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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF
THE SECURITIES EXCHANGE ACT OF 1934
OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter Ended October 2, 2005
Commission File Number 0-16852
KOMAG, INCORPORATED
(Registrant)
Incorporated in the State of Delaware
I.R.S. Employer Identification Number 94-2914864
1710 Automation Parkway, San Jose, California 95131
Telephone: (408) 576-2000
I.R.S. Employer Identification Number 94-2914864
1710 Automation Parkway, San Jose, California 95131
Telephone: (408) 576-2000
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. Yesþ Noo
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yesþ Noo
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yeso Noþ
Indicate by check mark whether the Registrant has filed all reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yesþ Noo
On October 2, 2005, 29,942,401 shares of the Registrant’s common stock, $0.01 par value, were issued and outstanding.
INDEX
KOMAG, INCORPORATED
KOMAG, INCORPORATED
Page No. | ||||||||
PART I. | ||||||||
Item 1. | ||||||||
4 | ||||||||
5 | ||||||||
6 | ||||||||
7-14 | ||||||||
Item 2. | 15-38 | |||||||
Item 3. | 39 | |||||||
Item 4. | 40 | |||||||
PART II. | ||||||||
Item 1. | 41 | |||||||
Item 2. | 41 | |||||||
Item 3. | 41 | |||||||
Item 4. | 41 | |||||||
Item 5. | 41 | |||||||
Item 6. | 41 | |||||||
SIGNATURES | 42 | |||||||
EXHIBIT 10.1 | ||||||||
EXHIBIT 10.2 | ||||||||
EXHIBIT 10.3 | ||||||||
EXHIBIT 31.1 | ||||||||
EXHIBIT 31.2 | ||||||||
EXHIBIT 32 |
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FORWARD-LOOKING INFORMATION
This report contains forward-looking statements within the meaning of the U.S. federal securities laws that involve risks and uncertainties. Certain statements contained in this report are not purely historical including, without limitation, statements regarding our expectations, beliefs, intentions, anticipations, commitments, or strategies regarding the future that are forward-looking. These statements include those discussed in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, including “Results of Operations,” “Critical Accounting Policies,” and “Liquidity and Capital Resources,” and elsewhere in this report. These statements include statements concerning product development, product acceptance, product demand, shipping volumes, projected revenues, international revenues, pricing pressures, sales returns, gross profit, expenses, reserves, taxes, net income, capital spending, and liquidity requirements.
In this report, the words “may,” “could,” “would,” “might,” “will,” “should,” “plan,” forecast,” “anticipate,” “believe,” “expect,” “intend,” “estimate,” “predict,” “potential,” “continue,” “future,” “moving toward” or the negative of these terms or other similar expressions also identify forward-looking statements. Our actual results could differ materially from those forward-looking statements contained in this report as a result of a number of risk factors, including, but not limited to, those set forth in the section entitled “Risk Factors” and elsewhere in this report. You should carefully consider these risks, in addition to the other information in this report and in our other filings with the Securities and Exchange Commission. All forward-looking statements and reasons why results may differ included in this report are made as of the date of this report, and we assume no obligation to update any such forward-looking statement or reason why such results might differ.
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PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
KOMAG, INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
Three Months Ended | Nine Months Ended | |||||||||||||||
October 2, 2005 | October 3, 2004 | October 2, 2005 | October 3, 2004 | |||||||||||||
Net sales | $ | 180,011 | $ | 102,424 | $ | 493,026 | $ | 327,148 | ||||||||
Cost of sales | 129,124 | 79,256 | 358,996 | 245,422 | ||||||||||||
Gross profit | 50,887 | 23,168 | 134,030 | 81,726 | ||||||||||||
Operating expenses: | ||||||||||||||||
Research, development, and engineering | 12,054 | 9,720 | 36,043 | 30,385 | ||||||||||||
Selling, general, and administrative | 6,090 | 3,923 | 17,412 | 13,185 | ||||||||||||
Loss (gain) on disposal of assets | 400 | (230 | ) | (1,349 | ) | (630 | ) | |||||||||
18,544 | 13,413 | 52,106 | 42,940 | |||||||||||||
Operating income | 32,343 | 9,755 | 81,924 | 38,786 | ||||||||||||
Other income (expense): | ||||||||||||||||
Interest income | 1,552 | 342 | 3,346 | 851 | ||||||||||||
Interest expense | (441 | ) | (437 | ) | (1,324 | ) | (2,744 | ) | ||||||||
Other, net | (297 | ) | (75 | ) | (348 | ) | (142 | ) | ||||||||
814 | (170 | ) | 1,674 | (2,035 | ) | |||||||||||
Income before income taxes | 33,157 | 9,585 | 83,598 | 36,751 | ||||||||||||
Provision for income taxes | 1,175 | 321 | 3,196 | 1,146 | ||||||||||||
Net income | $ | 31,982 | $ | 9,264 | $ | 80,402 | $ | 35,605 | ||||||||
Basic net income per share | $ | 1.09 | $ | 0.33 | $ | 2.79 | $ | 1.31 | ||||||||
Diluted net income per share | $ | 0.97 | $ | 0.31 | $ | 2.48 | $ | 1.20 | ||||||||
Number of shares used in basic per share computations | 29,396 | 27,792 | 28,842 | 27,200 | ||||||||||||
Number of shares used in diluted per share computations | 33,381 | 31,334 | 32,969 | 30,759 | ||||||||||||
See notes to condensed consolidated financial statements.
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KOMAG, INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
October 2, 2005 | January 2, 2005 | |||||||||||||||
ASSETS | ||||||||||||||||
Current assets | ||||||||||||||||
Cash and cash equivalents | $ | 74,921 | $ | 26,410 | ||||||||||||
Short-term investments | 104,000 | 77,700 | ||||||||||||||
Accounts receivable (less allowances of $1,687 and $1,075, respectively) | 116,090 | 79,213 | ||||||||||||||
Inventories | 49,380 | 35,815 | ||||||||||||||
Prepaid expenses and other current assets | 3,109 | 1,815 | ||||||||||||||
Total current assets | 347,500 | 220,953 | ||||||||||||||
Property, plant, and equipment (net of accumulated depreciation of $128,332 and $99,065, respectively) | 271,435 | 205,642 | ||||||||||||||
Other assets | 3,356 | 4,500 | ||||||||||||||
$ | 622,291 | $ | 431,095 | |||||||||||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||||||||||
Current liabilities | ||||||||||||||||
Trade accounts payable | $ | 70,640 | $ | 43,082 | ||||||||||||
Customer advances | 64,625 | — | ||||||||||||||
Accrued expenses and other liabilities | 22,143 | 19,887 | ||||||||||||||
Total current liabilities | 157,408 | 62,969 | ||||||||||||||
Long-term debt | 80,500 | 80,500 | ||||||||||||||
Long-term deferred rent | 1,922 | — | ||||||||||||||
Total liabilities | 239,830 | 143,469 | ||||||||||||||
Stockholders’ equity | ||||||||||||||||
Common stock, $0.01 par value per share: | ||||||||||||||||
Authorized — 50,000 shares | ||||||||||||||||
Issued and outstanding — 29,942 and 28,065 shares, respectively | 299 | 281 | ||||||||||||||
Additional paid-in capital | 263,058 | 241,960 | ||||||||||||||
Deferred stock-based compensation | (6,774 | ) | (91 | ) | ||||||||||||
Retained earnings | 125,878 | 45,476 | ||||||||||||||
Total stockholders’ equity | 382,461 | 287,626 | ||||||||||||||
$ | 622,291 | $ | 431,095 | |||||||||||||
See notes to condensed consolidated financial statements.
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KOMAG, INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Nine Months Ended | ||||||||
October 2, 2005 | October 3, 2004 | |||||||
Operating Activities | ||||||||
Net income | $ | 80,402 | $ | 35,605 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Depreciation and amortization of property, plant, and equipment | 31,907 | 27,499 | ||||||
Tax adjustment to additional paid-in capital | 3,156 | — | ||||||
Amortization and adjustments of intangible assets | 1,029 | 2,422 | ||||||
Stock-based compensation | 4,185 | 555 | ||||||
Deferred rent | 1,922 | — | ||||||
Non-cash interest charges | 115 | 398 | ||||||
Gain on disposal of assets | (1,349 | ) | (630 | ) | ||||
Changes in operating assets and liabilities: | ||||||||
Accounts receivable, net | (36,877 | ) | (2,244 | ) | ||||
Inventories | (13,565 | ) | (10,897 | ) | ||||
Prepaid expenses and deposits | (1,294 | ) | (492 | ) | ||||
Trade accounts payable | 12,473 | (4,322 | ) | |||||
Accrued expenses and other liabilities | 66,881 | (7,987 | ) | |||||
Net cash provided by operating activities | 148,985 | 39,907 | ||||||
Investing Activities | ||||||||
Acquisition of property, plant, and equipment | (84,358 | ) | (49,312 | ) | ||||
Purchases of short-term investments | (220,350 | ) | (112,600 | ) | ||||
Proceeds from short-term investments | 194,050 | 88,850 | ||||||
Proceeds from disposal of property, plant, and equipment | 3,092 | 1,290 | ||||||
Other | — | (256 | ) | |||||
Net cash used in investing activities | (107,566 | ) | (72,028 | ) | ||||
Financing Activities | ||||||||
Payment of debt | — | (116,341 | ) | |||||
Proceeds from the issuance of long-term debt | — | 77,419 | ||||||
Proceeds from issuance of common stock, net of issuance costs | 7,092 | 68,368 | ||||||
Net cash provided by financing activities | 7,092 | 29,446 | ||||||
Increase (decrease) in cash and cash equivalents | 48,511 | (2,675 | ) | |||||
Cash and cash equivalents at beginning of period | 26,410 | 27,208 | ||||||
Cash and cash equivalents at end of period | $ | 74,921 | $ | 24,533 | ||||
See notes to condensed consolidated financial statements
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KOMAG, INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
OCTOBER 2, 2005
Note 1. Basis of Presentation and Summary of Significant Accounting Policies
The accompanying unaudited condensed consolidated financial statements include the accounts of Komag, Incorporated, a Delaware corporation (the Company), and its wholly-owned subsidiaries. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America. While the financial information furnished is unaudited, in the opinion of management, all normal recurring adjustments considered necessary for a fair presentation of the condensed consolidated financial position, operating results, and cash flows for the periods presented, have been included. Operating results for the nine months ended October 2, 2005, are not necessarily indicative of the results that may be expected for the year ending January 1, 2006. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended January 2, 2005, which are included in the Company’s Annual Report on Form 10-K.
Use of Estimates in the Preparation of Financial Statements:The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Fiscal Year:The Company uses a 52-53 week fiscal year ending on the Sunday closest to December 31. The Company’s 2005 fiscal year will include 52 weeks. Accordingly, the Company’s three-month and nine-month reporting periods ended October 2, 2005, included 13 weeks and 39 weeks, respectively. Because the Company’s 2004 fiscal year included 53 weeks, its three-month and nine-month reporting periods ended October 3, 2004, included 13 weeks and 40 weeks, respectively.
