.
We have experienced quarterly and annual losses in the past and may experience losses in the future.
Although we have been profitable for most of our history, we have experienced losses on a quarterly and annual basis in the past. In 2003 and in the second quarter of
2004, we incurred net losses of $1.6 million and $1.9 million, respectively. We have expended, and will continue to expend, substantial funds to pursue engineering, research and development projects, enhance sales and marketing efforts, expand our
international operations and increase our manufacturing capacity, and otherwise operate our business. There can be no assurance that we will be profitable on a quarterly or annual basis in the future.
Disruption of our operations in our Santa Ana, California, manufacturing facility would substantially harm our business.
Substantially all of our manufacturing operations are located in our facilities in Santa Ana, California. Due to this geographic concentration, a disruption of our
manufacturing operations, resulting from sustained process abnormalities, human error, government intervention or natural disasters, including earthquakes, power failures, fires or floods, could cause us to cease or limit our manufacturing
operations and consequently harm our business, financial condition and results of operations.
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Compliance with environmental laws and regulations could harm our operating results.
We are subject to a variety of environmental laws and regulations governing, among other things, air emissions, waste water discharge, waste storage, treatment and
disposal, and remediation of releases of hazardous materials. Our failure to comply with present and future requirements could harm our ability to continue manufacturing our products. Such requirements could require us to acquire costly equipment or
to incur other significant expenses to comply with environmental regulations. The imposition of additional or more stringent environmental requirements, the results of future testing at our facilities, or a determination that we are potentially
responsible for remediation at other sites where problems are not presently known to us, could result in expenses in excess of amounts currently estimated to be required for such matters.
Failure to comply with governmental laws and regulations could harm our business.
Our business is subject to regulation by various federal and state governmental agencies. Such regulation includes the radio frequency emission regulatory activities of the Federal Communications Commission, the
anti-trust regulatory activities of the Federal Trade Commission and Department of Justice, the consumer protection laws of the Federal Trade Commission, the import/export regulatory activities of the Department of Commerce, the product safety
regulatory activities of the Consumer Products Safety Commission, the regulatory activities of the Occupational Safety and Health Administration, the environmental regulatory activities of the Environmental Protection Agency, the labor regulatory
activities of the Equal Employment Opportunity Commission and tax and other regulations by a variety of regulatory authorities in each of the areas in which we conduct business. We are also subject to regulation in other countries where we conduct
business. In certain jurisdictions, such regulatory requirements may be more stringent than in the United States. We are also subject to a variety of federal and state employment and labors laws and regulations, including the Americans with
Disabilities Act, the Federal Fair Labor Standards Act, the WARN Act and other regulations related to working conditions, wage-hour pay, over-time pay, employee benefits, anti-discrimination, and termination of employment.
Noncompliance with applicable regulations or requirements could subject us to investigations, sanctions, mandatory product recalls, enforcement actions, disgorgement of
profits, fines, damages, civil and criminal penalties, or injunctions. In addition from time to time we have received, and expect to continue to receive, correspondence from former employees terminated by us who threaten to bring claims against us
alleging that we have violated one or more labor and employment regulations. In certain of these instances the former employee has brought claims against us and we expect that we will encounter similar actions against us in the future. An adverse
outcome in any such litigation could require us to pay contractual damages, compensatory damages, punitive damages, attorneys’ fees and costs.
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enforcement actions could harm our business, financial condition, results of operations and cash flows. If any governmental sanctions are imposed, or if we do not prevail in any possible civil or criminal litigation, our business, financial
condition, results of operations and cash flows could be materially adversely affected. In addition, responding to any action will likely result in a significant diversion of management’s attention and resources and an increase in professional
fees.
Our stock price is likely to be volatile and could drop unexpectedly.
Our common stock has been publicly traded only since September 2000. The market price of our common stock has been subject to significant fluctuations since the date of our initial public offering. The stock market
has from time to time experienced significant price and volume fluctuations that have affected the market prices of securities, particularly securities of technology companies. As a result, the market price of our common stock may materially
decline, regardless of our operating performance. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. We may
become involved in this type of litigation in the future. Litigation of this type is often expensive and diverts management’s attention and resources.
Anti-takeover provisions in our charter documents and stock option plan could prevent or delay a change in control and, as a result, negatively impact our shareholders.
We have taken a number of actions that could have the effect of discouraging a takeover attempt. For example, provisions of our amended and restated articles of incorporation and amended and restated bylaws could make
it more difficult for a third party to acquire us, even if doing so would be beneficial to our shareholders. These provisions also could limit the price that certain investors might be willing to pay in the future for shares of our common stock.
These provisions include:
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limitations on who may call special meetings of shareholders;
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advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by shareholders at shareholder
meetings;
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elimination of cumulative voting in the election of directors;
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the right of a majority of directors in office to fill vacancies on the board of directors;
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the ability of our board of directors to issue, without shareholder approval, “blank check” preferred stock to increase the number of outstanding shares
and thwart a takeover attempt.
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Provisions of our 2000 Stock Incentive Plan allow for the automatic vesting of all outstanding options
granted under the 2000 Stock Incentive Plan upon a change in control under certain circumstances. Such provisions may have the effect of discouraging a third party from acquiring us, even if doing so would be beneficial to our shareholders.