UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
| x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
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| For quarterly period ended: September 30, 2009 |
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| OR |
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| o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number: 000-26887
Silicon Image, Inc.
(Exact name of registrant as specified in its charter)
| Delaware | | 77-0396307 |
| (State or other jurisdiction of incorporation or organization) | | (I.R.S. Employer I.D. Number) |
| | | |
1060 East Arques Avenue, Sunnyvale, California 94085
(Address of principal executive office)(Zip Code)
(408) 616-4000
(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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a small reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x | Accelerated filer o |
| | |
Non-accelerated filer o | Smaller reporting company o |
| (Do not check if a smaller reporting company) | |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
| CLASS | | OUTSTANDING AT September 30, 2009 |
| Common Stock, $0.001 par value | | 75,241,093 |
Silicon Image, Inc.
Form 10-Q for the quarter ended September 30, 2009
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| Part I Financial Information (Unaudited) | |
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Part I. Financial Information
Silicon Image, Inc.
(in thousands)
(unaudited)
| | | September 30, 2009 | | | December 31, 2008 | |
| Assets | | | | | | |
| Current Assets: | | | | | | |
| Cash and cash equivalents | | $ | 27,883 | | | $ | 95,414 | |
| Short-term investments | | | 125,335 | | | | 89,591 | |
Accounts receivable, net of allowances for doubtful accounts $1,563 at September 30, 2009 and $1,778 at December 31, 2008 | | | 24,454 | | | | 5,922 | |
| Inventories | | | 12,538 | | | | 12,775 | |
| Prepaid expenses and other current assets | | | 17,417 | | | | 15,275 | |
| Deferred income taxes | | | 6,731 | | | | 6,665 | |
| Total current assets | | | 214,358 | | | | 225,642 | |
| Property and equipment, net | | | 15,125 | | | | 19,394 | |
| Intangible assets, net | | | 28,503 | | | | 32,921 | |
| Deferred income taxes, non-current | | | 22,591 | | | | 28,193 | |
| Goodwill | | | - | | | | 19,210 | |
| Other assets | | | 719 | | | | 1,181 | |
| Total assets | | $ | 281,296 | | | $ | 326,541 | |
| Liabilities and Stockholders’ Equity | | | | | | | | |
| Current Liabilities: | | | | | | | | |
| Accounts payable | | $ | 13,570 | | | $ | 7,278 | |
| Accrued and other current liabilities | | | 18,178 | | | | 23,023 | |
| Deferred license revenue | | | 4,299 | | | | 2,348 | |
| Deferred margin on sales to distributors | | | 2,628 | | | | 6,881 | |
| Total current liabilities | | | 38,675 | | | | 39,530 | |
| Other long-term liabilities | | | 9,259 | | | | 8,064 | |
| Total liabilities | | | 47,934 | | | | 47,594 | |
Commitments and contingencies (See Note 9) | | | | | | | | |
| Stockholders’ Equity: | | | | | | | | |
| Common stock | | | 93 | | | | 92 | |
| Treasury stock | | | (106,556 | ) | | | (106,276 | ) |
| Additional paid-in capital | | | 458,484 | | | | 442,228 | |
| Accumulated deficit | | | (119,199 | ) | | | (57,030 | ) |
| Accumulated other comprehensive income (loss) | | | 540 | | | | (67 | ) |
| Total stockholders’ equity | | | 233,362 | | | | 278,947 | |
| Total liabilities and stockholders’ equity | | $ | 281,296 | | | $ | 326,541 | |
See accompanying Notes to Condensed Consolidated Financial Statements.
Silicon Image, Inc.
(in thousands, except per share amounts)
(unaudited)
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Revenue: | | | | | | | | | | | | |
| Product | | $ | 30,716 | | | $ | 64,974 | | | $ | 94,747 | | | $ | 183,997 | |
| Licensing | | | 6,440 | | | | 12,802 | | | | 20,257 | | | | 30,975 | |
| Total revenue | | | 37,156 | | | | 77,776 | | | | 115,004 | | | | 214,972 | |
| Cost of revenue and operating expenses: | | | | | | | | | | | | | | | | |
| Cost of product revenue (1) | | | 16,801 | | | | 31,518 | | | | 52,284 | | | | 87,921 | |
| Cost of licensing revenue | | | 156 | | | | 223 | | | | 626 | | | | 1,064 | |
| Research and development (2) | | | 17,807 | | | | 20,714 | | | | 53,160 | | | | 64,554 | |
| Selling, general and administrative (3) | | | 17,222 | | | | 17,468 | | | | 43,615 | | | | 54,853 | |
| Amortization of intangible assets | | | 1,473 | | | | 1,587 | | | | 4,419 | | | | 4,761 | |
| Restructuring expense (Note 5) | | | 348 | | | | 1,876 | | | | 8,205 | | | | 1,876 | |
| Goodwill impairment (Note 15) | | | - | | | | - | | | | 19,210 | | | | - | |
| Total cost of revenue and operating expenses | | | 53,807 | | | | 73,386 | | | | 181,519 | | | | 215,029 | |
| Income (loss) from operations | | | (16,651 | ) | | | 4,390 | | | | (66,515 | ) | | | (57 | ) |
| Interest income and other, net | | | 696 | | | | 1,798 | | | | 2,233 | | | | 5,094 | |
| Income (loss) before provision for income taxes | | | (15,955 | ) | | | 6,188 | | | | (64,282 | ) | | | 5,037 | |
| Income tax expense (benefit) | | | (444 | ) | | | 114 | | | | (2,113 | ) | | | (13 | ) |
| Net income (loss) | | $ | (15,511 | ) | | $ | 6,074 | | | $ | (62,169 | ) | | $ | 5,050 | |
| | | | | | | | | | | | | | | | | |
| Net income (loss) per share – basic and diluted | | $ | (0.21 | ) | | $ | 0.08 | | | $ | (0.83 | ) | | $ | 0.07 | |
| Weighted average shares – basic | | | 75,053 | | | | 73,861 | | | | 74,763 | | | | 76,088 | |
| Weighted average shares – diluted | | | 75,053 | | | | 75,334 | | | | 74,763 | | | | 77,185 | |
| | | | | | | | | | | | | | | | | | |
| (1) Includes stock-based compensation expense | | $ | 363 | | | $ | 351 | | | $ | 806 | | | $ | 1,132 | |
| (2) Includes stock-based compensation expense | | | 2,374 | | | | 1,753 | | | | 5,365 | | | | 5,200 | |
| (3) Includes stock-based compensation expense | | | 4,911 | | | | 2,004 | | | | 9,255 | | | | 8,057 | |
See accompanying Notes to Condensed Consolidated Financial Statements.
Silicon Image, Inc.
(in thousands)
(unaudited)
| | | Nine Months Ended September 30, | |
| | | 2009 | | | 2008 | |
| Cash flows from operating activities: | | | | | | |
| Net income (loss) | | $ | (62,169 | ) | | $ | 5,050 | |
| Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities: | | | | | | | | |
| Impairment of goodwill | | | 19,210 | | | | - | |
| Stock-based compensation expense | | | 15,426 | | | | 14,389 | |
| Depreciation | | | 6,814 | | | | 7,894 | |
| Deferred income taxes | | | 5,536 | | | | (5,306 | ) |
| Amortization of intangible assets | | | 4,419 | | | | 4,761 | |
| Amortization of investment premium | | | 2,351 | | | | 768 | |
| Non-cash restructuring expenses | | | 226 | | | | 459 | |
| Loss on disposal and retirement of property and equipment | | | 178 | | | | 562 | |
| Provision for doubtful accounts | | | 42 | | | | 621 | |
| Tax deficiency from employee stock-based compensation plans | | | (1,711 | ) | | | (475 | ) |
| Gain on derivative transactions | | | (211 | ) | | | - | |
| Excess tax benefits from employee stock transactions | | | (32 | ) | | | (527 | ) |
| Realized gain on sale of short-term investments | | | - | | | | (106 | ) |
| Changes in assets and liabilities: | | | | | | | | |
| Accounts receivable | | | (18,543 | ) | | | (2,835 | ) |
| Inventories | | | 237 | | | | 3,695 | |
| Prepaid expenses and other current assets | | | (1,437 | ) | | | 4,167 | |
| Accounts payable | | | 7,403 | | | | 4,590 | |
| Accrued and other current liabilities | | | (3,669 | ) | | | (7,090 | ) |
| Deferred license revenue | | | 1,951 | | | | (815 | ) |
| Deferred margin on sales to distributors | | | (4,253 | ) | | | (2,551 | ) |
| Cash provided by (used in) operating activities | | | (28,232 | ) | | | 27,251 | |
| Cash flows from investing activities: | | | | | | | | |
| Proceeds from sales of short-term investments | | | 110,716 | | | | 171,231 | |
| Purchases of short-term investments | | | (148,592 | ) | | | (188,443 | ) |
| Purchases of property and equipment | | | (2,855 | ) | | | (6,028 | ) |
| Proceeds from sale of property and equipment | | | 120 | | | | - | |
| Cash used in investing activities | | | (40,611 | ) | | | (23,240 | ) |
| Cash flows from financing activities: | | | | | | | | |
| Proceeds from issuances of common stock, net | | | 2,543 | | | | 4,748 | |
| Excess tax benefits from employee stock transactions | | | 32 | | | | 527 | |
| Payments for vendor financed software and intangibles purchased | | | (1,250 | ) | | | (6,153 | ) |
| Repurchase of restricted stock units for income tax withholding | | | (280 | ) | | | - | |
| Repurchase of common stock | | | - | | | | (68,180 | ) |
| Cash provided by (used in) financing activities | | | 1,045 | | | | (69,058 | ) |
| Effect of exchange rate changes on cash and cash equivalents | | | 267 | | | | (407 | ) |
| Net decrease in cash and cash equivalents | | | (67,531 | ) | | | (65,454 | ) |
| Cash and cash equivalents — beginning of period | | | 95,414 | | | | 137,822 | |
| Cash and cash equivalents — end of period | | $ | 27,883 | | | | 72,368 | |
| Supplemental cash flow information: | | | | | | | | |
| Net cash payment (refund) for income taxes | | $ | (4,766 | ) | | $ | 1,924 | |
| Restricted stock units vested | | $ | 780 | | | $ | - | |
| Unrealized net gain (loss) on short-term investments | | $ | 220 | | | $ | (399 | ) |
| Property and equipment purchased but not paid for | | $ | 167 | | | $ | 302 | |
See accompanying Notes to Condensed Consolidated Financial Statements.
Silicon Image, Inc.
September 30, 2009
(unaudited)
1. Basis of Presentation
In the opinion of management, the accompanying unaudited condensed consolidated financial statements of Silicon Image, Inc. (the “Company”, “Silicon Image”, “we” or “our”) included herein have been prepared on a basis consistent with our December 31, 2008 audited financial statements and include all adjustments, consisting of normal recurring adjustments, necessary to fairly state the condensed consolidated balance sheets of Silicon Image and our subsidiaries as of September 30, 2009 and December 31, 2008, the related consolidated statements of operations for the three and nine months ended September 30, 2009 and 2008, and the related consolidated statements of cash flows for the nine months ended September 30, 2009 and 2008. All significant intercompany accounts and transactions have been eliminated. These interim financial statements should be read in conjunction with the audited financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2008. The Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2009 are not necessarily indicative of future operating results to be expected for the fiscal year ending December 31, 2009.
2. Recent Accounting Pronouncements
In June 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Codification (“ASC”) No. 105, Generally Accepted Accounting Principles (“GAAP”) (“ASC 105” or “FASB Codification”), previously referred to as Statement of Financial Accounting Standard (“SFAS”) No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles - a replacement of FASB Statement No 162 (“SFAS 168”). The effective date for use of the FASB Codification is for interim and annual periods ending after September 15, 2009. Companies should account for the adoption of the guidance on a prospective basis. Effective July 1, 2009, the Company adopted the FASB Codification and its adoption did not have a material impact on its consolidated financial statements. The Company has appropriately updated its disclosures with the appropriate FASB Codification references during the three months ended September 30, 2009. As such, all the notes to the condensed consolidated financial statements below as well as the critical accounting policies in the Management’s Discussion and Analysis section have been updated with the appropriate FASB Codification references.
In December 2007, the FASB issued ASC No. 805, Business Combinations (“ASC 805”), previously referred to as SFAS 141 (revised 2007), Business Combinations. ASC 805 will significantly change current practices regarding business combinations. Among the more significant changes, ASC 805 expands the definition of a business and a business combination; requires the acquirer to recognize the assets acquired, liabilities assumed and noncontrolling interests (including goodwill), measured at fair value at the acquisition date; requires acquisition-related expenses and restructuring costs to be recognized separately from the business combination; and requires in-process research and development to be capitalized at fair value as an indefinite-lived intangible asset. ASC 805 is effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company adopted the provisions of ASC 805 on January 1, 2009 and the adoption did not have a significant impact on the Company’s consolidated financial statements. However, if the Company enters into material business combinations in the future, a transaction may significantly impact the Company’s consolidated financial statements as compared to the Company’s previous acquisitions accounted for under prior GAAP requirements, due to the changes described above.
In December 2007, the FASB issued ASC No. 810-10-65, Transition Related to Noncontrolling Interests in Consolidated Financial Statement (“ASC 810-10-65”), previously referred to as SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin (“ARB”) No. 51. ASC 810-10-65 is effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company adopted provisions under ASC 810-10-65 on January 1, 2009. The Company does not currently have any non-controlling interests in its subsidiaries, and accordingly the adoption of this standard did not have a material impact on the Company’s consolidated financial statements.
In March 2008, the FASB issued ASC No. 815-10-65, Transition Related to Disclosures about Derivative Instruments and Hedging Activities (“ASC 815-10-65”), previously referred to as SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133, which requires additional disclosures about the objectives of using derivative instruments, the method by which the derivative instruments and related hedged items are accounted for under ASC No. 815, Derivatives and Hedging (“ASC 815”), previously referred to as FASB Statement No.133 and its related interpretations, and the effect of derivative instruments and related hedged items on financial position, financial performance, and cash flows. ASC 815 also requires disclosure of the fair values of derivative instruments and their gains and losses in a tabular format. Per ASC 815-10-65, the additional disclosures about derivatives and hedging activities mentioned above are required for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged. The Company adopted the provisions mentioned above effective January 1, 2009 and its adoption did not have a material impact on its consolidated financial statements.
In April 2009, the FASB issued ASC No. 320-10-65, Transition Related to Recognition and Presentation of Other-Than-Temporary Impairments (“ASC 320-10-65”), previously referred to as FASB Staff Position (“FSP”) FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. ASC 320-10-65 amends the other-than-temporary impairment guidance for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments in the financial statements. The most significant change ASC 320-10-65 brings is a revision to the amount of other-than-temporary loss of a debt security recorded in earnings. ASC 320-10-65 is effective for interim and annual reporting periods ending after June 15, 2009. The Company adopted this FSP effective April 1, 2009 and the Company’s adoption did not have a material impact on its consolidated financial statements.
In April 2009, the FASB issued ASC No. 820-10-35, Fair Value Measurements and Disclosures – Subsequent Measurement (“ASC 820-10-35”), which discusses the provisions related to the determination of fair value when the volume and level of activity for the asset or liability have significantly decreased, which was previously discussed in FSP SFAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. ASC 820-10-35 provides additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased. ASC 820-10-35 also includes guidance on identifying circumstances that indicate a transaction is not orderly. ASC 820-10-35 emphasizes that even if there has been a significant decrease in the volume and level of activity for the asset or liability and regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. In accordance with FASB ASC No. 820-10-65, Transition Related to FASB Statement No. 157-4,” the above provisions are effective for interim and annual reporting periods ending after June 15, 2009, and is applied prospectively. The Company adopted the provisions relating to determining the fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly under ASC 820-10-35 effective April 1, 2009 and its adoption did not have a material impact on its consolidated financial statements.
In April 2009, the FASB issued ASC No. 805-10-35, Business Combinations Subsequent Measurement (“ASC 805-10-35”), which discusses the accounting for assets acquired and liabilities assumed in a business combination that arise from contingencies, which was previously discussed in FSP FAS 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies. ASC 805-10-35 addresses application issues on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. The provisions under ASC 805-10-35 relating to assets acquired and liabilities assumed in a business combination that arise from contingencies are effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company adopted the provisions of ASC 805 on January 1, 2009 and the adoption did not have a significant impact on the Company’s consolidated financial statements. However, if the Company enters into material business combinations in the future, a transaction may significantly impact the Company’s consolidated financial statements as compared to the Company’s previous acquisitions, accounted for under prior GAAP requirements, due to the changes described above.
In May 2009, the FASB issued ASC No. 855, Subsequent Events (“ASC 855”), previously referred to as SFAS No. 165, Subsequent Events. ASC 855 should be applied to the accounting for and disclosure of subsequent events. This Statement does not apply to subsequent events or transactions that are within the scope of other applicable GAAP that provide different guidance on the accounting treatment for subsequent events or transactions. ASC 855 would apply to both interim financial statements and annual financial statements. The objective of ASC 855 is to establish general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In particular, this Statement sets forth: 1) The period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; 2) The circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and, 3) The disclosures that an entity should make about events or transactions that occurred after the balance sheet date. ASC 855 is effective for interim or annual financial periods ending after June 15, 2009. The Company adopted this standard effective April 1, 2009 and the Company’s adoption did not have a material impact on its consolidated financial statements.
In October 2009, the FASB issued Accounting Standard Update No. 2009-13 on Topic 605, Revenue Recognition– Multiple Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force. The objective of this Update is to address the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. Vendors often provide multiple products or services to their customers. Those deliverables often are provided at different points in time or over different time periods. This Update provides amendments to the criteria in Subtopic 605-25 for separating consideration in multiple-deliverable arrangements. The amendments in this Update establish a selling price hierarchy for determining the selling price of a deliverable. The selling price used for each deliverable will be based on vendor specific objective evidence if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor specific objective evidence nor third-party evidence is available. The amendments in this Update also will replace the term fair value in the revenue allocation guidance with selling price to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. This update is effective for fiscal years beginning on or after June 15, 2010. The Company is currently evaluating the impact, if any, of this new accounting update on its consolidated financial statements.
3. Significant Accounting Policies
The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ materially from these estimates. Areas where significant judgment and estimates are applied include revenue recognition, stock based compensation, cash equivalents and short-term investments, allowance for doubtful accounts, inventory valuation, realization of long lived assets, including goodwill and intangibles, income taxes, deferred tax assets, accrued liabilities, guarantees, indemnifications and warranty liabilities, foreign currency, restructuring liability, and legal matters. The condensed consolidated financial statements include the accounts of Silicon Image, Inc. and its subsidiaries after elimination of all inter-company balances and transactions.
Revenue Recognition
The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable and collectability is reasonably assured.
Revenue from products sold to distributors with agreements allowing for stock rotations are generally recognized upon shipment. Reserves for stock rotations are estimated based primarily on historical experience and provided for at the time of shipment.
For products sold to distributors with agreements allowing for price concessions and stock rotation rights/product returns, the Company recognizes revenue based on its best estimate of when the distributor sold the product to its customer. The Company’s estimate of such distributor sell-through is based on point of sales reports received from the distributor which establishes a customer, quantity and final price. Revenue is not recognized upon the Company’s shipment of the product to the distributor, since, due to certain forms of price concessions, the sales price is not substantially fixed or determinable at the time of shipment. Price concessions are recorded when incurred, which is generally at the time the distributor sells the product to its customer. Additionally, these distributors have stock rotation rights permitting them to return products to the Company, up to a specified amount for a given period of time. Revenue is earned when the distributor reports that it has sold product to its customer, at which time our sales price to the distributor is fixed. Once the Company receives the point of sales reports from the distributor, it has satisfied all the requirements for revenue recognition and any product returns/stock rotation and price concession rights that the distributor has under its distributor agreement with the Company are exhausted. Pursuant to the Company’s distributor agreements, older, end-of-life and certain other products are generally sold with no right of return and are not eligible for price concessions. For these products, revenue is recognized upon shipment and title transfer assuming all other revenue recognition criteria are met.
At the time of shipment to distributors, the Company records a trade receivable for the selling price since there is a legally enforceable right to payment, relieves inventory for the carrying value of goods shipped since legal title has passed to the distributor and records the gross margin in “deferred margin on sale to distributors”, a component of current liabilities in its consolidated balance sheet. Deferred margin on the sale to distributor effectively represents the gross margin on the sale to the distributor. However, the amount of gross margin the Company recognizes in future periods will be less than the originally recorded deferred margin on sales to distributor as a result of negotiated price concessions. The Company sells each item in its product price book to all of its distributors worldwide at a relatively uniform list price. However, distributors resell our products to end customers at a very broad range of individually negotiated price points based on customer, product, quantity, geography, competitive pricing and other factors. The majority of the Company’s distributors’ resale is priced at a discount from the list price. Often, under these circumstances, the Company remits back to the distributor a portion of their original purchase price after the resale transaction is completed. Thus, a portion of the “deferred margin on the sale to distributor” balance represents a portion of distributor’s original purchase price that will be remitted back to the distributor in the future. The wide range and variability of negotiated price concessions granted to the distributors does not allow the Company to accurately estimate the portion of the balance in the deferred margin on the sale to distributors that will be remitted back to the distributors. The Company reduces deferred margin by anticipated or determinable future price concessions.