Reclassification:Certain amounts in fiscal 2004 as reported on the Condensed Consolidated Balance Sheet and Condensed Consolidated Statements of Cash Flows have been reclassified to conform to the current year presentation. The Company reclassified $77.7 million in auction rate securities from cash and cash equivalents to short-term investments on the Condensed Consolidated Balance Sheet as of January 2, 2005. The Company also reclassified $66.6 million and $42.9 million in auction rate securities from cash and cash equivalents to short-term investments as of October 3, 2004 and December 28, 2003, respectively. These reclassifications decreased cash flows from investing activities by $23.7 million in the Condensed Consolidated Statements of Cash Flows for the nine months ended October 3, 2004. The reclassification to short-term investments is based on the latest interpretation of cash equivalents pursuant
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to Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 95,Statement of Cash Flows.
Cash and Cash Equivalents:The Company considers as a cash equivalent any bank deposit, money market investments and any highly-liquid investment that mature within three months of its purchase date.
Short-Term Investments:The Company invests its excess cash in high-quality, short-term debt instruments and auction rate preferred securities (which the Company rolls over every three months or less). Interest and dividends on the investments are included in interest income. The cost of the Company’s investments approximates fair value.
Inventories:Inventories are stated at the lower of cost (first-in, first-out method) or market, and consist of the following (in thousands):
October 2, 2005 | January 2, 2005 | |||||||
Raw materials | $ | 33,841 | $ | 20,647 | ||||
Work in process | 7,689 | 7,785 | ||||||
Finished goods | 7,850 | 7,383 | ||||||
$ | 49,380 | $ | 35,815 | |||||
Stock-Based Compensation:The Company uses the intrinsic value method to account for employee stock-based compensation. The intrinsic value method is in accordance with the recognition and measurement principles of Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees.Accordingly, compensation cost is recorded on the date of grant to the extent that the fair value of the underlying share of common stock exceeds the exercise price for a stock option or the purchase price for a share of common stock.
In accordance with SFAS No. 123,Accounting for Stock-Based Compensation(SFAS 123), and SFAS No. 148,Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of SFAS 123,the Company provides pro forma disclosure of the effect on net income and earnings per share had the fair value method, as prescribed by SFAS 123, been used.
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The following table reflects the effect on the Company’s net income and income per share had the fair value method been applied to all outstanding and unvested awards. The table is in thousands, except per share amounts.
Three Months Ended | Nine Months Ended | |||||||||||||||
October 2, 2005 | October 3, 2004 | October 2, 2005 | October 3, 2004 | |||||||||||||
Net income, as reported | $ | 31,982 | $ | 9,264 | $ | 80,402 | $ | 35,605 | ||||||||
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects | 1,658 | 185 | 4,185 | 555 | ||||||||||||
Deduct: Stock-based compensation expense determined under the fair value method for all awards, net of related tax effects | (2,300 | ) | (887 | ) | (6,216 | ) | (2,799 | ) | ||||||||
Pro forma net income | $ | 31,340 | $ | 8,562 | $ | 78,371 | $ | 33,361 | ||||||||
Net income per share: | ||||||||||||||||
Basic — as reported | 1.09 | $ | 0.33 | $ | 2.79 | $ | 1.31 | |||||||||
Diluted — as reported | 0.97 | $ | 0.31 | $ | 2.48 | $ | 1.20 | |||||||||
Basic — pro forma | 1.07 | $ | 0.31 | $ | 2.72 | $ | 1.23 | |||||||||
Diluted — pro forma | 0.95 | $ | 0.29 | $ | 2.42 | $ | 1.12 | |||||||||
For pro forma disclosure purposes, the Company used the Black-Scholes option pricing model to estimate the fair value of each option and stock purchase right grant on the date of grant.
In December 2004, the FASB issued SFAS No. 123R,Share-Based Payment(SFAS 123R). SFAS 123R is a revision of SFAS 123, which addresses financial accounting and reporting for costs associated with stock-based compensation. SFAS 123 addresses all forms of share-based payment (SBP) awards, including shares issued under employee stock purchase plans, stock options, restricted stock, and stock appreciation rights. SFAS 123R requires the Company to adopt the new accounting provisions beginning in its first quarter of 2006, and applies to all outstanding and unvested SBP awards at the Company’s adoption date. The Company is allowed to select one of two alternative transition methods, each having different reporting implications. On March 29, 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107) on SFAS 123R to assist preparers by simplifying some of the implementation challenges of SFAS 123R. The Company has not completed its evaluation or determined the impact of adopting SFAS 123R. However, we expect the adoption to have a significant impact on our net income and net income per share.
Computation of Net Income Per Share:The Company determines net income per share in accordance with SFAS No. 128,Earnings per Share.
Basic net income per common share is computed by dividing income available to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing income available to common stockholders by the weighted-average number of shares and dilutive potential shares of common stock outstanding during the period. The dilutive effect of outstanding options and stock purchase rights is reflected in diluted net income per share by application of the treasury stock method.
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The following table sets forth the computation of net income per share. The table is in thousands, except per share amounts.
Three Months Ended | Nine Months Ended | |||||||||||||||
October 2, 2005 | October 3, 2004 | October 2, 2005 | October 3, 2004 | |||||||||||||
Numerator for basic net income per share: | ||||||||||||||||
Net income as reported | $ | 31,982 | $ | 9,264 | $ | 80,402 | $ | 35,605 | ||||||||
Numerator for diluted net income per share: | ||||||||||||||||
Net income as reported | $ | 31,982 | $ | 9,264 | $ | 80,402 | $ | 35,605 | ||||||||
Interest adjustment related to contigently convertible debt | 441 | 437 | 1,324 | 1,210 | ||||||||||||
$ | 32,423 | $ | 9,701 | $ | 81,726 | $ | 36,815 | |||||||||
Denominator for basic income per share: | ||||||||||||||||
Weighted average shares | 29,396 | 27,792 | 28,842 | 27,200 | ||||||||||||
Denominator for diluted income per share: | ||||||||||||||||
Weighted average shares | 29,396 | 27,792 | 28,842 | 27,200 | ||||||||||||
Effect of dilutive securities: | ||||||||||||||||
Contingently convertible shares under convertible debt | 3,049 | 3,049 | 3,049 | 2,722 | ||||||||||||
Stock options | 629 | 288 | 583 | 468 | ||||||||||||
Warrants | — | 201 | 287 | 357 | ||||||||||||
Stock purchase rights | 307 | 4 | 208 | 12 | ||||||||||||
33,381 | 31,334 | 32,969 | 30,759 | |||||||||||||
Basic net income per share | $ | 1.09 | $ | 0.33 | $ | 2.79 | $ | 1.31 | ||||||||
Diluted net income per share | $ | 0.97 | $ | 0.31 | $ | 2.48 | $ | 1.20 | ||||||||
In January 2004, the Company issued $80.5 million of 2.0% Convertible Subordinated Notes (the Notes). The Notes are convertible, under certain circumstances, into shares of the Company’s common stock at an initial conversion price of $26.40, or approximately 3,049,000 shares. In October 2004, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 04-08,Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share.This consensus, which became effective in the fourth quarter of 2004, requires the Company to include these additional shares in its calculation of diluted earnings per share as of the date of issuance of the Notes (the first quarter of 2004). Accordingly, these shares have been included in the Company’s diluted earnings per share calculations for the first, second, and third quarters of 2005 and 2004. Therefore, diluted net income per share has been adjusted for the three-month and nine-month periods ended October 3, 2004, to $0.31 and $1.20, respectively, from $0.33 and $1.27, respectively.
Recent Accounting Pronouncements:In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003),Consolidation of Variable Interest Entities(FIN 46R), which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46,Consolidation of Variable Interest Entities(VIE), which was issued in January 2003. The Company is required to apply FIN 46R to variable interests in VIEs created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, the Interpretation has been applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and non-controlling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If
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determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities and non-controlling interest of the VIE. The Company’s adoption of FIN 46R had no impact on its consolidated financial statements.
In December 2004, the FASB issued SFAS No. 151 (SFAS 151),Inventory Costs.SFAS 151 clarifies the accounting for inventory when there are abnormal amounts of idle facility expense, freight, handling costs, and wasted materials. Under existing generally accepted accounting principles, items such as idle facility expense, excessive spoilage, double freight, and re-handling costs may be “so abnormal” as to require treatment as current period charges rather than recorded as adjustments to the value of the inventory. SFAS 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after the date this Statement is issued. The Company will adopt this pronouncement beginning in fiscal year 2006. The adoption of SFAS 151 is not expected to have a material effect on the Company’s financial position or results of operations.
In May 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections.SFAS No. 154 replaces APB No. 20 and FASB Statement No. 3. SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. SFAS No. 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS No. 154. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will adopt this pronouncement beginning in fiscal year 2006.
Note 2. Concentration of Customer, Supplier, and Geographic Risk
The following table reflects the percentage of the Company’s revenue by major customer:
Three Months Ended | Nine Months Ended | |||||||||||||||
October 2, 2005 | October 3, 2004 | October 2, 2005 | October 3, 2004 | |||||||||||||
Maxtor Corporation | 34 | % | 48 | % | 33 | % | 48 | % | ||||||||
Western Digital Corporation | 25 | % | 8 | % | 21 | % | 12 | % | ||||||||
Hitachi Global Storage Technologies * | 20 | % | 36 | % | 22 | % | 29 | % | ||||||||
Seagate Technology | 16 | % | — | 18 | % | 5 | % |
* | (including sales to Hitachi Global Storage Technologies’ contract manufacturer, Excelstor) |
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The Company relies on a limited number of suppliers for some of the materials and equipment used in its manufacturing processes, including aluminum blanks, aluminum substrates, nickel plating solutions, polishing and texturing supplies, and sputtering target materials. Kobe Steel, Ltd. is the Company’s sole supplier of aluminum blanks, which is a fundamental component in producing disks. The Company also relies on a single supplier, Heraeus Incorporated, for a substantial quantity of its sputtering target requirements, and on OMG Fidelity, Incorporated for supplies of nickel plating solutions.
A majority of the Company’s long-lived assets is located at its Malaysian manufacturing facilities. These assets totaled $250.5 million as of October 2, 2005, and $190.0 million as of January 2, 2005. The majority of the Company’s sales is delivered to manufacturing facilities located in Asia.
Note 3. Income Taxes
The Company’s manufacturing facilities, which are located in Malaysia, have been granted various tax holidays with varying expiration dates. In July 2005, the Malaysian government agreed to reset the expiration dates of the existing tax holidays to December 2006 and approved a new, 10-year tax holiday covering all of the Company’s Malaysian operations. The new tax holiday commences in January 2007 and expires in December 2016.
In the first, second, and third quarters of 2005 and 2004, the Company utilized deferred tax assets generated prior to the Company’s reorganization in 2002. The Company provided a full valuation allowance against all tax assets; therefore, upon utilization of those deferred tax assets, the Company first reduced intangible assets to zero and then credited additional paid-in capital for the remaining $3.0 million in 2005. Future benefits from those previously fully reserved assets will be credited to additional paid-in capital.
Note 4. Accrued Expenses and Other Liabilities
The following table summarizes accrued expenses and other liabilities balances at October 2, 2005 and January 2, 2005 (in thousands):
October 2, 2005 | January 2, 2005 | |||||||
Accrued compensation and benefits | $ | 19,408 | $ | 15,777 | ||||
Other liabilities | 2,735 | 4,110 | ||||||
$ | 22,143 | $ | 19,887 | |||||
Note 5. Customer Advances
In June and July 2005, the Company entered into supply agreements with three major customers. Each agreement requires that the Company supply and the customer purchase certain specified media volumes and that the Company supply media from existing and new production capacity to meet such purchase requirements, subject to certain exceptions. Under the supply agreements, the customers are
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required to pay certain advances covering future purchases of media from the Company. One of the agreements is for an initial period of eighteen months after the Company has commenced full capacity production from its new capacity, subject to certain extension and renewal periods. Another supply agreement expires in 2008, and the third supply agreement, which expires in 2009, has certain renewal periods.
Note 6. Deferred Rent
In December 2004, the Company signed a second amendment to its lease on its headquarters facility, which became effective in January 2005. The second amendment to the lease agreement included scheduled rent increases. The Company recognizes lease obligations with scheduled rent increases over the term of the lease on a straight-line basis in accordance with FASB Technical Bulletin 85-3Accounting for Operating Leases with Scheduled Rent Increases. Accordingly, the total amount of base rentals over the term of the lease for the Company’s headquarter facility is charged to expense on a straight-line method, with the amount of rental expense in excess of lease payments recorded as a deferred rent liability.
Note 7. Stock Purchase Rights
In the first nine months of 2005, the Company issued a total of 498,060 stock purchase rights (net of terminations) with an exercise price of $0.01. The vesting for the stock purchase rights grants is one-third at the end of each of the first three anniversaries of the date of grant, subject to the employee, non-employee board member, or consultant continuing to be a service provider of the Company on each such date. In the first nine months of 2005, the Company initially recorded $10.6 million of deferred stock- based compensation to the consolidated balance sheet. This amount is being ratably amortized to expense over the vesting period.
Note 8. Derivative Financial Instruments
The Company accounts for its derivative and hedging activities under SFAS No. 133. The assets or liabilities associated with its derivative instruments and hedging activities are recorded at fair value in prepaid expenses and other current assets or other current liabilities, respectively, in the consolidated balance sheets. As discussed below, the accounting for gains and losses resulting from changes in fair value depends on the use of the derivative and whether it is designated and qualifies for hedge accounting.
As of October 2, 2005, the Company had foreign exchange forward contracts to purchase approximately $13.3 million of Japanese Yen for cash flow payments denominated in Japanese Yen for future equipment purchases. As of October 2, 2005, the company had not designated these foreign exchange forward contracts as a cash flow hedge in accordance with SFAS No. 133. The fair value of the Company’s forward contracts was recorded as a $0.1 million other current liability, and a corresponding loss in other income (expense) for the quarter ended October 2, 2005. Fair value is determined by the counterparty to the foreign exchange forward contracts. As of October 3, 2005, the Company’s foreign currency forward contracts were designated and qualify as cash flow hedges under SFAS No. 133. The effectiveness of the contracts that qualify as cash flow hedges will be assessed quarterly through an
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evaluation of critical terms and other criteria required by SFAS No. 133. The effective portion of gains or losses resulting from changes in fair value will initially be reported as a component of accumulated other comprehensive income or (loss), net of any tax effects, in stockholders’ equity and subsequently reclassified into depreciation expense over the useful life of the purchased equipment. The ineffective portion of gains or losses resulting from changes in fair value, if any, is reported in other income (expense) in the consolidated statements of income.
The Company’s foreign exchange forward contracts have maturities of less than 12 months. The Company does not use foreign exchange forward contracts for speculative or trading purposes.
Note 9. Subsequent Event
In November 2005, the Company entered into an Employment Agreement (the Agreement) with one Executive officer: Paul G. Judy.
The Agreement specifies base salary compensation, a term of employment of twenty-one (21) months, benefits and certain other severance benefits described below, subject to compliance with various terms and conditions, including the execution of a release of claims. The Agreement also includes non-solicitation obligations of the officer.
The Agreement provides that if the officer’s employment terminates other than voluntarily or for “cause” prior to a “change in control” (as such terms are defined in the Agreement) or more than six months following a change in control, the executive officer will receive a severance amount equal to twelve (12) months of base salary. The officer will also receive accelerated vesting of a portion of outstanding and unvested non-qualified stock options and restricted stock.
In addition, the Agreement provides the same severance payments referred to in the preceding paragraph, plus an additional cash severance payment based on target incentive bonus amounts and acceleration of any outstanding and unvested stock options and restricted stock, if the officer’s employment is terminated other than voluntarily or for cause within six months of a change of control.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the condensed consolidated financial statements and the accompanying notes included in Part I. Financial Information, Item 1. Condensed Consolidated Financial Statements of this report.
The following discussion contains predictions, estimates, and other forward-looking statements that involve a number of risks and uncertainties about our business, including but not limited to: our belief that we are a leading independent supplier of disks; our belief that we have developed a deep understanding of market needs in the disk drive market; our belief that our manufacturing and technology development programs provide us with competitive advantages in maintaining and growing our market share; our belief that we have developed strong relationships with many of the leading disk drive manufacturers; our belief that our manufacturing operations, together with our experience in the industry and our economies of scale, provide us with timing and cost advantages in delivering consistently high-quality products to our customers in high volumes; our plan to continue to generate cash from our operations for the remainder of 2005; our expectation that our revenues will increase by 2% to 4% in the fourth quarter of 2005 compared to the third quarter of 2005; our expectation that variable and fixed manufacturing costs per unit will be similar between the third and fourth quarters of 2005; our belief that we will continue to investigate areas where we can expand our presence in the disk market; our expectation that we will continue to generate cash from operations; our expectation that we will fund our expansion with cash from operations and customer advances; our expectation that we will expand our disk manufacturing capacity to 31 million disks a quarter by the first quarter of 2006, and to 40 million disks a quarter by the end of 2006; and our belief that the estimates and judgments made regarding future events in connection with the preparation of our financial statements are reasonable. These statements may be identified by the use of words such as “expects,” “anticipates,” “intends,” “plans,” and similar expressions. In addition, forward-looking statements include, but are not limited to, statements about our beliefs, estimates, or plans about our ability to maintain low manufacturing and operating costs and costs per unit, our ability to estimate revenues, shipping volumes, pricing pressures, returns, reserves, demand for our disks, selling, general, and administrative expenses, taxes, research, development, and engineering expenses, spending on property, plant, and equipment, expected sales of disks and the market for disk drives generally and certain customers specifically, and our beliefs regarding our liquidity needs.
Forward-looking statements are estimates reflecting the best judgment of our senior management, and they involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by the forward-looking statements. Our business is subject to a number of risks and uncertainties. While this discussion represents our current judgment on the future direction of our business, these risks and uncertainties could cause actual results to differ materially from any future performance suggested herein. Some of the important factors that may influence possible differences are continued competitive factors, technological developments, pricing pressures, changes in customer demand, and general economic conditions, as well as those discussed in the Risk Factors section below. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of such statements. Readers should review the Risk Factors section below, as well as other documents filed from time to time by us with the SEC.
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Due to continuing strong customer demand and supply agreements entered into with three of our major customers, in the first nine months of 2005, we increased our capacity to approximately 27 million disks per quarter. We are currently in the process of expanding our capacity by approximately four million disks a quarter to 31 million disks per quarter, which we plan to achieve by the end of the first quarter of 2006. We expect to expand our capacity to 40 million units per quarter by the end of 2006. If we are unable to utilize our expanded capacity, we may be unable to increase or sustain our gross margins.
Results of Operations
Overview
Komag, Incorporated was incorporated in Delaware in 1983. We are headquartered in San Jose, California. All of our manufacturing facilities are in Malaysia.
We design, manufacture, and market thin-film media (disks), which are incorporated into disk drives. Disks, such as the ones we manufacture, serve as a primary storage medium for digital data. Our net sales are driven by the level of demand for disks by disk drive manufacturers and the average selling prices of our disks. Demand for our disks is dependent on unit growth in the disk drive market, the growth of storage capacity in disk drives, which affects the number of disks needed per drive, and the number of disks our customers purchase from external suppliers. Average selling prices are dependent on overall supply and demand for disks and our product mix.
Our business is capital-intensive and is characterized by high fixed costs, making it imperative that we sell disks in high volume. Our contribution margin per disk sold varies with changes in selling price, input material costs, and production yield. As demand for our disks increases, our total contribution margin increases, improving our financial results because we generally do not have to increase our fixed cost structure in proportion to increases in demand and resultant capacity utilization. Conversely, our financial results would deteriorate rapidly if the disk market were to worsen and our production volume were to decrease.
A majority of our revenue, expense, and capital purchasing activities is transacted in U.S. dollars. However, a large portion of our payroll, certain manufacturing and operating expenses, and inventory and capital purchases is transacted in the Malaysian ringgit (ringgit). On July 21, 2005, Malaysia removed its currency peg to the U.S. dollar in favor of a managed float system. Changes in exchange rates could adversely affect the amount we spend on our payroll, certain manufacturing and operating expenses, and raw materials and capital purchases.
Our three-month and nine-month reporting periods ended October 2, 2005 included 13 weeks and 39 weeks, respectively. Because our 2004 fiscal year contained 53 weeks, our three-month and nine-month reporting periods ended October 3, 2004 included 13 weeks and 40 weeks, respectively.
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Net Sales
Consolidated net sales of $180.0 million in the third quarter of 2005 were 75.8% higher than the $102.4 million of net sales in the third quarter of 2004. Finished unit sales increased to 27.5 million in the third quarter of 2005 from 16.6 million in the third quarter of 2004. Finished unit average selling price increased by 2.9% in the third quarter of 2005 compared to the third quarter of 2004.
Other disk sales in the third quarter of 2005 were $24.3 million, compared to $11.1 million in the third quarter of 2004.
Consolidated net sales in the first nine months of 2005 increased by $165.9 million, to $493.0 million compared to $327.1 million in the first nine months of 2004. Our finished unit sales volume increased by 51.9% in the first nine months of 2005, to 77.3 million units from 50.9 million units in the first nine months of 2004. The volume increase was partially offset by a 3.1% decrease in our finished unit average selling price for the first nine months of 2005 compared to the first nine months of 2004.
Other disk sales in the first nine months of 2005 were $61.8 million, compared to $34.1 million in the first nine months of 2004.