The Company derives revenue from the license of its internally developed intellectual property (IP). The Company enters into IP licensing agreements that generally provide licensees the right to incorporate its IP components in their products with terms and conditions that vary by licensee. Revenue earned under contracts with the Company’s licensees is classified as licensing revenue. The Company’s license fee arrangements generally include multiple deliverables and for multiple deliverable arrangements it follows the guidance in FASB ASC No. 605-25-25, Multiple-Element Arrangements Revenue Recognition, previously discussed in Emerging Issues Task Force (EITF) 00-21, Revenue Arrangements with Multiple Deliverables, to determine whether there is more than one unit of accounting. To the extent that the deliverables are separable into multiple units of accounting, the Company allocates the total fee on such arrangements to the individual units of accounting using the residual method, if objective and reliable evidence of fair value does not exist for delivered elements. The Company then recognizes revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the unit of accounting in accordance with the revenue recognition criteria mentioned above.
The IP licensing agreements generally include a nonexclusive license for the underlying IP. Fees under these agreements generally include (a) license fees relating to our IP, (b) support, typically for one year; and (c) royalties payable following the sale by our licensees of products incorporating the licensed technology. The license for the Company’s IP has standalone value and can be used by the licensee without support. Further, objective and reliable evidence of fair value exists for support. Accordingly, license and support fees are each treated as separate units of accounting.
Certain licensing agreements provide for royalty payments based on agreed upon royalty rates. Such rates can be fixed or variable depending on the terms of the agreement. The amount of revenue the Company recognizes is determined based on a time period or on the agreed-upon royalty rate, extended by the number of units shipped by the customer. To determine the number of units shipped, the Company relies upon actual royalty reports from its customers when available and rely upon estimates in lieu of actual royalty reports when it has a sufficient history of receiving royalties from a specific customer for it to make an estimate based on available information from the licensee such as quantities held, manufactured and other information. These estimates for royalties necessarily involve the application of management judgment. As a result of the Company’s use of estimates, period-to-period numbers are “trued-up” in the following period to reflect actual units shipped. In cases where royalty reports and other information are not available to allow the Company to estimate royalty revenue, the Company recognizes revenue only when royalty reports are received.
For contracts related to licenses of the Company’s technology that involve significant modification, customization or engineering services, the Company recognizes revenue in accordance with the provisions of FASB ASC No. 605-35-25, Construction-Type and Production-Type Contracts Revenue Recognition, previously discussed in Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Revenues derived from such license contracts are accounted for using the percentage-of-completion method.
The Company determines progress to completion based on input measures using labor-hours incurred by its engineers. The amount of revenue recognized is based on the total contract fees and the percentage of completion achieved. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management. If there is significant uncertainty about customer acceptance, or the time to complete the development or the deliverables by either party, the Company applies the completed contract method. If application of the percentage-of-completion method results in recognizable revenue prior to an invoicing event under a customer contract, the Company recognizes the revenue and records an unbilled receivable assuming collectability is reasonably assured. Amounts invoiced to the Company’s customers in excess of recognizable revenues are recorded as deferred revenue.
Stock-based Compensation
The Company accounts for stock-based compensation in accordance with the provisions of FASB No. ASC 718-10-30, Stock Compensation Initial Measurement, previously discussed in SFAS No. 123R, “Share-Based Payment,” which requires the measurement and recognition of compensation expense for all stock-based awards made to employees, directors including employee stock options, restricted stock units (“RSUs”), performance share awards and employee stock purchases under the Company’s Employee Stock Purchase Plan (“ESPP”) based on estimated fair values. Following the provisions of FASB ASC No. 718-50-25, Employee Share Purchase Plans Recognition, previously discussed in SFAS 123R, the Company’s ESPP is considered a compensatory plan, therefore, the Company is required to recognize compensation cost for grants made under the ESPP. The Company estimates the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single option award approach, which incorporates various assumptions including volatility, risk-free interest rate, expected life, and dividend yield. Management estimates volatility for a given option grant by evaluating the historical volatility of the period immediately preceding the option grant date that is at least equal in length to the option’s expected term. Consideration is also given to unusual events (either historical or projected) or other factors that might suggest that historical volatility will not be a good indicator of future volatility. The expected life of an award is based on historical experience and on the terms and conditions of the stock awards granted to employees, as well as the potential effect from options that had not been exercised at the time. In accordance with FASB ASC No. 718-10-35, Subsequent Measurement of Stock Compensation, previously discussed in SFAS 123R, the Company recognizes stock-based compensation expense, net of estimated forfeitures, on a straight-line basis for all share-based payment awards over the requisite service periods of the awards, which is generally the vesting period or the remaining service (vesting) period.
Financial Instruments
The Company accounts for its investments in debt securities under FASB ASC No. 320-10-25, Investments in Debt and Equity Securities Recognition, previously discussed in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Management determines the appropriate classification of such securities at the time of purchase and reevaluates such classification as of each balance sheet date. The investments are adjusted for amortization of premiums and discounts to maturity and such amortization is included in interest income. The Company follows the guidance provided by FASB ASC No. 320-10-35, Subsequent Measurement of Investments in Debt and Equity, previously discussed in FSP 115-1/124-1 and EITF No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, to assess whether its investments with unrealized loss positions are other than temporarily impaired. The Company complies with the presentation and disclosure requirements of the other-than-temporary impairment for debt securities as discussed in FASB ASC No. 320-10-65, Transition Related to Recognition and Presentation of Other-Than-Temporary Impairments, previously referred to as FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in the consolidated statements of income. Factors considered in determining whether a loss is temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.
The classification of the Company’s investments into cash equivalents and short term investments is in accordance with FASB ASC No. 305-10-20, Cash and Cash Equivalents Glossary, previously discussed in SFAS 95, Statement of Cash Flows. Cash equivalents have maturities of three months or less from the date of purchase. Short-term investments consist of commercial paper, United States government agency obligations, corporate/municipal notes and bonds. These securities have maturities greater than three months from the date of purchase.
The Company complies with the provisions of FASB ASC No. 820, Fair Value Measurements and Disclosures (“ASC 820”), previously referred to as SFAS No. 157, Fair Value Measurements in measuring fair value and in disclosing fair value measurements. ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting pronouncements. FASB ASC No. 820-10-35, Fair Value Measurements and Disclosures- Subsequent Measurement (“ASC 820-10-35”), clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. ASC 820-10-35-3 also requires that a fair value measurement reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model.
ASC 820-10-35 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1measurements) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy under ASC 820-10-35 are described below:
Level 1 Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2 Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly;
Level 3 Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.
A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.
When the Company determines that the volume of activity for the asset or liability has significantly decreased and/or it has identified transactions that are not orderly, the Company complies with the provisions of ASC 820-10-65-4, previously referred to as FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.
Further information about the Company financial instruments can be found in Note 13 below.
The Company recognizes derivative instruments as either assets or liabilities and measures those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company accounts for derivative instruments in accordance with FASB ASC No. 815-20-25 – Derivatives and Hedging Recognition, previously discussed in SFAS 133 - Accounting for Derivative Instruments and Hedging Activities. For a derivative instrument designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion of the gain (loss) is reported immediately in other income (expense) on the Company’s consolidated statement of operations.
Allowance for Doubtful Accounts
The Company reviews collectability of accounts receivable on an on-going basis and provides an allowance for amounts it estimates will not be collectible. During the Company’s review, it considers its historical experience, the age of the receivable balance, the credit-worthiness of the customer and the reason for the delinquency. Delinquent account balances are written-off after the Company has determined that the likelihood of collection is remote. Write-offs to date have not been material.
Inventories
The Company records inventories at the lower of actual cost, determined on a first-in first-out (FIFO) basis, or market. Actual cost approximates standard cost, adjusted for variances between standard and actual. Standard costs are determined based on the Company’s estimate of material costs, manufacturing yields, costs to assemble, test and package its products and allocable indirect costs. The Company records differences between standard costs and actual costs as variances. These variances are analyzed and are either included on the consolidated balance sheet or the consolidated statement of operations in order to state the inventories at actual costs on a FIFO basis. Standard costs are evaluated at least annually.
Provisions are recorded for excess and obsolete inventory and are estimated based on a comparison of the quantity and cost of inventory on hand to the Company’s forecast of customer demand. Customer demand is dependent on many factors and requires the Company to use significant judgment in its forecasting process. The Company must also make assumptions regarding the rate at which new products will be accepted in the marketplace and at which customers will transition from older products to newer products. Generally, inventories in excess of six months forecasted demand are written down to zero and the related provision is recorded as a cost of revenue. Once a provision is established, it is maintained until the product to which it relates is sold or otherwise disposed of, even if in subsequent periods we forecast demand for the product.
Goodwill, Intangible and Long-lived Assets
Consideration paid in connection with acquisitions is required to be allocated to the assets, including identifiable intangible assets and liabilities acquired. Acquired assets and liabilities are recorded based on the Company’s estimate of fair value, which requires significant judgment with respect to future cash flows and discount rates.
For certain long-lived assets, primarily fixed assets and identifiable intangible assets, for example the Company’s IP acquired from Sunplus (refer to Notes 12 and 16 below), the Company is required to estimate the useful life of its asset and recognize the cost as an expense over the useful life. The Company uses the straight-line method to depreciate long-lived assets. The Company evaluates the recoverability of its long-lived assets in accordance with FASB ASC No. 360-10-35, Subsequent Measurement ofProperty, Plant and Equipment, paragraphs 15-49, Impairment or Disposal of Long-Lived Assets, previously discussed in SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Whenever events or circumstances indicate that the carrying amount of long-lived assets may not be recoverable, the Company compares the carrying amount of long-lived assets to its projection of future undiscounted cash flows, attributable to such assets. In the event that the carrying amount exceeds the future undiscounted cash flows, the Company records an impairment charge against income equal to the excess of the carrying amount over the asset’s fair value. Predicting future cash flows attributable to a particular asset is difficult and requires the use of significant judgment.
The Company assigns the following useful lives to its fixed assets — three years for computers and software, one to five years for equipment and five to seven years for furniture and fixtures. Leasehold improvements and assets held under capital leases are amortized on a straight-line basis over the shorter of the lease term or the estimated useful life, which ranges from two to five years. Depreciation expense was $6.8 million and $7.9 million for the nine months ended September 30, 2009 and 2008, respectively.
The Company periodically reviews the carrying value of intangible assets not subject to amortization, including goodwill, to determine whether impairment may exist. FASB ASC No. 350-20-35, Subsequent Measurement ofGoodwill, and FASB ASC No. 350-30-35, Subsequent Measurement ofGeneral Intangibles Other Than Goodwill (“ASC 350-30-35”), whose provisions were previously discussed in SFAS No. 142, Goodwill and Other Intangible Assets, require that goodwill and certain intangible assets be assessed annually for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. The Company has determined based on the criteria of FASB ASC No. 280-10-50, Segment Reporting Disclosure, previously discussed in SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, that it has one reporting unit. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined by comparing the fair value of the Company’s equity as of the date of the impairment testing to the carrying amount of stockholders equity. The impairment charge for other intangible assets not subject to amortization, for which impairment indicators exists, consists of a comparison of the fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Furthermore, ASC 350-30-35 requires purchased other intangible assets to be amortized over their useful lives unless these lives are determined to be indefinite. Significant assumptions are inherent and highly subjective in this process. During the nine months ended September 30, 2009, the Company recognized an impairment loss on goodwill as a result of the periodic review due to the presence of impairment indicators. Refer to Note 15 below for further information.
Income Taxes
The Company must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, tax benefits and deductions and in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. Significant changes to these estimates may result in an increase or decrease to our tax provision in the subsequent period when such a change in estimate occurs.
Deferred Tax Assets
The Company accounts for deferred tax assets in accordance with the FASB ASC No. 740-10, Income Taxes Recognition (“ASC 740-10”), previously discussed in SFAS No. 109, Accounting for Income Taxes. The Company uses an asset and liability approach, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in its financial statements, but have not been reflected in its taxable income. In general, a valuation allowance is established to reduce deferred tax assets to their estimated realizable value, if based on the weight of available evidence, it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. The Company evaluates the realizability of the deferred tax assets quarterly and will continue to assess the need for valuation allowances. In accordance with paragraphs 25-17 and 30-7 of ASC 740-10, Basic Recognition Threshold, the Company determines whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The provisions under paragraphs 25-17 and 30-7 of ASC 740-10 were previously discussed in FIN 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.
Guarantees, Indemnifications and Warranty Liabilities
Certain of the Company’s licensing agreements indemnify its customers for expenses or liabilities resulting from claimed infringements of patent, trademark or copyright by third parties related to the intellectual property content of our products. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances; the maximum amount of potential future indemnification is not limited. To date, the Company has not paid any such claims or been required to defend any lawsuits with respect to a claim.
At the time of revenue recognition, the Company provides an accrual for estimated costs (included in accrued liabilities in the accompanying consolidated balance sheets) to be incurred pursuant to its warranty obligation. The Company’s estimate is based primarily on historical experience.
Restructuring Expenses
The Company records provisions for workforce reduction costs and exit costs when they are probable and estimable. Severance paid under ongoing benefit arrangements is recorded in accordance with FASB ASC No. 712-10-25, Nonretirement Postemployment Benefits Recognition, previously discussed in SFAS No. 112, Employers’ Accounting for Postemployment Benefits. One-time termination benefits and contract settlement and lease costs are recorded in accordance with FASB ASC No. 420-10-25, Exit or Disposal Cost Obligations Recognition, previously discussed in SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities. At each reporting date, the Company evaluates its accruals related to workforce reduction charges, contract settlement and lease costs and plant and equipment write downs to ensure that these accruals are still appropriate. Restructuring expense accruals related to future lease commitments on exited facilities included estimates, primarily related to sublease income over the lease terms and other costs for vacated properties. Increases or decreases to the accruals for changes in estimates are classified as restructuring expenses in the consolidated statement of operations.
Foreign Currency Translation
The Company accounts for foreign currency transactions in accordance with FASB ASC No. 830-20, Foreign Currency Transactions, and FASB ASC No. 830-30, Translation of Financial Statements, previously discussed in SFAS No. 52, Foreign Currency Translation. The Company determines the functional currency for its foreign subsidiaries by reviewing the currencies in which their respective operating activities occur. The functional currency for the Company’s foreign subsidiaries is the local currency. Transaction gains and losses arising from activities in other than the applicable functional currency are calculated using average exchange rates for the applicable period and reported in the Company’s consolidated statement of operations as a non-operating item in each year. Monetary balance sheet items of the Company’s subsidiaries denominated in foreign currency are translated using the exchange rate in effect on the balance sheet date and any adjustments arising from re-measurements are included in other comprehensive income.
Research and Development
Research and development costs are expensed as incurred. It is the Company’s policy to record a reduction to research and development expense for funding received from outside parties for research and development projects.
4. Stock-Based Compensation
The Company has a share-based compensation program that provides its Board of Directors with broad discretion in creating equity incentives for employees, officers and non-employee board members. This program includes incentive and non-statutory stock option grants, restricted stock units (RSU’s) and an automatic grant program for non-employee board members pursuant to which such individuals will receive option grants at designated intervals over their period of board service. These awards are granted under various plans, all of which are stockholder approved. Grants under the discretionary grant program generally vest as follows: 25% of the shares vest on the first anniversary of the vesting commencement date and the remaining 75% vest proportionately each month over the next 36 months of continued service. Stock option grants to members of our Board of Directors vest monthly, over periods not to exceed four years. Some options provide for accelerated vesting if certain identified milestones are achieved, upon a termination of employment or upon a change in control of the Company. RSU grants generally vest over a one to four-year period and certain of the RSU grants also have performance based vesting criteria. Additionally, we have an Employee Stock Purchase Plan (ESPP) that allows employees to purchase shares of common stock at the lower of 85% of the fair market value on the commencement date of the six-month offering period or on the last day of the six-month offering period.
Valuation and Expense Information Under Stock-based Compensation
Share-based compensation expense recognized under FASB ASC No. 718-10-30, Initial Measurement of Stock Compensation, previously discussed in SFAS 123(R), Share-Based Payment, consists primarily of expenses for the share-based awards discussed above.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes- Merton option valuation model and the straight-line attribution approach with the following weighted-average assumptions:
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Employee stock option plans: | | | | | | | | | | | | |
| Expected life in years | | none | | | | 4.8 | | | | 4.7 | | | | 4.8 | |
| Expected volatility | | none | | | | 62.0 | % | | | 64.5 | % | | | 64.5 | % |
| Risk-free interest rate | | none | | | | 3.2 | % | | | 2.3 | % | | | 2.8 | % |
| Expected dividends | | none | | | none | | | none | | | none | |
| Weighted average fair value | | none | | | $ | 3.19 | | | $ | 1.37 | | | $ | 2.82 | |
| | | | | | | | | | | | | | | | |
| Employee Stock Purchase Plan: | | | | | | | | | | | | | | | |
| Expected life in years | | | 0.5 | | | | 0.5 | | | | 0.5 | | | | 0.5 | |
| Expected volatility | | | 73.6 | % | | | 45.7 | % | | | 85.6 | % | | | 65.8 | % |
| Risk-free interest rate | | | 0.4 | % | | | 2.1 | % | | | 0.8 | % | | | 3.0 | % |
| Expected dividends | | none | | | none | | | none | | | none | |
| Weighted average fair value | | $ | 0.94 | | | $ | 2.01 | | | $ | 1.03 | | | $ | 1.77 | |
The Company did not grant any stock options during the three months ended September 30, 2009.
As required by FASB ASC 718-10-35, Subsequent Measurement of Stock Compensation, previously discussed in SFAS 123(R), management made an estimate of expected forfeitures and is recognizing stock-based compensation expense only for those equity awards expected to vest. For the three months ended September 30, 2009 and 2008, 342,416 and 358,311 shares were purchased under the ESPP program, respectively. For the nine months ended September 30, 2009 and 2008, the Company’s employees purchased 887,045 and 808,308 shares of common stock under the ESPP program, respectively. At September 30, 2009, the Company had $378,000 of total unrecognized compensation expense, net of estimated forfeitures under the ESPP program. The unamortized compensation expense will be amortized on a straight-line basis over a period of approximately 0.4 year.
Stock Options Activity
The following is a summary of activity under the Company’s stock option plans during the nine months ended September 30, 2009, excluding RSUs (in thousands, except weighted average exercise price):
| | | Number of Shares | | | Weighted Average Exercise Price | | | Weighted Average Remaining Contractual Term in Years | | | Aggregate Intrinsic Value | |
| Outstanding at December 31, 2008 | | | 13,849 | | | $ | 8.65 | | | | 6.09 | | | $ | 2,396 | |
| Granted | | | 111 | | | | 2.53 | | | | | | | | | |
| Exercised | | | (120 | ) | | | 1.13 | | | | | | | | | |
| Forfeitures and cancellations | | | (1,683 | ) | | | 8.52 | | | | | | | | | |
| Outstanding at September 30, 2009 | | | 12,157 | | | $ | 8.68 | | | | 4.51 | | | $ | 561 | |
| Ending vested and expected to vest at September 30, 2009 | | | 11,466 | | | $ | 8.76 | | | | 4.33 | | | $ | 561 | |
| Exercisable at September 30, 2009 | | | 10,256 | | | $ | 8.98 | | | | 3.96 | | | $ | 561 | |
At September 30, 2009, the total unrecognized compensation expense related to options granted to employees under our share-based compensation plans was approximately $7.7 million, net of estimated forfeitures. The unamortized compensation expense will be amortized on a straight-line basis over a weighted average period of approximately 2.0 years.
Restricted Stock Units
The RSUs that the Company grants to its employees typically vest ratably over a certain period of time, subject to the employee’s continuing service to the Company over that period. RSUs granted to non-executive employees typically vest over a four-year period. RSUs granted to executives typically vest over a period of between one and four years.
RSUs are converted into shares of the Company’s common stock upon vesting on a one-for-one basis. The cost of the RSUs is determined using the fair value of the Company’s common stock on the date of the grant. Compensation is recognized on a straight-line basis over the requisite service period of each grant adjusted for estimated forfeitures.
A summary of activity with respect to the Company’s RSUs during the nine months ended September 30, 2009 is as follows: (in thousands):
| | | Number of shares | | | Weighted Average Remaining Contractual Term in Years | | | Aggregate Intrinsic Value | |
| Outstanding at December 31, 2008 | | | 3,712 | | | | 1.24 | | | $ | 15,591 | |
| Granted | | | 1,798 | | | | | | | | | |
| Vested | | | (255 | ) | | | | | | | | |
| Forfeitures and cancellations | | | (2,531 | ) | | | | | | | | |
| Outstanding at September 30, 2009 | | | 2,724 | | | | 1.42 | | | $ | 6,619 | |
| Ending vested and expected to vest at September 30, 2009 | | | 1,920 | | | | 1.29 | | | $ | 4,666 | |
As of September 30, 2009, the Company had $5.0 million of total unrecognized compensation expense, net of estimated forfeitures, related to RSUs. The unamortized compensation expense will be recognized on a straight-line basis, and the weighted average estimated remaining life is 2.1 years.
Purchases of Equity Securities
During the nine months ended September 30, 2009, the Company repurchased shares of stock from employees upon the vesting of the RSUs that were granted under the Company’s equity incentive plan to satisfy the employees’ minimum statutory tax withholding requirement as follows: (in thousands, except for the weighted average price per share):
| Period | | Total Number of Shares Repurchased | | | Weighted Average Price Per Share | | | Total Value | |
| Three months ended March 31, 2009 | | | 71 | | | | 3.15 | | | $ | 224 | |
| Three months ended June 30, 2009 | | | 7 | | | | 2.45 | | | $ | 17 | |
| Three months ended September 30, 2009 | | | 14 | | | | 2.91 | | | $ | 39 | |
| Nine months ended September 30, 2009 | | | 92 | | | | | | | $ | 280 | |
There were no RSUs that vested in fiscal year 2008. The Company will continue to repurchase shares of stock from employees as their RSUs vest to satisfy the employees’ minimum statutory tax withholding requirement.
Stock-based Compensation Expense
The table below shows total stock-based compensation expense included in the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2009 and 2008 (in thousands):
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Cost of sales | | $ | 363 | | | | 351 | | | $ | 806 | | | | 1,132 | |
| Research and development | | | 2,374 | | | | 1,753 | | | | 5,365 | | | | 5,200 | |
| Selling, general and administrative | | | 4,911 | | | | 2,004 | | | | 9,255 | | | | 8,057 | |
| Stock-based compensation expense before tax effects | | | 7,648 | | | | 4,108 | | | | 15,426 | | | | 14,389 | |
| Income tax benefit | | | (2,304 | ) | | | (1,354 | ) | | | (4,350 | ) | | | (4,443 | ) |
| Stock-based compensation expense after tax effects | | $ | 5,344 | | | $ | 2,754 | | | $ | 11,076 | | | $ | 9,946 | |
Adjustments during the three and nine months ended September 30, 2009
Subsequent to the issuance of its June 2009 unaudited interim consolidated financial statements, the Company identified errors in the calculation of stock-based compensation expense for fiscal years 2008, 2007 and 2006, and for the three months ended March 31, 2009 and the three and six months ended June 30, 2009. The errors were identified after the Company’s third-party software provider notified its clients, including the Company, that it made a change to how its software program calculates stock-based compensation expense. Specifically, the prior version of this software calculated stock-based compensation expense by incorrectly applying a weighted average forfeiture rate to the vested portion of stock option awards until the grant’s final vest date, rather than calculating stock-based compensation expense based upon the actual vested portion of the grant date fair value, resulting in an understatement of stock-based compensation expense in certain periods prior to the grant’s final vest date. Thus, this error relates to the timing of stock-based compensation expense recognition.
The Company determined that the cumulative error from the understatement of stock-based compensation expense related to the periods discussed above totaled $2.5 million, net of tax effects through June 30, 2009. The impact of the errors on fiscal years 2008, 2007 and 2006, is to decrease net income by $0.1 million, $1.6 million and $1.0 million, respectively and for three months ended March 31, 2009 and three months ended June 30, 2009 to increase (decrease) net loss by $0.1 million and ($0.3) million, respectively.
Management has determined that the impact of this error is not material to the previously issued annual and interim unaudited consolidated financial statements using the guidance of SEC Staff Accounting Bulletin No. 99 (“SAB 99”) and SAB 108. Accordingly, the interim unaudited consolidated financial statements for the three and nine months ended September 30, 2009 include the cumulative adjustment to increase stock-based compensation expense by $2.5 million net of tax effects, (or $0.03 per share) to correct these errors. The Company does not believe the correction of these errors is material to the consolidated financial statements for the three and nine months ended September 30, 2009 and does not believe that it will be material to the 2009 annual consolidated financial statements.
5. Restructuring Charges
Ongoing Restructuring Activities
For the three and nine months ended September 30, 2009, we recorded restructuring expense of approximately $0.4 million and $8.2 million, respectively. The amount recorded during the three months ended September 30, 2009 primarily related to the future lease commitments on exited facilities, net of sublease income and impairment of certain fixed assets. The expense recorded for the nine months ended September 30, 2009 primarily related the employee severance costs associated with the Company’s fiscal year 2009 restructuring plan.
Fiscal 2009 Restructuring Plan
In June 2009, the Company’s management approved and announced a restructuring program, which primarily included a reduction in force, to realign and focus the Company’s resources on its core competencies and in order to better align its revenues and expenses.
As of September 30, 2009, approximately $5.6 million of the costs associated with this restructuring program was unpaid. We expect that the severance-related charges and other costs will be substantially paid during the first two quarters of fiscal year 2010 and the facilities-related lease payments to be substantially paid by November 2012.
Fiscal 2008 Restructuring Plan
As of September 30, 2009, approximately $0.3 million of the costs associated with the restructuring plan announced in December 2008 remained unpaid. We expect that the severance-related charges and other costs will be substantially paid by the end of fiscal year 2009 and the facilities-related lease payments to be substantially paid by July 2011.
The table below summarizes the Company’s restructuring activities for the nine months ended September 30, 2009 (in thousands):
| | | Employee Severance and Benefits | | | Operating Lease Termination | | | Impaired Fixed Assets | | | Total | |
| Accrued restructuring balance as of December 31, 2008 | | $ | 3,252 | | | $ | 200 | | | $ | - | | | $ | 3,452 | |
| Additional accruals | | | 7,565 | | | | 225 | | | | 226 | | | | 8,016 | |
| Cash payments | | | (5,177 | ) | | | (145 | ) | | | - | | | | (5,322 | ) |
| Non-cash charges and adjustments | | | - | | | | - | | | | (226 | ) | | | (226 | ) |
| Accrued restructuring balance as of September 30, 2009 | | $ | 5,640 | | | $ | 280 | | | $ | - | | | $ | 5,920 | |
6. Comprehensive Income (Loss)
The components of comprehensive income (loss), net of related taxes, were as follows (in thousands):
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Net income (loss) | | $ | (15,511 | ) | | $ | 6,074 | | | $ | (62,169 | ) | | $ | 5,050 | |
| Change in unrealized value of investments | | | 140 | | | | (371 | ) | | | 220 | | | | (400 | ) |
| Foreign currency translation adjustments | | | 287 | | | | (409 | ) | | | 355 | | | | (276 | ) |
| Effective portion of cash flow hedges | | | 3 | | | | (284 | ) | | | 32 | | | | (284 | ) |
| Total comprehensive income (loss) | | $ | (15,081 | ) | | $ | 5,010 | | | $ | (61,562 | ) | | $ | 4,090 | |
7. Net Income (Loss) Per Share
Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period, excluding shares subject to repurchase and diluted net income per share is computed using weighted-average number of common shares and diluted equivalents outstanding during the period, if any ,determined using the treasury stock method. The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share amounts):
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Numerator: | | | | | | | | | | | | |
| Net income (loss) | | $ | (15,511 | ) | | $ | 6,074 | | | $ | (62,169 | ) | | $ | 5,050 | |
| Denominator: | | | | | | | | | | | | | | | | |
| Weighted average shares – basic | | | 75,053 | | | | 73,861 | | | | 74,763 | | | | 76,088 | |
| Weighted average shares – diluted | | | 75,053 | | | | 75,334 | | | | 74,763 | | | | 77,185 | |
| Net income (loss) per share – basic and diluted | | $ | (0.21 | ) | | $ | 0.08 | | | $ | (0.83 | ) | | $ | 0.07 | |
The table below is a reconciliation of the weighted-average common shares used to calculate basic net income (loss) per share to the weighted-average common shares used to calculate diluted net income (loss) per share (in thousands):
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Weighted-average common shares for basic net income (loss) per share | | | 75,053 | | | | 73,861 | | | | 74,763 | | | | 76,088 | |
| Weighted-average dilutive stock options and restricted stock units outstanding under the treasury stock method | | | - | | | | 1,473 | | | | - | | | | 1,097 | |
| Total | | | 75,053 | | | | 75,334 | | | | 74,763 | | | | 77,185 | |
The securities that were anti-dilutive and excluded from the net loss per share calculations were approximately 13.8 million and 13.6 million for the three and nine months ended September 30, 2009, respectively. For the three and nine months ended September 30, 2008, approximately 11.0 million and 12.3 million outstanding stock options were excluded from the calculation of diluted net income per share, respectively, because their inclusion would have been anti-dilutive.
8. Balance Sheet Components
The table below shows the components of the Company’s inventories, property and equipment and accrued and other current liabilities (in thousands).
| | | September 30, 2009 | | | December 31, 2008 | |
| Inventories: | | | | | | |
| Raw materials | | $ | 4,429 | | | $ | 4,962 | |
| Work in process | | | 1,895 | | | | 545 | |
| Finished goods | | | 6,214 | | | | 7,268 | |
| Total inventories | | $ | 12,538 | | | $ | 12,775 | |
| | | | | | | | | |
| Property and equipment | | | | | | | | |
| Computers and software | | $ | 23,065 | | | $ | 24,250 | |
| Equipment | | | 25,987 | | | | 25,059 | |
| Furniture and fixtures | | | 2,738 | | | | 2,701 | |
| | | | 51,790 | | | | 52,010 | |
| Less: accumulated depreciation | | | (36,665 | ) | | | (32,616 | ) |
| Total property and equipment, net | | $ | 15,125 | | | $ | 19,394 | |
| | | | | | | | | |
| Accrued and other current liabilities: | | | | | | | | |
| Accrued payroll and related expenses | | $ | 3,464 | | | $ | 5,359 | |
| Accrued restructuring | | | 5,920 | | | | 3,452 | |
| Software and IP liability | | | 625 | | | | 2,500 | |
| Amounts due to customers | | | 368 | | | | 1,966 | |
| Bonus accrual | | | - | | | | 1,556 | |
| Accrued and other current liabilities | | | 7,801 | | | | 8,190 | |
| Total accrued liabilities | | $ | 18,178 | | | $ | 23,023 | |
9. Commitments and Contingencies
Legal Proceedings
On December 7, 2001, the Company and certain of its officers and directors were named as defendants, along with the underwriters of the Company’s initial public offering, in a securities class action lawsuit. The lawsuit alleges that the defendants participated in a scheme to inflate the price of the Company’s stock in its initial public offering and in the aftermarket through a series of misstatements and omissions associated with the offering. The lawsuit is one of several hundred similar cases pending in the Southern District of New York that have been consolidated by the court. In February 2003, the District Court issued an order denying a motion to dismiss by all defendants on common issues of law. In July 2003, the Company, along with over 300 other issuers named as defendants, agreed to a settlement of this litigation with plaintiffs. While the parties’ request for court approval of the settlement was pending, in December 2006 the United States Court of Appeals for the Second Circuit reversed the District Court’s determination that six focus cases could be certified as class actions. In April 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but acknowledged that the District Court might certify a more limited class. At a June 26, 2007 status conference, the Court terminated the proposed settlement as stipulated among the parties. Plaintiffs filed an amended complaint on August 14, 2007. On September 27, 2007, plaintiffs filed a motion for class certification in the six focus cases, which was withdrawn on October 10, 2008. On November 13, 2007 defendants in the six focus cases filed a motion to dismiss the complaint for failure to state a claim, which the district court denied in March 2008. Plaintiffs, the issuer defendants (including the Company), the underwriter defendants, and the insurance carriers for the defendants, have engaged in mediation and settlement negotiations. The parties have reached a settlement agreement, which was submitted to the District Court for preliminary approval on April 2, 2009. As part of this settlement, the Company’s insurance carrier has agreed to assume the Company’s entire payment obligation under the terms of the settlement. On June 10, 2009, the District Court granted preliminary approval of the proposed settlement agreement. After a September 10, 2009 hearing, the District Court gave final approval to the settlement on October 5, 2009.
On July 31, 2007, the Company received a demand on behalf of alleged shareholder Vanessa Simmonds that its board of directors prosecute a claim against the underwriters of its initial public offering, in addition to certain unidentified officers, directors and principal shareholders as identified in our IPO prospectus, for violations of sections 16(a) and 16(b) of the Securities Exchange Act of 1934. In October 2007, a lawsuit was filed in the United States District Court for the Western District of Washington by Ms. Simmonds against certain of the underwriters of the Company’s initial public offering. The plaintiff alleges that the underwriters engaged in short-swing trades and seeks disgorgement of profits in amounts to be proven at trial from the underwriters. On February 25, 2008, Ms. Simmonds filed an amended complaint. The suit names the Company as a nominal defendant, contains no claims against the Company and seeks no relief from it. This lawsuit is one of more than fifty similar actions filed in the same court. On July 25, 2008, the underwriter defendants in the various actions filed a joint motion to dismiss the complaints for failure to state a claim. In addition, certain issuer defendants in the various actions filed a joint motion to dismiss the complaints for failure to state a claim. The parties entered into a stipulation, entered as an order by the court that the Company is not required to answer or otherwise respond to the amended complaint. Accordingly, the Company did not join the motion to dismiss filed by certain issuers. On March 12, 2009, the court dismissed the complaint in this lawsuit with prejudice. On April 10, 2009, the plaintiff filed a notice of appeal of the District Court’s order, and thereafter the underwriter defendants’ filed a cross appeal to a portion of the District Court’s order that dismissed thirty (30) of the cases without prejudice following the moving issuers’ motion to dismiss. On May 27, 2009, the Ninth Circuit issued an order stating that the cases were not selected for inclusion in the mediation program, and on May 22, 2009 issued an order granting the parties’ joint motion filed on May 22, 2009 to consolidate the 54 appeals and 30 cross-appeals. Under the current schedule, the briefing will be completed on November 17, 2009. No date has been set for oral argument in the Ninth Circuit.
In January 2005, the Company and certain of its officers were named as defendants in a securities class action captioned “Curry v. Silicon Image, Inc., Steve Tirado and Robert Gargus.” Plaintiffs filed the action on behalf of a putative class of stockholders who purchased Silicon Image stock between October 19, 2004 and January 24, 2005. The lawsuit alleged that the Company and certain of its officers and directors made alleged misstatements of material facts and violated certain provisions of Sections 20(a) and 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Final judgment was entered in favor of defendants on September 25, 2007. On October 19, 2007, plaintiffs filed notice of appeal of the court’s final judgment to the United States Court of Appeals for the Ninth Circuit. Appellants’ opening brief was filed February 28, 2008 and the Company’s responsive pleading was filed April 14, 2008. Appellants filed a reply brief on May 16, 2008. Oral argument was held on April 14, 2009. On May 1, 2009, the Ninth Circuit issued an order affirming the lower court’s final judgment, which dismissed the action with prejudice. The deadline for the plaintiffs to have filed a petition for rehearing or rehearing en banc was May 15, 2009; no such petitions were filed.
In addition, the Company has been named as defendants in a number of judicial and administrative proceedings incidental to its business and may be named again from time to time.
The Company intends to defend the above matters vigorously and although adverse decisions or settlements may occur in one or more of such cases, the final resolution of these matters, individually or in the aggregate, is not expected to have a material adverse effect on the Company’s results of operations, financial position or cash flows.
Guarantees
Certain of the Company’s licensing agreements indemnify it’s customers for any expenses or liabilities resulting from claimed infringements of third party patents, trademarks or copyrights by its products. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances; the maximum amount of potential future indemnification is not limited. To date, the Company has not paid any such claims or been required to defend any lawsuits with respect to any claim.
Contractual Obligations and Off-Balance Sheet Arrangements
The table below represents the future minimum payments under the Company’s operating leases outstanding at September 30, 2009 (in thousands):
| Contractual obligations | | Total | | | Less than 1 year | | | 1-3 years | | | 3-5 years | | | More than 5 years | |
| Operating lease obligations | | $ | 4,562 | | | $ | 2,695 | | | $ | 1,857 | | | $ | 10 | | | $ | - | |
The amounts above exclude liabilities under FASB ASC 740-10-25, “Income Taxes – Recognition section,” paragraphs 5-17 –“Basic Recognition Threshold,” previously contained in FIN 48 “Accounting for Uncertainty in Income Taxes,” as the Company is unable to reasonably estimate the ultimate amount or timing of settlement.
10. Customer and Geographic Information
The Company operates in one reportable operating segment, semiconductors and IP solutions for the secure storage, distribution and presentation of high-definition content. The Company’s President and Chief Operating Officer, who is considered to be the Company’s chief operating decision maker, reviews financial information presented on one operating segment basis for purposes of making operating decisions and assessing financial performance.
Revenue
Revenue by geographic area was as follows (in thousands):
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Japan | | $ | 11,957 | | | $ | 12,516 | | | $ | 31,782 | | | $ | 52,697 | |
| Taiwan | | | 9,063 | | | | 13,878 | | | | 29,282 | | | | 39,715 | |
| United States | | | 6,392 | | | | 13,461 | | | | 22,654 | | | | 38,443 | |
| Europe | | | 4,170 | | | | 5,470 | | | | 13,411 | | | | 22,367 | |
| Hong Kong | | | 2,391 | | | | 12,364 | | | | 7,308 | | | | 25,340 | |
| Korea | | | 1,566 | | | | 3,300 | | | | 3,692 | | | | 10,307 | |
| Other | | | 1,617 | | | | 16,787 | | | | 6,875 | | | | 26,103 | |
| Total revenue | | $ | 37,156 | | | $ | 77,776 | | | $ | 115,004 | | | $ | 214,972 | |
Revenue by product line was as follows (in thousands):
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Consumer Electronics (1) | | $ | 31,690 | | | $ | 55,883 | | | $ | 98,427 | | | $ | 155,728 | |
| Personal Computer (1) | | | 1,928 | | | | 11,713 | | | | 6,920 | | | | 34,640 | |
| Storage (1) | | | 3,538 | | | | 10,180 | | | | 9,657 | | | | 24,604 | |
| Total revenue | | $ | 37,156 | | | $ | 77,776 | | | $ | 115,004 | | | $ | 214,972 | |
| | | | | | | | | | | | | | | | | |
| (1) Includes development, licensing and royalty revenue (collectively "licensing revenue") | | | | | | | | | | | | | |
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | 2009 | | | 2008 | |
| Consumer Electronics | | $ | 25,588 | | | $ | 46,157 | | | $ | 78,850 | | | $ | 133,222 | |
| Personal Computer | | | 1,800 | | | | 9,704 | | | | 6,968 | | | | 30,681 | |
| Storage | | | 3,328 | | | | 9,113 | | | | 8,929 | | | | 20,094 | |
| Licensing revenue | | | 6,440 | | | | 12,802 | | | | 20,257 | | | | 30,975 | |
| Total revenue | | $ | 37,156 | | | $ | 77,776 | | | $ | 115,004 | | | $ | 214,972 | |
For the three months ended September 30, 2009, two customers represented 16.3% and 10.6% of the Company’s revenue. For the nine months ended September 30, 2009, two customers each represented 12.8% and 10.3% of the Company’s revenue. At September 30, 2009, three customers each represented 14.4%, 11.9% and 10.8% of gross accounts receivable.
For the three months ended September 30, 2008, four customers each represented 12.4%, 12.0%, 11.0% and 10.2% of the Company’s revenue. For the nine months ended September 30, 2008, four customers each represented 13.8%, 11.9%, 11.5% and 10.0% of the Company’s revenue. At September 30, 2008, four customers each represented 13.2%, 13.1%, 13.1%, and 10.2% of gross accounts receivable.
Property and Equipment
The majority of the Company’s property and equipment are located in the US.
11. Provision (Benefit) for Income Taxes
For the three and nine months ended September 30, 2009, the Company recorded an income tax benefit of $444,000 and $2.1 million, respectively. The effective tax rates for the three and nine months ended September 30, 2009 were 2.8% and 3.3%, respectively, and were based on our projected taxable income for 2009, plus certain discrete items recorded during the quarter. The difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to various forecasted items including tax exempt income, stock-based compensation expense, tax credits and foreign taxes, adjusted for certain discrete items recorded during the quarter.
During the three months ended March 31, 2009, the State of California legislature enacted significant California tax law changes. As a result of the enacted legislation, the Company expects that in years 2011 and beyond, the Company’s income subject to tax in California will be less than under prior tax law and accordingly its California deferred tax assets are less likely to be realized. The Company recorded a net discrete tax charge of $9.4 million for the three months ended March 31, 2009 related to the re-measurement of the Company’s California deferred tax assets to account for this change in tax law, as well as an increase in the valuation allowance for the Company’s California deferred tax assets that existed as of December 31, 2008. The Company will continue to assess its valuation allowance on its California deferred tax assets in future periods.
The Company has concluded that it is more likely than not that as of September 30, 2009, the Company’s net deferred tax assets will be realized. In making its conclusion, the Company considered all available evidence, both positive and negative. Key components of the evaluation are the cumulative results of operations in recent years, the nature of recent losses, and forecasts of a return to profitability. A significant negative factor in the evaluation is cumulative losses in recent years and the Company may reach that position during fiscal year 2009. The assessment of whether a valuation allowance is necessary will be made each quarter by considering all of the positive and negative evidence in existence at that time and, depending upon the nature and weighting of such evidence, a substantial increase in the valuation allowance may be required to reduce the deferred tax assets in the near term, which would result in a material charge to income tax expense.
For the three and nine months ended September 30, 2008, the Company recorded a provision for income taxes of $114,000 and a benefit of ($13,000), respectively. The effective tax rates for the three and nine months ended September 30, 2008 were 1.8% and (0.3%), respectively, and were based on the Company’s projected taxable income for 2008, plus certain discrete items recorded during the quarter.
The Company’s policy is to include interest and penalties related to unrecognized tax benefits within the provision for income taxes. The Company had interest and penalties of $100,000 and $273,000 for the three and nine months ended September 30, 2009, respectively, and approximately $141,000 and $339,000 for the three and nine months ended September 30, 2008, respectively. The Company conducts business globally and, as a result, the Company and its subsidiaries file income tax returns in various jurisdictions throughout the world including with the U.S. federal and various U.S. state jurisdictions as well as with various foreign jurisdictions. In the normal course of business, the Company is subject to examination by taxing authorities throughout the world.