The finished unit shipment and other disk sales increase in the first nine months of 2005 compared to the same period in 2004 resulted from an overall improvement in industry conditions, which resulted in a significant increase in our customers’ demand. The decline in the finished unit average selling price in the first nine months of 2005 compared to the same period in 2004 primarily reflected the higher mix of more mature product offerings in the current year period.
In the third quarter of 2005, sales to Maxtor Corporation (Maxtor), Western Digital Corporation (Western Digital), Hitachi Global Storage Technologies (HGST) (including sales to HGST’s contract manufacturer, Excelstor), and Seagate Technology (Seagate), accounted for 34%, 25%, 20%, and 16%, respectively, of our revenue. In the third quarter of 2004, sales to Maxtor, HGST, Western Digital, and Seagate accounted for 48%, 36%, 8%, and zero, respectively, of our revenue. We expect to continue to derive a substantial portion of our sales from these customers.
Sales of 100GB and above per platter disks increased to 30% of net sales in the third quarter of 2005, compared to 10% in the third quarter of 2004. The increase reflected the continued customer migration to higher storage densities.
Finished disk shipments for desktop and consumer applications together represented 92% of our unit shipment volume in the third quarter of 2005. The remaining finished disk shipments in the third quarter of 2005 were disks for high-end server (enterprise) drives.
Overall demand remains very strong entering the traditionally seasonally strong fourth quarter. We expect revenue in the fourth quarter of 2005 to increase by 2% to 4% compared to the third quarter of 2005.
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Gross Profit
For the third quarter of 2005, we achieved a gross profit percentage of 28.3% compared to a gross profit percentage of 22.6% for the third quarter of 2004. Improved manufacturing yields, the economies of scale associated with higher factory utilization, and higher sales and production volumes accounted for a 3.6-point increase. In addition, an increase in the finished unit average selling price accounted for a 2.1-point increase in gross profit.
For the first nine months of 2005, we achieved a gross profit percentage of 27.2% compared to a gross profit percentage of 25.0% for the first nine months of 2004. Improved manufacturing yields, the economies of scale associated with higher factory utilization, and higher sales and production volumes accounted for a 4.6-point increase. This was offset by a decline in the finished unit average selling price, which accounted for a 2.4-point reduction.
As we are currently operating at full manufacturing capacity, we expect variable and fixed manufacturing costs per unit in the fourth quarter of 2005 to be similar to the third quarter of 2005, excluding the impact of fluctuations in the exchange rate for the Malaysian ringgit.
Research, Development, and Engineering Expenses
Research, development and engineering (R&D) expenses in the third quarter of 2005 were $12.1 million compared to $9.7 million in the third quarter of 2004. R&D expenses in the first nine months of 2005 were $36.0 million compared to $30.4 million in the first nine months of 2004. The increases primarily reflected higher incentive compensation, higher payroll expenses related to increased headcount, and higher stock compensation expense.
As a percentage of sales, we expect R&D spending in the fourth quarter of 2005 to be slightly higher than the third quarter of 2005.
Selling, General, and Administrative Expenses
Selling, general, and administrative (SG&A) expenses in the third quarter of 2005 were $6.1 million compared to $3.9 million in the third quarter of 2004. SG&A expenses in the first nine months of 2005 were $17.4 million compared to $13.2 million in the first nine months of 2004. The increases primarily reflected higher incentive compensation, higher stock compensation expense, and higher payroll expenses related to increased headcount.
As a percentage of sales, we expect SG&A spending in the fourth quarter of 2005 to be similar to the third quarter of 2005.
Interest Expense
Interest expense in the third quarter of 2005 and 2004 was $0.4 million, and reflected interest on our $80.5 million, 2% Convertible Subordinated Notes, which were issued on January 28, 2004.
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Interest expense in the first nine months of 2005 was $1.3 million, and reflected interest on our 2% Convertible Subordinated Notes. Interest expense in the first nine months of 2004 was $2.7 million, and included $1.1 million of interest expense on our 2% Convertible Subordinate Notes, and $1.6 million of interest on the Senior Secured Notes and certain promissory notes. The Senior Secured Notes and promissory notes were redeemed in full, including accrued interest, in February 2004. There was no gain or loss on the redemption, and there were no unamortized debt issuance costs.
Income Taxes
Our effective income tax rates, which reflect tax expenses related to our U.S. and international operations, were 3.5% and 3.8%, respectively, for the three and nine months ended October 2, 2005, and 3.3% and 3.1%, respectively, for the three and nine months ended October 3, 2004.
Our manufacturing facilities, which are located in Malaysia, have been granted various tax holidays with varying expiration dates. In July 2005, the Malaysian government agreed to reset the expiration dates of the existing tax holidays to December 2006 and approved a new, 10-year tax holiday covering all of our Malaysian operations. The new tax holiday commences in January 2007 and expires in December 2016.
Critical Accounting Policies
In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. We regularly evaluate our estimates, including those related to our revenues, allowance for inventories, commitments and contingencies, income taxes, and asset impairments. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ significantly from those estimates if our assumptions are incorrect. We believe that the following discussion addresses our most critical accounting policies. These policies are most important to the portrayal of our financial condition and results and require management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
Allowance for Sales Returns
We estimate our allowance for sales returns based on historical data as well as current knowledge of product quality. We have not experienced material differences between our estimated reserves for sales returns and actual results. It is possible that the failure rate on products sold could be higher than it has historically been, which could result in significant changes in future returns.
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Since estimated sales returns are recorded as a reduction in revenues, any significant difference between our estimated and actual experience or changes in our estimate would be reflected in our reported revenues in the period we determine that difference. There were no significant changes from prior year estimates in the first nine months of 2005.
Impairment of Long-lived Assets
Long-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that these assets may be impaired or the estimated useful lives are no longer appropriate. We consider the primary indicators of impairment to include significant decreases in unit volumes, unit prices or significant increases in production costs. We review our long-lived assets for impairment based on estimated future undiscounted cash flows attributable to the assets. In the event that these cash flows are not expected to be sufficient to recover the recorded value of the assets, the assets are written down to their estimated fair values utilizing discounted estimates of future cash flows. The discount rate used is based on the estimated incremental borrowing rate at the date of the event that triggers the impairment. There were no impairments of long-lived assets in the first nine months of 2005.
Inventory Obsolescence
Our policy is to provide for inventory obsolescence based upon an estimated obsolescence percentage applied to the inventory based on age, historical trends, and requirements to support forecasted sales. In addition, and as necessary, we may provide additional charges for future known or anticipated events. There were no significant changes from prior year estimates in the first nine months of 2005.
Liquidity and Capital Resources
Cash, cash equivalents, and short-term investments of $178.9 million at the end of the third quarter of 2005 increased by $74.8 million from the end of the 2004 fiscal year. The increase primarily reflected a $149.0 million increase resulting from consolidated operating activities, $7.1 million in proceeds from the sale of common stock, and $3.1 million in proceeds from idle equipment sales, offset by $84.4 million of spending on property, plant, and equipment.
On July 21, 2005, Malaysia removed its currency peg to the U.S. dollar in favor of a managed float system. As of October 2, 2005, we held approximately $41.5 million (Malaysian ringgit 156.5 million) of cash and cash equivalents that were denominated in Malaysian ringgit.
Consolidated operating activities generated $149.0 million in cash in the first nine months of 2005. The primary components of this change include the following:
• | net income of $80.4 million, net of non-cash depreciation and amortization of property, plant and equipment of $31.9 million and other non-cash charges and gains of $9.1 million; | ||
• | an accounts receivable increase of $36.9 million primarily due to an increase in sales during the first nine months of 2005 compared to the first nine months of 2004; |
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• | an inventory increase of $13.6 million; | ||
• | a prepaid expense increase of $1.3 million primarily due to the payment of insurance premiums; | ||
• | an accounts payable increase of $12.5 million related to increased inventory and higher capital spending; and | ||
• | an accrued expenses and other liabilities increase of $66.9 million, which primarily reflected the receipt of customer advances. |
Our total capital spending in the first nine months of 2005 was $99.4 million (on an accrual basis), and included capital expenditures to increase our substrate and finished disk capacity, to improve our equipment capability for the manufacture of advanced products, and for projects designed to improve yield and productivity. There are no non-cancelable capital commitments as of October 2, 2005. For the remainder of 2005, we plan to spend approximately $100 million on property, plant, and equipment in order to increase our finished disk and related substrate capacity and continue to ramp new production processes. We expect to fund this capital spending with cash from operations and customer advances.
We have $80.5 million of 2% Convertible Subordinated Notes (the Notes) outstanding. The Notes mature on February 1, 2024, bear interest at 2.0%, and require semiannual interest payments beginning on August 1, 2004. The Notes will be convertible, under certain circumstances, into shares of our common stock based on an initial effective conversion price of $26.40. Holders of the Notes may convert the Notes into shares of our common stock prior to maturity if: 1) the sale price of our common stock equals or exceeds $31.68 for at least 20 trading days in any 30 consecutive trading day period within any of our fiscal quarters; 2) the trading price of the Notes falls below a specified threshold prior to February 19, 2019; 3) the Notes have been called for redemption; or 4) certain specified corporate transactions (as described in the offering prospectus for the Notes) occur. As of October 2, 2005, the Notes were not convertible. We may redeem the Notes on or after February 6, 2007, at specified declining redemption premiums. Holders of the Notes may require us to purchase the Notes on February 1, 2011, 2014, or 2019, or upon the occurrence of a fundamental change, at a purchase price equal to 100% of the principal amount of the Notes, plus accrued and unpaid interest. There are no financial covenants, guarantees, or collateral associated with the Notes.
We have a Malaysian ringgit 12.5 million (approximately $3.3 million) bank guarantee. There is no expiration date on the bank guarantee. No interest will be charged on the bank guarantee, but there is a commission of 0.05% on the amount of bank guarantee utilized. As of October 2, 2005, there were no liabilities outstanding related to this bank guarantee.
We have a Malaysian ringgit 2.0 million (approximately $0.5 million) stand-by letter of credit (LOC), which expires in January 2006. The LOC is secured by fixed deposits of Malaysian ringgit 2.0 million.
We lease our research and administrative facility in San Jose, California under an operating lease, which expires in 2014. Additionally, we lease certain equipment under operating leases. These leases expire on various dates through 2008. We have no capital leases.
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We currently anticipate that existing cash and cash equivalents, and cash generated from operations, will be adequate to meet our cash needs for at least the next 12 months.
As of October 2, 2005, our long-term debt obligations, operating lease obligations, and unconditional purchase obligations were as follows (in thousands):
Remainder | ||||||||||||||||||||||||||||
of | ||||||||||||||||||||||||||||
2005 | 2006 | 2007 | 2008 | 2009 | Thereafter | Total | ||||||||||||||||||||||
Long-Term Debt Obligations | $ | — | $ | — | $ | — | $ | — | $ | — | $ | 80,500 | $ | 80,500 | ||||||||||||||
Operating Lease Obligations | 20 | 2,334 | 2,053 | 2,046 | 3,147 | 16,384 | 25,984 | |||||||||||||||||||||
Unconditional Purchase Obligations (1) | 2,873 | 1,335 | 1,196 | 1,155 | 1,155 | 3,466 | 11,180 | |||||||||||||||||||||
Total Contractual Cash Obligations | $ | 2,893 | $ | 3,669 | $ | 3,249 | $ | 3,201 | $ | 4,302 | $ | 100,350 | $ | 117,664 | ||||||||||||||
(1) | Unconditional purchase obligations are defined as agreements to purchase goods or services that are enforceable and legally binding, and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable pricing provisions; and the approximate timing of the transactions. The amounts are based on our contractual commitments. |
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RISK FACTORS
These risks and uncertainties are not the only ones facing our company. Additional risks and uncertainties that we are unaware of or currently deem immaterial may also become important factors that may harm our business. If any of the following risks actually occur, or other unexpected events occur, our business, financial condition or results of operations could be materially adversely affected, the value of our stock could decline, and you may lose part or all of your investment. Further, thisForm 10-Q contains forward-looking statements and actual results may differ significantly from the results contemplated by our forward-looking statements.
Risks Related to Our Business
Our business is concentrated in the disk drive market, so downturns in the disk drive manufacturing market and related markets may decrease our revenues and margins.
The market for our products depends on economic conditions affecting the disk drive manufacturing and related markets. Our products are incorporated into disk drives manufactured by our customers for the desktop personal computer market as well as the enterprise storage systems market and electronic device market. Because of the concentration of our products in the disk drive market, which we expect to continue, our business is linked to the success of this market. The disk drive market has historically been seasonal and cyclical, and has experienced periods of oversupply and reduced production levels, resulting in significantly reduced demand for disks and pricing pressures. It is very difficult to achieve and maintain profitability and revenue growth in the disk drive industry because the average selling price of a disk drive rapidly declines over its commercial life as a result of technological enhancement and increases in supply. The effect of these cycles on suppliers has been magnified by disk drive manufacturers’ practice of ordering components, including disks, in excess of their needs during periods of rapid growth, thereby increasing the severity of the drop in the demand for components during periods of reduced growth or contraction. Accordingly, downturns in the disk drive market may cause disk drive manufacturers to delay or cancel projects, reduce their production, or reduce or cancel orders for our products. This, in turn, may lead to longer sales cycles, delays in payment and collection, pricing pressures, and unused capacity, causing us to realize lower revenues and margins and causing our operating results to suffer. For example, in the fourth quarter of fiscal year 2003, disk drive manufacturers appear to have overbuilt product, which resulted in an excess of supply of disk drives that was not fully corrected until approximately the third quarter of fiscal year 2004. Due to these factors, forecasts may not be achieved, either because expected sales do not occur or because they occur at lower prices or on terms that are less favorable to us. This increases the chances that our revenues and margins could be lower than the expectations of investors and analysts, which could make our stock price more volatile.
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We are in the process of significantly increasing the scope of our manufacturing operations in Malaysia, and if we fail to successfully manage and integrate our expanding operations, we may be unable to exploit potential market opportunities, which would materially and adversely affect our business.
We are in the process of significantly increasing the scope of our manufacturing operations in Malaysia. We are in the process of expanding our manufacturing capacity by approximately four million disks per quarter to 31 million disks per quarter, which we plan to achieve by the end of the first quarter of 2006. We expect to expand further our capacity to 40 million units per quarter by the end of 2006. We are expanding our capacity as a result of commitments we have made to certain customers pursuant to strategic supply agreements. In the event we do not increase our capacity as planned on a timely basis, we could lose significant future orders from major customers. In the event we are successful in expanding our manufacturing capacity as planned, there can be no assurance we will receive sufficient orders to utilize our additional capacity. In addition, the utilization of our expanded capacity is dependent on our obtaining sufficient operating supplies and raw materials from our limited and sole source suppliers to accommodate the increased capacity. We do not have binding commitments from these limited and sole source suppliers to provide sufficient supplies and raw materials to fully utilize the additional capacity.
Addressing the challenges of our capacity expansion requires, and will continue to require, substantial management attention and financial resources. We expect to fund our expansion efforts with cash from operations and customer advances. In the event that our expansion efforts require additional funding, or if we have insufficient resources to fund our expansion efforts, we may need to seek additional capital, which may not be available on favorable terms, or at all. If we are unable to successfully develop and integrate our expanded manufacturing operations in Malaysia in a timely and effective manner, our business could be materially and adversely affected.
If our production capacity is underutilized, our gross margin will be adversely affected and we could sustain significant losses.
Our business is characterized by high fixed overhead costs, including expensive plant facilities and production equipment. Our per-unit costs and our gross profit are significantly affected by the number of units we produce and the amount of our production capacity that we utilize. In the third quarter of 2004, we completed the installation of additional equipment, which increased our production capacity from approximately 20 million disks a quarter to approximately 24 million disks a quarter. Our finished disk shipments were below this capacity level in the third quarter and fourth quarter of 2004. In the first nine months of 2005, we increased our capacity to approximately 27 million disks a quarter. We are currently in the process of expanding our capacity by approximately four million disks a quarter to 31 million disks a quarter, which we plan to achieve by the end of the first quarter of 2006. We expect to expand our capacity to 40 million units per quarter by the end of 2006. If we are unable to utilize our expanded capacity, we may be unable to increase or sustain our gross margins.
If our capacity utilization decreases for any reason, including lack of customer demand or cancellation or delay of customer orders, we could experience significantly higher unit production costs, lower margins, and potentially significant losses, as occurred for several years prior to 2003. Underutilization of our production capacity could also result in equipment write-offs, restructuring charges, and employee layoffs. If our production capacity is underutilized for any reason, our financial results and our business would be severely harmed.
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If future demand for our products exceeds the production capability of our existing facilities, we may be required to invest significant capital expenditures to increase capacity or else risk losing market share.
In the third quarter of 2004, we completed the installation of additional equipment, which increased our production capacity to approximately 24 million disks a quarter. In the first nine months of 2005, we increased our capacity to approximately 27 million disks a quarter, and we are currently operating at full manufacturing capacity. Based on very strong demand that currently exceeds our manufacturing capacity and expected continuing strong overall market growth, we are in the process of expanding our capacity by approximately four million disks per quarter. We expect initial incremental capacity from this expansion in the fourth quarter of 2005 and total capacity of approximately 31 million disks a quarter by the end of the first quarter of 2006. Additionally, we plan to expand further our capacity during 2006 at our current manufacturing sites in Malaysia, in an attempt to keep up with the growing demand for media. This further additional capacity is expected to be available beginning in the second quarter of 2006 with total capacity of approximately 40 million disks a quarter by the end of 2006. If demand for our products at any point in time were to exceed significantly our capacity levels, we may not be able to satisfy the increased demand. To increase further our production capacity to meet significant increases in demand for our disks beyond the expansion in process, if needed, we would be required to expand further our existing facilities, construct new facilities, or acquire entities with additional production capacities. These alternatives would require significant capital investments by us and may require us to seek additional equity or debt financing. There can be no assurance that such financing would be available to us when needed on acceptable terms, or at all. If we were unable to expand capacity on a timely basis to meet increases in demand, we could lose market opportunities for sales, and our market share could decline. Further, we cannot assure you that the increased demand for our disk products would continue for a sufficient period of time to recoup our capital investments associated with increasing our production capacity.
Our customer supply agreements with several of our major customers require us to meet certain production demands and volume goals, and if we fail to successfully perform under these agreements, we may incur substantial costs and expenses, and our business could be materially and adversely affected.
We have entered into strategic supply agreements and arrangements with several of our major customers that require us to meet certain production demands and volume goals. Pursuant to these agreements, monies have been advanced to us to help fund the expansion of our capacity, and if we fail to meet the agreed upon volume goals, we may need to refund some of our customer advances. Even if we succeed in expanding our production capacity in a timely and effective manner as required by our contractual obligations, there can be no assurance that we will meet the product specifications or timetables required by our customers for delivery. In addition, forecast modifications or cancellations by our customers under our customer agreements may result in underutilization of our production capacity, which could result in equipment write-offs, restructuring charges, and employee layoffs. Moreover, certain of our customer agreements include expanded indemnification obligations. Our inability to perform successfully and competently our obligations under our agreements may cause us to incur substantial costs and expenses, and would have an adverse effect on our business, results of operations, and financial condition.
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We receive a large percentage of our net sales from only a few disk drive manufacturing customers, the loss of any of which would adversely affect our sales.
We sell most of our products to a limited number of customers. Our customers are disk drive manufacturers. A relatively small number of disk drive manufacturers dominates the disk drive market. According to Dataquest, four of these manufacturers (HGST, Maxtor, Seagate, and Western Digital) accounted for approximately 80% of worldwide hard disk drive sales in 2004. Accordingly, we expect that the success of our business will continue to depend on a limited number of customers that have comparatively strong bargaining power in negotiating contracts with us.
In the first nine months of 2005, 33% of our net sales were to Maxtor, 22% were to HGST, 21% were to Western Digital, and 18% were to Seagate. In 2004, 48% of our net sales were to Maxtor, 29% were to HGST, 12% were to Western Digital, and 5% were to Seagate. If any one of our significant customers reduces its disk requirements, cancels existing orders or develops or expands capacity to produce its own disks, and we are unable to replace these orders with sales to new customers, our sales would be reduced and our business, financial condition, and operating results would suffer. Our ability to maintain strong relationships with our significant customers is essential to our future performance. Mergers, acquisitions, consolidations, or other significant transactions involving our significant customers may adversely affect our business and operating results.
Because we depend on a limited number of suppliers, if our suppliers experience capacity constraints or production failures, our production, operating results and growth potential could be harmed.
We rely on a limited number of suppliers for some of the materials and equipment used in our manufacturing processes, including aluminum blanks, aluminum substrates, nickel plating solutions, polishing and texturing supplies, and sputtering target materials. For example, Kobe Steel, Ltd. is our sole supplier of aluminum substrate blanks, which is a fundamental component in producing our disks. Further, as a result of current increased worldwide demand, the supply of sputtering target materials is constrained, resulting in longer lead times and product allocation from certain suppliers. We rely on a single supplier, Heraeus Incorporated, for a substantial quantity of our sputtering target requirements. In addition, we also rely on OMG Fidelity, Inc. for supplies of nickel plating solutions. The supplier base has been weakened by the poor financial condition of the industry in recent years, and some suppliers have exited the business. Additionally, the increasing demand for many of these materials provides our sole-source suppliers with additional bargaining power. Our production capacity would be limited if one or more of these materials were to become unavailable or available in reduced quantities, or if we were unable to find alternative suppliers. If our sources of materials and supplies were limited or unavailable for a significant period of time or the costs of such materials were to increase, our production, operating results, and ability to grow our business could be adversely affected. We cannot assure you that we will be able to obtain adequate supplies of critical components in a timely and economic manner, or at all. The success of our products also depends on our ability to effectively integrate parts and components that use leading-edge technology. If we are unable to successfully manage the integration of parts obtained from third party suppliers, our business, financial condition and operating results could suffer.