12. Investment in Intellectual Property
In February 2007, the Company entered into an agreement with Sunplus Technology Co., Ltd. (Sunplus) to license certain technology (Sunplus IP) from Sunplus for $40.0 million. The purpose of this licensing agreement is to obtain advanced technology for development of future products. The agreement provides for the Company to pay an aggregate of $40.0 million to Sunplus, $35.0 million of which is payable in consideration for the Sunplus IP and related deliverables, and $5.0 million of which is payable in consideration for Sunplus support and maintenance obligations. Through September 30, 2009, the Company has paid Sunplus $38.7 million of the consideration for the licensed technology and related deliverables and support. The Company is required to pay the remaining $1.3 million by the end of 2009. Refer to Note 16 for the subsequent event discussion on this technology.
13. Fair Value Measurements
The Company records its financial instruments that are accounted for under FASB ASC No. 320-10-25, Recognition of Investments in Debt and Equity Securities, previously discussed in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and derivative contracts under FASB ASC No. 815, Derivatives and Hedging, previously discussed in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, at fair value. The determination of fair value is based upon the fair value framework established by FASB ASC No. 820-10-35, Fair Value Measurements and Disclosures – Subsequent Measurement (“ASC 820-10-35”), previously discussed in SFAS 157, Fair Value Measurements. ASC 820-10-35 provides that a fair value measurement assumes that the transaction to sell an asset or transfer a liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The carrying value of the Company’s financial instruments including cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable, accrued compensation, and other accrued liabilities, approximates fair market value due to the relatively short period of time to maturity. The fair value of investments is determined using quoted market prices for those securities or similar financial instruments.
The Company’s cash equivalents and short term investments are generally classified within level 1 or level 2 of the fair value hierarchy because they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency.
The types of instruments valued based on quoted market prices in active markets include most U.S. government and agency securities and most money market securities. Such instruments are generally classified within level 1 of the fair value hierarchy.
The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include most investment-grade corporate bonds, and state, municipal and provincial obligations. Such instruments are generally classified within level 2 of the fair value hierarchy.
The table below sets forth the Company’s cash and cash equivalents and short-term investments and derivative asset as of September 30, 2009, which are measured at fair value on a recurring basis by level within the fair value hierarchy. As required by ASC 820-10-35, these are classified based on the lowest level of input that is significant to the fair value measurement.
| | | Fair value measurements using | | | Assets | |
| (dollars In thousands) | | Level 1 | | | Level 2 | | | Level 3 | | | at fair value | |
| Cash equivalents and short-term investments | | $ | 5,550 | | | $ | 120,226 | | | $ | - | | | $ | 125,776 | |
| Derivative asset | | | - | | | | 243 | | | | - | | | | 243 | |
| Total | | $ | 5,550 | | | $ | 120,469 | | | $ | - | | | $ | 126,019 | |
Cash and cash equivalents and short term investments in the above table excludes $27.4 million in cash held by the Company or in its accounts with investment fund managers as of September 30, 2009. During the three and nine months ended September 30, 2009, the Company held no direct investments in auction rate securities, collateralized debt obligations, structured investment vehicles or mortgage-backed securities.
The Company’s derivative instruments are classified within Level 2 of the valuation hierarchy. The Company’s derivatives are valued using internal models that use as their basis readily observable market inputs, such as time value, forward interest rates, volatility factors and foreign currency exchange rates. Refer to Note 14 for more discussion on derivative instruments.
As of September 30, 2009, the Company did not hold financial assets and liabilities which were recorded at fair value in the Level 3 category.
14. Derivative Instruments
The Company accounts for derivative instruments in accordance with the provisions of FASB ASC No. 815-20-25, Derivatives and Hedging – Hedging Recognition, previously discussed in SFAS 133, Accounting for Derivative Instruments and Hedging Activities. The Company recognizes derivative instruments as either assets or liabilities and measures those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company’s derivatives are designated as cash flow hedges. For a derivative instrument designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion of the gain (loss) is reported immediately in other income (expense) on the Company’s consolidated statement of operations.
Silicon Image is a global company that is exposed to foreign currency exchange rate fluctuations in the normal course of its business. The Company has operations in the United States, Europe and Asia, however, a majority of its revenue, costs of revenue, expense and capital purchasing activities are being transacted in U.S. Dollars. As a corporation with international as well as domestic operations, the Company is exposed to changes in foreign exchange rates. These exposures may change over time and could have a material adverse impact on the Company’s financial results. Periodically, the Company uses foreign currency forward contracts to hedge certain forecasted foreign currency transactions relating to operating expenses. The Company does not enter into derivatives for speculative or trading purposes. The Company uses derivative instruments primarily to manage exposures to foreign currency fluctuations on forecasted cash flows and balances primarily denominated in Euro. The Company’s primary objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates. These derivatives are designated as cash flow hedges and have maturities of less than one year.
The derivatives expose the Company to credit and non performance risks to the extent that the counterparties may be unable to meet the terms of the agreement. The Company seeks to mitigate such risks by limiting the counterparties to major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored. Management does not expect material losses as a result of defaults by counterparties.
The amount of gain recognized in other comprehensive income (“OCI”) on effective cashflow hedges as of September 30, 2009, the amount of gain reclassified from accumulated OCI to operating expenses for the three and nine months ended September 30, 2009, and the amount of gain recognized in income on ineffective cashflow hedges for the three and nine months ended September 30, 2009 are insignificant.
As of September 30, 2009, the outstanding foreign currency forward contracts had a notional value of approximately $4.6 million. The unrealized gain relating to the effective cashflow hedges recorded in accumulated other comprehensive income as part of stockholders' equity and prepaid expenses and other current assets in the condensed consolidated balance sheet as of September 30, 2009 was insignificant.
15. Impairment of Goodwill and Other Long-lived Assets
The Company periodically reviews the carrying value of intangible assets not subject to amortization, including goodwill, to determine whether impairment may exist. FASB ASC No. 350-20-35, Subsequent Measurement of Goodwill, and FASB ASC No. 350-30-35, Subsequent Measurement of General Intangibles Other Than Goodwill, whose provisions were previously discussed in SFAS 142, Goodwill and Other Intangible Assets, require that goodwill and certain intangible assets be assessed annually for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined by comparing the fair value of the Company’s equity as of the date of the impairment testing to the carrying amount of stockholders equity. The impairment charge for other intangible assets not subject to amortization, for which impairment indicators exists, consists of a comparison of the fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Furthermore, FASB ASC 350-30-35 requires purchased other intangible assets to be amortized over their useful lives unless these lives are determined to be indefinite.
The Company has one reportable operating segment and the goodwill impairment testing was done at the reporting unit level. In accordance with the current policy, the Company conducted its annual goodwill impairment test on September 30, 2008 and noted no impairment. During the three months ended March 31, 2009, the Company assessed goodwill for impairment since it observed there were indicators of impairment. The notable indicators were a sustained and significant decline in the Company’s stock price, depressed market conditions and declining industry trends. The Company’s stock price had been in a period of sustained decline and the business climate had deteriorated substantially in the past three months. Based on the results of the first step of the goodwill analysis, it was determined that the Company’s net book value exceeded its estimated fair value. As a result, the Company performed the second step of the impairment test to determine the implied fair value of goodwill. Under step two, the difference between the estimated fair value of the Company and the sum of the fair value of the identified net assets results in the residual value of goodwill. Specifically, the Company allocated the estimated fair value of the Company as determined in the first step of the goodwill analysis to the recognized and unrecognized net assets, including allocations to intangible assets. Based on the analysis performed under step two, there was no remaining implied value attributable to goodwill and accordingly, the Company wrote off the entire goodwill balance and recognized goodwill impairment charges of approximately $19.2 million in the consolidated statement of operations under operating expenses, “Impairment of Goodwill.”
As required by FASB ASC No. 360-10-35, Subsequent Measurement of Property, Plant and Equipment, paragraphs 15-49, Impairment or Disposal of Long-Lived Assets, previously discussed in SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company also made an impairment evaluation of its long-lived assets and determined that its long-lived assets were not impaired as of March 31, 2009. No impairment indicators were present during the three months ended June 30, 2009 and September 30, 2009, hence, no impairment loss was recognized in those periods. Refer to Note 16 for the subsequent event discussion on the impairment of Sunplus IP technology.
16. Subsequent Events
The Company’s management evaluated subsequent events through October 23, 2009, which is the date these financial statements were available to be issued. The following events took place subsequent to September 30, 2009.
On October 18, 2009, the Company determined that, in light of certain changes to its product strategy going forward, the intellectual property licensed from Sunplus Technology Co., Ltd in February 2007 (the “Sunplus IP”) no longer aligns with the Company’s product roadmap and therefore will not be used. The reason for acquiring the Sunplus IP was to provide the Company with advanced technology for the development of large scale integrated circuits, which included comprehensive digital television system functionality. Given the Company’s current product strategy, which is to continue to focus on discrete semiconductor products and related intellectual property, the Sunplus IP no longer aligns with the Company’s product roadmap. The change in the Company’s product strategy was due to market place and related competitive dynamics. The carrying value of such technology was $28.0 million as of September 30, 2009. In connection with the decision to discontinue the use of the Sunplus IP, the Company expects to incur a pre-tax impairment charge of $28.0 million during the three months ending December 31, 2009.
Given the Company’s decision regarding the Sunplus IP discussed above and its decision to focus on discrete semiconductor products and related intellectual property, on October 18, 2009, the Company also decided to restructure its research and development operations resulting in the planned closure of its two sites in Germany. The Company currently has approximately 150 employees in Germany primarily focused on research and development activities. The Company plans to complete the activities related to these site closures during the first half of fiscal year 2010. The Company expects to record pre-tax restructuring charges in the range of $14.0 to $16.0 million during the three months ending December 31, 2009, primarily related to employee severance arrangements. Substantially all of the charges are, or will be, cash expenditures.
This report contains forward-looking statements within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act of 1933. These forward-looking statements involve a number of risks and uncertainties, including those identified in the section of this Form 10-Q entitled “Factors Affecting Future Results,” that may cause actual results to differ materially from those discussed in, or implied by, such forward-looking statements. Forward-looking statements within this Form 10-Q are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “estimates,” “may,” “will” and variations of such words and other similar expressions. However, these words are not the only means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. We undertake no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances occurring subsequent to the filing of this Form 10-Q with the SEC. Our actual results could differ materially from those anticipated in, or implied by, forward-looking statements as a result of various factors, including the risks outlined elsewhere in this report. Readers are urged to carefully review and consider the various disclosures made by Silicon Image, Inc. in this report and in our other reports filed with the SEC that attempt to advise interested parties of the risks and factors that may affect our business.
Silicon Image and Simplay HD are trademarks, registered trademarks or service marks of Silicon Image, Inc. in the United States and other countries. HDMI™ and High-Definition Multimedia Interface are trademarks or registered trademarks of HDMI Licensing, LLC in the United States and other countries, and are used under license from HDMI Licensing, LLC. All other trademarks and registered trademarks are the property of their respective owners.
Overview
Silicon Image, Inc. is a technology innovator and a global leader developing high-bandwidth semiconductor and intellectual property (IP) solutions based on our innovative, digital interconnect technology. Our vision is digital content everywhere. Our mission is to be the leader in the innovation, design, development and implementation of semiconductors and IP solutions for the secure storage, distribution and presentation of high-definition content in the home and mobile environments. We are dedicated to the development and promotion of technologies, standards and products that facilitate the movement of digital content between and among digital devices across the consumer electronics (CE), personal computer (PC), mobile and storage markets. We believe our track record of innovation around our core competencies, establishing industry standards and building strategic relationships, positions us to continue to drive change in the emerging world for high quality digital media storage, distribution and presentation.
We provide integrated and discrete semiconductor products as well as license IP to consumer electronics, computing, display, storage, mobile and network equipment manufacturers. Our product and IP portfolio includes solutions for high-definition television (HDTV), high-definition set-top boxes (STBs), high-definition digital video disc (DVD and Blu-ray) players, digital and personal video recorders (DVRs and PVRs), mobile devices, high-definition game systems, consumer and enterprise storage products and PC display products.
We have worked with industry leaders to create industry standards such as the,High-Definition Multimedia Interface (HDMItm) and Digital Visual Interface (DVItm) specifications for digital content delivery. We have been, and are likely to be in the future, significant contributors to broader standards specifications such as the Serial ATA (SATA) specification for PC & Enterprise storage applications. We actively promote and participate in working groups and consortiums to develop new standards such as the recently announced MHDI working group chartered with creating a new High Definition mobile video standard and the Serial Port Memory Technology (SPMT) consortium which is working on serial connection standards for dynamic random access memory (DRAM). We capitalize on our leadership position through first-to-market, standards-based semiconductor and IP solutions. Our portfolio of IP solutions that we license to third parties for consumer electronics, PCs, multimedia, communications, mobile, networking and storage devices further leverages our expertise in these markets. In addition, through Simplay Labs, LLC, our wholly owned subsidiary, we offer one of the most robust and comprehensive test suites and testing technology platforms in the consumer electronics industry. We utilize independent foundries and third-party subcontractors to manufacture, assemble and test all of our semiconductor products.
Our customers are equipment manufacturers in each of our target markets — Consumer Electronics, Personal Computer, Mobile and Storage. Because we leverage our technologies across different markets, certain of our products may be incorporated into equipment used in multiple markets. We sell our products to original equipment manufacturers (OEMs) throughout the world using a direct sales force and through a network of distributors and manufacturer’s representatives. Our net revenue is generated principally by sales of our semiconductor products, with other revenues derived from IP core licensing and licensing and royalty fees from our standards activities. We maintain relationships with the eco-system of companies that provide the products that drive digital content creation and consumption, including the major Hollywood studios, consumer electronics companies, retailers and service providers. To that end, we have developed relationships with Hollywood studios such as Universal, Warner Brothers, Disney and Fox and with major consumer electronics companies such as Sony, Nokia, Samsung, Sharp, Toshiba, Matsushita, Phillips and Thomson. Through these and other relationships, we have formed a strong understanding of the requirements for storing, distributing and viewing high quality digital video and audio in the home and mobile environments, especially in the area of High Definition (HD) content. We have also developed a substantial intellectual property base for building the standards and products necessary to promote opportunities for our products.
Historically, we have grown our business by introducing and promoting the adoption of new standards and entering new markets. We collaborated with several companies and jointly developed the DVI and HDMI standards. Our first products addressed the PC market. Subsequently, we introduced products for a variety of CE market segments, including STB, game console and digital television (DTV) markets. More recently, we have expanded our research and development activities and are developing products based on our innovative digital interconnect core technology for the mobile device market, including digital still cameras, HD camcorders, portable media players and smart phones.
We are headquartered in Sunnyvale, California. Our Internet website address is www.SiliconImage.com. We are not including the information contained on our web site as a part of, or incorporating it by reference into, this Quarterly Report on Form 10-Q. We make available through our Internet website free of charge, our Annual Report on Form 10-K quarterly reports on Form 10-Q current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable, after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.
Concentrations
Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For instance, our top five customers, including distributors, generated 51.6% and 43.7% of our revenue for the three and nine months ended September 30, 2009, respectively, compared to 52.4% and 54.7% of our revenue for the three and nine months ended September 30, 2008. Additionally, the percentage of revenue generated through distributors tends to be significant, since many OEMs rely upon third party manufacturers or distributors to provide purchasing and inventory management services. For the three and nine months ended September 30, 2009, 22.5% and 33.1% of our revenue, respectively, was generated through distributors, compared to 47.4% and 50.7% in the comparable periods of 2008, respectively. Our licensing revenue is not generated through distributors, and to the extent licensing revenue increases faster than product revenue, we would expect a decrease in the percentage of our total revenue generated through distributors.
A significant portion of our revenue is generated from products sold overseas. Sales to customers in Asia, including distributors, represented 71.6% and 68.4% of our revenue for the three and nine months ended September 30, 2009, respectively and 75.7% and 71.7% for the three and nine months ended September 30, 2008, respectively. The reason for the geographical concentration in Asia is that most of our products are components of consumer electronics, computer and storage products, the majority of which are manufactured in Asia. The percentage of our revenue derived from any country is dependent upon where our end customers choose to manufacture their products. Accordingly, variability in our geographic revenue is not necessarily indicative of any geographic trends, but rather is the combined effect of new design wins and changes in customer manufacturing locations. All revenue to date has been denominated in U.S. dollars except for a relatively insignificant portion generated in Euros through our subsidiary in Germany.
Critical Accounting Policies
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in our consolidated financial statements and accompanying notes. We base our estimates on historical experience and all known facts and circumstances that we believe are relevant. Actual results may differ materially from our estimates. We believe the accounting policies discussed below to be most critical to an understanding of our financial condition and results of operations because they require us to make estimates, assumptions and judgments about matters that are inherently uncertain.
Revenue Recognition
We recognize revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable and collectability is reasonably assured.
Revenue from products sold directly to end-users, or to distributors that do not receive price concessions and rights of return, is generally recognized when title and risk of loss has passed to the buyer which typically occurs upon shipment. All shipping costs are charged to cost of product revenue.
Revenue from products sold to distributors with agreements allowing for stock rotations are generally recognized upon shipment. Reserves for stock rotations are estimated based primarily on historical experience and provided for at the time of shipment.
For products sold to distributors with agreements allowing for price concessions and stock rotation rights/product returns, we recognize revenue based on our best estimate of when the distributor sells the product to its customer. Our estimate of such distributor sell-through is based on point of sales reports received from the distributor which establishes a customer, quantity and final price. Revenue is not recognized upon our shipment of product to the distributor, since, due to certain forms of price concessions, the sales price is not substantially fixed or determinable at the time of shipment. Price concessions are recorded when incurred, which is generally at the time the distributor sells the product to its customer. Additionally, these distributors have stock rotation rights permitting them to return products to us, up to a specified amount for a given period of time. Revenue is earned when the distributor reports that it has sold product to its customer, at which time our sales price to the distributor is fixed. Once we receive the point of sales reports from a distributor, it has satisfied all the requirements for revenue recognition and any product returns/stock rotation and price concession rights that the distributor has under its distributor agreement with Silicon Image are exhausted. Pursuant to our distributor agreements, older, end-of-life and certain other products are generally sold with no right of return and are not eligible for price concessions. For these products, revenue is recognized upon shipment and title transfer assuming all other revenue recognition criteria are met.
At the time of shipment to distributors, we record a trade receivable for the selling price since there is a legally enforceable right to payment, relieve inventory for the carrying value of goods shipped since legal title has passed to the distributor and record the gross margin in “deferred margin on sale to distributors,” a component of current liabilities in our consolidated balance sheets. Deferred margin on the sale to distributor effectively represents the gross margin on the sale to the distributor. However, the amount of gross margin we recognize in future periods will be less than the originally recorded deferred margin on sales to distributor as a result of negotiated price concessions. We sell each item in our product price book to all of our distributors worldwide at a relatively uniform list price. However, distributors resell our products to end customers at a very broad range of individually negotiated price points based on customer, product, quantity, geography, competitive pricing and other factors. The majority of our distributors’ resale is priced at a discount from list price. Often, under these circumstances, we remit back to the distributor a portion of their original purchase price after the resale transaction is completed. Thus, a portion of the “deferred margin on the sale to distributor” balance represents a portion of distributors’ original purchase price that will be remitted back to the distributor in the future. The wide range and variability of negotiated price concessions granted to distributors does not allow us to accurately estimate the portion of the balance in the deferred margin on the sale to distributors line item that will be remitted back to the distributors. We reduce deferred margin by anticipated or determinable future price concessions.
We derive revenue from license of its internally developed intellectual property (IP). We enter into IP licensing agreements that generally provide licensees the right to incorporate our IP components in their products with terms and conditions that vary by licensee. Revenue earned under contracts with our licensees is classified as licensing revenue. Our license fee arrangements generally include multiple deliverables and for multiple deliverable arrangements, we follow the guidance in FASB ASC No. 605-25-25, Multiple-Element Arrangements Recognition, previously discussed in EITF 00-21, Revenue Arrangements with Multiple Deliverables, to determine whether there is more than one unit of accounting. To the extent that the deliverables are separable into multiple units of accounting, we allocate the total fee on such arrangements to the individual units of accounting using the residual method, if objective and reliable evidence of fair value does not exist for delivered elements. We then recognize revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the unit of accounting in accordance with the revenue criteria mentioned above.
The IP licensing agreements generally include a nonexclusive license for the underlying IP. Fees under these agreements generally include (a) license fees relating to our IP, (b) support, typically for one year; and (c) royalties payable following the sale by our licensees of products incorporating the licensed technology. The license of our IP has standalone value and can be used by the licensee without support. Further, objective and reliable evidence of fair value exists for support. Accordingly, license and support fees are each treated as separate units of accounting.
Certain licensing agreements provide for royalty payments based on agreed upon royalty rates. Such rates can be fixed or variable depending on the terms of the agreement. The amount of revenue we recognize is determined based on a time period or on the agreed-upon royalty rate, extended by the number of units shipped by the customer. To determine the number of units shipped, we rely upon actual royalty reports from our customers when available and rely upon estimates in lieu of actual royalty reports when we have a sufficient history of receiving royalties from a specific customer for us to make an estimate based on available information from the licensee such as quantities held, manufactured and other information. These estimates for royalties necessarily involve the application of management judgment. As a result of our use of estimates, period-to-period numbers are “trued-up” in the following period to reflect actual units shipped. In cases where royalty reports and other information are not available to allow us to estimate royalty revenue, we recognize revenue only when royalty reports are received.