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Changes in the accounting treatment of stock-based awards may adversely affect our reported results of operations.
In December 2004, the FASB issued SFAS 123R, which is a revision of SFAS 123. SFAS 123R is currently expected to be effective for Komag beginning in the first quarter of 2006. SFAS 123R requires all share-based payments to employees to be recognized in the financial statements based on their fair values and does not permit pro forma disclosure as an alternative to financial statement recognition. The adoption of the SFAS 123R fair value method may have a significant adverse impact on our reported results of operations because the stock-based compensation expense will be charged directly against our reported earnings. The impact of our adoption of SFAS 123R cannot be predicted at this time because it would depend in part on the future fair values and number of share-based payments granted in the future. However, we expect the adoption to have a significant impact on our net income and net income per share.
Price competition may force us to lower our prices, causing our gross margin to suffer.
We face significant price competition in the disk industry, even during periods when demand is stable. High levels of competition have historically put downward pressure on unit prices. Additionally, the average selling price of disks and disk drives rapidly declines over their commercial life as a result of technological enhancements, productivity improvements and industry supply increases. We may be forced to lower our prices or add new products and features at lower prices to remain competitive, and we may otherwise be unable to introduce new products at higher prices. We cannot be assured that we will be able to compete successfully in this kind of price competitive environment. Lower prices would reduce our ability to generate sales, and our gross margin would suffer. If we fail to mitigate the effect of these pressures through increased sales volume or changing our product mix, our net sales and gross margin could be adversely affected. Price declines are also affected by any imbalances between demand and supply. For most of 2002, as in the several years prior, disk supply exceeded demand. As independent suppliers like us struggled to utilize their capacity, the excess disk supply caused average selling prices for disks to decline. Supply and demand conditions have improved since 2002, resulting in a more stable pricing environment. Supply and demand factors and industry-wide competition could adjust in the future and force disk prices down, which, in turn, would put pressure on our gross margin.
Increasing competition could reduce the demand for our products and/or the prices of our products as a result of the introduction of technologically better and cheaper products, which could reduce our revenues. In addition, new competitors could emerge and rapidly capture market share. If we fail to compete successfully against current or future competitors, our business, financial condition and operating results will suffer.
Internal disk operations of disk drive manufacturers may adversely affect our ability to sell our disk products.
Disk drive manufacturers such as HGST, Maxtor, and Seagate have large internal thin-film media manufacturing operations, and are able to produce a substantial percentage of their disk requirements. We compete directly with these internal operations when we market our products to these disk drive
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companies, and compete indirectly when we sell our disks to customers who must compete with vertically-integrated disk drive manufacturers. Vertically-integrated companies have the opportunity to keep their disk-making operations fully utilized, thus lowering their costs of production. This cost advantage contributes to the pressure on us and other independent disk manufacturers to sell disks at lower prices and can severely affect our profitability. Vertically-integrated companies are also able to achieve a large manufacturing scale that supports the development resources necessary to advance technology rapidly. HGST previously announced that it intends to consolidate its internal thin-film media manufacturing operations in China, which could result in decreased demand for our products by HGST or increased pricing pressure. We may not have sufficient resources or manufacturing scale to be able to compete effectively with these companies as to production costs or technology development, which would negatively impact our net sales and market share.
All of our manufacturing operations have been consolidated in Malaysia and our foreign operations and international sales subject us to additional risks inherent in doing business on an international level that make it more costly or difficult to conduct our business.
As a result of our consolidation of manufacturing operations in Malaysia, technology developed at our U.S.-based research and development center must now be first implemented for high-volume production at our Malaysian facilities without the benefit of being implemented at a U.S. factory. Therefore, we rely heavily on electronic communications between our U.S. headquarters and our Malaysian facilities to transfer specifications and procedures, diagnose operational issues, and meet customer requirements. If our operations in Malaysia or overseas communications are disrupted for a prolonged period for any reason, including a failure in electronic communications with our U.S. operations, the manufacture and shipment of our products would be delayed, and our results of operations would suffer.
Additionally, because a large portion of our payroll, certain manufacturing and operating expenses, and inventory and capital purchases is transacted in the Malaysian ringgit (ringgit), we are particularly sensitive to any change in the foreign currency exchange rate for the ringgit. For approximately the last seven years, the exchange rate between the ringgit and the U.S. dollar has been pegged at 3.8 ringgits to one U.S. dollar by the Malaysian government. On July 21, 2005, Malaysia removed its currency peg to the U.S. dollar in favor of a managed float system. The change in exchange rates could adversely affect the amount we spend on our payroll, certain manufacturing and operating expenses, and raw materials and capital purchases. In the first nine months of 2005, our spending on payroll, manufacturing, and operating expenses, and raw materials and capital purchases that were denominated in ringgit was approximately $161.5 million. Additionally, in the first nine months of 2005, we paid approximately $57.8 million U.S. dollars to a Malaysian supplier for raw materials purchases, based on a cost plus a percentage arrangement. This Malaysian supplier incurs certain costs that are denominated in ringgit; therefore, any change in the valuation of the ringgit could materially impact the cost per unit we pay for such raw materials.
Furthermore, our ability to transfer funds from our Malaysian operations to the United States is subject to Malaysian rules and regulations. In 1999, the Malaysian government repealed a regulation that restricted the amount of dividends that a Malaysian company may pay to its stockholders. Had it not been
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repealed, this regulation would have potentially limited our ability to transfer funds to the United States from our Malaysian operations. Because a significant percentage of our revenues is generated from our Malaysian operations, we would be unable to finance our U.S.-based research and development and/or repay our U.S. debt obligations if similar regulations are enacted in the future.
Additionally, there are a number of risks associated with conducting business outside of the United States. Our sales to Asian customers, including the foreign subsidiaries of domestic disk drive companies, account for substantially all of our net sales. While our Asian customers assemble a substantial portion of their disk drives in Asia, they subsequently sell these products throughout the world. Therefore, our high concentration of Asian sales does not accurately reflect the eventual point of consumption of the assembled disk drives. We anticipate that international sales will continue to represent the majority of our net sales, and as a result the success of our business is subject to factors affecting global markets generally.
We are subject to these risks to a greater extent than most companies because, in addition to selling our products outside the United States, our Malaysian operations account for substantially all of our net sales. Accordingly, our operating results are subject to the risks inherent with international operations, including, but not limited to:
• | compliance with changing legal and regulatory requirements of foreign jurisdictions; | ||
• | fluctuations in tariffs or other trade barriers; | ||
• | foreign currency exchange rate fluctuations; | ||
• | difficulties in staffing and managing foreign operations; | ||
• | political, social and economic instability; | ||
• | increased exposure to threats and acts of terrorism; | ||
• | exposure to taxes in multiple jurisdictions; | ||
• | local infrastructure problems or failures including but not limited to loss of power and water supply; and | ||
• | transportation delays and interruptions. |
If we do not effectively manage the risks associated with international operations and sales, our business, financial condition, and operating results could suffer.
If we are unable to perform successfully in the highly competitive and increasingly concentrated disk industry, we may not be able to maintain or gain additional market share, and our operating results would be harmed.
The market for our products is highly competitive, and we expect competition to continue in the future. Competitors in the thin-film media industry fall primarily into two groups: Asian-based independent disk manufacturers, and captive disk manufacturers. Our major Asian-based independent competitors include Fuji Electric, Hoya, and Showa Denko (of which Trace Storage Technology became a part in mid-2004). The captive disk manufacturers who produce thin-film media internally for their own use include HGST, Maxtor, and Seagate. Many of these competitors have greater financial resources than we have, which could allow them to adjust to fluctuating market conditions better than we. Further, they may have
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greater technical and manufacturing resources, more extensive name recognition, more marketing power, a broader array of product lines and preferred vendor status. To the extent our competitors continue to consolidate and achieve greater economies of scale, we will face additional competitive challenges. Our competitors may also lower their product prices to gain market share, sell their products with other products to increase demand for their products, develop new technology which would significantly reduce the cost of their products, or offer more products than we do and therefore enter into agreements with customers to supply their products as part of a larger supply agreement. If we are not able to compete successfully in the future, we would not be able to gain additional market share for our products, or we may lose our existing market share, and our operating results could be harmed.
Because our products require a lengthy sales cycle with no assurance of high volume sales, we may expend significant financial and other resources without a return.
With short product life cycles and the rapid technological change experienced in the disk drive industry, we must frequently qualify new products with our disk drive manufacturing customers, based on criteria such as quality, storage capacity, performance, and price. Qualifying disks for incorporation into new disk drive products requires us to work extensively with our customer and the customer’s other suppliers to meet product specifications. Therefore, customers often require a significant number of product presentations and demonstrations, as well as substantial interaction with our senior management, before making a purchasing decision. Accordingly, our products typically have a lengthy sales cycle, which can range from six to twelve months or longer. During this time, we may expend substantial financial resources and management time and effort, while having no assurances that a sale will result, or that disk drive programs ultimately will result in high-volume production. To the extent we expend significant resources to qualify products without realizing sales, our operations will suffer.
If our customers cancel orders, our sales could suffer and we are generally not entitled to receive cancellation penalties to offset the loss of sales revenue.
Our sales are generally made pursuant to purchase orders that are subject to cancellation, modification, or rescheduling without significant penalties. As a result, if a customer cancels, modifies, or reschedules an order, we may have already made expenditures that are not recoverable, and our profitability will suffer. Furthermore, if our current customers do not continue to place orders with us or if we are unable to obtain orders from new customers, our sales and operating results will suffer.
Disk drive program life cycles are short, and disk drive programs are highly customized. If we fail to respond to our customers’ demanding requirements, we will not be able to compete effectively.
The disk industry is subject to rapid technological change, and if we are unable to anticipate and develop products and production technologies on a timely basis, our competitive position could be harmed. In general, the life cycles of disk drive programs are short. Additionally, disks must be more customized to each disk drive program. Short program life cycles and customization have increased the risk of product obsolescence, and as a result, supply chain management, including just-in-time delivery, has become a standard industry practice. In order to sustain customer relationships and sustain profitability, we must be
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able to develop new products and technologies in a timely fashion in order to help customers reduce their time-to-market performance, and continue to maintain operational excellence that supports high-volume manufacturing ramps and tight inventory management throughout the supply chain. Accordingly, we have invested, and intend to continue to invest heavily, in our research and development program. If we cannot respond to this rapidly changing environment or fail to meet our customers’ demanding product and qualification requirements, we will not be able to compete effectively. As a result, we would not be able to maximize the use of our production facilities, and our profitability would be negatively impacted.
If we do not keep pace with the rapid technological change in the disk drive industry, we will not be able to compete effectively, and our operating results could suffer.
Our products primarily serve the 3 1/2-inch disk drive market where product performance, consistent quality, price, and availability are of great competitive importance. Advances in disk drive technology require continually lower flying heights and higher areal density. Until recently, areal density was roughly doubling from year-to-year and even today continues to increase rapidly, requiring significant improvement in every aspect of disk design. These advances require substantial on-going process and technology development. New process technologies, including SAF and PMR, must support cost-effective, high-volume production of disks that meet these ever-advancing customer requirements for enhanced magnetic recording performance. We may not be able to develop and implement these technologies in a timely manner in order to compete effectively against our competitors’ products or entirely new data storage technologies. In addition, we must transfer our technology from our U.S.-based research and development center to our Malaysian manufacturing operations.
If we cannot advance our process technologies or do not successfully implement those advanced technologies in our Malaysian operations, or if technologies that we have chosen not to develop prove to be viable competitive alternatives, we would not be able to compete effectively. As a result, we would lose market share and face increased price competition from other manufacturers, and our operating results would suffer. Further, as we introduce more technologically advanced product offerings, they can result in lower introductory yields, which would negatively impact our gross margins.
If we fail to improve the quality of, and control contamination in our manufacturing processes, we will lose our ability to remain competitive.
The manufacture of our products requires a tightly-controlled, multi-stage process, and the use of high-quality materials. Efficient production of our products requires utilization of advanced manufacturing techniques and clean room facilities. Disk fabrication occurs in a highly controlled, clean environment to minimize particles and other yield-limiting and quality-limiting contaminants. In spite of stringent manufacturing controls, weaknesses in process control or minute impurities in materials may cause a substantial percentage of the disks in a production lot to be defective. The success of our manufacturing operations depends, in part, on our ability to maintain process control and minimize such impurities in order to maximize yield of acceptable high-quality disks. Minor variations from specifications could have a disproportionately adverse impact on our manufacturing yields. If we are not able to continue to improve on our manufacturing processes or maintain stringent quality controls, or if contamination problems arise, we will not remain competitive, and our operating results would be harmed.
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An industry trend towards glass-based applications could negatively impact our ability to remain competitive.
Our finished disks are manufactured primarily from aluminum substrates, which are the primary substrate used in desktop PC and enterprise applications. Some disk manufacturers emphasize the use of glass as a basis for the manufacture of their disks to primarily serve the mobile PC market and certain other consumer applications. These applications are expected to achieve significant growth in the near future. To the extent glass-based applications were to achieve significant growth in the market place, we may lose market share if we were unable to move rapidly to produce glass-based disks to address the demand.
If we are not able to attract and retain key personnel, our operations could be harmed.
Our future success depends on the continued service of our executive officers, our highly-skilled research, development, and engineering team, our manufacturing team, and our key administrative, sales and marketing, and support personnel, many of whom would be extremely difficult to replace. Acquiring and retaining talented personnel who possess the advanced skills we require has been difficult, particularly at our Malaysian manufacturing facilities where there is high growth in the marketplace We may not be able to attract, assimilate, or retain highly-qualified personnel to maintain the capabilities that are necessary to compete effectively. Further, we do not have key person life insurance on any of our key personnel. If we are unable to retain existing or hire key personnel, our business, financial condition, and operating results could be harmed.
If we do not protect our patents and other intellectual property rights, our revenues could suffer.
Our protection of our intellectual property is limited. It is commonplace to protect technology through patents and other forms of intellectual property rights in technically sophisticated fields. We may not receive patents for our pending or future patent applications, and any patents that we own or that are issued to us may be invalidated, circumvented or challenged. In the disk and disk drive industries, companies and individuals have initiated actions against others in the industry to enforce intellectual property rights. Although we attempt to protect our intellectual property rights through patents, copyrights, trade secrets, and other measures, we may not be able to protect adequately our technology. In addition, we may not be able to discover significant infringements of our technology or successfully enforce our rights to our technology if we discover infringing uses by others, and such infringements could have a negative impact on our ability to compete effectively. Competitors may be able to develop similar technology and also may have or may develop intellectual property rights and enforce those rights to prevent us from using such technologies, or demand royalty payments from us in return for using such technologies. Either of these events may affect our production, which could materially reduce our revenues and harm our operating results.
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We may face intellectual property infringement claims that are costly to resolve, may divert our management’s attention, and may negatively impact our operations.
We have occasionally received, and may receive in the future, communications from third parties that assert violation of intellectual property rights alleged to cover certain of our products or manufacturing processes or equipment. We evaluate on a case-by-case basis whether it would be necessary to defend against such claims or to seek licenses to the rights referred to in such communications. We may have to litigate to enforce patents issued or licensed to us, to protect trade secrets or know-how owned by us or to determine the enforceability, scope and validity of our proprietary rights and the proprietary rights of others. Enforcing or defending our proprietary rights could be expensive and might not bring us timely and effective relief. In certain cases, we may not be able to negotiate necessary licenses on commercially reasonable terms, or at all. Also, if we have to defend such claims, we could incur significant expenses and our management’s attention could be diverted from our core business. Further, we may not be able to anticipate claims by others that we infringe on their technology or successfully defend ourselves against such claims. Any litigation resulting from such claims could have a material adverse effect on our business and financial results.
Historical quarterly results may not accurately predict our performance due to a number of uncertainties and market factors, and as a result it is difficult to predict our future results.
Our operating results historically have fluctuated significantly on both a quarterly and annual basis. We believe that our future operating results will continue to be subject to quarterly variations based on a wide variety of factors, including:
• | timing of significant orders, or order cancellations; | ||
• | changes in our product mix and average selling prices; | ||
• | modified, adjusted, or rescheduled shipments; | ||
• | availability of disks versus demand for disks; | ||
• | the cyclical nature of the disk drive industry; | ||
• | our ability to develop and implement new manufacturing process technologies; | ||
• | increases in our production and engineering costs associated with initial design and production of new product programs; | ||
• | fluctuations in exchange rates, particularly between the U.S. dollar and the Malaysian ringgit; | ||
• | the ability of our process equipment to meet more stringent future product requirements; | ||
• | our ability to introduce new products that achieve cost-effective high-volume production in a timely manner, timing of product announcements, and market acceptance of new products; | ||
• | the availability of our production capacity, and the extent to which we can use that capacity; | ||
• | changes in our manufacturing efficiencies, in particular product yields and input costs for direct materials, operating supplies and other running costs; | ||
• | prolonged disruptions of operations at any of our facilities for any reason; | ||
• | changes in the cost of or limitations on availability of labor; | ||
• | structural changes within the disk industry, including combinations, failures, and joint venture arrangements; and |
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• | changes in tax regulations in foreign jurisdictions that could potentially reduce our tax incentives in areas such as Malaysian capital allowances, tax holidays, and exemptions on withholding tax on royalty payments made by our Malaysian operations to our subsidiary in The Netherlands. |
We cannot forecast with certainty the impact of these and other factors on our revenues and operating results in any future period. Our expense levels are based, in part, on expectations as to future revenues. Many of our expenses are relatively fixed and difficult to reduce or modify. The fixed nature of our operating expenses will magnify any adverse effect of a decrease in revenue on our operating results. Because of these and other factors, period to period comparisons of our historical results of operations are not a good predictor of our future performance. If our future operating results are below the expectations of stock market analysts, our stock price may decline. Our ability to predict demand for our products and our financial results for current and future periods may be affected by economic conditions. This may adversely affect both our ability to adjust production volumes and expenses and our ability to provide the financial markets with forward-looking information. If our revenue levels are below expectations, our operating results are likely to suffer.
If we make unprofitable acquisitions or are unable to successfully integrate future acquisitions, our business could suffer.
We have in the past acquired, and in the future may acquire, businesses, products, equipment, or technologies that we believe will complement or expand our existing business. Acquisitions involve numerous risks, including the following:
• | difficulties in integrating the operations, technologies, products and personnel of the acquired companies, especially given the specialized nature of our technology; | ||
• | diversion of management’s attention from normal daily operations of the business; | ||
• | potential difficulties in completing projects associated with in-process research and development; | ||
• | initial dependence on unfamiliar supply chains or relatively small supply partners; and | ||
• | the potential loss of key employees of the acquired companies. |
Acquisitions may also cause us to:
• | issue stock that would dilute our current stockholders’ percentage ownership; | ||
• | assume liabilities; | ||
• | record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges; | ||
• | incur amortization expenses related to certain intangible assets; | ||
• | incur large and immediate write-offs; or | ||
• | become subject to litigation. |
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Mergers and acquisitions of high-technology companies are inherently risky, and no assurance can be given that any future acquisitions by us will be successful and will not materially adversely affect our business, operating results, or financial condition. The failure to manage and successfully integrate acquisitions we make could harm our business and operating results in a material way. Even if an acquired company has already developed and marketed products, there can be no assurance that product enhancements will be made in a timely fashion or that pre-acquisition due diligence will have identified all possible issues that might arise with respect to products or the integration of the company into our company.
The nature of our operations makes us susceptible to material environmental liabilities, which could result in significant compliance and clean-up expenses and adversely affect our financial condition.
We are subject to a variety of federal, state, local, and foreign regulations relating to:
• | the use, storage, discharge, and disposal of hazardous materials used during our manufacturing process; | ||
• | the treatment of water used in our manufacturing process; and | ||
• | air quality management. |
We are required to obtain necessary permits for expanding our facilities. We must also comply with new regulations on our existing operations, which may result in significant costs. Public attention has increasingly been focused on the environmental impact of manufacturing operations that use hazardous materials.
If we fail to comply with environmental regulations or fail to obtain the necessary permits:
• | we could be subject to significant penalties; | ||
• | our ability to expand or operate in California or Malaysia could be restricted; | ||
• | our ability to establish additional operations in other locations could be restricted; or | ||
• | we could be required to obtain costly equipment or incur significant expenses to comply with environmental regulations. |
Furthermore, our manufacturing processes rely on the use of hazardous materials, and any accidental hazardous discharge could result in significant liability and clean-up expenses, which could harm our business, financial condition, and results of operations.
From time to time, we may have to defend lawsuits in connection with the operation of our business.
We are subject to litigation in the ordinary course of our business. If we do not prevail in any lawsuit which may occur we could be subject to significant liability for damages, our patents and other proprietary rights could be invalidated, and we could be subject to injunctions preventing us from taking certain actions. If any of the above occurs, our business and financial position could be harmed.
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Earthquakes or other natural or man-made disasters could disrupt our operations.
Our U.S. facilities are located in San Jose, California. In addition, Kobe and other Japanese suppliers of our key manufacturing supplies and sputtering machines are located in areas with seismic activity. Our Malaysian operations have been subject to temporary production interruptions due to localized flooding, disruptions in the delivery of electrical power, and, on one occasion in 1997, by smoke generated by large, widespread fires in Indonesia. If any natural or man-made disasters do occur, operations could be disrupted for prolonged periods, and our business would suffer.
Terrorist attacks may adversely affect our business and operating results
The continued threat of terrorist activity and other acts of war or hostility, including the war in Iraq, have created uncertainty in the financial and insurance markets, and have significantly increased the political, economic, and social instability in some of the geographic areas in which we operate. Acts of terrorism, either domestic or foreign, could create further uncertainties and instability. To the extent this results in disruption or delays of our manufacturing capabilities or shipments of our products, our business, operating results, and financial condition could be adversely affected.