For contracts related to licenses of our technology that involve significant modification, customization or engineering services, we recognize revenue in accordance the provisions of FASB ASC No. 605-35-25, Construction-Type and Production-Type Contracts Recognition, previously discussed in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Revenues derived from such license contracts are accounted for using the percentage-of-completion method.
We determine progress to completion based on input measures using labor-hours incurred by our engineers. The amount of revenue recognized is based on the total contract fees and the percentage of completion achieved. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management. If there is significant uncertainty about customer acceptance, or the time to complete the development or the deliverables by either party, we apply the completed contract method. If application of the percentage-of-completion method results in recognizable revenue prior to an invoicing event under a customer contract, we recognize the revenue and record an unbilled receivable assuming collectability is reasonably assured. Amounts invoiced to our customers in excess of recognizable revenues are recorded as deferred revenue.
Financial Instruments
We account for our investments in debt and equity securities under FASB ASC No. 320-10-25, Investments in Debt and Equity Securities Recognition, previously discussed in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities and FASB ASC No. 320-10-35, Subsequent Measurement of Investments in Debt and Equity Securities (“ASC 320-10-35”), previously discussed in FSP115-1/124-1 and EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. Management determines the appropriate classification of such securities at the time of purchase and reevaluates such classification as of each balance sheet date. The investments are adjusted for amortization of premiums and discounts to maturity and such amortization is included in interest income. We follow the guidance provided by ASC 320-10-35 to assess whether our investments with unrealized loss positions are other than temporarily impaired. We comply with the presentation and disclosure requirements of the other-than-temporary impairment for debt securities as discussed in FASB ASC No. 320-10-65, Transition Related To Recognition and Presentation of Other-Than-Temporary Impairments, previously discussed in FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in the statements of income. Factors considered in determining whether a loss is temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. We place our investments in instruments that meet high credit quality standards, as specified in our investment policy guidelines. These guidelines also limit the amount of credit exposure to any one issue, issuer or type of instrument.
The longer the duration of our investment securities, the more susceptible they are to changes in market interest rates and bond yields. As yields increase, those securities purchased with a lower yield-at-cost show a mark-to-market unrealized loss. All unrealized losses are due to changes in interest rates and bond yields. We expect to realize the full value of all these investments upon maturity or sale.
The classification of our investments into cash equivalents and short term investments is in accordance with FASB ASC No. 305-10-20, Cash and Cash Equivalents Glossary, previously discussed in SFAS No. 95, Statement of Cash Flows. Cash equivalents consist of short-term, highly liquid financial instruments with insignificant interest rate risk that are readily convertible to cash and have maturities of three months or less from the date of purchase. Short-term investments consist of taxable commercial paper, United States government agency obligations, corporate/municipal notes and bonds with high-credit quality and money market preferred stock. These securities have maturities greater than three months from the date of purchase.
We believe all of the financial instruments’ recorded values approximate current fair values because of their nature and respective durations. The fair value of marketable securities is determined using quoted market prices for those securities or similar financial instruments.
Derivative Instruments
We recognize derivative instruments as either assets or liabilities and measures those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. We account for derivative instruments in accordance with FASB ASC No. 815-20-25 – Derivatives and Hedging Recognition, previously discussed in SFAS 133 - Accounting for Derivative Instruments and Hedging Activities. For a derivative instrument designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion of the gain (loss) is reported immediately in other income (expense) on our consolidated statement of operations.
Allowance for Doubtful Accounts
We review collectability of accounts receivable on an on-going basis and provide an allowance for amounts we estimate will not be collectible. During our review, we consider our historical experience, the age of the receivable balance, the credit-worthiness of the customer and the reason for the delinquency. Delinquent account balances are written-off after management has determined that the likelihood of collection is remote. Write-offs to date have not been material. While we endeavor to accurately estimate the allowance, we may record unanticipated write-offs in the future.
Inventories
We record inventories at the lower of actual cost, determined on a first-in first-out (FIFO) basis, or market. Actual cost approximates standard cost, adjusted for variances between standard and actual. Standard costs are determined based on our estimate of material costs, manufacturing yields, costs to assemble, test and package our products and allocable indirect costs. We record differences between standard costs and actual costs as variances. These variances are analyzed and are either included on the consolidated balance sheet or the consolidated statement of operations in order to state the inventories at actual costs on a FIFO basis. Standard costs are evaluated at least annually.
Provisions are recorded for excess and obsolete inventory and are estimated based on a comparison of the quantity and cost of inventory on hand to management’s forecast of customer demand. Customer demand is dependent on many factors and requires us to use significant judgment in our forecasting process. We must also make assumptions regarding the rate at which new products will be accepted in the marketplace and at which customers will transition from older products to newer products. Generally, inventories in excess of six months demand are written down to zero and the related provision is recorded as a cost of revenue. Once a provision is established, it is maintained until the product to which it relates is sold or otherwise disposed of, even if in subsequent periods we forecast demand for the product.
Goodwill, Intangible and Long-lived Assets
Consideration paid in connection with acquisitions is required to be allocated to the assets, including identifiable intangible assets and liabilities acquired. Acquired assets and liabilities are recorded based on our estimate of fair value, which requires significant judgment with respect to future cash flows and discount rates.
For certain long-lived assets, primarily fixed assets and identifiable intangible assets, for example, our IP acquired from Sunplus (refer to Notes 12 and 16 in our notes to the consolidated financial statements), we are required to estimate the useful life of the asset and recognize its cost as an expense over the useful life. We use the straight-line method to depreciate long-lived assets. We evaluate the recoverability of our long-lived assets in accordance with FASB ASC No. 360-10-35, Subsequent Measurement of Property, Plant and Equipment, paragraphs 15-49, Impairment or Disposal of Long-Lived Assets, previously discussed in SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Whenever events or circumstances indicate that the carrying amount of long-lived assets may not be recoverable, we compare the carrying amount of long-lived assets to our projection of future undiscounted cash flows, attributable to such assets. In the event that the carrying amount exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying amount over the asset’s fair value. Predicting future cash flows attributable to a particular asset is difficult and requires the use of significant judgment.
We assign the following useful lives to our fixed assets — three years for computers and software, one to five years for equipment and five to seven years for furniture and fixtures. Leasehold improvements and assets held under capital leases are amortized on a straight-line basis over the shorter of the lease term or the estimated useful life, which ranges from two to five years. Depreciation expense was $6.8 million and $7.9 million for the nine months ended September 30, 2009 and 2008, respectively.
We periodically review the carrying value of intangible assets not subject to amortization, including goodwill, to determine whether impairment may exist. FASB ASC No. 350-20-35, Subsequent Measurement of Goodwill, and FASB ASC No. 350-30-35, Subsequent Measurement of General Intangibles Other Than Goodwill (“ASC 350-30-35”), whose provisions were previously discussed in SFAS 142, Goodwill and Other Intangible Assets, require that goodwill and certain intangible assets be assessed annually for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. We have determined based on the criteria of FASB ASC No. 280-10-50, Segment Reporting Disclosure, previously discussed in SFAS 131, Disclosures about Segments of an Enterprise and Related Information, that we have one reporting unit for this goodwill impairment assessment. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined by comparing the fair value of our company’s equity as of the date of the impairment testing to the carrying amount of stockholders equity. The impairment charge for other intangible assets not subject to amortization, for which impairment indicators exists, consists of a comparison of the fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Furthermore, ASC 350-30-35 requires purchased other intangible assets to be amortized over their useful lives unless these lives are determined to be indefinite. During the three months ended March 31, 2009, we recognized an impairment loss on goodwill as a result of the periodic review due to the presence of impairment indicators.
Income Taxes
We make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, tax benefits and deductions and in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. Significant changes to these estimates may result in an increase or decrease to our tax provision in the subsequent period when such a change in estimate occurs.
Deferred Tax Assets
We account for deferred tax assets in accordance with the FASB ASC No. 740-10, Income Taxes Recognition (“ASC 740-10”), previously discussed in SFAS No. 109, Accounting for Income Taxes. We use an asset and liability approach, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements, but have not been reflected in our taxable income. In general, a valuation allowance is established to reduce deferred tax assets to their estimated realizable value, if based on the weight of available evidence, it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. We evaluate the realizability of the deferred tax assets quarterly and will continue to assess the need for valuation allowances. In accordance with paragraphs 25-17 and 30-7 of ASC 740-10, Basic Recognition Threshold, we determine whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The provisions under paragraphs 25-17 and 30-7 of ASC 740-10 were previously discussed in FIN 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.
Legal Matters
We are subject to various legal proceedings and claims, either asserted or unasserted. We evaluate, among other factors, the degree of probability of an unfavorable outcome and reasonably estimate the amount of the loss. Significant judgment is required in both the determination of the probability and as to whether an exposure can be reasonably estimated. When we determine that it is probable that a loss has been incurred, the effect is recorded promptly in the consolidated financial statements. Although the outcome of these claims cannot be predicted with certainty, we do not believe that any of the existing legal matters will have a material adverse effect on our financial condition and results of operations. However, significant changes in legal proceedings and claims or the factors considered in the evaluation of those matters could have a material adverse effect on our business, financial condition and results of operations.
Results of Operations
REVENUE
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Product revenue | | $ | 30,716 | | | $ | 64,974 | | | | -52.7 | % | | $ | 94,747 | | | $ | 183,997 | | | | -48.5 | % |
| Licensing revenue | | | 6,440 | | | | 12,802 | | | | -49.7 | % | | | 20,257 | | | | 30,975 | | | | -34.6 | % |
| Total revenue | | $ | 37,156 | | | $ | 77,776 | | | | -52.2 | % | | $ | 115,004 | | | $ | 214,972 | | | | -46.5 | % |
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Consumer Electronics (1) | | $ | 31,690 | | | $ | 55,883 | | | | -43.3 | % | | $ | 98,427 | | | $ | 155,728 | | | | -36.8 | % |
| Personal Computers (1) | | | 1,928 | | | | 11,713 | | | | -83.5 | % | | | 6,920 | | | | 34,640 | | | | -80.0 | % |
| Storage (1) | | | 3,538 | | | | 10,180 | | | | -65.2 | % | | | 9,657 | | | | 24,604 | | | | -60.7 | % |
| Total revenue | | $ | 37,156 | | | $ | 77,776 | | | | -52.2 | % | | $ | 115,004 | | | $ | 214,972 | | | | -46.5 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| (1) Includes development, licensing and royalty revenue (collectively "licensing revenue") | | | | | | | | | | |
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Consumer Electronics | | $ | 25,588 | | | $ | 46,157 | | | | -44.6 | % | | $ | 78,850 | | | $ | 133,222 | | | | -40.8 | % |
| Personal Computers | | | 1,800 | | | | 9,704 | | | | -81.5 | % | | | 6,968 | | | | 30,681 | | | | -77.3 | % |
| Storage | | | 3,328 | | | | 9,113 | | | | -63.5 | % | | | 8,929 | | | | 20,094 | | | | -55.6 | % |
| Licensing revenue | | | 6,440 | | | | 12,802 | | | | -49.7 | % | | | 20,257 | | | | 30,975 | | | | -34.6 | % |
| Total revenue | | $ | 37,156 | | | $ | 77,776 | | | | -52.2 | % | | $ | 115,004 | | | $ | 214,972 | | | | -46.5 | % |
Total revenue for the three and nine months ended September 30, 2009 was $37.2 million and $115.0 million, respectively and represented a decline of 52.2% or $40.6 million and 46.5% or $100.0 million from the same periods in 2008, respectively. The decrease in our overall revenue was driven primarily by the decrease in our product revenue which decreased by 52.7% or $34.3 million and 48.5% or $89.3 million for the three and nine months ended September 30, 2009, respectively, when compared to the same periods in the prior year. Product shipments decreased by approximately 42.0% and 31.3% and average selling price declined by approximately 22.6% and 26.8% during the three and nine months ended September 30, 2009, respectively, when compared to the same periods last year primarily due to the ongoing global recession, increased competition, product mix changes in the DTV market and our ongoing product transition as customers transition from HDMI receivers to more cost effective Port Processors. We expect the revenue in the quarter ending December 31, 2009 to be in the range of $34 million to $37 million.
We also experienced significant declines in our licensing revenues for the three and nine months ended September 30, 2009 as compared to the comparable periods in 2008 primarily due to the fewer licensing arrangements we entered into during 2009 as compared to prior year.
We enter into “direct agreements” for certain parts to certain identified end customers with our distributors who previously had the rights for price concessions and product returns. The “direct agreements” convert the previously existing distributor relationships for these parts for identified end customers into direct customer relationships whereby the distributor does not have price protection or return rights. Revenue for these types of transactions are recorded at the time of conversion of applicable products previously shipped for which revenue had not been recognized upon shipment. Thereafter, revenue for products covered under the direct agreements is recognized upon shipment. During the three months ended September 30, 2009, we did not generate revenue from the above mentioned conversions under this arrangement. For the nine months ended September 30, 2009, we recorded approximately $2.8 million in revenue under this arrangement. We did not enter into similar type of arrangement in the same periods last year.
COST OF REVENUE AND GROSS PROFIT
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Product cost of revenue (1) | | $ | 16,801 | | | $ | 31,518 | | | | -46.7 | % | | $ | 52,284 | | | $ | 87,921 | | | | -40.5 | % |
| Licensing cost of revenue | | | 156 | | | | 223 | | | | -30.0 | % | | | 626 | | | | 1,064 | | | | -41.1 | % |
| Total Cost of revenue | | | 16,957 | | | | 31,741 | | | | -46.6 | % | | | 52,910 | | | | 88,985 | | | | -40.5 | % |
| Total gross profit | | | 20,199 | | | | 46,035 | | | | -56.1 | % | | | 62,094 | | | | 125,987 | | | | -50.7 | % |
| Gross profit margin | | | 54.4 | % | | | 59.2 | % | | | | | | | 54.0 | % | | | 58.6 | % | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| (1) Includes stock-based compensation expense | | $ | 363 | | | $ | 351 | | | | | | | $ | 806 | | | $ | 1,132 | | | | | |
Cost of revenue consists primarily of costs incurred to manufacture, assemble and test our products, and costs to license our technology which involves modification, customization or engineering services, as well as other overhead costs relating to the aforementioned costs including stock-based compensation expense. Gross profit margin was 54.4% and 54.0% for the three and nine months ended September 30, 2009, respectively, and 59.2% and 58.6% in the comparable periods in 2008, respectively. Product mix, unfavorable variances and the impact of fixed overhead with lower revenue volume during the three and nine months ended September 30, 2009 were the primary reasons for the decrease in gross margin as percentage of revenue. Consistent with the gross margin during the three and nine months ended September 30, 2009, we expect our gross margin to be within the 54%-55% range in the fourth quarter of 2009.
OPERATING EXPENSES
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Research and development (1) | | $ | 17,807 | | | $ | 20,714 | | | | -14.0 | % | | $ | 53,160 | | | $ | 64,554 | | | | -17.7 | % |
| Percentage of total revenue | | | 47.9 | % | | | 26.6 | % | | | | | | | 46.2 | % | | | 30.0 | % | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| (1) Includes stock-based compensation expense | | $ | 2,374 | | | $ | 1,753 | | | | | | | $ | 5,365 | | | $ | 5,200 | | | | | |
Research and Development (R&D). R&D expense consists primarily of employee compensation, including stock compensation expense, and other related costs and fees for independent contractors, the cost of software tools used for designing and testing our products, and costs associated with prototype materials. R&D expense for the three and nine months ended September 30, 2009 included stock-based compensation expense of approximately $2.4 million and $5.4 million, respectively, as compared to $1.8 million and $5.2 million for the same periods in 2008, respectively. For the three months ended September 30, 2009, approximately $1.1 million of the $2.4 million stock-based compensation expense was related to the cumulative adjustment pertaining to the errors we identified with respect to the stock-based compensation expense as calculated by by our third-party software (refer to discussion in Note 4 under Item 1 of Part I). R&D expense decreased by $2.9 million and $11.4 million for the three and nine months ended September 30, 2009, respectively, as compared to the same periods in prior year. The decrease was mainly driven by lower compensation related expenses and lower project related and tape-out expenses, partially offset by the $1.1 million stock-based compensation cummulative adjustment previously mentioned. The decreases in these expenses were primarily driven by the lower headcount due to the restructuring activities completed in the second quarter of 2009 and third and fourth quarters of 2008. We expect R&D expenses to remain flat in the last quarter of fiscal year 2009.
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Selling, general and administrative (1) | | $ | 17,222 | | | $ | 17,468 | | | | -1.4 | % | | $ | 43,615 | | | $ | 54,853 | | | | -20.5 | % |
| Percentage of total revenue | | | 46.4 | % | | | 22.5 | % | | | | | | | 37.9 | % | | | 25.5 | % | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| (1) Includes stock-based compensation expense | | $ | 4,911 | | | $ | 2,004 | | | | | | | $ | 9,255 | | | $ | 8,057 | | | | | |
Selling, General and Administrative (SG&A). SG&A expense consists primarily of compensation, including stock-based compensation, sales commissions, professional fees, and marketing and promotional expenses. SG&A expense for the three months ended September 30, 2009 was relatively flat compared to the same period in prior year. Had it not been for approximately $2.0 million in professional fees incurred during the three months ended September 30, 2009 associated with a potential strategic acquisition which we evaluated but decided not to pursue, the $1.2 million compensation package provided to the Chief Executive Officer upon his resignation and the $2.6 million cummulative adjustment pertaining to the errors we identified with respect to the stock-based compensation expense as calculated by by our third-party software (refer to discussion in Note 4 under Item 1 of Part I), SG&A expense for the three months ended September 30, 2009 would have been lower by approximately $6.0 million compared to what was incurred in the same period in the prior year, a trend consistent with the movement in this expense for the nine months ended September 30, 2009. SG&A expense for the nine months ended September 30, 2009 was $11.2 million lower than what was incurred in the same period in the prior year primarily due to lower compensation related expenses and legal expenses, partially offset by the $2.8 million stock-based compensation cummulative adjustment previously mentioned. The decreases in these expenses are mainly attributable to the decrease in head count because of the reduction in forces implemented in the second quarter of 2009 and in the third and fourth quarters of 2008. We expect SG&A expenses to remain flat in the last quarter of fiscal year 2009.
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Amortization of intangible assets | | $ | 1,473 | | | $ | 1,587 | | | | -7.2 | % | | $ | 4,419 | | | $ | 4,761 | | | | -7.2 | % |
| Percentage of total revenue | | | 4.0 | % | | | 2.0 | % | | | | | | | 3.8 | % | | | 2.2 | % | | | | |
Amortization of Intangible Assets. The decrease in the amortization of intangible assets was primarily due to the complete amortization of certain intangible assets related to a 2007 acquisition.
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Interest income and other, net | | $ | 696 | | | $ | 1,798 | | | | -61.3 | % | | $ | 2,233 | | | $ | 5,094 | | | | -56.2 | % |
| Percentage of total revenue | | | 1.9 | % | | | 2.3 | % | | | | | | | 1.9 | % | | | 2.4 | % | | | | |
Interest Income and Other, net. The net amount of interest income and other primarily includes interest income. The decrease was due to lower cash balances and lower interest rate environment.
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | | | 2009 | | | 2008 | | | Change | |
| | | (dollars in thousands) | | | | | | (dollars in thousands) | | | | |
| Income tax expense (benefit) | | $ | (444 | ) | | $ | 114 | | | | -489.5 | % | | $ | (2,113 | ) | | $ | (13 | ) | | | 16153.8 | % |
| Percentage of total revenue | | | -1.2 | % | | | 0.1 | % | | | | | | | -1.8 | % | | | 0.0 | % | | | | |
Provision (Benefit) for Income Taxes. For the three and nine months ended September 30, 2009, we recorded an income tax benefit of ($444,000) and ($2.1) million, respectively. The effective tax rates for the three and nine months ended September 30, 2009 were 2.8% and 3.3%, respectively and was based on our projected taxable income for 2009, plus certain discrete items recorded during the quarter. The difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to various forecasted items including tax exempt income, stock-based compensation expense, tax credits and foreign taxes, adjusted for certain discrete items recorded during the quarter.
During the three months ended March 31, 2009, the State of California legislature enacted significant state tax law changes. As a result of the enacted legislation, we expect that in years 2011 and beyond our income subject to tax in California will be less than under prior tax law and accordingly our California deferred tax assets are less likely to be realized. We recorded a net discrete tax charge of $9.4 million for the three months ended March 31, 2009 related to the re-measurement of our California deferred tax assets to account for this change in tax law, as well as an increase in the valuation allowance for our California deferred tax assets that existed as of December 31, 2008. We will continue to assess our valuation allowance on our California deferred tax assets in future periods.
We have concluded that it is more likely than not that as of September 30, 2009, our net deferred tax assets will be realized. In making our conclusion, we considered all available evidence, both positive and negative. Key components of the evaluation are the cumulative results of operations in recent years, the nature of recent losses, and forecasts of a return to profitability. A significant negative factor in the evaluation is cumulative losses in recent years and we may reach that position during fiscal year 2009. The assessment of whether a valuation allowance is necessary will be made each quarter by considering all of the positive and negative evidence in existence at that time and, depending upon the nature and weighting of such evidence, a substantial increase in the valuation allowance may be required to reduce the deferred tax assets in the near term, which would result in a material charge to income tax expense.
For the three and nine months ended September 30, 2008, we recorded a provision for income taxes of $114,000 and a benefit of ($13,000), respectively. The effective tax rate for the three and nine months ended September 30, 2008 was 1.8% and (0.3%), respectively, and were based on our projected taxable income for 2008, plus certain discrete items recorded during the quarter. The difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to various forecasted items including tax exempt income, state taxes and foreign taxes, adjusted for certain discrete items recorded during the quarter.
Recent Accounting Pronouncements
See Note 2, “Recent Accounting Pronouncements” in the Notes to Condensed Consolidated Financial Statements under Part I Item I of this report.
LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL CONDITION
The following sections discuss the effects of changes in our balance sheet and cash flows, contractual obligations, other commitments, and the stock repurchase program on our liquidity and capital resources.
Cash and Cash Equivalents, Investments and Working Capital. The table below summarizes our cash and cash equivalents, investments and working capital and the related movements (in thousands).
| | | September 30, 2009 | | | December 31, 2008 | | | Change | |
| Cash and cash equivalents | | $ | 27,883 | | | $ | 95,414 | | | | -70.8 | % |
| Short-term investments | | | 125,335 | | | | 89,591 | | | | 39.9 | % |
| Total cash and cash equivalents and short-term investments | | $ | 153,218 | | | $ | 185,005 | | | | -17.2 | % |
| | | | | | | | | | | | | |
| Total current assets | | $ | 214,357 | | | $ | 225,642 | | | | -5.0 | % |
| Total current liabilities | | | 38,675 | | | | 39,530 | | | | -2.2 | % |
| Working capital | | $ | 175,682 | | | $ | 186,112 | | | | -5.6 | % |
Cash and cash equivalents and short-term investments were $153.2 million at September 30, 2009, a decrease of $31.8 million from $185.0 million at December 31, 2008. The decrease was primarily due to the cash used in operations for the nine months ended September 30, 2009.
The significant components of our working capital are cash and cash equivalents, short-term investments, accounts receivable, prepaid expenses and other current assets, inventories and deferred income taxes reduced by accounts payable, accrued and other current liabilities, deferred license revenue, and deferred margin on sales to distributors. Working capital at September 30, 2009 decreased by approximately $10.4 million when compared to the working capital at December 31, 2008 primarily due to the decreases in cash and cash equivalents and short-term investments and the increase in accounts payable and deferred license revenue, partially offset by the increases in operating assets, such as accounts receivable and prepaid expenses and other current assets and the decreases in operating liabilities, such as deferred margin on sales to distributors and accrued and other current liabilities.
Summary of Cash Flows. The table below summarizes the cash and cash equivalents provided by (used in) in our operating, investing and financing activities (in thousands).
| | | Nine months ended September 30, | |
| | | 2009 | | | 2008 | | | Change | |
| Cash provided by (used in) operating activities | | $ | (28,232 | ) | | $ | 27,251 | | | | -203.6 | % |
| Cash used in investing activities | | | (40,611 | ) | | | (23,240 | ) | | | 74.7 | % |
| Cash provided by (used in) financing activities | | | 1,045 | | | | (69,058 | ) | | | -101.5 | % |
| Effect of exchange rate changes on cash & cash equivalents | | | 267 | | | | (407 | ) | | | -165.6 | % |
| Net decrease in cash and cash equivalents | | $ | (67,531 | ) | | $ | (65,454 | ) | | | 3.2 | % |
During the nine months ended September 30, 2009, cash and cash equivalents decreased by $67.5 million. This decrease was the result of the cash used in our operating and investing activities of $28.2 million and $40.6 million, respectively, partially offset by the cash generated from our financing activities of approximately $1.0 million.
Operating Activities
The $28.2 million net cash used in operating activities during the nine months ended September 30, 2009 was primarily due to the cash used for working capital as a result of the increase in accounts receivable and prepaid expenses and other current assets, and the decrease in accrued and other current liabilities and deferred margin on sales to distributors, partially offset by the increase in accounts payable and deferred license revenue.
Investing Activities
The $40.6 million net cash used in investing activities during the nine months ended September 30, 2009 was due primarily to net purchases of short-term investments of approximately $37.9 million and net investment in property and equipment of approximately $2.7 million. During the nine months ended September 30, 2009, we purchased $148.6 million and sold $110.7 million of short-term investments.
Financing Activities
The $1.0 million net cash generated from our financing activities during the nine months ended September 30, 2009 was primarily due to the proceeds from issuances of common stock of approximately $2.5 million, partially offset by payments to vendor of financed software and intangibles purchased of approximately $1.3 million and cash used to repurchase restricted stock units for income tax withholding of approximately $0.2 million.
Accounts Receivable, Net. The table below summarizes our accounts receivable, net (in thousands):
| | | September 30, | | | December 31, | | | | |
| | | 2009 | | | 2008 | | | Change | |
| Accounts receivable, net | | $ | 24,454 | | | $ | 5,922 | | | | 312.9 | % |
Net accounts receivable as of September 30, 2009 were $24.5 million, which represents 59 days of sales outstanding. This compares to 9 days of sales outstanding on December 31, 2008. Accounts receivable as of September 30, 2009 significantly increased compared to the balance as of December 31, 2008 primarily due to the timing of shipments and collections of cash.
Commitments and Contractual Obligations
See Note 9, “Commitments and Contingencies,” in the Notes to Condensed Consolidated Financial Statements under Part I Item I of this report.
We purchase components from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, we enter into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by us or that establish the parameters defining our requirements. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. Consequently, only a portion of our reported purchase commitments arising from these agreements are firm, non-cancelable, and unconditional commitments.
Liquidity and Capital Resource Requirements
Based on our estimated cash flows, we believe our existing cash and short-term investments are sufficient to meet our capital and operating requirements for at least the next 12 months. Our future operating and capital requirements depend on many factors, including the levels at which we generate product revenue and related margins, the extent to which we generate cash through stock option exercises and proceeds from sales of shares under our employee stock purchase plan, the timing and extent of development, licensing and royalty revenue, investments in inventory and accounts receivable, the cost of securing access to adequate manufacturing capacity, our operating expenses, including legal and patent assertion costs, and general economic conditions. In addition, cash may be required for future acquisitions should we choose to pursue any. To the extent existing resources and cash from operations are insufficient to support our activities; we may need to raise additional funds through public or private equity or debt financing. These funds may not be available, or if available, we may not be able to obtain them on terms favorable to us.
Interest Rate Risk
A sensitivity analysis was performed on our investment portfolio as of September 30, 2009. This sensitivity analysis was based on a modeling technique that measures the hypothetical market value changes that would result from a parallel shift in the yield curve of plus 50, 100, or 150 basis points over a twelve-month time horizon. The following represents the potential decrease to the value of our investments given a negative shift in the yield curve used in our sensitivity analysis.
| | 0.5% | | | | 1.0% | | | | 1.5% | |
| | $ 503,000 | | | | $ 1,006,000 | | | | $ 1,509,000 | |
Foreign Currency Exchange Risk
A majority of our revenue, expense, and capital purchasing activities are transacted in U.S. dollars. However, certain operating expenditures and capital purchases are incurred in or exposed to other currencies, primarily the Euro, British Pound, the South Korean Won, Taiwan Dollar and the Chinese Yuan. Additionally, many of our foreign distributors price our products in the local currency of the countries in which they sell. Therefore, significant strengthening or weakening of the U.S. dollar relative to those foreign currencies could result in reduced demand or lower U.S. dollar prices or vice versa, for our products, which would negatively affect our operating results. Cash balances held in foreign countries are subject to local banking laws and may bear higher or lower risk than cash deposited in the United States. The following represents the potential impact of a change in the value of the U.S. dollar compared to the foreign currencies which we use in our operations. As of September 30, 2009, cash held in foreign countries was approximately $2.0 million. The following represents the potential impact of a change in the value of the U.S. dollar compared to the Euro, British Pound, Japanese Yen, Chinese Yuan, Taiwan Dollar and Korean Won. This sensitivity analysis aggregates our nine months activity in these currencies, translated to U.S. dollars, and applies a change in the U.S. dollar value of 5%, 7.5% and 10%.
| | 5.0% | | | | 7.5% | | | | 10.0% | |
| | $ 1,280,000 | | | | $ 1,919,000 | | | | $ 2,559,000 | |
Derivative Instruments
We have operations in the United States, Europe and Asia, however, the majority of our revenue, costs of sales, expense and capital purchasing activities are transacted in U.S. Dollars. As a corporation with international as well as domestic operations, we are exposed to changes in foreign exchange rates. These exposures may change over time and could have a material adverse impact on our financial results. Periodically, we use foreign currency forward contracts to hedge certain forecasted foreign currency transactions relating to operating expenses. We do not enter into derivatives for speculative or trading purposes. We use derivative instruments primarily to manage exposures to foreign currency fluctuations on forecasted cash flows and balances primarily denominated in Euro. Our primary objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates. These derivatives are designated as cash flow hedges and have maturities of less than one year. The effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and, upon occurrence of the forecasted transaction, is subsequently reclassified into the line item in the consolidated statements of operations to which the hedged transaction relates. We record any ineffective portion of the hedging instruments gain (loss) in other income (expense) on our consolidated statements of operations.
Our derivatives expose us to credit and non performance risks to the extent that the counterparties may be unable to meet the terms of the agreement. We seek to mitigate such risks by limiting the counterparties to major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored. Management does not expect material losses as a result of defaults by counterparties.
As of September 30, 2009, the outstanding foreign exchange contracts had a total notional value of $4.6 million. See Note 14 to the Consolidated Financial Statements.
Evaluation of Disclosure Controls and Procedures
Based on our management’s evaluation (with the participation of our president, chief operating officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our third quarter of fiscal 2009 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Please refer to Note 9 to our consolidated financial statements under Part I Item I financials statements.
A description of the risk factors associated with our business is set forth below. You should carefully consider the following risk factors, together with all other information contained or incorporated by reference in this filing, before you decide to purchase shares of our common stock. These factors could cause our future results to differ materially from those expressed in or implied by forward-looking statements made by us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also harm our business. The trading price of our common stock could decline due to any of these risks and you may lose all or part of your investment.
Our annual and quarterly operating results may fluctuate significantly and are difficult to predict, particularly given adverse domestic and global economic conditions.
Our annual and quarterly operating results are likely to vary significantly in the future based on a number of factors many of which we have little or no control. These factors include, but are not limited to:
| | • | the growth, evolution and rate of adoption of industry standards for our key markets, including consumer electronics, digital-ready PCs and displays and storage devices and systems; |
| | • | the fact that our licensing revenue is heavily dependent on a few key licensing transactions being completed for any given period, the timing of which is not always predictable and is especially susceptible to delay beyond the period in which completion is expected and our concentrated dependence on a few licensees in any period for substantial portions of our expected licensing revenue and profits; |
| | • | the fact that our licensing revenue has been uneven and unpredictable over time and is expected to continue to be uneven and unpredictable for the foreseeable future, resulting in considerable fluctuation in the amount of revenue recognized in a particular quarter; |
| | • | competitive pressures, such as the ability of competitors to successfully introduce products that are more cost-effective or that offer greater functionality than our products, including integration into their products of functionality offered by our products, the prices set by competitors for their products and the potential for alliances, combinations, mergers and acquisitions among our competitors; |
| | • | average selling prices of our products, which are influenced by competition and technological advancements, among other factors; |
| | • | government regulations regarding the timing and extent to which digital content must be made available to consumers; |
| | • | the availability of other semiconductors or other key components that are required to produce a complete solution for the |
| | customer; usually, we supply one of many necessary components; and |
| | • | the cost of components for our products and prices charged by the third parties who manufacture, assemble and test our products. |
| | • | in order to address fluctuations in market demand, one-time sales opportunities and meet sales goals, we sometimes engage in heightened sales efforts during a given period that may adversely affect our sales in future periods. |
Because we have little or no control over these factors and/or their magnitude, our operating results are difficult to predict. Any substantial adverse change in any of these factors could negatively affect our business and results of operations.
Our future annual and quarterly operating results are highly dependent upon how wellwe manage our business.
Our annual and quarterly operating results may fluctuate based on how well we manage our business. Some of these factors include the following:
| | • | our ability to manage product introductions and transitions, develop necessary sales and marketing channels and manage other matters necessary to enter new market segments; |
| | • | our ability to successfully manage our business in multiple markets such as CE, PC and storage, which may involve additional research and development, marketing or other costs and expenses; |
| | • | our ability to enter into licensing deals when expected and make timely deliverables and milestones on which recognition of revenue often depends; |
| | • | our ability to engineer customer solutions that adhere to industry standards in a timely and cost-effective manner; |
| | • | our ability to achieve acceptable manufacturing yields and develop automated test programs within a reasonable time frame for our new products; |
| | • | our ability to manage joint ventures and projects, design services and our supply chain partners; |
| | • | our ability to monitor the activities of our licensees to ensure compliance with license restrictions and remittance of royalties; |
| | • | our ability to structure our organization to enable achievement of our operating objectives and to meet the needs of our customers and markets; |
| | • | the success of the distribution and partner channels through which we choose to sell our products and |
| | • | our ability to manage expenses and inventory levels; and |
| | • | our ability to successfully maintain certain structural and various compliance activities in support of our global structure which in the long run, will result in certain operational benefits as well as achieve an overall lower tax rate. |
If we fail to effectively manage our business, this could adversely affect our results of operations.
Our business has been and may continue to be significantly impacted by the deterioration in worldwide economic conditions, and the current uncertainty in the outlook for the global economy makes it more likely that our actual results will differ materially from expectations.
Global credit and financial markets have been experiencing extreme disruptions in recent months, including severely diminished liquidity and credit availability, declines in consumer confidence, declines in economic growth, increases in unemployment rates, and uncertainty about economic stability. There can be no assurance that there will not be further deterioration in credit and financial markets and confidence in economic conditions. These economic uncertainties affect businesses such as ours in a number of ways, making it difficult to accurately forecast and plan our future business activities. The current tightening of credit in financial markets may lead consumers and businesses to postpone spending, which may cause our customers to cancel, decrease or delay their existing and future orders with us. In addition, financial difficulties experienced by our suppliers or distributors could result in product delays, increased accounts receivable defaults and inventory challenges. The volatility in the credit markets has severely diminished liquidity and capital availability. Our CE product revenue, which comprised approximately 68.9% and 68.6% of total revenue for the three and nine months ended September 30, 2009, respectively, is dependent on continued demand for consumer electronics, including but not limited to, DTVs, STBs, DVDs and game consoles. Demand for consumer electronics business is a function of the health of the economies in the United States and around the world. Since the US economy and other economies around the world have moved into a recession, the demand for overall consumer electronics have been and may continue to be adversely affected and therefore, demand for our CE, PC and storage products and our operating results have been and may continue to be adversely affected as well. We cannot predict the timing, strength or duration of any economic disruption or subsequent economic recovery, worldwide, in the United States, in our industry, or in the consumer electronics market. These and other economic factors have had and may continue to have a material adverse effect on demand for our CE, PC and storage products and on our financial condition and operating results.
Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate debt securities may have their market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates. We may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. Recent adverse events in the global economy and in the credit markets could negatively impact our return on investment for these debt securities and thereby reduce the amount of cash and cash equivalents and investments on our balance sheet.
The licensing component of our business strategy increases business risk and volatility.
Part of our business strategy is to license intellectual property (IP) through agreements with companies whereby companies incorporate our IP into their respective technologies that address markets in which we do not want to directly participate. There can be no assurance that additional companies will be interested in purchasing our technology on commercially favorable terms or at all. We also cannot ensure that companies who purchase our technology will introduce and sell products incorporating our technology, will accurately report royalties owed to us, will pay agreed upon royalties, will honor agreed upon market restrictions, will not infringe upon or misappropriate our intellectual property and will maintain the confidentiality of our proprietary information. The IP agreements are complex and depend upon many factors including completion of milestones, allocation of values to delivered items and customer acceptances. Many of these factors require significant judgments. Licensing revenue could fluctuate significantly from period to period because it is heavily dependent on a few key deals being completed in a particular period, the timing of which is difficult to predict and may not match our expectations. Because of its high margin content, the licensing mix of our revenue can have a disproportionate impact on gross profit and profitability. Also, generating revenue from these arrangements is a lengthy and complex process that may last beyond the period in which efforts begin and once an agreement is in place, the timing of revenue recognition may be dependent on customer acceptance of deliverables, achievement of milestones, our ability to track and report progress on contracts, customer commercialization of the licensed technology and other factors. Licensing that occurs in connection with actual or contemplated litigation is subject to risk that the adversarial nature of the transaction will induce non-compliance or non-payment. The accounting rules associated with recognizing revenue from these transactions are increasingly complex and subject to interpretation. Due to these factors, the amount of license revenue recognized in any period may differ significantly from our expectations.
We face intense competition in our markets, which may lead to reduced revenue from sales of our products and increased losses.
The CE, PC and storage markets in which we operate are intensely competitive. These markets are characterized by rapid technological change, evolving standards, short product life cycles and declining selling prices. We expect competition for many of our products to increase, as industry standards become widely adopted, as competitors reduce prices and offer products with greater levels of integration, and as new competitors enter our markets.
Our products face competition from companies selling similar discrete products and from companies selling products such as chipsets with integrated functionality. Our competitors include semiconductor companies that focus on the CE, display or storage markets, as well as major diversified semiconductor companies and we expect that new competitors will enter our markets. Current or potential customers, including our own licensees, may also develop solutions that could compete with us, including solutions that integrate the functionality of our products into their solutions. In addition, current or potential OEM customers may have internal semiconductor capabilities and may develop their own solutions for use in their products rather than purchasing them from companies such as us. Some of our competitors have already established supplier or joint development relationships with current or potential customers and may be able to leverage their existing relationships to discourage these customers from purchasing products from us or persuade them to replace our products with theirs. Many of our competitors have longer operating histories, greater presence in key markets, better name recognition, access to larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do and as a result, they may be able to adapt more quickly to new or emerging technologies and customer requirements, or devote greater resources to the promotion and sale of their products. In particular, well-established semiconductor companies, such as Analog Devices, Intel, National Semiconductor and Texas Instruments and CE manufacturers, such as Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba, may compete against us in the future. Some of our competitors could merge, which may enhance their market presence. Existing or new competitors may also develop technologies that more effectively address our markets with products that offer enhanced features and functionality, lower power requirements, greater levels of integration or lower cost. Increased competition has resulted in and is likely to continue to result in price reductions and loss of market share in certain markets. We cannot assure you that we can compete successfully against current or potential competitors, or that competition will not reduce our revenue and gross margins.
We operate in rapidly evolving markets, which makes it difficult to evaluate our future prospects.
The markets in which we compete are characterized by rapid technological change, evolving customer needs and frequent introductions of new products and standards. As we adjust to evolving customer requirements and technological advances, we may be required to further reposition our existing offerings and to introduce new products and services. We may not be successful in developing and marketing such new offerings, or we may experience difficulties that could delay or prevent the development and marketing of such new offerings. Moreover, new standards that compete with standards that we promote have been and in the future may be introduced from time to time, which could impact our success. Accordingly, we face risks and difficulties frequently encountered by companies in new and rapidly evolving markets. If we do not successfully address these risks and difficulties, our results of operations could be negatively affected.
Our success depends on demand for our new products.
Our future growth and success depends on our ability to develop and bring to market on a timely basis new products, such as our HDTV port and input processors and LiquidHD products, which we have recently introduced into the market. There can be no assurance that we will be successful in developing and marketing these new or other future products. Moreover, there is no assurance that our new or future products will achieve the desired level of market acceptance in the anticipated timeframes or that any such new or future products will contribute significantly to our revenue. Our new products face significant competition from established companies that have been selling competitive products for longer periods of time than we have.
Demand for our HDMI based products is dependent on continued adoption and widespread implementation of the HDMI specification.
Our success in the HDMI market is largely dependent upon the continued adoption and widespread implementation of the HDMI specification. Demand for our products may be inhibited by unanticipated unfavorable changes in or new regulations that delay or impede the transition to digital broadcast technologies in the U.S. or abroad. Demand for our consumer electronics products may also be inhibited in the event of negative consumer experience with HDMI technology as more consumers put it into service. Transmission of audio and video from “player devices” (such as a DVD player or set-top box) to intermediary devices (such as an audio-video receiver (AVR)) to displays (such as an HDTV) over HDMI with HDCP represents a combination of new technologies working in concert. Complexities with these technologies, the interactions between content protection technologies and HDMI with HDCP and the variability in HDMI implementations between manufacturers may cause some of these products to work incorrectly, or for the transmissions to not occur correctly, or for certain products not to be interoperable. Delays or difficulties in integration of these technologies into products or failure of products incorporating this technology to achieve market acceptance could have an adverse effect on our business. In addition, we believe that the rate of HDMI adoption may be affected by changes in FCC rules and European Information Communications and Consumer Electronics Technology Industry Associations (EICTA) and Cable & Satellite Broadcasting Association of Asia (CASBAA) recommendations described below.
In the United States, the FCC issued its Plug and Play order in October 2003. In November 2003 and March 2004, these rules, known as the Plug & Play Final Rules (Plug & Play Rules), became effective. The Plug and Play Rules are relevant to DVI and HDMI with respect to high definition set-top boxes and the labeling of digital cable ready televisions. Regarding high-definition set-top boxes, the FCC stated that, as of July 1, 2005, all high definition set-top boxes acquired by cable operators for distribution to subscribers would need to include either a DVI or HDMI with HDCP. Regarding digital cable ready televisions, the FCC stated that a 720p or 1080i unidirectional digital cable television may not be labeled or marketed as “digital cable ready” unless it includes either a DVI or HDMI with HDCP, according to a phase-in timetable. In the past, the FCC has made modifications to its rules and timetable for the DTV transition and it may do so in the future. We cannot predict whether these FCC rules will be amended prior to completion of the phase-in dates or that such phase-in dates will not be delayed. In addition, we cannot guarantee that the FCC will not in the future reverse these rules or adopt rules requiring or supporting different interface technologies, either of which would adversely affect our business.