Compliance with the rules and regulations concerning corporate governance may be costly, time-consuming, and difficult to achieve, which could harm our operating results and business.
The Sarbanes-Oxley Act (the Act), which was signed into law in October 2002, mandates, among other things, that companies maintain rigorous corporate governance measures, and imposes comprehensive reporting and disclosure requirements. The Act also imposes increased civil and criminal penalties on a corporation, its chief executive and chief financial officers, and members of its board of directors, for securities law violations. In addition, the Nasdaq National Market, on which our common stock is traded, has adopted and is considering the adoption of additional comprehensive rules and regulations relating to corporate governance. These rules, laws, and regulations have increased the scope, complexity, and cost of our corporate governance, reporting, and disclosure practices. Because compliance with these rules, laws, and regulations is costly and time-consuming, our management’s attention could be diverted from managing our day-to-day business operations, and our operating expenses could increase. In addition, because of the inherent limitations in all financial control systems, it is possible that, in the future, a material weakness may be found in our internal controls over financial reporting, which could affect our ability to insure proper financial reporting.
Further, our board members, Chief Executive Officer, and Chief Financial Officer face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficulty attracting and retaining qualified board members and executive officers, which could harm our business.
In the future, we may need additional capital, which may not be available on favorable terms, or at all.
Our business is capital-intensive and we may need more capital in the future. Our future capital requirements will depend on many factors, including:
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• | the rate of our sales growth; | ||
• | the level of our profits or losses; | ||
• | the timing and extent of our spending to expand manufacturing capacity, support facilities upgrades and product development efforts; | ||
• | the timing and size of business or technology acquisitions; | ||
• | the timing of introductions of new products and enhancements to our existing products; and | ||
• | the length of product life cycles. |
If we require additional capital it is uncertain whether we will be able to obtain additional financing on favorable terms, if at all. Further, if we issue equity securities in connection with additional financing, our stockholders may experience dilution and/or the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products and services in a timely manner, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements or may be forced to limit the number of products and services we offer, any of which could seriously harm our business.
Anti-takeover provisions in our certificate of incorporation could discourage potential acquisition proposals or delay or prevent a change of control.
We have in place protective provisions designed to provide our board of directors with time to consider whether a hostile takeover is in our and our stockholders’ best interests. Our certificate of incorporation provides for three classes of directors. As a result, a person could not take control of the board until the third annual meeting after the closing of the takeover, since a majority of our directors will not stand for election until that third annual meeting. This provision could discourage potential acquisition proposals and could delay or prevent a change in control of the company, and also could diminish the opportunities for a holder of our common stock to participate in tender offers, including offers at a price above the then-current market price for our common stock. These provisions also may inhibit fluctuations in our stock price that could result from takeover attempts.
Risks Related to our Indebtedness
We are leveraged, and our debt obligations will continue to make us vulnerable to economic downturns.
In the first quarter of 2004, we completed a public common stock offering of 4.0 million shares (of which 0.5 million were sold by selling stockholders) and a public $80.5 million Convertible Subordinated Notes offering. Debt service obligations arising from the offering of our Convertible Subordinated Notes could limit our ability to borrow more money for operations and implement our business strategy in the future. We will continue to be more leveraged than some of our competitors, which may place us at a competitive disadvantage because our interest and debt repayment requirements make us more susceptible to downturns in our business.
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Our holding company structure makes us dependent on cash flow from our subsidiaries to meet our obligations.
Most of our operations are conducted through, and most of our assets are held by, our subsidiaries. Therefore, we are dependent on the cash flow of our subsidiaries to meet our debt obligations. Our subsidiaries are separate legal entities that have no obligation to pay any amounts due under the Convertible Subordinated Notes, or to make any funds available therefore, whether by dividends, loans, or other payments. Our subsidiaries have not guaranteed the payment of the Convertible Subordinated Notes, and payments on the Convertible Subordinated Notes are required to be made only by us. Except to the extent we may ourselves be a creditor with recognized claims against our subsidiaries, subject to any limitations contained in our debt agreements, all claims of creditors and holders of preferred stock, if any, of our subsidiaries will have priority with respect to the assets of such subsidiaries over the claims of our creditors, including holders of the Convertible Subordinated Notes.
The assets of our subsidiaries may not be available to make payments on our debt obligations.
We may not have direct access to the assets of our subsidiaries unless these assets are transferred by dividend or otherwise to us. The ability of our subsidiaries to pay dividends or otherwise transfer assets to us is subject to various restrictions, including restrictions under other agreements to which we are a party under applicable law.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. We invest primarily in high-quality, short-term debt instruments and auction rate preferred securities (which the Company rolls over every three months or less), which are accounted for as cash equivalents or short-term investments, depending on the period of time from the purchase date to the maturity date.
We are exposed to foreign currency exchange rate risk. A majority of our revenue, expense, and capital purchasing activities is transacted in U.S. dollars. However, a large portion of our payroll, certain manufacturing and operating expenses, and inventory and capital purchases is transacted in the Malaysian ringgit (ringgit). For approximately the last seven years, the exchange rate between the ringgit and the U.S. dollar has been pegged at 3.8 ringgits to one U.S. dollar by the Malaysian government. On July 21, 2005, Malaysia removed its currency peg to the U.S. dollar in favor of a managed float system. Changes in exchange rates could adversely affect the amount we spend on our payroll, certain manufacturing and operating expenses, and raw materials and capital purchases. In the first nine months of 2005, our spending on payroll, manufacturing and operating expenses, and raw materials and capital purchases that were denominated in ringgit was approximately $161.5 million. Additionally, we paid approximately $57.8 million denominated in Malaysian ringgit to a Malaysian supplier for raw materials purchases in the first nine months of 2005, based on a cost plus a percentage arrangement. The Malaysian supplier incurs certain costs denominated in ringgit; therefore, any change in the valuation of the ringgit could impact the cost per unit we pay for such raw materials. As of October 2, 2005, we held approximately $41.5 million (Malaysian ringgit 156.5 million) of cash and cash equivalents that were denominated in Malaysian ringgit.
In late September 2005, we began to hedge some of our foreign currency risk related to anticipated foreign currency denominated equipment purchases by entering into foreign exchange forward contracts that generally have maturities of 12 months or less. As of October 2, 2005 the Company had not designated these foreign exchange forward contracts as a cash flow hedge in accordance with SFAS No. 133. As of October 3, 2005 these transactions were designated and qualify as cash flow hedges. The derivatives associated with our hedging activities are marked to market at fair value and any resulting liability is recorded in other liabilities and any resulting asset is recorded to prepaid and other current assets in the Condensed Consolidated Balance Sheets. The effective portion of gains or losses resulting from changes in fair value is initially reported as a component of accumulated other comprehensive income (loss), net of any tax effects, in stockholders’ equity and subsequently reclassified into depreciation expense in the periods in which the related equipment purchase is depreciated after the forecasted transaction actually occurs. The ineffective portion of gains or losses resulting from changes in fair value is reported in interest and other income, net in the Consolidated Statements of Operations. Our hedging programs reduce, but do not entirely eliminate, the impact of currency exchange rate movements.
As of October 2, 2005 we had foreign exchange contracts to purchase approximately $13.3 million of Japanese Yen. The fair value of our forward contracts was recorded as a $0.1 million other current liability as of October 2, 2005.
The counterparty to these forward contracts is a creditworthy multinational commercial bank. The risks of counterparty nonperformance associated with these contracts are not considered to be material.
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Notwithstanding our efforts to mitigate some foreign currency exchange rate risks, there can be no assurances that our mitigating activities will adequately protect us against the risks associated with foreign currency fluctuations.
We have $80.5 million in convertible subordinated notes outstanding. These notes bear interest at 2% and mature in February 2024. A hypothetical 100 basis point increase in interest rates would result in approximately $0.8 million of additional interest expense each year.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of October 2, 2005, our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), has conducted an evaluation of the effectiveness of our disclosure controls and procedures pursuant to Rule 13a — 15(b) of the Exchange Act. Based on that evaluation, the CEO and CFO concluded that our disclosure controls and procedures are effective in ensuring that all material information required to be filed in this quarterly report has been made known to them in a timely manner.
Internal Control over Financial Reporting
Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that:
• | pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; | ||
• | provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and | ||
• | provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements. |
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions and that the degree of compliance with the policies or procedures may deteriorate.
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Changes in Internal Control Over Financial Reporting
There has been no change in our internal control over financial reporting during our third fiscal quarter ended October 2, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
Not applicable.
ITEM 2. Unregistered Sales of Equity Securities
Not applicable.
ITEM 3. Defaults Upon Senior Securities
Not applicable.
ITEM 4. Submission of Matters to a Vote of Security Holders
Not applicable.
ITEM 5. Other Information
In November 2005, the Company entered into an employment agreement with an executive officer. For more information on the agreement, please refer to Note 9 of the Notes to Condensed Consolidated Financial Statements (Unaudited) included in this report on Form 10-Q. The form of employment agreement is filed as an exhibit to this report on Form 10-Q.
ITEM 6. Exhibits
10.1 | Media Supply Agreement dated July 4, 2005 between Seagate Technology International and Komag USA (Malaysia) Sdn. And Komag, Incorporated. * | ||
10.2 | Addendum to Business Agreement between Maxtor, Inc. and Komag, Incorporated dated October 6, 2003, as amended on July 8, 2005.* | ||
10.3 | Form of Officer Employment Agreements. | ||
31.1 | Rule 13a — 14 (a) Certification of Chief Executive Officer | ||
31.2 | Rule 13a — 14 (a) Certification of Chief Financial Officer | ||
32 | Section 1350 Certification of Chief Executive Officer and Chief Financial Officer |
* | Confidential treatment has been requested with respect to certain portions of this exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
KOMAG, INCORPORATED | ||||||
(Registrant) | ||||||
DATE: November 7, 2005 | BY: | /s/ Thian Hoo Tan | ||||
Thian Hoo Tan | ||||||
Chief Executive Officer | ||||||
DATE: November 7, 2005 | BY: | /s/ Kathleen A. Bayless | ||||
Kathleen A. Bayless | ||||||
Senior Vice President, Chief Financial Officer |
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EXHIBIT INDEX
10.1 | Media Supply Agreement dated July 4, 2005 between Seagate Technology International and Komag USA (Malaysia) Sdn. And Komag, Incorporated. * | ||
10.2 | Addendum to Business Agreement between Maxtor, Inc. and Komag, Incorporated dated October 6, 2003, as amended on July 8, 2005.* | ||
10.3 | Form of Officer Employment Agreements. | ||
31.1 | Rule 13a — 14 (a) Certification of Chief Executive Officer | ||
31.2 | Rule 13a — 14 (a) Certification of Chief Financial Officer | ||
32 | Section 1350 Certification of Chief Executive Officer and Chief Financial Officer |
* | Confidential treatment has been requested with respect to certain portions of this exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission. |
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