In January 2005, the European Industry Association for Information Systems, Communication Technologies and Consumer Electronics (EICTA) issued its “Conditions for High Definition Labeling of Display Devices” which requires all HDTVs using the “HD Ready” logo to have either an HDMI or DVI input with HDCP. In August 2005, EICTA issued its “Minimum Requirements for HD Television Receivers” which requires HD Receivers without an integrated display (e.g. HD STBs) utilizing the “HDTV” logo and intended for use with HD sources (e.g. television broadcasts), some of which require content protection in order to permit HD quality output, to have either a DVI or HDMI output with HDCP.
In August 2005, the Cable and Satellite Broadcasting Association of Asia (CASBAA) issued a series of recommendations in its “CASBAA Principles for Content Protection in the Asia-Pacific Pay-TV Industry” for handling digital output from future generations of set-top boxes for VOD, PPV, Pay-TV and other encrypted digital programming applications. These recommendations include the use of one or more HDMI with HDCP or DVI with HDCP digital outputs for set-top boxes capable of outputting uncompressed high-definition content.
With respect to the EICTA and CASBAA recommendations, we cannot predict the rate at which manufacturers will implement the HDMI-related recommendations in their products.
The HDMI founders decided to reduce the annual license fee payable by HDMI adopters from $15,000 to $10,000 per year effective on November 1, 2006 for all adopters after that date in order to encourage more widespread adoption of HDMI. The annual fees collected by our subsidiary HDMI Licensing, LLC are recognized as revenues by us. Accordingly, if there are not sufficient new adopters of HDMI to offset the reduction in the annual license fee payable per adopter, our revenues will be negatively impacted. In addition, during 2007, at a founders meeting, the founders decided to share the HDMI adopter’s royalty revenues among the various founders. Our subsidiary no longer recognizes 100% of the HDMI adopter royalty revenues.
We may experience difficulties in transitioning to smaller geometry process technologies or in achieving higher levels of design integration, which may result in reduced manufacturing yields, delays in product deliveries and increased expenses.
To remain competitive, we expect to continue to transition our semiconductor products to increasingly smaller line width geometries. This transition requires us to modify the manufacturing processes for our products and to redesign some products as well as standard cells and other integrated circuit designs that we may use in multiple products. We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometry process technologies to reduce our costs. Currently most of our products are manufactured in .18 micron and .13 micron, geometry processes. We are now designing a new product in 65 nanometer process technology and planning for the transition to smaller process geometries. In the past, we have experienced some difficulties in shifting to smaller geometry process technologies or new manufacturing processes, which resulted in reduced manufacturing yields, delays in product deliveries and increased expenses. The transition to 65 nanometer geometry process technology will result in significantly higher mask and prototyping costs, as well as additional expenditures for engineering design tools and related computer hardware. We may face similar difficulties, delays and expenses as we continue to transition our products to smaller geometry processes.
We are dependent on our relationships with our foundry subcontractors to transition to smaller geometry processes successfully. We cannot assure you that the foundries that we use will be able to effectively manage the transition in a timely manner, or at all, or that we will be able to maintain our existing foundry relationships or develop new ones. If any of our foundry subcontractors or we experience significant delays in this transition or fail to efficiently implement this transition, we could experience reduced manufacturing yields, delays in product deliveries and increased expenses, all of which could harm our relationships with our customers and our results of operations.
We will have difficulty selling our products if customers do not design our products into their product offerings or if our customers’ product offerings are not commercially successful.
Our products are generally incorporated into our customers’ products at the design stage. As a result, we rely on equipment manufacturers to select our products to be designed into their products. Without these “design wins,” it is very difficult to sell our products. We often incur significant expenditures on the development of a new product without any assurance that an equipment manufacturer will select our product for design into its own product. Additionally, in some instances, we are dependent on third parties to obtain or provide information that we need to achieve a design win. Some of these third parties may be our competitors and, accordingly, may not supply this information to us on a timely basis, if at all. Once an equipment manufacturer designs a competitor’s product into its product offering, it becomes significantly more difficult for us to sell our products to that customer because changing suppliers involves significant cost, time, effort and risk for the customer. Furthermore, even if an equipment manufacturer designs one of our products into its product offering, we cannot be assured that its product will be commercially successful or that we will receive any revenue from that product. Sales of our products largely depend on the commercial success of our customers’ products. Our customers generally can choose at any time to stop using our products if their own products are not commercially successful or for any other reason. We cannot assure you that we will continue to achieve design wins or that our customers’ equipment incorporating our products will ever be commercially successful.
Our products typically have lengthy sales cycles. A customer may decide to cancel or change its product plans, which could cause us to lose anticipated sales. In addition, our average product life cycles tend to be short and, as a result, we may hold excess or obsolete inventory that could adversely affect our operating results.
After we have developed and delivered a product to a customer, the customer will usually test and evaluate our product prior to designing its own equipment to incorporate our product. Our customers generally need three months to over six months to test, evaluate and adopt our product and an additional three months to over nine months to begin volume production of equipment that incorporates our product. Due to this lengthy sales cycle, we may experience significant delays from the time we incur operating expenses and make investments in inventory until the time that we generate revenue from these products. It is possible that we may never generate any revenue from these products after incurring such expenditures. Even if a customer selects our product to incorporate into its equipment, we have no assurances that the customer will ultimately market and sell its equipment or that such efforts by our customer will be successful. The delays inherent in our lengthy sales cycle increase the risk that a customer will decide to cancel or change its product plans. Such a cancellation or change in plans by a customer could cause us to lose sales that we had anticipated. In addition, anticipated sales could be materially and adversely affected if a significant customer curtails, reduces or delays orders during our sales cycle or chooses not to release equipment that contains our products. Further, the combination of our lengthy sales cycles coupled with worldwide economic conditions could have a compounding negative impact on the results of our operations.
While our sales cycles are typically long, our average product life cycles tend to be short as a result of the rapidly changing technology environment in which we operate. As a result, the resources devoted to product sales and marketing may not generate material revenue for us and from time to time, we may need to write off excess and obsolete inventory. If we incur significant marketing expenses and investments in inventory in the future that if we are not able to recover and we are not able to compensate for those expenses, our operating results could be adversely affected. In addition, if we sell our products at reduced prices in anticipation of cost reductions but still hold higher cost products in inventory, our operating results would be harmed.
Our customers may not purchase anticipated levels of products, which can result in excess inventories.
We generally do not obtain firm, long-term purchase commitments from our customers and, in order to accommodate the requirements of certain customers, we may from time to time build inventory that is specific to that customer in advance of receiving firm purchase orders. The short-term nature of our customers’ commitments and the rapid changes in demand for their products reduce our ability to accurately estimate the future requirements of those customers. Should the customer’s needs shift so that they no longer require such inventory, we may be left with excessive inventories, which could adversely affect our operating results.
We depend on a few key customers and the loss of any of them could significantlyreduce our revenue.
Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For the three months ended September 30, 2009, shipments to Microtek, Inc. and EDOM Technology Company, Ltd. generated 16.3% and 10.6% of our revenue, respectively. For the nine months ended September 30, 2009, shipments to Microtek, Inc and Weikeng Industrial generated 12.8% and 10.3% of our revenue, respectively. For the three months ended September 30, 2008, shipments to Innotech Corporation, World Peace Industrial, Weikeng Industrial and Microtek, Inc. generated 12.4%, 12.0%, 11.0% and 10.2% of our revenue, respectively. For the nine months ended September 30, 2008, shipments to World Peace Industrial, Innotech Corporation, Microtek, Inc. and Weikeng Industrial accounted for 13.8%, 11.9%, 11.5% and 10.0% of our revenue, respectively. In addition, an end-customer may buy our products through multiple distributors, contract manufacturers and /or directly, which could create an even greater concentration. We cannot be certain that customers and key distributors that have accounted for significant revenue in past periods, individually or as a group, will continue to sell our products and generate revenue. As a result of this concentration of our customers, our results of operations could be negatively affected if any of the following occurs:
| | • | one or more of our customers, including distributors, becomes insolvent or goes out of business; |
| | • | one or more of our key customers or distributors significantly reduces, delays or cancels orders; and/or |
| | • | one or more significant customers selects products manufactured by one of our competitors for inclusion in their future product generations. |
While our participation in multiple markets, has broadened our customer base, as product mix fluctuates from quarter to quarter, we may become more dependent on a small number of customers or a single customer for a significant portion of our revenue in a particular quarter, the loss of which could adversely affect our operating results.
We sell our products through distributors, which limits our direct interaction withour end customers, therefore reducing our ability to forecast sales and increasing thecomplexity of our business.
Many original equipment manufacturers (“OEMs”) rely on third-party manufacturers or distributors to provide inventory management and purchasing functions. For the three and nine months ended September 30, 2009, distributors generated 22.6% and 33.1% of our revenue, respectively. Sales to distributors accounted for 47.4% and 50.7% of our revenue for the three and nine months ended September 30, 2008, respectively. Selling through distributors reduces our ability to forecast sales and increases the complexity of our business, requiring us to:
| | • | manage a more complex supply chain; |
| | • | monitor and manage the level of inventory of our products at each distributor; |
| • | estimate the impact of credits, return rights, price protection and unsold inventory at distributors; and, |
| | • | monitor the financial condition and credit-worthiness of our distributors, many of which are located outside of the United States and the majority of which are not publicly traded. |
Since we have limited ability to forecast inventory levels at our end customers, it is possible that there may be significant build-up of inventories in the distributor channel, with the OEM or the OEM’s contract manufacturer. Such a buildup could result in a slowdown in orders, requests for returns from customers, or requests to move out planned shipments. This could adversely impact our revenues and profits.
Any failure to manage these challenges could disrupt or reduce sales of our products and unfavorably impact our financial results.
Our success depends on the development and introduction of new products, which we may not be able to do in a timely manner because the process of developing high-speed semiconductor products is complex and costly.
The development of new products is highly complex and we have experienced delays, some of which exceeded one year, in the development and introduction of new products on several occasions in the past. We have recently introduced new products and will continue to introduce new products in the future. As our products integrate new, more advanced functions, they become more complex and increasingly difficult to design, manufacture and debug. Successful product development and introduction depends on a number of factors, including, but not limited to:
| | • | accurate prediction of market requirements and the establishment of market standards and the evolution of existing standards, including enhancements or modifications to existing standards such as HDMI, HDCP, DVI, SATA I and SATA II; |
| | • | identification of customer needs where we can apply our innovation and skills to create new standards or areas for product differentiation that improve our overall competitiveness either in an existing market or in a new market; |
| | • | development of advanced technologies and capabilities and new products that satisfy customer requirements; |
| • | competitors’ and customers’ integration of the functionality of our products into their products, which puts pressure on us to continue to develop and introduce new products with new functionality; |
| | • | timely completion and introduction of new product designs; |
| | • | management of product life cycles; |
| | • | use of leading-edge foundry processes, when use of such processes are required and achievement of high manufacturing yields and low cost testing; |
| | • | market acceptance of new products; and, |
| • | market acceptance of new architectures such as our input processors. |
Accomplishing all of this is extremely challenging, time-consuming and expensive and there is no assurance that we will succeed. Product development delays may result from unanticipated engineering complexities, changing market or competitive product requirements or specifications, difficulties in overcoming resource constraints, the inability to license third-party technology or other factors. Competitors and customers may integrate the functionality of our products into their own products, thereby reducing demand for our products. If we are not able to develop and introduce our products successfully and in a timely manner, our costs could increase or our revenue could decrease, both of which would adversely affect our operating results. In addition, it is possible that we may experience delays in generating revenue from these products or that we may never generate revenue from these products. We must work with a semiconductor foundry and with potential customers to complete new product development and to validate manufacturing methods and processes to support volume production and potential re-work. Each of these steps may involve unanticipated difficulties, which could delay product introduction and reduce market acceptance of the product. In addition, these difficulties and the increasing complexity of our products may result in the introduction of products that contain defects or that do not perform as expected, which would harm our relationships with customers and our ability to achieve market acceptance of our new products. There can be no assurance that we will be able to achieve design wins for our planned new products, that we will be able to complete development of these products when anticipated, or that these products can be manufactured in commercial volumes at acceptable yields, or that any design wins will produce any revenue. Failure to develop and introduce new products, successfully and in a timely manner, may adversely affect our results of operations.
There are risks to our global strategy.
In 2006, we implemented a global strategy that involves maintaining operations in various countries around the world. Since its implementation, we have begun to realize certain operational benefits from our global strategy and our overall tax rate has benefited favorably. The effectiveness of the strategy requires, in addition to maintaining and increasing profitability, continued maintenance of a certain corporate structure and various compliance activities required by foreign jurisdictions in support of the structure. Should management fail to adhere to these compliance requirements or fail to maintain supportive processes, our ability to continue to realize the benefits of our global strategy may be jeopardized, which may adversely affect our business, operating results or financial condition.
Potential Government Action – Governmental action against companies located in offshore jurisdictions may lead to a reduction in the demand for our common shares.
Recent federal and state legislation has been proposed, and additional legislation may be proposed in the future which, if enacted, could have an adverse tax impact on either Silicon Image or our shareholders. For example, the ability to defer taxes as a result of permanent investments offshore could be limited, thus raising the Company’s effective tax rate.
We have made acquisitions in the past and may make acquisitions in the future, and these acquisitions involve numerous risks.
Our growth depends upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. Acquisitions of companies or intangible assets is a strategy we may use to develop new products and enter new markets. In January 2007, we completed the acquisition of sci-worx, now Silicon Image, GmbH. We may acquire additional companies or technologies in the future. Acquisitions involve numerous risks, including, but not limited to, the following:
| | • | difficulty and increased costs in assimilating employees, including our possible inability to keep and retain key employees of the acquired business; |
| | • | disruption of our ongoing business; |
| | • | discovery of undisclosed liabilities of the acquired companies and legal disputes with founders or shareholders of acquired companies; |
| | • | inability to commercialize acquired technology; and |
| | • | the need to take impairment charges or write-downs with respect to acquired assets. |
No assurance can be given that our prior acquisitions or our future acquisitions, if any, will be successful or provide the anticipated benefits, or that they will not adversely affect our business, operating results or financial condition. Failure to manage growth effectively and to successfully integrate acquisitions made by us could materially harm our business and operating results.
Industry cycles may strain our management and resources.
Cycles of growth and contraction in our industry may strain our management and resources. To manage these industry cycles effectively, we must:
| | • | improve operational and financial systems; |
| | • | train and manage our employee base; |
| | • | successfully integrate operations and employees of businesses we acquire or have acquired; |
| | • | attract, develop, motivate and retain qualified personnel with relevant experience; and |
| | • | adjust spending levels according to prevailing market conditions. |
If we cannot manage industry cycles effectively, our business could be seriously harmed.
The cyclical nature of the semiconductor industry may create constrictions in ourfoundry, test and assembly capacity.
The semiconductor industry is characterized by significant downturns and wide fluctuations in supply and demand. This cyclicality has led to significant fluctuations in product demand and in the foundry, test and assembly capacity of third-party suppliers. Production capacity for fabricated semiconductors is subject to allocation, whereby not all of our production requirements would be met. This may impact our ability to meet demand and could also increase our production costs and inventory levels. Cyclicality has also accelerated decreases in average selling prices per unit. We may experience fluctuations in our future financial results because of changes in industry-wide conditions. Our financial performance has been and may in the future be, negatively impacted by downturns in the semiconductor industry. In a downturn situation, we may incur substantial losses if there is excess production capacity or excess inventory levels in the distribution channel.
We depend on third-party sub-contractors to manufacture, assemble and test nearly allof our products, which reduce our control over the production process.
We do not own or operate a semiconductor fabrication facility. We rely on one third party semiconductor company overseas to produce substantially all of our semiconductor products. We also rely on outside assembly and test services to test all of our semiconductor products. Our reliance on independent foundries, assembly and test facilities involves a number of significant risks, including, but not limited to:
| | • | reduced control over delivery schedules, quality assurance, manufacturing yields and production costs; |
| | • | lack of guaranteed production capacity or product supply, potentially resulting in higher inventory levels; |
| | • | lack of availability of, or delayed access to, next-generation or key process technologies; and |
We do not have a long-term supply agreement with all of our subcontractors and instead obtain production services on a purchase order basis. Our outside sub-contractors have no obligation to manufacture our products or supply products to us for any specific period of time, in any specific quantity or at any specific price, except as set forth in a particular purchase order. Our requirements represent a small portion of the total production capacity of our outside foundries, assembly and test facilities and our sub-contractors may reallocate capacity on short notice to other customers who may be larger and better financed than we are, or who have long-term agreements with our sub-contractors, even during periods of high demand for our products. These foundries may allocate or move production of our products to different foundries under their control, even in different locations, which may be time consuming, costly and difficult, have an adverse affect on quality, yields and costs and require us and/or our customers to re-qualify the products, which could open up design wins to competition and result in the loss of design wins and design-ins. If our subcontractors are unable or unwilling to continue manufacturing our products in the required volumes, at acceptable quality, yields and costs and in a timely manner, our business will be substantially harmed. As a result, we would have to identify and qualify substitute sub-contractors, which would be time-consuming, costly and difficult; there is no guarantee that we would be able to identify and qualify such substitute sub-contractors on a timely basis or obtain commercially reasonable terms from them. This qualification process may also require significant effort by our customers and may lead to re-qualification of parts, opening up design wins to competition and loss of design wins and design-ins. Any of these circumstances could substantially harm our business. In addition, if competition for foundry, assembly and test capacity increases, our product costs may increase and we may be required to pay significant amounts or make significant purchase commitments to secure access to production services.
The complex nature of our production process, which can reduce yields and preventidentification of problems until well into the production cycle or, in some cases,after the product has been shipped.
The manufacture of semiconductors is a complex process and it is often difficult for semiconductor foundries to achieve acceptable product yields. Product yields depend on both our product design and the manufacturing process technology unique to the semiconductor foundry. Since low yields may result from either design or process difficulties, identifying problems can often only occur well into the production cycle, when an actual product exists that can be analyzed and tested.
Further, we only test our products after they are assembled, as their high-speed nature makes earlier testing difficult and expensive. As a result, defects often are not discovered until after assembly. This could result in a substantial number of defective products being assembled and tested or shipped, thus lowering our yields and increasing our costs. These risks could result in product shortages or increased costs of assembling, testing or even replacing our products.
Although we test our products before shipment, they are complex and may contain defects and errors. In the past we have encountered defects and errors in our products. Because our products are sometimes integrated with products from other vendors, it can be difficult to identify the source of any particular problem. Delivery of products with defects or reliability, quality or compatibility problems, may damage our reputation and our ability to retain existing customers and attract new customers. In addition, product defects and errors could result in additional development costs, diversion of technical resources, delayed product shipments, increased product returns, warranty and product liability claims against us that may not be fully covered by insurance. Any of these circumstances could substantially harm our business.
We face foreign business, political and economic risks because a majority of ourproducts and our customers’ products are manufactured and sold outside of the UnitedStates.
A substantial portion of our business is conducted outside of the United States. As a result, we are subject to foreign business, political and economic risks. Nearly all of our products are manufactured in Taiwan or elsewhere in Asia. For the three and nine months ended September 30, 2009, approximately 82.8% and 80.3% of our revenue, respectively, was generated from customers and distributors located outside of the United States, primarily in Asia. We anticipate that sales outside of the United States will continue to account for a substantial portion of our revenue in future periods. In addition, we undertake various sales and marketing activities through regional offices in several other countries and we have significantly expanded our research and development operations outside of the United States. We intend to continue to expand our international business activities. Accordingly, we are subject to international risks, including, but not limited to:
| | • | political, social and economic instability; |
| | • | exposure to different business practices and legal standards, particularly with respect to intellectual property; |
| | • | natural disasters and public health emergencies; |
| | • | nationalization of business and blocking of cash flows; |
| | • | trade and travel restrictions |
| | • | the imposition of governmental controls and restrictions; |
| | • | burdens of complying with a variety of foreign laws; |
| | • | import and export license requirements and restrictions of the United States and each other country in which we operate; |
| | • | unexpected changes in regulatory requirements; |
| | • | foreign technical standards; |
| | • | changes in taxation and tariffs; |
| | • | difficulties in staffing and managing international operations; |
| | • | fluctuations in currency exchange rates; |
| | • | difficulties in collecting receivables from foreign entities or delayed revenue recognition; |
| | • | expense and difficulties in protecting our intellectual property in foreign jurisdictions; |
| | • | exposure to possible litigation or claims in foreign jurisdictions; and |
| | • | potentially adverse tax consequences. |
Any of the factors described above may have a material adverse effect on our ability to increase or maintain our foreign sales. In addition, original equipment manufacturers that design our semiconductors into their products sell them outside of the United States. This exposes us indirectly to foreign risks. Because sales of our products are denominated exclusively in United States dollars, relative increases in the value of the United States dollar will increase the foreign currency price equivalent of our products, which could lead to a change in the competitive nature of these products in the marketplace. This in turn could lead to a reduction in sales and profits.
The success of our business depends upon our ability to adequately protect ourintellectual property.
We rely on a combination of patent, copyright, trademark, mask work and trade secret laws, as well as nondisclosure agreements and other methods, to protect our proprietary technologies. We have been issued patents and have a number of pending patent applications. However, we cannot assure you that any patents will be issued as a result of any applications or, if issued, that any claims allowed will protect our technology. In addition, we do not file patent applications on a worldwide basis, meaning we do not have patent protection in some jurisdictions. It may be possible for a third-party, including our licensees, to misappropriate our copyrighted material or trademarks. It is possible that existing or future patents may be challenged, invalidated or circumvented and effective patent, copyright, trademark and trade secret protection may be unavailable or limited in foreign countries. It may be possible for a third-party to copy or otherwise obtain and use our products or technology without authorization, develop similar technology independently or design around our patents in the United States and in other jurisdictions. It is also possible that some of our existing or new licensing relationships will enable other parties to use our intellectual property to compete against us. Legal actions to enforce intellectual property rights tend to be lengthy and expensive and the outcome often is not predictable. As a result, despite our efforts and expenses, we may be unable to prevent others from infringing upon or misappropriating our intellectual property, which could harm our business. In addition, practicality also limits our assertion of intellectual property rights. Patent litigation is expensive and its results are often unpredictable. Assertion of intellectual property rights often results in counterclaims for perceived violations of the defendant’s intellectual property rights and/or antitrust claims. Certain parties after receipt of an assertion of infringement will cut off all commercial relationships with the party making the assertion, thus making assertions against suppliers, customers and key business partners risky. If we forgo making such claims, we may run the risk of creating legal and equitable defenses for an infringer.
We generally enter into confidentiality agreements with our employees, consultants and strategic partners. We also try to control access to and distribution of our technologies, documentation and other proprietary information. Despite these efforts, internal or external parties may attempt to copy, disclose, obtain or use our products, services or technology without our authorization. Also, current or former employees may seek employment with our business partners, customers or competitors, and we cannot assure you that the confidential nature of our proprietary information will be maintained in the course of such future employment. Additionally, current, departing or former employees or third parties could attempt to penetrate our computer systems and networks to misappropriate our proprietary information and technology or interrupt our business. Because the techniques used by computer hackers and others to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate, counter or ameliorate these techniques. As a result, our technologies and processes may be misappropriated, particularly in countries where laws may not protect our proprietary rights as fully as in the United States.
Our products may contain technology provided to us by other parties such as contractors, suppliers or customers. We may have little or no ability to determine in advance whether such technology infringes the intellectual property rights of a third party. Our contractors, suppliers and licensors may not be required to indemnify us in the event that a claim of infringement is asserted against us, or they may be required to indemnify us only up to a maximum amount, above which we would be responsible for any further costs or damages. In addition, we may have little or no ability to correct errors in the technology provided by such contractors, suppliers and licensors, or to continue to develop new generations of such technology. Accordingly, we may be dependent on their ability and willingness to do so. In the event of a problem with such technology, or in the event that our rights to use such technology become impaired, we may be unable to ship our products containing such technology, and may be unable to replace the technology with a suitable alternative within the time frame needed by our customers.
Our participation in working groups for the development and promotion of industrystandards in our target markets, including the Digital Visual Interface and HDMIspecifications, requires us to license some of our intellectual property for free orunder specified terms and conditions, which may make it easier for others to competewith us in such markets.
A key element of our business strategy includes participation in working groups to establish industry standards in our target markets, promote and enhance specifications and develop and market products based on such specifications and future enhancements. We are a promoter of the Digital Display Working Group (DDWG), which published and promotes the DVI specification and a founder in the working group that develops and promotes the HDMI specification. In connection with our participation in such working groups:
| | • | we must license for free specific elements of our intellectual property to others for use in implementing the DVI specification; and we may license additional intellectual property for free as the DDWG promotes enhancements to the DVI specification |
and
| | • | we must license specific elements of our intellectual property to others for use in implementing the HDMI specification and we may license additional intellectual property as the HDMI founders group promotes enhancements to the HDMI specification. |
Accordingly, certain companies that implement the DVI and HDMI specifications in their products can use specific elements of our intellectual property to compete with us, in certain cases for free. Although in the case of the HDMI specification, there are annual fees and royalties associated with the adopters’ agreements, there can be no assurance that such annual fees and royalties will adequately compensate us for having to license our intellectual property. Fees and royalties received during the early years of adoption of HDMI will be used to cover costs we incur to promote the HDMI standard and to develop and perform interoperability tests; in addition, after an initial period during which we received all of the royalties associated with HDMI adopters’ agreements, in 2007, the HDMI founders reallocated the royalties to reflect each founder’s relative contribution of intellectual property to the HDMI specification. Our subsidiary no longer recognizes 100% of the HDMI adopter royalty revenues.
We intend to promote and continue to be involved and actively participate in other standard setting initiatives. For example, we also recently joined the Serial Port Memory Technology Working Group (SPMTWG) to develop and promote a new memory technology. Accordingly, we may license additional elements of our intellectual property to others for use in implementing, developing, promoting or adopting standards in our target markets, in certain circumstances at little or no cost. This may make it easier for others to compete with us in such markets. In addition, even if we receive license fees and/or royalties in connection with the licensing of our intellectual property, there can be no assurance that such license fees and/or royalties will adequately compensate us for having to license our intellectual property.
Our success depends in part on our relationships with strategic partners and use of technologies
We have entered into and expect to continue to enter into strategic partnerships with third parties. Negotiating and performing under these strategic partnerships involves significant time and expense; we may not realize anticipated increases in revenue, standards adoption or cost savings; and these strategic partnerships may make it easier for the third parties to compete with us; any of which may have a negative effect our business and results of operations.
In February 2007, we entered into a licensing agreement with Sunplus Technology, which grants us the rights to use and further develop advanced intellectual property (IP) technology. Previously, we believed that the IP licensed under this agreement was enhancing our ability to develop DTV technology and other related consumer product offerings. Based on the Company’s product strategy as of October 2009, the Sunplus IP does not align with our product roadmap and during October 2009, the Company decided to write off its investment in Sunplus IP. This decision was prompted by a change in our product strategy due to market place and related competitive dynamics. Please also refer to note 16 in our financial statements.
Our success depends on managing our relationship with Intel.
Intel has a dominant role in many of the markets in which we compete, such as PCs and storage and is a growing presence in the CE market. We have a multi-faceted relationship with Intel that is complex and requires significant management attention, including:
| | • | Intel and Silicon Image have been parties to business cooperation agreements; |
| | • | Intel and Silicon Image are parties to a patent cross-license; |
| | • | Intel and Silicon Image worked together to develop HDCP; |
| | • | an Intel subsidiary has the exclusive right to license HDCP, of which we are a licensee; |
| | • | Intel and Silicon Image were two of the promoters of the DDWG; |
| | • | Intel is a promoter of the SATA working group, of which we are a contributor; |
| | • | Intel is a supplier to us and a customer for our products; |
| | • | we believe that Intel has the market presence to drive adoption of SATA by making it widely available in its chipsets and motherboards, which could affect demand for our products; |
| | • | we believe that Intel has the market presence to affect adoption of HDMI by either endorsing complementary technology or promulgating a competing standard, which could affect demand for our products; |
| | • | Intel may potentially integrate the functionality of our products, including SATA, DVI, or HDMI into its own chips and chipsets, thereby displacing demand for some of our products; |
| | • | Intel may design new technologies that would require us to re-design our products for compatibility, thus increasing our R&D expense and reducing our revenue; |
| | • | Intel’s technology, including its 845G chipset, may lower barriers to entry for other parties who may enter the market and compete with us; and |
| | • | Intel may enter into or continue relationships with our competitors that can put us at a relative disadvantage. |
Our cooperation and competition with Intel can lead to positive benefits, if managed effectively. If our relationship with Intel is not managed effectively, it could seriously harm our business, negatively affect our revenue and increase our operating expenses.
We have granted Intel rights with respect to our intellectual property, which couldallow Intel to develop products that compete with ours or otherwise reduce the valueof our intellectual property.
We entered into a patent cross-license agreement with Intel in which each of us granted the other a license to use the patents filed by the grantor prior to a specified date, except for identified types of products. We believe that the scope of our license to Intel excludes our current products and anticipated future products. Intel could, however, exercise its rights under this agreement to use our patents to develop and market other products that compete with ours, without payment to us. Additionally, Intel’s rights to our patents could reduce the value of our patents to any third-party who otherwise might be interested in acquiring rights to use our patents in such products. Finally, Intel could endorse competing products, including a competing digital interface, or develop its own proprietary digital interface. Any of these actions could substantially harm our business and results of operations.
We may become engaged in additional intellectual property litigation that could betime-consuming, may be expensive to prosecute or defend and could adversely affectour ability to sell our product.
In recent years, there has been significant litigation in the United States and in other jurisdictions involving patents and other intellectual property rights. This litigation is particularly prevalent in the semiconductor industry, in which a number of companies aggressively use their patent portfolios to bring infringement claims. In addition, in recent years, there has been an increase in the filing of so-called “nuisance suits,” alleging infringement of intellectual property rights. These claims may be asserted as counterclaims in response to claims made by a company alleging infringement of intellectual property rights. These suits pressure defendants into entering settlement arrangements to quickly dispose of such suits, regardless of merit. In addition, as is common in the semiconductor industry, from time to time we have been notified that we may be infringing certain patents or other intellectual property rights of others. Responding to such claims, regardless of their merit, can be time consuming, result in costly litigation, divert management’s attention and resources and cause us to incur significant expenses. As each claim is evaluated, we may consider the desirability of entering into settlement or licensing agreements. No assurance can be given that settlements will occur or that licenses can be obtained on acceptable terms or that litigation will not occur. In the event there is a temporary or permanent injunction entered prohibiting us from marketing or selling certain of our products, or a successful claim of infringement against us requiring us to pay damages or royalties to a third-party and we fail to develop or license a substitute technology, our business, results of operations or financial condition could be materially adversely affected.
Any potential intellectual property litigation against us or in which we become involved may be expensive and time-consuming and may divert our resources and the attention of our executives. It could also force us to do one or more of the following:
| | • | stop selling products or using technology that contains the allegedly infringing intellectual property; |
| | • | attempt to obtain a license to the relevant intellectual property, which license may not be available on reasonable terms or at all; and |
| | • | attempt to redesign products that contain the allegedly infringing intellectual property. |
If we take any of these actions, we may be unable to manufacture and sell our products. We may be exposed to liability for monetary damages, the extent of which would be very difficult to accurately predict. In addition, we may be exposed to customer claims, for potential indemnity obligations and to customer dissatisfaction and a discontinuance of purchases of our products while the litigation is pending. Any of these consequences could substantially harm our business and results of operations.
We have entered into and may again be required to enter into, patent or otherintellectual property cross-licenses.
Many companies have significant patent portfolios or key specific patents, or other intellectual property in areas in which we compete. Many of these companies appear to have policies of imposing cross-licenses on other participants in their markets, which may include areas in which we compete. As a result, we have been required, either under pressure of litigation or by significant vendors or customers, to enter into cross licenses or non-assertion agreements relating to patents or other intellectual property. This permits the cross-licensee, or beneficiary of a non-assertion agreement, to use certain or all of our patents and/or certain other intellectual property for free to compete with us.
We indemnify certain of our licensing customers against infringement.
We indemnify certain of our licensing agreements customers for any expenses or liabilities resulting from third-party claims of infringements of patent, trademark, trade secret, or copyright rights by the technology we license. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances; the maximum amount of potential future indemnification is not limited. To date, we have not paid any such claims or been required to defend any lawsuits with respect to any claim. In the event that we were required to defend any lawsuits with respect to our indemnification obligations, or to pay any claim, our results of operations could be materially adversely affected.
We must attract and retain qualified personnel to be successful and competition forqualified personnel is increasing in our market.
Our success depends to a significant extent upon the continued contributions of our key management, technical and sales personnel, many of who would be difficult to replace. The loss of one or more of these employees could harm our business. Although we have entered into a limited number of employment contracts with certain executive officers, we generally do not have employment contracts with our key employees. Our success also depends on our ability to identify, attract and retain qualified technical, sales, marketing, finance and managerial personnel. Competition for qualified personnel is particularly intense in our industry and in our location. This makes it difficult to retain our key personnel and to recruit highly qualified personnel. We have experienced and may continue to experience, difficulty in hiring and retaining candidates with appropriate qualifications. To be successful, we need to hire candidates with appropriate qualifications and retain our key executives and employees. Replacing departing executive officers and key employees can involve organizational disruption and uncertain timing.
The volatility of our stock price has had an impact on our ability to offer competitive equity-based incentives to current and prospective employees, thereby affecting our ability to attract and retain highly qualified technical personnel. If these adverse conditions continue, we may not be able to hire or retain highly qualified employees in the future and this could harm our business. In addition, regulations adopted by The NASDAQ Stock Market requiring shareholder approval for all stock option plans, as well as regulations adopted by the New York Stock Exchange prohibiting NYSE member organizations from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions, could make it more difficult for us to grant options to employees in the future. In addition, FASB ASC No. 718-10, Stock Compensation,, requires us to record compensation expense for options granted to employees. To the extent that new regulations make it more difficult or expensive to grant options to employees, we may incur increased cash compensation costs or find it difficult to attract, retain and motivate employees, either of which could harm our business.
If our internalcontrol over financial reporting or disclosure controls and procedures are noteffective, there may be errors in our financial statements that could requirea restatement or our filings may not be timely and investors may loseconfidence in our reported financial information, which could lead to adecline in our stock price. While we have not identified any material weaknesses in the past three years, we cannot assure you that amaterial weakness will not be identified in the future.
Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K. Section 404 also requires our independent registered public accounting firm to report on, our internal control over financial reporting.
Our management, including our president and chief operating officer and Chief Financial Officer, does not expect that our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
As a result, we cannot assure you that significant deficiencies or material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to timely meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.
We have experienced transitions in our management team, our board of directors in the past and may continue to doso in the future, which could result in disruptions in our operations and require additional costs.
We have experienced a number of transitions with respect to our board of directors and executive officers in recent quarters, including the following:
| | • | In January 2006, Dale Zimmerman was appointed as our vice president of worldwide marketing. |
| | • | In February 2006, John Hodge was elected to our board of directors. |
| • | In September 2006, Patrick Reutens resigned from the position of chief legal officer. |
| | • | In January 2007, Edward Lopez was appointed as our chief legal officer. |
| | • | In February 2007, David Hodges advised our board of directors that he decided to retire and he did not stand for reelection to our board of directors when his term expired at our 2007 Annual Meeting of Stockholders. |
| | • | In April 2007, Rob Valiton resigned from his position as vice president of worldwide sales and Sal Cobar was appointed as his successor. |
| | • | In July 2007, Paul Dal Santo was appointed as chief operating officer. |
| | • | In October 2007, Robert Freeman resigned from his position as chief financial officer. |
| | • | In October 2007, Harold L. Covert was appointed as chief financial officer. |
| | • | In December 2008, Dale Zimmerman resigned from his position as vice president of worldwide marketing. |
| | • | In March 2009, Paul Dal Santo resigned from his position as chief operating officer. |
| | • | In September 2009, Steve Tirado resigned from his positions as chief executive officer and director and Hal Covert was appointed as president and chief operating officer. |
Any future transitions may result in disruptions in our operations and require additional costs.
We have been and may continue to become the target of securities class action suitsand derivative suits which could result in substantial costs and divert managementattention and resources.
Securities class action suits and derivative suits are often brought against companies, particularly technology companies, following periods of volatility in the market price of their securities. Defending against these suits, even if meritless, can result in substantial costs to us and could divert the attention of our management.
Our operations and the operations of our significant customers, third-party waferfoundries and third-party assembly and test subcontractors are located in areassusceptible to natural disasters.
Our operations are headquartered in the San Francisco Bay Area, which is susceptible to earthquakes. TSMC, the outside foundry that produces the majority of our semiconductor products, is located in Taiwan. Siliconware Precision Industries Co. Ltd., or SPIL, Advanced Semiconductor Engineering, or ASE, and Amkor Taiwan are subcontractors located in Taiwan that assemble and test our semiconductor products. For the three and nine months period ended September 30, 2009 customers and distributors located in Japan generated 32.2% and 27.6% of our revenue, respectively, and customers and distributors located in Taiwan generated 24.4% and 25.4% of our revenue, respectively. For the three and nine months ended September 30, 2008, customers and distributors located in Japan accounted for 16.1% and 25.3% of our revenue, respectively and customers and distributors located in Taiwan generated 17.8% and 19.2% of our revenue, respectively. Both Taiwan and Japan are susceptible to earthquakes, typhoons and other natural disasters.
Our business would be negatively affected if any of the following occurred:
| | • | an earthquake or other disaster in the San Francisco Bay Area or the Los Angeles area damaged our facilities or disrupted the supply of water or electricity to our headquarters or our Irvine facility; |
| | • | an earthquake, typhoon or other disaster in Taiwan or Japan resulted in shortages of water, electricity or transportation, limiting the production capacity of our outside foundries or the ability of ASE to provide assembly and test services; |
| | • | an earthquake, typhoon or other disaster in Taiwan or Japan damaged the facilities or equipment of our customers and distributors, resulting in reduced purchases of our products; or |
| | • | an earthquake, typhoon or other disaster in Taiwan or Japan disrupted the operations of suppliers to our Taiwanese or Japanese customers, outside foundries or ASE, which in turn disrupted the operations of these customers, foundries or ASE and resulted in reduced purchases of our products or shortages in our product supply. |
Terrorist attacks or war could lead to economic instability and adversely affect ouroperations, results of operations and stock price.
The United States has taken and continues to take, military action against terrorism and currently has troops in Iraq and in Afghanistan. In addition, the current tensions regarding nuclear arms in North Korea and Iran could escalate into armed hostilities or war. Acts of terrorism or armed hostilities may disrupt or result in instability in the general economy and financial markets and in consumer demand for the OEM’s products that incorporate our products. Disruptions and instability in the general economy could reduce demand for our products or disrupt the operations of our customers, suppliers, distributors and contractors, many of whom are located in Asia, which would in turn adversely affect our operations and results of operations. Disruptions and instability in financial markets could adversely affect our stock price. Armed hostilities or war in South Korea could disrupt the operations of the research and development contractors we utilize there, which would adversely affect our research and development capabilities and ability to timely develop and introduce new products and product improvements.
Changes in environmental rules and regulations could increase our costs and reduceour revenue.
Several jurisdictions have implemented rules that would require that certain products, including semiconductors, be made “green,” which means that the products need to be lead free and be free of certain banned substances. All of our products are available to customers in a green format. While we believe that we are generally in compliance with existing regulations, such environmental regulations are subject to change and the jurisdictions may impose additional regulations which could require us to incur costs to develop replacement products. These changes will require us to incur cost or may take time or may not always be economically or technically feasible, or may require disposal of non-compliant inventory. In addition, any requirement to dispose or abate previously sold products would require us to incur the costs of setting up and implementing such a program.
Provisions of our charter documents and Delaware law could prevent or delay a changein control and may reduce the market price of our common stock.
Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:
| | • | authorizing the issuance of preferred stock without stockholder approval; |
| | • | providing for a classified board of directors with staggered, three-year terms; |
| | • | requiring advance notice of stockholder nominations for the board of directors; |
| | • | providing the board of directors the opportunity to expand the number of directors without notice to stockholders; |
| | • | prohibiting cumulative voting in the election of directors; |
| | • | requiring super-majority voting to amend some provisions of our certificate of incorporation and bylaws; |
| | • | limiting the persons who may call special meetings of stockholders; and |
| | • | prohibiting stockholder actions by written consent. |
Provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us.
The price of our stock fluctuates substantially and may continue to do so.
The stock market has experienced extreme price and volume fluctuations that have affected the market valuation of many technology companies, including Silicon Image. These factors, as well as general economic and political conditions, may materially and adversely affect the market price of our common stock in the future. The market price of our common stock has fluctuated significantly and may continue to fluctuate in response to a number of factors, including, but not limited to:
| | • | actual or anticipated changes in our operating results; |
| | • | changes in expectations of our future financial performance; |
| | • | changes in market valuations of comparable companies in our markets; |
| | • | changes in market valuations or expectations of future financial performance of our vendors or customers; |
| | • | changes in our key executives and technical personnel; and |
| | • | announcements by us or our competitors of significant technical innovations, design wins, contracts, standards or acquisitions. |
Due to these factors, the price of our stock may decline. In addition, the stock market experiences volatility that is often unrelated to the performance of particular companies. These market fluctuations may cause our stock price to decline regardless of our performance.
None.
None.
None.
None.
(a) Exhibits
| 3131.01 | Certification of Pricipal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 3131.02 | Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 3232.01* | Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 3232.02* | Certification of Pricipal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
____________
| * | This exhibit is being furnished, rather than filed, and shall not be deemed incorporated by reference into any filing of the registrant, in accordance with Item 601 of Regulation S-K. |
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.
| Date: October 26, 2009 | Silicon Image, Inc. |
| | /s/ Harold Covert | |
| | Harold Covert |
| | President, Chief Operating Officer and Chief Financial Officer |
Exhibit Index
| 3131.01 | Certification of Pricipal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 3131.02 | Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 3232.01* | Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 3232.02* | Certification of Pricipal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
_________
| * | This exhibit is being furnished, rather than filed, and shall not be deemed incorporated by reference into any filing of the registrant, in accordance with Item 601 of Regulation S-K. |
